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OSHKOSH CORP

2016-11-22

2016-09-30

ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS General The Company is a leading designer, manufacturer and marketer of a wide range of specialty vehicles and vehicle bodies, including access equipment, defense trucks and trailers, fire & emergency vehicles, concrete mixers and refuse collection vehicles. The Company is a leading global manufacturer of aerial work platforms under the “JLG” brand name. The Company is among the worldwide leaders in the manufacturing of telehandlers under the “JLG” and “SkyTrak” brand names. Under the “Jerr-Dan” brand name, the Company is a leading domestic manufacturer and marketer of towing and recovery equipment. The Company manufactures defense trucks under the “Oshkosh” brand name and is a leading manufacturer of severe-duty, tactical wheeled vehicles for the DoD. Under the “Pierce” brand name, the Company is among the leading global manufacturers of fire trucks assembled on both custom and commercial chassis. Under the “Frontline” brand name, the Company is a leading domestic manufacturer and marketer of broadcast vehicles. The Company manufactures ARFF and airport snow removal vehicles under the “Oshkosh” brand name. Under the “McNeilus,” “Oshkosh,” “London” and “CON-E-CO” brand names, the Company manufactures rear- and front-discharge concrete mixers and portable and stationary concrete batch plants. Under the “McNeilus” brand name, the Company manufactures a wide range of automated, rear, front, side and top loading refuse collection vehicles. Under the “IMT” brand name, the Company is a leading domestic manufacturer of field service vehicles and truck-mounted cranes. Major products manufactured and marketed by each of the Company’s business segments are as follows: Access equipment - aerial work platforms and telehandlers used in a wide variety of construction, agricultural, industrial, institutional and general maintenance applications to position workers and materials at elevated heights, as well as carriers and wreckers. Access equipment customers include equipment rental companies, construction contractors, manufacturing companies, home improvement centers and towing companies in the U.S. and abroad. Defense - tactical trucks, trailers and supply parts and services sold to the U.S. military and to other militaries around the world. Fire & emergency - custom and commercial firefighting vehicles and equipment, ARFF vehicles, snow removal vehicles, simulators and other emergency vehicles primarily sold to fire departments, airports and other governmental units, and broadcast vehicles sold to broadcasters and TV stations in the U.S. and abroad. Commercial - concrete mixers, refuse collection vehicles, portable and stationary concrete batch plants and vehicle components sold to ready-mix companies and commercial and municipal waste haulers in the Americas and other international markets and field service vehicles and truck-mounted cranes sold to mining, construction and other companies in the U.S. and abroad. All estimates referred to in this “Management’s Discussion and Analysis of Financial Condition and Results of Operations” refer to the Company’s estimates as of November 22, 2016. Executive Overview Consolidated net sales increased $181.1 million, or 3.0%, to $6.28 billion in fiscal 2016 compared to fiscal 2015. The sales increase was driven by strong percentage increases in sales in both the defense and fire & emergency segments, offset in part by lower access equipment segment sales. As the Company had expected, defense segment sales rebounded from a trough year in fiscal 2015, driven by international sales of almost 600 M-ATVs and a full year of FHTV production. The fire & emergency segment continued to experience strong demand for fire trucks as new product launches and the improved municipal spending environment in the U.S. continued to benefit the Company's traditional fire truck business as cities and towns looked to replace aged equipment. Access equipment segment sales were lower than the prior year due primarily to a continued slowdown in North American replacement demand as a result of low purchases of access equipment in the 2009 and 2010 time-period. Consolidated operating income decreased 8.7% to $364.0 million, or 5.8% of sales, in fiscal 2016 compared to $398.6 million, or 6.5% of sales, in fiscal 2015. Consolidated operating income in fiscal 2016 was adversely impacted by an asset impairment charge of $26.9 million, or 0.4% of sales. The Company's defense, fire & emergency and commercial segments' operating income and operating income margins all improved in fiscal 2016 as compared to fiscal 2015, reflecting continued improved market outlooks and execution on the Company's goal to improve operational performance. This improved performance was offset by lower access equipment segment operating income driven by lower sales and more competitive pricing as well as higher corporate expenses due to increased costs to support the start-up of a shared manufacturing facility in Mexico and higher incentive compensation expense. The Company reported earnings per share of $2.91 in fiscal 2016 as compared to $2.90 in fiscal 2015. Fiscal 2016 results were negatively impacted by $0.23 per share related to asset impairment and workforce reduction charges in the access equipment segment. Earnings in fiscal 2015 included $0.12 of net costs related to workforce reductions, debt extinguishment costs related to the refinancing of the Company's senior notes due 2020 and a postretirement benefit curtailment gain. Share repurchases completed during the 24 month period ended September 30, 2016 benefited earnings per share in fiscal 2016 by $0.17 compared to fiscal 2015. The Company continued to return cash to shareholders in fiscal 2016 as it repurchased approximately 2.5 million shares of its stock as part of its capital allocation strategy. The Company also announced an increase in the quarterly dividend of approximately 11% beginning in November 2016. This was the Company's third straight year of double digit percentage increases in its dividend rate. Access equipment segment net sales decreased $388.2 million, or 11.4%, to $3.01 billion in fiscal 2016 compared to fiscal 2015. The Company believes that access equipment customers in North America remain cautious and that they are closely watching their fleet utilization rates and local market rental rates, leading them to continue to be selective with their capital expenditures for rental equipment. Additionally, the impact of extremely low levels of access equipment purchases by rental companies during 2009 and 2010 continues to negatively impact replacement-driven demand in North America. On September 21, 2016, the Company committed to transition its access equipment segment aftermarket parts distribution network to a third party logistics company. Concurrent with this decision, the Company’s access equipment segment committed to cease operations at its Orrville, Ohio parts distribution center by August 1, 2017. This initiative is intended to increase operational efficiency and allow the Company to reallocate resources to invest in future growth. With the Company’s announced intent to outsource its aftermarket parts distribution to a third party, the Company abandoned an information system developed to support aftermarket parts distribution. As a result the Company recognized a pre-tax, non-cash impairment charge associated with accumulated costs of $26.9 million, or $0.22 per share, in the fourth quarter of fiscal 2016. The Company expects that utilizing a third party to manage its parts distribution centers in the access equipment segment will save approximately $6 million per year starting in fiscal 2018. In the defense segment, the Company began building JLTVs on its production line in Oshkosh during fiscal 2016, shipping the first of these units to the U.S. Army in September 2016 to support government testing activities during the Low Rate Initial Production (LRIP) phase of the JLTV program. The Company expects approximately three years of LRIP, including extensive government testing, will occur prior to the planned attainment of Full Rate Production in fiscal 2019. The Company expects production to ramp up over this three-year period with deliveries under the JLTV contract of nearly 750 vehicles in fiscal 2017, 2,000 vehicles in fiscal 2018 and 3,000 vehicles in fiscal 2019. The Company also continues to be pleased with the level of interest it is receiving for the JLTV from international militaries. The Company believes that international JLTV sales are a few years away, but expects that international JLTV sales represent a significant opportunity for its defense segment. In the fire & emergency segment, higher demand as a result of the continued recovery of the North American fire truck market contributed to margin improvement. Higher margins were also driven by the implementation of numerous operational improvements over the last several years in its Pierce factories in Wisconsin and Florida, as well as in its front-end order processing. The commercial segment's domestic refuse collection vehicle market remains attractive and grew again in fiscal 2016, in large part due to fleet replenishment by larger private waste haulers. During fiscal 2016, the Company believes it outperformed its competitors and gained share in the domestic refuse collection vehicle market. The Company expects the domestic refuse collection vehicle market growth rate to moderate in fiscal 2017, following several years of solid growth. The Company continued to experience modest and choppy order flow from customers in the commercial segment's concrete mixer market in fiscal 2016, with customers placing orders for new equipment at a measured pace as they remained cautious due to short-term economic uncertainties. The Company believes consolidated net sales will increase approximately 3.5% to 6.7% in fiscal 2017 compared to fiscal 2016, resulting in consolidated sales of between $6.5 billion and $6.7 billion. The defense segment is expected to be the biggest driver of the increase in sales, overcoming an expected decline in access equipment segment sales. Sales in the fire & emergency and commercial segments are also expected to be higher in fiscal 2017 as compared to fiscal 2016. The Company expects consolidated operating income will be in the range of $390 million to $430 million, with earnings per share of approximately $3.00 to $3.40 assuming a full year average share count of approximately 74.5 million shares. The Company expects weakness in the access equipment segment to be overcome by collective stronger performance in the defense, fire & emergency and commercial segments. Results of Operations Consolidated Net Sales - Three Years Ended September 30, 2016 The following table presents net sales (see definition of net sales contained in Note 2 of the Notes to Consolidated Financial Statements) by business segment (in millions): The following table presents net sales by geographic region based on product shipment destination (in millions): Fiscal 2016 Compared to Fiscal 2015 Consolidated net sales increased $181.1 million, or 3.0%, to $6.28 billion in fiscal 2016 compared to fiscal 2015. Higher sales in the defense and fire & emergency segments were partially offset by a decline in sales in the access equipment segment. The strengthening U.S. dollar negatively impacted net sales in fiscal 2016 by $25 million, or 40 basis points, compared to fiscal 2015. Access equipment segment net sales decreased $388.2 million, or 11.4%, to $3.01 billion in fiscal 2016 compared to fiscal 2015. The decline in sales was primarily due to the slowdown in North American replacement demand that began in the third quarter of fiscal 2015 and a challenging pricing environment (down $75 million). A stronger U.S. dollar also negatively impacted sales by $20 million, or 60 basis points, compared to the fiscal 2015. Defense segment net sales increased $411.3 million, or 43.8%, to $1.35 billion in fiscal 2016 compared to fiscal 2015. The increase in sales was primarily due to international sales of M-ATVs to the Middle East and increased sales to the DoD, as higher FHTV sales were offset in part by lower FMTV sales. The Company experienced a break in production under the FHTV program in the second and third quarters of fiscal 2015. Fire & emergency segment net sales increased $138.2 million, or 16.9%, to $953.3 million in fiscal 2016 compared to fiscal 2015. Sales in fiscal 2016 benefited from higher domestic fire truck deliveries and favorable pricing. Improved operational efficiencies have allowed the fire & emergency segment to increase fire apparatus production rates to meet increased demand. Commercial segment net sales increased $1.2 million, or 0.1%, to $979.2 million in fiscal 2016 compared to fiscal 2015. Higher refuse collection vehicle sales were almost completely offset by lower sales of field service vehicles and truck-mounted cranes. Fiscal 2015 Compared to Fiscal 2014 Consolidated net sales decreased $710.1 million, or 10.4%, to $6.10 billion in fiscal 2015 compared to fiscal 2014 largely as a result of an expected significant decline in defense segment sales. Foreign currency exchange rates also adversely impacted sales by $103 million compared to the prior year. Access equipment segment net sales decreased $105.9 million, or 3.0%, to $3.40 billion in fiscal 2015 compared to fiscal 2014, due largely to an unfavorable currency impact of $94 million as a result of the weakening of most major currencies against the U.S. dollar during the year. Access equipment segment sales were also negatively impacted in the second half of the fiscal year as a result of the beginning of a mid-cycle dip in North American demand due to lower oil & gas related demand and lower replacement demand as a result of lower access equipment purchases in 2009 and 2010. Defense segment net sales decreased $784.7 million, or 45.5%, to $939.8 million in fiscal 2015 compared to fiscal 2014. The decrease in defense segment sales was primarily due to an expected decline in sales to the DoD (down $706 million) and lower international sales of M-ATVs. The Company experienced a break in production under the FHTV program in the second and third quarters of fiscal 2015. Fire & emergency segment net sales increased $58.6 million, or 7.8%, to $815.1 million in fiscal 2015 compared to fiscal 2014. The increase in sales primarily reflected higher fire truck deliveries (up $46 million) as a result of improved production rates and improved pricing (up $14 million). Commercial segment net sales increased $112.1 million, or 12.9%, to $978.0 million in fiscal 2015 compared to fiscal 2014. The increase in commercial segment sales was primarily attributable to higher refuse collection vehicle unit volume (up $46 million), higher package sales, consisting of a purchased chassis and manufactured body (up $42 million) and improved aftermarket parts and service sales (up $20 million). Consolidated Cost of Sales - Three Years Ended September 30, 2016 The following table presents costs of sales by business segment (in millions): Fiscal 2016 Compared to Fiscal 2015 Consolidated cost of sales was $5.22 billion, or 83.2% of sales, in fiscal 2016 compared to $5.06 billion, or 83.0% of sales, in fiscal 2015. The 20 basis point increase in cost of sales as a percentage of sales in fiscal 2016 compared to fiscal 2015 was primarily due to higher access equipment costs as a percentage of sales and start-up costs for a shared manufacturing facility in Mexico, offset in part by improved defense, fire & emergency and commercial segment performance. Access equipment segment cost of sales was $2.44 billion, or 80.8% of sales, in fiscal 2016 compared to $2.70 billion, or 79.3% of sales, in fiscal 2015. The 150 basis point increase in cost of sales as a percentage of sales in fiscal 2016 compared to fiscal 2015 was primarily due to a more competitive pricing environment (230 basis points) and adverse manufacturing absorption (80 basis points) associated with lower production, offset in part by lower spending on engine emissions standards changes (100 basis points). Defense segment cost of sales was $1.15 billion, or 84.9% of sales, in fiscal 2016 compared to $862.7 million, or 91.8% of sales, in fiscal 2015. The 690 basis point decrease in cost of sales as a percentage of sales in fiscal 2016 compared to fiscal 2015 was primarily attributable to favorable product mix (260 basis points), lower Company funded research & development related to the JLTV program (250 basis points) and contractual price increases, offset in part by the absence of a pension and other postretirement curtailment benefit recorded in fiscal 2015 (30 basis points). Fire & emergency segment cost of sales was $816.0 million, or 85.6% of sales, in fiscal 2016 compared to $703.9 million, or 86.4% of sales, in fiscal 2015. The 80 basis point decline in cost of sales as a percentage of sales in fiscal 2016 compared to fiscal 2015 was largely attributable to favorable pricing (140 basis points), offset in part by adverse product mix (50 basis points). Commercial segment cost of sales was $817.5 million, or 83.5% of sales, in fiscal 2016 compared to $820.6 million, or 83.9% of sales, in fiscal 2015. The 40 basis point decrease in cost of sales as a percentage of sales in fiscal 2016 compared to fiscal 2015 was largely due to favorable product mix (90 basis points) as a result of lower package sales, offset in part by production inefficiencies associated with the start-up of new products (50 basis points). Intersegment eliminations and other includes intercompany profit on inter-segment sales not yet sold to third party customers, net of start-up costs of a shared manufacturing facility in Mexico not allocated to segments. Fiscal 2015 Compared to Fiscal 2014 Consolidated cost of sales was $5.06 billion, or 83.0% of sales, in fiscal 2015 compared to $5.63 billion, or 82.6% of sales, in fiscal 2014. The 40 basis point increase in cost of sales as a percentage of sales in fiscal 2015 was primarily due to adverse absorption of fixed costs due to the lower production rates in the defense segment and a higher concentration of less profitable telehandler sales in the access equipment segment. Access equipment segment cost of sales was $2.70 billion, or 79.3% of sales, in fiscal 2015 compared to $2.71 billion, or 77.2% of sales, in fiscal 2014. The 210 basis point increase in cost of sales as a percentage of sales in fiscal 2015 was primarily due to a higher concentration of less profitable telehandler sales (160 basis points) and adverse production variances (80 basis points). Defense segment cost of sales was $862.7 million, or 91.8% of sales, in fiscal 2015 compared to $1.57 billion, or 90.8% of sales, in fiscal 2014. The 100 basis point increase in cost of sales as a percentage of sales was primarily attributable to adverse production absorption (310 basis points) on significantly lower sales, offset in part by the combined impact of pension and other postretirement benefit curtailments in fiscal 2015 and fiscal 2014 (100 basis points) and favorable product mix (60 basis points). Fire & emergency segment cost of sales was $703.9 million, or 86.4% of sales, in fiscal 2015 compared to $666.3 million, or 88.1% of sales, in fiscal 2014. The 170 basis point decline in cost of sales as a percentage of sales in fiscal 2015 compared to fiscal 2014 was largely attributable to improved product mix (50 basis points), favorable overhead absorption (50 basis points) and improved pricing (50 basis points). Commercial segment cost of sales of $820.6 million, or 83.9% of sales, in fiscal 2015 was largely unchanged as a percentage of sales compared to $727.6 million, or 84.0% of sales, in fiscal 2014 as adverse sales mix (30 basis points) and higher material costs (30 basis points) were offset by lower warranty expenses (60 basis points). Intersegment eliminations and other includes intercompany profit on inter-segment sales not yet sold to third party customers as well as start-up costs of a shared manufacturing facility in Mexico not allocated to segments. Consolidated Operating Income (Loss) - Three Years Ended September 30, 2016 The following table presents operating income (loss) by business segment (in millions): Fiscal 2016 Compared to Fiscal 2015 Consolidated operating income decreased 8.7% to $364.0 million, or 5.8% of sales, in fiscal 2016 compared to $398.6 million, or 6.5% of sales, in fiscal 2015. Consolidated operating income in fiscal 2016 was adversely impacted by an asset impairment charge of $26.9 million, or 0.4% of sales. Access equipment segment operating income decreased 35.3% to $263.4 million, or 8.7% of sales, in fiscal 2016 compared to $407.0 million, or 12.0% of sales, in fiscal 2015. The decrease in operating income was primarily the result of the lower gross income associated with lower sales volume (down $95 million), a challenging pricing environment (down $75 million), an asset impairment charge related to a decision to outsource aftermarket parts distribution ($27 million) and adverse manufacturing absorption (down $12 million) associated with lower production, offset in part by lower spending (down $43 million) on engine emissions standards changes and selling, general and administrative cost reductions ($7 million). Fiscal 2015 results also benefited from a $8 million vendor recovery settlement. Defense segment operating income increased 1,226.0% to $122.5 million, or 9.1% of sales, in fiscal 2016 compared to $9.2 million, or 1.0% of sales, in fiscal 2015. The increase in operating income was largely due to higher gross income associated with higher sales (up $51 million), favorable product mix (up $33 million), contractual price increases and lower Company funded research & development related to the JLTV program (down $12 million), offset in part by higher selling, general and administrative costs (up $13 million) to ramp up for the JLTV contract. Fire & emergency segment operating income increased 53.1% to $67.0 million, or 7.0% of sales, in fiscal 2016, compared to $43.8 million, or 5.4% of sales, in fiscal 2015. Higher gross income on increased sales volume was the largest contributor to the increase in operating income. Commercial segment operating income increased 4.8% to $67.6 million, or 6.9% of sales, in fiscal 2016 compared to $64.5 million, or 6.6% of sales, in fiscal 2015. The increase in operating income was primarily a result of favorable product mix (up $11 million), offset in part by production inefficiencies associated with the start-up of new products. Corporate operating costs increased $30.5 million to $156.5 million in fiscal 2016 compared to fiscal 2015. The increase in corporate operating costs in fiscal 2016 was primarily due to increased costs to support the start-up of a shared manufacturing facility in Mexico (up $13 million) and higher incentive compensation expense. Consolidated selling, general and administrative expenses increased 4.3% to $612.4 million, or 9.7% of sales, in fiscal 2016 compared to $587.4 million, or 9.6% of sales, in fiscal 2015. The increase in consolidated selling, general and administrative expenses in fiscal 2016 compared to fiscal 2015 was generally a result of higher incentive compensation, offset in part by reductions in outside services and travel spending. Fiscal 2015 Compared to Fiscal 2014 Consolidated operating income decreased 20.8% to $398.6 million, or 6.5% of sales, in fiscal 2015 compared to $503.3 million, or 7.4% of sales, in fiscal 2014. Reductions in corporate expenses and improved performance in the fire & emergency and commercial segments were not sufficient to offset the adverse product mix in the access equipment segment as well as the impact of significantly lower sales volumes in the defense segment. Access equipment segment operating income decreased 18.8% to $407.0 million, or 12.0% of sales, in fiscal 2015 compared to $501.1 million, or 14.3% of sales, in fiscal 2014. The decrease in operating income was primarily the result of an adverse product mix (down $56 million) and unfavorable production variances (up $25 million). Defense segment operating income decreased 87.9% to $9.2 million, or 1.0% of sales, in fiscal 2015 compared to $76.4 million, or 4.4% of sales, in fiscal 2014. The decrease in operating income was largely due to lower gross income associated with lower sales (down $111 million), partially offset by lower operating expenses (down $14 million) and lower engineering costs (down $10 million). Operating income in fiscal 2014 was adversely impacted by an $8.9 million reduction to net sales as a result of the reversal of billings to the DoD for other post-employment benefit costs determined to be unallowable under cost-plus government contracts. Fire & emergency segment operating income increased 64.5% to $43.8 million, or 5.4% of sales, in fiscal 2015, compared to $26.6 million, or 3.5% of sales, in fiscal 2014. The increase in operating income was largely due to higher gross income on increased sales (up $8 million), improved pricing, net of higher input costs (up a combined $7 million) and improved absorption (up $4 million), partially offset by increased operating expenses (up $4 million). Commercial segment operating income increased 19.7% to $64.5 million, or 6.6% of sales, in fiscal 2015 compared to $53.9 million, or 6.2% of sales, in fiscal 2014. The increase in operating income was primarily a result of gross income associated with higher sales volume (up $28 million) and favorable warranty performance (down $4 million), partially offset by increased operating expenses (up $9 million), including investments in MOVE initiatives. Corporate operating expenses decreased $28.7 million to $126.0 million in fiscal 2015 compared to fiscal 2014. The decrease in corporate operating expenses in fiscal 2015 was primarily due to lower incentive compensation expense (down $12 million), lower information technology expense (down $9 million) and lower stock-based compensation expense (down $7 million), partially offset by costs to support the start-up of a corporate-led manufacturing facility to support multiple business segments. Stock-based compensation expense declined because the Company granted few equity-based long-term incentive awards in fiscal 2015 because it moved the annual employee stock-based compensation grants from September to November. Consolidated selling, general and administrative expenses decreased 5.9% to $587.4 million, or 9.6% of sales, in fiscal 2015 compared to $624.1 million, or 9.2% of sales, in fiscal 2014. The decrease in selling, general and administrative expenses was largely the result of lower incentive compensation expense for fiscal 2015 compared to fiscal 2014. The increase in consolidated selling, general and administrative expenses as a percentage of sales was largely due to a shift in the percentage of consolidated sales to segments (non-defense) that have a higher percentage of selling, general and administrative expenses. The Company’s defense segment generally has lower selling, general and administrative costs as a percentage of sales compared to its other segments, in large part due to concentration of business with the DoD. For example, the defense segment has limited sales and marketing expenses and has operations/locations primarily in the United States, as compared to the Company’s access equipment segment, which has a diverse customer base with a significant number of customers, significant sales and marketing costs, and operations/locations in various regions of the world. As the Company’s defense segment sales decreased and the Company’s non-defense segment sales increased as a percentage of consolidated sales, consolidated selling, general and administrative expenses as a percentage of sales increased. Non-Operating Income (Expense) - Three Years Ended September 30, 2016 Fiscal 2016 Compared to Fiscal 2015 Interest expense net of interest income decreased $9.3 million to $58.3 million in fiscal 2016 compared to fiscal 2015. Fiscal 2015 interest expense included $14.7 million of debt extinguishment costs in connection with the refinancing of portions of the Company’s long-term debt during fiscal 2015. The full year benefit in fiscal 2016 of lower interest rates on the senior notes refinanced in the second quarter of fiscal 2015 was offset by increased borrowings to support increased working capital requirements throughout fiscal 2016. Other miscellaneous income of $1.3 million in fiscal 2016 and expense of $4.9 million in fiscal 2015 primarily related to net foreign currency transaction gains and losses. Fiscal 2015 Compared to Fiscal 2014 Interest expense net of interest income decreased $1.8 million to $67.6 million in fiscal 2015 compared to fiscal 2014 primarily as a result of lower interest rates on the Company's senior notes refinanced in the second quarters of fiscal 2015 and fiscal 2014. Included in interest expense are $14.7 million and $10.9 million of debt extinguishment costs in connection with the refinancing of portions of the Company’s long-term debt during fiscal 2015 and 2014, respectively. Other miscellaneous expense of $4.9 million in fiscal 2015 and $2.0 million in fiscal 2014 primarily related to net foreign currency transaction losses. Provision for Income Taxes - Three Years Ended September 30, 2016 Fiscal 2016 Compared to Fiscal 2015 The Company recorded income tax expense of $92.4 million in fiscal 2016, or 30.1% of pre-tax income, compared to $99.2 million, or 30.4% of pre-tax income in fiscal 2015. See Note 18 of the Notes to Consolidated Financial Statements for a reconciliation of the effective tax rate compared to the U.S. statutory tax rate. Fiscal 2015 Compared to Fiscal 2014 The Company recorded income tax expense of $99.2 million in fiscal 2015, or 30.4% of pre-tax income, compared to $125.0 million, or 29.0% of pre-tax income in fiscal 2014. See Note 18 of the Notes to Consolidated Financial Statements for a reconciliation of the effective tax rate compared to the U.S. statutory tax rate. Equity in Earnings of Unconsolidated Affiliates - Three Years Ended September 30, 2016 Fiscal 2016 Compared to Fiscal 2015 Equity in earnings of unconsolidated affiliates of $1.8 million in fiscal 2016 and $2.6 million in fiscal 2015 primarily represented the Company's equity interest in a commercial entity in Mexico and a joint venture in Europe. Fiscal 2015 Compared to Fiscal 2014 Equity in earnings of unconsolidated affiliates of $2.6 million in fiscal 2015 and $2.4 million in fiscal 2014 primarily represented the Company's equity interest in a commercial entity in Mexico and a joint venture in Europe. Liquidity and Capital Resources The Company generates significant capital resources from operating activities, which is the expected primary source of funding for its operations. Other resources of liquidity are availability under the Revolving Credit Facility and available cash and cash equivalents. At September 30, 2016, the Company had cash and cash equivalents of $321.9 million. The Company expects to meet its fiscal 2017 U.S. funding needs without repatriating undistributed profits that are indefinitely reinvested outside the United States. In addition to cash and cash equivalents, the Company had $739.2 million of unused available capacity under the Revolving Credit Facility (as defined in “Liquidity”) as of September 30, 2016. Borrowings under the Revolving Credit Facility could, as discussed below, be limited by the financial covenants contained within the Credit Agreement (as defined in “Liquidity”). These sources of liquidity are needed to fund the Company's working capital requirements, debt service requirements, capital expenditures, share repurchases and dividends. At September 30, 2016, the Company had approximately 7.5 million shares of Common Stock remaining under a repurchase authorization approved by the Company's Board of Directors in August 2015. Due to expected working capital requirements in the defense segment to support international M-ATV sales in fiscal 2017, the Company expects to generate $100 million to $150 million of cash flow from operations in fiscal 2017, significantly less than in fiscal 2016. The Company expects that working capital utilized to support the international M-ATV contract will be converted to cash in fiscal 2018. The Company expects fiscal 2017 capital spending to be approximately $100 million. The Company expects to have sufficient liquidity to finance its operations over the next twelve months. Financial Condition at September 30, 2016 The Company’s cash and cash equivalents and capitalization were as follows (in millions): The Company's ratio of debt to total capitalization of 30.0% at September 30, 2016 remained within its targeted range. Consolidated days sales outstanding (defined as “Trade Receivables” at quarter end divided by “Net Sales” for the most recent quarter multiplied by 90 days) were 49 days at September 30, 2016, down slightly from 50 days at September 30, 2015. Days sales outstanding for segments other than the defense segment were 51 days at September 30, 2016, down from 53 days at September 30, 2015. This decrease in days sales outstanding was primarily due to improved collections at Pierce. Consolidated inventory turns (defined as “Cost of Sales” on an annualized basis, divided by the average “Inventory” at the past five quarter end periods) was 4.1 times at September 30, 2016, down from 4.3 times at September 30, 2015. The decrease in inventory turns was largely due to higher inventory levels in the access equipment segment during fiscal 2016. Operating Cash Flows Fiscal 2016 Compared to Fiscal 2015 The Company generated $577.7 million of cash from operating activities during fiscal 2016 compared to $82.5 million during fiscal 2015. The increase in cash generated from operating activities in fiscal 2016 compared to fiscal 2015 was primarily due to a significant reduction in inventory levels in the access equipment segment in fiscal 2016 and a significant build of inventories in the access equipment and defense segments in the prior year. The access equipment segment reduced inventories (down $305.8 million) in fiscal 2016 to better align inventory levels with lower market demand. In fiscal 2015, the access equipment segment experienced an increase in inventory (up $182.8 million) as a result of the combination of a plan to level-load production during the year to address seasonal fluctuations in demand and a subsequent reduction in access equipment third and fourth quarter sales compared to previous estimates as a result of the start of a mid-cycle dip in North American demand for access equipment related to lower oil & gas related demand and lower replacement demand as a result of lower purchases of access equipment by rental companies in 2009 and 2010. In fiscal 2015, defense inventory levels grew (up $134.0 million) to support new contracts, both domestic and international. The magnitude and duration of these contracts has resulted in continued increased working capital requirements in the defense segment during fiscal 2016. Defense segment inventory is expected to remain at current levels as a result of increased demand. Fiscal 2015 Compared to Fiscal 2014 The Company generated $82.5 million of cash from operating activities during fiscal 2015 compared to $170.4 million during fiscal 2014. The decrease in cash generated from operating activities in fiscal 2015 compared to fiscal 2014 was primarily due to lower operating income and higher inventory levels in the access equipment and defense segments at September 30, 2015, partially offset by increased customer advances on higher order backlog in the fire & emergency segment. Increased inventory in the access equipment segment (up $182.8 million) resulted from the combination of a plan to level-load production during the year to address seasonal fluctuations in demand and a subsequent reduction in access equipment third and fourth quarter sales compared to previous estimates as a result of the start of a mid-cycle dip in North American demand for access equipment related to lower oil & gas related demand and lower replacement demand as a result of lower purchases of access equipment by rental companies in 2009 and 2010. Defense inventory levels grew (up $134.0 million) to support new contracts, both domestic and international. The magnitude and duration of these contracts has resulted in heightened working capital requirements in the defense segment. Investing Cash Flows Fiscal 2016 Compared to Fiscal 2015 Net cash used in investing activities in fiscal 2016 was $89.2 million compared to $140.1 million in fiscal 2015. Additions to property, plant and equipment of $92.5 million in fiscal 2016 reflected a decrease in capital spending of $39.2 million compared to fiscal 2015. In fiscal 2015, the Company increased investments in property, plant and equipment to fund the Company's vertical integration strategy and global information systems replacement initiative. Fiscal 2015 Compared to Fiscal 2014 Net cash used in investing activities in fiscal 2015 was $140.1 million compared to $114.8 million in fiscal 2014. Additions to property, plant and equipment of $131.7 million in fiscal 2015 reflected an increase in capital spending of $39.5 million compared to fiscal 2014 as a result of investments in the Company's vertical integration strategy and global information systems replacement initiative. Financing Cash Flows Fiscal 2016 Compared to Fiscal 2015 Financing activities resulted in a net use of cash of $215.8 million in fiscal 2016 compared to $212.9 million in fiscal 2015. The Company utilized cash flow from operations to repay $63.5 million on its Revolving Credit Facility in fiscal 2016 as compared to borrowing $63.5 million on its Revolving Credit Facility in fiscal 2015 to fund operations. In fiscal 2016 and 2015, the Company repurchased approximately 2.5 million and 4.9 million shares of its Common Stock, respectively, under its share repurchase authorization at an aggregate cost of $100.1 million and $200.4 million, respectively. At September 30, 2016, the Company had approximately 7.5 million shares of Common Stock remaining under a repurchase authorization approved by the Company's Board of Directors in August 2015. The Company targets returning half of its free cash flows (defined as “cash flows from operations” less “additions to property, plant and equipment” less “additions to equipment held for rental” plus “proceeds from sale of equipment held for rental”) to shareholders over the course of the operating cycle. The Company plans to be opportunistic with share repurchases. It may take a number of years to repurchase the remaining 7.5 million shares currently authorized for repurchase or the Company could accelerate the repurchase pace depending on the Company's share price performance. In addition, the Company paid dividends of $55.9 million and $53.1 million in fiscal 2016 and 2015, respectively. The Company subsequently increased its dividend rate by approximately 11% in November 2016. Fiscal 2015 Compared to Fiscal 2014 Financing activities resulted in a net use of cash of $212.9 million in fiscal 2015 compared to $476.0 million in fiscal 2014. The Company made required quarterly debt payments during fiscal 2015 totaling $20.0 million compared to $37.5 million in fiscal 2014. The Company also prepaid $22.5 million of term debt in fiscal 2014 as part of refinancing the Credit Agreement. In fiscal 2015 and 2014, the Company repurchased approximately 4.9 million and 8.3 million shares of its Common Stock, respectively, under its share repurchase authorization at an aggregate cost of $200.4 million and $403.3 million, respectively. In addition, the Company paid dividends of $53.1 million and $50.7 million in fiscal 2015 and 2014, respectively. Liquidity Senior Secured Credit Agreement In March 2014, the Company entered into an Amended and Restated Credit Agreement with various lenders (the “Credit Agreement”). The Credit Agreement provides for (i) a revolving credit facility (Revolving Credit Facility) that matures in March 2019 with an initial maximum aggregate amount of availability of $600 million and (ii) a $400 million term loan due in quarterly principal installments of $5.0 million with a balloon payment of $310.0 million due at maturity in March 2019. In January 2015, the Company entered into an agreement with lenders under the Credit Agreement that increased the Revolving Credit Facility by $250.0 million to an aggregate maximum amount of $850.0 million. Refer to Note 9 of the Notes to Consolidated Financial Statements for additional information regarding the Credit Agreement. The Company’s obligations under the Credit Agreement are guaranteed by certain of its domestic subsidiaries, and the Company will guarantee the obligations of certain of its subsidiaries under the Credit Agreement. Subject to certain exceptions, the Credit Agreement is collateralized by (i) a first-priority perfected lien and security interests in substantially all of the personal property of the Company, each material subsidiary of the Company and each subsidiary guarantor, (ii) mortgages upon certain real property of the Company and certain of its domestic subsidiaries and (iii) a pledge of the equity of each material subsidiary of the Company. Under the Credit Agreement, the Company must pay (i) an unused commitment fee ranging from 0.225% to 0.35% per annum of the average daily unused portion of the aggregate revolving credit commitments under the Credit Agreement and (ii) a fee ranging from 0.625% to 2.00% per annum of the maximum amount available to be drawn for each letter of credit issued and outstanding under the Credit Agreement. Borrowings under the Credit Agreement bear interest at a variable rate equal to (i) LIBOR plus a specified margin, which may be adjusted upward or downward depending on whether certain criteria are satisfied, or (ii) for dollar-denominated loans only, the base rate (which is the highest of (a) the administrative agent's prime rate, (b) the federal funds rate plus 0.50% or (c) the sum of 1% plus one-month LIBOR) plus a specified margin, which may be adjusted upward or downward depending on whether certain criteria are satisfied. Covenant Compliance The Credit Agreement contains various restrictions and covenants, including requirements that the Company maintain certain financial ratios at prescribed levels and restrictions, subject to certain exceptions, on the ability of the Company and certain of its subsidiaries to consolidate or merge, create liens, incur additional indebtedness, dispose of assets, consummate acquisitions and make investments in joint ventures and foreign subsidiaries. The Credit Agreement contains the following financial covenants: • Leverage Ratio: A maximum leverage ratio (defined as, with certain adjustments, the ratio of the Company’s consolidated indebtedness to consolidated net income before interest, taxes, depreciation, amortization, non-cash charges and certain other items (EBITDA)) as of the last day of any fiscal quarter of 4.50 to 1.0. • Interest Coverage Ratio: A minimum interest coverage ratio (defined as, with certain adjustments, the ratio of the Company’s consolidated EBITDA to the Company’s consolidated cash interest expense) as of the last day of any fiscal quarter of 2.50 to 1.0. • Senior Secured Leverage Ratio: A maximum senior secured leverage ratio (defined as, with certain adjustments, the ratio of the Company’s consolidated secured indebtedness to the Company’s consolidated EBITDA) of 3.00 to 1.0. With certain exceptions, the Company may elect to have the collateral pledged in connection with the Credit Agreement released during any period that the Company maintains an investment grade corporate family rating from either Standard & Poor’s Ratings Group or Moody’s Investor Service Inc. During any such period when the collateral has been released, the Company’s leverage ratio as of the last day of any fiscal quarter must not be greater than 3.75 to 1.0, and the Company would not be subject to any additional requirement to limit its senior secured leverage ratio. The Company was in compliance with the financial covenants contained in the Credit Agreement as of September 30, 2016 and expects to be able to meet the financial covenants contained in the Credit Agreement over the next twelve months. Additionally, with certain exceptions, the Credit Agreement limits the ability of the Company to pay dividends and other distributions, including repurchases of shares of its Common Stock. However, so long as no event of default exists under the Credit Agreement or would result from such payment, the Company may pay dividends and other distributions after March 3, 2010 in an aggregate amount not exceeding the sum of: i. 50% of the consolidated net income of the Company and its subsidiaries (or if such consolidated net income is a deficit, minus 100% of such deficit), accrued on a cumulative basis during the period beginning on January 1, 2010 and ending on the last day of the fiscal quarter immediately preceding the date of the applicable proposed dividend or distribution; and ii. 100% of the aggregate net proceeds received by the Company subsequent to March 3, 2010 either as a contribution to its common equity capital or from the issuance and sale of its Common Stock. Senior Notes On February 2014, the Company issued $250.0 million of 5.375% unsecured senior notes due March 1, 2022 (the “2022 Senior Notes”). In March 2015, the Company issued $250.0 million of 5.375% unsecured senior notes due March 1, 2025 (the “2025 Senior Notes”). The proceeds of both note issuances were used to repay existing outstanding notes of the Company. The Company has the option to redeem the 2022 Senior Notes and the 2025 Senior Notes for a premium after March 1, 2017 and March 1, 2020, respectively. The 2022 Senior Notes and the 2025 Senior Notes were issued pursuant to separate indentures (the “Indentures”) among the Company, the subsidiary guarantors named therein and a trustee. The Indentures contain customary affirmative and negative covenants. Certain of the Company’s subsidiaries jointly, severally, fully and unconditionally guarantee the Company’s obligations under the 2022 Senior Notes and 2025 Senior Notes. See Note 23 of the Notes to Consolidated Financial Statements for separate financial information of the subsidiary guarantors. Refer to Note 9 of the Notes to Consolidated Financial Statements for additional information regarding the Company’s outstanding debt as of September 30, 2016. Contractual Obligations, Commitments and Off-Balance Sheet Arrangements Following is a summary of the Company’s contractual obligations and payments due by period following September 30, 2016 (in millions): _________________________ (1) Interest was calculated based upon the interest rate in effect on September 30, 2016. (2) The Company utilizes blanket purchase orders to communicate expected annual requirements to many of its suppliers or contractors. Requirements under blanket purchase orders generally do not become “firm” until four weeks prior to the Company’s scheduled unit production. The purchase obligations amounts included above represent the values of commitments considered firm, plus the value of all outstanding subcontracts. (3) Due to the uncertainty of the timing of settlement with taxing authorities, the Company is unable to make reasonably reliable estimates of the period of cash settlement of unrecognized tax benefits for the remaining uncertain tax liabilities. Therefore, $37.4 million of unrecognized tax benefits as of September 30, 2016 have been excluded from the Contractual Obligations table above. See Note 18 of the Notes to Consolidated Financial Statements for additional information regarding the Company’s unrecognized tax benefits as of September 30, 2016. (4) Represents other long-term liabilities on the Company's Consolidated Balance Sheet, including the current portion of these liabilities. The projected timing of cash flows associated with these obligations is based on management's estimates, which are based largely on historical experience. This amount also includes all liabilities under the Company's pension and other postretirement benefit plans. See Note 17 of the Notes to Consolidated Financial Statements for information regarding these liabilities and the plan assets available to satisfy them. The following is a summary of the Company’s commitments by period following September 30, 2016 (in millions): The Company incurs contingent limited recourse liabilities with respect to customer financing activities primarily in the access equipment segment. For additional information relative to guarantees, see Note 11 of the Notes to Consolidated Financial Statements. Fiscal 2017 Outlook The Company believes consolidated net sales will increase 3.5% to 6.7% in fiscal 2017 compared to fiscal 2016, resulting in consolidated sales of between $6.5 billion and $6.7 billion. The defense segment is expected to be the largest driver of the increase in sales, overcoming an expected decline in access equipment segment sales. Sales in the fire & emergency and commercial segments are also expected to be higher in fiscal 2017 as compared to fiscal 2016. The Company expects consolidated operating income will be in the range of $390 million to $430 million, with earnings per share of approximately $3.00 to $3.40 assuming a full year average share count of approximately 74.5 million shares. The Company expects weakness in the access equipment segment to be overcome by stronger collective performance in the defense, fire & emergency and commercial segments. The Company believes access equipment segment sales will be between $2.7 billion and $2.8 billion in fiscal 2017, representing a decrease of 7% to 10% compared to fiscal 2016. The Company expects the sales decrease will be driven by continued lower replacement demand in North America. The Company expects operating income margins in the access equipment segment will be in the range of 7.75% to 8.5%, reflecting the continued challenging pricing environment, foreign exchange headwinds and higher overall material costs, partially offset by modestly higher absorption and the impact of cost reduction initiatives. The Company expects that defense segment sales will be approximately $1.85 billion in fiscal 2017, an increase of approximately 37% from fiscal 2016 sales. The increase in defense segment sales is expected to be driven by higher international M-ATV deliveries. The Company expects the defense segment to sell approximately 1,000 international M-ATVs in fiscal 2017. The ramp up of JLTV deliveries in fiscal 2017 is also expected to contribute to the higher year-over-year sales. The Company expects the defense segment will sell approximately 750 JLTVs in fiscal 2017. The Company believes operating income margins in this segment will increase slightly to approximately 9.5%, driven by a higher mix of M-ATVs versus fiscal 2016, partially offset by bid and proposal and vehicle testing costs for the FMTV contract re-competition and higher international marketing costs for JLTVs. The Company expects fire & emergency segment sales will be approximately $1.0 billion in fiscal 2017, reflecting the continued recovery in the municipal fire apparatus market and the full year benefit from higher production rates implemented in fiscal 2016. The Company expects operating income margins in this segment to increase to approximately 8.5% in fiscal 2017 driven by further operational efficiency gains and improved absorption on modestly higher sales. The Company believes commercial segment sales will be approximately $1.0 billion in fiscal 2017, a 2% improvement over fiscal 2016. The Company expects the cautious approach to concrete mixer purchases shown by concrete producers in fiscal 2016 to continue into fiscal 2017. The Company also expects refuse collection vehicle market growth to moderate after several years of solid growth. The Company expects operating income margins in this segment to be approximately 6.75% in fiscal 2017. The Company expects corporate expenses in fiscal 2017 will be between $140 million and $145 million. The Company estimates its effective tax rate for fiscal 2017 will be up approximately 300 basis points to 33%. The Company does not expect fiscal 2016 benefits of a change in filing position (90 basis points) and discrete tax optimization benefits (110 basis points) to benefit the fiscal 2017 effective tax rate. The Company expects the first quarter of fiscal 2017 to be the weakest quarter of fiscal 2017 due to seasonal factors. The Company also expects earnings per share in the first quarter of fiscal 2017 to be lower than the prior-year quarter as the first quarter of fiscal 2016 included the sale of more than 200 M-ATVs in the defense segment. The Company does not expect to sell any M-ATVs in the first quarter of fiscal 2017. Critical Accounting Policies The Company’s significant accounting policies are described in Note 2 of the Notes to Consolidated Financial Statements. The Company considers the following policy to be the most critical in understanding the judgments that are involved in the preparation of the Company’s consolidated financial statements and the uncertainties that could impact the Company’s financial condition, results of operations and cash flows. Revenue Recognition. The Company recognizes revenue on equipment and parts sales when contract terms are met, collectability is reasonably assured and a product is shipped or risk of ownership has been transferred to and accepted by the customer. Revenue from service agreements is recognized as earned, when services have been rendered. Appropriate provisions are made for discounts, returns and sales allowances. Sales are recorded net of amounts invoiced for taxes imposed on the customer such as excise or value-added taxes. Sales to the U.S. government of non-commercial products manufactured to the government’s specifications are recognized under percentage-of-completion accounting using either the units-of-delivery method or cost-to-cost method to measure contract performance. Under the units-of-delivery method, the Company records sales as units are accepted by the DoD generally based on unit sales values stated in the respective contracts. Costs of sales are based on actual costs incurred to produce the units delivered under the contract. Under the cost-to-cost method, sales, including estimated margins, are recognized as contract costs are incurred. The measurement method selected is generally determined based on the nature of the contract. The Company includes amounts representing contract change orders, claims or other items in sales only when they can be reliably estimated and realization is probable. The Company has significant experience in contracting and producing vehicles for the defense industry, which has resulted in a history of making reasonable estimates of revenues and costs when measuring progress toward contract completion. The Company charges anticipated losses on contracts or programs in progress to earnings when identified. Approximately 19% of the Company’s revenues for fiscal 2016 were recognized under the percentage-of-completion accounting method. Critical Accounting Estimates “Management’s Discussion and Analysis of Financial Condition and Results of Operations” is based on the Company's Consolidated Financial Statements, which have been prepared in accordance with generally accepted accounting principles in the United States of America (U.S. GAAP). The preparation of financial statements in accordance with U.S. GAAP requires management to make estimates and judgments that affect reported amounts and related disclosures. On an ongoing basis, management evaluates and updates its estimates. Management employs judgment in making its estimates but they are based on historical experience and currently available information and various other assumptions that the Company believes to be reasonable under the circumstances. The results of these estimates form the basis for making judgments about the carrying values of assets and liabilities that are not readily available from other sources. Actual results could differ from those estimates. Management believes that its judgment is applied consistently and produces financial information that fairly depicts the results of operations for all periods presented. Percentage-of-Completion Accounting. The percentage-of-completion accounting method is used to account for long-term contracts that involve the design, development, manufacture, or modification of complex equipment to a buyers specification. Contracts accounted for under this method generally are long-term in nature and may involve related services. Revenue is recognized on these types of contracts based on the extent of progress toward completion of the overall contract. The determination of the method to measure progress toward completion of a contract requires judgment, which is generally dependent on the nature of the Company's obligations under the contract. Under the units-of-delivery measure of progress, the extent of progress on a contract is measured as units are accepted by the DoD generally based on unit sales values stated in the respective contracts. Costs of sales are based on actual costs incurred to produce the units delivered under the contract. Under the cost-to-cost measure of progress, the extent of progress toward completion is measured based on the ratio of costs incurred to date to the total estimated costs at the completion of the contract. Revenues, including margins, are recorded as costs are incurred. The revenue and cost estimates used under the cost-to-cost measurement method are complex and involve significant judgment. The Company has implemented a rigorous Estimate at Completion (EAC) process that requires management to perform a detailed evaluation of contract progress and performance on at least a quarterly basis. During this process all key inputs and variables that may impact contract performance are analyzed and the EAC is updated for any changes. Adjustments to revenue, costs and operating income resulting from this process are recorded in the period they become known. Allowance for Doubtful Accounts. The allowance for doubtful accounts requires management to estimate a customer’s ability to satisfy its obligations. The estimate of the allowance for doubtful accounts is particularly critical in the Company’s access equipment segment. In circumstances where the Company is aware of a specific customer’s inability to meet its financial obligations, a specific reserve is recorded against amounts due to reduce the net recognized receivable to the amount reasonably expected to be collected. Additional reserves are established based upon the Company’s perception of the quality of the current receivables, including the length of time the receivables are past due, past experience of collectability and underlying economic conditions. At September 30, 2016, reserves for potentially uncollectible receivables totaled $21.2 million. If the financial condition of the Company’s customers were to deteriorate resulting in an impairment of their ability to make payments, additional reserves would be required. Inventories. Inventories are stated at the lower of cost or market (LCM) value. In valuing inventory, the Company is required to make assumptions regarding the level of reserves required to value potentially obsolete or over-valued items. These assumptions require the Company to analyze the aging of and forecasted demand for its inventory, forecast future product sales prices, pricing trends and margins, and to make judgments and estimates regarding obsolete or excess inventory. Future product sales prices, pricing trends and margins are based on the best available information at that time including actual orders received, negotiations with customers for future orders, including their plans for expenditures, and market trends for similar products. The Company's judgments and estimates for excess or obsolete inventory are based on analysis of actual and forecasted usage. The valuation of used equipment taken in trade from customers requires the Company to use the best information available to determine the value of the equipment to potential customers. This value is subject to change based on numerous conditions. Inventory reserves are established taking into account age, frequency of use, or sale, and in the case of repair parts, the installed base of machines. While calculations are made involving these factors, significant management judgment regarding expectations for future events is involved. Future events that could significantly influence the Company's judgment and related estimates include general economic conditions in markets where the Company's products are sold, new equipment price fluctuations, actions of the Company's competitors, including the introduction of new products and technological advances. The Company makes adjustments to its inventory reserves based on the identification of specific situations and increases its inventory reserves accordingly. At September 30, 2016, inventory had been reduced by $80.1 million as a result of LCM valuation and reserves for excess and obsolescence. Impairment of Goodwill and Indefinite-Lived Intangible Assets. Goodwill and indefinite-lived intangible assets are tested for impairment annually, or more frequently if events or changes in circumstances indicate that the assets might be impaired. Such circumstances include a significant adverse change in the business climate for one of the Company's reporting units, a material negative change in relationships with significant customers, or strategic decisions made in response to economic and competitive conditions. The Company performs its annual review at the beginning of the fourth quarter of each fiscal year. The Company evaluates the recoverability of goodwill by estimating the fair value of the businesses to which the goodwill relates. A reporting unit is an operating segment or, under certain circumstances, a component of an operating segment that constitutes a business. When the fair value of the reporting unit is less than the carrying value of the reporting unit, a further analysis is performed to measure and recognize the amount of the impairment loss, if any. Impairment losses, limited to the carrying value of goodwill, represent the excess of the carrying amount of a reporting unit’s goodwill over the implied fair value of that goodwill. The Company evaluates the recoverability of indefinite-lived trade names based upon a “relief from royalty” method. This methodology determines the fair value of each trade name through use of a discounted cash flow model that incorporates an estimated “royalty rate” the Company would be able to charge a third party for the use of the particular trade name. In determining the estimated future cash flows, the Company considers projected future sales, a fair market royalty rate for each applicable trade name and an appropriate discount rate to measure the present value of the anticipated cash flows. In evaluating the recoverability of goodwill, it is necessary to estimate the fair value of the reporting units. The estimate of the fair value of the reporting units is generally determined on the basis of discounted future cash flows and a market approach. In estimating the fair value, management must make assumptions and projections regarding such items as the Company performance and profitability under existing contracts, its success in securing future business, the appropriate risk-adjusted interest rate used to discount the projected cash flows, and terminal value growth and earnings rates. The assumptions used in the estimate of fair value are generally consistent with the past performance of each reporting unit and are also consistent with the projections and assumptions that are used in current operating plans. Such assumptions are subject to change as a result of changing economic and competitive conditions. The rate used to discount estimated cash flows is a rate corresponding to the Company’s cost of capital, adjusted for risk where appropriate, and is dependent upon interest rates at a point in time. To assess the reasonableness of the discounted projected cash flows, the Company compares the sum of its reporting units' fair value to the Company's market capitalization and calculates an implied control premium (the excess of the sum of the reporting units' fair values over the market capitalization). The reasonableness of this control premium is evaluated by comparing it to control premiums for recent comparable market transactions. Consistent with prior years, the Company weighted the income approach more heavily (75%) as the income approach uses long-term estimates that consider the expected operating profit of each reporting unit during periods where residential and non-residential construction and other macroeconomic indicators are nearer historical averages. The Company believes the income approach more accurately considers the expected recovery in the U.S. and European construction markets than the market approach. There are inherent uncertainties related to these factors and management’s judgment in applying them to the analysis of goodwill impairment. It is possible that assumptions underlying the impairment analysis will change in such a manner to cause further impairment of goodwill, which could have a material impact on the Company’s results of operations. The Company completed the required goodwill impairment test as of July 1, 2016. The Company identified no indicators of goodwill impairment in the test performed as of July 1, 2016. In order to evaluate the sensitivity of any quantitative fair value calculations on the goodwill impairment test, a hypothetical 10% decrease to the fair values of any reporting unit was calculated. This hypothetical 10% decrease would still result in excess fair value over carrying value for the reporting units as of July 1, 2016. At July 1, 2016, approximately 90% of the Company’s recorded goodwill and indefinite-lived purchased intangibles were concentrated within the JLG reporting unit in the access equipment segment. Assumptions utilized in the impairment analysis are highly judgmental. While the Company currently believes that an impairment of intangible assets at JLG is unlikely, events and conditions that could result in the impairment of intangibles at JLG include a sharp decline in economic conditions, significantly increased pricing pressure on JLG's margins or other factors leading to reductions in expected long-term sales or profitability at JLG. Guarantees of the Indebtedness of Others. The Company enters into agreements with finance companies whereby the Company will guarantee the indebtedness of third-party end-users to whom the finance company lends to purchase the Company’s equipment. In some instances, the Company retains an obligation to the finance companies in the event the customer defaults on the financing. In accordance with Financial Accounting Standards Board (FASB) Accounting Standards Codification (ASC) Topic 460, Guarantees, the Company recognizes the greater of the fair value of the guarantee or the contingent liability required by FASB ASC Topic 450, Contingencies. The Company is party to multiple agreements whereby at September 30, 2016 it guaranteed an aggregate of $563.2 million in indebtedness of customers. The Company estimated that its maximum loss exposure under these contracts at September 30, 2016 was $116.3 million. Reserves are initially established related to these guarantees at the fair value of the guarantee based upon the Company’s understanding of the current financial position of the underlying customers and based on estimates and judgments made from information available at that time in accordance with FASB ASC Topic 460, Guarantees. If the Company becomes aware of deterioration in the financial condition of the customer/borrower or of any impairment of the customer/borrower’s ability to make payments, additional allowances are considered as required by FASB ASC Topic 450, Contingencies. Although the Company may be liable for the entire amount of a customer/borrower’s financial obligation under guarantees, its losses would generally be mitigated by the value of any underlying collateral including financed equipment, the finance company’s inability to provide clear title of foreclosed equipment to the Company, loss pools established in accordance with the agreements and other conditions. During periods of economic downturn, the value of the underlying collateral supporting these guarantees can decline sharply to further increase losses in the event of a customer/borrower’s default. Reserves for guarantees of the indebtedness of others under these contracts was $8.4 million at September 30, 2016. If the financial condition of the Company’s customers were to deteriorate resulting in an impairment of their ability to make payments, additional reserves would be required. Product Liability. Due to the nature of the Company’s products, the Company is subject to product liability claims in the normal course of business. A substantial portion of these claims and lawsuits involve the Company’s access equipment, concrete placement and refuse collection vehicle businesses, while such lawsuits in the Company’s defense and fire & emergency businesses have historically been limited. To the extent permitted under applicable law, the Company maintains insurance to reduce or eliminate risk to the Company. Most insurance coverage includes self-insured retentions that vary by business segment and by year. As of September 30, 2016, the Company was generally self-insured for future claims up to $5.0 million per claim. The Company establishes product liability reserves for its self-insured retention portion of any known outstanding matters based on the likelihood of loss and the Company’s ability to reasonably estimate such loss. There is inherent uncertainty as to the eventual resolution of unsettled matters due to the unpredictable nature of litigation. The Company makes estimates based on available information and the Company’s best judgment after consultation with appropriate experts. The Company periodically revises estimates based upon changes to facts or circumstances. The Company also utilizes actuarial methodologies to calculate reserves required for estimated incurred but not reported claims as well as to estimate the effect of the adverse development of claims over time. At September 30, 2016, the estimated net liabilities for product and general liability claims totaled $38.3 million. New Accounting Standards Refer to Note 2 of the Notes to Consolidated Financial Statements for a discussion of the impact of new accounting standards on the Company’s consolidated financial statements. Customers and Backlog Sales to the U.S. government comprised approximately 19% of the Company’s net sales in fiscal 2016. No other single customer accounted for more than 10% of the Company’s net sales for this period. A substantial majority of the Company’s net sales are derived from the fulfillment of customer orders that are received prior to commencing production. The Company’s backlog as of September 30, 2016 increased 35.7% to $3.54 billion compared to $2.61 billion at September 30, 2015 due largely to an increase in the defense segment backlog as a result of new contracts in fiscal 2016. Access equipment segment backlog decreased 14.5% to $179.3 million at September 30, 2016 compared to $209.7 million at September 30, 2015 primarily due to the slowdown in North American replacement demand. Defense segment backlog increased 65.0% to $2.33 billion at September 30, 2016 compared to $1.41 billion at September 30, 2015 primarily due to the receipt of a large international contract for the delivery of M-ATVs, higher order levels on the FHTV and FMTV programs and increased funding for the JLTV program. Defense segment backlog at September 30, 2016 includes orders under the recently extended FMTV contract. A third party protest of the FMTV contract extension was subsequently withdrawn. Fire & emergency segment backlog increased 7.9% to $852.9 million at September 30, 2016 compared to $790.7 million at September 30, 2015 due largely to increased orders for domestic fire trucks as a result of continued market recovery and share gains. Commercial segment backlog decreased 10.2% to $173.3 million at September 30, 2016 compared to $193.0 million at September 30, 2015. Unit backlog for concrete mixers and refuse collection vehicles as of September 30, 2016 was down 18.8% and 29.7%, respectively, compared to September 30, 2015 due to continued softness in the concrete mixer market and the timing of fleet replacement demand for refuse collection vehicles. Reported backlog excludes purchase options and announced orders for which definitive contracts have not been executed. Backlog information and comparisons thereof as of different dates may not be accurate indicators of future sales or the ratio of the Company’s future sales to the DoD versus its sales to other customers. Approximately 18% of the Company’s September 30, 2016 backlog is not expected to be filled in fiscal 2017. Financial Market Risk The Company is exposed to market risk from changes in interest rates, certain commodity prices and foreign currency exchange rates. To reduce the risk from changes in foreign currency exchange and interest rates, the Company selectively uses financial instruments. All hedging transactions are authorized and executed pursuant to clearly defined policies and procedures, which strictly prohibit the use of financial instruments for speculative purposes. Interest Rate Risk. The Company’s earnings exposure related to adverse movements in interest rates is primarily derived from outstanding floating rate debt instruments that are indexed to short-term market interest rates. In this regard, changes in U.S. and off-shore interest rates affect interest payable on the Company’s borrowings under its Credit Agreement. Based on debt outstanding at September 30, 2016, a 100 basis point increase or decrease in the average cost of the Company’s variable rate debt would increase or decrease annual pre-tax interest expense by approximately $3.5 million. The table below provides information about the Company’s debt obligations, which are sensitive to changes in interest rates (dollars in millions): The table presents principal cash flows and related weighted-average interest rates by expected maturity dates. Weighted-average variable rates are based on implied forward rates in the yield curve at the reporting date. Commodity Price Risk. The Company is a purchaser of certain commodities, including steel, aluminum and composites. In addition, the Company is a purchaser of components and parts containing various commodities, including steel, aluminum, rubber and others which are integrated into the Company’s end products. The Company generally buys these commodities and components based upon market prices that are established with the vendor as part of the purchase process. The Company does not use commodity financial instruments to hedge commodity prices. The Company generally obtains firm quotations from its suppliers for a significant portion of its orders under firm, fixed-price contracts in its defense segment. In the Company’s access equipment, fire & emergency and commercial segments, the Company generally attempts to obtain firm pricing from most of its suppliers, consistent with backlog requirements and/or forecasted annual sales. To the extent that commodity prices increase and the Company does not have firm pricing from its suppliers, or its suppliers are not able to honor such prices, then the Company may experience margin declines to the extent it is not able to increase selling prices of its products. Foreign Currency Risk. The Company’s operations consist of manufacturing in the U.S., Belgium, Mexico, Canada, France, Australia, Romania, the United Kingdom and China and sales and limited vehicle body mounting activities on five continents. International sales comprised approximately 24% of overall net sales in fiscal 2016, of which approximately 70% involved exports from the U.S. The majority of export sales in fiscal 2016 were denominated in U.S. dollars. As a result of the manufacture and sale of the Company’s products in foreign markets, the Company’s earnings are affected by fluctuations in the value of foreign currencies in which certain of the Company’s transactions are denominated as compared to the value of the U.S. dollar. The Company’s operating results are principally exposed to changes in exchange rates between the U.S. dollar and the European currencies, primarily the Euro and the U.K. pound sterling, changes between the U.S. dollar and the Australian dollar, changes between the U.S. dollar and the Brazilian real, changes between the U.S. dollar and the Mexican peso and changes between the U.S. dollar and the Chinese renminbi. The Company enters into certain forward foreign currency exchange contracts to mitigate the Company’s foreign currency exchange risk on monetary assets or liabilities. These contracts qualify as derivative instruments under FASB ASC Topic 815, Derivatives and Hedging; however, the Company has not designated all of these instruments as hedge transactions under ASC Topic 815. Accordingly, the mark-to-market impact of these derivatives is recorded each period to current earnings along with the offsetting foreign currency transaction gain/loss recognized on the related balance sheet exposure. At September 30, 2016, the Company was managing $111.6 million (notional) of foreign currency contracts, including $110.5 million (notional) which were not designated as accounting hedges. All outstanding foreign currency contracts as of September 30, 2016 will settle within 365 days. The following table quantifies outstanding forward foreign exchange contracts intended to hedge non-U.S. dollar denominated cash, receivables and payables and the corresponding U.S. dollar impact on the value of these instruments assuming a 10% appreciation/depreciation of the sell currency at September 30, 2016 (dollars in millions): As previously noted, the Company’s policy prohibits the trading of financial instruments for speculative purposes or the use of leveraged instruments. It is important to note that gains and losses indicated in the sensitivity analysis would be offset by gains and losses on the underlying receivables and payables.

<s>[INST] General The Company is a leading designer, manufacturer and marketer of a wide range of specialty vehicles and vehicle bodies, including access equipment, defense trucks and trailers, fire & emergency vehicles, concrete mixers and refuse collection vehicles. The Company is a leading global manufacturer of aerial work platforms under the “JLG” brand name. The Company is among the worldwide leaders in the manufacturing of telehandlers under the “JLG” and “SkyTrak” brand names. Under the “JerrDan” brand name, the Company is a leading domestic manufacturer and marketer of towing and recovery equipment. The Company manufactures defense trucks under the “Oshkosh” brand name and is a leading manufacturer of severeduty, tactical wheeled vehicles for the DoD. Under the “Pierce” brand name, the Company is among the leading global manufacturers of fire trucks assembled on both custom and commercial chassis. Under the “Frontline” brand name, the Company is a leading domestic manufacturer and marketer of broadcast vehicles. The Company manufactures ARFF and airport snow removal vehicles under the “Oshkosh” brand name. Under the “McNeilus,” “Oshkosh,” “London” and “CONECO” brand names, the Company manufactures rear and frontdischarge concrete mixers and portable and stationary concrete batch plants. Under the “McNeilus” brand name, the Company manufactures a wide range of automated, rear, front, side and top loading refuse collection vehicles. Under the “IMT” brand name, the Company is a leading domestic manufacturer of field service vehicles and truckmounted cranes. Major products manufactured and marketed by each of the Company’s business segments are as follows: Access equipment aerial work platforms and telehandlers used in a wide variety of construction, agricultural, industrial, institutional and general maintenance applications to position workers and materials at elevated heights, as well as carriers and wreckers. Access equipment customers include equipment rental companies, construction contractors, manufacturing companies, home improvement centers and towing companies in the U.S. and abroad. Defense tactical trucks, trailers and supply parts and services sold to the U.S. military and to other militaries around the world. Fire & emergency custom and commercial firefighting vehicles and equipment, ARFF vehicles, snow removal vehicles, simulators and other emergency vehicles primarily sold to fire departments, airports and other governmental units, and broadcast vehicles sold to broadcasters and TV stations in the U.S. and abroad. Commercial concrete mixers, refuse collection vehicles, portable and stationary concrete batch plants and vehicle components sold to readymix companies and commercial and municipal waste haulers in the Americas and other international markets and field service vehicles and truckmounted cranes sold to mining, construction and other companies in the U.S. and abroad. All estimates referred to in this “Management’s Discussion and Analysis of Financial Condition and Results of Operations” refer to the Company’s estimates as of November 22, 2016. Executive Overview Consolidated net sales increased $181.1 million, or 3.0%, to $6.28 billion in fiscal 2016 compared to fiscal 2015. The sales increase was driven by strong percentage increases in sales in both the defense and fire & emergency segments, offset in part by lower access equipment segment sales. As the Company had expected, defense segment sales rebounded from a trough year in fiscal 2015, driven by international sales of almost 600 MATVs and a full year of FHTV production. The fire & emergency segment continued to experience strong demand for fire trucks as new product launches and the improved municipal spending environment in the U.S. continued to benefit the Company's traditional fire truck business as cities and towns looked to replace aged equipment. Access equipment segment sales were lower than the prior year due primarily to a continued slowdown in North American replacement demand as a result of low purchases of access equipment in the 2009 and 2010 timeperiod. Consolidated operating income decreased 8.7% to $364.0 million, or 5.8% of sales, in fiscal 2016 compared to $398.6 million, or 6.5% of sales, in fiscal 2 [/INST] Positive. </s>

OSHKOSH CORP

2017-11-21

2017-09-30

ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS General The Company is a leading designer, manufacturer and marketer of a wide range of specialty vehicles and vehicle bodies, including access equipment, defense trucks and trailers, fire & emergency vehicles, concrete mixers and refuse collection vehicles. The Company is a leading global manufacturer of aerial work platforms under the “JLG” brand name. The Company is among the worldwide leaders in the manufacturing of telehandlers under the “JLG” and “SkyTrak” brand names. Under the “Jerr-Dan” brand name, the Company is a leading domestic manufacturer and marketer of towing and recovery equipment. The Company manufactures defense trucks under the “Oshkosh” brand name and is a leading manufacturer of severe-duty, tactical wheeled vehicles for the DoD. Under the “Pierce” brand name, the Company is among the leading global manufacturers of fire trucks assembled on both custom and commercial chassis. Under the “Frontline” brand name, the Company is a leading domestic manufacturer and marketer of broadcast vehicles. The Company manufactures aircraft rescue and firefighting and airport snow removal vehicles under the “Oshkosh” brand name. Under the “McNeilus,” “Oshkosh,” “London” and “CON-E-CO” brand names, the Company manufactures rear- and front-discharge concrete mixers and portable and stationary concrete batch plants. Under the “McNeilus” brand name, the Company manufactures a wide range of automated, rear, front, side and top loading refuse collection vehicles. Under the “IMT” brand name, the Company is a leading domestic manufacturer of field service vehicles and truck-mounted cranes. Major products manufactured and marketed by each of the Company’s business segments are as follows: Access equipment - aerial work platforms and telehandlers used in a wide variety of construction, industrial, institutional and general maintenance applications to position workers and materials at elevated heights, as well as carriers and wreckers. Access equipment customers include equipment rental companies, construction contractors, manufacturing companies, home improvement centers and towing companies in the U.S. and abroad. Defense - tactical trucks, trailers and supply parts and services sold to the U.S. military and to other militaries around the world. Fire & emergency - custom and commercial firefighting vehicles and equipment, ARFF vehicles, snow removal vehicles, simulators and other emergency vehicles primarily sold to fire departments, airports and other governmental units, and broadcast vehicles sold to broadcasters and TV stations in the U.S. and abroad. Commercial - concrete mixers, refuse collection vehicles, portable and stationary concrete batch plants and vehicle components sold to ready-mix companies and commercial and municipal waste haulers in the Americas and other international markets and field service vehicles and truck-mounted cranes sold to mining, construction and other companies in the U.S. and abroad. All estimates referred to in this “Management’s Discussion and Analysis of Financial Condition and Results of Operations” refer to the Company’s estimates as of November 21, 2017. Executive Overview The Company delivered strong financial results in fiscal 2017, the Company's 100th year in business. Consolidated net sales increased $550.4 million, or 8.8%, to $6.83 billion, consolidated operating income increased $99.0 million, or 27.2%, to $463.0 million, and diluted earnings per share increased $0.86 per share, or 29.6%, to $3.77 per share. The significant improvement in fiscal 2017 results was achieved in spite of incurring $0.25 per share higher restructuring-related and asset impairment charges than in fiscal 2016. Fiscal 2017 results were negatively impacted by $0.48 per share of restructuring-related charges. Fiscal 2016 results were negatively impacted by $0.23 per share related to asset impairment and workforce reduction charges. The Company also announced an increase in its quarterly dividend rate of approximately 14%, to $0.24 per share beginning in November 2017. This was the Company's fourth straight year of double digit percentage increases in its dividend rate. The $550.4 million sales increase was primarily the result of higher sales volumes in the defense segment, as the Company increased production under the JLTV program and sold approximately 400 more M-ATVs under an international contract than it sold in fiscal 2016, along with improved fire & emergency segment sales. Market conditions in the Company's non-defense segments were generally positive and year-end order backlog in these segments was higher as compared to September 30, 2016. Rental rates, fleet utilization percentages and used equipment values, all key to the access equipment segments rental company customers, strengthened over the past year, leading to stronger demand for access equipment than the Company expected entering fiscal 2017. In addition, construction data in the U.S. continued to be generally positive. While the U.S. fire apparatus market remained about 20% below pre-recession levels in fiscal 2017, it was stable compared to fiscal 2016. Fire apparatus fleet ages continued to grow and municipal tax receipts, which help fund the purchase of fire apparatus, were stable or up slightly in fiscal 2017 compared to fiscal 2016. The domestic refuse collection vehicle market increased mid- to high-single digits in fiscal 2017 and recently exceeded pre-recession levels. The concrete mixer market remained 20% - 25% below pre-recession levels in fiscal 2017 and fleets continued to age, which should lead to improved market demand after fiscal 2018. Although defense segment backlog was down at September 30, 2017 compared to September 30, 2016 on lower international orders, this segment made great progress on the JLTV program during fiscal 2017 and the Company expects the segment to deliver sales in fiscal 2018 approximately equivalent to fiscal 2017 levels. Consolidated operating income increased to $463.0 million, or 6.8% of sales, in fiscal 2017 compared to $364.0 million, or 5.8% of sales, in fiscal 2016. The increase in operating income was driven by higher gross margin associated with higher consolidated sales, improved performance in the fire & emergency and defense segments as well as lower start-up costs of a corporate-led shared manufacturing facility in Mexico, offset in part by lower performance in the commercial segment. Both the defense and fire & emergency segments achieved operating income margins of more than 10.0% and if not for the restructuring-related charges in the access equipment segment, this segment would have also achieved this higher level of performance. The Company believes these strong results are a testament to the power of the Company's MOVE strategy. The commercial segment was challenged in fiscal 2017 with atypical market dynamics which led to significant production schedule volatility and related inefficiencies. The Company believes that the implementation of simplification strategies in the commercial segment, which started late in fiscal 2017, will lead to improved results starting later in fiscal 2018. In January 2017, the Company announced its intention to rationalize operations in the access equipment segment. These plans included the closure of its manufacturing plant and pre-delivery inspection facilities in Belgium, the streamlining of telehandler product offerings to a reduced range in Europe, the transfer of remaining European telehandler manufacturing to the Company’s facility in Romania and reductions in engineering staff supporting European telehandlers, including the closure of a UK-based engineering facility. The announced plans also included the move of North American telehandler production from Ohio to facilities in Pennsylvania. The Company has largely completed the domestic portion of its actions. The Company's activities in Europe are progressing, and the Company expects to substantially complete these actions in the first quarter of fiscal 2018. In total, the Company expects these actions will result in ongoing savings of $20 million to $25 million per year. The Company continues to expect to realize $15 million to $20 million of benefits in fiscal 2018 before achieving full run rate savings in fiscal 2019. The Company now expects the pre-tax cost of implementing these actions will be approximately $50 million, of which $43 million was recognized in fiscal 2017. The Company is expecting another strong year in fiscal 2018. The Company believes consolidated net sales will be $6.9 billion to $7.1 billion, an approximate 1% to 4% increase compared to fiscal 2017. The Company expects sales to grow in all non-defense segments and defense segment sales to be approximately flat compared to fiscal 2017. As a result of the expected increase in sales, anticipated improved operational performance in each of the non-defense segments and an expected adverse product mix in the defense segment, the Company expects fiscal 2018 consolidated operating income will be in the range of $510 million to $560 million, resulting in earnings per share of $4.20 to $4.60. The Company expects to incur approximately $5 million in pre-tax restructuring-related charges in connection with plans announced in January 2017 to rationalize operations in the access equipment segment. Excluding expected access equipment segment restructuring-related charges, the Company expects fiscal 2018 adjusted consolidated operating income will be in the range of $515 million to $565 million, resulting in adjusted earnings per share of $4.25 to $4.65. Results of Operations Consolidated Net Sales - Three Years Ended September 30, 2017 The following table presents net sales (see definition of net sales contained in Note 2 of the Notes to Consolidated Financial Statements) by business segment (in millions): The following table presents net sales by geographic region based on product shipment destination (in millions): Fiscal 2017 Compared to Fiscal 2016 Consolidated net sales increased $550.4 million, or 8.8%, to $6.83 billion in fiscal 2017 compared to fiscal 2016. The increase in sales was primarily the result of higher sales volumes in the defense segment and improved fire & emergency segment sales. Access equipment segment net sales increased $14.0 million, or 0.5%, to $3.03 billion in fiscal 2017 compared to fiscal 2016. Rental rates, fleet utilization percentages and used equipment values, all key to the access equipment segments rental company customers, strengthened over the past year, leading to stronger demand for access equipment than the Company expected entering fiscal 2017. Defense segment net sales increased $469.0 million, or 34.7%, to $1.82 billion in fiscal 2017 compared to fiscal 2016. The increase in sales was primarily due to the ramp-up of production under the JLTV program, higher international sales of M-ATVs and higher sales of FHTVs to the U.S. government. During fiscal 2016, production of FHTVs was low as it was ramping back up after a break in production experienced in fiscal 2015. Fire & emergency segment net sales increased $77.6 million, or 8.1%, to $1.03 billion in fiscal 2017 compared to fiscal 2016. The increase in sales was primarily due to improved pricing (up $34 million), the sale of higher content units (up $29 million) and the timing of fire apparatus deliveries as a result of increased production rates (up $11 million). Commercial segment net sales decreased $8.9 million, or 0.9%, to $970.3 million in fiscal 2017 compared to fiscal 2016. The decrease in sales was primarily due to lower refuse collection vehicle unit volume (down $53 million) due to the atypical timing of orders, offset in part by sales of higher content units (up $21 million) and higher concrete mixer unit volume (up $23 million). Fiscal 2016 Compared to Fiscal 2015 Consolidated net sales increased $181.1 million, or 3.0%, to $6.28 billion in fiscal 2016 compared to fiscal 2015. Higher sales in the defense and fire & emergency segments were partially offset by a decline in sales in the access equipment segment. The strengthening U.S. dollar negatively impacted net sales in fiscal 2016 by $25 million, or 40 basis points, compared to fiscal 2015. Access equipment segment net sales decreased $388.2 million, or 11.4%, to $3.01 billion in fiscal 2016 compared to fiscal 2015. The decline in sales was primarily due to the slowdown in North American replacement demand that began in the third quarter of fiscal 2015 and a challenging pricing environment (down $75 million). A stronger U.S. dollar also negatively impacted sales by $20 million, or 60 basis points, compared to fiscal 2015. Defense segment net sales increased $411.3 million, or 43.8%, to $1.35 billion in fiscal 2016 compared to fiscal 2015. The increase in sales was primarily due to international sales of M-ATVs and increased sales to the DoD, as higher FHTV sales were offset in part by lower FMTV sales. The Company experienced a break in production under the FHTV program in the second and third quarters of fiscal 2015. Fire & emergency segment net sales increased $138.2 million, or 16.9%, to $953.3 million in fiscal 2016 compared to fiscal 2015. Sales in fiscal 2016 benefited from higher domestic fire truck deliveries and favorable pricing. Improved operational efficiencies allowed the fire & emergency segment to increase fire apparatus production rates to meet increased demand. Commercial segment net sales increased $1.2 million, or 0.1%, to $979.2 million in fiscal 2016 compared to fiscal 2015. Higher refuse collection vehicle sales were almost completely offset by lower sales of field service vehicles and truck-mounted cranes. Consolidated Cost of Sales - Three Years Ended September 30, 2017 The following table presents costs of sales by business segment (in millions): Fiscal 2017 Compared to Fiscal 2016 Consolidated cost of sales was $5.66 billion, or 82.8% of sales, in fiscal 2017 compared to $5.22 billion, or 83.2% of sales, in fiscal 2016. The 40 basis point decrease in cost of sales as a percentage of sales in fiscal 2017 compared to fiscal 2016 was primarily due to improved pricing (40 basis points), improved operating results related to the corporate-led shared manufacturing facility in Mexico, which incurred higher start-up costs in fiscal 2016 (30 basis points) and improved absorption as a result of increased production (30 basis points), offset in part by higher restructuring-related and asset impairment costs in the access equipment segment (60 basis points). Access equipment segment cost of sales was $2.47 billion, or 81.7% of sales, in fiscal 2017 compared to $2.44 billion, or 80.8% of sales, in fiscal 2016. The 90 basis point increase in cost of sales as a percentage of sales in fiscal 2017 compared to fiscal 2016 was primarily due to higher restructuring-related and asset impairment costs (140 basis points), offset in part by improved absorption as a result of increased production (50 basis points) and favorable mix (40 basis points). Defense segment cost of sales was $1.52 billion, or 83.4% of sales, in fiscal 2017 compared to $1.15 billion, or 84.9% of sales, in fiscal 2016. The 150 basis point decrease in cost of sales as a percentage of sales in fiscal 2017 compared to fiscal 2016 was primarily attributable to improved absorption as a result of increased production (60 basis points), improved product mix (40 basis points) and relatively flat new product development spending on higher sales (30 basis points). Fire & emergency segment cost of sales was $849.2 million, or 82.4% of sales, in fiscal 2017 compared to $816.0 million, or 85.6% of sales, in fiscal 2016. The 320 basis point decline in cost of sales as a percentage of sales in fiscal 2017 compared to fiscal 2016 was largely attributable to improved pricing (260 basis points), relatively flat new product development spending on higher sales (30 basis points) and improved manufacturing performance (20 basis points). Commercial segment cost of sales was $827.2 million, or 85.3% of sales, in fiscal 2017 compared to $817.5 million, or 83.5% of sales, in fiscal 2016. The 180 basis point increase in cost of sales as a percentage of sales in fiscal 2017 compared to fiscal 2016 was largely due to operational inefficiencies associated with variability in production volumes during fiscal 2017 (100 basis points) and an adverse product mix (50 basis points). Intersegment eliminations and other includes intercompany profit on inter-segment sales not yet sold to third party customers as well as start-up costs not allocated to segments relating to the corporate-led shared manufacturing facility in Mexico. Fiscal 2016 Compared to Fiscal 2015 Consolidated cost of sales was $5.22 billion, or 83.2% of sales, in fiscal 2016 compared to $5.06 billion, or 83.0% of sales, in fiscal 2015. The 20 basis point increase in cost of sales as a percentage of sales in fiscal 2016 compared to fiscal 2015 was primarily due to higher access equipment costs as a percentage of sales and start-up costs for the corporate-led shared manufacturing facility in Mexico, offset in part by improved defense, fire & emergency and commercial segment performance. Access equipment segment cost of sales was $2.44 billion, or 80.8% of sales, in fiscal 2016 compared to $2.70 billion, or 79.3% of sales, in fiscal 2015. The 150 basis point increase in cost of sales as a percentage of sales in fiscal 2016 compared to fiscal 2015 was primarily due to a more competitive pricing environment (230 basis points) and adverse manufacturing absorption (80 basis points) associated with lower production, offset in part by lower spending on engine emissions standards changes (100 basis points). Defense segment cost of sales was $1.15 billion, or 84.9% of sales, in fiscal 2016 compared to $862.7 million, or 91.8% of sales, in fiscal 2015. The 690 basis point decrease in cost of sales as a percentage of sales in fiscal 2016 compared to fiscal 2015 was primarily attributable to favorable product mix (260 basis points), lower Company-funded research & development related to the JLTV program (250 basis points) and contractual price increases, offset in part by the absence of a pension and other postretirement curtailment benefit recorded in fiscal 2015 (30 basis points). Fire & emergency segment cost of sales was $816.0 million, or 85.6% of sales, in fiscal 2016 compared to $703.9 million, or 86.4% of sales, in fiscal 2015. The 80 basis point decline in cost of sales as a percentage of sales in fiscal 2016 compared to fiscal 2015 was largely attributable to favorable pricing (140 basis points), offset in part by adverse product mix (50 basis points). Commercial segment cost of sales was $817.5 million, or 83.5% of sales, in fiscal 2016 compared to $820.6 million, or 83.9% of sales, in fiscal 2015. The 40 basis point decrease in cost of sales as a percentage of sales in fiscal 2016 compared to fiscal 2015 was largely due to favorable product mix (90 basis points) as a result of lower package sales, offset in part by production inefficiencies associated with the start-up of new products (50 basis points). Intersegment eliminations and other includes intercompany profit on inter-segment sales not yet sold to third party customers, net of start-up costs of the corporate-led shared manufacturing facility in Mexico not allocated to segments. Consolidated Operating Income (Loss) - Three Years Ended September 30, 2017 The following table presents operating income (loss) by business segment (in millions): Fiscal 2017 Compared to Fiscal 2016 Consolidated operating income increased 27.2% to $463.0 million, or 6.8% of sales, in fiscal 2017 compared to $364.0 million, or 5.8% of sales, in fiscal 2016. The increase in operating income in fiscal 2017 compared to fiscal 2016 was driven by higher gross margin associated with higher sales, improved performance in the fire & emergency and defense segments as well as lower start-up costs of the corporate-led shared manufacturing facility in Mexico, offset in part by lower performance in the commercial segment. In addition, consolidated operating income was adversely impacted by $43.3 million of restructuring-related charges in fiscal 2017 and by an asset impairment and workforce reduction charges of $27.8 million in fiscal 2016. Access equipment segment operating income decreased 1.6% to $259.1 million, or 8.6% of sales, in fiscal 2017 compared to $263.4 million, or 8.7% of sales, in fiscal 2016. Access equipment segment operating income was adversely impacted by $43.3 million of restructuring-related charges in fiscal 2017 and by an asset impairment and workforce reduction charges of $27.8 million in fiscal 2016. Improved absorption as a result of increased production (up $14 million) and favorable mix (up $13 million), were offset in part by increased incentive compensation on the higher earnings. Defense segment operating income increased 69.7% to $207.9 million, or 11.4% of sales, in fiscal 2017 compared to $122.5 million, or 9.1% of sales, in fiscal 2016. The increase in operating income was primarily the result of higher gross margin associated with higher sales volume (up $98 million), offset in part by higher selling, general and administrative costs (up $13 million), primarily related to incentive compensation on the higher earnings. In addition, in fiscal 2017, changes in estimates on contracts accounted for under the cost-to-cost method on prior year revenues increased defense segment operating income by $6.3 million. Fire & emergency segment operating income increased 55.5% to $104.2 million, or 10.1% of sales, in fiscal 2017 compared to $67.0 million, or 7.0% of sales, in fiscal 2016. The increase in operating income in fiscal 2017 compared to fiscal 2016 was primarily the result of improved pricing. Commercial segment operating income decreased 35.2% to $43.8 million, or 4.5% of sales, in fiscal 2017 compared to $67.6 million, or 6.9% of sales, in fiscal 2016. The decrease in operating income in fiscal 2017 compared to fiscal 2016 was primarily a result of lower gross margin associated with lower sales volume (down $9 million) and operational inefficiencies associated with variability in production volumes in fiscal 2017 (up $10 million). Corporate operating costs decreased $4.5 million to $152.0 million in fiscal 2017 compared to fiscal 2016. The decrease in corporate operating costs in fiscal 2017 compared to fiscal 2016 was primarily due to improved operating results related to the corporate-led shared manufacturing facility in Mexico which incurred higher start-up costs during fiscal 2016, offset in part by higher incentive compensation expense (up $8 million), higher corporate-funded research & development (up $3 million) and higher share-based compensation (up $3 million). Consolidated selling, general and administrative expenses increased 8.7% to $665.6 million, or 9.7% of sales, in fiscal 2017 compared to $612.4 million, or 9.7% of sales, in fiscal 2016. The increase in consolidated selling, general and administrative expenses in fiscal 2017 compared to fiscal 2016 was generally a result of higher incentive compensation expense and higher salaries. Fiscal 2016 Compared to Fiscal 2015 Consolidated operating income decreased 8.7% to $364.0 million, or 5.8% of sales, in fiscal 2016 compared to $398.6 million, or 6.5% of sales, in fiscal 2015. Consolidated operating income in fiscal 2016 was adversely impacted by an asset impairment charge of $26.9 million, or 0.4% of sales. Access equipment segment operating income decreased 35.3% to $263.4 million, or 8.7% of sales, in fiscal 2016 compared to $407.0 million, or 12.0% of sales, in fiscal 2015. The decrease in operating income was primarily the result of the lower gross income associated with lower sales volume (down $95 million), a challenging pricing environment (down $75 million), an asset impairment charge related to a decision to outsource aftermarket parts distribution ($27 million) and adverse manufacturing absorption (down $12 million) associated with lower production, offset in part by lower spending (down $43 million) on engine emissions standards changes and selling, general and administrative cost reductions ($7 million). Fiscal 2015 results also benefited from an $8 million vendor recovery settlement. Defense segment operating income increased 1,226.0% to $122.5 million, or 9.1% of sales, in fiscal 2016 compared to $9.2 million, or 1.0% of sales, in fiscal 2015. The increase in operating income was largely due to higher gross income associated with higher sales (up $51 million), favorable product mix (up $33 million), contractual price increases and lower Company funded research & development related to the JLTV program (down $12 million), offset in part by higher selling, general and administrative costs (up $13 million) to ramp up for the JLTV contract. Fire & emergency segment operating income increased 53.1% to $67.0 million, or 7.0% of sales, in fiscal 2016 compared to $43.8 million, or 5.4% of sales, in fiscal 2015. Higher gross income on increased sales volume was the largest contributor to the increase in operating income. Commercial segment operating income increased 4.8% to $67.6 million, or 6.9% of sales, in fiscal 2016 compared to $64.5 million, or 6.6% of sales, in fiscal 2015. The increase in operating income was primarily a result of favorable product mix (up $11 million), offset in part by production inefficiencies associated with the start-up of new products. Corporate operating costs increased $30.5 million to $156.5 million in fiscal 2016 compared to fiscal 2015. The increase in corporate operating costs in fiscal 2016 was primarily due to increased costs to support the start-up of the corporate-led shared manufacturing facility in Mexico (up $13 million) and higher incentive compensation expense. Consolidated selling, general and administrative expenses increased 4.3% to $612.4 million, or 9.7% of sales, in fiscal 2016 compared to $587.4 million, or 9.6% of sales, in fiscal 2015. The increase in consolidated selling, general and administrative expenses in fiscal 2016 compared to fiscal 2015 was generally a result of higher incentive compensation, offset in part by reductions in outside services and travel spending. Non-Operating Income (Expense) - Three Years Ended September 30, 2017 Fiscal 2017 Compared to Fiscal 2016 Interest expense net of interest income decreased $3.4 million to $54.9 million in fiscal 2017 compared to fiscal 2016 due to lower borrowing levels. Other miscellaneous income, net of $3.2 million in fiscal 2017 and $1.3 million in fiscal 2016 primarily related to net foreign currency transaction gains and losses and investment gains and losses. Fiscal 2016 Compared to Fiscal 2015 Interest expense net of interest income decreased $9.3 million to $58.3 million in fiscal 2016 compared to fiscal 2015. Fiscal 2015 interest expense included $14.7 million of debt extinguishment costs in connection with the refinancing of portions of the Company’s long-term debt during fiscal 2015. The full year benefit in fiscal 2016 of lower interest rates on the senior notes refinanced in the second quarter of fiscal 2015 was offset by increased borrowings to support increased working capital requirements throughout fiscal 2016. Other miscellaneous income of $1.3 million in fiscal 2016 and expense of $4.9 million in fiscal 2015 primarily related to net foreign currency transaction gains and losses. Provision for Income Taxes - Three Years Ended September 30, 2017 Fiscal 2017 Compared to Fiscal 2016 The Company recorded income tax expense of $127.2 million, or 30.9% of pre-tax income, in fiscal 2017 compared to $92.4 million, or 30.1% of pre-tax income, in fiscal 2016. See Note 18 of the Notes to Consolidated Financial Statements for a reconciliation of the effective tax rate compared to the U.S. statutory tax rate. Fiscal 2016 Compared to Fiscal 2015 The Company recorded income tax expense of $92.4 million, or 30.1% of pre-tax income, in fiscal 2016 compared to $99.2 million, or 30.4% of pre-tax income, in fiscal 2015. See Note 18 of the Notes to Consolidated Financial Statements for a reconciliation of the effective tax rate compared to the U.S. statutory tax rate. Equity in Earnings of Unconsolidated Affiliates - Three Years Ended September 30, 2017 Fiscal 2017 Compared to Fiscal 2016 Equity in earnings of unconsolidated affiliates of $1.5 million in fiscal 2017 and $1.8 million in fiscal 2016 primarily represented the Company's equity interest in a commercial entity in Mexico and a joint venture in Europe. Fiscal 2016 Compared to Fiscal 2015 Equity in earnings of unconsolidated affiliates of $1.8 million in fiscal 2016 and $2.6 million in fiscal 2015 primarily represented the Company's equity interest in a commercial entity in Mexico and a joint venture in Europe. Liquidity and Capital Resources The Company generates significant capital resources from operating activities, which is the expected primary source of funding for its operations. Other sources of liquidity are availability under the Revolving Credit Facility (as defined in “Liquidity”) and available cash and cash equivalents. At September 30, 2017, the Company had cash and cash equivalents of $447.0 million. In addition to cash and cash equivalents, the Company had $753.1 million of unused available capacity under the Revolving Credit Facility (as defined in “Liquidity”) as of September 30, 2017. Borrowings under the Revolving Credit Facility could, as discussed below, be limited by the financial covenants contained within the Credit Agreement (as defined in “Liquidity”). These sources of liquidity are needed to fund the Company's working capital requirements, debt service requirements, capital expenditures, dividends and share repurchases. At September 30, 2017, the Company had approximately 7.5 million shares of Common Stock remaining under a repurchase authorization approved by the Company's Board of Directors in August 2015. The Company expects to meet its fiscal 2018 U.S. funding needs without repatriating undistributed profits that are indefinitely reinvested outside the United States. The Company expects to generate approximately $450 million of cash flow from operations in fiscal 2018. The Company expects working capital utilized to support the international M-ATV contract will be converted to cash , but that working capital requirements associated with the JLTV contract will be greater in fiscal 2018 than in fiscal 2017. The Company expects fiscal 2018 capital spending to be approximately $100 million. This estimate does not include any capital associated with the potential construction of a new global headquarters building. If the Company proceeds with a new global headquarters building, the Company believes any related additional capital spending in fiscal 2018 would not have a significant impact on the Company's liquidity. The Company expects to have sufficient liquidity to finance its operations over the next twelve months. Financial Condition at September 30, 2017 The Company’s capitalization was as follows (in millions): The Company's ratio of debt to total capitalization of 26.5% at September 30, 2017 remained within its targeted range. Consolidated days sales outstanding (defined as “Trade Receivables” at quarter end divided by “Net Sales” for the most recent quarter multiplied by 90 days) were 56 days at September 30, 2017, up from 49 days at September 30, 2016. Days sales outstanding for segments other than the defense segment were 52 days at September 30, 2017, up slightly from 51 days at September 30, 2016. This increase in days sales outstanding was primarily due to higher receivables in the defense segment compared to the prior year driven by the longer collection cycle on international sales. Consolidated inventory turns (defined as “Cost of Sales” on an annualized basis, divided by the average “Inventory” at the past five quarter end periods) was 4.5 times at September 30, 2017, up from 4.1 times at September 30, 2016. The increase in inventory turns was largely due to lower average inventory levels in the access equipment segment during fiscal 2017. Operating Cash Flows Fiscal 2017 Compared to Fiscal 2016 The Company generated $246.5 million of cash from operating activities during fiscal 2017 compared to $583.9 million during fiscal 2016. The decrease in cash generated from operating activities in fiscal 2017 compared to fiscal 2016 was primarily due to a significant increase in accounts receivable in the defense segment in fiscal 2017 and increased inventory levels in the access equipment segment in fiscal 2017 compared to a significant reduction in inventory levels in fiscal 2016, offset in part by higher accounts payable as a result of higher inventory levels. Increased sales in the fourth quarter and the longer collection cycle on international sales drove higher accounts receivables (up $212.5 million) within the defense segment. The alignment of inventory with higher market demand drove the increase in inventories (up $143.3 million) in the access equipment segment. The access equipment segment reduced inventories significantly (down $305.8 million) in fiscal 2016 to better align inventory levels with lower market demand. Fiscal 2016 Compared to Fiscal 2015 The Company generated $583.9 million of cash from operating activities during fiscal 2016 compared to $91.4 million during fiscal 2015. The increase in cash generated from operating activities in fiscal 2016 compared to fiscal 2015 was primarily due to a significant reduction in inventory levels in the access equipment segment in fiscal 2016 and a significant build of inventories in the access equipment and defense segments in the prior year. The access equipment segment reduced inventories (down $305.8 million) in fiscal 2016 to better align inventory levels with lower market demand. In fiscal 2015, the access equipment segment experienced an increase in inventory (up $182.8 million) as a result of the combination of a plan to level-load production during the year to address seasonal fluctuations in demand and a subsequent reduction in access equipment third and fourth quarter sales compared to previous estimates as a result of the start of a mid-cycle dip in North American demand for access equipment related to lower oil & gas related demand and lower replacement demand as a result of lower purchases of access equipment by rental companies in 2009 and 2010. In fiscal 2015, defense inventory levels grew (up $134.0 million) to support new contracts, both domestic and international. The magnitude and duration of these contracts resulted in continued increased working capital requirements in the defense segment during fiscal 2016. Investing Cash Flows Fiscal 2017 Compared to Fiscal 2016 Net cash used in investing activities in fiscal 2017 was $65.2 million compared to $89.2 million in fiscal 2016. Additions to property, plant and equipment of $85.8 million in fiscal 2017 reflected a decrease in capital spending of $6.7 million compared to fiscal 2016. Fiscal 2016 Compared to Fiscal 2015 Net cash used in investing activities in fiscal 2016 was $89.2 million compared to $140.1 million in fiscal 2015. Additions to property, plant and equipment of $92.5 million in fiscal 2016 reflected a decrease in capital spending of $39.2 million compared to fiscal 2015. In fiscal 2015, the Company increased investments in property, plant and equipment to fund the Company's vertical integration strategy and global information systems replacement initiative. Financing Cash Flows Fiscal 2017 Compared to Fiscal 2016 Financing activities resulted in a net use of cash of $44.8 million in fiscal 2017 compared to $222.0 million in fiscal 2016. In 2016, the Company repurchased approximately 2.5 million shares of its Common Stock at an aggregate cost of $100.1 million under a repurchase authorization approved by the Company's Board of Directors in August 2015. The Company did not repurchase any Common Stock under the authorization during fiscal 2017. At September 30, 2017, the Company had approximately 7.5 million shares of Common Stock remaining under the repurchase authorization. The Company targets returning half of its free cash flows (defined as “cash flows from operations” less “additions to property, plant and equipment” less “additions to equipment held for rental” plus “proceeds from sale of equipment held for rental”) to shareholders over the course of the operating cycle. The Company plans to repurchase shares in fiscal 2018 sufficient to offset the dilution associated with its share-based compensation plans. In addition, the Company paid dividends of $62.8 million and $55.9 million in fiscal 2017 and 2016, respectively. The Company increased its quarterly dividend rate by approximately 14% in November 2017. Fiscal 2016 Compared to Fiscal 2015 Financing activities resulted in a net use of cash of $222.0 million in fiscal 2016 compared to $221.8 million in fiscal 2015. The Company utilized cash flow from operations to repay $63.5 million on its Revolving Credit Facility in fiscal 2016 as compared to borrowing $63.5 million on its Revolving Credit Facility in fiscal 2015 to fund operations. In fiscal 2016 and 2015, the Company repurchased approximately 2.5 million and 4.9 million shares of its Common Stock, respectively, under its share repurchase authorization at an aggregate cost of $100.1 million and $200.4 million, respectively. In addition, the Company paid dividends of $55.9 million and $53.1 million in fiscal 2016 and 2015, respectively. Liquidity Senior Secured Credit Agreement In March 2014, the Company entered into an Amended and Restated Credit Agreement with various lenders (the “Credit Agreement”). The Credit Agreement provides for (i) a revolving credit facility (Revolving Credit Facility) that matures in March 2019 with an initial maximum aggregate amount of availability of $600 million and (ii) a $400 million term loan due in quarterly principal installments of $5.0 million with a balloon payment of $310.0 million due at maturity in March 2019. In January 2015, the Company entered into an agreement with lenders under the Credit Agreement that increased the Revolving Credit Facility to an aggregate maximum amount of $850 million. Refer to Note 9 of the Notes to Consolidated Financial Statements for additional information regarding the Credit Agreement. The Company’s obligations under the Credit Agreement are guaranteed by certain of its domestic subsidiaries, and the Company will guarantee the obligations of certain of its subsidiaries under the Credit Agreement. Subject to certain exceptions, the Credit Agreement is collateralized by (i) a first-priority perfected lien and security interests in substantially all of the personal property of the Company, each material subsidiary of the Company and each subsidiary guarantor, (ii) mortgages upon certain real property of the Company and certain of its domestic subsidiaries and (iii) a pledge of the equity of each material subsidiary of the Company. Under the Credit Agreement, the Company must pay (i) an unused commitment fee ranging from 0.225% to 0.35% per annum of the average daily unused portion of the aggregate revolving credit commitments under the Credit Agreement and (ii) a fee ranging from 0.625% to 2.00% per annum of the maximum amount available to be drawn for each letter of credit issued and outstanding under the Credit Agreement. Borrowings under the Credit Agreement bear interest at a variable rate equal to (i) LIBOR plus a specified margin, which may be adjusted upward or downward depending on whether certain criteria are satisfied, or (ii) for dollar-denominated loans only, the base rate (which is the highest of (a) the administrative agent's prime rate, (b) the federal funds rate plus 0.50% or (c) the sum of 1% plus one-month LIBOR) plus a specified margin, which may be adjusted upward or downward depending on whether certain criteria are satisfied. Covenant Compliance The Credit Agreement contains various restrictions and covenants, including requirements that the Company maintain certain financial ratios at prescribed levels and restrictions, subject to certain exceptions, on the ability of the Company and certain of its subsidiaries to consolidate or merge, create liens, incur additional indebtedness, dispose of assets, consummate acquisitions and make investments in joint ventures and foreign subsidiaries. The Credit Agreement contains the following financial covenants: • Leverage Ratio: A maximum leverage ratio (defined as, with certain adjustments, the ratio of the Company’s consolidated indebtedness to consolidated net income before interest, taxes, depreciation, amortization, non-cash charges and certain other items (EBITDA)) as of the last day of any fiscal quarter of 4.50 to 1.00. • Interest Coverage Ratio: A minimum interest coverage ratio (defined as, with certain adjustments, the ratio of the Company’s consolidated EBITDA to the Company’s consolidated cash interest expense) as of the last day of any fiscal quarter of 2.50 to 1.00. • Senior Secured Leverage Ratio: A maximum senior secured leverage ratio (defined as, with certain adjustments, the ratio of the Company’s consolidated secured indebtedness to the Company’s consolidated EBITDA) of 3.00 to 1.00. With certain exceptions, the Company may elect to have the collateral pledged in connection with the Credit Agreement released during any period that the Company maintains an investment grade corporate family rating from either S&P Global Ratings or Moody’s Investor Service. During any such period when the collateral has been released, the Company’s leverage ratio as of the last day of any fiscal quarter must not be greater than 3.75 to 1.00, and the Company would not be subject to any additional requirement to limit its senior secured leverage ratio. The Company was in compliance with the financial covenants contained in the Credit Agreement as of September 30, 2017 and expects to be able to meet the financial covenants contained in the Credit Agreement over the next twelve months. Additionally, with certain exceptions, the Credit Agreement limits the ability of the Company to pay dividends and other distributions, including repurchases of shares of its Common Stock. However, so long as no event of default exists under the Credit Agreement or would result from such payment, the Company may pay dividends and other distributions after March 3, 2010 in an aggregate amount not exceeding the sum of: i. 50% of the consolidated net income of the Company and its subsidiaries (or if such consolidated net income is a deficit, minus 100% of such deficit), accrued on a cumulative basis during the period beginning on January 1, 2010 and ending on the last day of the fiscal quarter immediately preceding the date of the applicable proposed dividend or distribution; and ii. 100% of the aggregate net proceeds received by the Company subsequent to March 3, 2010 either as a contribution to its common equity capital or from the issuance and sale of its Common Stock. Senior Notes In February 2014, the Company issued $250.0 million of 5.375% unsecured senior notes due March 1, 2022 (the “2022 Senior Notes”). In March 2015, the Company issued $250.0 million of 5.375% unsecured senior notes due March 1, 2025 (the “2025 Senior Notes”). The net proceeds of both note issuances were used to repay existing outstanding notes of the Company. The Company has the option to redeem the 2022 Senior Notes and the 2025 Senior Notes for a premium after March 1, 2017 and March 1, 2020, respectively. The 2022 Senior Notes and the 2025 Senior Notes were issued pursuant to separate indentures (the “Indentures”) among the Company, the subsidiary guarantors named therein and a trustee. The Indentures contain customary affirmative and negative covenants. Certain of the Company’s subsidiaries jointly, severally, fully and unconditionally guarantee the Company’s obligations under the 2022 Senior Notes and 2025 Senior Notes. See Note 23 of the Notes to Consolidated Financial Statements for separate financial information of the subsidiary guarantors. Refer to Note 9 of the Notes to Consolidated Financial Statements for additional information regarding the Company’s outstanding debt as of September 30, 2017. Contractual Obligations, Commitments and Off-Balance Sheet Arrangements Following is a summary of the Company’s contractual obligations and payments due by period following September 30, 2017 (in millions): _________________________ (1) Interest was calculated based upon the interest rate in effect on September 30, 2017. (2) The amounts for purchase obligations included above represent all obligations to purchase goods or services under agreements that are enforceable and legally binding and that specify all significant terms. (3) Due to the uncertainty of the timing of settlement with taxing authorities, the Company is unable to make reasonably reliable estimates of the period of cash settlement of unrecognized tax benefits for the remaining uncertain tax liabilities. Therefore, $37.2 million of unrecognized tax benefits as of September 30, 2017 have been excluded from the Contractual Obligations table above. See Note 18 of the Notes to Consolidated Financial Statements for additional information regarding the Company’s unrecognized tax benefits as of September 30, 2017. (4) Represents other long-term liabilities on the Company's Consolidated Balance Sheet, including the current portion of these liabilities. The projected timing of cash flows associated with these obligations is based on management's estimates, which are based largely on historical experience. This amount also includes all liabilities under the Company's pension and other postretirement benefit plans. See Note 17 of the Notes to Consolidated Financial Statements for information regarding these liabilities and the plan assets available to satisfy them. The following is a summary of the Company’s commitments by period following September 30, 2017 (in millions): The Company incurs contingent limited recourse liabilities with respect to customer financing activities primarily in the access equipment segment. For additional information relative to guarantees, see Note 11 of the Notes to Consolidated Financial Statements. Fiscal 2018 Outlook The Company believes consolidated net sales will be $6.9 billion to $7.1 billion in fiscal 2018, an approximate 1% to 4% increase compared to fiscal 2017. The Company expects sales to grow in all non-defense segments and defense segment sales to be approximately flat compared to fiscal 2017. As a result of the expected increase in sales, anticipated improved operational performance in each of the non-defense segments and an expected adverse product mix in the defense segment, the Company expects consolidated operating income will be in the range of $510 million to $560 million, resulting in earnings per share of $4.20 to $4.60. The Company expects to incur approximately $5 million in pre-tax restructuring-related charges in fiscal 2018 in connection with plans announced in January 2017 to rationalize operations in the access equipment segment. Excluding expected access equipment segment restructuring-related charges, the Company expects adjusted consolidated operating income will be in the range of $515 million to $565 million, resulting in adjusted earnings per share of $4.25 to $4.65. Earnings per share assumes an average share count of 76 million shares, flat with fiscal 2017 as the Company expects to repurchase shares in fiscal 2018 sufficient to offset the dilution associated with the Company’s share-based compensation plans. The Company believes access equipment segment sales will be between $3.1 billion and $3.2 billion in fiscal 2018, an increase of 2% to 6% compared to fiscal 2017. The Company expects the increase in sales will primarily result from continued positive rental market conditions, with rental companies again exercising a disciplined approach to their rental fleet capital expenditures. The Company also expects this segment to benefit from price realization. The Company expects operating income margins in the access equipment segment in fiscal 2018 will be in the range of 10.3% to 10.8%. Excluding expected restructuring-related charges, the Company expects adjusted operating income margins in the access equipment segment in fiscal 2018 will be in the range of 10.5% to 11.0%. The anticipated improvement in operating income margins from fiscal 2017 reflects the expected price realization and anticipated savings associated with the restructuring actions initiated in fiscal 2017, offset in part by higher material costs. The Company expects defense segment sales will be between $1.8 billion and $1.85 billion in fiscal 2018, approximately flat with fiscal 2017 sales. The Company expects significantly lower international M-ATV volume as the Company finishes deliveries under the existing contract, offset by higher JLTV and FMTV sales. The Company expects defense segment operating income margins will be in the range of 9.5% to 9.75% in fiscal 2018, reflecting the operating margin impact of the shift in sales among the various programs. The Company expects fire & emergency segment sales will be approximately $1.1 billion in fiscal 2018, an increase of approximately 7% from fiscal 2017 sales, reflecting an expected small increase in the North American fire apparatus market. The Company expects it will need to increase production rates at Pierce slightly to accommodate the higher sales level. The Company expects operating income margins in the fire & emergency segment to increase to a range of 10.5% to 11.0% in fiscal 2018 driven by improved absorption on higher sales, a continued solid pricing environment and further operational efficiency gains. The Company estimates commercial segment sales will be between $950 million and $975 million in fiscal 2018. The Company expects the North American refuse collection vehicle market to be largely flat in fiscal 2018 compared to fiscal 2017. Despite aging fleets, the Company also does not expect an increase in the concrete mixer market from fiscal 2017, which remained 20% - 25% below pre-recession average levels. The Company expects operating income margins in this segment to be in the range of 5.75% to 6.25% as simplification initiatives that have either recently been launched, or that will be launched soon, are expected to improve margins. Additionally, the commercial segment is entering fiscal 2018 with a stronger backlog than fiscal 2017, which is expected to help reduce the impact of production variability that the segment experienced in fiscal 2017. The Company expects corporate expenses in fiscal 2018 will be approximately $150 million. The Company estimates its effective tax rate for fiscal 2018 will be down approximately 60 basis points to 30.3%. The effective tax rate in fiscal 2018 includes an estimate for share-based compensation tax benefits. Excluding the tax impact of the expected access equipment segment restructuring-related charges, the Company expects the adjusted tax rate for fiscal 2018 will be approximately 30.5%. The Company expects sales and operating income in the first quarter of fiscal 2018 to be higher than the first quarter of fiscal 2017, driven by higher defense segment sales related to the continued ramp up of the JLTV program and higher international M-ATV sales, as the Company ships the final units for that contract. With a backlog that is more than double the end of the prior year, the Company also expects higher sales in the access equipment segment in the first quarter of fiscal 2018 as compared to the first quarter of fiscal 2017. However, the Company expects that incremental margins in the access equipment segment in the first quarter of fiscal 2018 will be challenged as it deals with another quarter of higher material costs before the announced price increase takes effect at the beginning of the calendar year. Non-GAAP Financial Measures The Company is forecasting operating income, operating income margin and earnings per share excluding items that affect comparability. When the Company forecasts operating income, operating income margin and earnings per share, excluding items, these are considered non-GAAP financial measures. The Company believes excluding the impact of these items is useful to investors to allow a more accurate comparison of the Company's operating performance to prior year results. Non-GAAP financial measures should be viewed in addition to, and not as an alternative for, the Company's results prepared in accordance with GAAP. The table below presents a reconciliation of the Company's expected non-GAAP measures to the most directly comparable GAAP measures: Critical Accounting Policies The Company’s significant accounting policies are described in Note 2 of the Notes to Consolidated Financial Statements. The Company considers the following policy to be the most critical in understanding the judgments that are involved in the preparation of the Company’s consolidated financial statements and the uncertainties that could impact the Company’s financial condition, results of operations and cash flows. Revenue Recognition. The Company recognizes revenue on equipment and parts sales when contract terms are met, collectability is reasonably assured and a product is shipped or risk of ownership has been transferred to and accepted by the customer. Revenue from service agreements is recognized as earned, when services have been rendered. Appropriate provisions are made for discounts, returns and sales allowances. Sales are recorded net of amounts invoiced for taxes imposed on the customer such as excise or value-added taxes. Sales to the U.S. government of non-commercial products manufactured to the government’s specifications are recognized under percentage-of-completion accounting using either the units-of-delivery method or cost-to-cost method to measure contract performance. Under the units-of-delivery method, the Company records sales as units are accepted by the DoD generally based on unit sales values stated in the respective contracts. Costs of sales are based on actual costs incurred to produce the units delivered under the contract. Under the cost-to-cost method, sales, including estimated margins, are recognized as contract costs are incurred. The measurement method selected is generally determined based on the nature of the contract. The Company includes amounts representing contract change orders, claims or other items in sales only when they can be reliably estimated and realization is probable. The Company has significant experience in contracting and producing vehicles for the defense industry, which has resulted in a history of making reasonable estimates of revenues and costs when measuring progress toward contract completion. The Company charges anticipated losses on contracts or programs in progress to earnings when identified. Approximately 16% of the Company’s revenues for fiscal 2017 were recognized under the percentage-of-completion accounting method. Critical Accounting Estimates “Management’s Discussion and Analysis of Financial Condition and Results of Operations” is based on the Company's Consolidated Financial Statements, which have been prepared in accordance with generally accepted accounting principles in the United States of America (U.S. GAAP). The preparation of financial statements in accordance with U.S. GAAP requires management to make estimates and judgments that affect reported amounts and related disclosures. On an ongoing basis, management evaluates and updates its estimates. Management employs judgment in making its estimates but they are based on historical experience and currently available information and various other assumptions that the Company believes to be reasonable under the circumstances. The results of these estimates form the basis for making judgments about the carrying values of assets and liabilities that are not readily available from other sources. Actual results could differ from those estimates. Management believes that its judgment is applied consistently and produces financial information that fairly depicts the results of operations for all periods presented. Percentage-of-Completion Accounting. The percentage-of-completion accounting method is used to account for long-term contracts that involve the design, development, manufacture, or modification of complex equipment to a buyer's specification. Contracts accounted for under this method generally are long-term in nature and may involve related services. Revenue is recognized on these types of contracts based on the extent of progress toward completion of the overall contract. The determination of the method to measure progress toward completion of a contract requires judgment, which is generally dependent on the nature of the Company's obligations under the contract. Under the units-of-delivery measure of progress, the extent of progress on a contract is measured as units are accepted by the DoD generally based on unit sales values stated in the respective contracts. Costs of sales are based on actual costs incurred to produce the units delivered under the contract. Under the cost-to-cost measure of progress, the extent of progress toward completion is measured based on the ratio of costs incurred to date to the total estimated costs at the completion of the contract. Revenues, including margins, are recorded as costs are incurred. The revenue and cost estimates used under the cost-to-cost measurement method are complex and involve significant judgment. The Company has implemented a rigorous Estimate at Completion (EAC) process that requires management to perform a detailed evaluation of contract progress and performance on at least a quarterly basis. During this process all key inputs and variables that may impact contract performance are analyzed and the EAC is updated for any changes. Adjustments to revenue, costs and operating income resulting from this process are recorded in the period they become known. Inventories. Inventories are stated at the lower of cost or market (LCM) value. In valuing inventory, the Company is required to make assumptions regarding the level of reserves required to value potentially obsolete or over-valued items. These assumptions require the Company to analyze the aging of and forecasted demand for its inventory, forecast future product sales prices, pricing trends and margins, and to make judgments and estimates regarding obsolete or excess inventory. Future product sales prices, pricing trends and margins are based on the best available information at that time including actual orders received, negotiations with customers for future orders, including their plans for expenditures, and market trends for similar products. The Company's judgments and estimates for excess or obsolete inventory are based on analysis of actual and forecasted usage. The valuation of used equipment taken in trade from customers requires the Company to use the best information available to determine the value of the equipment to potential customers. This value is subject to change based on numerous conditions. Inventory reserves are established taking into account age, frequency of use, or sale, and in the case of repair parts, the installed base of machines. While calculations are made involving these factors, significant management judgment regarding expectations for future events is involved. Future events that could significantly influence the Company's judgment and related estimates include general economic conditions in markets where the Company's products are sold, new equipment price fluctuations, actions of the Company's competitors, including the introduction of new products and technological advances. The Company makes adjustments to its inventory reserves based on the identification of specific situations and increases its inventory reserves accordingly. At September 30, 2017, inventory had been reduced by $85.2 million as a result of LCM valuation and reserves for excess and obsolescence. Impairment of Goodwill and Indefinite-Lived Intangible Assets. Goodwill and indefinite-lived intangible assets are tested for impairment annually, or more frequently if events or changes in circumstances indicate that the assets might be impaired. Such circumstances include a significant adverse change in the business climate for one of the Company's reporting units, a material negative change in relationships with significant customers, or strategic decisions made in response to economic and competitive conditions. The Company performs its annual review at the beginning of the fourth quarter of each fiscal year. The Company evaluates the recoverability of goodwill by estimating the fair value of the businesses to which the goodwill relates. A reporting unit is an operating segment or, under certain circumstances, a component of an operating segment that constitutes a business. When the fair value of the reporting unit is less than the carrying value of the reporting unit, a further analysis is performed to measure and recognize the amount of the impairment loss, if any. Impairment losses, limited to the carrying value of goodwill, represent the excess of the carrying amount of a reporting unit’s goodwill over the implied fair value of that goodwill. In evaluating the recoverability of goodwill, it is necessary to estimate the fair value of the reporting units. The estimate of the fair value of the reporting units is generally determined on the basis of discounted future cash flows and a market approach. In estimating the fair value, management must make assumptions and projections regarding such items as the Company performance and profitability under existing contracts, its success in securing future business, the appropriate risk-adjusted interest rate used to discount the projected cash flows, and terminal value growth and earnings rates. The assumptions used in the estimate of fair value are generally consistent with the past performance of each reporting unit and are also consistent with the projections and assumptions that are used in current operating plans. Such assumptions are subject to change as a result of changing economic and competitive conditions. The rate used to discount estimated cash flows is a rate corresponding to the Company’s cost of capital, adjusted for risk where appropriate, and is dependent upon interest rates at a point in time. To assess the reasonableness of the discounted projected cash flows, the Company compares the sum of its reporting units' fair value to the Company's market capitalization and calculates an implied control premium (the excess of the sum of the reporting units' fair values over the market capitalization). The reasonableness of this control premium is evaluated by comparing it to control premiums for recent comparable market transactions. Consistent with prior years, the Company weighted the income approach more heavily (75%) as the Company believes the income approach more accurately considers long-term fluctuations in the U.S. and European construction markets than the market approach. There are inherent uncertainties related to these factors and management’s judgment in applying them to the analysis of goodwill impairment. It is possible that assumptions underlying the impairment analysis will change in such a manner to cause further impairment of goodwill, which could have a material impact on the Company’s results of operations. The Company completed the required goodwill impairment test as of July 1, 2017. The Company identified no indicators of goodwill impairment in the test performed as of July 1, 2017. In order to evaluate the sensitivity of any quantitative fair value calculations on the goodwill impairment test, a hypothetical 10% decrease to the fair values of any reporting unit was calculated. This hypothetical 10% decrease would still result in excess fair value over carrying value for the reporting units as of July 1, 2017. The Company evaluates the recoverability of indefinite-lived trade names based upon a “relief from royalty” method. This methodology determines the fair value of each trade name through use of a discounted cash flow model that incorporates an estimated “royalty rate” the Company would be able to charge a third party for the use of the particular trade name. In determining the estimated future cash flows, the Company considers projected future sales, a fair market royalty rate for each applicable trade name and an appropriate discount rate to measure the present value of the anticipated cash flows. At July 1, 2017, approximately 89% of the Company’s recorded goodwill and indefinite-lived purchased intangibles were concentrated within the JLG reporting unit in the access equipment segment. Assumptions utilized in the impairment analysis are highly judgmental. While the Company currently believes that an impairment of intangible assets at JLG is unlikely, events and conditions that could result in the impairment of intangibles at JLG include a sharp decline in economic conditions, significantly increased pricing pressure on JLG's margins or other factors leading to reductions in expected long-term sales or profitability at JLG. Guarantees of the Indebtedness of Others. The Company enters into agreements with finance companies whereby the Company will guarantee the indebtedness of third-party end-users to whom the finance company lends to purchase the Company’s equipment. In some instances, the Company retains an obligation to the finance companies in the event the customer defaults on the financing. In accordance with Financial Accounting Standards Board (FASB) Accounting Standards Codification (ASC) Topic 460, Guarantees, the Company recognizes the greater of the fair value of the guarantee or the contingent liability required by FASB ASC Topic 450, Contingencies. The Company is party to multiple agreements under which at September 30, 2017 it guaranteed an aggregate of $568.2 million in indebtedness of customers. The Company estimated that its maximum loss exposure under these contracts at September 30, 2017 was $101.9 million. Reserves are initially established related to these guarantees at the fair value of the guarantee based upon the Company’s understanding of the current financial position of the underlying customer/borrower and based on estimates and judgments made from information available at that time in accordance with FASB ASC Topic 460, Guarantees. If the Company becomes aware of deterioration in the financial condition of the customer/borrower or of any impairment of the customer/borrower’s ability to make payments, additional allowances are considered as required by FASB ASC Topic 450, Contingencies. Although the Company may be liable for the entire amount of a customer/borrower’s financial obligation under guarantees, its losses would generally be mitigated by the value of any underlying collateral including financed equipment, the finance company’s inability to provide clear title of foreclosed equipment to the Company, loss pools established in accordance with the agreements and other conditions. During periods of economic downturn, the value of the underlying collateral supporting these guarantees can decline sharply to further increase losses in the event of a customer/borrower’s default. Reserves for guarantees of the indebtedness of others under these contracts was $9.1 million at September 30, 2017. If the financial condition of the Company’s customer/borrower’s were to deteriorate resulting in an impairment of their ability to make payments, additional reserves would be required. Product Liability. Due to the nature of the Company’s products, the Company is subject to product liability claims in the normal course of business. A substantial portion of these claims and lawsuits involve the Company’s access equipment, concrete placement and refuse collection vehicle businesses, while such lawsuits in the Company’s defense and fire & emergency businesses have historically been limited. To the extent permitted under applicable law, the Company maintains insurance to reduce or eliminate risk to the Company. Most insurance coverage includes self-insured retentions that vary by business segment and by year. As of September 30, 2017, the Company was generally self-insured for future claims up to $5.0 million per claim. The Company establishes product liability reserves for its self-insured retention portion of any known outstanding matters based on the likelihood of loss and the Company’s ability to reasonably estimate such loss. There is inherent uncertainty as to the eventual resolution of unsettled matters due to the unpredictable nature of litigation. The Company makes estimates based on available information and the Company’s best judgment after consultation with appropriate experts. The Company periodically revises estimates based upon changes to facts or circumstances. The Company also utilizes actuarial methodologies to calculate reserves required for estimated incurred but not reported claims as well as to estimate the effect of the adverse development of claims over time. At September 30, 2017, the estimated net liabilities for product and general liability claims totaled $39.1 million. New Accounting Standards Refer to Note 2 of the Notes to Consolidated Financial Statements for a discussion of the impact of new accounting standards on the Company’s consolidated financial statements. Customers and Backlog Sales to the U.S. government comprised approximately 20% of the Company’s net sales in fiscal 2017. No other single customer accounted for more than 10% of the Company’s net sales for this period. A substantial majority of the Company’s net sales are derived from the fulfillment of customer orders that are received prior to commencing production. The Company’s backlog as of September 30, 2017 increased 7.2% to $3.79 billion compared to $3.54 billion at September 30, 2016 due largely to strong order volumes in the non-defense segments. Access equipment segment backlog increased 152.2% to $452.2 million at September 30, 2017 compared to $179.3 million at September 30, 2016 primarily due to improved market conditions in North America and Europe. Defense segment backlog decreased 10.6% to $2.09 billion at September 30, 2017 compared to $2.33 billion at September 30, 2016 primarily due to the fulfillment of a large international contract for the delivery of M-ATVs. Fire & emergency segment backlog increased 9.2% to $931.6 million at September 30, 2017 compared to $852.9 million at September 30, 2016 due largely to favorable custom chassis mix and a higher mix of aerial orders. Commercial segment backlog increased 85.2% to $321.0 million at September 30, 2017 compared to $173.3 million at September 30, 2016. Unit backlog for concrete mixers as of September 30, 2017 was up 61.8% due to a lower production rate for concrete mixers as a result of a shift to increase refuse collection vehicle production. Unit backlog for refuse collection vehicles as of September 30, 2017 was up 103.5%, compared to September 30, 2016 due to improved market conditions. Reported backlog excludes purchase options and announced orders for which definitive contracts have not been executed. Backlog information and comparisons thereof as of different dates may not be accurate indicators of future sales or the ratio of the Company’s future sales to the DoD versus its sales to other customers. Approximately12% of the Company’s September 30, 2017 backlog is not expected to be filled in fiscal 2018. Financial Market Risk The Company is exposed to market risk from changes in interest rates, certain commodity prices and foreign currency exchange rates. To reduce the risk from changes in foreign currency exchange and interest rates, the Company selectively uses financial instruments. All hedging transactions are authorized and executed pursuant to clearly defined policies and procedures, which strictly prohibit the use of financial instruments for speculative purposes. Interest Rate Risk. The Company’s earnings exposure related to adverse movements in interest rates is primarily derived from outstanding floating rate debt instruments that are indexed to short-term market interest rates. In this regard, changes in U.S. and off-shore interest rates affect interest payable on the Company’s borrowings under its Credit Agreement. Based on debt outstanding at September 30, 2017, a 100 basis point increase or decrease in the average cost of the Company’s variable rate debt would increase or decrease annual pre-tax interest expense by approximately $3.5 million. The table below provides information about the Company’s debt obligations, which are sensitive to changes in interest rates (dollars in millions): The table presents principal cash flows and related weighted-average interest rates by expected maturity dates. Weighted-average variable rates are based on implied forward rates in the yield curve at the reporting date. Commodity Price Risk. The Company is a purchaser of certain commodities, including steel, aluminum and composites. In addition, the Company is a purchaser of components and parts containing various commodities, including steel, aluminum, rubber and others which are integrated into the Company’s end products. The Company generally buys these commodities and components based upon market prices that are established with the vendor as part of the purchase process. The Company does not use commodity financial instruments to hedge commodity prices. The Company generally obtains firm quotations from its significant components suppliers for its orders under firm, fixed-price contracts in its defense segment. In the Company’s access equipment, fire & emergency and commercial segments, the Company generally attempts to obtain firm pricing from most of its suppliers, consistent with backlog requirements and/or forecasted annual sales. To the extent that commodity prices increase and the Company does not have firm pricing from its suppliers, or its suppliers are not able to honor such prices, then the Company may experience margin declines to the extent it is not able to increase selling prices of its products. Foreign Currency Risk. The Company’s operations consist of manufacturing in the U.S., Mexico, Canada, Belgium, France, Australia, Romania, the United Kingdom and China and sales and limited vehicle body mounting activities on five continents. International sales comprised approximately 25% of overall net sales in fiscal 2017, of which approximately 73% involved exports from the U.S. The majority of export sales in fiscal 2017 were denominated in U.S. dollars. As a result of the manufacture and sale of the Company’s products in foreign markets, the Company’s earnings are affected by fluctuations in the value of foreign currencies in which certain of the Company’s transactions are denominated as compared to the value of the U.S. dollar. The Company’s operating results are principally exposed to changes in exchange rates between the U.S. dollar and the European currencies, primarily the Euro and the U.K. pound sterling, changes between the U.S. dollar and the Australian dollar, changes between the U.S. dollar and the Brazilian real, changes between the U.S. dollar and the Mexican peso and changes between the U.S. dollar and the Chinese renminbi. The Company enters into certain forward foreign currency exchange contracts to mitigate the Company’s foreign currency exchange risk on monetary assets or liabilities. These contracts qualify as derivative instruments under FASB ASC Topic 815, Derivatives and Hedging; however, the Company has not designated all of these instruments as hedge transactions under ASC Topic 815. Accordingly, the mark-to-market impact of these derivatives is recorded each period to current earnings along with the offsetting foreign currency transaction gain/loss recognized on the related balance sheet exposure. At September 30, 2017, the Company was managing $87.2 million (notional) of foreign currency contracts, including $79.3 million (notional) which were not designated as accounting hedges. All outstanding foreign currency contracts as of September 30, 2017 will settle within 365 days. The following table quantifies outstanding forward foreign exchange contracts intended to hedge non-U.S. dollar denominated cash, receivables and payables and the corresponding U.S. dollar impact on the value of these instruments assuming a 10% appreciation/depreciation of the sell currency at September 30, 2017 (dollars in millions): As previously noted, the Company’s policy prohibits the trading of financial instruments for speculative purposes or the use of leveraged instruments. It is important to note that gains and losses indicated in the sensitivity analysis would be offset by gains and losses on the underlying receivables and payables.

<s>[INST] General The Company is a leading designer, manufacturer and marketer of a wide range of specialty vehicles and vehicle bodies, including access equipment, defense trucks and trailers, fire & emergency vehicles, concrete mixers and refuse collection vehicles. The Company is a leading global manufacturer of aerial work platforms under the “JLG” brand name. The Company is among the worldwide leaders in the manufacturing of telehandlers under the “JLG” and “SkyTrak” brand names. Under the “JerrDan” brand name, the Company is a leading domestic manufacturer and marketer of towing and recovery equipment. The Company manufactures defense trucks under the “Oshkosh” brand name and is a leading manufacturer of severeduty, tactical wheeled vehicles for the DoD. Under the “Pierce” brand name, the Company is among the leading global manufacturers of fire trucks assembled on both custom and commercial chassis. Under the “Frontline” brand name, the Company is a leading domestic manufacturer and marketer of broadcast vehicles. The Company manufactures aircraft rescue and firefighting and airport snow removal vehicles under the “Oshkosh” brand name. Under the “McNeilus,” “Oshkosh,” “London” and “CONECO” brand names, the Company manufactures rear and frontdischarge concrete mixers and portable and stationary concrete batch plants. Under the “McNeilus” brand name, the Company manufactures a wide range of automated, rear, front, side and top loading refuse collection vehicles. Under the “IMT” brand name, the Company is a leading domestic manufacturer of field service vehicles and truckmounted cranes. Major products manufactured and marketed by each of the Company’s business segments are as follows: Access equipment aerial work platforms and telehandlers used in a wide variety of construction, industrial, institutional and general maintenance applications to position workers and materials at elevated heights, as well as carriers and wreckers. Access equipment customers include equipment rental companies, construction contractors, manufacturing companies, home improvement centers and towing companies in the U.S. and abroad. Defense tactical trucks, trailers and supply parts and services sold to the U.S. military and to other militaries around the world. Fire & emergency custom and commercial firefighting vehicles and equipment, ARFF vehicles, snow removal vehicles, simulators and other emergency vehicles primarily sold to fire departments, airports and other governmental units, and broadcast vehicles sold to broadcasters and TV stations in the U.S. and abroad. Commercial concrete mixers, refuse collection vehicles, portable and stationary concrete batch plants and vehicle components sold to readymix companies and commercial and municipal waste haulers in the Americas and other international markets and field service vehicles and truckmounted cranes sold to mining, construction and other companies in the U.S. and abroad. All estimates referred to in this “Management’s Discussion and Analysis of Financial Condition and Results of Operations” refer to the Company’s estimates as of November 21, 2017. Executive Overview The Company delivered strong financial results in fiscal 2017, the Company's 100th year in business. Consolidated net sales increased $550.4 million, or 8.8%, to $6.83 billion, consolidated operating income increased $99.0 million, or 27.2%, to $463.0 million, and diluted earnings per share increased $0.86 per share, or 29.6%, to $3.77 per share. The significant improvement in fiscal 2017 results was achieved in spite of incurring $0.25 per share higher restructuringrelated and asset impairment charges than in fiscal 2016. Fiscal 2017 results were negatively impacted by $0.48 per share of restructuringrelated charges. Fiscal 2016 results were negatively impacted by $0.23 per share related to asset impairment and workforce reduction charges. The Company also announced an increase in its quarterly dividend rate of approximately 14%, to $0.24 per share beginning in November 2017. This was the Company's fourth straight year of double digit percentage increases in its dividend rate. The $550. [/INST] Negative. </s>

OSHKOSH CORP

2018-11-20

2018-09-30

ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS General The Company is a leading designer, manufacturer and marketer of a wide range of specialty vehicles and vehicle bodies, including access equipment, defense trucks and trailers, fire & emergency vehicles, concrete mixers and refuse collection vehicles. The Company is a leading global designer and manufacturer of aerial work platforms under the “JLG” brand name. The Company is among the worldwide leaders in the design and manufacturing of telehandlers under the “JLG” and “SkyTrak” brand names. Under the “Jerr-Dan” brand name, the Company is a leading domestic designer and manufacturer and marketer of towing and recovery equipment. The Company manufactures defense trucks under the “Oshkosh” brand name and is a leading designer and manufacturer of severe-duty, tactical wheeled vehicles for the DoD. Under the “Pierce” brand name, the Company is among the leading global designers and manufacturers of fire trucks assembled on both custom and commercial chassis. Under the “Frontline” brand name, the Company is a leading domestic designer, manufacturer and marketer of broadcast vehicles. The Company designs and manufactures aircraft rescue and firefighting and airport snow removal vehicles under the “Oshkosh” brand name. Under the “McNeilus,” “Oshkosh,” “London” and “CON-E-CO” brand names, the Company designs and manufactures rear- and front-discharge concrete mixers and portable and stationary concrete batch plants. Under the “McNeilus” brand name, the Company designs and manufactures a wide range of automated, rear, front, side and top loading refuse collection vehicles. Under the “IMT” brand name, the Company is a leading domestic designer and manufacturer of field service vehicles and truck-mounted cranes. Major products manufactured and marketed by each of the Company’s business segments are as follows: Access equipment - aerial work platforms and telehandlers used in a wide variety of construction, industrial, institutional and general maintenance applications to position workers and materials at elevated heights, as well as carriers and wreckers. Access equipment customers include equipment rental companies, construction contractors, manufacturing companies, home improvement centers and towing companies in the U.S. and abroad. Defense - tactical trucks, trailers and supply parts and services sold to the U.S. military and to other militaries around the world. Fire & emergency - custom and commercial firefighting vehicles and equipment, ARFF vehicles, snow removal vehicles, simulators and other emergency vehicles primarily sold to fire departments, airports and other governmental units, and broadcast vehicles sold to broadcasters and TV stations in the U.S. and abroad. Commercial - concrete mixers, refuse collection vehicles, portable and stationary concrete batch plants and vehicle components sold to ready-mix companies and commercial and municipal waste haulers in the Americas and other international markets and field service vehicles and truck-mounted cranes sold to mining, construction and other companies in the U.S. and abroad. All estimates referred to in this “Management’s Discussion and Analysis of Financial Condition and Results of Operations” refer to the Company’s estimates as of November 20, 2018. Executive Overview The Company achieved another year of significantly improved earnings growth in fiscal 2018. Consolidated net sales increased $875.9 million, or 12.8%, to $7.71 billion, consolidated operating income increased $190.5 million, or 41.1%, to $653.5 million, and diluted earnings per share increased $2.52 per share, or 66.8%, to $6.29 per share. This was the second consecutive year that the Company increased operating income by more than 25%. All segments reported higher sales and operating income in fiscal 2018 compared to fiscal 2017. The lower U.S. federal income tax rate benefited fiscal 2018 results by $0.86 per share compared to the prior year. Share repurchases completed during the past year also benefited earnings per share by $0.12 compared to fiscal 2017. Fiscal 2018 results included after-tax charges of $27.5 million, or $0.37 per share, for costs and inefficiencies associated with restructuring actions in the access equipment and commercial segments, after-tax charges of $7.7 million, or $0.10 per share, of debt extinguishment costs incurred in connection with the refinancing of the Company’s senior notes and credit agreement and an after-tax loss of $1.0 million, or $0.01 per share, on the sale of a small product line in the commercial segment. Fiscal 2018 also included after-tax gains of $15.4 million, or $0.21 per share, related to a litigation settlement in the defense segment, $10.7 million, or $0.13 per share, related to the implementation of tax reform in the United States and an after-tax gain of $4.9 million, or $0.07 per share, related to the receipt of business interruption insurance proceeds in the commercial segment. In the aggregate, these items accounted for a net $5.2 million, or $0.07 per share, charge. Fiscal 2017 results included after-tax charges of $36.2 million, or $0.48 per share, for restructuring-related actions in the access equipment segment. The $875.9 million sales increase was driven by strong demand for access equipment. Orders for access equipment were up nearly 30% in fiscal 2018 as compared to fiscal 2017 reflecting a strong rental market for access equipment in North America and most regions around the globe. Consolidated operating income increased to $653.5 million, or 8.5% of sales, in fiscal 2018 compared to $463.0 million, or 6.8% of sales, in fiscal 2017. The increase in operating income was driven by higher gross margin associated with higher consolidated sales, improved pricing and a litigation settlement in the defense segment, offset in part by higher material and freight costs and unfavorable foreign exchange rates. Similar to many industrial companies, the Company is working through challenges as a result of the strong economy in the United States and current trade policies. Labor markets are tight, commodity and logistics costs have increased significantly and rapidly, and higher production levels are causing a strain on the Company’s supply chain. These challenges are especially apparent in the access equipment segment, which has ramped up production to meet significantly higher demand for its products. Trade policies have resulted in higher commodity costs, and as a result, the Company is paying significantly more for its raw materials compared to a year ago. During fiscal 2018, the Company implemented surcharges in its non-defense segments to address the dramatic cost increases it was experiencing. Approximately 74% of the Company’s fiscal 2019 first quarter non-defense backlog does not have a surcharge associated with it as the orders were placed prior to the implementation of the surcharge or the orders were placed for products produced outside of the United States. The Company continued to execute its disciplined capital allocation strategy in fiscal 2018. The Company refinanced its credit agreement, lowering the interest rate and extending the term of the credit agreement to April 2023. In addition, the Company replaced its 5.375% interest rate unsecured senior notes due in March 2022 with $300 million of new senior unsecured notes due in May 2028 at a 4.6% interest rate. The Company also returned more than $320 million of cash to shareholders through the repurchase of nearly 3.3 million shares of stock and payment of quarterly dividends. In addition, the Company announced an increase in its quarterly dividend rate of 12.5%, to $0.27, per share beginning in November 2018. This was the Company’s fifth straight year of a double digit percentage increase in its dividend rate. The Company believes fiscal 2019 consolidated net sales will be $7.85 billion to $8.15 billion, an approximate 2% to 6% increase compared to fiscal 2018. The Company expects fiscal 2019 consolidated operating income will be in the range of $640 million to $710 million, resulting in earnings per share of $6.50 to $7.25. Results of Operations Consolidated Net Sales - Three Years Ended September 30, 2018 The following table presents net sales (see definition of net sales contained in Note 2 of the Notes to Consolidated Financial Statements) by business segment (in millions): The following table presents net sales by geographic region based on product shipment destination (in millions): Fiscal 2018 Compared to Fiscal 2017 Consolidated net sales increased $875.9 million, or 12.8%, to $7.71 billion in fiscal 2018 compared to fiscal 2017 driven by strong demand for access equipment. All segments reported an increase in sales in fiscal 2018 compared to fiscal 2017. Access equipment segment net sales increased $750.4 million, or 24.8%, to $3.78 billion in fiscal 2018 compared to fiscal 2017. The increase in sales was driven by improved demand for aerial work platforms and telehandlers in both North America and Europe. A weaker U.S. dollar benefited sales in the access equipment segment in fiscal 2018 by $34 million compared to fiscal 2017. Defense segment net sales increased $8.8 million, or 0.5%, to $1.83 billion in fiscal 2018 compared to fiscal 2017. The increase in sales was primarily due to the continued ramp-up of production under the JLTV program and higher FMTV sales, offset in part by lower international M-ATV sales. Fire & emergency segment net sales increased $38.8 million, or 3.8%, to $1.07 billion in fiscal 2018 compared to fiscal 2017 primarily due to improved pricing ($31 million). Commercial segment net sales increased $84.4 million, or 8.7%, to $1,054.7 million in fiscal 2018 compared to fiscal 2017. The increase in sales was primarily due to higher refuse collection vehicle unit volume due to the atypical timing of orders in the prior year and higher concrete placement volume. Fiscal 2017 Compared to Fiscal 2016 Consolidated net sales increased $550.4 million, or 8.8%, to $6.83 billion in fiscal 2017 compared to fiscal 2016. The increase in sales was primarily the result of higher sales volumes in the defense segment and improved fire & emergency segment sales. Access equipment segment net sales increased $14.0 million, or 0.5%, to $3.03 billion in fiscal 2017 compared to fiscal 2016. Rental rates, fleet utilization percentages and used equipment values, all key to the access equipment segments rental company customers, strengthened over the past year, leading to stronger demand for access equipment than the Company expected during fiscal 2017. Defense segment net sales increased $469.0 million, or 34.7%, to $1.82 billion in fiscal 2017 compared to fiscal 2016. The increase in sales was primarily due to the ramp-up of production under the JLTV program, higher international sales of M-ATVs and higher sales of FHTVs to the U.S. government. During fiscal 2016, production of FHTVs was low as it was ramping back up after a break in production in fiscal 2015. Fire & emergency segment net sales increased $77.6 million, or 8.1%, to $1.03 billion in fiscal 2017 compared to fiscal 2016. The increase in sales was primarily due to improved pricing ($34 million), the sale of higher content units ($29 million) and the timing of fire apparatus deliveries as a result of increased production rates ($11 million). Commercial segment net sales decreased $8.9 million, or 0.9%, to $970.3 million in fiscal 2017 compared to fiscal 2016. The decrease in sales was primarily due to lower refuse collection vehicle unit volume ($53 million) due to the atypical timing of orders, offset in part by sales of higher content units ($21 million) and higher concrete mixer unit volume ($23 million). Consolidated Cost of Sales - Three Years Ended September 30, 2018 The following table presents costs of sales by business segment (in millions): Fiscal 2018 Compared to Fiscal 2017 Consolidated cost of sales was $6.35 billion, or 82.4% of sales, in fiscal 2018 compared to $5.66 billion, or 82.8% of sales, in fiscal 2017. The 40 basis point decrease in cost of sales as a percentage of sales in fiscal 2018 compared to fiscal 2017 was primarily due to improved pricing (80 basis points) and lower restructuring-related costs and inefficiencies (30 basis points), offset in part by higher material and freight costs (80 basis points). Access equipment segment cost of sales was $3.11 billion, or 82.3% of sales, in fiscal 2018 compared to $2.47 billion, or 81.7% of sales, in fiscal 2017. The 60 basis point increase in cost of sales as a percentage of sales in fiscal 2018 compared to fiscal 2017 was largely due to higher material and freight costs (130 basis points), the impact of unfavorable foreign currency rates (50 basis points) and challenges associated with the ramp-up of production (30 basis points), offset in part by improved pricing (80 basis points) and lower restructuring-related costs and inefficiencies (60 basis points). Defense segment cost of sales was $1.53 billion, or 83.6% of sales, in fiscal 2018 compared to $1.52 billion, or 83.4% of sales, in fiscal 2017. The 20 basis point increase in cost of sales as a percentage of sales in fiscal 2018 compared to fiscal 2017 was primarily attributable to adverse product mix (210 basis points) offset in part by improved manufacturing efficiencies (180 basis points). Fire & emergency segment cost of sales was $844.4 million, or 78.9% of sales, in fiscal 2018 compared to $849.2 million, or 82.4% of sales, in fiscal 2017. The 350 basis point decline in cost of sales as a percentage of sales in fiscal 2018 compared to fiscal 2017 was largely attributable to improved pricing (220 basis points), improved product mix (140 basis points) and improved manufacturing efficiencies (60 basis points), offset in part by higher material costs (90 basis points). Commercial segment cost of sales was $886.7 million, or 84.1% of sales, in fiscal 2018 compared to $827.2 million, or 85.3% of sales, in fiscal 2017. The 120 basis point decrease in cost of sales as a percentage of sales in fiscal 2018 compared to fiscal 2017 was largely due to favorable product mix (80 basis points), lower warranty costs (60 basis points) and the receipt of business interruption insurance proceeds (60 basis points), offset in part by higher material costs (110 basis points). Intersegment eliminations and other includes intercompany profit on inter-segment sales not yet sold to third party customers. Fiscal 2017 Compared to Fiscal 2016 Consolidated cost of sales was $5.66 billion, or 82.8% of sales, in fiscal 2017 compared to $5.22 billion, or 83.2% of sales, in fiscal 2016. The 40 basis point decrease in cost of sales as a percentage of sales in fiscal 2017 compared to fiscal 2016 was primarily due to improved pricing (40 basis points), improved operating results related to a corporate-led shared manufacturing facility in Mexico, which incurred higher start-up costs in fiscal 2016 (30 basis points), and improved absorption as a result of increased production (30 basis points), offset in part by higher restructuring-related and asset impairment costs in the access equipment segment (60 basis points). Access equipment segment cost of sales was $2.47 billion, or 81.7% of sales, in fiscal 2017 compared to $2.44 billion, or 80.8% of sales, in fiscal 2016. The 90 basis point increase in cost of sales as a percentage of sales in fiscal 2017 compared to fiscal 2016 was primarily due to higher restructuring-related and asset impairment costs (140 basis points), offset in part by improved absorption as a result of increased production (50 basis points) and favorable mix (40 basis points). Defense segment cost of sales was $1.52 billion, or 83.4% of sales, in fiscal 2017 compared to $1.15 billion, or 84.9% of sales, in fiscal 2016. The 150 basis point decrease in cost of sales as a percentage of sales in fiscal 2017 compared to fiscal 2016 was primarily attributable to improved absorption as a result of increased production (60 basis points), improved product mix (40 basis points) and relatively flat new product development spending on higher sales (30 basis points). Fire & emergency segment cost of sales was $849.2 million, or 82.4% of sales, in fiscal 2017 compared to $816.0 million, or 85.6% of sales, in fiscal 2016. The 320 basis point decline in cost of sales as a percentage of sales in fiscal 2017 compared to fiscal 2016 was largely attributable to improved pricing (260 basis points), relatively flat new product development spending on higher sales (30 basis points) and improved manufacturing performance (20 basis points). Commercial segment cost of sales was $827.2 million, or 85.3% of sales, in fiscal 2017 compared to $817.5 million, or 83.5% of sales, in fiscal 2016. The 180 basis point increase in cost of sales as a percentage of sales in fiscal 2017 compared to fiscal 2016 was largely due to operational inefficiencies associated with variability in production volumes during fiscal 2017 (100 basis points) and an adverse product mix (50 basis points). Intersegment eliminations and other includes intercompany profit on inter-segment sales not yet sold to third party customers as well as start-up costs not allocated to segments relating to the corporate-led shared manufacturing facility in Mexico in fiscal 2016. Consolidated Operating Income (Loss) - Three Years Ended September 30, 2018 The following table presents operating income (loss) by business segment (in millions): Fiscal 2018 Compared to Fiscal 2017 Consolidated operating income increased 41.1% to $653.5 million, or 8.5% of sales, in fiscal 2018 compared to $463.0 million, or 6.8% of sales, in fiscal 2017. The increase in operating income in fiscal 2018 compared to fiscal 2017 was primarily a result of higher gross margin associated with higher sales ($183 million), improved pricing ($80 million), a gain on a litigation settlement in the defense segment ($19 million), lower charges and inefficiencies associated with restructuring actions in the access equipment and commercial segments ($8 million) and a gain on the receipt of business interruption insurance proceeds in the commercial segment ($7 million), offset in part by increased material and freight costs ($79 million), unfavorable foreign exchange rates ($16 million) and adverse product mix ($12 million). Access equipment segment operating income increased 49.7% to $387.8 million, or 10.3% of sales, in fiscal 2018 compared to $259.1 million, or 8.6% of sales, in fiscal 2017. The increase in operating income was primarily the result of the margin impact of higher sales volumes ($177 million), improved pricing ($42 million) and lower restructuring-related charges and inefficiencies ($14 million), offset in part by higher material and freight costs ($53 million) and challenges associated with the ramp-up of production ($25 million). In fiscal 2018, charges and operating inefficiencies associated with restructuring plans in the access equipment segment were significantly higher than the Company had expected. The access equipment segment had made significant progress implementing the plan to outsource aftermarket parts distribution and relocate manufacturing in the U.S. and Europe in fiscal 2017. However, during fiscal 2018, the access equipment segment experienced issues that caused operational inefficiencies resulting in additional costs. The Company believes these issues have been rectified. Defense segment operating income increased 7.2% to $222.9 million, or 12.2% of sales, in fiscal 2018 compared to $207.9 million, or 11.4% of sales, in fiscal 2017. The increase in operating income was primarily the result of improved manufacturing performance ($32 million) and a gain on a litigation settlement ($19 million), offset in part by adverse product mix due to the ramp-up of JLTV production and lower international M-ATV sales ($39 million). Changes in estimates on contracts accounted for under the cost-to-cost method on prior year revenues increased defense segment operating income by $2.2 million and $6.3 million in fiscal 2018 and 2017, respectively. Fire & emergency segment operating income increased 31.7% to $137.2 million, or 12.8% of sales, in fiscal 2018 compared to $104.2 million, or 10.1% of sales, in fiscal 2017. The increase in operating income in fiscal 2018 compared to fiscal 2017 was primarily the result of improved pricing ($31 million), improved product mix ($15 million) and improved manufacturing performance ($6 million), offset in part by higher selling, general and administrative expenses ($11 million) and higher material costs ($9 million). Commercial segment operating income increased 54.1% to $67.5 million, or 6.4% of sales, in fiscal 2018 compared to $43.8 million, or 4.5% of sales, in fiscal 2017. The increase in operating income in fiscal 2018 compared to fiscal 2017 was primarily a result of higher gross margin associated with higher sales volume ($17 million) and improved product mix ($8 million). Results for fiscal 2018 included $5.9 million of charges associated with restructuring actions, a $1.4 million loss on the sale of a small product line and a $6.6 million gain on the receipt of business interruption insurance proceeds. Corporate operating costs increased $9.9 million to $161.9 million in fiscal 2018 compared to fiscal 2017. The increase in corporate operating costs in fiscal 2018 compared to fiscal 2017 was primarily due to higher consulting costs ($7 million). Consolidated selling, general and administrative expenses decreased 0.3% to $663.9 million, or 8.6% of sales, in fiscal 2018 compared to $665.6 million, or 9.7% of sales, in fiscal 2017. The slight decrease in consolidated selling, general and administrative expenses in fiscal 2018 compared to fiscal 2017 was generally a result of a gain on a litigation settlement in the defense segment ($19 million) offset in part by higher salaries and benefits. Fiscal 2017 Compared to Fiscal 2016 Consolidated operating income increased 27.2% to $463.0 million, or 6.8% of sales, in fiscal 2017 compared to $364.0 million, or 5.8% of sales, in fiscal 2016. The increase in operating income in fiscal 2017 compared to fiscal 2016 was driven by higher gross margin associated with higher sales, improved performance in the fire & emergency and defense segments as well as lower start-up costs of the corporate-led shared manufacturing facility in Mexico, offset in part by lower performance in the commercial segment. In addition, consolidated operating income was adversely impacted by $43.3 million of restructuring-related charges in fiscal 2017 and by an asset impairment and workforce reduction charges of $27.8 million in fiscal 2016. Access equipment segment operating income decreased 1.6% to $259.1 million, or 8.6% of sales, in fiscal 2017 compared to $263.4 million, or 8.7% of sales, in fiscal 2016. Access equipment segment operating income was adversely impacted by $43.3 million of restructuring-related charges in fiscal 2017 and by an asset impairment and workforce reduction charges of $27.8 million in fiscal 2016. Improved absorption as a result of increased production ($14 million) and favorable mix ($13 million), were offset in part by increased incentive compensation on the higher earnings. Defense segment operating income increased 69.7% to $207.9 million, or 11.4% of sales, in fiscal 2017 compared to $122.5 million, or 9.1% of sales, in fiscal 2016. The increase in operating income was primarily the result of higher gross margin associated with higher sales volume ($98 million), offset in part by higher selling, general and administrative costs ($13 million), primarily related to incentive compensation on the higher earnings. In addition, in fiscal 2017, changes in estimates on contracts accounted for under the cost-to-cost method on prior year revenues increased defense segment operating income by $6.3 million. Fire & emergency segment operating income increased 55.5% to $104.2 million, or 10.1% of sales, in fiscal 2017 compared to $67.0 million, or 7.0% of sales, in fiscal 2016. The increase in operating income in fiscal 2017 compared to fiscal 2016 was primarily the result of improved pricing. Commercial segment operating income decreased 35.2% to $43.8 million, or 4.5% of sales, in fiscal 2017 compared to $67.6 million, or 6.9% of sales, in fiscal 2016. The decrease in operating income in fiscal 2017 compared to fiscal 2016 was primarily a result of lower gross margin associated with lower sales volume ($9 million) and operational inefficiencies associated with variability in production volumes in fiscal 2017 ($10 million). Corporate operating costs decreased $4.5 million to $152.0 million in fiscal 2017 compared to fiscal 2016. The decrease in corporate operating costs in fiscal 2017 compared to fiscal 2016 was primarily due to improved operating results related to the corporate-led shared manufacturing facility in Mexico which incurred higher start-up costs during fiscal 2016, offset in part by higher incentive compensation expense ($8 million), higher corporate-funded research & development ($3 million) and higher share-based compensation ($3 million). Consolidated selling, general and administrative expenses increased 8.7% to $665.6 million, or 9.7% of sales, in fiscal 2017 compared to $612.4 million, or 9.7% of sales, in fiscal 2016. The increase in consolidated selling, general and administrative expenses in fiscal 2017 compared to fiscal 2016 was generally a result of higher incentive compensation expense and higher salaries. Non-Operating Income (Expense) - Three Years Ended September 30, 2018 Fiscal 2018 Compared to Fiscal 2017 Interest expense net of interest income increased $0.7 million to $55.6 million in fiscal 2018 compared to fiscal 2017 primarily due to $9.9 million of debt extinguishment costs incurred in connection with the refinancing of the Company’s senior notes and credit agreement offset in part by the receipt of interest from a customer that had been on non-accrual status. Other miscellaneous expense, net of $3.3 million in fiscal 2018 and other miscellaneous income, net of $3.2 million in fiscal 2017 primarily related to net foreign currency transaction gains and losses and investment gains and losses. Fiscal 2017 Compared to Fiscal 2016 Interest expense net of interest income decreased $3.4 million to $54.9 million in fiscal 2017 compared to fiscal 2016 due to lower borrowing levels. Other miscellaneous income, net of $3.2 million in fiscal 2017 and $1.3 million in fiscal 2016 primarily related to net foreign currency transaction gains and losses and investment gains and losses. Provision for Income Taxes - Three Years Ended September 30, 2018 Fiscal 2018 Compared to Fiscal 2017 The Company recorded income tax expense of $123.8 million, or 20.8% of pre-tax income, in fiscal 2018 compared to $127.2 million, or 30.9% of pre-tax income, in fiscal 2017. Fiscal 2018 results were favorably impacted by discrete tax benefits of $21.7 million, primarily due to a $10.7 million net tax benefit related to tax reform in the United States (180 basis points), favorable share-based compensation tax benefits of $7.2 million (120 basis points), $5.1 million of tax benefits related to state tax matters (90 basis points) and a $2.5 million tax benefit related to a foreign provision-to-return adjustment (40 basis points). Fiscal 2017 results were favorably impacted by discrete tax benefits of $20.1 million largely due to net tax benefits related to the release of valuation allowances on a federal capital loss and state net operating losses of $5.7 million (140 basis points), tax benefits from stock-based compensation of $5.3 million (130 basis points), a $5.4 million tax benefit related to state tax matters (130 basis points) and benefits due to a provision-to-return adjustment on the Company’s 2016 federal income tax return of $2.1 million (50 basis points). See Note 18 of the Notes to Consolidated Financial Statements for a reconciliation of the effective tax rate compared to the U.S. statutory tax rate. On December 22, 2017, the U.S. Tax Cuts and Jobs Act (the “Tax Reform Act”) was signed into law by President Trump. The Tax Reform Act significantly revised the U.S. corporate income tax regime by, among other things, lowering the U.S. corporate tax rate from 35% to 21% effective January 1, 2018, repealing the deduction for domestic production activities, implementing a territorial tax system and imposing a repatriation tax on deemed repatriated earnings of foreign subsidiaries. As a result of the Tax Reform Act, the Company recorded a tax benefit of $30.2 million due to a remeasurement of deferred tax assets and liabilities and a tax charge of $19.5 million due to the transition tax on deemed repatriation of deferred foreign income in fiscal 2018. The remeasurement of the deferred tax assets and liabilities has been finalized as of September 30, 2018. The transition tax charge represents a provisional amount and the Company’s best estimates as of September 30, 2018. Any adjustments recorded to the provisional transition tax through the first quarter of fiscal 2019 will be included in income from operations as an adjustment to tax expense. The provisional transition tax incorporates assumptions made based upon the Company’s current interpretation of the Tax Reform Act and may change as the Company receives additional clarification and implementation guidance. Fiscal 2017 Compared to Fiscal 2016 The Company recorded income tax expense of $127.2 million, or 30.9% of pre-tax income, in fiscal 2017 compared to $92.4 million, or 30.1% of pre-tax income, in fiscal 2016. See Note 18 of the Notes to Consolidated Financial Statements for a reconciliation of the effective tax rate compared to the U.S. statutory tax rate. Equity in Earnings of Unconsolidated Affiliates - Three Years Ended September 30, 2018 Fiscal 2018 Compared to Fiscal 2017 Equity in earnings of unconsolidated affiliates of $1.1 million in fiscal 2018 and $1.5 million in fiscal 2017 primarily represented the Company’s equity interest in a commercial entity in Mexico and a joint venture in Europe. Fiscal 2017 Compared to Fiscal 2016 Equity in earnings of unconsolidated affiliates of $1.5 million in fiscal 2017 and $1.8 million in fiscal 2016 primarily represented the Company’s equity interest in a commercial entity in Mexico and a joint venture in Europe. Liquidity and Capital Resources The Company generates significant capital resources from operating activities, which is the expected primary source of funding for its operations. Other sources of liquidity are availability under the Revolving Credit Facility (as defined in “Liquidity”) and available cash and cash equivalents of $454.6 million at September 30, 2018. The Company had $764.5 million of unused available capacity under the Revolving Credit Facility as of September 30, 2018 if liquidity needs would arise. Borrowings under the Revolving Credit Facility could, as discussed below, be limited by the financial covenants contained within the Credit Agreement (as defined in “Liquidity”). These sources of liquidity are needed to fund the Company’s working capital requirements, debt service requirements, capital expenditures, share repurchases, dividends and acquisitions. At September 30, 2018, the Company had approximately 4.2 million shares of Common Stock remaining under a repurchase authorization approved by the Company’s Board of Directors in August 2015. The Company expects to meet its fiscal 2019 U.S. funding needs without repatriating undistributed profits that are indefinitely reinvested outside the United States. The Company expects to generate approximately $615 million of cash flow from operations in fiscal 2019. The Company expects that during fiscal 2019 approximately $165 million of cash will be utilized for capital spending needs and that an additional $350 million will be utilized for share repurchases. The Company expects to have sufficient liquidity to finance its operations over the next twelve months. Financial Condition at September 30, 2018 The Company’s capitalization was as follows (in millions): The Company’s ratio of debt to total capitalization of 24.6% at September 30, 2018 remained within its targeted range. Consolidated days sales outstanding (defined as “Trade Receivables” at quarter end divided by “Net Sales” for the most recent quarter multiplied by 90 days) increased from 56 days at September 30, 2017 to 63 days at September 30, 2018 primarily as a result of the increase in unbilled receivables associated with utilizing percentage-of-completion accounting on the JLTV contract and the timing of a payment on a large international order in the defense segment. Days sales outstanding for segments other than the defense segment were 53 days at September 30, 2018, up slightly from 52 days at September 30, 2017. Consolidated inventory turns (defined as “Cost of Sales” on an annualized basis, divided by the average “Inventory” at the past five quarter end periods) increased from 4.5 times at September 30, 2017 to 5.1 times at September 30, 2018 as a result of lower inventory levels in the defense segment. Operating Cash Flows Fiscal 2018 Compared to Fiscal 2017 The Company generated $436.3 million of cash from operating activities during fiscal 2018 compared to $246.5 million during fiscal 2017. The increase in cash generated from operating activities in fiscal 2018 compared to fiscal 2017 was primarily due to an increase in net income of $186.3 million. Fiscal 2017 Compared to Fiscal 2016 The Company generated $246.5 million of cash from operating activities during fiscal 2017 compared to $583.9 million during fiscal 2016. The decrease in cash generated from operating activities in fiscal 2017 compared to fiscal 2016 was primarily due to a significant increase in accounts receivable in the defense segment in fiscal 2017 and increased inventory levels in the access equipment segment in fiscal 2017 compared to a significant reduction in inventory levels in fiscal 2016, offset in part by higher accounts payable as a result of higher inventory levels. Increased sales in the fourth quarter and the longer collection cycle on international sales drove higher accounts receivables ($212.5 million) within the defense segment. The alignment of inventory with higher market demand drove the increase in inventories ($143.3 million) in the access equipment segment. The access equipment segment reduced inventories significantly ($305.8 million) in fiscal 2016 to better align inventory levels with lower market demand. Investing Cash Flows Fiscal 2018 Compared to Fiscal 2017 Net cash used in investing activities in fiscal 2018 was $90.4 million compared to $65.2 million in fiscal 2017. Additions to property, plant and equipment of $95.3 million in fiscal 2018 reflected an increase in capital spending of $9.5 million compared to fiscal 2017. The Company anticipates that it will spend $165 million on capital expenditures in fiscal 2019, higher than the Company’s typical capital spending, reflecting the construction of the Company’s new global headquarters in Oshkosh, Wisconsin. Proceeds from the sale of equipment held for rental, net of additions, decreased $21.1 million after a large sale of equipment in fiscal 2017. Fiscal 2017 Compared to Fiscal 2016 Net cash used in investing activities in fiscal 2017 was $65.2 million compared to $89.2 million in fiscal 2016. Additions to property, plant and equipment of $85.8 million in fiscal 2017 reflected a decrease in capital spending of $6.7 million compared to fiscal 2016. Financing Cash Flows Fiscal 2018 Compared to Fiscal 2017 Financing activities used cash of $338.9 million in fiscal 2018 compared to $44.8 million in fiscal 2017. In fiscal 2018, the Company repurchased approximately 3.3 million shares of its Common Stock at an aggregate cost of $249.3 million under a repurchase authorization approved by the Company’s Board of Directors in August 2015. The Company did not repurchase any Common Stock under the authorization during fiscal 2017. At September 30, 2018, the Company had approximately 4.2 million shares of Common Stock remaining under the repurchase authorization. In addition, the Company paid dividends of $71.2 million and $62.8 million in fiscal 2018 and 2017, respectively. The Company increased its quarterly dividend rate by approximately 12.5% in November 2018. The Company targets returning half of its free cash flows (defined as “cash flows from operations” less “additions to property, plant and equipment” less “additions to equipment held for rental” plus “proceeds from sale of equipment held for rental”) to shareholders over the course of the economic cycle. The Company plans to utilize $350 million of its fiscal 2019 expected free cash flow to repurchase shares in fiscal 2019. Fiscal 2017 Compared to Fiscal 2016 Financing activities resulted in a net use of cash of $44.8 million in fiscal 2017 compared to $222.0 million in fiscal 2016. In 2016, the Company repurchased approximately 2.5 million shares of its Common Stock at an aggregate cost of $100.1 million under the share repurchase authorization. The Company did not repurchase any Common Stock under the authorization during fiscal 2017. In addition, the Company paid dividends of $62.8 million and $55.9 million in fiscal 2017 and 2016, respectively. Liquidity Senior Credit Agreement On April 3, 2018, the Company entered into a Second Amended and Restated Credit Agreement with various lenders (the “Credit Agreement”). The Credit Agreement provides for (i) an unsecured revolving credit facility (the “Revolving Credit Facility”) that matures in April 2023 with an initial maximum aggregate amount of availability of $850 million and (ii) an unsecured $325 million term loan (the “Term Loan”) due in quarterly principal installments of $4.1 million commencing September 30, 2019 with a balloon payment of $264.1 million due at maturity in April 2023. At September 30, 2018, outstanding letters of credit of $85.5 million reduced available capacity under the Revolving Credit Facility to $764.5 million. See Note 9 of the Notes to Consolidated Financial Statements for additional information regarding the Credit Agreement. Effective April 3, 2018, to transition from the secured facilities under the previous credit agreement to unsecured facilities under the Credit Agreement, (i) the guaranties made pursuant to the previous credit agreement and the related loan documents were terminated (other than the Company’s guaranty under the previous credit agreement of certain obligations of its subsidiaries, which guaranty was superseded and replaced by a similar guaranty made by the Company under the Credit Agreement), and (ii) the collateral documents executed by the Company and/or its subsidiaries in connection with the previous credit agreement and the related loan documents and the liens created under such collateral documents were terminated, released and discharged. Under the Credit Agreement, the Company is obligated to pay (i) an unused commitment fee ranging from 0.125% to 0.275% per annum of the average daily unused portion of the aggregate revolving credit commitments under the Credit Agreement and (ii) a fee ranging from 0.563% to 1.75% per annum of the maximum amount available to be drawn for each letter of credit issued and outstanding under the Credit Agreement. Borrowings under the Credit Agreement bear interest at a variable rate equal to (i) LIBOR plus a specified margin, which may be adjusted upward or downward depending on whether certain criteria are satisfied, or (ii) for dollar-denominated loans only, the base rate (which is the highest of (a) the administrative agent’s prime rate, (b) the federal funds rate plus 0.50% or (c) the sum of 1% plus one-month LIBOR) plus a specified margin, which may be adjusted upward or downward depending on whether certain criteria are satisfied. Covenant Compliance The Credit Agreement contains various restrictions and covenants, including requirements that the Company maintain certain financial ratios at prescribed levels and restrictions, subject to certain exceptions, on the ability of the Company and certain of its subsidiaries to consolidate or merge, create liens, incur additional indebtedness, dispose of assets, consummate acquisitions and make investments in joint ventures and foreign subsidiaries. The Credit Agreement contains the following financial covenants: • Leverage Ratio: A maximum leverage ratio (defined as, with certain adjustments, the ratio of the Company’s consolidated indebtedness to consolidated net income before interest, taxes, depreciation, amortization, non-cash charges and certain other items (EBITDA)) as of the last day of any fiscal quarter of 3.75 to 1.00. • Interest Coverage Ratio: A minimum interest coverage ratio (defined as, with certain adjustments, the ratio of the Company’s consolidated EBITDA to the Company’s consolidated cash interest expense) as of the last day of any fiscal quarter of 2.50 to 1.00. With certain exceptions, the Credit Agreement limits the ability of the Company to pay dividends and other distributions, including repurchases of shares of its Common Stock. However, so long as no event of default exists under the Credit Agreement or would result from such payment, the Company may pay dividends and other distributions after April 3, 2018 in an aggregate amount not exceeding the sum of: i. $1.46 billion; ii. 50% of the consolidated net income of the Company and its subsidiaries (or if such consolidated net income is a deficit, minus 100% of such deficit), accrued on a cumulative basis during the period beginning on April 3, 2018 and ending on the last day of the fiscal quarter immediately preceding the date of the applicable proposed dividend or distribution; and iii. 100% of the aggregate net proceeds received by the Company subsequent to April 3, 2018 either as a contribution to its common equity capital or from the issuance and sale of its Common Stock. The Company was in compliance with the financial covenants contained in the Credit Agreement as of September 30, 2018 and expects to be able to meet the financial covenants contained in the Credit Agreement over the next twelve months. Senior Notes In February 2014, the Company issued $250.0 million of 5.375% unsecured senior notes due March 1, 2022 (the “2022 Senior Notes”). In March 2015, the Company issued $250.0 million of 5.375% unsecured senior notes due March 1, 2025 (the “2025 Senior Notes”). The net proceeds of both note issuances were used to repay existing outstanding notes of the Company. On May 17, 2018 the Company issued $300.0 million of 4.600% unsecured senior notes due May 15, 2028 (the “2028 Senior Notes”) at a $1.0 million discount. The Company used the net proceeds from the sale of the 2028 Senior Notes to redeem all of the outstanding 2022 Senior Notes at a price of 102.688% and to pre-pay $49.2 million of quarterly principal installment payments under the Term Loan. The 2025 Senior Notes and the 2028 Senior Notes were issued pursuant to separate indentures (the “Indentures”) between the Company and a trustee. The Indentures contain customary affirmative and negative covenants. The Company has the option to redeem the 2025 Senior Notes for a premium after March 1, 2020. The Company has the option to redeem the 2028 Senior Notes at any time for a premium. On April 3, 2018, the Company also entered into a First Supplemental Indenture relating to the 2025 Senior Notes, which amended and supplemented the 2025 Senior Notes indenture to release and discharge all note guaranties made by subsidiaries of the Company pursuant thereto as a result of the termination of all guaranties of the subsidiaries of the Company made pursuant to the Credit Agreement and the related loan documents. See Note 9 of the Notes to Consolidated Financial Statements for additional information regarding the Company’s outstanding debt as of September 30, 2018. Contractual Obligations, Commitments and Off-Balance Sheet Arrangements Following is a summary of the Company’s contractual obligations and payments due by period following September 30, 2018 (in millions): _________________________ (1) Interest was calculated based upon the interest rate in effect on September 30, 2018. (2) The amounts for purchase obligations included above represent all obligations to purchase goods or services under agreements that are enforceable and legally binding and that specify all significant terms. (3) Due to the uncertainty of the timing of settlement with taxing authorities, the Company is unable to make reasonably reliable estimates of the period of cash settlement of unrecognized tax benefits for the remaining uncertain tax liabilities. Therefore, $33.7 million of unrecognized tax benefits as of September 30, 2018 have been excluded from the Contractual Obligations table above. See Note 18 of the Notes to Consolidated Financial Statements for additional information regarding the Company’s unrecognized tax benefits as of September 30, 2018. (4) Represents other long-term liabilities on the Company’s Consolidated Balance Sheet, including the current portion of these liabilities. The projected timing of cash flows associated with these obligations is based on management’s estimates, which are based largely on historical experience. This amount also includes all liabilities under the Company’s pension and other postretirement benefit plans. See Note 17 of the Notes to Consolidated Financial Statements for information regarding these liabilities and the plan assets available to satisfy them. The following is a summary of the Company’s commitments by period following September 30, 2018 (in millions): The Company incurs contingent limited recourse liabilities with respect to customer financing activities primarily in the access equipment segment. For additional information relative to guarantees, see Note 11 of the Notes to Consolidated Financial Statements. Fiscal 2019 Outlook The Company believes consolidated net sales will be $7.85 billion to $8.15 billion in fiscal 2019, compared to $7.71 billion in fiscal 2018. The Company expects fiscal 2019 consolidated operating income will be in the range of $640 million to $710 million, resulting in earnings per share of $6.50 to $7.25. Earnings per share assumes an average share count of 71.5 million, which reflects the full year impact of fiscal 2018 share repurchases and a target of $350 million of share repurchases spread throughout fiscal 2019. The fiscal 2019 estimates reflect the adoption of the new revenue recognition standard, which is effective for the Company on October 1, 2018. The fiscal 2019 consolidated sales expectations do not anticipate a material impact as a result of the adoption of the new revenue standard. The Company’s consolidated operating income expectations anticipates an approximate $10 million, or $0.10 per share, favorable impact from the new revenue standard as compared to the old revenue standard. The Company believes access equipment segment sales will be between $3.6 billion and $3.9 billion in fiscal 2019, as compared to $3.8 billion in fiscal 2018. The Company’s estimates for this segment assume continued positive rental market conditions. The Company also continues to believe replacement demand will be a favorable driver for the next several years, although it is difficult to pinpoint the exact magnitude of replacement demand by year. The Company’s estimates assume a larger than normal price increase to address significant inflation that the Company is experiencing, especially from steel and freight, along with other inflationary cost increases. The wide sales estimate range assumes that the Company could lose some volume as it exercises price discipline. The Company expects operating income margins in the access equipment segment in fiscal 2019 will be in the range of 10.0% to 11.0%. The Company expects the anticipated price increase for this segment to be dilutive to operating income margins as the increase only covers anticipated cost increases and does not include any profit. In addition, the Company expects this segment to benefit from improved operational efficiencies compared to the prior year, The Company expects defense segment sales will be approximately $2.0 billion in fiscal 2019, an increase of 9% compared to fiscal 2018. The Company expects overall strong domestic sales as JLTV volume continues to ramp-up, offset in part by lower FHTV sales and lower international sales as the most recent international M-ATV contract was completed in the first quarter of fiscal 2018. The defense segment is actively working on securing additional international contracts, but the Company does not expect any international contracts that the Company may secure to have a meaningful impact on fiscal 2019 defense segment results. The Company expects defense segment operating income margins will be in the range of 9.5% to 9.75% in fiscal 2019, reflecting the continued mix shift to JLTVs, as the Company expects this product to comprise more than 50% of new vehicle sales in the segment in fiscal 2019. Included in the outlook for the defense segment is an estimated $35 million adverse sales impact and $5 million positive operating income impact relating to the adoption of the new revenue recognition standard. While the new standard does not change the overall expected profitability of any contract, it will impact the margin recognized by the Company throughout the life of the contract. Under the new revenue recognition standard, the accounting definition of the contract has changed, which prevents the Company from including units for which a firm delivery orders have not been received in its estimate of profitability. Therefore, option years in indefinite delivery/indefinite quantity contracts are not included in program profitability until the Company receives a delivery order. Vehicles ordered later in the contract, after startup and learning curve, are typically more profitable than those ordered under the first several years of a contract. As new delivery orders are received, the Company will update program margin assumptions to include the additional quantities and adjust life-to-date margins to reflect the new expected contract margin through a cumulative adjustment to earnings. The Company expects this change to result in increased earnings volatility on a quarterly basis as orders are received. The Company expects that fire & emergency segment sales will be approximately $1.2 billion in fiscal 2019, an increase of approximately 12% from fiscal 2018 sales, reflecting a continuation of relatively flat to low growth in the domestic fire apparatus market along with higher airport products sales. The Company expects operating income margins in the fire & emergency segment to increase to a range of 13.25% to 13.5% in fiscal 2019 reflecting the continued progress on this segment’s simplification journey, including improved operational execution and higher pricing, offset in part by the impact of higher steel, aluminum and other input costs. Included in the outlook for the fire & emergency segment is an estimated $40 million of positive sales impact and $5 million of positive operating income impact related to the adoption of the new revenue recognition standard. The largest change from adopting the new standard relates to the timing of revenue recognition on sales where Pierce, versus the dealer, has the contract with the municipality. The Company does not expect this change to result in a meaningful impact beyond the first quarter of fiscal 2019. The Company estimates commercial segment sales will be approximately $1.05 billion in fiscal 2019, flat with fiscal 2018 sales. The Company expects a continued strong refuse collection vehicle market in fiscal 2019, along with a concrete mixer market that remains at levels below historical averages. The Company expects operating income margins in this segment to be in the range of 7.0% to 7.25%, reflecting the continuation of the simplification journey launched early in fiscal 2018. The Company estimates corporate expenses in fiscal 2019 will be between $145 million and $150 million, down from fiscal 2018 expenses of $162 million due to cost reduction efforts and expected lower incentive compensation. The Company estimates its effective tax rate for fiscal 2019 will be between 20% and 21%, reflecting a full year impact of U.S. tax reform. The Company expects sales and operating income in the first quarter of fiscal 2019 to be higher than the first quarter of fiscal 2018, led by sales growth in the access equipment and fire & emergency segments. The Company expects to see the full impact of higher steel prices experienced in fiscal 2018, especially in the access equipment segment, which will have a meaningful portion of its first quarter fiscal 2019 sales that do not benefit from the surcharges. The Company expects higher margins in the access equipment segment in subsequent quarters as it will be through the backlog of orders that were not subject to the surcharge. The Company expects defense segment margins to be higher than the prior year quarter even though there were high margin international M-ATV sales in the prior year quarter, due to the expected receipt of additional JLTV orders. Critical Accounting Policies The Company’s significant accounting policies are described in Note 2 of the Notes to Consolidated Financial Statements. The Company considers the following policy to be the most critical in understanding the judgments that are involved in the preparation of the Company’s consolidated financial statements and the uncertainties that could impact the Company’s financial condition, results of operations and cash flows. Revenue Recognition. Through September 30, 2018, the Company recognized revenue on equipment and parts sales when contract terms were met, collectability was reasonably assured and a product was shipped or risk of ownership had been transferred to and accepted by the customer. Revenue from service agreements was recognized as earned, when services had been rendered. Appropriate provisions were made for discounts, returns and sales allowances. Sales were recorded net of amounts invoiced for taxes imposed on the customer such as excise or value-added taxes. Sales to the U.S. government of non-commercial products manufactured to the government’s specifications are recognized under percentage-of-completion accounting using either the units-of-delivery method or cost-to-cost method to measure contract performance. Under the units-of-delivery method, the Company records sales as units are accepted by the DoD generally based on unit sales values stated in the respective contracts. Costs of sales are based on actual costs incurred to produce the units delivered under the contract. Under the cost-to-cost method, sales, including estimated margins, are recognized as contract costs are incurred. The measurement method selected is generally determined based on the nature of the contract. The Company includes amounts representing contract change orders, claims or other items in sales only when they can be reliably estimated and realization is probable. The Company has significant experience in contracting and producing vehicles for the defense industry, which has resulted in a history of making reasonable estimates of revenues and costs when measuring progress toward contract completion. The Company charges anticipated losses on contracts or programs in progress to earnings when identified. Approximately 21% of the Company’s revenues for fiscal 2018 were recognized under the percentage-of-completion accounting method. Critical Accounting Estimates “Management’s Discussion and Analysis of Financial Condition and Results of Operations” is based on the Company’s Consolidated Financial Statements, which have been prepared in accordance with generally accepted accounting principles in the United States of America (U.S. GAAP). The preparation of financial statements in accordance with U.S. GAAP requires management to make estimates and judgments that affect reported amounts and related disclosures. On an ongoing basis, management evaluates and updates its estimates. Management employs judgment in making its estimates but they are based on historical experience and currently available information and various other assumptions that the Company believes to be reasonable under the circumstances. The results of these estimates form the basis for making judgments about the carrying values of assets and liabilities that are not readily available from other sources. Actual results could differ from those estimates. Management believes that its judgment is applied consistently and produces financial information that fairly depicts the results of operations for all periods presented. Percentage-of-Completion Accounting. The percentage-of-completion accounting method is used to account for long-term contracts that involve the design, development, manufacture, or modification of complex equipment to a buyer’s specification. Contracts accounted for under this method generally are long-term in nature and may involve related services. Revenue is recognized on these types of contracts based on the extent of progress toward completion of the overall contract. The determination of the method to measure progress toward completion of a contract requires judgment, which is generally dependent on the nature of the Company’s obligations under the contract. Under the units-of-delivery measure of progress, the extent of progress on a contract is measured as units are accepted by the DoD generally based on unit sales values stated in the respective contracts. Costs of sales are based on actual costs incurred to produce the units delivered under the contract. Under the cost-to-cost measure of progress, the extent of progress toward completion is measured based on the ratio of costs incurred to date to the total estimated costs at the completion of the contract. Revenues, including margins, are recorded as costs are incurred. The revenue and cost estimates used under the cost-to-cost measurement method are complex and involve significant judgment. There are numerous factors that may impact estimated sales and costs associated with a contract such as, incentive based fees, penalties, availability of materials and labor, manufacturing performance, complexity of contract requirements and length of contract term. These factors are subject to change during contract performance, which may impact contract profitability. The Company has implemented a rigorous Estimate at Completion (EAC) process that requires management to perform a detailed evaluation of contract performance on at least a quarterly basis. During this process all key inputs and factors that may impact contract performance are analyzed and the EAC is updated for any changes. Adjustments to revenue, costs and operating income resulting from this process are recorded in the period they become known. Changes in estimates on contracts accounted for under the cost-to-cost method on prior year revenues increased defense segment operating income by $2.2 million and $6.3 million in fiscal 2018 and 2017, respectively. Impairment of Goodwill and Indefinite-Lived Intangible Assets. Goodwill and indefinite-lived intangible assets are tested for impairment annually, or more frequently if events or changes in circumstances indicate that the assets might be impaired. Such circumstances include a significant adverse change in the business climate for one of the Company’s reporting units, a material negative change in relationships with significant customers, or strategic decisions made in response to economic and competitive conditions. The Company performs its annual review at the beginning of the fourth quarter of each fiscal year. The Company evaluates the recoverability of goodwill by estimating the fair value of the businesses to which the goodwill relates. A reporting unit is an operating segment or, under certain circumstances, a component of an operating segment that constitutes a business. When the fair value of the reporting unit is less than the carrying value of the reporting unit, a further analysis is performed to measure and recognize the amount of the impairment loss, if any. Impairment losses, limited to the carrying value of goodwill, represent the excess of the carrying amount of a reporting unit’s goodwill over the implied fair value of that goodwill. In evaluating the recoverability of goodwill, it is necessary to estimate the fair value of the reporting units. The estimate of the fair value of the reporting units is generally determined on the basis of discounted future cash flows and a market approach. In estimating the fair value, management must make assumptions and projections regarding such items as the Company performance and profitability under existing contracts, its success in securing future business, the appropriate risk-adjusted interest rate used to discount the projected cash flows, and terminal value growth and earnings rates. The assumptions used in the estimate of fair value are generally consistent with the past performance of each reporting unit and are also consistent with the projections and assumptions that are used in current operating plans. Such assumptions are subject to change as a result of changing economic and competitive conditions. The rate used to discount estimated cash flows is a rate corresponding to the Company’s cost of capital, adjusted for risk where appropriate, and is dependent upon interest rates at a point in time. To assess the reasonableness of the discounted projected cash flows, the Company compares the sum of its reporting units’ fair value to the Company’s market capitalization and calculates an implied control premium (the excess of the sum of the reporting units’ fair values over the market capitalization). The reasonableness of this control premium is evaluated by comparing it to control premiums for recent comparable market transactions. Consistent with prior years, the Company weighted the income approach more heavily (75%) as the Company believes the income approach more accurately considers long-term fluctuations in the U.S. and European construction markets than the market approach. There are inherent uncertainties related to these factors and management’s judgment in applying them to the analysis of goodwill impairment. It is possible that assumptions underlying the impairment analysis will change in such a manner to cause further impairment of goodwill, which could have a material impact on the Company’s results of operations. The Company completed the required goodwill impairment test as of July 1, 2018. The Company identified no indicators of goodwill impairment in the test performed as of July 1, 2018. In order to evaluate the sensitivity of any quantitative fair value calculations on the goodwill impairment test, a hypothetical 10% decrease to the fair values of any reporting unit was calculated. This hypothetical 10% decrease would still result in excess fair value over carrying value for the reporting units as of July 1, 2018. The Company evaluates the recoverability of indefinite-lived trade names based upon a “relief from royalty” method. This methodology determines the fair value of each trade name through use of a discounted cash flow model that incorporates an estimated “royalty rate” the Company would be able to charge a third party for the use of the particular trade name. In determining the estimated future cash flows, the Company considers projected future sales, a fair market royalty rate for each applicable trade name and an appropriate discount rate to measure the present value of the anticipated cash flows. At July 1, 2018, approximately 90% of the Company’s recorded goodwill and indefinite-lived purchased intangibles were concentrated within the JLG reporting unit in the access equipment segment. Assumptions utilized in the impairment analysis are highly judgmental. While the Company currently believes that an impairment of intangible assets at JLG is unlikely, events and conditions that could result in the impairment of intangibles at JLG include a sharp decline in economic conditions, significantly increased pricing pressure on JLG’s margins or other factors leading to reductions in expected long-term sales or profitability at JLG. Guarantees of the Indebtedness of Others. The Company enters into agreements with finance companies whereby the Company will guarantee the indebtedness of third-party end-users to whom the finance company lends to purchase the Company’s equipment. In some instances, the Company retains an obligation to the finance companies in the event the customer defaults on the financing. In accordance with Financial Accounting Standards Board (FASB) Accounting Standards Codification (ASC) Topic 460, Guarantees, the Company recognizes the greater of the fair value of the guarantee or the contingent liability required by FASB ASC Topic 450, Contingencies. The Company is party to multiple agreements under which at September 30, 2018 it guaranteed an aggregate of $685.3 million in indebtedness of customers. The Company estimated that its maximum loss exposure under these contracts at September 30, 2018 was $121.8 million. Reserves are initially established related to these guarantees at the fair value of the guarantee based upon the Company’s understanding of the current financial position of the underlying customer/borrower and based on estimates and judgments made from information available at that time in accordance with FASB ASC Topic 460, Guarantees. If the Company becomes aware of deterioration in the financial condition of the customer/borrower or of any impairment of the customer/borrower’s ability to make payments, additional allowances are considered as required by FASB ASC Topic 450, Contingencies. Although the Company may be liable for the entire amount of a customer/borrower’s financial obligation under guarantees, its losses would generally be mitigated by the value of any underlying collateral including financed equipment, the finance company’s inability to provide clear title of foreclosed equipment to the Company, loss pools established in accordance with the agreements and other conditions. During periods of economic downturn, the value of the underlying collateral supporting these guarantees can decline sharply to further increase losses in the event of a customer/borrower’s default. Reserves for guarantees of the indebtedness of others under these contracts was $10.4 million at September 30, 2018. If the financial condition of the Company’s customer/borrower’s were to deteriorate resulting in an impairment of their ability to make payments, additional reserves would be required. New Accounting Standards See Note 2 of the Notes to Consolidated Financial Statements for a discussion of the impact of new accounting standards on the Company’s consolidated financial statements. Customers and Backlog Sales to the U.S. government comprised approximately 22% of the Company’s net sales in fiscal 2018. No other single customer accounted for more than 10% of the Company’s net sales for this period. A substantial majority of the Company’s net sales are derived from the fulfillment of customer orders that are received prior to commencing production. The Company’s backlog as of September 30, 2018 increased 10.1% to $4.17 billion compared to $3.79 billion at September 30, 2017. Access equipment segment backlog increased 112.8% to $962.4 million at September 30, 2018 compared to $452.2 million at September 30, 2017 primarily due to improved market conditions that generated strong demand. Defense segment backlog decreased 11.0% to $1.86 billion at September 30, 2018 compared to $2.09 billion at September 30, 2017 primarily due to delivery of vehicles under the Company’s legacy FMTV and FHTV programs and the fulfillment of a large international contract for the delivery of M-ATVs. Fire & emergency segment backlog increased 5.0% to $978.1 million at September 30, 2018 compared to $931.6 million at September 30, 2017 due largely to a large order received from the U.S. Air Force for snow removal units. Commercial segment backlog increased 17.1% to $376.0 million at September 30, 2018 compared to $321.0 million at September 30, 2017. Unit backlog for concrete mixers as of September 30, 2018 was up 24.0% due to return to a more normal ordering pattern as compared to the atypical order pattern experienced in the prior year and an increase in international demand. Unit backlog for refuse collection vehicles as of September 30, 2018 was up 7.3% compared to September 30, 2017 due to improved market conditions. Reported backlog excludes purchase options and announced orders for which definitive contracts have not been executed. Backlog information and comparisons thereof as of different dates may not be accurate indicators of future sales or the ratio of the Company’s future sales to the DoD versus its sales to other customers. Approximately 8% of the Company’s September 30, 2018 backlog is not expected to be filled in fiscal 2019. Financial Market Risk The Company is exposed to market risk from changes in interest rates, certain commodity prices and foreign currency exchange rates. To reduce the risk from changes in foreign currency exchange and interest rates, the Company selectively uses financial instruments. All hedging transactions are authorized and executed pursuant to clearly defined policies and procedures, which strictly prohibit the use of financial instruments for speculative purposes. Interest Rate Risk. The Company’s earnings exposure related to adverse movements in interest rates is primarily derived from outstanding floating rate debt instruments that are indexed to short-term market interest rates. In this regard, changes in U.S. and off-shore interest rates affect interest payable on the Company’s borrowings under its Credit Agreement. Based on debt outstanding at September 30, 2018, a 100 basis point increase or decrease in the average cost of the Company’s variable rate debt would increase or decrease annual pre-tax interest expense by approximately $2.8 million. The table below provides information about the Company’s debt obligations, which are sensitive to changes in interest rates (dollars in millions): The table presents principal cash flows and related weighted-average interest rates by expected maturity dates. Weighted-average variable rates are based on implied forward rates in the yield curve at the reporting date. Commodity Price Risk. The Company is a purchaser of certain commodities, including steel, aluminum and composites. In addition, the Company is a purchaser of components and parts containing various commodities, including steel, aluminum, rubber and others which are integrated into the Company’s end products. The Company generally buys these commodities and components based upon market prices that are established with the vendor as part of the purchase process. The Company does not use commodity financial instruments to hedge commodity prices. The Company generally obtains firm quotations from its significant components suppliers for its orders under firm, fixed-price contracts in its defense segment. In the Company’s access equipment, fire & emergency and commercial segments, the Company generally attempts to obtain firm pricing from most of its suppliers, consistent with backlog requirements and/or forecasted annual sales. To the extent that commodity prices increase and the Company does not have firm pricing from its suppliers, or its suppliers are not able to honor such prices, then the Company may experience margin declines to the extent it is not able to increase selling prices of its products. Foreign Currency Risk. The Company’s operations consist of manufacturing in the U.S., Mexico, Canada, France, Australia, Romania, the United Kingdom and China and sales and limited vehicle body mounting activities on five continents. International sales comprised approximately 20% of overall net sales in fiscal 2018, of which approximately 80% involved exports from the U.S. The majority of export sales in fiscal 2018 were denominated in U.S. dollars. As a result of the manufacture and sale of the Company’s products in foreign markets, the Company’s earnings are affected by fluctuations in the value of foreign currencies in which certain of the Company’s transactions are denominated as compared to the value of the U.S. dollar. The Company’s operating results are principally exposed to changes in exchange rates between the U.S. dollar and the European currencies, primarily the Euro and the U.K. pound sterling, changes between the U.S. dollar and the Australian dollar, changes between the U.S. dollar and the Brazilian real, changes between the U.S. dollar and the Mexican peso and changes between the U.S. dollar and the Chinese renminbi.

<s>[INST] General The Company is a leading designer, manufacturer and marketer of a wide range of specialty vehicles and vehicle bodies, including access equipment, defense trucks and trailers, fire & emergency vehicles, concrete mixers and refuse collection vehicles. The Company is a leading global designer and manufacturer of aerial work platforms under the “JLG” brand name. The Company is among the worldwide leaders in the design and manufacturing of telehandlers under the “JLG” and “SkyTrak” brand names. Under the “JerrDan” brand name, the Company is a leading domestic designer and manufacturer and marketer of towing and recovery equipment. The Company manufactures defense trucks under the “Oshkosh” brand name and is a leading designer and manufacturer of severeduty, tactical wheeled vehicles for the DoD. Under the “Pierce” brand name, the Company is among the leading global designers and manufacturers of fire trucks assembled on both custom and commercial chassis. Under the “Frontline” brand name, the Company is a leading domestic designer, manufacturer and marketer of broadcast vehicles. The Company designs and manufactures aircraft rescue and firefighting and airport snow removal vehicles under the “Oshkosh” brand name. Under the “McNeilus,” “Oshkosh,” “London” and “CONECO” brand names, the Company designs and manufactures rear and frontdischarge concrete mixers and portable and stationary concrete batch plants. Under the “McNeilus” brand name, the Company designs and manufactures a wide range of automated, rear, front, side and top loading refuse collection vehicles. Under the “IMT” brand name, the Company is a leading domestic designer and manufacturer of field service vehicles and truckmounted cranes. Major products manufactured and marketed by each of the Company’s business segments are as follows: Access equipment aerial work platforms and telehandlers used in a wide variety of construction, industrial, institutional and general maintenance applications to position workers and materials at elevated heights, as well as carriers and wreckers. Access equipment customers include equipment rental companies, construction contractors, manufacturing companies, home improvement centers and towing companies in the U.S. and abroad. Defense tactical trucks, trailers and supply parts and services sold to the U.S. military and to other militaries around the world. Fire & emergency custom and commercial firefighting vehicles and equipment, ARFF vehicles, snow removal vehicles, simulators and other emergency vehicles primarily sold to fire departments, airports and other governmental units, and broadcast vehicles sold to broadcasters and TV stations in the U.S. and abroad. Commercial concrete mixers, refuse collection vehicles, portable and stationary concrete batch plants and vehicle components sold to readymix companies and commercial and municipal waste haulers in the Americas and other international markets and field service vehicles and truckmounted cranes sold to mining, construction and other companies in the U.S. and abroad. All estimates referred to in this “Management’s Discussion and Analysis of Financial Condition and Results of Operations” refer to the Company’s estimates as of November 20, 2018. Executive Overview The Company achieved another year of significantly improved earnings growth in fiscal 2018. Consolidated net sales increased $875.9 million, or 12.8%, to $7.71 billion, consolidated operating income increased $190.5 million, or 41.1%, to $653.5 million, and diluted earnings per share increased $2.52 per share, or 66.8%, to $6.29 per share. This was the second consecutive year that the Company increased operating income by more than 25%. All segments reported higher sales and operating income in fiscal 2018 compared to fiscal 2017. The lower U.S. federal income tax rate benefited fiscal 2018 results by $0.86 per share compared to the prior year. Share repurchases completed during the past year also benefited earnings per share by $0.12 compared to fiscal 2017. Fiscal 2018 results included aftertax charges of $27.5 million, or $0.37 per share, for costs and inefficiencies associated with restructuring actions in the access [/INST] Positive. </s>

OSHKOSH CORP

2019-11-19

2019-09-30

ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS General The Company is a leading designer, manufacturer and marketer of a wide range of specialty vehicles and vehicle bodies, including access equipment, defense trucks and trailers, fire & emergency vehicles, concrete mixers and refuse collection vehicles. The Company is a leading global designer and manufacturer of aerial work platforms under the “JLG” brand name. The Company is among the worldwide leaders in the design and manufacturing of telehandlers under the “JLG” and “SkyTrak” brand names. Under the “Jerr-Dan” brand name, the Company is a leading domestic designer and manufacturer and marketer of towing and recovery equipment. The Company manufactures defense trucks under the “Oshkosh” brand name and is a leading designer and manufacturer of severe-duty, tactical wheeled vehicles for the DoD. Under the “Pierce” brand name, the Company is among the leading global designers and manufacturers of fire trucks assembled on both custom and commercial chassis. Under the “Frontline” brand name, the Company is a leading domestic designer, manufacturer and marketer of broadcast vehicles. The Company designs and manufactures aircraft rescue and firefighting and airport snow removal vehicles under the “Oshkosh” brand name. Under the “McNeilus,” “Oshkosh,” “London” and “CON-E-CO” brand names, the Company designs and manufactures rear- and front-discharge concrete mixers and portable and stationary concrete batch plants. Under the “McNeilus” brand name, the Company designs and manufactures a wide range of automated, rear, front, side and top loading refuse collection vehicles. Under the “IMT” brand name, the Company is a leading domestic designer and manufacturer of field service vehicles and truck-mounted cranes. Major products manufactured and marketed by each of the Company’s business segments are as follows: Access equipment - aerial work platforms and telehandlers used in a wide variety of construction, industrial, institutional and general maintenance applications to position workers and materials at elevated heights, as well as carriers and wreckers. Access equipment customers include equipment rental companies, construction contractors, manufacturing companies, home improvement centers and towing companies in the U.S. and abroad. Defense - tactical trucks, trailers and supply parts and services sold to the U.S. military and to other militaries around the world. Fire & emergency - custom and commercial firefighting vehicles and equipment, ARFF vehicles, snow removal vehicles, simulators and other emergency vehicles primarily sold to fire departments, airports and other governmental units, and broadcast vehicles sold to broadcasters and TV stations in the U.S. and abroad. Commercial - concrete mixers, refuse collection vehicles, portable and stationary concrete batch plants and vehicle components sold to ready-mix companies and commercial and municipal waste haulers in the Americas and other international markets and field service vehicles and truck-mounted cranes sold to mining, construction and other companies in the U.S. and abroad. All estimates referred to in this “Management’s Discussion and Analysis of Financial Condition and Results of Operations” refer to the Company’s estimates as of November 19, 2019. Executive Overview The Company achieved another year of significantly improved earnings growth in fiscal 2019, reflecting strong execution in an uncertain environment. The Company successfully navigated the impacts of volatile trade policy and tariffs, along with talk of an impending recession to deliver consolidated net sales of $8.38 billion, an increase of $676.5 million, or 8.8%, compared to fiscal 2018, consolidated operating income of $797.0 million, an increase of $141.0 million, or 21.5%, and diluted earnings per share of $8.21, an increase of $1.92 per share, or 30.5%. This was the third consecutive year that the Company increased operating income by more than 20%. Fiscal 2019 results included $7.0 million, or $0.10 per share, of charges related to adjustments to the repatriation tax on deemed repatriated earnings of foreign subsidiaries required under the U.S. Tax Cuts and Jobs Act enacted in the United States in December 2017. Fiscal 2018 results included an after-tax charge of $27.5 million, or $0.37 per share, for costs and inefficiencies associated with restructuring actions in the access equipment and commercial segments, an after-tax gain of $15.4 million, or $0.21 per share, related to a litigation settlement in the defense segment, a gain of $10.7 million, or $0.13 per share, related to the implementation of tax reform in the United States, an after-tax charge of $7.7 million, or $0.10 per share, of debt extinguishment costs incurred in connection with the refinancing of the Company’s senior notes and credit agreement, an after-tax gain of $4.9 million, or $0.07 per share, related to the receipt of business interruption insurance proceeds in the commercial segment and an after-tax loss of $1.0 million, or $0.01 per share, on the sale of a small product line in the commercial segment. In the aggregate, these items accounted for a net $5.2 million, or $0.07 per share, charge. Sales increased $676.5 million, or 8.8%, in fiscal 2019 as compared to fiscal 2018. The Company reported double digit percentage sales increases in the defense and fire & emergency segments and record sales of more than $4.0 billion in the access equipment segment. Fiscal 2019 sales without the adoption of Accounting Standards Codification (ASC) 606, the new revenue recognition standard, would have been $8.30 billion, an increase of 7.7% compared to fiscal 2018. Consolidated operating income increased to $797.0 million, or 9.5% of sales, in fiscal 2019 compared to $656.0 million, or 8.5% of sales, in fiscal 2018. The fire & emergency, access equipment and defense segments all reported operating income margins of at least 10%. The commercial segment was on track for solid improvement in fiscal 2019 as well, until production was disrupted by a partial roof collapse at one of its manufacturing facilities in February as a result of heavy snow accumulation. The Company estimates that the disruption to production as a result of the partial roof collapse caused a loss in sales and operating income in fiscal 2019 of approximately $30 million and $12.5 million, respectively. The Company expects insurance will cover much of the costs and lost profits related to the damaged facility. Proceeds related to business interruption insurance are recorded in income only upon settlement with the insurance company. The Company continued to execute its disciplined capital allocation strategy in fiscal 2019. The Company returned $425 million of cash to shareholders through the repurchase of approximately 4.9 million shares of stock and payment of quarterly dividends. Share repurchases completed during the past year also benefited earnings per share by $0.53 compared to fiscal 2018. In addition, the Company recently announced an increase in its quarterly dividend rate of 11.1%, to $0.30, per share beginning in November 2019. This was the Company’s sixth straight year of a double-digit percentage increase in its dividend rate. The Company expects to deliver results in fiscal 2020 that would be the third highest in the Company’s history. The benefits of the Company’s diverse end markets and operational leverage are reflected in the Company’s fiscal 2020 outlook. The Company estimates fiscal 2020 consolidated net sales will be $7.9 billion to $8.2 billion, compared to $8.38 billion in fiscal 2019. The expected decline is sales in fiscal 2020 is attributable to an expected decline in sales in the access equipment segment. The Company believes that uncertainty in the economy is causing access equipment customers in North America and the Europe, Africa and Middle East region to be more cautious in ordering equipment to grow their fleets. The Company expects fiscal 2020 consolidated operating income will be in the range of $690 million to $765 million, resulting in earnings per share of $7.30 to $8.10. The Company’s expectations for fiscal 2020 assume that the Company will continue to execute its MOVE strategy, including increasing new product development spending and expanding access equipment production capacity in China, which has been that segment’s fastest growing market. Results of Operations A detailed discussion of the year-over-year changes from the Company’s fiscal 2017 to fiscal 2018 can be found in the Management’s Discussion and Analysis section in the Company’s fiscal 2018 Annual Report on Form 10-K filed November 20, 2018. Consolidated Net Sales - Two Years Ended September 30, 2019 The following table presents net sales (see definition of net sales contained in Note 2 of the Notes to Consolidated Financial Statements) by business segment (in millions): The following table presents net sales by geographic region based on product shipment destination (in millions): Consolidated net sales increased $676.5 million, or 8.8%, to $8.38 billion in fiscal 2019 compared to fiscal 2018. Higher sales volumes in the access equipment, defense and fire & emergency segments as well as higher pricing in response to significant material costs escalation drove the improvement in sales. Fiscal 2019 without the adoption of the new revenue recognition standard would have been $8.30 billion, an increase of 7.7% compared to fiscal 2018. Access equipment segment net sales increased $302.9 million, or 8.0%, to $4.08 billion in fiscal 2019 compared to fiscal 2018. The increase in sales was led by a significant increase in telehandler sales in North America ($285 million), in part as a result of improved production rates as the access equipment segment completed the move of North American telehandler production in fiscal 2018, offset in part by lower Europe, Africa and the Middle East sales ($82 million). Higher pricing to cover significant material costs escalation also contributed to the increase in sales. A stronger U.S. dollar reduced sales in the access equipment segment in fiscal 2019 by $33 million compared to fiscal 2018. Defense segment net sales increased $203.2 million, or 11.1%, to $2.03 billion in fiscal 2019 compared to fiscal 2018. The increase in sales was primarily due to the continued ramp up of sales to the U.S. government under the JLTV program ($307 million) offset in part by the absence of international Mine Resistant Ambush Protected-All Terrain Vehicle sales ($94 million). Defense segment sales for fiscal 2019 without the adoption of the new revenue recognition standard would have been $2.01 billion, an increase of 10.1% compared to fiscal 2018. Fire & emergency segment net sales increased $196.4 million, or 18.4%, to $1.27 billion in fiscal 2019 compared to fiscal 2018 as a result of higher fire apparatus sales volume ($77 million) as approximately $40 million of sales moved from the fourth quarter of fiscal 2018 into the first quarter of fiscal 2019, changes associated with the application of the new revenue recognition standard ($61 million) and improved pricing to cover significant material costs escalation. Fire & emergency segment sales for fiscal 2019 without the adoption of the new revenue recognition standard would have been $1.20 billion, an increase of 12.6% compared to fiscal 2018. Commercial segment net sales decreased $32.5 million, or 3.1%, to $1.02 billion in fiscal 2019 compared to fiscal 2018 on lower concrete mixer and refuse collection vehicle volumes as severe winter weather, including the partial roof collapse as a result of extreme snow accumulation, negatively impacted production at one of its manufacturing facilities in the second and third quarters of fiscal 2019. Improved pricing to cover significant material costs escalation helped offset part of the volume decline experienced in fiscal 2019. Consolidated Cost of Sales - Two Years Ended September 30, 2019 The following table presents costs of sales by business segment (in millions): Consolidated cost of sales was $6.86 billion, or 81.9% of sales, in fiscal 2019 compared to $6.35 billion, or 82.4% of sales, in fiscal 2018. The 50 basis point decrease in cost of sales as a percentage of sales was primarily due to improved pricing (160 basis points) and lower restructuring-related costs and inefficiencies in the access equipment and commercial segments (40 basis points), offset in part by higher material costs (120 basis points). Access equipment segment cost of sales was $3.29 billion, or 80.7% of sales, in fiscal 2019 compared to $3.11 billion, or 82.3% of sales, in fiscal 2018. The 160 basis point decrease in cost of sales as a percentage of sales was largely due to the absence of restructuring-related costs and inefficiencies (80 basis points), lower freight costs (50 basis points) and improved regional mix (20 basis points). Improved pricing (220 basis points) was completely offset by higher material costs (220 basis points). Defense segment cost of sales was $1.73 billion, or 85.0% of sales, in fiscal 2019 compared to $1.53 billion, or 83.5% of sales, in fiscal 2018. The 150 basis point increase in cost of sales as a percentage of sales was primarily attributable to adverse product mix (160 basis points) due largely to the continued shift to a higher weighting of JLTV sales and lower international M-ATV sales. JLTV revenue represented approximately 50% of the defense segments sales in fiscal 2019. Fire & emergency segment cost of sales was $998.0 million, or 78.8% of sales, in fiscal 2019 compared to $844.0 million, or 78.9% of sales, in fiscal 2018. Improved pricing (240 basis points) and lower new product development spending (100 basis points) were offset by higher material and production costs (240 basis points) and adverse product mix (120 basis points). Commercial segment cost of sales was $862.4 million, or 84.4% of sales, in fiscal 2019 compared to $886.7 million, or 84.1% of sales, in fiscal 2018. The 30 basis point increase in cost of sales as a percentage of sales was largely due to production disruptions as a result of the roof collapse (160 basis points), material cost increases (70 basis points) and the receipt of business interruption insurance proceeds in fiscal 2018 (60 basis points), offset in part by improved mix (140 basis points) and improved pricing (110 basis points). Intersegment eliminations and other includes intercompany profit on intersegment sales not yet sold to third party customers. Consolidated Operating Income (Loss) - Two Years Ended September 30, 2019 The following table presents operating income (loss) by business segment (in millions): Consolidated operating income increased $141.0 million, or 21.5%, to $797.0 million, or 9.5% of sales, in fiscal 2019 compared to $656.0 million, or 8.5% of sales, in fiscal 2018. The increase in operating income was primarily a result of higher gross margin associated with higher sales ($131 million), improved price/cost dynamics ($46 million) and lower restructuring-related costs and inefficiencies in the access equipment and commercial segments ($35 million), offset in part by adverse product mix ($27 million), a gain on a litigation settlement in the defense segment in fiscal 2018 ($19 million) and a gain on the receipt of business interruption insurance proceeds in the commercial segment in fiscal 2018 ($7 million). Fiscal 2018 also included benefits of $8.9 million related to the collection of receivables that had previously been fully reserved and $7.7 million related to the recognition of deferred margin upon the receipt of cash from a customer. Access equipment segment operating income increased $115.1 million, or 29.7%, to $502.6 million, or 12.3% of sales, in fiscal 2019 compared to $387.5 million, or 10.3% of sales, in fiscal 2018. The increase in operating income was primarily the result of higher gross margin associated with higher sales volume ($59 million), the absence of restructuring-related charges and inefficiencies ($30 million), improved price/cost dynamics ($22 million) and lower freight costs ($20 million). Fiscal 2018 also included benefits of $8.9 million related to the collection of receivables that had previously been fully reserved and $7.7 million related to the recognition of deferred margin upon the receipt of cash from a customer. Defense segment operating income decreased $22.1 million, or 9.8%, to $203.3 million, or 10.0% of sales, in fiscal 2019 compared to $225.4 million, or 12.3% of sales, in fiscal 2018. The decrease in operating income was primarily the result of a gain on a litigation settlement in fiscal 2018 ($19 million), adverse product mix due to the ramp-up of JLTV production and lower international M-ATV sales ($17 million) and costs to start up a manufacturing facility in Tennessee ($10 million), offset in part by higher gross margin associated with higher sales volume ($23 million). Included in mix are changes in estimates on contracts accounted for under the cost-to-cost method on prior year revenues, which increased defense segment operating income by $44.7 million and $2.2 million in fiscal 2019 and 2018, respectively. Defense segment operating income for fiscal 2019 without the adoption of the new revenue recognition standard would have been $192.2 million, or 9.5% of sales. Fire & emergency segment operating income increased $38.9 million, or 28.3%, to $176.5 million, or 13.9% of sales, in fiscal 2019 compared to $137.6 million, or 12.9% of sales, in fiscal 2018. The increase in operating income was primarily the result of higher gross margin attributable to higher sales volume ($44 million) and improved price/cost dynamics ($11 million), offset in part by adverse product mix ($16 million). Fire & emergency segment operating income for fiscal 2019 without the adoption of the new revenue recognition standard would have been $167.2 million, or 13.9% of sales. Commercial segment operating income decreased $0.7 million, or 1.0%, to $66.8 million, or 6.5% of sales, in fiscal 2019 compared to $67.5 million, or 6.4% of sales, in fiscal 2018. The decrease in operating income was primarily a result of the impact of the business disruption caused by the weather-related partial roof collapse at one of its manufacturing facilities in the second quarter of fiscal 2019 ($12 million), offset in part by favorable product mix ($14 million) and improved price/cost dynamics ($8 million). Fiscal 2018 results included a $6.6 million gain on the receipt of business interruption insurance proceeds, $5.9 million of charges associated with restructuring actions and a $1.4 million loss on the sale of a small product line. Corporate operating costs decreased $9.8 million to $152.2 million in fiscal 2019 compared to fiscal 2018. The decrease in corporate operating costs was primarily due to lower management incentive compensation expense ($4 million) and lower consulting costs ($4 million). Consolidated selling, general and administrative expenses increased $19.2 million, or 2.9%, to $683.5 million, or 8.2% of sales, in fiscal 2019 compared to $664.3 million, or 8.6% of sales, in fiscal 2018. The increase in consolidated selling, general and administrative expenses was generally a result of a gain on a litigation settlement in the defense segment in fiscal 2018 ($19 million). Non-Operating Income (Expense) - Two Years Ended September 30, 2019 Interest expense net of interest income decreased $8.0 million to $47.6 million in fiscal 2019 compared to fiscal 2018 primarily due to $9.9 million of debt extinguishment costs incurred in connection with the refinancing of the Company’s senior notes and credit agreement in April 2018 and lower interest costs as the result of refinancing the Company’s debt, offset in part by the receipt of interest in fiscal 2018 from a customer that had been on non-accrual status. Other miscellaneous income, net of $1.3 million in fiscal 2019 and other miscellaneous expense, net of $5.8 million in fiscal 2018 primarily related to net foreign currency transaction gains and losses, investment gains and losses on a rabbi trust and non-service related costs of the Company’s pension plans. Provision for Income Taxes - Two Years Ended September 30, 2019 The Company recorded income tax expense of $171.3 million, or 22.8% of pre-tax income, in fiscal 2019 compared to $123.8 million, or 20.8% of pre-tax income, in fiscal 2018. Results for fiscal 2019 were adversely impacted by discrete tax charges of $1.9 million, including $7.0 million of charges for uncertain tax position reserves related to a repatriation tax on deemed repatriated earnings of foreign subsidiaries created by tax reform in the United States (the “Transition Tax”) (90 basis points), offset in part by favorable share-based compensation tax benefits of $1.5 million (20 basis points), $1.5 million of tax benefits related to state tax matters (20 basis points) and a $1.4 million tax benefit related to a foreign provision-to-return adjustment (20 basis points). Results for fiscal 2018 were favorably impacted by discrete tax benefits of $21.7 million, primarily due to a $10.7 million net tax benefit related to tax reform in the United States (180 basis points), favorable share-based compensation tax benefits of $7.2 million (120 basis points), $5.1 million of tax benefits related to state tax matters (90 basis points) and a $2.5 million tax benefit related to a foreign provision-to-return adjustment (40 basis points). See Note 7 of the Notes to Consolidated Financial Statements for a reconciliation of the effective tax rate compared to the U.S. statutory tax rate. On December 22, 2017, the U.S. Tax Cuts and Jobs Act (the “Tax Reform Act”) was signed into law. The Tax Reform Act significantly revised the U.S. corporate income tax regime by, among other things, lowering the U.S. corporate tax rate from 35% to 21% effective January 1, 2018, repealing the deduction for domestic production activities, implementing a territorial tax system and imposing a repatriation tax on deemed repatriated earnings of foreign subsidiaries. As a result of the Tax Reform Act, the Company recorded a tax benefit of $30.2 million due to a remeasurement of deferred tax assets and liabilities and a tax charge of $19.5 million due to the Transition Tax in fiscal 2018. The Company recorded a $7.0 million charge for changes to uncertain tax position reserves related to the Transition Tax liability in fiscal 2019. Equity in Earnings of Unconsolidated Affiliates - Two Years Ended September 30, 2019 Equity in earnings of unconsolidated affiliates of $1.1 million in fiscal 2018 primarily represented the Company’s equity interest in a commercial entity in Mexico and a joint venture in Europe. Liquidity and Capital Resources The Company generates significant capital resources from operating activities, which is the expected primary source of funding for its operations. Other sources of liquidity are availability under the Revolving Credit Facility (as defined in “Liquidity”) and available cash and cash equivalents of $448.4 million at September 30, 2019. The Company had $786.3 million of unused available capacity under the Revolving Credit Facility as of September 30, 2019 if liquidity needs would arise. Borrowings under the Revolving Credit Facility could, as discussed below, be limited by the financial covenants contained within the Credit Agreement (as defined in “Liquidity”). These sources of liquidity are needed to fund the Company’s working capital requirements, debt service requirements, capital expenditures, share repurchases, dividends and acquisitions that the Company may pursue on an opportunistic basis. The Company expects to meet its fiscal 2020 U.S. funding needs without repatriating undistributed profits that are indefinitely reinvested outside the United States. The Company expects to generate approximately $590 million of cash flow from operations in fiscal 2020, with approximately $150 million of the cash generated from operations planned to be utilized for capital spending needs. The Company expects to return approximately 50% of its free cash flow (defined as “cash flows from operations” less “additions to property, plant and equipment” less “additions to equipment held for rental” plus “proceeds from sale of property, plant and equipment” plus “proceeds from sale of equipment held for rental”) to shareholders in the form of dividends and share repurchases in fiscal 2020. The Company expects to have sufficient liquidity to finance its operations over the next twelve months. Financial Condition at September 30, 2019 The Company’s capitalization was as follows (in millions): The Company’s ratio of debt to total capitalization of 24.0% at September 30, 2019 remained within its targeted range. During fiscal 2019, the Company repurchased 4,866,532 shares of its Common Stock at a cost of $350.1 million under repurchase authorizations approved by the Company’s Board of Directors. At September 30, 2019, the Company had approximately 8 million shares of Common Stock remaining under this purchase authorization. In August 2015, the Company’s Board of Directors approved a stock repurchase authorization for which there was as of May 7, 2019 a remaining authority to repurchase 1,362,821 shares of Common Stock. On May 7, 2019 the Board of Directors increased the repurchase authorization by 8,637,719 shares to 10,000,000 shares. Consolidated days sales outstanding (defined as “Trade Receivables” at quarter end divided by “Net Sales” for the most recent quarter multiplied by 90 days) was 63 days at both September 30, 2018 and September 30, 2019. Days sales outstanding for segments other than the defense segment were 52 days at September 30, 2019, down slightly from 53 days at September 30, 2018. Consolidated inventory turns (defined as “Cost of Sales” on an annualized basis, divided by the average “Inventory” at the past five quarter end periods) increased from 5.1 times at September 30, 2018 to 5.2 times at September 30, 2019. As a result of the adoption of the new revenue recognition standard, work-in process inventory that related to government programs or was mounted on a customer chassis was recognized as cost of sales and is no longer in the Company’s inventory. A detailed discussion of the year-over-year changes in cash flows from the Company’s fiscal 2017 and 2018 can be found in the Management Discussion and Analysis section in the Company’s fiscal 2018 Annual Report on Form 10-K filed November 20, 2018. Operating Cash Flows The Company generated $568.3 million of cash from operating activities during fiscal 2019 compared to $436.3 million during fiscal 2018. The increase in cash generated from operating activities in fiscal 2019 compared to fiscal 2018 was primarily due to an increase in consolidated net income of $107.5 million and a $50 million increase in income taxes payable. Investing Cash Flows Net cash used in investing activities in fiscal 2019 was $153.0 million compared to $90.4 million in fiscal 2018. Additions to property, plant and equipment of $147.6 million in fiscal 2019 reflected an increase in capital spending of $52.3 million compared to fiscal 2018. The higher than typical capital spending for the Company largely reflects the construction of the Company’s new global headquarters in Oshkosh, Wisconsin. The Company expects that approximately $150 million of cash will be utilized for additions to property, plant and equipment in fiscal 2020. Financing Cash Flows Financing activities used cash of $421.6 million in fiscal 2019 compared to $338.9 million in fiscal 2018. The increase in cash utilized for financing activities was due to an increase in Common Stock repurchases under the authorization approved by the Company’s Board of Directors. In fiscal 2019, the Company repurchased approximately 4.9 million shares of its Common Stock at an aggregate cost of $350.1 million. In fiscal 2018, the Company repurchased approximately 3.3 million shares of its Common Stock at an aggregate cost of $249.3 million. In addition, the Company paid dividends of $75.5 million and $71.2 million in fiscal 2019 and 2018, respectively. The Company increased its quarterly dividend rate by approximately 11% in November 2019. Liquidity Senior Credit Agreement On April 3, 2018, the Company entered into a Second Amended and Restated Credit Agreement with various lenders (the “Credit Agreement”). The Credit Agreement provides for (i) an unsecured revolving credit facility (the “Revolving Credit Facility”) that matures in April 2023 with an initial maximum aggregate amount of availability of $850 million and (ii) an unsecured $325 million term loan (the “Term Loan”) due in quarterly principal installments of $4.1 million commencing September 30, 2019 with a balloon payment of $264.1 million due at maturity in April 2023. At September 30, 2019, outstanding letters of credit of $63.7 million reduced available capacity under the Revolving Credit Facility to $786.3 million. See Note 14 of the Notes to Consolidated Financial Statements for additional information regarding the Credit Agreement. Under the Credit Agreement, the Company is obligated to pay (i) an unused commitment fee ranging from 0.125% to 0.275% per annum of the average daily unused portion of the aggregate revolving credit commitments under the Credit Agreement and (ii) a fee ranging from 0.563% to 1.75% per annum of the maximum amount available to be drawn for each letter of credit issued and outstanding under the Credit Agreement. Borrowings under the Credit Agreement bear interest at a variable rate equal to (i) LIBOR plus a specified margin, which may be adjusted upward or downward depending on whether certain criteria are satisfied, or (ii) for dollar-denominated loans only, the base rate (which is the highest of (a) the administrative agent’s prime rate, (b) the federal funds rate plus 0.50% or (c) the sum of 1% plus one-month LIBOR) plus a specified margin, which may be adjusted upward or downward depending on whether certain criteria are satisfied. Covenant Compliance The Credit Agreement contains various restrictions and covenants, including requirements that the Company maintain certain financial ratios at prescribed levels and restrictions, subject to certain exceptions, on the ability of the Company and certain of its subsidiaries to consolidate or merge, create liens, incur additional indebtedness, dispose of assets, and consummate acquisitions. The Credit Agreement contains the following financial covenants: • Leverage Ratio: A maximum leverage ratio (defined as, with certain adjustments, the ratio of the Company’s consolidated indebtedness to consolidated net income before interest, taxes, depreciation, amortization, non-cash charges and certain other items (EBITDA)) as of the last day of any fiscal quarter of 3.75 to 1.00. • Interest Coverage Ratio: A minimum interest coverage ratio (defined as, with certain adjustments, the ratio of the Company’s consolidated EBITDA to the Company’s consolidated cash interest expense) as of the last day of any fiscal quarter of 2.50 to 1.00. With certain exceptions, the Credit Agreement limits the ability of the Company to pay dividends and other distributions, including repurchases of shares of its Common Stock. However, so long as no event of default exists under the Credit Agreement or would result from such payment, the Company may pay dividends and other distributions after April 3, 2018 in an aggregate amount not exceeding the sum of: i. $1.46 billion; ii. 50% of the consolidated net income of the Company and its subsidiaries (or if such consolidated net income is a deficit, minus 100% of such deficit), accrued on a cumulative basis during the period beginning on April 3, 2018 and ending on the last day of the fiscal quarter immediately preceding the date of the applicable proposed dividend or distribution; and iii. 100% of the aggregate net proceeds received by the Company subsequent to April 3, 2018 either as a contribution to its common equity capital or from the issuance and sale of its Common Stock. The Company was in compliance with the financial covenants contained in the Credit Agreement as of September 30, 2019 and expects to be able to meet the financial covenants contained in the Credit Agreement over the next twelve months. Senior Notes In March 2015, the Company issued $250.0 million of 5.375% unsecured senior notes due March 1, 2025 (the “2025 Senior Notes”). The proceeds of the note issuance were used to repay existing outstanding notes of the Company. On May 17, 2018 the Company issued $300.0 million of 4.600% unsecured senior notes due May 15, 2028 (the “2028 Senior Notes”) at a $1.0 million discount. The Company used the net proceeds from the sale of the 2028 Senior Notes to repay certain outstanding notes of the Company and to pre-pay $49.2 million of quarterly principal installment payments under the Term Loan. The 2025 Senior Notes and the 2028 Senior Notes were issued pursuant to separate indentures (the “Indentures”) between the Company and a trustee. The Indentures contain customary affirmative and negative covenants. The Company has the option to redeem the 2025 Senior Notes for a premium after March 1, 2020. The Company has the option to redeem the 2028 Senior Notes at any time for a premium. See Note 14 of the Notes to Consolidated Financial Statements for additional information regarding the Company’s outstanding debt as of September 30, 2019. Contractual Obligations, Commitments and Off-Balance Sheet Arrangements Following is a summary of the Company’s contractual obligations and payments due by period following September 30, 2019 (in millions): (1) Interest was calculated based upon the interest rate in effect on September 30, 2019. (2) The amounts for purchase obligations included above represent all obligations to purchase goods or services under agreements that are enforceable and legally binding and that specify all significant terms. (3) Due to the uncertainty of the timing of settlement with taxing authorities, the Company is unable to make reasonably reliable estimates of the period of cash settlement of unrecognized tax benefits for the remaining uncertain tax liabilities. Therefore, $97.3 million of unrecognized tax benefits as of September 30, 2019 have been excluded from the Contractual Obligations table above. See Note 7 of the Notes to Consolidated Financial Statements for additional information regarding the Company’s unrecognized tax benefits as of September 30, 2019. (4) Represents other long-term liabilities on the Company’s Consolidated Balance Sheet, including the current portion of these liabilities. The projected timing of cash flows associated with these obligations is based on management’s estimates, which are based largely on historical experience. This amount also includes all liabilities under the Company’s pension and other postretirement benefit plans. See Note 5 of the Notes to Consolidated Financial Statements for information regarding these liabilities and the plan assets available to satisfy them. The following is a summary of the Company’s commitments by period following September 30, 2019 (in millions): The Company incurs contingent limited recourse liabilities with respect to customer financing activities primarily in the access equipment segment. For additional information relative to guarantees, see Note 16 of the Notes to Consolidated Financial Statements. Fiscal 2020 Outlook The Company estimates consolidated net sales will be $7.9 billion to $8.2 billion in fiscal 2020, compared to $8.38 billion in fiscal 2019. The Company expects consolidated operating income will be in the range of $690 million to $765 million, resulting in earnings per share of $7.30 to $8.10. The fiscal 2020 estimates assume an average share count of 69.0 million, which reflects the full year impact of fiscal 2019 share repurchases and an expectation that the Company will return 50% of its free cash flow to shareholders in the form of dividends and share repurchases, consistent with its long-term target. The Company believes access equipment segment net sales will be between $3.5 billion to $3.8 billion in fiscal 2020, a 7% to 14% decline compared to fiscal 2019 net sales. The Company’s estimates reflect expectations that North American sales will be down low 13% to 20% reflecting a pause in fleet growth by rental companies compared to the last two years, a double-digit percentage decline in sales in the Europe, Middle East and Africa region and strong double digit percentage increase in demand in the Pacific Rim region. The increase in the Pacific Rim region reflects expected continued product adoption in that region. The Company expects operating margin in the access equipment segment in fiscal 2020 will be in the range of 11.25% to 12.25%. The Company expects lower amortization expense and the positive impact of operational initiatives to offset the impact of a less favorable regional sales mix compared to fiscal 2019 and higher new product development spending. The Company expects defense segment net sales will be approximately $2.2 billion in fiscal 2020, an increase of 8.25% compared to fiscal 2019. The fiscal 2020 estimate reflects additional JLTV production and modestly lower FHTV and FMTV sales. The Company expects defense segment operating income margin will be approximately 9.0% in fiscal 2020, reflecting the continued mix shift to a higher percentage of JLTVs and increased new product development spending. The Company expects fire & emergency segment net sales will be approximately $1.2 billion in fiscal 2020, approximately $65 million lower than fiscal 2019. The lower expected fire & emergency segment sales are mostly a reflection of activity in fiscal 2019, where approximately $40 million of sales moved from the fourth quarter of fiscal 2018 into the first quarter of fiscal 2019. The Company expects operating margin in the fire & emergency segment to increase to a range of 14.5% to 15.0% in fiscal 2020 as a result of the continued execution of the Company’s simplification strategy. The Company estimates commercial segment net sales will be approximately $1.05 billion in fiscal 2020, up slightly from fiscal 2019 sales. The Company expects operating income margin in this segment to be in the range of 7.0% to 7.25% after fiscal 2019 margins were negatively impacted by the partial roof collapse at one of its manufacturing facilities. The Company estimates corporate expenses in fiscal 2020 will be between $150 million and $155 million, approximately equivalent to fiscal 2019. The Company estimates its effective tax rate for fiscal 2020 will be between 21.25% to 21.50%, similar to fiscal 2019. The Company expects consolidated sales in the first quarter of fiscal 2020 to be down by a mid-single digit percent compared to the first quarter of fiscal 2019, with lower access equipment and fire & emergency segment sales more than offsetting higher defense segment sales. The Company expects operating income and earnings per share in the first quarter of fiscal 2020 to be down meaningfully more than the expected decline in sales on a percentage basis due to the impact in the prior year quarter of receipt of a large JLTV order in the defense segment, which increased operating income in the first quarter of fiscal 2019 by $30.3 million. The defense segment is also expecting higher new product development spending in the first quarter of fiscal 2020 as compared to the first quarter of fiscal 2019. The Company also expects commercial segment operating income margin will be down due to several favorable adjustments in the first quarter of fiscal 2019 that the Company does not expect to repeat in the first quarter of fiscal 2020. Critical Accounting Policies The Company’s significant accounting policies are described in Note 2 of the Notes to Consolidated Financial Statements. The Company considers the following policy to be the most critical in understanding the judgments that are involved in the preparation of the Company’s consolidated financial statements and the uncertainties that could impact the Company’s financial condition, results of operations and cash flows. Revenue Recognition. The Company recognizes revenue in accordance with ASC 606, Revenue from Contracts with Customers. Accordingly, revenue is recognized when control of the goods or services promised under a contract is transferred to the customer either at a point in time (e.g., upon delivery) or over time (e.g., as the Company performs under the contract) in an amount that reflects the consideration to which the Company expects to be entitled in exchange for the goods or services. The Company accounts for a contract when it has approval and commitment from both parties, the rights and payment terms of the parties are identified, the contract has commercial substance and collectability of consideration is probable. If collectability is not probable, the sale is deferred until collection becomes probable or payment is received. Approximately 31%, of the Company’s revenues were recognized under the percentage-of-completion accounting method in fiscal 2019. Contracts are reviewed to determine whether there is one or multiple performance obligations. A performance obligation is a promise to transfer a distinct good or service to a customer and represents the unit of accounting for revenue recognition. For contracts with multiple performance obligations, the expected consideration (e.g., the transaction price) is allocated to each performance obligation identified in the contract based on the relative standalone selling price of each performance obligation, which is determinable based on observable standalone selling prices or is estimated using an expected cost plus a margin approach. Revenue is then recognized for the transaction price allocated to the performance obligation when control of the promised goods or services underlying the performance obligation is transferred. When the amount of consideration allocated to a performance obligation through this process differs from the invoiced amount, it results in a contract asset or liability. The identification of performance obligations within a contract requires significant judgment. The following is a description of the primary activities from which the Company generates revenue. Access equipment, Fire & emergency and Commercial segments revenue The Company derives revenue in the access equipment, fire & emergency and commercial segments (non-defense segments) through the sale of machinery, vehicles and related aftermarket parts and services. Customers include distributors and end-users. Contracts with customers generally exist upon the approval of a quote and/or purchase order by the Company and customer. Each contract is also assessed at inception to determine whether it is necessary to combine the contract with other contracts. The Company’s non-defense segments offer various customer incentives within contracts, such as sales and marketing rebates, volume discounts and interest subsidies, some of which are variable and therefore must be estimated by the Company. Transaction prices may also be impacted by rights of return, primarily within the aftermarket parts business, which requires the Company to record a liability and asset representing its rights and obligations in the event a return occurs. The estimated return liability is based on historical experience rates. Revenue for performance obligations consisting of machinery, vehicle and after-market parts (together, “product”) is recognized when the customer obtains control of the product, which typically occurs at a point in time, based on the shipping terms within the contract. In the commercial segment, concrete mixer and refuse collection products are sold on both Company owned chassis and customer owned chassis. When performing work on a customer owned chassis, revenue is recognized over time based on the cost-to-cost method, as the Company is enhancing a customer owned asset. All non-defense segments offer aftermarket services related to their respective products such as repair, refurbishment and maintenance (together, “services”). The Company generally recognizes revenue on service performance obligations over time using the method that results in the most faithful depiction of transfer of control to the customer. Non-defense segments also offer extended warranty coverage as an option on most products. The Company considers extended warranties to be service-type warranties and therefore a performance obligation. Service-type warranties differ from the Company’s standard, or assurance-type warranties, as they are generally separately priced and negotiated as part of the contract and/or provide additional coverage beyond what the customer or customer group that purchases the product would receive under an assurance-type warranty. The Company has concluded that its extended warranties are stand-ready obligations to perform and therefore recognizes revenue ratably over the coverage period. The Company also provides a standard warranty on its products and services at no additional cost to its customers in most instances. Defense segment revenue The majority of the Company’s defense segment net sales are derived through long-term contracts with the U.S. government to design, develop, manufacture or modify defense products. These contracts, which also include those under the U.S. Government-sponsored Foreign Military Sales (FMS) program, accounted for approximately 95% of defense segment revenue in fiscal 2019. Contracts with defense segment customers are generally fixed-price or cost-reimbursement type contracts. Under fixed-price contracts, the price paid to the Company is generally not adjusted to reflect the Company’s actual costs except for costs incurred as a result of contract modifications. Certain fixed-price contracts include an incentive component under which the price paid to the Company is subject to adjustment based on the actual costs incurred. Under cost-reimbursement contracts, the price paid to the Company is determined based on the allowable costs incurred to perform plus a fee. The fee component of cost-reimbursement contracts can be fixed based on negotiations at contract inception or can vary based on performance against target costs established at the time of contract inception. The Company also designs, develops, manufactures or modifies defense products for international customers through Direct Commercial Sale contracts. The defense segment supports its products through the sale of aftermarket parts and services. Aftermarket contracts can range from long-term supply agreements to ad hoc purchase orders for replacement parts. The Company evaluates the promised goods and services within defense segment contracts at inception to identify performance obligations. The goods and services in defense segment contracts are typically not distinct from one another as they are generally customized and have complex inter-relationships and the Company is responsible for overall management of the contract. As a result, defense segment contracts are typically accounted for as a single performance obligation. The defense segment provides standard warranties for its products for periods that typically range from one to two years. These assurance-type warranties typically cannot be purchased separately and do not meet the criteria to be considered a performance obligation. The Company determines the transaction price for each contract at inception based on the consideration that it expects to receive for the goods and services promised under the contract. This determination is made based on the Company’s current rights, excluding the impact of any subsequent contract modifications (including unexercised options) until they become legally enforceable. Contract modifications frequently occur within the defense segment. The Company evaluates each modification to identify changes that impact price or scope of its contracts, which are then assessed to determine if the modification should be accounted for as an adjustment to an existing contract or as a separate contract. Contract modifications within the defense segment are generally accounted for as a cumulative effect adjustment to existing contracts as they are not distinct from the goods and services within the existing contract. For defense segment contracts that include a variable component of the sale price, the Company estimates variable consideration. Variable consideration is included within the contract’s transaction price to the extent it is probable that a significant reversal of revenue will not occur. The Company evaluates its estimates of variable consideration on an ongoing basis and any adjustments are accounted for as changes in estimates in the period identified. Common forms of variable consideration within defense segment contracts include cost reimbursement contracts that contain incentives, customer reimbursement rights and regulatory or customer negotiated penalties tied to contract performance. The Company recognizes revenue on defense segment contracts as performance obligations are satisfied and control of the underlying goods and services is transferred to the customer. In making this evaluation, the defense segment considers contract terms, payment terms and whether there is an alternative future use for the good or service. Through this process the Company has concluded that substantially all of the defense segment’s performance obligations, including a majority of performance obligations for aftermarket goods and services, transfer to the customer continuously during the contract term and therefore revenue is recognized over time. For U.S. government and FMS program contracts, this determination is supported by the inclusion of clauses within contracts that allow the customer to terminate a contract at its convenience. When the clause is present, the Company is entitled to compensation for the work performed through the date of notification at a price that reflects actual costs plus a reasonable margin in exchange for transferring its work in process to the customer. For contracts that do not contain termination for convenience provisions, the Company is generally able to support the continuous transfer of control determination as a result of the customized nature of its goods and services and contractual rights. Critical Accounting Estimates “Management’s Discussion and Analysis of Financial Condition and Results of Operations” is based on the Company’s Consolidated Financial Statements, which have been prepared in accordance with generally accepted accounting principles in the United States of America (U.S. GAAP). The preparation of financial statements in accordance with U.S. GAAP requires management to make estimates and judgments that affect reported amounts and related disclosures. On an ongoing basis, management evaluates and updates its estimates. Management employs judgment in making its estimates but they are based on historical experience and currently available information and various other assumptions that the Company believes to be reasonable under the circumstances. The results of these estimates form the basis for making judgments about the carrying values of assets and liabilities that are not readily available from other sources. Actual results could differ from those estimates. Management believes that its judgment is applied consistently and produces financial information that fairly depicts the results of operations for all periods presented. Estimate-at-Completion (EAC). The Company has concluded that control of substantially all of the defense segment’s performance obligations transfers to the customer continuously during the contract term and therefore revenue is recognized over time. The defense segment recognizes revenue on its performance obligations that are satisfied over time by measuring progress using the cost-to-cost method of percentage-of-completion because it best depicts the transfer of control to the customer. Under the cost-to-cost method of percentage-of-completion, the defense segment measures progress based on the ratio of costs incurred to date to total estimated costs for the performance obligations. Due to the size and nature of these contracts, the estimation of total revenues and costs is highly complicated and judgmental. The Company must make assumptions regarding expected increases in wages and employee benefits, productivity and availability of labor, material costs and allocated fixed costs. Each contract is evaluated at contract inception to identify risks and estimate revenue and costs. In performing this evaluation, the defense segment considers risks of contract performance such as technical requirements, schedule, duration and key contract dependencies. These considerations are then factored into the Company’s estimated revenue and costs. If a loss is expected on a performance obligation, the complete estimated loss is recorded in the period in which the loss is identified. Preliminary contract estimates are subject to change throughout the duration of the contract as additional information becomes available that impacts risks and estimated revenue and costs. Changes to production costs, overhead rates, learning curve and/or supplier performance can also impact these estimates. These estimates are highly judgmental, particularly the non-production costs currently being incurred on the JLTV and FMTV A2 contracts. The Company recognizes changes in estimated sales or costs and the resulting profit or loss on a cumulative basis. In addition, as contract modifications (e.g., new orders) are received, they are evaluated to determine if they represent a separate contract or the impact on the existing contract. As of September 30, 2019, the estimated remaining costs on the JLTV and FMTV A2 contracts represent the majority of the total estimated costs to complete in the defense segment. Changes in estimates on contracts accounted for under the cost-to-cost method on prior year revenues increased defense segment operating income by $44.7 million in fiscal 2019. Changes in estimates on contracts accounted for under the cost-to-cost method on prior year revenues increased defense segment operating income by $2.2 million in fiscal 2018. Impairment of Goodwill and Indefinite-Lived Intangible Assets. Goodwill and indefinite-lived intangible assets are tested for impairment annually, or more frequently if events or changes in circumstances indicate that the assets might be impaired. Such circumstances include a significant adverse change in the business climate for one of the Company’s reporting units, a material negative change in relationships with significant customers, or strategic decisions made in response to economic and competitive conditions. The Company performs its annual review at the beginning of the fourth quarter of each fiscal year. The Company evaluates the recoverability of goodwill by estimating the fair value of the businesses to which the goodwill relates. A reporting unit is an operating segment or, under certain circumstances, a component of an operating segment that constitutes a business. When the fair value of the reporting unit is less than the carrying value of the reporting unit, a further analysis is performed to measure and recognize the amount of the impairment loss, if any. Impairment losses, limited to the carrying value of goodwill, represent the excess of the carrying amount of a reporting unit’s goodwill over the implied fair value of that goodwill. In evaluating the recoverability of goodwill, it is necessary to estimate the fair value of the reporting units. The estimate of the fair value of the reporting units is generally determined on the basis of discounted future cash flows and a market approach. In estimating the fair value, management must make assumptions and projections regarding such items as the Company performance and profitability under existing contracts, its success in securing future business, the appropriate risk-adjusted interest rate used to discount the projected cash flows, and terminal value growth and earnings rates. The assumptions used in the estimate of fair value are generally consistent with the past performance of each reporting unit and are also consistent with the projections and assumptions that are used in current operating plans. Such assumptions are subject to change as a result of changing economic and competitive conditions. The rate used to discount estimated cash flows is a rate corresponding to the Company’s cost of capital, adjusted for risk where appropriate, and is dependent upon interest rates at a point in time. To assess the reasonableness of the discounted projected cash flows, the Company compares the sum of its reporting units’ fair value to the Company’s market capitalization and calculates an implied control premium (the excess of the sum of the reporting units’ fair values over the market capitalization). The reasonableness of this control premium is evaluated by comparing it to control premiums for recent comparable market transactions. Consistent with prior years, the Company weighted the income approach more heavily (75%) as the Company believes the income approach more accurately considers long-term fluctuations in the U.S. and European construction markets than the market approach. There are inherent uncertainties related to these factors and management’s judgment in applying them to the analysis of goodwill impairment. It is possible that assumptions underlying the impairment analysis will change in such a manner to cause further impairment of goodwill, which could have a material impact on the Company’s results of operations. The Company completed the required goodwill impairment test as of July 1, 2019. The Company identified no indicators of goodwill impairment in the test performed as of July 1, 2019. In order to evaluate the sensitivity of any quantitative fair value calculations on the goodwill impairment test, a hypothetical 10% decrease to the fair values of any reporting unit was calculated. This hypothetical 10% decrease would still result in excess fair value over carrying value for the reporting units as of July 1, 2019. The Company evaluates the recoverability of indefinite-lived trade names based upon a “relief from royalty” method. This methodology determines the fair value of each trade name through use of a discounted cash flow model that incorporates an estimated “royalty rate” the Company would be able to charge a third party for the use of the particular trade name. In determining the estimated future cash flows, the Company considers projected future sales, a fair market royalty rate for each applicable trade name and an appropriate discount rate to measure the present value of the anticipated cash flows. At July 1, 2019, the Company had approximately $1.38 billion of goodwill and indefinite-lived purchased intangibles, of which 90% were concentrated within the JLG reporting unit in the access equipment segment. Assumptions utilized in the impairment analysis are highly judgmental. While the Company currently believes that an impairment of intangible assets at JLG is unlikely, events and conditions that could result in the impairment of intangibles at JLG include a sharp decline in economic conditions, significantly increased pricing pressure on JLG’s margins or other factors leading to reductions in expected long-term sales or profitability at JLG. New Accounting Standards See Note 2 of the Notes to Consolidated Financial Statements for a discussion of the impact of new accounting standards on the Company’s consolidated financial statements. Customers and Backlog Sales to the U.S. government comprised approximately 24% of the Company’s net sales in fiscal 2019. No other single customer accounted for more than 10% of the Company’s net sales for this period. A substantial majority of the Company’s net sales are derived from the fulfillment of customer orders that are received prior to commencing production. The Company’s backlog as of September 30, 2019 decreased 0.7% to $4.14 billion compared to $4.17 billion at September 30, 2018. Access equipment segment backlog decreased 59.5% to $390.1 million at September 30, 2019 compared to $962.4 million at September 30, 2018 due to a moderation of customer demand in North America and Europe and the timing of orders as customers have become more cautious in their ordering resulting in a shift in order patterns away from placing large annual orders in advance to placing more frequent orders closer to when the equipment is needed. Defense segment backlog increased 34.0% to $2.49 billion at September 30, 2019 compared to $1.86 billion at September 30, 2018 primarily due to a $1.7 billion order for approximately 6,100 JLTVs and kits received from the U.S. Army during the first quarter of fiscal 2019, offset in part by shipments on all contracts during fiscal 2019. Fire & emergency segment backlog decreased 0.8% to $970.1 million at September 30, 2019 compared to $978.1 million at September 30, 2018. Commercial segment backlog decreased 21.1% to $296.7 million at September 30, 2019 compared to $376.0 million at September 30, 2018. Unit backlog for concrete mixers as of September 30, 2019 was down 36.4% due to lower market demand and timing of fleet orders. Unit backlog for refuse collection vehicles as of September 30, 2019 was down 18.2% compared to September 30, 2018 due to a large customer order that occurred late in fiscal 2018 that did not reoccur in fiscal 2019. Reported backlog excludes purchase options and announced orders for which definitive contracts have not been executed. Backlog information and comparisons thereof as of different dates may not be accurate indicators of future sales or the ratio of the Company’s future sales to the DoD versus its sales to other customers. Approximately 11% of the Company’s September 30, 2019 backlog is not expected to be filled in fiscal 2020. Financial Market Risk The Company is exposed to market risk from changes in interest rates, certain commodity prices and foreign currency exchange rates. To reduce the risk from changes in foreign currency exchange and interest rates, the Company selectively uses financial instruments. All hedging transactions are authorized and executed pursuant to clearly defined policies and procedures, which strictly prohibit the use of financial instruments for speculative purposes. Interest Rate Risk. The Company’s earnings exposure related to adverse movements in interest rates is primarily derived from outstanding floating rate debt instruments that are indexed to short-term market interest rates. In this regard, changes in U.S. and off-shore interest rates affect interest payable on the Company’s borrowings under its Credit Agreement. Based on debt outstanding at September 30, 2019, a 100 basis point increase or decrease in the average cost of the Company’s variable rate debt would increase or decrease annual pre-tax interest expense by approximately $2.8 million. The table below provides information about the Company’s debt obligations, which are sensitive to changes in interest rates (dollars in millions): The table presents principal cash flows and related weighted-average interest rates by expected maturity dates. Weighted-average variable rates are based on implied forward rates in the yield curve at the reporting date. Commodity Price Risk. The Company is a purchaser of certain commodities, including steel, aluminum and composites. In addition, the Company is a purchaser of components and parts containing various commodities, including steel, aluminum, rubber and others which are integrated into the Company’s end products. The Company generally buys these commodities and components based upon market prices that are established with the vendor as part of the purchase process. The Company does not use commodity financial instruments to hedge commodity prices. The Company generally obtains firm quotations from its significant components’ suppliers for its orders under firm, fixed-price contracts in its defense segment. In the Company’s access equipment, fire & emergency and commercial segments, the Company generally attempts to obtain firm pricing from most of its suppliers, consistent with backlog requirements and/or forecasted annual sales. To the extent that commodity prices increase and the Company does not have firm pricing from its suppliers, or its suppliers are not able to honor such prices, then the Company may experience margin declines to the extent it is not able to increase selling prices of its products. Foreign Currency Risk. The Company’s operations consist of manufacturing in the U.S., Mexico, Canada, France, Australia, Romania, the United Kingdom and China and sales and limited vehicle body mounting activities on five continents. International sales comprised approximately 18% of overall net sales in fiscal 2019, of which approximately 82% involved exports from the U.S. The majority of export sales in fiscal 2019 were denominated in U.S. dollars. As a result of the manufacture and sale of the Company’s products in foreign markets, the Company’s earnings are affected by fluctuations in the value of foreign currencies in which certain of the Company’s transactions are denominated as compared to the value of the U.S. dollar. The Company’s operating results are principally exposed to changes in exchange rates between the U.S. dollar and the European currencies, primarily the Euro and the U.K. pound sterling, changes between the U.S. dollar and the Australian dollar, changes between the U.S. dollar and the Brazilian real, changes between the U.S. dollar and the Mexican peso and changes between the U.S. dollar and the Chinese renminbi.

<s>[INST] The Company is a leading designer, manufacturer and marketer of a wide range of specialty vehicles and vehicle bodies, including access equipment, defense trucks and trailers, fire & emergency vehicles, concrete mixers and refuse collection vehicles. The Company is a leading global designer and manufacturer of aerial work platforms under the “JLG” brand name. The Company is among the worldwide leaders in the design and manufacturing of telehandlers under the “JLG” and “SkyTrak” brand names. Under the “JerrDan” brand name, the Company is a leading domestic designer and manufacturer and marketer of towing and recovery equipment. The Company manufactures defense trucks under the “Oshkosh” brand name and is a leading designer and manufacturer of severeduty, tactical wheeled vehicles for the DoD. Under the “Pierce” brand name, the Company is among the leading global designers and manufacturers of fire trucks assembled on both custom and commercial chassis. Under the “Frontline” brand name, the Company is a leading domestic designer, manufacturer and marketer of broadcast vehicles. The Company designs and manufactures aircraft rescue and firefighting and airport snow removal vehicles under the “Oshkosh” brand name. Under the “McNeilus,” “Oshkosh,” “London” and “CONECO” brand names, the Company designs and manufactures rear and frontdischarge concrete mixers and portable and stationary concrete batch plants. Under the “McNeilus” brand name, the Company designs and manufactures a wide range of automated, rear, front, side and top loading refuse collection vehicles. Under the “IMT” brand name, the Company is a leading domestic designer and manufacturer of field service vehicles and truckmounted cranes. Major products manufactured and marketed by each of the Company’s business segments are as follows: Access equipment aerial work platforms and telehandlers used in a wide variety of construction, industrial, institutional and general maintenance applications to position workers and materials at elevated heights, as well as carriers and wreckers. Access equipment customers include equipment rental companies, construction contractors, manufacturing companies, home improvement centers and towing companies in the U.S. and abroad. Defense tactical trucks, trailers and supply parts and services sold to the U.S. military and to other militaries around the world. Fire & emergency custom and commercial firefighting vehicles and equipment, ARFF vehicles, snow removal vehicles, simulators and other emergency vehicles primarily sold to fire departments, airports and other governmental units, and broadcast vehicles sold to broadcasters and TV stations in the U.S. and abroad. Commercial concrete mixers, refuse collection vehicles, portable and stationary concrete batch plants and vehicle components sold to readymix companies and commercial and municipal waste haulers in the Americas and other international markets and field service vehicles and truckmounted cranes sold to mining, construction and other companies in the U.S. and abroad. All estimates referred to in this “Management’s Discussion and Analysis of Financial Condition and Results of Operations” refer to the Company’s estimates as of November 19, 2019. Executive Overview The Company achieved another year of significantly improved earnings growth in fiscal 2019, reflecting strong execution in an uncertain environment. The Company successfully navigated the impacts of volatile trade policy and tariffs, along with talk of an impending recession to deliver consolidated net sales of $8.38 billion, an increase of $676.5 million, or 8.8%, compared to fiscal 2018, consolidated operating income of $797.0 million, an increase of $141.0 million, or 21.5%, and diluted earnings per share of $8.21, an increase of $1.92 per share, or 30.5%. This was the third consecutive year that the Company increased operating income by more than 20%. Fiscal 2019 results included $7.0 million, or $0.10 per share, of charges related to adjustments to the repatriation tax on deemed repatriated earnings of foreign subsidiaries required under the U.S. Tax Cuts and Jobs Act enacted in the United States in December 2017. Fiscal 2018 results included an [/INST] Negative. </s>

AXIALL CORP/DE/

2015-02-27

2014-12-31

Item 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS. We are a leading North American manufacturer and international marketer of chemicals and building products. Our chlorovinyls and aromatics chemical products are sold for further processing into a wide variety of end-use applications, including plastic pipe and pipe fittings, siding and window frames, bonding agents for wood products, high-quality plastics, acrylic sheeting and coatings for wire and cable, paper, minerals, metals and water treatment industries. Our building products segment manufactures window and door profiles, trim, mouldings and deck products, siding, pipe and pipe fittings. Merger with PPG's Chemicals Business On January 28, 2013, we completed a series of transactions that resulted in our acquisition of substantially all of the assets and liabilities of PPG Industries, Inc.'s ("PPG") business relating to the production of chlorine, caustic soda and related chemicals (the "Merged Business") through a merger between a subsidiary of PPG and a subsidiary of the Company (the "Merger") and the related financings (collectively, the "Transactions"). The operations of the Merged Business are included in our chlorovinyls segment and are reflected in our financial results from January 28, 2013, the closing date of the Merger. The purchase price of the Merged Business was approximately $2.8 billion and consisted of: (i) the issuance of approximately 35.2 million shares of our common stock valued at approximately $1.8 billion; (ii) assumed debt of approximately $967.0 million; and (iii) the assumption of other liabilities, including pension and OPEB obligations. In connection with the Merger, we incurred costs to attain synergies including plant reliability improvement initiatives, and transition costs such as consulting professionals' fees, information technology implementation costs, relocation costs and severance costs, which management believed were necessary to realize approximately $140.0 million of anticipated annualized cost synergies within two years from the consummation of the Merger. As of December 31, 2014, we incurred approximately $59.7 million of such costs to attain Merger-related synergies, which includes capitalized expenditures. In addition, we achieved $140.7 million of annualized cost synergies within two years after the consummation of the Merger. Results of Operations Overview Consolidated Overview For the year ended December 31, 2014, net sales totaled $4,568.7 million, a decrease of 2 percent compared to $4,666.0 million for the year ended December 31, 2013. Operating income was $134.1 million for the year ended December 31, 2014, compared to $370.8 million for the year ended December 31, 2013. Adjusted EBITDA was $436.3 million for the year ended December 31, 2014 compared to $672.0 million for the year ended December 31, 2013. In addition, the Company reported net income attributable to Axiall of $46.3 million, or $0.65 per diluted share for the year ended December 31, 2014, compared to net income attributable to Axiall of $165.3 million, or $2.44 per diluted share for the year ended December 31, 2013. Adjusted Net Income was $93.4 million and Adjusted Earnings Per Share was $1.32 for the year ended December 31, 2014, compared to Adjusted Net Income of $266.1 million and Adjusted Earnings Per Share of $3.93 for the year ended December 31, 2013. See Reconciliation of Non-GAAP Financial Measures in this Annual Report on Form 10-K. The decrease in net sales for the year ended December 31, 2014 as compared to the year ended December 31, 2013 was primarily attributable to a $138.9 million decrease in the net sales of our aromatics segment which was due to decreased domestic demand for cumene and decreased export opportunities for phenol, partially offset by increases in the net sales of our chlorovinyls and building products segments. The $12.9 million increase in our chlorovinyls segment's net sales was partly due to the inclusion of twelve months of sales results from the Merged Business for the year ended December 31, 2014 versus eleven months in the year ended December 31, 2013, coupled with higher vinyl resin pricing during the year ended December 31, 2014. Net sales in our building products segment increased $28.7 million primarily due to higher sales volumes in the United States. The decreases in operating income, Adjusted EBITDA, net income attributable to Axiall and Adjusted Net Income, for the year ended December 31, 2014, as compared to the year ended December 31, 2013, were primarily attributable to: (i) lower operating rates and increased maintenance and operating costs due to several outages within our chlor-alkali operations, the most significant of which included extended outages at our PHH vinyl chloride monomer ("VCM") manufacturing facility; (ii) lower electro-chemical unit ("ECU") values, especially with respect to caustic soda pricing, resulting primarily from the addition of new production capacity in North America coupled with slower growth in the demand needed to absorb that capacity, partially offset by higher pricing for our vinyl resins, VCM and chlorinated derivative products; (iii) a significant increase in our cost of natural gas and ethylene; and (iv) the decrease in domestic and export demand for aromatics products made in North America due to new production capacity in Asia. Chlorovinyls Business Overview Our chlorovinyls segment produces a highly integrated chain of chlor-alkali and derivative products (chlorine, caustic soda, VCM, vinyl resins, ethylene dichloride, chlorinated solvents, calcium hypochlorite, muriatic acid and phosgene derivatives) and compound products (vinyl compounds and compound additives and plasticizers). As discussed further below, certain highlights from our chlorovinyls segment results of operations for the year ended December 31, 2014 compared to the year ended December 31, 2013 were as follows: • Net sales totaled $2,930.2 million and $2,917.3 million for the years ended December 31, 2014 and 2013, respectively, increasing approximately $12.9 million. • Operating income and Adjusted EBITDA decreased to $213.9 million and $448.1 million, respectively, during the year ended December 31, 2014 versus operating income and Adjusted EBITDA of $434.9 million and $624.5 million, respectively, for the year ended December 31, 2013. Our chlorovinyls segment is cyclical in nature and is affected by domestic and worldwide economic conditions. Cyclical price swings, driven by changes in supply and demand, can lead to significant changes in the overall profitability of our chlorovinyls segment. The demand for our chlorovinyls products tends to reflect fluctuations in downstream markets that are affected by consumer spending for durable and non-durable goods as well as construction. Global capacity also materially affects the prices of chlorovinyls products. Historically, in periods of high operating rates, prices rise and margins increase and, as a result, new capacity is announced. Since world scale size plants are generally the most cost-competitive, new increases in capacity tend to be on a large scale and are often undertaken by existing industry participants. Usually, as new capacity is added, prices decline until increases in demand improve operating rates and the new capacity is absorbed or, in some instances, until less efficient producers withdraw capacity from the market. As the additional supply is absorbed, operating rates rise, prices increase and the cycle repeats. In addition, purchased raw materials and natural gas costs account for the majority of our cost of sales and can also have a material effect on our profitability and margins. Some of the primary raw materials used in our chlorovinyls products, including ethylene, are crude oil and natural gas derivatives and therefore follow the oil and gas industry price trends. Building Products Business Overview Our building products segment consists of two primary product groups: (i) window and door profiles and trim, mouldings and deck products, which include extruded vinyl window and door profiles, interior and exterior trim and mouldings products, as well as deck products; and (ii) outdoor building products, which includes siding, pipe and pipe fittings. As discussed further below, certain highlights from our building products segment results of operations for the year ended December 31, 2014 compared to the year ended December 31, 2013 were as follows: • Net sales totaled $878.6 million and $849.9 million for the years ended December 31, 2014 and 2013, respectively, increasing 3 percent. On a constant currency basis, net sales for the year ended December 31, 2014 increased by 7 percent. • For the year ended December 31, 2014, our building products segment's geographical sales to the United States and Canada were 54 percent and 45 percent respectively, compared with 50 percent and 49 percent for the year ended December 31, 2013. • Operating income was $25.8 million and Adjusted EBITDA was $67.7 million for the year ended December 31, 2014 compared to operating income of $3.0 million and Adjusted EBITDA of $70.7 million for the year ended December 31, 2013. The building products segment is impacted by changes in the North American home repair and remodeling sectors, as well as the new construction industry, which may be significantly affected by changes in economic and other conditions such as gross domestic product levels, employment levels, demographic trends, consumer confidence, increases in interest rates and availability of consumer financing for home repair and remodeling projects as well as the availability of financing for new home purchases. These factors can lower the demand for, and pricing of our products, while we may not be able to reduce our costs by an equivalent amount. Aromatics Business Overview Our aromatics segment manufactures cumene products and phenol and acetone products (co-products made from cumene). As discussed further below, certain highlights of our aromatics segment results of operations for the year ended December 31, 2014 compared to the year ended December 31, 2013 were as follows: • Net sales were $759.9 million and $898.8 million for the years ended December 31, 2014 and 2013, respectively, decreasing 15 percent in the aggregate and reflecting a 15 percent decrease in cumene sales volume and a 23 percent decrease in phenol and acetone sales volumes. • Operating loss was $20.7 million and Adjusted EBITDA was negative $18.5 million for the year ended December 31, 2014 compared to operating income of $29.1 million and Adjusted EBITDA of $30.3 million for the year ended December 31, 2013. In our aromatics business, significant volatility in raw materials costs can decrease product margins as sales price increases sometimes lag raw materials cost increases. Product margins may also suffer from a sharp decline in raw materials costs due to the time lag between the purchase of raw materials and the sale of the finished goods manufactured using those raw materials. Results of Operations The following table sets forth our consolidated statements of operations data for each of the years ended December 31, 2014, 2013 and 2012, and the percentage of net sales of each line item for the years presented. The following table sets forth certain financial data, by reportable segment, for each of the years ended December 31, 2014, 2013 and 2012. Year Ended December 31, 2014 Compared With Year Ended December 31, 2013 Consolidated Results Net sales. For the year ended December 31, 2014, net sales totaled $4,568.7 million, a decrease of 2 percent compared to $4,666.0 million for the year ended December 31, 2013. The decrease in our consolidated net sales was primarily attributable to a $138.9 million decrease in the net sales in our aromatics segment partially offset by increases in the net sales of our chlorovinyls and building products segments. The decrease in our aromatics net sales was primarily due to decreased export opportunities for phenol, which was caused primarily by recent additions of significant phenol production capacity in Asia. These same factors were also primarily responsible for the decrease in our sales volume of cumene, as domestic producers of phenol manufactured less phenol, for which cumene is a raw material. Net sales in our chlorovinyls segment increased by $12.9 million primarily due to the inclusion of twelve months of sales results from the Merged Business for the year ended December 31, 2014 versus the inclusion of only eleven months of sales results from the Merged Business for the year ended December 31, 2013, offset by: (i) lower operating rates and related sales volumes due to several outages within our chlor-alkali operations, the most significant of which included extended outages at our PHH VCM manufacturing facility; and (ii) lower ECU values, for both chlorine and caustic soda pricing, caused primarily by the addition of new production capacity in North America coupled with slower growth in the demand needed to absorb that capacity, partially offset by higher PVC and VCM prices. Net sales in our building products segment increased by $28.7 million primarily driven by a 17 percent increase in sales volumes in the United States, partially offset by the impact of a stronger U.S. dollar against a weaker Canadian dollar. Gross margin percentage. Total gross margin percentage decreased to 11 percent for the year ended December 31, 2014 from 16 percent for the year ended December 31, 2013. This decrease was principally due to: (i) lower operating rates and higher maintenance and operating costs due to several outages within our chlor-alkali operations, the most significant of which included extended outages at our PHH VCM manufacturing facility; (ii) lower ECU values, for both chlorine and caustic soda pricing, caused primarily by the factors discussed in the preceding paragraph, partially offset by higher pricing for our vinyl resins, VCM and chlorinated derivative products; (iii) higher natural gas and ethylene costs; and (iv) the decrease in domestic and export demand for aromatics products made in North America due to new production capacity in Asia. In December 2014, IHS reported that natural gas prices increased 20 percent and ethylene prices increased by 3 percent for the year ended December 31, 2014 as compared to the year ended December 31, 2013. In 2013, the chlorovinyls segment's gross margin was negatively impacted by a $13.4 million fair value inventory acquisition accounting adjustment related to the Merged Business. Selling, general and administrative expenses. Selling, general and administrative expenses totaled $310.5 million for the year ended December 31, 2014, an increase of 4 percent from $299.1 million for the year ended December 31, 2013. This increase was primarily due to the inclusion of twelve months of expenses from the Merged Business during the year ended December 31, 2014, versus only eleven months for the year ended December 31, 2013, as well as increased amortization expense, professional fees and promotional costs. Transaction-related costs and other, net. Transaction-related costs and other, net, increased 8 percent to $38.4 million during the year ended December 31, 2014 from $35.6 million during the year ended December 31, 2013. During 2014, our U.S. Pension Plans were amended to provide a one-time voluntary lump-sum distribution offer to terminated vested participants and we recorded a settlement charge of $5.8 million related to these costs. During the year ended December 31, 2013, the company recorded a curtailment gain of $15.5 million related to certain pension plan amendments, partially offset by lower integration costs, costs to attain Merger-related synergies and deal-related costs. Long-lived asset impairment charges, net. Long-lived asset impairment charges, net decreased $18.4 million to $17.6 million during the year ended December 31, 2014 from $36.0 million during the year ended December 31, 2013. During the year ended December 31, 2014, the Company incurred approximately $16.6 million in long-lived and intangible asset impairment charges related to our phosgene derivatives product line that is classified as held-for-sale in our chlorovinyls segment. In 2013, we recorded an impairment charge of $24.9 million to write-down goodwill and other intangible assets in the window and door profiles reporting unit. The write-down was due primarily to the prolonged downturn in the North American housing and construction markets, continued pricing declines, and the expected impact of those declines on projected cash flows on the window and door profiles reporting unit. Operating income. Operating income was $134.1 million for the year ended December 31, 2014 compared to an operating income of $370.8 million for the year ended December 31, 2013. The decrease in operating income was primarily a result of: (i) lower operating rates and increased maintenance and operating costs due to several outages within our chlor-alkali operations, the most significant of which included extended outages at our PHH VCM manufacturing facility; (ii) lower ECU values for both chlorine and caustic soda pricing, partially offset by higher pricing for our vinyl resins, VCM and chlorinated derivative products; (iii) higher natural gas and ethylene costs; and (iv) the decrease in domestic and export demand for aromatics products made in North America due to new production capacity in Asia. Interest expense. Interest expense totaled $76.5 million and $77.6 million for the years ended December 31, 2014 and 2013, respectively. Loss on redemption and other debt cost. Loss on redemption and other debt cost resulted from the financing of the Transactions and financing fees associated with the retirement of our 9 percent notes in 2013, which included a $55.4 million make-whole payment. There were no similar transactions or refinancing activities during the year ended December 31, 2014. Gain on acquisition of controlling interest. In January 2013, we acquired the Merged Business and the remaining 50 percent interest of PHH that we did not previously own. Prior to the Merger, we owned 50 percent of PHH and accounted for our ownership interest as an equity method investment. During the year ended December 31, 2013, we recognized a gain of $25.9 million as a result of remeasuring our prior equity interest in PHH held before the Merger in accordance with GAAP. We had no such gain during the year ended December 31, 2014. Foreign currency exchange loss. Foreign currency exchange loss totaled $0.6 million for the year ended December 31, 2014 and was nominal for the year ended December 31, 2013. The foreign currency exchange loss for the year ended December 31, 2014 is primarily due to the impact of a stronger U.S. dollar against a weaker Canadian dollar. Interest income. Interest income totaled $0.7 million and $1.0 million for the years ended December 31, 2014 and 2013, respectively. Provision for income taxes. The provision for income taxes was $7.5 million for the year ended December 31, 2014, compared to a provision for income taxes of $73.6 million for the year ended December 31, 2013. The decrease was primarily due to a lower income before income taxes during the year ended December 31, 2014 compared to the year ended December 31, 2013, as well as the release of uncertain tax positions for which the statute of limitations has expired, or effective settlement has occurred. Our effective income tax rates for the years ended December 31, 2014 and 2013 were 13.0 percent and 30.5 percent, respectively. The difference in the effective income tax rate as compared to the United States statutory federal income tax rate in 2014 was primarily due to various permanent differences, including deductions for manufacturing activities, as well as a $9.2 million favorable impact from changes in uncertain tax positions. The difference in the effective income tax rate as compared to the United States statutory federal income tax rate in 2013 was primarily due to various permanent differences including deductions for manufacturing activities and a $2.7 million favorable impact from changes in uncertain tax positions. Chlorovinyls Segment Net sales. Net sales totaled $2,930.2 million for the year ended December 31, 2014, an increase of $12.9 million versus net sales of $2,917.3 million for the year ended December 31, 2013. Our overall net sales increase was primarily due to the inclusion of twelve months of sales results from the Merged Business for the year ended December 31, 2014 versus the inclusion of only eleven months of sales results from the Merged Business for the year ended December 31, 2013, offset by: (i) lower operating rates and related sales volumes due to several outages in our chlor-alkali operations, the most significant of which included extended outages at our PHH VCM manufacturing facility; and (ii) lower ECU values for both chlorine and caustic soda pricing, caused primarily by the addition of new production capacity in North America coupled with slower growth in the demand needed to absorb that capacity, partially offset by higher pricing for our vinyl resins, VCM and chlorinated derivative products. Operating income. Operating income decreased by $221.0 million to $213.9 million for the year ended December 31, 2014 from $434.9 million for the year ended December 31, 2013. The decrease was principally due to: (i) lower operating rates and increased maintenance and operating costs from several outages within our chlor-alkali operations, the most significant of which included extended outages at our PHH VCM manufacturing facility; (ii) lower ECU values resulting primarily from the reasons discussed above, partially offset by higher pricing for our vinyl resins, VCM and chlorinated derivative products; and (iii) increases in our cost of natural gas and ethylene. In December 2014, IHS reported that industry natural gas prices increased 20 percent and ethylene prices increased 3 percent for the year ended December 31, 2014 compared to the year ended December 31, 2013. During the year ended December 31, 2013, the segment's operating income was negatively impacted by a $13.4 million fair value inventory acquisition accounting adjustment related to the Merged Business and by $13.8 million of costs to attain Merger-related synergies, which included $10.3 million of plant reliability improvement initiatives. Adjusted EBITDA decreased $176.4 million to $448.1 million for the year ended December 31, 2014 from $624.5 million for the year ended December 31, 2013. That decrease was predominantly due to the same factors discussed above with respect to operating income, partially offset by the twelve full months of Adjusted EBITDA contributed by the Merged Business in 2014 compared to eleven months in 2013. Building Products Segment Net sales. Net sales totaled $878.6 million for the year ended December 31, 2014, increasing 3 percent, versus $849.9 million for the year ended December 31, 2013. The net sales increase was primarily driven by a 17 percent increase in sales volumes in the United States, partially offset by the impact of a stronger U.S. dollar against a weaker Canadian dollar. On a constant currency basis, net sales increased by 7 percent. For the year ended December 31, 2014, our building products segment's geographical sales to the United States and Canada were 54 percent and 45 percent respectively, compared with 50 percent and 49 percent for the year ended December 31, 2013. Operating income. Operating income was $25.8 million and $3.0 million for the years ended December 31, 2014, and 2013, respectively. The increase in operating income was primarily a result of $24.4 million in lower impairment and restructuring charges in the year ended December 31, 2014 compared to the year ended December 31, 2013. The year ended December 31, 2013 included a $24.9 million impairment charge to write down goodwill and other intangible assets as a result of our evaluation of the window and door profiles reporting unit's fair value. There were no such impairment charges related to goodwill and other intangible assets for the year ended December 31, 2014. Adjusted EBITDA was $67.7 million for the year ended December 31, 2014 compared to Adjusted EBITDA of $70.7 million for the year ended December 31, 2013. The $3.0 million decrease in Adjusted EBITDA was primarily a result of higher material costs, the impact of a stronger U.S. dollar against a weaker Canadian dollar and higher distribution and selling expenses, offset in part by lower conversion costs, higher sales volumes and lower general and administrative expenses. Aromatics Segment Net sales. Net sales were $759.9 million for the year ended December 31, 2014, a decrease of 15 percent versus $898.8 million for the year ended December 31, 2013. The net sales decrease primarily resulted from a 15 percent decrease in cumene sales volume and a 23 percent decrease in phenol and acetone sales volumes. The decrease in our sales volume of phenol is primarily due to a significant decline in export demand for phenol produced in the United States, which is primarily the result of the recent addition of a significant amount of new phenol production capacity in Asia. These same factors are also primarily responsible for the decrease in our sales volume of cumene. Specifically, domestic producers of phenol are manufacturing less phenol, for which cumene is a raw material, in response to the decline in export demand for phenol. Accordingly, those domestic producers, some of which have historically been our customers, have required significantly less cumene. In addition, the decline in our cumene sales volume has been caused in part by certain of our customers purchasing less cumene from us on a contracted basis. We expect these lower levels of phenol sales volumes to continue in 2015. Operating income (loss). Operating loss was $20.7 million and operating income was $29.1 million for the years ended December 31, 2014 and 2013, respectively. Our operating rates for the aromatics segment were lower in the year ended December 31, 2014, versus the year ended December 31, 2013 and were lower than the industry operating rates for the year ended December 31, 2014, as reported in the December 2014 IHS publication. The $49.8 million decrease in operating income and our lower operating rates were due primarily to (i) the overall weakening of the domestic and international aromatics markets; (ii) a $11.9 million inventory holding loss due to a significant decline in raw material costs; and (iii) a $9.2 million lower-of-cost or market adjustment for inventory during the year ended December 31, 2014. The Adjusted EBITDA decrease of $48.8 million to negative $18.5 million for the year ending December 31, 2014 from $30.3 million for the year ending December 31, 2013 was principally due to lower domestic and export sales volumes, the inventory holding loss due to a significant decline in raw material costs, and the lower of cost or market inventory adjustment, as well as the factors discussed in the preceding paragraph. Year Ended December 31, 2013 Compared With Year Ended December 31, 2012 Consolidated Results Net sales. For the year ended December 31, 2013, net sales totaled $4,666.0 million, an increase of $1,340.2 million or 40 percent versus $3,325.8 million for the year ended December 31, 2012. The net sales increase was primarily attributable to our chlorovinyls segment, principally due to the inclusion of eleven months of sales from the Merged Business in 2013. Gross margin percentage. Total gross margin percentage rose to 16 percent for the year ended December 31, 2013 from 14 percent for the year ended December 31, 2012. This increase in gross margin percentage was primarily attributable to higher caustic soda sales after the addition of the Merged Business, with the chlorovinyls segment contributing 76 percent to the total gross margin during the year ended December 31, 2013 versus a 56 percent contribution from that segment during the comparable period in 2012. The chlorovinyls segment's gross margin for the year ended December 31, 2013 was negatively impacted by approximately $13.4 million in fair value inventory acquisition accounting adjustment related to the Merged Business during the year ended December 31, 2013. Gross margin was also impacted unfavorably by $10.3 million of costs to attain Merger-related synergies related to plant reliability improvement initiatives during the year ended December 31, 2013. These unfavorable impacts were offset by the higher caustic soda sales from the addition of the Merged Business in 2013. Selling, general and administrative expenses. Selling, general and administrative expenses totaled $299.1 million for the year ended December 31, 2013, a 47 percent increase from $203.5 million for the year ended December 31, 2012. The increase in selling, general and administrative expenses was primarily due to the addition of selling, general and administrative expenses of the Merged Business. Transaction related costs and other, net. Transaction related costs and other, net, decreased 8 percent to $35.6 million for the year ended December 31, 2013 from $38.9 million during the year ended December 31, 2012. The decrease was primarily due to a lower amount of professional fees associated with the Transactions in the year ended December 31, 2013, as compared to the year ended December 31, 2012. During the year ended December 31, 2013, we incurred $34.4 million in integration costs to attain Merger-related synergies versus $5.6 million for the year ended December 31, 2012. In addition, during the year ended December 31, 2013, we incurred $7.2 million in Merger-related deal costs versus $30.2 million in 2012, which for 2012 included costs related to a withdrawn unsolicited proposal to acquire us. Long-lived asset impairment charges (recoveries), net. Long-lived asset impairment charges totaled $36.0 million for the year ended December 31, 2013 compared to a recovery of $0.8 million, net for the year ended December 31, 2012. The $36.8 million increase was primarily due to a $24.9 million impairment charge to write-down the goodwill and other intangible assets related to our window and door profiles reporting unit in our building products segment during 2013. The impairment charge was the result of our evaluation of the window and door profiles reporting unit's fair value that has been negatively impacted by the prolonged downturn in the North American housing and construction markets and continued pricing declines, and the expected impact of those declines on projected cash flows. In addition, in 2013 we recognized asset impairment charges of approximately $11.1 million primarily related to certain duplicated assets as a result of the Merger and other restructuring transactions. Gain on sale of assets. In January 2012, we sold our on-site air separation unit at our Plaquemine, Louisiana facility for $18.0 million, resulting in a gain of $17.4 million. In addition, during the year ended December 31, 2012, we recognized a gain of $1.9 million on the sale of other assets. These gains are included in gain on sale of assets in our chlorovinyls segment and in our consolidated statements of operations for the year ended December 31, 2012. Operating Income. Operating income increased to $370.8 million for the year ended December 31, 2013 from $238.1 million for the year ended December 31, 2012, as a result of the reasons described above and in more detail in our segment discussions. Interest expense. Interest expense increased to $77.6 million for the year ended December 31, 2013 from $57.5 million for the year ended December 31, 2012. This increase of $20.1 million in interest expense was primarily attributable to a higher overall average debt balance during the year ended December 31, 2013, primarily due to the additional debt we incurred in connection with the Transactions, compared to the year ended December 31, 2012, partially offset by lower interest rates on our outstanding indebtedness. Loss on redemption and other debt cost. Loss on redemption and other debt costs resulted from financing the Transactions and financing fees associated with the redemption of our 9 percent notes during the year ended December 31, 2013. The redemption of our 9 percent notes included a $55.4 million make-whole payment that is included in loss on redemption and other debt costs. Gain on acquisition of controlling interest. In the Merger, we acquired the Merged Business and the remaining 50 percent interest in our PHH joint venture that we did not previously own as of January 28, 2013, the date of the Merger. Prior to the Transactions, we owned 50 percent of PHH and accounted for our ownership interest as an equity method investment. We recognized a gain of $25.9 million as a result of remeasuring our prior equity interest in PHH that we held before the Merger. Interest income. Interest income totaled $1.0 million and $0.4 million for the years ended December 31, 2013 and 2012, respectively. Provision for income taxes. The provision for income taxes was $73.6 million and $57.2 million for the years ended December 31, 2013 and 2012, respectively. Our effective income tax rates for the years ended December 31, 2013 and 2012, were 30.5 percent and 32.2 percent, respectively. The difference in the effective income tax rates as compared to the U.S. statutory federal income tax rate in 2013 was primarily due to various permanent differences, including deductions for manufacturing activities and a $2.7 million favorable impact from changes in uncertain tax positions. The difference in the effective income tax rate as compared to the U.S. statutory federal income tax rate in 2012 was primarily due to provisions for state tax and various permanent differences, including deductions for manufacturing activities, certain Merger-related costs and a $6.0 million favorable impact from changes in uncertain tax position. Chlorovinyls Segment Net sales. Net sales totaled $2,917.3 million for the year ended December 31, 2013, an increase of 117 percent versus net sales of $1,344.9 million for the year ended December 31, 2012. Our overall net sales increase was primarily due to the inclusion of eleven months of sales results from the Merged Business for the year ended December 31, 2013. Our operating rates in the chlorovinyls segment for the year ended December 31, 2013 exceeded the IHS published December 2013 year-to-date estimated industry operating rates for both the chlorine/caustic and vinyl resins industries. Operating income. Operating income increased by $197.7 million to $434.9 million for the year ended December 31, 2013 from $237.2 million for the year ended December 31, 2012. This increase in operating income was due primarily to the impact of the Merged Business. Operating income was negatively impacted by approximately $13.4 million in fair value inventory acquisition accounting adjustments related to the Merger, which is reflected in the increased cost of sales. Operating income was also unfavorably impacted by the increase in ethylene and natural gas prices for the year ended December 31, 2013 compared to the year ended December 31, 2012. Operating income was also impacted by $10.3 million of costs incurred in the year ended December 31, 2013 to attain Merger-related synergies related to plant reliability improvement initiatives. The Adjusted EBITDA increase of $360.1 million to $624.5 million for the year ended December 31, 2013 from $264.4 million for the year ended December 31, 2012 was predominantly due to the same reasons as the increase in operating income, less the impact of: (i) a $13.4 million fair value of inventory acquisition accounting adjustment; (ii) cost to attain Merger-related synergies; (iii) integration costs; and (iv) additional depreciation and amortization expense from the fair value adjustments to property, plant and equipment and intangible assets related to the acquisition of the Merged Business. These unfavorable impacts were offset by the higher caustic soda sales from the addition of the Merged Business. Building Products Segment Net Sales. Net sales totaled $849.9 million for the year ended December 31, 2013, a decrease of 3 percent versus $876.6 million for the year ended December 31, 2012. The decrease in net sales was a result of lower sales volumes in Canada partially offset by higher sales volumes in the U.S. For the year ended December 31, 2013, our building products segment's geographical sales to the U.S. and Canada were 50 percent and 49 percent respectively, compared with 46 percent and 53 percent for the year ended December 31, 2012. Operating Income. Operating income was $3.0 million for the year ended December 31, 2013 compared to $18.4 million for the year ended December 31, 2012, representing a $15.4 million unfavorable change for 2013 versus 2012. The decrease in operating income was primarily driven by a $24.9 million impairment charge to write down goodwill and other intangible assets in our window and door profiles reporting unit during 2013. The impairment charge was the result of our evaluation of the window and door profiles reporting unit's fair value that has been negatively impacted by the prolonged downturn in the North American housing and construction markets, continued pricing declines, and the expected impact of those declines on projected cash flows. There were no impairment charges related to goodwill and other intangible assets for the year ended December 31, 2012. In addition, we recorded $3.6 million in restructuring related long-lived asset impairment charges during the year ended December 31, 2013, compared to a recovery of $0.8 million, net for restructuring charges during the year ended December 31, 2012. In September 2013, we initiated a restructuring plan in our building products segment consisting of various cost saving initiatives, including the reduction of overhead and plant labor, and the consolidation of various plants within the window and door profiles reporting unit to improve utilization and efficiencies. Adjusted EBITDA increased to $70.7 million for the year ended December 31, 2013 compared to Adjusted EBITDA of $57.5 million for the year ended December 31, 2012. The $13.2 million increase in Adjusted EBITDA was primarily due to higher gross margin, as a result of lower materials costs, improved conversion costs and lower selling, general and administrative expenses. Aromatics Segment Net Sales. Net sales were $898.8 million for the year ended December 31, 2013, a decrease of 19 percent versus $1,104.3 million for the year ended December 31, 2012. The net sales decrease primarily resulted from a 28 percent decline in our overall sales volume driven by lower cumene, phenol and acetone demand, lower export contract sales volumes for phenol and lower opportunistic export and domestic sales volumes for cumene during the year ended December 31, 2013 versus the year ended December 31, 2012. The decrease in sales volume for phenol was primarily attributable to lower export sales due to reduced export opportunities. The sales volume decrease was partially offset by a 13 percent increase in overall average sales prices driven by a 10 percent increase in the sales price of cumene and 6 percent increase in the sales price for phenol and acetone. The sales price increases reflected higher costs for propylene and benzene. Operating income. Operating income decreased by $35.5 million to $29.1 million for the year ended December 31, 2013 from $64.6 million for the year ended December 31, 2012. The decline in operating income was due to a decline in sales volume in 2013 when compared to 2012, coupled with an inventory holding gain of $0.6 million in the year ended December 31, 2013 compared to an inventory holding gain of $16.3 million during the year ended December 31, 2012. In addition, our operating rates for the aromatics segment were lower in the year ended December 31, 2013, versus the year ended December 31, 2012. For the year ended December 31, 2013, our aromatics segment's operating rates for both cumene and phenol/acetone were below the industry operating rates as reported in the December 2013 IHS publication. The reduction in our operating rates for 2013 as compared to 2012 was caused primarily by a planned phenol plant outage during August 2013. Adjusted EBITDA decreased by $35.8 million to $30.3 million for the year ended December 31, 2013 from $66.1 million for the year ended December 31, 2012 predominantly due to the same reasons as the decrease in operating income. Reconciliation of Non-GAAP Financial Measures Axiall has supplemented its financial statements prepared in accordance with GAAP that are set forth in this Annual Report on Form 10-K (the "Financial Statements") with four non-GAAP financial measures: (i) Adjusted Net Income; (ii) Adjusted Earnings Per Share; (iii) Adjusted EBITDA; and (iv) building products net sales on a constant currency basis. Adjusted Net Income is defined as net income attributable to Axiall excluding adjustments for tax effected cash and non-cash restructuring charges and certain other charges, if any, related to financial restructuring and business improvement initiatives, gains or losses on redemption and other debt costs, and sales of certain assets, certain acquisition accounting and certain non-income tax reserve adjustments, professional fees related to a previously disclosed and withdrawn unsolicited offer and the Merger, costs to attain Merger-related synergies, goodwill, intangible assets, and other long-lived asset impairments. Adjusted Earnings Per Share is calculated using Adjusted Net Income rather than consolidated net income calculated in accordance with GAAP. Adjusted EBITDA is defined as Earnings Before Interest, Taxes, Depreciation and Amortization, cash and non-cash restructuring charges and certain other charges, if any, related to financial restructuring and business improvement initiatives, gains or losses on redemption and other debt costs, and sales of certain assets, certain acquisition accounting and certain non-income tax reserve adjustments, professional fees related to a previously disclosed and withdrawn unsolicited offer and the Merger, costs to attain Merger-related synergies, goodwill, intangible assets, other long-lived asset impairments, certain pension and other post-retirement plan curtailment gains and settlement losses and interest expense related to the lease-financing transaction discussed in Note 8 to this Annual Report on Form 10-K. Axiall has supplemented the financial statements with Adjusted Net Income and Adjusted Earnings Per Share because investors commonly use financial measures such as Adjusted Net Income and Adjusted Earnings Per Share as a component of performance and valuation analysis for companies, such as Axiall, that recently have engaged in transactions that result in non-recurring pre-tax charges or benefits that have a significant impact on the calculation of consolidated net income pursuant to GAAP, in order to approximate the amount of net income that such a company would have achieved absent those non-recurring, transaction-related charges or benefits. In addition, Axiall has supplemented the Financial Statements with Adjusted Net Income and Adjusted Earnings Per Share because we believe these financial measures will be helpful to investors in approximating what our net income would have been absent the impact of certain non-recurring, pre-tax charges and benefits related to the Merger, the Company's issuance of its 4.875 Notes and the tender offer for, and related redemption of its 9 percent notes. We have supplemented the financial statements with Adjusted EBITDA because investors commonly use Adjusted EBITDA as a main component of valuation analysis of cyclical companies such as Axiall. In addition, we may compare certain financial information, including building products net sales, on a constant currency basis. We present such information to provide a framework for investors to assess how our underlying businesses performed, excluding the effect of foreign currency rate fluctuations, primarily fluctuations in the Canadian dollar. To present this information, current and comparative prior period financial information for certain businesses reporting in currencies other than United States dollars are converted into United States dollars at the average exchange rate in effect during the period, rather than the average exchange rates in effect during the respective periods. Adjusted Earnings Per Share, Adjusted Net Income, Adjusted EBITDA and building products net sales on a constant currency basis, are not measurements of financial performance under GAAP and should not be considered as an alternative to net income, GAAP diluted earnings per share or net sales, as a measure of performance or to cash provided by operating activities as a measure of liquidity. In addition, our calculation of Adjusted Net Income, Adjusted Earnings Per Share, Adjusted EBITDA and building products net sales on a constant currency basis, may be different from the calculations used by other companies and, therefore, comparability may be limited. Reconciliations of these non-GAAP financial measures to the most comparable GAAP measures are presented in the tables set forth below. Adjusted Earnings Per Share Reconciliation Adjusted Net Income Reconciliation Adjusted EBITDA Reconciliations Year Ended December 31, 2014 (1)Includes $11.7 million of plant reliability improvement initiatives that are included in cost of sales on our consolidated statements of operations. (2)Includes $30.2 million of Merger-related and other, net, partially offset by $6.5 million of lease financing obligations interest and $5.2 million for debt issuance cost amortization. (3)Earnings of our segments exclude interest income and expense, unallocated corporate expenses and general plant services, and provision for income taxes. Year Ended December 31, 2013 (1)Includes $10.3 million of plant reliability improvement initiatives that are included in cost of sales on our condensed consolidated statements of operations. (2)Includes $21.2 million of Merger-related and other, net, and $13.4 million of inventory fair value purchase accounting adjustment, partially offset by $7.1 million of lease financing obligations interest and $5.1 million for debt issuance cost amortization expense. (3)Earnings of our segments exclude interest income and expense, unallocated corporate expenses and general plant services, and provision for income taxes. Year Ended December 31, 2012 (1)Includes $38.9 million of Merger-related and other, net, offset by $7.3 million of lease financing obligations interest and $3.6 million for debt issuance cost amortization expense. (2)Earnings of our segments exclude interest income and expense, unallocated corporate expenses and general plant services, and provision for income taxes. Building Products Constant Currency Net Sales Liquidity and Capital Resources Overview Historically, our primary sources of liquidity and capital resources have included cash provided by operations, the issuance of debt, and the use of available borrowing facilities. The net change in cash and cash equivalents for the years ended December 31, 2014, 2013 and 2012 consisted of the following: Operating Activities. In the consolidated statements of cash flows, changes in operating assets and liabilities are presented excluding the effects of changes in foreign currency, non-cash transactions and the effects of acquisitions and divestitures. Accordingly, the amounts in the consolidated statements of cash flows differ from changes in the operating assets and liabilities that are presented in the consolidated balance sheets. Net working capital for the years ended December 31, 2014, 2013 and 2012 was $621.0 million, $625.4 million, and $488.3 million, respectively. Cash flows from operating activities decreased $34.6 million for the year ending December 31, 2014 and increased $94.5 million and $43.8 million during the years ending December 31, 2013 and 2012, respectively. The changes in our cash flows provided by operating activities were primarily driven by our net operating results coupled with changes in our operating working capital. The changes in our operating assets and liabilities and the impact of the change on operating working capital for the years ended December 31, 2014, 2013 and 2012 consisted of the following: (1)An increase in assets increases our operating working capital which decreases operating cash flows and an increase in liabilities decreases our operating working capital and increases our operating cash flows. Conversely, a decrease in assets decreases our operating working capital which increases our operating cash flows and a decrease in liabilities increases our operating working capital which decreases our operating cash flows. Investing Activities. Cash used in investing activities increased $68.9 million and $82.9 million for the years ended December 31, 2014 and 2013, respectively, and decreased $79.8 million for the year ended December 31, 2012. Capital expenditures increased $14.4 million, $115.8 million and $13.9 million for the years ended December 31, 2014, 2013 and 2012, respectively. In 2014, the increase in investing activities was primarily due to capital expenditures associated with the Merged Business, including repairs associated with the December 2013 fire at our PHH VCM manufacturing facility in Lake Charles, Louisiana (net of $3.9 million of proceeds pertaining to a settlement with our insurers related to that event), and acquisitions, net of cash acquired, of $6.1 million, offset by proceeds of $8.1 million, primarily from government grants and the sale of assets. The increase in 2013 was primarily due to the operations acquired in the Merger, offset by $45.1 million of cash acquired with the Merged Business which included a $22.0 million payment that PPG made to us in November 2013 for the net working capital settlement in connection with the Merger and $11.4 million in proceeds from the sale of assets. During 2012, our capital investments were reduced by proceeds from the sale of assets totaling $23.6 million, primarily relating to the sale of our on-site air separation unit at our Plaquemine, Louisiana facility for $18.0 million. On January 28, 2013, we completed the Merger and acquired the Merged Business. The purchase price for the Merged Business was approximately $2.8 billion and consisted of: (i) the issuance of approximately 35.2 million shares of our common stock valued at approximately $1.8 billion; (ii) the assumed debt of approximately $967.0 million; and (iii) the assumption of certain other liabilities including pension and OPEB obligations. We incurred maintenance expense for our production facilities of $329.9 million, $312.4 million and $157.3 million during the years ended December 31, 2014, 2013 and 2012, respectively, with the increases in 2014 and 2013 primarily due to the operations acquired in the Merger. Financing Activities. Cash used in financing activities decreased $140.9 million in 2014, increased $152.4 million in 2013 and decreased $21.8 million in 2012. In 2014, our financing activities included $45.0 million for dividend payments and $10.0 million related to deferred acquisition payments to PPG. In 2013, our financing activities included the issuance and redemption of long-term debt as described in the preceding paragraphs, $98.1 million in make-whole and other fees related to the Transactions and $22.2 million in dividend payments. During 2012, cash used in financing activities primarily consisted of the early redemption of $50.0 million principal amount of our 9 percent notes, plus early redemption fees and $8.3 million related to our reinstatement of paying dividends on outstanding common stock in the aggregate amount of $0.24 per share during 2012. As of December 31, 2014 and 2013, our long-term debt consisted of the following: 4.625 Notes The Company and certain of its subsidiaries guarantee $688.0 million aggregate principal amount of senior unsecured notes due 2021 bearing interest at a rate of 4.625 percent per annum (the "4.625 Notes") that were issued by Eagle Spinco Inc., ("Spinco"). Interest payments on the 4.625 Notes commenced on August 15, 2013 and interest is payable semi-annually in arrears on February 15 and August 15 of each year. The 4.625 Notes are fully and unconditionally guaranteed, jointly and severally, on a senior unsecured basis by the Company and by the Company's existing and future domestic subsidiaries, other than certain excluded subsidiaries. The proceeds from the 4.625 Notes retired a $688.0 million bridge loan for which we incurred $11.0 million of costs for the year ended December 31, 2013, related to financing fees that are included in "Loss on redemption and other debt costs" in our consolidated statements of operations. 4.875 Notes On February 1, 2013, Axiall Corporation issued $450.0 million in aggregate principal amount of senior unsecured notes due 2023 which bear interest at a rate of 4.875 percent per annum (the "4.875 Notes"). Interest payments on the 4.875 Notes commenced on May 15, 2013 and interest is payable semi-annually in arrears on May 15 and November 15 of each year. The 4.875 Notes are fully and unconditionally guaranteed, jointly and severally, on a senior unsecured basis by each of our existing and future domestic subsidiaries, other than certain excluded subsidiaries. The net proceeds from the offering of the 4.875 Notes, together with cash on hand, funded the repurchase of our 9 percent senior secured notes due 2017 (the "9 percent notes") in a tender offer and related consent solicitation (the "Tender Offer") for an aggregate tender price of $502.3 million, including a make whole payment of $55.4 million. We accounted for the repurchase of the 9 percent notes as an extinguishment and expensed approximately $8.5 million of deferred financing fees and incurred charges of $2.2 million associated with the Tender Offer during the year ended December 31, 2013. Term Loan During the year ended December 31, 2013, the Company also guaranteed a $279.0 million term loan due 2017 made to Spinco (the "Term Loan"). The Term Loan bears interest at a rate equal to (at the Company's election): (i) the Base Rate (as defined in the Term Loan agreement and subject to a 2 percent floor) plus 1.50 percent per annum; or (ii) the reserve adjusted Eurodollar Rate (as defined in the Term Loan agreement and subject to a 1 percent floor) plus 2.50 percent per annum. As of December 31, 2014, outstanding borrowings under the Company's Term Loan had a stated interest rate of 3.50 percent per annum and an effective interest rate, inclusive of amortization of deferred debt issuance cost, of approximately 3.9 percent. Obligations under the Term Loan are fully and unconditionally guaranteed, on a senior secured basis, by the Company and its existing and future domestic subsidiaries, other than certain excluded subsidiaries and are secured by all the assets of the Company and the subsidiary guarantors. During the year ended December 31, 2013, we repaid approximately $81.8 million of the outstanding balance of the Term Loan. In connection with the repayment, we expensed $1.4 million of deferred financing fees, which is included in "Loss on redemption and other debt costs" in our consolidated statements of operations. During the year ended December 31, 2014, we repaid an additional $2.8 million of the outstanding balance of our Term Loan in accordance with the contractual terms of our agreement. ABL Revolver In December 2014, the Company amended and restated its asset-based revolving credit facility (the "ABL Revolver") to, among other things, increase the commitments under the ABL Revolver from $500.0 million to $600.0 million and extend the maturity date to December 17, 2019. At the Company's election, with respect to borrowings in the United States under the ABL Revolver, the borrowings bear interest at a rate equal to either: (i) the higher of certain index rates; or (ii) three-month London Interbank Offered Rate ("LIBOR"), plus an applicable margin. At the election of the Company, with respect to borrowings in Canada under the ABL Revolver, the borrowings will bear interest at a rate equal to either: (i) the higher of certain index rates; or (ii) three-month LIBOR, if available, in each case, plus an applicable margin. The applicable margin for borrowings under the ABL Revolver will be 0.50 percent per annum for base rate and index loans and 1.50 percent per annum for LIBOR margin loans, provided that if the Company has not received a corporate family credit rating of at least Ba3 from Moody's and BB- from S&P, the applicable margin will range from 0.5 percent to 1.0 percent, with respect to base rate and index loans and 1.5 percent to 2.0 percent with respect to LIBOR margin loans, depending on the utilization percentages set forth in the ABL Revolver. As of December 31, 2014 and 2013, we had no outstanding balance on our ABL Revolver. As of December 31, 2014, our availability under the ABL Revolver was approximately $429.8 million, net of outstanding letters of credit totaling $82.3 million. The ABL Revolver is fully and unconditionally guaranteed, on a senior secured basis, by each of the Company's existing and subsequently acquired or organized direct or indirect domestic subsidiaries, other than certain excluded subsidiaries. Canadian borrowing obligations under the ABL Revolver are unconditionally guaranteed by each of the Company's existing and subsequently acquired or organized direct or indirect domestic and Canadian subsidiaries, other than certain excluded subsidiaries. All obligations under the ABL Revolver, and the guarantees of those obligations, are secured, subject to certain exceptions, by substantially all of the Company's assets and the assets of the subsidiary guarantors. The ABL Revolver, the Term Loan agreement and the indentures governing the 4.625 Notes and the 4.875 Notes each contain customary covenants, including certain restrictions on the Company and its subsidiaries ability to pay dividends and repurchase shares of Company stock. These covenants are subject to certain exceptions and qualifications. Under the ABL Revolver, dividend payments and repurchases of our common stock in an aggregate amount not to exceed $150 million in any fiscal year may be made if both borrowing availability under the ABL Revolver would have exceeded $75 million at all times during the thirty days immediately preceding any such restricted payment and our consolidated fixed charge coverage ratio (as defined in the ABL Revolver) is equal to or exceeds 1.00 to 1.00, each on a pro forma basis after giving effect to any such proposed restricted payment. In addition, under the ABL Revolver, additional cash dividend payments may be made if both borrowing availability under the ABL Revolver then exceeds $100 million and our consolidated fixed charge coverage ratio (as defined in the ABL Revolver) is equal to or exceeds 1.10 to 1.00, each on a pro forma basis after giving effect to the proposed cash dividend payment. As of December 31, 2014, we were in compliance with the covenants under the ABL Revolver, the Term Loan agreement and the indentures governing the 4.625 Notes and 4.875 Notes. In connection with the issuance of each of the 4.625 Notes and 4.875 Notes, we entered into a registration rights agreement, pursuant to which we and the guarantors agreed to use our commercially reasonable efforts to file an exchange offer registration statement registering the 4.625 Notes and 4.875 Notes. On June 27, 2014, the Company completed the exchange offer registering the 4.625 Notes and 4.875 Notes with the SEC in satisfaction of the terms of these agreements. Borrowings under the ABL Revolver, if any, were at variable interest rates. (1)As of December 31, 2014, the applicable rate for future borrowings would have been 1.75 percent to 3.75 percent under the ABL Revolver. Subsequent Events On February 27, 2015, Axiall Holdco, Inc., a wholly-owned subsidiary of the Company ("Axiall Holdco"), entered into a credit agreement with a syndicate of financial institutions (the "Term Loan Agreement") for a new $250 million term loan facility (the "New Term Loan Facility") in order to refinance the principal amount outstanding under Spinco's existing Term Loan Facility, pay related fees and expenses, and for general corporate purposes. Obligations under the New Term Loan Facility are fully and unconditionally guaranteed, on a senior secured basis, by the Company and by each of the Company's existing and future wholly-owned domestic subsidiaries, other than certain excluded subsidiaries. The obligations under the New Term Loan Facility are secured by substantially all of the assets of Axiall Holdco, the Company and the subsidiary guarantors. Borrowings under the New Term Loan are expected to mature on the seventh anniversary of the closing date. At the election of Axiall Holdco, the New Term Loan Facility bears interest at a rate equal to: (i) the Base Rate (as defined in the Term Loan Agreement) plus 1.50 percent per annum; or (ii) LIBOR (as defined in the Term Loan Agreement) plus 3.25 percent per annum; provided that at no time will the Base Rate be deemed to be less than 2.00 percent per annum or LIBOR be deemed to be less than 0.75 percent per annum. The Term Loan Agreement contains customary covenants (subject to exceptions), including certain restrictions on the Company and its subsidiaries to pay dividends. Lease Financing Obligation As of December 31, 2014 and 2013, we had a lease financing obligation of $94.2 million and $104.7 million, respectively. The change from the December 31, 2013 balance is due to a one-time $2.3 million payment and the change in the Canadian dollar exchange rate as of December 31, 2014. The lease financing obligation is the result of the sale and concurrent leaseback of certain land and buildings in Canada in 2007 for a term of ten years. In connection with this transaction, a collateralized letter of credit was issued in favor of the buyer-lessor. That factor and certain other terms and conditions resulted in the transaction being recorded as a financing transaction rather than a sale for GAAP purposes. As a result, the land, building and related accounts continue to be recognized in the consolidated balance sheets. The amount of the collateralized letter of credit was $1.6 million and $3.8 million as of December 31, 2014 and 2013, respectively. The collateralized letter of credit expired on February 2, 2015 and is no longer required. We are not obligated to repay the lease financing obligation amount of $94.2 million. Our obligation is for the future minimum lease payments under the terms of the related lease agreements. The future minimum lease payments under the terms of the related lease agreements as of December 31, 2014 are $5.5 million in 2015, $5.5 million in 2016 and $1.4 million in 2017, the final year of the lease agreements. The change in the future minimum lease payments from such amounts disclosed as of December 31, 2013 is due to the one-time $2.3 million payment, current period lease payments and the change in the Canadian dollar exchange rate as of December 31, 2014. Dividends During the year ended December 31, 2014, the Company's Board of Directors declared dividends of $0.64 per share, in equal installments of $0.16 per share, according to the following record and payment dates: On both March 5, 2013 and May 21, 2013, the Company's Board of Directors declared a $0.08 per share cash dividend, with a record date of March 28, 2013 and June 28, 2013, respectively, and a payment date of April 10, 2013 and July 10, 2013, respectively. On September 11, 2013 and December 10, 2013, the Company's Board of Directors declared a $0.16 per share cash dividend, with a record date of September 27, 2013 and December 27, 2013, respectively and a payment date of October 10, 2013 and January 10, 2014, respectively. Management believes, based on current and projected levels of operations and conditions in our markets and cash flow from operations, together with our cash and cash equivalents on hand and the availability to borrow under our ABL Revolver, we have adequate funding for the foreseeable future to make required payments of interest on our debt, fund our operating needs, working capital and capital expenditure requirements, comply with the financial ratios in our debt agreements, and make any required prepayments of principal under our debt agreements. As of February 27, 2015, we have no significant required payments of principal on our debt until December 2019. To the extent our cash flow and liquidity exceeds the levels necessary for us to make required payments on our debt, fund our working capital and capital expenditure requirements and comply with our ABL Revolver, we may use the excess liquidity to further grow our business through investments or acquisitions, payment of dividends and/or to reduce our debt. Contractual Obligations Our aggregate future payments under contractual obligations by category as of December 31, 2014, were as follows: Purchase obligations. Purchase obligations primarily include agreements to purchase goods or services that are enforceable and legally binding and that specify all significant terms. We have certain long-term raw material supply contracts and energy purchase agreements with various terms extending through 2026. These commitments are designed to assure sources of supply for our normal requirements. Amounts are based upon contractual raw material volumes and market rates as of December 31, 2014. Long-term debt, principal. Long-term debt principal obligations are listed in the table above based on the contractual due dates. On February 27, 2015, we entered into a new $250 million term loan facility, which matures on February 27, 2022, to refinance our existing term loan facility, pay related fees and expenses, and for general corporate purposes. See Note 9 of the Notes to the Consolidated Financial Statements. Long-term debt, interest. Long-term debt interest payments set forth in the table above are based on our contractual rates, or in the case of variable interest rate obligations, the weighted average interest rates as of December 31, 2014. Lease financing obligations. We lease land and buildings for certain of our Canadian manufacturing facilities under leases with varying maturities through the year 2017. Capital lease obligations. We lease railcars for our chlorovinyls segment under capital leases with varying maturities through the year 2020. Operating lease obligations. We lease railcars, storage terminals, computer equipment, automobiles, barges and warehouse and office space under non-cancelable operating leases with varying maturities through the year 2025. Expected pension and OPEB contributions. Expected pension contributions for the funded obligations represent the projected minimum required contributions based on assumptions as of December 31, 2014 and are determined in accordance with local requirements such as the Employee Retirement Income Security Act. Also included are contributions for the unfunded pension and OPEB plans which are based on the expected benefit payments estimated as of December 31, 2014. Deferred acquisition payments. Payments of deferred purchase price represent amounts due to PPG based upon the final funding status of the pension plans assumed in the Merger. In 2014, we made a payment of $10 million to PPG in connection with the funding status of certain assumed pension plans of the Merged Business. We will make remaining payments in the aggregate amount of $40 million to PPG over the next three years. Asset retirement obligations. We have recognized a liability for the present value of cost we estimate we will incur to retire certain assets. The amount reported in the Contractual Obligations table above, represents the undiscounted estimated cost to retire such assets. The estimated average timing of these obligations is in excess of thirty years. Uncertain income tax positions. We have recognized a liability for our uncertain income tax positions of approximately $10.0 million as of December 31, 2014. We do not believe we are likely to pay any amounts during the year ended December 31, 2015. The ultimate resolution and timing of payment for remaining matters continues to be uncertain and are therefore excluded from the Contractual Obligations table above. Outlook We expect our first quarter 2015 financial results to be negatively impacted by several factors including: (i) above average maintenance expenses and reduced operating rates due to planned outages in our VCM, PVC, chlor-alkali and chlorinated derivatives operations; and (ii) a continued weak Canadian dollar, as compared to a stronger U.S. dollar, which we expect to negatively impact the earnings of our Building Products segment. Prices for both chlorine and caustic soda have declined in the last several quarters. Although demand for chlorine has been solid in January and February 2015, we believe the near-term direction of caustic prices is uncertain and ultimately will be determined by the pace at which global demand absorbs the chlor-alkali manufacturing capacity added to North America in early 2014. In addition, PVC price declines accelerated in January 2015, and current margins for PVC are well below the average PVC margin achieved in the quarter ended December 31, 2014. Taking all of these factors into consideration, we believe expectations for margins in both ECU products and PVC will not become clear before the second quarter of 2015. Over the longer term, we expect to sustain our operations at the improved levels we realized in the second half of 2014. In addition, we believe ECU values will be driven higher by the strength of domestic demand and improved export volumes for ECU products. We believe we are also well positioned to take advantage of a number of macro-economic and industry trends. In particular, we expect that North America's natural gas cost advantage over oil-based economies in other parts of the world will continue to provide a competitive cost advantage to us. We expect this advantage to allow consistent access to growing export markets for both chlorine, in the form of PVC, and caustic soda. In addition, we believe the pace of global capacity growth in our key products has slowed dramatically compared to the beginning of the decade, which should improve the supply-demand balance for those products. Moreover, we believe the gradual improvement in the United States housing market, both in terms of starts and renovation activity will continue, which should drive building products volumes higher. We expect the combination of these macro-economic and industry trends to increase demand for ECU and vinyl products. Inflation The most significant component of our cost of sales is raw materials, which include basic oil-based commodities and natural gas or derivatives thereof. The costs of raw materials and natural gas are based primarily on market forces and have not been significantly affected by inflation. Inflation has not had a material impact on our sales or income from operations. New Accounting Pronouncements In January 2015, the Financial Accounting Standards Board ("FASB") issued Accounting Standards Update ("ASU" or "Update) 2015-01-Extraordinary and Unusual Items (Subtopic 225-20). The Update eliminates from GAAP the concept of extraordinary items as part of FASB's initiative to reduce the complexity in current accounting standards. Previous GAAP guidance required an entity to separately classify, present, and disclose extraordinary events and transactions. An event or transaction was presumed to be both ordinary and usual unless evidence clearly supported classification as an extraordinary item. However, the concept of extraordinary items caused uncertainty in practice because it was unclear as to when an item should be considered both unusual and infrequent and it was extremely rare in practice for a transaction or event to meet the classification requirement of an extraordinary item. Going forward, items that would have met the definition of extraordinary items will be treated in a similar manner as unusual and infrequent items. The amendments in this Update are effective for annual reporting periods beginning after December 15, 2015 and early adoption is permitted. We have adopted the amendments in this Update and there was no material impact on our consolidated financial statements. In June 2014, FASB issued ASU 2014-12-Compensation-Stock Compensation (Topic 718). Under this Update: Accounting for Share-Based Payments When the Terms of an Award Provide That a Performance Target Could Be Achieved after the Requisite Service Period (a consensus of the FASB Emerging Issues Task Force), a performance target that affects vesting, and that could be achieved after the requisite service period, would be treated as a performance condition. GAAP did not address these issues. The Update states that a reporting entity should apply existing guidance in Topic 718 to account for awards with performance conditions that affect the vesting of such awards. As such, the performance target should not be reflected in estimating the grant-date fair value of the award. Compensation cost should be recognized in the period in which it becomes probable that the performance target will be achieved and should represent the compensation cost attributable to the periods for which the requisite service has already been rendered. If the performance target becomes probable of being achieved before the end of the requisite service period, the remaining unrecognized compensation cost should be recognized prospectively over the remaining requisite service period. The total amount of compensation cost recognized during and after the requisite service period should reflect the number of awards that are expected to vest and should be adjusted to reflect those awards that ultimately vest. The requisite service period ends when the employee can cease rendering service and still be eligible to vest in the award if the performance target is achieved. The stated vesting period (which includes the period in which the performance target could be achieved) may differ from the requisite service period. The amendments in this Update are effective for annual reporting periods beginning after December 15, 2015. Earlier adoption is permitted. We are evaluating the amendments in this Update and have not yet determined the impact on our consolidated financial statements. In May 2014, the FASB issued ASU 2014-09, Revenue from Contracts with Customers. The Update outlines a single, comprehensive model for entities to use in accounting for revenue arising from contracts with customers and supersedes most current revenue recognition guidance issued by the FASB, including industry specific guidance. The Update provides accounting guidance for all revenue arising from contracts with customers and affects all entities that enter into contracts with customers to provide goods and services. The guidance also provides a model for the measurement and recognition of gains and losses on the sale of certain nonfinancial assets, such as property and equipment, including real estate. The Update is effective for annual reporting periods, including interim reporting periods within those periods, beginning after December 15, 2016. The new standard must be adopted using either a full retrospective approach for all periods presented in the period of adoption or a modified retrospective approach. The modified retrospective approach requires that the new standard be applied to all new and existing contracts as of the date of adoption, with a cumulative catch-up adjustment recorded to the opening balance of retained earnings at the effective date for existing contracts that still require performance by the entity. Under the modified retrospective approach, amounts reported prior to the date of adoption will be presented under existing guidance. The Update also requires entities to disclose both quantitative and qualitative information to enable users of the financial statements to understand the nature, amount, timing, and uncertainty of revenue and cash flows arising from contracts with customers. We have not yet determined the impact of adopting the standard on our consolidated financial statements, nor have we determined whether we will utilize the full retrospective or modified retrospective approach. In April 2014, the FASB issued ASU 2014-08-Reporting Discontinued Operations and Disclosures of Disposals of Components of an Entity. The amendments in this Update change the requirements for reporting discontinued operations in Subtopics 205 (Presentation of Financial Statements) and 360 (Property, Plant, and Equipment). The Update changes the criteria for reporting discontinued operations and enhances the FASB's convergence with International Accounting Standards. The Update improves the definition of discontinued operations by limiting discontinued operations reporting specifically to the disposal of a component or a group of components of an entity that results in a strategic shift that has (or will have) a major effect on an entity's operations and financial results when certain criteria are met. The Update raises the threshold for disposals to qualify as discontinued operations and expands the disclosure requirements for discontinued operations and certain other disposals that do not qualify as discontinued operations. The amendments in this Update are effective for annual periods beginning on or after December 15, 2014, and interim periods within that year. We have adopted the amendments in this Update and there was no material impact on our consolidated financial statements. In July 2013, the FASB issued ASU 2013-11, Income Taxes (Topic 740): Presentation of an Unrecognized Tax Benefit When a Net Operating Loss Carryforward, a Similar Tax Loss, or a Tax Credit Carryforward Exists. Prior to this Update, GAAP did not include explicit guidance on the financial statement presentation of an unrecognized tax benefit when a net operating loss carryforward, a similar tax loss, or a tax credit carryforward existed. The Update provides that a liability related to an unrecognized tax benefit would be offset against a deferred tax asset for a net operating loss carryforward, a similar tax loss or a tax credit carryforward if such settlement is required or expected in the event the uncertain tax position is disallowed. In that case, the liability associated with the unrecognized tax benefit is presented in the financial statements as a reduction to the related deferred tax asset for a net operating loss carryforward, a similar tax loss or a tax credit carryforward. In situations in which a net operating loss carryforward, a similar tax loss or a tax credit carryforward is not available at the reporting date under the tax law of the jurisdiction or the tax law of the jurisdiction does not require, and the entity does not intend to use, the deferred tax asset for such purpose, the unrecognized tax benefit will be presented in the financial statements as a liability and will not be combined with deferred tax assets. The amendments in this Update do not require new recurring disclosures. The Update is effective for fiscal years beginning after December 15, 2013. In accordance with this Update, the Company reclassified liabilities associated with certain unrecognized tax benefits as a reduction to deferred tax assets for a net operating loss carryforward in the amount of $4.5 million. Critical Accounting Policies and Estimates Our consolidated financial statements are prepared in accordance with accounting principles generally accepted in the United States, which require management to make estimates, judgments and assumptions that affect the amounts reported in our consolidated financial statements and accompanying notes. We believe our most critical accounting policies and estimates relate to the following: • Long-Lived Assets • Goodwill and Other Intangible Assets • Pension and OPEB Liabilities • Environmental Accruals • Income Taxes Management has discussed the development, selection and disclosure of critical accounting policies and estimates with the Audit Committee of the Company's Board of Directors and with our independent public accounting firm. Critical accounting policies are those that are important to our financial condition and require management's most difficult, subjective or complex judgments. While our estimates and assumptions are based on our knowledge of current events and actions we may undertake in the future, actual results may ultimately differ from these estimates and assumptions. For a discussion of the Company's significant accounting policies, refer to Note 1 of Notes to Consolidated Financial Statements in Item 8. Long-Lived Assets Our long-lived assets, such as property, plant and equipment, are reviewed for impairment whenever events or changes in circumstances indicate that the carrying value of an asset may not be recoverable. Recoverability of an asset to be held and used is measured by comparing the carrying value of the asset to the estimated undiscounted future cash flows expected to be generated by the asset. If the carrying value of an asset exceeds its estimated undiscounted future cash flows, an impairment charge is recognized for the amount by which the carrying value of the asset exceeds the fair value of the asset. Our judgments regarding the existence of impairment indicators are based on macro-economic conditions, market conditions and assumptions for operational performance of our businesses. The assumptions used to estimate our future undiscounted cash flows are predominately identified from our financial forecasts. The actual impairment charge incurred could vary significantly from amounts that we estimate. Additionally, future events could cause us to conclude that impairment indicators exist and that associated long-lived assets of our businesses are impaired. During the year ended December 31, 2014, the Company incurred approximately $10.9 million in long-lived assets impairment charges of which $9.9 million related to property, plant and equipment for our phosgene derivatives product line that is classified as held-for-sale in our chlorovinyls segment. During the year ended December 31, 2013, the Company recognized $7.5 million in long-lived asset impairment charges. Goodwill and Other Intangible Assets Our intangible assets consist of goodwill, customer relationships, supply contracts, trade names, and technology. Goodwill is the excess of the cost of an acquired entity over the fair value of tangible and intangible assets (including, but not limited to, customer relationships, supply contracts, trade names and technology) acquired and liabilities assumed under acquisition accounting for business combinations. As of December 31, 2014, we have two segments that contain reporting units with goodwill and intangible assets: our chlorovinyls segment includes goodwill in its chlor-alkali and derivatives and compound reporting units and our building products segment includes goodwill in its siding and mouldings reporting units. Our other indefinite-lived assets consist only of trade names in our building products segment. Impairment testing for indefinite-lived intangible assets other than goodwill involves comparing the fair value of the intangible asset to its carrying value. The fair values of our trade names are estimated based on the relief from royalty method under the income approach. This approach utilizes a discounted cash flow analysis. In December 2014, the Company recorded an impairment charge of approximately $4.1 million of goodwill and $2.6 million of customer relationships relating to our phosgene derivatives product line that is classified as held-for-sale. Based on the results of our 2013 evaluation, we recorded an impairment charge to write-down goodwill and other intangible assets in the window and door profiles reporting unit by $24.9 million in the year ended December 31, 2013. The write-down was due primarily to the prolonged downturn in the North American housing and construction markets, continued pricing declines, and the expected impact of those declines on projected cash flows on the window and door profiles reporting unit. The 2013 write-down included $18.2 million for goodwill, $3.1 million for indefinite-lived trade names and $3.6 million for customer relationship assets. Valuation of Goodwill and Indefinite-Lived Intangible Assets The carrying values of our goodwill and indefinite-lived intangible assets are tested for impairment annually in the fourth quarter, using a measurement date of October 1. In addition, we evaluate the carrying value of our intangible assets for impairment between annual impairment test dates if an event occurs or circumstances change that would indicate the carrying value may be impaired. Such events and indicators may include, without limitation, significant declines in the industries in which our products are used, significant changes in the estimated future cash flows of our reporting units, significant changes in capital market conditions and significant changes in our market capitalization. Impairment testing for goodwill is a two-step test performed at a reporting unit level. The first step of the impairment analysis involves comparing the fair value of the reporting unit to its book value, including goodwill. If the fair value of the reporting unit exceeds the book value, goodwill is not considered impaired. If the book value exceeds the fair value, the second step of the impairment analysis is performed, in which we measure the amount of impairment. Our goodwill evaluations utilize discounted cash flow analyses and market multiple analyses in estimating the fair value. The weighting of the discounted cash flow and market approaches varies by each reporting unit based on factors specific to each reporting unit. Inherent in our fair value determinations are certain judgments and estimates relating to future cash flows, including our interpretation of current economic indicators and market conditions, overall economic conditions and our strategic operational plans with regard to our business units. In addition, to the extent significant changes occur in market conditions, overall economic conditions or our strategic operational plan, it is possible that goodwill not currently impaired, may become impaired in the future. We tested our reporting units with goodwill and other indefinite-lived intangible assets in the fourth quarter of 2014 in accordance with our annual October 1 impairment testing. None of our reporting units showed indications of impairment for goodwill or other indefinite-lived intangible assets. The estimated fair value of each of our chlor-alkali and derivatives, compound, siding and mouldings reporting units exceeds the unit's carrying value by more than 10 percent. Definite-Lived Intangible Assets We have definite-lived intangible assets that include customer relationships, supply contracts, technology and trade names. We evaluate these assets for impairment if an event occurs or circumstances change that would indicate the carrying value could be impaired. If indicators suggest that the related undiscounted cash flows do not exceed the carrying value of the asset, we recognize an impairment charge to the extent that the carrying value exceeds the fair value of the definite lived intangible asset. Pension and OPEB Liabilities Accounting for employee pension and OPEB plans involves estimating the cost of benefits that are to be provided in the future and attempting to match, for each employee, that estimated cost to the period worked. To accomplish this, we make assumptions about discount rates, expected long-term rates of return on plan assets, salary increases, employee turnover and mortality rates, among others. We reevaluate all assumptions annually with our independent actuaries taking into consideration existing and forecasted economic conditions and our investment policy and strategy with regard to managing the plans. We believe our estimates, the most significant of which are stated below, are reasonable. Assumptions for Benefit Obligations Mortality is a key assumption used to determine the benefit obligation for the defined benefit pension and OPEB plans. The Company has historically utilized the Society of Actuaries' (SOA) published mortality data in developing a best estimate of mortality. On October 27, 2014, the SOA published updated mortality tables for U.S. plans ("RP-2014") and an updated generational improvement scale ("MP-2014"), which both reflect improved longevity. The Company adopted the SOA's new RP-2014 and MP-2014 as published by the SOA for purposes of measuring pension and OPEB benefit obligations at year-end. The change to the mortality assumption increased the year-end pension and OPEB obligations by $74 million and $2 million, respectively, as of December 31, 2014. The discount rate reflects the rate at which pension benefit obligations could be effectively settled. We determined our discount rate by matching the expected cash flows of our pension and OPEB obligations to a yield curve generated from a broad portfolio of high-quality fixed rate debt instruments. The rate of compensation is based on projected salary increases for our plan participants. The healthcare cost trend assumption is based on a number of factors including our actual healthcare cost increases, the design of our benefit programs, the demographics of our active and retiree populations and external expectations of future medical cost inflation rates. The weighted average assumptions used for determining our benefit obligations are as follows: Assumptions for Annual Projected Expense The discount rate for determining annual pension and OPEB expense is determined by matching the expected cash flows of our pension and OPEB obligations to a yield curve generated by a broad portfolio of high-quality fixed rate debt instruments. The expected long-term rate of return on plan assets assumption is based on historical and projected rates of return for current and planned asset classes in the plan's investment portfolio. Our weighted average asset allocation as of December 31, 2014, is 61 percent equity securities, 37 percent debt securities, and 2 percent other. Assumed projected rates of return for each of the plan's projected asset classes were selected by us after analyzing historical experience and future expectations of the returns and volatility of the various asset classes. The rate of compensation is based on projected salary increases for our plan participants. The weighted average expected discount rate, expected long-term rate of return on plan assets and rate of compensation increase assumptions used for determining annual pension expense for our pension and OPEB plans are as follows: Sensitivity for Key Underlying Assumptions The following table shows the impact of a 25 basis point change in the assumed discount rate and expected long-term rate of return on plan assets for our pension and OPEB plans, and the impact of the increase (decrease) on benefit obligations and expense for the year ended December 31, 2014. For the plan year ended December 31, 2014, if the assumed healthcare inflation trend rates were 1 percent higher or 1 percent lower for the OPEB plans, the benefit obligations would increase by $2.4 million or decrease by $2.1 million respectively. For the plan year ended December 31, 2014, a 1 percent increase in the assumed healthcare inflation trend rates would increase the OPEB plan aggregate service and interest cost by $0.1 million, while a 1 percent decrease would decrease the aggregate service and interest cost by $0.1 million. Environmental Accruals In our determination of the estimates relating to ongoing environmental costs and legal proceedings (see Note 10 of the Notes to Consolidated Financial Statements included in Item 8), we consult with our advisors (consultants, engineers and attorneys). Such consultation provides us with the information on which we base our judgments on these matters and under which we accrue an expense when it has been determined that it is probable that a liability has been incurred and the amount is reasonably estimable. While we believe that the amounts recorded in the accompanying consolidated financial statements related to these contingencies are based on the best estimates and judgments available to us, the actual outcomes could differ from our estimates. To the extent that actual outcomes differ from our estimates by 10 percent, our net income would be higher or lower by approximately $5.4 million, on an after-tax basis. Environmental Remediation Our operations and assets are subject to extensive environmental, health and safety regulations, including laws and regulations related to air emissions, water discharges, waste disposal and remediation of contaminated sites, at both the national and local levels in the United States. We are also subject to similar laws and regulations in Canada and other jurisdictions in which we operate. The nature of the chemical and building products industries exposes us to risks of liability under these laws and regulations due to the production, storage, use, transportation and sale of materials that can cause contamination or personal injury, including, in the case of chemicals, potential releases into the environment. Environmental laws may have a significant effect on the costs of use, transportation and storage of raw materials and finished products, as well as the costs of the storage and disposal of wastes. We have and will continue to incur substantial operating and capital costs to comply with environmental laws and regulations. In addition, we may incur substantial costs, including fines, damages, criminal or civil sanctions and remediation costs, or experience interruptions in our operations for violations arising under these laws and regulations. As of December 31, 2014 and 2013, we had reserves for environmental contingencies totaling approximately $54 million and $64 million, respectively, of which approximately $12 million were classified as a current liability in both years. Our assessment of the potential impact of these environmental contingencies is subject to considerable uncertainty due to the complex, ongoing and evolving process of investigation and remediation, if necessary, of such environmental contingencies, and the potential for technological and regulatory developments. Some of our significant environmental contingencies include the following matters: • We have entered into a Cooperative Agreement with the Louisiana Department of Environmental Quality ("LDEQ") and various other parties for the environmental remediation of a portion of the Bayou d'Inde area of the Calcasieu River Estuary in Lake Charles, Louisiana. Remedy implementation began in the fourth quarter of 2014 and is expected to be completed during 2016 with a period of monitoring for remedy effectiveness to follow remediation. As of December 31, 2014 and 2013, we have reserved approximately $18 million and $25 million, respectively, for the costs associated with this matter. • As of December 31, 2014 and 2013, we have reserved approximately $15 million for environmental contingencies related to on-site remediation at our Lake Charles South Facility principally for ongoing remediation of groundwater and soil in connection with our corrective action permit issued pursuant to the Hazardous and Solid Waste Amendments of the Resource Conservation and Recovery Act. The remedial activity is primarily related to the operation of a series of well water treatment systems across the Lake Charles South Facility. In addition, remediation of possible soil contamination will be conducted in certain areas. These remedial activities are expected to continue for an extended period of time. • As of December 31, 2014 and 2013, we have reserved approximately $15 million and $14 million, respectively, for environmental contingencies related to remediation activities at our Natrium, West Virginia facility. The remedial actions address National Pollutant Discharge Elimination System permit requirements related primarily to hexachlorocyclohexane, (commonly referred to as BHC) and mercury. We expect that these remedial actions will be in place for an extended period of time. Our assessment of the potential impact of environmental contingencies is subject to considerable uncertainty due to the complex, ongoing and evolving process of investigation and remediation, if necessary, of such environmental contingencies, and the potential for technological and regulatory developments. As such, in addition to the amounts currently reserved, we may be subject to reasonably possible loss contingencies related to environmental matters in the range of $52 million to $89 million. Initial remedial actions are occurring with respect to these matters at two plant sites: the Lake Charles South Facility and the Natrium Facility. Environmental Laws and Regulations Due to the nature of environmental laws, regulations and liabilities, it is possible that we may not have identified all potentially adverse conditions. Such conditions may not currently exist or be detectable through reasonable methods, or may not be estimable. For example, our Natrium, West Virginia facility and Lake Charles South Facility have both been in operation for over 65 years. There may be significant latent liabilities or future claims arising from the operation of facilities of this age, and we may be required to incur material future remediation or other costs in connection with future actions or developments at these or other facilities. We expect to be continually subjected to increasingly stringent environmental and health and safety laws and regulations, and that continued compliance will require increased capital expenditures and increased operating costs or may impose restrictions on our present or future operations. It is difficult to predict the future interpretation and development of these laws and regulations or their impact on our future earnings and operations. Any increase in these costs, or any material restrictions, could materially adversely affect our liquidity, financial condition and results of operations. However, estimated costs for future environmental compliance and remediation may be materially lower than actual costs, or we may not be able to quantify potential costs in advance. Actual costs related to any environmental compliance in excess of estimated costs could have a material adverse effect on our financial condition in one or more future periods. Heightened interest in environmental regulation, such as climate change issues, has the potential to materially impact our costs and present and future operations. We, and other chemical companies, are currently required to file certain governmental reports relating to GHG emissions. The U.S. Government has considered, and may in the future implement restrictions or other controls on GHG emissions, any of which could require us to incur significant capital expenditures or further restrict our present or future operations. In addition to GHG regulations, the EPA has recently taken certain actions to limit or control certain pollutants created by companies such as ours. For example: • In January 2013, the EPA issued the Boiler MACT regulations, which are aimed at controlling emissions of toxic air contaminants. The regulations would require covered facilities to comply by January 2016. The coal fired power plant at our Natrium, West Virginia facility is our source most significantly impacted by the Boiler MACT regulations. Bringing our operations into compliance with the new regulations will require capital expenditures of approximately $30 million. • In April 2012, the EPA issued the PVC MACT regulation to update emissions limits for PVC and copolymer production. The PVC MACT regulation sets standards for major sources of PVC production and establishes certain working practices, as well as monitoring, reporting and record-keeping requirements. We would have until April 2015 to come into compliance with certain requirements of the PVC MACT regulation, and due to compliance extensions we recently received from the relevant government agencies, until April 2016 to come into compliance with other requirements. We have already undertaken significant efforts to achieve compliance by these deadlines. Following the issuance of the PVC MACT regulation, legal challenges were filed by the vinyl industry's trade organization, several vinyl manufacturers and several environmental groups, which will likely impact provisions of the PVC MACT regulation. However, there could be significant changes from the currently existing PVC MACT regulation after all legal challenges have been exhausted, which could require us to incur capital expenditures or increase our operating costs, to levels significantly higher than what we have previously estimated. We currently estimate the capital expenditures we would incur to comply with the PVC MACT regulation would be approximately $15 million. • In March 2011, the EPA proposed amendments to the emission standards for hazardous air pollutants for mercury emissions from mercury cell chlor-alkali plants. These proposed amendments would require improvements in work practices to reduce fugitive mercury emissions and would result in reduced levels of mercury emissions while still allowing the mercury cell facilities to continue to operate. We operate a mercury cell production unit at our Natrium, West Virginia facility. No assurances as to the timing or content of the final regulation, or its ultimate cost to, or impact on us, can be provided. Income Taxes Income taxes are accounted for under the liability method. Deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying value of existing assets and liabilities and their respective tax bases. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the enactment date. We evaluate the realizability of deferred tax assets by assessing whether it is more likely than not that some or all of the deferred tax assets will not be realized. The ultimate realization of deferred tax assets depends on the generation of future taxable income during the periods in which those temporary differences are deductible. Management considers the scheduled reversal of deferred tax liabilities (including the impact of available carryback and carryforward periods), projected taxable income and tax-planning strategies available to us in making this assessment. If it is not more likely than not that we will realize a deferred tax asset, we record a valuation allowance against such asset. As of December 31, 2014, a valuation allowance of $86.6 million has been provided against the deferred taxes in Canada. We use a similar evaluation for determining when to release previously recorded valuation allowances. We recognize tax benefits for uncertain tax positions when it is more likely than not, based upon the technical merits, that the position will be sustained upon examination.

<s>[INST] Merger with PPG's Chemicals Business On January 28, 2013, we completed a series of transactions that resulted in our acquisition of substantially all of the assets and liabilities of PPG Industries, Inc.'s ("PPG") business relating to the production of chlorine, caustic soda and related chemicals (the "Merged Business") through a merger between a subsidiary of PPG and a subsidiary of the Company (the "Merger") and the related financings (collectively, the "Transactions"). The operations of the Merged Business are included in our chlorovinyls segment and are reflected in our financial results from January 28, 2013, the closing date of the Merger. The purchase price of the Merged Business was approximately $2.8 billion and consisted of: (i) the issuance of approximately 35.2 million shares of our common stock valued at approximately $1.8 billion; (ii) assumed debt of approximately $967.0 million; and (iii) the assumption of other liabilities, including pension and OPEB obligations. In connection with the Merger, we incurred costs to attain synergies including plant reliability improvement initiatives, and transition costs such as consulting professionals' fees, information technology implementation costs, relocation costs and severance costs, which management believed were necessary to realize approximately $140.0 million of anticipated annualized cost synergies within two years from the consummation of the Merger. As of December 31, 2014, we incurred approximately $59.7 million of such costs to attain Mergerrelated synergies, which includes capitalized expenditures. In addition, we achieved $140.7 million of annualized cost synergies within two years after the consummation of the Merger. Results of Operations Overview Consolidated Overview For the year ended December 31, 2014, net sales totaled $4,568.7 million, a decrease of 2 percent compared to $4,666.0 million for the year ended December 31, 2013. Operating income was $134.1 million for the year ended December 31, 2014, compared to $370.8 million for the year ended December 31, 2013. Adjusted EBITDA was $436.3 million for the year ended December 31, 2014 compared to $672.0 million for the year ended December 31, 2013. In addition, the Company reported net income attributable to Axiall of $46.3 million, or $0.65 per diluted share for the year ended December 31, 2014, compared to net income attributable to Axiall of $165.3 million, or $2.44 per diluted share for the year ended December 31, 2013. Adjusted Net Income was $93.4 million and Adjusted Earnings Per Share was $1.32 for the year ended December 31, 2014, compared to Adjusted Net Income of $266.1 million and Adjusted Earnings Per Share of $3.93 for the year ended December 31, 2013. See Reconciliation of NonGAAP Financial Measures in this Annual Report on Form 10K. The decrease in net sales for the year ended December 31, 2014 as compared to the year ended December 31, 2013 was primarily attributable to a $138.9 million decrease in the net sales of our aromatics segment which was due to decreased domestic demand for cumene and decreased export opportunities for phenol, partially offset by increases in the net sales of our chlorovinyls and building products segments. The $12.9 million increase in our chlorovinyls segment's net sales was partly due to the inclusion of twelve months of sales results from the Merged Business for the year ended December 31, 2014 versus eleven months in the year ended December 31, 2013, coupled with higher vinyl resin pricing during the year ended December 31, 201 [/INST] Negative. </s>

AXIALL CORP/DE/

2016-02-29

2015-12-31

Item 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS. We are a leading North American manufacturer and international marketer of chemicals and building products. Our chlorovinyls chemical products are sold for further processing into a wide variety of end-use applications, including plastic pipe and pipe fittings, siding and window frames, high-quality plastics, and coatings for wire and cable, paper, minerals, metals and water treatment industries. Our building products segment manufactures window and door profiles, trim, mouldings, deck, siding, pipe and pipe fittings products. Portfolio Initiatives Sale of Aromatics Business: Discontinued Operations On September 30, 2015, the Company entered into and consummated the transactions contemplated by an asset purchase agreement (the “Asset Purchase Agreement”) between INEOS Americas LLC (“INEOS”) and Axiall LLC, a wholly-owned subsidiary of the Company. Pursuant to the Asset Purchase Agreement, INEOS acquired certain assets used in the Company’s aromatics business, including but not limited to, its cumene production facility located in Pasadena, Texas. The Company retained the land and plant at its phenol, acetone and alpha-methylstyrene production facility located in Plaquemine, Louisiana (the “Plaquemine Phenol Facility”), which is part of a broader set of other Axiall chemical manufacturing facilities located in Plaquemine. In addition, the Company retained the following assets associated with its aromatics business: (i) cash and cash equivalents; (ii) accounts receivable; and (iii) inventory, other than certain raw materials and work-in-process inventory at its Pasadena facility. The Company has discontinued the manufacture of products at its Plaquemine Phenol Facility and expects to dismantle and shutdown that facility. At closing, the Company received $52.4 million in cash, which consisted of: (i) the selling price of $47.4 million; and (ii) a $5.0 million advance toward the cost of decommissioning and dismantling our Plaquemine Phenol Facility. That advance was recorded as a liability in our consolidated balance sheets. During the fourth quarter of 2015, the Company met certain terms and conditions set forth in the Asset Purchase Agreement that entitled us to receive $5.5 million of contingent consideration, pursuant to which we recorded $5.3 million, as a gain, net of a $0.2 million working capital adjustment, related to the sale. Further, the Company may receive an additional $5.0 million from INEOS to help defray the costs of decommissioning and dismantling the Plaquemine Phenol Facility. The Company’s receipt of all or any portion of the remaining $5.0 million that INEOS may be required to pay and our right to retain the $5.0 million advance payment will depend on the amount of costs incurred by us to decommission and dismantle the Plaquemine Phenol Facility. During 2015, the Company incurred $0.8 million of such costs and our remaining liability is $4.6 million as of December 31, 2015. For the year ended December 31, 2015, the Company recorded a pre-tax gain of $21.5 million on the sale of our aromatics business assets as described above, the net effect of which is reflected in income (loss) from discontinued operations on our consolidated statements of operations. During the fourth quarter, the Company also received net cash from retained working capital totaling $33.0 million. We expect cash flows attributable to discontinued operations in future periods to be primarily related to the cost of decommissioning the Plaquemine Phenol Facility, partially offset by the related contingent consideration we expect to receive from INEOS if certain other conditions are satisfied. Changes to the estimates and liabilities related to discontinued operations as of December 31, 2015, including the estimated post-closing purchase price adjustment or accrued expenses related to the sale transaction, may result in an adjustment to our gain on the sale transaction. The aromatics segment has been classified as discontinued operations for all periods presented. As a result, our manufacturing operations are concentrated in two reportable segments: chlorovinyls and building products. Ethane Cracker Project with Lotte Chemical On June 17, 2015, Eagle US 2 LLC (“Eagle”), a wholly-owned subsidiary of the Company, entered into an amended and restated limited liability company agreement with Lotte Chemical USA Corporation (“Lotte”) related to the formation of LACC, LLC (“LACC”), which is an entity formed by Eagle and Lotte to design, build and operate a state-of-the-art 1.0 million metric tons per annum ethane cracker (ethylene manufacturing plant) in Lake Charles, Louisiana (the “Plant”). The Plant will provide partial backward integration for Axiall’s vinyls business and will supply a new monoethylene glycol (“MEG”) facility being built by Lotte. Pursuant to a contribution and subscription agreement, dated as of June 17, 2015, between the Company, Eagle and LACC, Eagle has agreed to make a maximum capital commitment to LACC of up to $225 million to fund the construction costs of the Plant. Eagle’s investment is expected to represent approximately 10 percent of the interests of LACC. Eagle and Lotte also entered into a call option agreement, dated as of June 17, 2015, pursuant to which Eagle has the right, but not the obligation, until the third anniversary of the substantial completion of the Plant, to acquire up to a 50 percent ownership interest in LACC from Lotte. On December 17, 2015, Axiall and Lotte announced that the companies reached a final investment decision to construct the Plant. The Plant is being built adjacent to Axiall’s largest chlor-alkali chemical facility, located in Lake Charles, Louisiana, to take advantage of Axiall’s existing infrastructure, access to competitive feedstock resources, and ethylene distribution infrastructure. The anticipated start-up for the Plant is expected to be the beginning of 2019. Building Products The Company has engaged financial advisors to assist the Company with the sale of its building products segment. A sale process for the entire building products segment is ongoing. We expect to complete the sale of two non-core business units during the first quarter of 2016, and are targeting the sale of the remainder of the building products businesses by the end of the second quarter of 2016. Results of Operations Overview Consolidated Overview • For the year ended December 31, 2015, net sales totaled $3,361.1 million, decreasing 12 percent compared to $3,808.8 million for the year ended December 31, 2014. For the year ended December 31, 2014, net sales increased $41.6 million from $3,767.2 million for the year ended December 31, in 2013. • Operating loss was $810.9 million for the year ended December 31, 2015 compared to operating income of $154.8 million and $341.7 million for the years ended December 31, 2014 and 2013, respectively. Adjusted EBITDA was $330.3 million, $454.8 million and $641.7 million for the years ended December 31, 2015, 2014, and 2013, respectively. • The Company reported net loss attributable to Axiall of $816.4 million, or a loss of $11.59 per diluted share, for the year ended December 31, 2015, compared to net income attributable to Axiall of $46.3 million, or $0.65 per diluted share, for the year ended December 31, 2014. For the year ended December 31, 2013, the Company reported net income attributable to Axiall of $165.3 million or $2.44 per diluted share. • Adjusted Net Income was $83.5 million and Adjusted Earnings Per Share was $1.18 for the year ended December 31, 2015, compared to Adjusted Net Income of $139.9 million and Adjusted Earnings Per Share of $1.98 for the year ended December 31, 2014. Adjusted Net Income was $312.0 million and Adjusted Earnings Per Share was $4.60 for the year ended December 31, 2013. See Reconciliation of Non-GAAP Financial Measures in this Annual Report on Form 10-K. Chlorovinyls Business Overview Our chlorovinyls segment produces a highly integrated chain of chlor-alkali and derivative products (chlorine, caustic soda, VCM, vinyl resins, ethylene dichloride, chlorinated solvents, calcium hypochlorite, and HCL) and compound products (vinyl compounds and compound additives and plasticizers). As discussed further below, certain highlights from our chlorovinyls segment results of operations for the years ended December 31, 2015, 2014 and 2013 were as follows: • Net sales totaled $2,506.1 million and $2,930.2 million for the years ended December 31, 2015 and 2014, respectively, decreasing approximately $424.1 million. For the year ended December 2014, net sales increased $12.9 million when compared to net sales of $2,917.3 million for the year ended December 31, 2013. • Operating loss was $768.5 million and Adjusted EBITDA $301.1 million during the year ended December 31, 2015 versus operating income of $213.9 million and Adjusted EBITDA of $448.1 million for the year ended December 31, 2014. For the year ended December 31, 2014, operating income and Adjusted EBITDA decreased $221.0 million and $176.4 million, respectively, when compared to operating income and Adjusted EBITDA of $434.9 million and $624.5 million, respectively, for the year ended December 31, 2013. Our chlorovinyls segment is cyclical in nature and is affected by domestic and worldwide economic conditions. Cyclical price swings, driven by changes in supply and demand, can lead to significant changes in the overall profitability of our chlorovinyls segment. The demand for our chlorovinyls products tends to reflect fluctuations in downstream markets that are affected by consumer spending for durable and non-durable goods as well as construction. Global capacity also materially affects the prices of chlorovinyls products. Historically, in periods of high operating rates, prices rise and margins increase and, as a result, new capacity is announced. Since world scale size plants are generally the most cost-competitive, new increases in capacity tend to be on a large scale and are often undertaken by existing industry participants. Usually, as new capacity is added, prices decline until increases in demand improve operating rates and the new capacity is absorbed or, in some instances, until less efficient producers withdraw capacity from the market. As the additional supply is absorbed, operating rates rise, prices increase and the cycle repeats. In addition, purchased raw materials and natural gas costs account for the majority of our cost of sales and can also have a material effect on our profitability and margins. Some of the primary raw materials used in our chlorovinyls products are ethylene, crude oil and natural gas derivatives and therefore follow the oil and gas industry price trends. Building Products Business Overview Our building products segment consists of two primary product groups: (i) window and door profiles and trim, mouldings and deck products, which include extruded vinyl window and door profiles, interior and exterior trim and mouldings products, as well as deck products; and (ii) outdoor building products, which includes siding, pipe and pipe fittings. As discussed further below, certain highlights from our building products segment results of operations for the years ended December 31, 2015, 2014 and 2013 were as follows: • Net sales totaled $855.0 million and $878.6 million for the years ended December 31, 2015 and 2014, respectively, decreasing 3 percent. On a constant currency basis, net sales for the year ended December 31, 2015 increased by 3 percent. During the year ended December 31, 2014, net sales increased 3 percent from $849.9 million for the year ended December 31, 2013. On a constant currency basis, net sales for the year ended December 31, 2014 increased by 7 percent when compared to the year ended December 31, 2013. • For the year ended December 31, 2015, our building products segment’s geographical sales to the United States and Canada were 59 percent and 40 percent respectively, compared with 54 percent and 45 percent for the year ended December 31, 2014. For the year ended December 31, 2013, our building products segment’s geographical sales to the United States and Canada were 50 percent and 49 percent, respectively. • Operating income was $35.0 million and Adjusted EBITDA was $77.8 million for the year ended December 31, 2015 compared to operating income of $25.8 million and Adjusted EBITDA of $67.7 million for the year ended December 31, 2014. For the year ended December 31, 2014, operating income increased $22.8 million and Adjusted EBITDA decreased $3.0 million when compared to operating income of $3.0 million and Adjusted EBITDA of $70.7 million for the year ended December 31, 2013. The building products segment is impacted by changes in the North American home repair and remodeling sectors, as well as the new construction industry, which may be significantly affected by changes in economic and other conditions such as gross domestic product levels, employment levels, demographic trends, consumer confidence, increases in interest rates and availability of consumer financing for home repair and remodeling projects as well as the availability of financing for new home purchases. These factors can lower the demand for, and pricing of our products, while we may not be able to reduce our costs by an equivalent amount. Results of Operations The following table sets forth our consolidated statements of operations data for each of the years ended December 31, 2015, 2014 and 2013, and the percentage of net sales of each line item for the years presented. The following table sets forth certain financial data, by reportable segment, for each of the years ended December 31, 2015, 2014 and 2013. Year Ended December 31, 2015 Compared With Year Ended December 31, 2014 Consolidated Results Net sales. For the year ended December 31, 2015, net sales totaled $3,361.1 million, decreasing 12 percent compared to $3,808.8 million for the year ended December 31, 2014. The decrease in net sales for the year ended December 31, 2015 as compared to the year ended December 31, 2014 was primarily attributable to: (i) a $424.1 million decrease in the net sales of our chlorovinyls segment due to lower PVC, VCM and chlorinated derivatives sales prices; (ii) lower ECU values, especially with respect to caustic soda pricing; and (iii) lower ECU volumes driven by weaker demand. These unfavorable factors were partially offset by higher operating rates and related sales volumes for PVC during the year ended December 31, 2015 compared to the year ended December 31, 2014. The lower sales prices for PVC, VCM and chlorinated derivatives were driven by: (i) an oversupply of PVC in North America and globally, relative to slower demand; (ii) a significant reduction in global oil prices making many foreign producers of PVC and chlorinated derivatives more competitive (i.e., a reduction in the natural-gas-based cost advantage enjoyed by North American producers), which has reduced pricing and margins on North American-produced PVC and chlorinated derivatives; and (iii) lower average industry costs for natural gas and ethylene. The lower ECU values, especially with respect to caustic soda pricing, have been caused primarily by: (i) the addition of new production capacity in North America since 2014, coupled with slower growth in the demand needed to absorb that capacity; and (ii) a significant reduction in global energy prices, primarily oil and coal, making many foreign ECU producers more competitive. The decrease in net sales was also attributable to the decrease in the net sales of our building products segment primarily due to the impact of a stronger United States dollar against a weaker Canadian dollar, partially offset by higher overall sales volumes. Gross margin percentage. Total gross margin percentage was 12 percent and 14 percent, respectively, for the years ended December 31, 2015 and 2014. The decrease in gross margin was primarily due to the decreases in net sales, which were only partially offset by decreases in the cost of raw materials, primarily natural gas and ethylene. Selling, general and administrative expenses. Selling, general and administrative expenses decreased 2 percent to $299.7 million as of December 31, 2015 compared to $305.6 million for the year ended December 31, 2014. This reduction is a result of actions taken to-date in the Company’s announced plan to reduce annualized selling, general and administrative expenses by $25 million by the end of 2016. Integration-related costs and other, net. Integration-related costs and other, net, decreased approximately 50 percent to $16.0 million for the year ended December 31, 2015 from $32.2 million for the year ended December 31, 2014. The decrease for the year ended December 31, 2015 was primarily due to less integration activity associated with the Merged Business compared to the year ended December 31, 2014. During 2014, our pension plans covering our United States (“U.S. Pension Plans) employees were amended to provide a one-time voluntary lump-sum distribution offer to terminated vested participants and we recorded a settlement charge of $5.8 million related to these costs. In addition, during the year ended December 31, 2014, we incurred higher costs for merger-related and other integration activities pertaining to our merger (the “Merger”) with the Merged Business. Restructuring and divestiture costs. Restructuring and divestiture costs consist of three components: (i) costs associated with restructuring activities; (ii) costs associated with divestiture activities; and (iii) impairment charges related to restructuring and divestiture activities. During the year ended December 31, 2015, restructuring costs totaled $14.1 million, of which $8.9 million and $5.1 million pertained to severance costs in our corporate unallocated and building products segment, respectively. During the year ended December 31, 2014, our building products segment incurred restructuring costs of $4.5 million. During the years ended December 31, 2015 and 2014, management incurred $6.5 million and $1.8 million, respectively, pertaining to divestiture activities primarily due to divestitures in our building products segment and the sale of certain of our aromatics business assets. During the years ended December 31, 2015 and 2014, the company impaired long-lived assets totaling $2.8 million and $13.5 million, respectively. During the year ended December 31, 2014, the Company impaired $12.5 million in assets pertaining to an immaterial phosgene derivatives product line that was classified as held-for-sale in 2014 and was subsequently sold in 2015. Goodwill impairment charges. During the year ended December 31, 2015, the Company determined that the estimated fair value of its chlor-alkali and derivatives reporting unit was lower than the carrying value of that reporting unit, and consequently, we proceeded with the second step (“Step-2”) of the goodwill impairment test in order to measure the magnitude of impairment, if any. That Step-2 considered management’s revised projections for our operating results and cash flows of the chlor-alkali and derivatives reporting unit, and the sustained deterioration of market conditions in the chlor-alkali and derivatives industries, as well as the decline in our market capitalization below book value. Based on the results of the Step-2 impairment test, we recorded an $864.1 million goodwill impairment charge related to our chlor-alkali and derivatives reporting unit during the year ended December 31, 2015. During the year ended December 31, 2014, we recorded a $4.1 million in goodwill impairment charge related to the write-down of an immaterial phosgene derivatives product line that was classified as held-for-sale in 2014 and was subsequently sold in 2015. Further reductions in our future projections of operating results and cash flows from our chlor-alkali and derivatives reporting unit, or certain reporting units in our building products business, or a further deterioration of market conditions in the chlor-alkali and derivatives or building products industries in which we operate, among other factors, could result in the Company incurring additional goodwill impairment charges for one or more of those reporting units. Operating income (loss). Operating loss was $810.9 million and operating income was $154.8 million, for the years ended December 31, 2015 and 2014, respectively. The operating loss was partly attributable to: (i) a $768.5 million operating loss in our chlorovinyls segment which included a goodwill impairment charge of $864.1 million resulting from the impairment test performed in our chlor-alkali and derivatives reporting unit during the year ended December 31, 2015; (ii) lower PVC, VCM and chlorinated derivatives sales prices and margins, driven by an oversupply of PVC in North America and globally, relative to slower demand; a significant reduction in global oil prices making many foreign producers of PVC and chlorinated derivatives more competitive (i.e., a reduction in the natural-gas-based cost advantage enjoyed by North American producers), which has reduced pricing and margins on North American-produced PVC and chlorinated derivatives; and (iii) lower ECU values, especially with respect to caustic soda pricing, caused primarily by the addition of new production capacity in North America since 2014, coupled with slower growth in the demand needed to absorb that capacity, as well as a significant reduction in global energy prices, primarily oil and coal, making many foreign ECU producers more competitive. These unfavorable factors were partially offset by decreases in our average cost of ethylene and natural gas, higher operating rates and sales volume increases for PVC for the year ended December 31, 2015 compared to the year ended December 31, 2014. Average industry natural gas prices decreased 39 percent and average industry ethylene prices decreased 27 percent for the year ended December 31, 2015, compared to the year ended December 31, 2014, according to the January 2016 IHS report. Debt refinancing costs. During the year ended December 31, 2015, the Company refinanced its existing term loan facility and increased the principal balance to $250 million and incurred $3.2 million in fees related to the transaction. There were no similar activities during the year ended December 31, 2014. Interest expense. Interest expense totaled $78.1 million and $76.5 million for the years ended December 31, 2015 and 2014, respectively. Foreign currency exchange loss. Foreign currency exchange loss totaled $1.2 million and $0.6 million during the years ended December 31, 2015 and 2014, respectively. Interest income. Interest income totaled $0.4 million and $0.7 million for the years ended December 31, 2015 and 2014, respectively. Provision for (benefit from) income taxes. The benefit from income taxes from continuing operations was $43.9 million for the year ended December 31, 2015 and the provision for income taxes was $14.3 million for the year ended December 31, 2014. The decrease in income tax to a benefit in 2015 from a provision in 2014 was primarily due to: (i) a loss from continuing operations before income taxes during the year ended December 31, 2015, primarily caused by the $864.1 million goodwill impairment charge, compared to the income from continuing operations for the year ended December 31, 2014; (ii) the tax benefit from our domestic manufacturing activities and depletion deductions; and (iii) the impact to our deferred tax liability recorded for our outside basis differences in foreign subsidiaries resulting from the goodwill impairment charge that was recorded for the year ended December 31, 2015. During the years ended December 31, 2015 and 2014, the Company also recorded a tax provision of $2.7 million and an income tax benefit of $6.8 million, respectively, pertaining to the discontinued operations of our aromatics business. Our effective income tax rate for the year ended December 31, 2015 was 4.9 percent, resulting from a benefit from income taxes on a loss from continuing operations. The difference in the effective income tax rate as compared to the United States statutory federal income tax rate in 2015 was primarily due to the unfavorable permanent difference for the goodwill impairment charge related to our chlor-alkali and derivatives reporting unit during the year ended December 31, 2015. Our effective tax rate for the year ended December 31, 2014 was 18.2 percent, resulting from a provision for income taxes on income from continuing operations. The difference in the effective income tax rate as compared to the United States statutory federal income tax rate in 2014 was primarily due to various permanent differences including deductions for manufacturing activities, as well as the favorable impact of changes in uncertain tax positions of approximately $9.2 million. Net income (loss) from discontinued operations. On September 30, 2015 we entered into the Asset Purchase Agreement with, and sold to, INEOS certain assets in our aromatics business, including our cumene plant located in Pasadena, Texas. In conjunction with the sale of those assets, we recorded a pre-tax gain on sale of $21.5 million, which is included in the results of operations for the year ended December 31, 2015. Net income from discontinued operations for the year ended December 31, 2015 was $12.0 million compared to a net loss from discontinued operations of $13.9 million for the year ended December 31, 2014. Chlorovinyls Segment Net sales. Net sales totaled $2,506.1 million for the year ended December 31, 2015, a decrease of 14 percent versus net sales of $2,930.2 million for the year ended December 31, 2014. This net sales decrease was primarily due to: (i) lower PVC, VCM and chlorinated derivatives sales prices; (ii) lower ECU values, especially with respect to caustic soda pricing; and (ii) lower ECU volumes driven by weaker demand. These unfavorable factors were partially offset by higher operating rates and sales volumes for PVC, as the year ended December 31, 2014 was negatively impacted by an extended outage at our PHH VCM manufacturing facility. The lower sales prices for PVC, VCM and chlorinated derivatives were driven by: (i) an oversupply of PVC in North America and globally, relative to slower demand; (ii) a significant reduction in global oil prices making many foreign producers of PVC and chlorinated derivatives more competitive (i.e., a reduction in the natural-gas-based cost advantage enjoyed by North American producers), which has reduced pricing and margins on North American-produced PVC and chlorinated derivatives; and (iii) lower average industry costs for natural gas and ethylene. Lower ECU values, especially with respect to caustic soda pricing, were caused primarily by: (i) the addition of new production capacity in North America since 2014, coupled with slower growth in the demand needed to absorb that capacity; and (ii) a significant reduction in global energy prices, primarily oil and coal, making many foreign ECU producers more competitive. Operating income (loss). Operating loss was $768.5 million for the year ended December 31, 2015, a decrease of $982.4 million compared to an operating income of $213.9 million for the year ended December 31, 2014. The decrease was principally due to: (i) a goodwill impairment charge of $864.1 million resulting from the impairment test performed in our chlor-alkali and derivatives reporting unit during the year ended December 31, 2015, based on management’s projections of operating results and cash flows for that reporting unit, and the sustained deterioration of market conditions in the chlor-alkali and derivatives industries, as well as the decline in our market capitalization below book value; (ii) lower PVC, VCM and chlorinated derivatives sales prices and margins, driven by the factors described in the preceding paragraph; (iii) lower ECU values, especially with respect to caustic soda pricing, due to the factors described in the preceding paragraph; and (iv) lower ECU volumes driven by weaker demand. These unfavorable factors were partially offset by decreases in our average cost of ethylene and natural gas, and higher operating rates and sales volumes for PVC for the year ended December 31, 2015 compared to the year ended December 31, 2014. Adjusted EBITDA decreased $147.0 million to $301.1 million for the year ended December 31, 2015 from $448.1 million for the year ended December 31, 2014. That decrease was predominantly due to the factors discussed above in items (ii), (iii) and (iv). Building Products Segment Net Sales. Net sales totaled $855.0 million for the year ended December 31, 2015, decreasing 3 percent from $878.6 million compared to the year ended December 31, 2014. The net sales decrease was driven by the impact of a stronger United States dollar relative to a weaker Canadian dollar. On a constant currency basis, net sales increased by 3 percent. Sales volumes increased by 3 percent for the year ended December 31, 2015 compared to the same period of the prior year, with sales volumes in the United States higher by 10 percent and sales volumes in Canada lower by 6 percent. For the year ended December 31, 2015, our building products segment’s geographical sales to the United States and Canada were 59 percent and 40 percent, respectively, compared with 54 percent and 45 percent, respectively, for the year ended December 31, 2014. Operating Income. Operating income was $35.0 million and $25.8 million for the years ended December 31, 2015 and 2014, respectively. The increase in operating income was primarily a result of lower raw materials cost and higher sales volumes in the United States, partially offset by the impact of a stronger United States dollar relative to a weaker Canadian dollar and higher costs relating to restructuring activities. Adjusted EBITDA was $77.8 million and $67.7 million for the years ended December 31, 2015 and 2014, respectively. The increase in Adjusted EBITDA was primarily a result of lower raw materials costs and higher sales volumes in the United States, partially offset by the impact of a stronger United States dollar relative to a weaker Canadian dollar. Year Ended December 31, 2014 Compared With Year Ended December 31, 2013 Consolidated Results Net sales. For the year ended December 31, 2014, net sales totaled $3,808.8 million, an increase of 1 percent compared to $3,767.2 million for the year ended December 31, 2013. Net sales in our chlorovinyls segment increased by $12.9 million primarily due to the inclusion of twelve months of sales results from the Merged Business for the year ended December 31, 2014 versus the inclusion of only eleven months of sales results from the Merged Business for the year ended December 31, 2013, offset by: (i) lower operating rates and related sales volumes due to several outages within our chlor-alkali operations, the most significant of which included extended outages at our PHH VCM manufacturing facility; and (ii) lower ECU values, for both chlorine and caustic soda pricing, caused primarily by the addition of new production capacity in North America coupled with slower growth in the demand needed to absorb that capacity, partially offset by higher PVC and VCM prices. Net sales in our building products segment increased by $28.7 million primarily driven by a 17 percent increase in sales volumes in the United States, partially offset by the impact of a stronger U.S. dollar against a weaker Canadian dollar. Gross margin percentage. Total gross margin percentage decreased to 14 percent for the year ended December 31, 2014 from 19 percent for the year ended December 31, 2013. This decrease was principally due to: (i) lower operating rates and higher maintenance and operating costs due to several outages within our chlor-alkali operations, the most significant of which included extended outages at our PHH VCM manufacturing facility; (ii) lower ECU values, for both chlorine and caustic soda pricing, caused primarily by the factors discussed in the preceding paragraph, partially offset by higher pricing for our vinyl resins, VCM and chlorinated derivative products; (iii) higher natural gas and ethylene costs; and (iv) the decrease in domestic and export demand for aromatics products made in North America due to new production capacity in Asia. In January 2015, IHS reported that natural gas prices increased 20 percent and ethylene prices increased by 3 percent for the year ended December 31, 2014 as compared to the year ended December 31, 2013. In 2013, the chlorovinyls segment’s gross margin was negatively impacted by a $13.4 million fair value inventory acquisition accounting adjustment related to the Merged Business. Selling, general and administrative expenses. Selling, general and administrative expenses totaled $305.6 million for the year ended December 31, 2014, an increase of 4 percent from $294.5 million for the year ended December 31, 2013. This increase was primarily due to the inclusion of twelve months of expenses from the Merged Business during the year ended December 31, 2014, versus only eleven months for the year ended December 31, 2013, as well as increased amortization expense, professional fees and promotional costs. Integration-related costs and other, net. Integration-related costs and other, net, decreased 1 percent to $32.2 million during the year ended December 31, 2014 from $32.6 million during the year ended December 31, 2013. During 2014, our U.S. Pension Plans were amended to provide a one-time voluntary lump-sum distribution offer to terminated vested participants and we recorded a settlement charge of $5.8 million related to these costs. During the year ended December 31, 2013, the company recorded a curtailment gain of $15.5 million related to certain pension plan amendments, partially offset by higher integration costs, costs to attain Merger-related synergies and deal-related costs when compared to the year ended December 31, 2014. Restructuring and divestiture costs. Restructuring and divestiture costs consists of three components: (i) costs associated with restructuring activities; (ii) costs associated with divestiture activities; and (iii) impairment charges related to restructuring and divestiture activities. Restructuring and divestiture costs decreased by $1.0 million to $19.8 million during the year ended December 31, 2014 from $20.8 million during the year ended December 31, 2013. During the year ended December 31, 2014, the Company incurred approximately $12.5 million in long-lived and intangible asset impairment charges related to a product line that was classified as held-for-sale in our chlorovinyls segment. Also during the year ended December 31, 2014, the Company recorded $4.5 million and $1.8 million in restructuring and divestiture costs, respectively, in its building products segment. During 2013, the Company recorded $6.7 million in impairment charges to write-down long-lived intangible assets in its window and door reporting units as well as $11.1 million primarily related to certain duplicated assets as a result of the Company’s merger activity and other restructuring transactions. The write-down was due primarily to the prolonged downturn in the North American housing and construction markets, continued pricing declines, and the expected impact of those declines on projected cash flows on the window and door profiles reporting unit. Goodwill impairment charges: During the year ended December 31, 2014, we recorded $4.1 million in goodwill impairment charges related to the write-down of an immaterial phosgene derivative product line that was classified as held-for-sale. During the year ended December 31, 2013, the Company recorded a goodwill impairment charge of $18.2 million in its window and door profiles reporting unit. The write-down was due primarily to the prolonged downturn in the North American housing and construction markets, pricing declines, and the expected impact of those declines on projected cash flows on the window and door profiles reporting unit during the year ended December 31, 2013. Operating income. Operating income was $154.8 million for the year ended December 31, 2014 compared to an operating income of $341.7 million for the year ended December 31, 2013. The decrease in operating income was primarily a result of: (i) lower operating rates and increased maintenance and operating costs due to several outages within our chlor-alkali operations, the most significant of which included extended outages at our PHH VCM manufacturing facility; (ii) lower ECU values for both chlorine and caustic soda pricing, partially offset by higher pricing for our vinyl resins, VCM and chlorinated derivative products; and (iii) higher natural gas and ethylene costs. Interest expense. Interest expense totaled $76.5 million and $77.6 million for the years ended December 31, 2014 and 2013, respectively. Debt refinancing costs. Debt refinancing costs resulted from the financing of our long-term debt and financing fees associated with the retirement of our higher interest rate notes during the year ended December 31, 2013, which included a $55.4 million make-whole payment. There were no similar transactions or refinancing activities during the year ended December 31, 2014. Gain on acquisition of controlling interest. In January 2013, we acquired the Merged Business and the remaining 50 percent interest of PHH that we did not previously own. Prior to the Merger, we owned 50 percent of PHH and accounted for our ownership interest as an equity method investment. During the year ended December 31, 2013, we recognized a gain of $25.9 million as a result of remeasuring our prior equity interest in PHH held before the Merger in accordance with GAAP. We had no such gain during the year ended December 31, 2014. Foreign currency exchange loss. Foreign currency exchange loss totaled $0.6 million for the year ended December 31, 2014 and was nominal for the year ended December 31, 2013. The foreign currency exchange loss for the year ended December 31, 2014 is primarily due to the impact of a stronger U.S. dollar against a weaker Canadian dollar. Interest income. Interest income totaled $0.7 million and $1.0 million for the years ended December 31, 2014 and 2013, respectively. Provision for income taxes. The provision for income taxes was $14.3 million for the year ended December 31, 2014, compared to $62.9 million for the year ended December 31, 2013. The decrease was primarily due to a lower income before income taxes during the year ended December 31, 2014 compared to the year ended December 31, 2013, as well as the release of uncertain tax positions for which the statute of limitations has expired, or effective settlement has occurred. During the years ended December 31, 2014 and 2013, the Company also recorded a tax benefit of $6.8 million and an income tax provision of $10.7 million, respectively, pertaining to the discontinued operations of our aromatics business. Our effective income tax rates for the years ended December 31, 2014 and 2013 were 18.2 percent and 29.6 percent, respectively. The difference in the effective income tax rate as compared to the United States statutory federal income tax rate in 2014 was primarily due to various permanent differences, including deductions for manufacturing activities, as well as a $9.2 million favorable impact from changes in uncertain tax positions. The difference in the effective income tax rate as compared to the United States statutory federal income tax rate in 2013 was primarily due to various permanent differences including deductions for manufacturing activities and a $2.7 million favorable impact from changes in uncertain tax positions. Net income (loss) from discontinued operations. On September 30, 2015, we sold certain assets used in our aromatics business to INEOS, pursuant to the terms of the Asset Purchase Agreement, including our cumene plant located in Pasadena, Texas. Net loss from discontinued operations for the years ended December 31, 2014 was $13.9 million compared to net income of $18.4 million for the year ended December 31, 2013. The operating results of our discontinued operation are included in our results of operations for the years ended December 31, 2014 and 2013. Chlorovinyls Segment Net sales. Net sales totaled $2,930.2 million for the year ended December 31, 2014, an increase of $12.9 million versus net sales of $2,917.3 million for the year ended December 31, 2013. Our overall net sales increase was primarily due to the inclusion of twelve months of sales results from the Merged Business for the year ended December 31, 2014 versus the inclusion of only eleven months of sales results from the Merged Business for the year ended December 31, 2013, offset by: (i) lower operating rates and related sales volumes due to several outages in our chlor-alkali operations, the most significant of which included extended outages at our PHH VCM manufacturing facility; and (ii) lower ECU values for both chlorine and caustic soda pricing, caused primarily by the addition of new production capacity in North America coupled with slower growth in the demand needed to absorb that capacity, partially offset by higher pricing for our vinyl resins, VCM and chlorinated derivative products. Operating income. Operating income decreased by $221.0 million to $213.9 million for the year ended December 31, 2014 from $434.9 million for the year ended December 31, 2013. The decrease was principally due to: (i) lower operating rates and increased maintenance and operating costs from several outages within our chlor-alkali operations, the most significant of which included extended outages at our PHH VCM manufacturing facility; (ii) lower ECU values resulting primarily from the reasons discussed above, partially offset by higher pricing for our vinyl resins, VCM and chlorinated derivative products; and (iii) increases in our cost of natural gas and ethylene. In January 2015, IHS reported that industry natural gas prices increased 20 percent and ethylene prices increased 3 percent for the year ended December 31, 2014 compared to the year ended December 31, 2013. During the year ended December 31, 2013, the segment’s operating income was negatively impacted by a $13.4 million fair value inventory acquisition accounting adjustment related to the Merged Business and by $13.8 million of costs to attain Merger-related synergies, which included $10.3 million of plant reliability improvement initiatives. Adjusted EBITDA decreased $176.4 million to $448.1 million for the year ended December 31, 2014 from $624.5 million for the year ended December 31, 2013. That decrease was predominantly due to the same factors discussed above with respect to operating income, partially offset by the twelve full months of Adjusted EBITDA contributed by the Merged Business in 2014 compared to eleven months in 2013. Building Products Segment Net sales. Net sales totaled $878.6 million for the year ended December 31, 2014, increasing 3 percent, versus $849.9 million for the year ended December 31, 2013. The net sales increase was primarily driven by a 17 percent increase in sales volumes in the United States, partially offset by the impact of a stronger U.S. dollar against a weaker Canadian dollar. On a constant currency basis, net sales increased by 7 percent. For the year ended December 31, 2014, our building products segment’s geographical sales to the United States and Canada were 54 percent and 45 percent respectively, compared with 50 percent and 49 percent for the year ended December 31, 2013. Operating income. Operating income was $25.8 million and $3.0 million for the years ended December 31, 2014, and 2013, respectively. The increase in operating income was primarily a result of $24.4 million in lower impairment and restructuring charges in the year ended December 31, 2014 compared to the year ended December 31, 2013. The year ended December 31, 2013 included a $24.9 million impairment charge to write down goodwill and other intangible assets as a result of our evaluation of the window and door profiles reporting unit’s fair value. There were no such impairment charges related to goodwill and other intangible assets for the year ended December 31, 2014. Adjusted EBITDA was $67.7 million for the year ended December 31, 2014 compared to Adjusted EBITDA of $70.7 million for the year ended December 31, 2013. The $3.0 million decrease in Adjusted EBITDA was primarily a result of higher material costs, the impact of a stronger U.S. dollar against a weaker Canadian dollar and higher distribution and selling expenses, offset in part by lower conversion costs, higher sales volumes and lower general and administrative expenses. Reconciliation of Non-GAAP Financial Measures Axiall supplements its consolidated financial statements prepared in accordance with GAAP that are set forth in this Annual Report on Form 10-K (the “Financial Statements”) with four non-GAAP financial measures: (i) Adjusted Net Income (Loss); (ii) Adjusted Earnings (Loss) Per Share; (iii) Adjusted EBITDA; and (iv) building products net sales on a constant currency basis. Adjusted Earnings (Loss) Per Share is calculated using Adjusted Net Income (Loss) rather than consolidated net income (loss) attributable to Axiall calculated in accordance with GAAP. Adjusted Net Income (Loss) is defined as consolidated net income (loss) attributable to Axiall excluding adjustments for tax-effected restructuring and certain other charges, if any, related to discontinued operations, financial restructuring and business improvement initiatives, gains or losses on sales of certain assets, debt refinancing costs, certain acquisition accounting and non-income tax reserve adjustments, certain professional fees associated with various potential and completed mergers and acquisitions, joint ventures and other transactions, costs to attain synergies related to the integration of the Merged Business, amortization of definite-lived intangible assets, impairment charges for goodwill, intangible assets, and other long-lived assets. For the year ended December 31, 2015 we have excluded amortization of definite-lived intangible assets from our calculation of Adjusted Net Income (Loss) and intend to do so in future periods. We believe excluding this item from our calculation of Adjusted Net Income is helpful to investors because the amortization of our intangible assets is a non-cash charge that does not impact our liquidity or our operational performance. Adjusted EBITDA is defined as Earnings (Loss) Before Interest, Taxes, Depreciation and Amortization, restructuring and certain other charges, if any, related to discontinued operations, financial restructuring and business improvement initiatives, gains or losses on sales of certain assets, debt refinancing costs, certain acquisition accounting and non-income tax reserve adjustments, certain professional fees associated with various potential and completed mergers and acquisitions, divestitures, joint ventures and other transactions, costs to attain synergies related to the integration of the Merged Business, impairment charges for goodwill, intangible assets, and other long-lived assets, certain pension and other post-retirement plan curtailment gains and settlement losses and interest expense related to the lease-financing transaction discussed in Note 10 of the Notes to the Consolidated Financial Statements in Item 8. Axiall supplements its consolidated financial statements with Adjusted Net Income (Loss) and Adjusted Earnings (Loss) Per Share because investors commonly use financial measures such as Adjusted Net Income (Loss) and Adjusted Earnings (Loss) Per Share as a component of performance and valuation analysis for companies, such as Axiall, that recently have engaged in transactions and have incurred expenses such as professional fees related to potential transactions, that result in non-recurring pre-tax charges or benefits that have a significant impact on the calculation of consolidated net income (loss) attributable to Axiall pursuant to GAAP, in order to approximate the amount of net income (loss) that such a company would have achieved absent those non-recurring, integration-related charges or benefits. In addition, Axiall supplements the consolidated financial statements with Adjusted Net Income (Loss) and Adjusted Earnings (Loss) Per Share because we believe these financial measures will be helpful to investors in approximating what our net income (loss) would have been absent the impact of certain non-recurring, pre-tax charges and benefits. We have supplemented the consolidated financial statements with Adjusted EBITDA because investors commonly use Adjusted EBITDA as a main component of valuation analysis of cyclical companies such as Axiall. In addition, we may compare certain financial information, including building products net sales on a constant currency basis. We present such information to provide a framework for investors to assess how our underlying businesses performed, excluding the effect of foreign currency rate fluctuations, primarily fluctuations in the Canadian dollar. To present this information, current and comparative prior period financial information for certain businesses reporting in currencies other than United States dollars are converted into United States dollars at the average exchange rate in effect during the base period, rather than the average exchange rates in effect during the respective periods. Adjusted Earnings (Loss) Per Share, Adjusted Net Income (Loss), Adjusted EBITDA and building products net sales on a constant currency basis, are not measurements of financial performance under GAAP and should not be considered as an alternative to net income (loss), GAAP diluted earnings (loss) per share or net sales, as a measure of performance or as an alternative to cash provided by (used in) operating activities as a measure of liquidity. In addition, our calculation of these various non-GAAP measurements may be different from the calculations used by other companies and, therefore, comparability may be limited. Reconciliations of our non-GAAP financial measures to the most comparable GAAP measures are presented in the tables set forth below. Adjusted Earnings Per Share Reconciliation Adjusted Net Income Reconciliation (1) Includes $0.6 million, $11.7 million and $10.4 million for the years ended December 31, 2015, 2014 and 2013, respectively, of plant reliability improvement initiatives that are included in cost of sales on our consolidated statements of operations. The year ended December 31, 2013 also includes a $13.4 million inventory fair value acquisition accounting adjustment in cost of sales on our consolidated statements of operations. (2) Goodwill impairment charges of $864.1 recognized during the year ended December 31, 2015, less $24.7 million, the portion attributable to our noncontrolling interest. Adjusted EBITDA Reconciliations Year Ended December 31, 2015 (1) Includes $0.6 million of plant reliability improvement initiatives that are included in cost of sales on our consolidated statements of operations. (2) Includes $5.7 million of lease financing obligations interest and $4.4 million for debt issuance cost amortization. (3) Earnings of our segments exclude interest income and expense, unallocated corporate expenses and general plant services, and benefit from income taxes. Year Ended December 31, 2014 (1) Includes $11.7 million of plant reliability improvement initiatives that are included in cost of sales on our consolidated statements of operations. (2) Includes $6.5 million of lease financing obligations interest and $5.2 million for debt issuance cost amortization. (3) Earnings of our segments exclude interest income and expense, unallocated corporate expenses and general plant services, and provision for income taxes. Year Ended December 31, 2013 (1) Includes $13.4 million of inventory fair value acquisition accounting adjustment and $10.4 million of plant reliability improvement initiatives that are included in cost of sales on our consolidated statements of operations. (2) Includes $7.1 million of lease financing obligations interest and $5.1 million for debt issuance cost amortization. (3) Earnings of our segments exclude interest income and expense, unallocated corporate expenses and general plant services, and provision for income taxes. Building Products Constant Currency Net Sales Liquidity and Capital Resources Overview Historically, our primary sources of liquidity and capital resources have included cash provided by operations, proceeds from the sale of assets and other, the issuance of debt, and the use of available borrowing facilities. As of December 31, 2015, we had liquidity of $627.2 million, comprised of approximately $369.2 million of availability under our ABL Revolver and $258.0 million in cash and cash equivalents. The net change in cash and cash equivalents for the years ended December 31, 2015, 2014 and 2013 consisted of the following: Operating Activities. In the consolidated statements of cash flows, changes in operating assets and liabilities are presented excluding the effects of changes in foreign currency, non-cash transactions and the effects of acquisitions and divestitures. Accordingly, the amounts in the consolidated statements of cash flows differ from changes in the operating assets and liabilities that are presented in the consolidated balance sheets. Net working capital for the years ended December 31, 2015, 2014 and 2013 was $573.9 million, $621.1 million, and $625.4 million, respectively. The decrease in net working capital during the year ended December 31, 2015 as compared to the year ended December 31, 2014 was primarily due to the reduction of current assets resulting from the reclassification of deferred taxes from current assets to noncurrent assets in our consolidated balance sheets and a decrease in raw material prices. The decrease in net working capital during the year ended December 31, 2014 as compared to the year ended December 31, 2013 was primarily due to a decrease in accounts receivables caused by lower sales, and a reduction in our inventory balances, which resulted from decreased raw material prices. Operating working capital used in operating activities decreased $82.1 million for the year ended December 31, 2015 when compared to the year ended December 31, 2014, primarily due to: (i) a decrease of $50.3 million in prepaid expenses and other; (ii) a decrease of $38.1 million in accrued compensation; (iii) a decrease of $14.4 million in accounts receivables; and (iv) a decrease of $11.8 million in accrued income taxes; partially offset by an increase of $32.0 million in other accrued liabilities. Operating working capital used in operating activities decreased $68.5 million for the year ended December 31, 2014 when compared to the year ended December 31, 2013, primarily due to: (i) a decrease of $71.0 million in inventories; (ii) a decrease of $66.1 million in accounts receivables; (iii) a decrease of $32.9 million in other accrued liabilities; partially offset by: (iv) an increase of $37.7 million in prepaid expenses; (v) an increase of $37.6 million in accounts payable; and (vi) an increase of $24.4 million in accrued compensation. Investing Activities. For the year ended December 31, 2015, cash used in investing activities decreased $66.8 million when compared to the year ended December 31, 2014, $53.0 million of which is attributable to the discontinued operations of our aromatics business, $5.8 million due to a reduction in capital expenditures and $6.1 million due to a reduction in cash flows from acquisitions, net of cash acquired. For the year ended December 31, 2014, cash used in investing activities increased $68.9 million when compared to the year ended December 31, 2013. During the year ended December 31, 2014, capital expenditures increased $13.5 million and cash used in connection with acquisitions, net of cash acquired increased $51.2 million compared to the year ended December 31, 2013 which included a $22.0 million payment by PPG to us for the net working capital settlement and $11.4 million in proceeds from the sale of assets. Financing Activities. Cash used in financing activities decreased $52.2 million in 2015 when compared to the year ended December 31, 2014. The decrease was primarily due to the refinancing of our existing term loan facility in which we increased the principal amount to $250 million. During the year ended December 31, 2015, we repaid $195.2 million in settlement of the existing term loan facility and $2.5 million toward our principal payments on the new term loan facility (the “New Term Loan Facility”). In 2014, our primary financing activities included $45.0 million for dividend payments, $10.0 million related to deferred acquisition payments to PPG and $7.7 million distribution to noncontrolling interest. In 2013, our financing activities included the issuance and redemption of long-term debt, $98.1 million in make-whole and other fees related to financing the Merger with PPG’s chlor-alkali and derivatives business and $22.2 million in dividend payments and a distribution to noncontrolling interest of $13.3 million. As of December 31, 2015 and 2014, our long-term debt consisted of the following: 4.625 Notes Axiall Corporation and certain of its subsidiaries guarantee $688.0 million in aggregate principal amount of 4.625 percent senior unsecured notes due 2021 (the “4.625 Notes”) that were issued by a wholly-owned subsidiary, Eagle Spinco Inc. (“Spinco”) on January 28, 2013. Interest payments on the 4.625 Notes commenced on August 15, 2013 and interest is payable semi-annually in arrears on February 15 and August 15 of each year. The 4.625 Notes are fully and unconditionally guaranteed, jointly and severally, on a senior unsecured basis by Axiall Corporation and by its existing and future domestic subsidiaries, other than certain excluded subsidiaries. 4.875 Notes On February 1, 2013, Axiall Corporation issued $450.0 million in aggregate principal amount of 4.875 percent senior unsecured notes due 2023 (the “4.875 Notes”). Interest payments on the 4.875 Notes commenced on May 15, 2013 and interest is payable semi-annually in arrears on May 15 and November 15 of each year. The 4.875 Notes are fully and unconditionally guaranteed, jointly and severally, on a senior unsecured basis by each of our existing and future domestic subsidiaries, other than certain excluded subsidiaries. Term Loan On February 27, 2015, Axiall Holdco, Inc., a wholly-owned subsidiary of the Company (“Axiall Holdco”), entered into a credit agreement with a syndicate of financial institutions (the “Term Loan Agreement”) for a new $250 million term loan facility (the “New Term Loan Facility”) to refinance the principal amount outstanding under the Company’s existing term loan facility, to pay related fees and expenses, and for general corporate purposes. Obligations under the New Term Loan Facility are fully and unconditionally guaranteed, on a senior secured basis, by Axiall Corporation and by each of its existing and future wholly-owned domestic subsidiaries, other than certain excluded subsidiaries. The obligations under the New Term Loan Facility are secured by substantially all of the assets of Axiall Holdco, Axiall Corporation and the subsidiary guarantors. The New Term Loan Facility contains an accordion feature that permits Axiall Holdco, subject to certain conditions and to obtaining lender commitments, to incur additional term loans under the New Term Loan Facility in an amount up to the greater of: (i) $250 million; and (ii) an amount that would not result in the Company’s consolidated secured debt ratio being greater than 2.50 to 1.00. At the election of Axiall Holdco, the New Term Loan Facility bears interest at a rate equal to: (i) the Base Rate (as defined in the Term Loan Agreement) plus 1.50 percent per annum; or (ii) LIBOR (as defined in the Term Loan Agreement) plus 3.25 percent per annum; provided that at no time will the Base Rate be deemed to be less than 2.00 percent per annum or LIBOR be deemed to be less than 0.75 percent per annum. As of December 31, 2015, outstanding borrowings under the Company’s New Term Loan Facility had a stated interest rate of 4.00 percent per annum. The Term Loan Agreement contains customary covenants (subject to exceptions), including certain restrictions on the Company and its subsidiaries to pay dividends. ABL Revolver The Company’s second amended and restated asset based revolving credit facility (the “ABL Revolver”), which the Company entered into in December 2014, provides for a maximum of $600.0 million of revolving credit, subject to applicable borrowing base limitations and certain other conditions. The credit agreement governing the ABL Revolver (the “ABL Credit Agreement”) contains customary covenants, including certain restrictions on the Company and its subsidiaries to pay dividends and repurchase shares of Company stock. These covenants are subject to certain exceptions and qualifications. Under the ABL Revolver, dividend payments and repurchases of our common stock in an aggregate amount not to exceed $150 million in any fiscal year may be made if both borrowing availability under the ABL Revolver would have exceeded $75 million at all times during the thirty days immediately preceding any such restricted payment and our consolidated fixed charge coverage ratio (as defined in the ABL Revolver) is equal to or exceeds 1.00 to 1.00, each on a pro forma basis after giving effect to any such proposed restricted payment. In addition, under the ABL Revolver, additional cash dividend payments may be made if both borrowing availability under the ABL Revolver then exceeds $100 million and our consolidated fixed charge coverage ratio (as defined in the ABL Revolver) is equal to or exceeds 1.10 to 1.00, each on a pro forma basis after giving effect to the proposed cash dividend payment. In December 2015, we amended our ABL Credit Agreement to, among other things, provide additional flexibility to pay dividends and consummate stock repurchases, modify the definition of consolidated EBITDA to include certain additional add backs and reductions to net income in determining consolidated EBITDA (as defined in the ABL Revolver), revise the definition of consolidated capital expenditures to exclude capital expenditures made in connection with the proposed Plant, and provide for a reduction in the amount of its basket for investments in such a plant by the amount of such capital expenditures that are excluded from the definition of consolidated capital expenditures. As of December 31, 2015 and 2014, we had no outstanding balance under our ABL Revolver. Our availability under the ABL Revolver at December 31, 2015 was approximately $369.2 million, net of outstanding letters of credit totaling $81.9 million. As of December 31, 2015, depending on the duration of the loan, the applicable rate for borrowings would have been between 2.11 percent to 4.00 percent based on LIBOR or the Prime Rate, plus the applicable margin under the ABL Revolver. As of December 31, 2015, we were in compliance with the covenants under our ABL Credit Agreement, the Term Loan Agreement and the indentures governing the 4.625 Notes and the 4.875 Notes. Borrowings under the ABL Revolver, if any, were at variable interest rates. (1) As of December 31, 2015, the applicable rate for future borrowings would have been 2.11 percent to 4.00 percent under the ABL Revolver. Ability to Pay Dividends Under the ABL Revolver Under the ABL Revolver, cash dividend payments in an aggregate amount not to exceed $150 million in any fiscal year may be made if both borrowing availability under the ABL Revolver would have exceeded $75 million at all times during the thirty days immediately preceding the dividend payment and our consolidated fixed charge coverage ratio (as defined in the definitive documentation governing the ABL Revolver) is equal to or exceeds 1.00 to 1.00, each on a pro forma basis after giving effect to the proposed dividend payment. In addition, under the ABL Revolver, additional cash dividend payments may be made if both borrowing availability under the ABL Revolver then exceeds $100 million and our consolidated fixed charge coverage ratio (as defined in the definitive documentation governing the ABL Revolver) is equal to or exceeds 1.10 to 1.00, each on a pro forma basis after giving effect to the proposed cash dividend payment. Additionally, under the ABL Revolver, cash dividend payments in an aggregate amount not to exceed $50 million in any fiscal year may be made if both borrowing availability under the ABL Revolver would have exceeded $250 million at all times during the 45 days immediately preceding the dividend payment declaration and exceeds $250 million on the day of declaration of such dividend payment, and is reasonably expected to exceed $250 million on the last day of the calendar month during which such dividend payment is declared, and on the last day of the next two succeeding calendar months. Cash Interest for Long-term Debt Cash payments for interest during the years ended December 31, 2015, 2014 and 2013 were $68.7 million, $66.4 million and $69.2 million, respectively. Lease Financing Obligation As of December 31, 2015 and 2014, we had a lease financing obligation of $79.6 million and $94.2 million, respectively. The change from the December 31, 2014 balance is due to the change in the Canadian dollar exchange rate as of December 31, 2015. The lease financing obligation is the result of the sale and concurrent leaseback of certain land and buildings in Canada in 2007 for a term of ten years. In connection with this transaction, certain terms and conditions, including the requirement to execute a collateralized letter of credit in favor of the buyer-lessor, resulted in the transaction being recorded as a financing transaction rather than a sale for GAAP purposes. As a result, the land, building and related accounts continue to be recognized in the consolidated balance sheets. The collateralized letter of credit expired on February 2, 2015 and is no longer required. We are not obligated to repay the lease financing obligation amount of $79.6 million. Our obligation is for the future minimum lease payments under the terms of the related lease agreements. The future minimum lease payments under the terms of the related lease agreements as of December 31, 2015 are $4.6 million in 2016, and $1.2 million in 2017, the final year of the lease agreements. The change in the future minimum lease payments from such amounts disclosed as of December 31, 2014 is due to current period payments and the change in the Canadian dollar exchange rate as of December 31, 2015. Dividends During the years ended December 31, 2015 and 2014, the Company’s Board of Directors declared dividends of $0.64 per share, in equal installments of $0.16 per share, according to the following record and payment dates: Management believes, based on current and projected levels of operations and conditions in our markets and cash flow from operations, together with our cash and cash equivalents on hand and the availability to borrow under our ABL Revolver, we have adequate funding for the foreseeable future to make required payments of interest on our debt, fund our operating needs, working capital and capital expenditure requirements, comply with the financial ratios in our debt agreements, and make any required prepayments of principal under our debt agreements. As of December 31, 2015, we have no significant required payments of principal on our debt until February 2021. To the extent our cash flow and liquidity exceeds the levels necessary for us to make required payments on our debt, fund our working capital and capital expenditure requirements and comply with our ABL Revolver, we may use the excess liquidity to further grow our business through investments or acquisitions, payment of dividends and/or to reduce our debt. Contractual Obligations Our aggregate future payments under contractual obligations by category as of December 31, 2015, were as follows: Purchase obligations. Purchase obligations primarily include agreements to purchase goods or services that are enforceable and legally binding and that specify all significant terms. We have certain long-term raw material supply contracts and energy purchase agreements with various terms extending through 2026. These commitments are designed to assure sources of supply for our normal requirements. Amounts are based upon contractual raw material volumes and market rates as of December 31, 2015. Long-term debt, principal. Long-term debt principal obligations are listed in the table above based on the contractual due dates. Long-term debt, interest. Long-term debt interest payments set forth in the table above are based on our contractual rates, or in the case of variable interest rate obligations, the weighted average interest rates as of December 31, 2015. Lease financing obligations. We lease land and buildings for certain of our Canadian manufacturing facilities under leases with varying maturities through the year 2017. Capital lease obligations. We lease railcars for our chlorovinyls segment under capital leases with varying maturities through the year 2026. Operating lease obligations. We lease railcars, storage terminals, computer equipment, automobiles, barges, warehouses and office spaces under non-cancelable operating leases with varying maturities through the year 2025. Expected pension and other post retirement employment benefit (“OPEB”) contributions. Expected pension contributions for the funded obligations represent the projected minimum required contributions based on assumptions as of December 31, 2015 and determined in accordance with local requirements such as the Employee Retirement Income Security Act. Also included are contributions for the unfunded OPEB plans which are based on the expected benefit payments estimated as of December 31, 2015. Investment in LACC. On June 17, 2015, Eagle entered into an amended and restated limited liability company agreement with Lotte related to the formation of LACC, which is a joint venture by Eagle and Lotte to design, build and operate a new ethylene Plant. Eagle’s investment is expected to represent approximately 10 percent of the interests of LACC. Eagle and Lotte also entered into a call option agreement, dated as of June 17, 2015, pursuant to which Eagle has the right, but not the obligation, until the third anniversary of the substantial completion of the Plant, to acquire up to a 50 percent ownership interest in LACC from Lotte. On December 17, 2015, Axiall and Lotte announced that the companies reached a final investment decision to construct the Plant, and LACC entered into the engineering, procurement and construction agreement with CB&I Inc., the construction contractor. The Company’s annual commitment will be up to a maximum of $50.0 million per year through 2018 with the remainder due in 2019. Deferred acquisition payments. Payments of deferred purchase price represent amounts due to PPG based upon the final funding status of the pension plans assumed in the Merger. During the year ended December 31, 2015, we made a $10 million deferred acquisition payment to PPG in connection with the funding status of certain assumed pension plans of the Merged Business. We will make remaining payments in the aggregate amount of $30 million to PPG over the next two years. Asset retirement obligations. We have recognized a liability for the present value of cost we estimate we will incur to retire certain assets. The amount reported in the Contractual Obligations table above, represents the estimated cost to retire such assets. Uncertain income tax positions. We have recognized a liability for our uncertain income tax positions of approximately $6.7 million as of December 31, 2015. We do not believe we are likely to pay any amounts during the year ended December 31, 2016. The ultimate resolution and timing of payment for remaining matters continues to be uncertain and are therefore excluded from the Contractual Obligations table above. Outlook The Company expects the following factors to impact its first-quarter 2016 and longer term results: • In the chlorovinyls segment, the Company expects increased caustic soda and vinyl resin sales volumes primarily due to fewer planned outages in the first quarter of 2016 as compared to the fourth quarter of 2015. Vinyl resin and caustic soda prices, particularly export caustic soda and export vinyl resin prices, are below the average for the fourth quarter 2015. The impact of these factors on first quarter 2016 results will primarily depend on the timing and magnitude of vinyl resin and caustic soda price changes and ethylene costs. The company does not expect any material changes in the components of its ethylene supply portfolio during the first quarter. • The Company expects first-quarter 2016 sales volume and Adjusted EBITDA for the building products segment to follow normal seasonal patterns and decrease compared to results for the fourth quarter of 2015 but exceed first quarter 2015 results. • Over the longer term, Axiall believes ECU values will be driven higher by the strength of domestic demand and improved export volumes for ECU products. The Company believes it is well positioned to take advantage of a number of macro-economic and industry trends. In particular, that North America’s natural gas cost advantage over oil-based economies in other parts of the world will continue to provide a competitive cost advantage to North American producers. This advantage is expected to allow consistent access to growing export markets for both chlorine, in the form of PVC, and caustic soda. In addition, the pace of global capacity growth in our key products has slowed dramatically compared to the beginning of the decade, which the Company believes will improve the supply-demand balance for those products. Moreover, if the gradual improvement in the United States housing market, both in terms of starts and renovation activity continues, Axiall believes this will drive building products volumes higher. The combination of these macro-economic and industry trends is expected to increase demand for ECU and vinyl products. Inflation The most significant component of our cost of sales is raw materials, which include basic oil-based commodities and natural gas or derivatives thereof. The costs of raw materials and natural gas are based primarily on market forces and have not been significantly affected by inflation. Inflation has not had a material impact on our sales or income from operations. New Accounting Pronouncements In November 2015, the Financial Accounting Standards Board (“FASB” or the “Board”) issued Accounting Standards Update (“ASU” or “Update”) 2015-17 - Income Taxes (Topic 740)-Balance Sheet Classification of Deferred Taxes. The Board issued this Update as part of its continuing initiative to reduce complexity in accounting standards and further align U.S. GAAP with International Financial Reporting Standards (“IFRS”). Current GAAP requires an entity to separate deferred income tax assets and liabilities into current and noncurrent amounts in a classified balance sheet. To simplify the presentation of deferred income taxes, the amendments in this Update require that deferred tax assets and liabilities be classified as noncurrent in a classified balance sheet. The current requirement to offset deferred tax assets and liabilities and present the net as a single amount is not affected by the amendments in this Update. The amendments in this Update may be applied either prospectively to all deferred tax assets and liabilities or retrospectively for all periods presented. If an entity applies the guidance prospectively, the entity should disclose in the first interim and first annual period of change, the nature of and reason for the change in accounting principle and a statement that prior periods were not retrospectively adjusted. The amendments in this Update are effective for annual periods, including interim periods, beginning after December 15, 2016. We have adopted the amendments in this Update prospectively. In July 2015, the FASB issued ASU 2015-11 - Inventory (Topic 330). The amendments in this update apply to entities that measure inventory using the first-in, first-out or average cost methods. Under this guidance, such entities are required to measure inventory at the lower of cost or net realizable value. Net realizable value is the estimated selling price in the ordinary course of business, less the reasonably predictable costs of completion, disposal and transportation. Subsequent measurement is unchanged for inventory valued using the last-in, first-out and the retail inventory methods. The amendments in this Update are effective for annual periods, including interim periods, beginning after December 15, 2016. We have adopted the amendments in this Update and there was no impact on our consolidated financial statements. In May 2015, the FASB issued ASU 2015-07 - Disclosures for Investments in Certain Entities That Calculate Net Asset Value per Share (or Its Equivalent) (Topic 820). The amendments in this Update remove the requirement to categorize within the fair value hierarchy, all investments for which fair value is measured using the net asset value per share practical expedient. The amendments also remove the requirement to make certain disclosures for all investments that are eligible to be measured at fair value, using the net asset value per share practical expedient. Rather, those disclosures are limited to investments for which the entity has elected to measure the fair value using that practical expedient. This ASU should be applied retrospectively for all periods presented. We have adopted the amendments in this Update retrospectively and there was no impact on our consolidated statements of operations. In April 2015, the FASB issued ASU 2015-05 - Intangibles-Goodwill and Other-Internal-Use Software (Subtopic 350-40). The amendments in this Update provide explicit guidance to companies about fees paid in cloud-based computing arrangements for various hosting services. Previous GAAP guidance did not include such explicit direction. Specifically, the Update stipulates that if a cloud-based computing arrangement includes a software license, the company should account for the software license element of the arrangement consistent with the acquisition of other software licenses. If a cloud-based computing arrangement does not include a software license, the company should account for the arrangement as a service contract. The guidance does not change the accounting treatment for service contracts. However, all software licenses within the scope of this Update should be accounted for consistent with other licenses of intangible assets. The amendments in this Update are effective for annual periods, including interim periods, beginning after December 15, 2015, and early adoption is permitted. We have adopted the amendments in this Update prospectively and have determined there was no impact on our consolidated financial statements. In April 2015, the FASB issued ASU 2015-03 - Interest-Imputation of Interest (Subtopic 835-30). The amendments in this Update simplifies the presentation of debt issuance costs by requiring debt issuance costs related to a recognized debt liability to be presented on the balance sheet as a direct deduction from the carrying amount of the related debt liability, similar to the accounting treatment for debt discounts. The amendments in this Update are effective for financial statements issued for fiscal years beginning after December 15, 2015, and early adoption is permitted. We adopted the amendments to the Update which required us to reclassify approximately $15.9 million and $18.3 million of deferred financing fees as of December 31, 2015 and 2014, respectively, from other assets to long-term debt in our consolidated balance sheets. The Company did not reclassify debt issuance costs of $7.1 million and $7.9 million, for the years ended December 31, 2015 and 2014, respectively, related to the ABL Revolver as there was no outstanding balance for the ABL Revolver as of December 31, 2015 and 2014, and will not reclassify such costs in future periods where a balance exists. The adoption had no impact on our consolidated statements of operations. In February 2015, the FASB issued ASU 2015-02 - Consolidation (Topic 810)-Amendments to the Consolidation Analysis to assist companies in evaluating whether certain legal entities should be consolidated. The ASU stipulates that all legal entities are subject to reevaluation under the revised consolidation model in the guidance. This Update reduces the number of consolidation models, simplifies the FASB Accounting Standards Codification and improves current GAAP by placing more emphasis on risk of loss when determining a controlling financial interest. A reporting organization may no longer have to consolidate a legal entity under certain circumstances based solely on its fee arrangement when certain criteria are met. This reduces the frequency of the application of related-party guidance when determining a controlling financial interest in a variable interest entity (“VIE”). The Update changes the consolidation conclusions for public and private companies in several industries that typically make use of limited partnerships or VIEs. The amendments in this Update are effective for annual periods, including interim periods, beginning after December 15, 2015. We have adopted the amendments in this Update and have determined there is no impact on our consolidated financial statements. In June 2014, FASB issued ASU 2014-12 - Compensation-Stock Compensation (Topic 718). Under this Update: Accounting for Share-Based Payments When the Terms of an Award Provide That a Performance Target Could Be Achieved after the Requisite Service Period (a consensus of the FASB Emerging Issues Task Force), a performance target that affects vesting, and that could be achieved after the requisite service period, would be treated as a performance condition. GAAP did not address these issues. The Update states that a reporting entity should apply existing guidance in Topic 718 to account for awards with performance conditions that affect the vesting of such awards. As such, the performance target should not be reflected in estimating the grant-date fair value of the award. Compensation cost should be recognized in the period in which it becomes probable that the performance target will be achieved and should represent the compensation cost attributable to the periods for which the requisite service has already been rendered. If the performance target becomes probable of being achieved before the end of the requisite service period, the remaining unrecognized compensation cost should be recognized prospectively over the remaining requisite service period. The total amount of compensation cost recognized during and after the requisite service period should reflect the number of awards that are expected to vest and should be adjusted to reflect those awards that ultimately vest. The requisite service period ends when the employee can cease rendering service and still be eligible to vest in the award if the performance target is achieved. The stated vesting period (which includes the period in which the performance target could be achieved) may differ from the requisite service period. The amendments in this Update are effective for annual reporting periods beginning after December 15, 2015. We have adopted the amendments in this Update and have determined there was no impact on our consolidated financial statements. In May 2014, the FASB issued ASU 2014-09 - Revenue from Contracts with Customers. The Update outlines a single, comprehensive model for entities to use in accounting for revenue arising from contracts with customers and supersedes most current revenue recognition guidance issued by the FASB, including industry specific guidance. The Update provides accounting guidance for all revenue arising from contracts with customers and affects all entities that enter into contracts with customers to provide goods and services. The guidance also provides a model for the measurement and recognition of gains and losses on the sale of certain nonfinancial assets, such as property and equipment, including real estate. In August 2015, the FASB issued ASU 2015-14 - Revenue from Contracts with Customers (Topic 606): Deferral of the Effective Date. This Update provides for a one year deferral of the effective date of ASU 2014-09. As a result, the Company expects that it will apply the new revenue standard to annual and interim reporting periods beginning after December 15, 2017. The new standard must be adopted using either a full retrospective approach for all periods presented in the period of adoption or a modified retrospective approach. The modified retrospective approach requires that the new standard be applied to all new and existing contracts as of the date of adoption, with a cumulative catch-up adjustment recorded to the opening balance of retained earnings at the effective date for existing contracts that still require performance by the entity. Under the modified retrospective approach, amounts reported prior to the date of adoption will be presented under existing guidance. The Update also requires entities to disclose both quantitative and qualitative information to enable users of the financial statements to understand the nature, amount, timing, and uncertainty of revenue and cash flows arising from contracts with customers. We have not yet determined the impact of adopting the standard on our consolidated financial statements, nor have we determined whether we will utilize the full retrospective or modified retrospective approach. Critical Accounting Policies and Estimates Our consolidated financial statements are prepared in accordance with accounting principles generally accepted in the United States, which require management to make estimates, judgments and assumptions that affect the amounts reported in our consolidated financial statements and accompanying notes. We believe our most critical accounting policies and estimates relate to the following: • Long-Lived Assets • Goodwill and Other Intangible Assets • Pension and OPEB Liabilities • Environmental Matters • Income Taxes Management has discussed the development, selection and disclosure of critical accounting policies and estimates with the Audit Committee of the Company’s Board of Directors and with our independent registered public accounting firm. Critical accounting policies are those that are important to our financial condition and require management’s most difficult, subjective or complex judgments. While our estimates and assumptions are based on our knowledge of current events and actions we may undertake in the future, actual results may ultimately differ from these estimates and assumptions. For a discussion of the Company’s significant accounting policies, refer to Note 1 of Notes to Consolidated Financial Statements in Item 8. Long-Lived Assets Our long-lived assets, such as property, plant and equipment, are reviewed for impairment whenever events or changes in circumstances indicate that the carrying value of an asset may not be recoverable. Recoverability of an asset to be held and used is measured by comparing the carrying value of the asset to the estimated undiscounted future cash flows expected to be generated by the asset. If the carrying value of an asset exceeds its estimated undiscounted future cash flows, an impairment charge is recognized for the amount by which the carrying value of the asset exceeds the fair value of the asset. Our judgments regarding the existence of impairment indicators are based on macro-economic conditions, market conditions and assumptions for operational performance of our businesses. The assumptions used to estimate our future undiscounted cash flows are predominately identified from our financial forecasts. The actual impairment charge incurred could vary significantly from amounts that we estimate. Additionally, future events could cause us to conclude that impairment indicators exist and that associated long-lived assets of our businesses are impaired. During the year ended December 31, 2015, the Company recognized $2.8 million in long-lived asset impairment charges, primarily in the window and door profiles reporting unit of our building products segment. During the year ended December 31, 2014, the Company incurred approximately $13.5 million in long-lived assets impairment charges of which $12.5 million related to property, plant and equipment for a product line in our chlorovinyls segment that was sold during 2015. Goodwill and Other Intangible Assets Our intangible assets consist of goodwill, customer relationships, supply contracts, technology, and trade names. Goodwill is the excess of the cost of an acquired entity over the fair value of tangible and intangible assets (including, but not limited to, customer relationships, supply contracts, technology, and trade names) acquired and liabilities assumed under acquisition accounting for business combinations. As of December 31, 2015, we have two segments that contain reporting units with goodwill and intangible assets: our chlorovinyls segment includes goodwill in its chlor-alkali and derivatives and compound reporting units and our building products segment includes goodwill primarily in its siding reporting unit. Valuation of Goodwill and Indefinite-Lived Intangible Assets. The carrying values of our goodwill and indefinite-lived intangible assets are tested for impairment annually in the fourth quarter, using a measurement date of October 1. In addition, we evaluate the carrying values of these assets for impairment between annual impairment tests if an event occurs or circumstances change that would more likely than not reduce the fair value of a reporting unit below its carrying amount. Such events and indicators may include, without limitation, significant declines in the industries in which our products are used, significant changes in the estimated future cash flows of our reporting units, significant changes in capital market conditions and significant changes in our market capitalization. Impairment testing for goodwill is a two-step test performed at the reporting unit level. The first step (“Step-1”) of the impairment analysis involves comparing the fair value of the reporting unit to its carrying value, including goodwill. If the fair value of the reporting unit exceeds the carrying value, goodwill is not considered impaired. If the carrying value exceeds the fair value, Step-2 of the impairment analysis is performed, in which we determine the fair-value of the underlying net assets of the reporting unit and compare this to the carrying value in order to measure the amount of impairment. Our goodwill evaluations utilize discounted cash flow analyses (the “income approach”) and market multiple analyses (the “market approach”), in estimating fair value. The weighting of the discounted cash flow and market approaches varies by each reporting unit based on factors specific to each reporting unit. Inherent in our fair value determinations are certain judgments and estimates relating to future cash flows, including our interpretation of current economic indicators and market conditions, overall economic conditions and our strategic and operational plans with regard to our business units. In addition, to the extent significant changes occur in market conditions, overall economic conditions or our strategic or operational plans, it is possible that goodwill not currently impaired, may become impaired in the future. Our other indefinite-lived assets consist only of trade names in our building products segment. Impairment testing for indefinite-lived intangible assets other than goodwill involves comparing the fair value of the intangible asset to its carrying value. The fair values of our trade names are estimated based on the relief from royalty method under the income approach. This approach utilizes a discounted cash flow analysis. Interim impairment testing: During the third quarter of 2015, we determined there were indicators that required us to perform an interim impairment test in our reporting units that carry goodwill and other indefinite-lived intangible assets. These factors included, but were not limited to, the operating results during the nine months ended September 30, 2015, the sustained deterioration of market conditions in certain of our industries and the resulting decline in our market capitalization. Based on our analysis, we concluded there was no impairment for our other indefinite-lived intangible assets. During the three months ended September 30, 2015, we concluded that the estimated fair values of our compound, mouldings and siding reporting units exceeded the carrying values in each respective unit by more than 10 percent. We also concluded that the estimated fair value of our chlor-alkali and derivatives reporting unit was lower than its carrying value, and consequently, we proceeded with Step-2 of the goodwill impairment test in order to measure the magnitude of impairment, if any. Based on the results of the Step-2 test, the Company recorded a goodwill impairment charge of $864.1 million related to our chlor-alkali and derivatives reporting unit during the year ended December 31, 2015. In December 2014, the Company recorded an impairment charge of approximately $4.1 million of goodwill and $2.6 million of customer relationships relating the sale of a product-line in our chlor-alkali derivatives business. During the year ended December 31, 2013, the Company recorded a goodwill impairment charge of $18.2 million in its window and door profiles reporting unit. The write-down was due primarily to the prolonged downturn in the North American housing and construction markets, pricing declines, and the expected impact of those declines on projected cash flows on the window and door profiles reporting unit during the year ended December 31, 2013. Annual impairment testing: We tested our reporting units with goodwill and other indefinite-lived intangible assets in the fourth quarter of 2015 in accordance with our annual October 1 impairment testing. Based on our Step-1 analysis, the estimated fair values of our compound and siding reporting units exceeded the carrying values in each respective unit by more than 10 percent. The estimated fair value of our chlor-alkali and derivatives reporting unit exceeded its carrying value at an amount that was less than 10 percent. Based on these results, none of our reporting units had any impairment. However, management will continue to monitor the reporting units for any future indicators of impairment. Further reductions in our future projections of operating results and cash flows from our chlor-alkali and derivatives reporting unit, or certain reporting units in our building products business, or a further deterioration of market conditions in the chlor-alkali and derivatives or building products industries in which we operate, among other factors, could result in the Company incurring additional goodwill impairment charges for one or more of those reporting units. Definite-Lived Intangible Assets We have definite-lived intangible assets that include customer relationships, supply contracts, technology and trade names. We evaluate these assets for impairment if an event occurs or circumstances change that would indicate the carrying value could be impaired. If indicators suggest that the related undiscounted cash flows do not exceed the carrying value of the asset, we recognize an impairment charge to the extent that the carrying value exceeds the fair value of the definite lived intangible asset. Pension and OPEB Liabilities Accounting for employee pension and OPEB plans involves estimating the cost of benefits that are to be provided in the future and attempting to match, for each employee, that estimated cost to the period worked. To accomplish this, we make assumptions about discount rates, expected long-term rates of return on plan assets, salary increases, employee turnover and mortality rates, among others. We reevaluate all assumptions annually with our independent actuaries taking into consideration existing and forecasted economic conditions and our investment policy and strategy with regard to managing the plans. We believe our estimates, the most significant of which are stated below, are reasonable. Assumptions for Benefit Obligations Mortality is a key assumption used to determine the benefit obligation for our defined benefit pension and OPEB plans. The Company continues to measure year-end benefit obligations using the SOA’s RP-2014, with adjustments by plan. The Company selected the BB-2D scale to reflect mortality improvement rates as published by the SOA for purposes of measuring pension and OPEB benefit obligations at year-end. The discount rate reflects the rate at which pension benefit obligations could be effectively settled. For the majority of our obligations, we determined our discount rate by matching the expected cash flows of our pension and OPEB obligations to a yield curve generated from a broad portfolio of high-quality fixed rate debt instruments. The rate of compensation is based on projected salary increases for our plan participants. The healthcare cost trend assumption is based on a number of factors including our actual healthcare cost increases, the design of our benefit programs, the demographics of our active and retiree populations and external expectations of future medical cost inflation rates. The weighted average assumptions used for determining our benefit obligations are as follows: Assumptions for Annual Projected Expense The discount rate for determining annual pension and OPEB expense is determined by matching the expected cash flows of our pension and OPEB obligations to a yield curve generated by a broad portfolio of high-quality fixed rate debt instruments. The expected long-term rate of return on plan assets assumption is based on historical and projected rates of return for current and planned asset classes in the plan’s investment portfolio. Our weighted average asset allocation as of December 31, 2015, is 61 percent equity securities, 38 percent debt securities, and 1 percent other. Assumed projected rates of return for each of the plan’s projected asset classes were selected by us after analyzing historical experience and future expectations of the returns and volatility of the various asset classes. The rate of compensation is based on projected salary increases for our plan participants. The weighted average expected discount rate, expected long-term rate of return on plan assets and rate of compensation increase assumptions used for determining annual pension expense for our pension and OPEB plans are as follows: Recently approved amendments to the OPEB plans were made to further deliver retiree medical benefits through health reimbursement account contributions and to further limit life insurance benefits. Effective January 1, 2016, the majority of Medicare and non-Medicare eligible retirees will receive retiree medical benefits through health reimbursement account contributions. In addition, effective January 1, 2016, most life insurance benefits for non-bargained retirees were eliminated and a sunset period was provided for life insurance benefits for the majority of other retirees. These OPEB benefit changes were approved and communicated to participants in August 2015 and the quantitative financial impact is reflected in the year ended December 31, 2015. These changes reduced the OPEB benefit obligation by $29.8 million and the resulting prior service credit will be amortized through 2025. In the third quarter of 2015, we changed the approach used to estimate the service and interest components of net periodic benefit cost for the U.S. postretirement benefits. This new estimation approach discounts the individual expected cash flows underlying the service cost and interest cost using the applicable spot rates derived from the yield curve used to discount the cash flows used to measure the benefit obligation. Historically, we estimated these service and interest cost components utilizing a single weighted-average discount rate derived from the yield curve used to measure the benefit obligation at the beginning of the period. We have made this change to provide a more precise measurement of service and interest costs by improving the correlation between projected benefit cash flows to the corresponding spot yield curve rates. We have accounted for this change as a change in accounting estimate that is inseparable from a change in accounting principle and accordingly have accounted for it prospectively. While the benefit obligation measured under this approach is unchanged, the more granular application of the spot rates reduced the service and interest cost for the OPEB plan for the last four months of fiscal 2015 by $0.2 million. For the OPEB plan, the spot rates used to determine service and interest costs ranged from 0.65 percent to 5.01 percent and 0.65 percent to 5.01 percent, respectively. Under the Company’s prior methodology, these rates would have resulted in weighted-average rates for service and interest costs of 3.59 percent and 3.59 percent, respectively. The new approach will be used to measure the service and interest cost for our other U.S. pension plans in 2016. For the pension plans, the spot rates that will be used to determine 2016 service and interest costs range from 0.92 percent to 4.97 percent and 0.92 percent to 4.97 percent, respectively. Under the Company’s prior methodology, these rates would have resulted in a single weighted-average rate of 4.37 percent for both service and interest costs. Based on current economic conditions, we estimate the service cost and interest cost for the pension plans will be reduced by approximately $7.0 million in 2016 as a result of the change. Sensitivity for Key Underlying Assumptions The following table shows the impact of a 25 basis point change in the assumed discount rate and expected long-term rate of return on plan assets for our pension and OPEB plans, and the impact of the increase (decrease) on benefit obligations and expense for the year ended December 31, 2015. For the plan year ended December 31, 2015, if the assumed healthcare inflation trend rates were 1 percent higher or 1 percent lower for the OPEB plans, the benefit obligations would increase by $1.2 million or decrease by $1.1 million respectively. For the plan year ended December 31, 2015, a 1 percent increase in the assumed healthcare inflation trend rates would increase the OPEB plan aggregate service and interest cost by $0.1 million, while a 1 percent decrease would decrease the aggregate service and interest cost by $0.1 million. Environmental Matters In our determination of the estimates relating to ongoing environmental costs and legal proceedings (see Note 12 of the Notes to Consolidated Financial Statements included in Item 8), we consult with our advisors (consultants, engineers and attorneys). Such consultation provides us with the information on which we base our judgments on these matters and under which we accrue an expense when it has been determined that it is probable that a liability has been incurred and the amount is reasonably estimable. While we believe that the amounts recorded in the accompanying consolidated financial statements related to these contingencies are based on the best estimates and judgments available to us, the actual outcomes could differ from our estimates. To the extent that actual outcomes differ from our estimates by 10 percent, our net loss attributable to Axiall would be higher or lower by approximately $4.1 million. Environmental Remediation Our operations and assets are subject to extensive environmental, health and safety regulations, including laws and regulations related to air emissions, water discharges, waste disposal and remediation of contaminated sites, at both the national and local levels in the United States. We are also subject to similar laws and regulations in Canada and other jurisdictions in which we operate. The nature of the chemical and building products industries exposes us to risks of liability under these laws and regulations due to the production, storage, use, transportation and sale of materials that can cause contamination or personal injury, including, in the case of chemicals, potential releases into the environment. Environmental laws may have a significant effect on the costs of use, transportation and storage of raw materials and finished products, as well as the costs of the storage and disposal of wastes. We have incurred and will continue to incur substantial operating and capital costs to comply with environmental laws and regulations. In addition, we may incur substantial costs, including fines, damages, criminal or civil sanctions and remediation costs, or experience interruptions in our operations for violations arising under these laws and regulations. As of December 31, 2015 and 2014, we had reserves for environmental contingencies totaling approximately $41 million and $54 million, respectively, of which approximately $1 million and $12 million, respectively, were classified as current liabilities. Our assessment of the potential impact of these environmental contingencies is subject to considerable uncertainty due to the complex, ongoing and evolving process of investigation and remediation, if necessary, of such environmental contingencies, and the potential for technological and regulatory developments. Some of our significant environmental contingencies include the following matters: • We have entered into a Cooperative Agreement with the Louisiana Department of Environmental Quality (“LDEQ”) and various other parties for the environmental remediation of a portion of the Bayou d’Inde area of the Calcasieu River Estuary in Lake Charles, Louisiana. Remedy implementation began in the fourth quarter of 2014 and is expected to be completed during 2016, with a period of monitoring for remedy effectiveness to follow remediation. As of December 31, 2015 and 2014, we have reserved approximately $4 million and $18 million, respectively, for the costs associated with this matter. The decrease in the amount of this reserve is primarily due to spending against the reserve. • As of December 31, 2015 and 2014, we had reserved approximately $12 million and $15 million, respectively, for environmental contingencies related to on-site remediation at the Lake Charles South Facility, principally for ongoing remediation of groundwater and soil in connection with our corrective action permit issued pursuant to the Hazardous and Solid Waste Amendments of the Resource Conservation and Recovery Act. The remedial activity is primarily related to the operation of a series of well water treatment systems across the Lake Charles South Facility. In addition, remediation of possible soil contamination will be conducted in certain areas. These remedial activities are expected to continue for an extended period of time. The reduction in the amount of this reserve is due to our assessment, during the year ended December 31, 2015, of the estimated costs to be incurred after December 31, 2015 to conduct this on-going remedial activity, and in particular, our assessment of the portion of the future operating costs of certain water treatment assets at our Lake Charles South Facility that should be allocated to this remediation project, as opposed to other non-remediation uses of those water treatment assets. • As of December 31, 2015 and 2014, we had reserved approximately $18 million and $15 million, respectively, for environmental contingencies related to remediation activities at our Natrium, West Virginia facility (the “Natrium Facility”). The remedial actions address National Pollutant Discharge Elimination System permit requirements related primarily to hexachlorocyclohexane (commonly referred to as BHC) and mercury. We expect that these remedial actions will be in place for an extended period of time. The increase in the amount of this reserve is due to our assessment, during the year ended December 31, 2015, of the estimated costs that will be incurred after December 31, 2015 to conduct this on-going remedial activity, and in particular, due to an increase in the estimated duration of the remediation period. Environmental Laws and Regulations Due to the nature of environmental laws, regulations and liabilities, it is possible that we may not have identified all potentially adverse conditions. Such conditions may not currently exist or be detectable through reasonable methods, or may not be estimable. For example, our Natrium Facility and Lake Charles South Facility have both been in operation for over 65 years. There may be significant latent liabilities or future claims arising from the operation of facilities of this age, and we may be required to incur material future remediation or other costs in connection with future actions or developments at these or other facilities. We expect to be continually subjected to increasingly stringent environmental and health and safety laws and regulations, and that continued compliance will require increased capital expenditures and increased operating costs or may impose restrictions on our present or future operations. It is difficult to predict the future interpretation and development of these laws and regulations or their impact on our future earnings and operations. Any increase in these costs, or any material restrictions on our ability to operate or the manner in which we operate, could materially adversely affect our liquidity, financial condition and results of operations. However, estimated costs for future environmental compliance and remediation may be materially lower than actual costs, or we may not be able to quantify potential costs in advance. Actual costs related to any environmental compliance in excess of estimated costs could have a material adverse effect on our financial condition in one or more future periods. Heightened interest in environmental regulation, such as climate change issues, has the potential to materially impact our costs and present and future operations. We, and other chemical companies, are currently required to file certain governmental reports relating to greenhouse gas (“GHG”) emissions. The U.S. Government has considered, and may in the future implement, restrictions or other controls on GHG emissions, any of which could require us to incur significant capital expenditures or further restrict our present or future operations. In addition to GHG regulations, the United States Environmental Protection Agency (the “EPA”) has recently taken certain actions to limit or control certain pollutants created by companies such as ours. For example: • In January 2013, the EPA issued Clean Air Act emission standards for boilers and incinerators (the “Boiler MACT regulations”), which are aimed at controlling emissions of toxic air contaminants at covered facilities. The coal fired power plant at our Natrium Facility is our source most significantly impacted by the Boiler MACT regulations. Pursuant to an extension granted by the West Virginia Department of Environmental Protection (WVDEP), we expect to comply with the requirements of the Boiler MACT regulations on or before December 2016. • In April 2012, the EPA issued final regulations to update emissions limits for PVC and copolymer production (the “PVC MACT regulation”). The PVC MACT regulation sets standards for major sources of PVC production and establishes certain working practices, as well as monitoring, reporting and record-keeping requirements. Following the issuance of the PVC MACT regulation, a variety of legal challenges were filed by the vinyl industry’s trade organization, several vinyl manufacturers and several environmental groups. Most of these challenges have been resolved; however, there are several petitions to reconsider certain provisions in the rule that are still pending. We anticipate that some of these provisions will likely be changed as a result of these petitions, and there could be significant changes from the currently existing PVC MACT regulation after all legal challenges have been exhausted. These changes, could require us to incur further capital expenditures, or increase our operating costs, to levels significantly higher than what we have previously estimated. • In March 2011, the EPA proposed amendments to the emission standards for hazardous air pollutants for mercury emissions from mercury cell chlor-alkali plants. These proposed amendments would require improvements in work practices to reduce fugitive mercury emissions and would result in reduced levels of mercury emissions while still allowing the mercury cell facilities to continue to operate. We operate a mercury cell production unit at our Natrium Facility. No assurances as to the timing or content of the final regulation, or its ultimate cost to, or impact on us, can be provided. The potential impact of these and/or unrelated future, legislative or regulatory actions on our current or future operations cannot be predicted at this time but could be significant. Such impacts could include the potential for significant compliance costs, including capital expenditures, which could result in operating restrictions or could require us to incur significant legal or other costs related to compliance or other activities. For example, a recent revision to ambient air quality standards for ozone may, in the future, result in significant operating costs, compliance costs, and capital expenditures at some of our facilities. Any increase in the costs related to these initiatives, or restrictions on our operations, could materially adversely affect our liquidity, financial condition or results of operations. Income Taxes Income taxes are accounted for under the liability method. Deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying value of existing assets and liabilities and their respective tax bases. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the enactment date. We evaluate the realizability of deferred tax assets by assessing whether it is more likely than not that some or all of the deferred tax assets will not be realized. The ultimate realization of deferred tax assets depends on the generation of future taxable income during the periods in which those temporary differences are deductible. Management considers the scheduled reversal of deferred tax liabilities (including the impact of available carryback and carryforward periods), projected taxable income and tax-planning strategies available to us in making this assessment. If it is not more likely than not that we will realize a deferred tax asset, we record a valuation allowance against such asset. As of December 31, 2015, a valuation allowance of $77.5 million has been provided against the deferred taxes in Canada. We use a similar evaluation for determining when to release previously recorded valuation allowances. It is reasonably possible that our valuation allowance may decrease significantly during the next 12 months. We recognize tax benefits for uncertain tax positions as income tax expense when it is more likely than not, based upon the technical merits, that the position will be sustained upon examination.

<s>[INST] Portfolio Initiatives Sale of Aromatics Business: Discontinued Operations On September 30, 2015, the Company entered into and consummated the transactions contemplated by an asset purchase agreement (the “Asset Purchase Agreement”) between INEOS Americas LLC (“INEOS”) and Axiall LLC, a whollyowned subsidiary of the Company. Pursuant to the Asset Purchase Agreement, INEOS acquired certain assets used in the Company’s aromatics business, including but not limited to, its cumene production facility located in Pasadena, Texas. The Company retained the land and plant at its phenol, acetone and alphamethylstyrene production facility located in Plaquemine, Louisiana (the “Plaquemine Phenol Facility”), which is part of a broader set of other Axiall chemical manufacturing facilities located in Plaquemine. In addition, the Company retained the following assets associated with its aromatics business: (i) cash and cash equivalents; (ii) accounts receivable; and (iii) inventory, other than certain raw materials and workinprocess inventory at its Pasadena facility. The Company has discontinued the manufacture of products at its Plaquemine Phenol Facility and expects to dismantle and shutdown that facility. At closing, the Company received $52.4 million in cash, which consisted of: (i) the selling price of $47.4 million; and (ii) a $5.0 million advance toward the cost of decommissioning and dismantling our Plaquemine Phenol Facility. That advance was recorded as a liability in our consolidated balance sheets. During the fourth quarter of 2015, the Company met certain terms and conditions set forth in the Asset Purchase Agreement that entitled us to receive $5.5 million of contingent consideration, pursuant to which we recorded $5.3 million, as a gain, net of a $0.2 million working capital adjustment, related to the sale. Further, the Company may receive an additional $5.0 million from INEOS to help defray the costs of decommissioning and dismantling the Plaquemine Phenol Facility. The Company’s receipt of all or any portion of the remaining $5.0 million that INEOS may be required to pay and our right to retain the $5.0 million advance payment will depend on the amount of costs incurred by us to decommission and dismantle the Plaquemine Phenol Facility. During 2015, the Company incurred $0.8 million of such costs and our remaining liability is $4.6 million as of December 31, 2015. For the year ended December 31, 2015, the Company recorded a pretax gain of $21.5 million on the sale of our aromatics business assets as described above, the net effect of which is reflected in income (loss) from discontinued operations on our consolidated statements of operations. During the fourth quarter, the Company also received net cash from retained working capital totaling $33.0 million. We expect cash flows attributable to discontinued operations in future periods to be primarily related to the cost of decommissioning the Plaquemine Phenol Facility, partially offset by the related contingent consideration we expect to receive from INEOS if certain other conditions are satisfied. Changes to the estimates and liabilities related to discontinued operations as of December 31, 2015, including the estimated postclosing purchase price adjustment or accrued expenses related to the sale transaction, may result in an adjustment to our gain on the sale transaction. The aromatics segment has been classified as discontinued operations for all periods presented. As a result, our manufacturing operations are concentrated in two reportable segments: chlorovinyls and building products. Ethane Cracker Project with Lotte Chemical On June 17, 2015, Eagle US 2 LLC (“Eagle”), a whollyowned subsidiary of the Company, entered into an amended and restated limited liability company agreement with Lotte Chemical USA Corporation (“Lotte”) related to the formation of LACC, LLC (“LAC [/INST] Negative. </s>

ROGERS CORP

2015-02-18

2014-12-31

Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations The following discussion and analysis of our financial condition and results of operations should be read together with the Selected Financial Data and our Consolidated Financial Statements and the related notes that appear elsewhere in this Form 10-K. In the following discussion and analysis, we sometimes provide financial information that was not prepared in accordance with U.S. generally accepted accounting principles (GAAP). Management believes that this non-GAAP information provides meaningful supplemental information regarding the Company's performance by excluding certain expenses that are generally non-recurring or otherwise may not be indicative of the core business operating results. In general, the Company believes that the additional non-GAAP financial information provided herein is useful to management and investors in assessing the Company's historical performance and for planning, forecasting and analyzing future periods. However, non-GAAP information has limitations as an analytical tool and should not be considered in isolation from, or solely as an alternative to, financial information prepared in accordance with GAAP. Any time we provide non-GAAP information in the following narrative we identify it as such and in close proximity provide the most directly comparable GAAP financial measure, as well as the information necessary to reconcile the two measures. Forward Looking Statements Certain statements in this Form 10-K may constitute “forward-looking statements” within the meaning of the Private Securities Litigation Reform Act of 1995. Such forward-looking statements are based on management's expectations, estimates, projections and assumptions. Words such as “expects,” “anticipates,” “intends,” “believes,” “estimates,” “should,” “target,” “may,” “project,” “guidance,” and variations of such words and similar expressions are intended to identify such forward-looking statements. Such forward-looking statements involve known and unknown risks, uncertainties, and other factors that may cause our actual results or performance to be materially different from any future results or performance expressed or implied by such forward-looking statements. Such factors include, but are not limited to, changing business, economic, and political conditions both in the United States and in foreign countries, particularly in light of the uncertain outlook for global economic growth, particularly in several of our key markets; increasing competition; any difficulties in integrating acquired businesses into our operations and the possibility that anticipated benefits of acquisitions and divestitures may not materialize as expected; delays or problems in completing planned operational enhancements to various facilities; our achieving less than anticipated benefits and/or incurring greater than anticipated costs relating to streamlining initiatives or that such initiatives may be delayed or not fully implemented due to operational, legal or other challenges; changes in product mix; the possibility that changes in technology or market requirements will reduce the demand for our products; the possibility of significant declines in our backlog; the possibility of breaches of our information technology infrastructure; the development and marketing of new products and manufacturing processes and the inherent risks associated with such efforts and the ability to identify and enter new markets; the outcome of current and future litigation; our ability to retain key personnel; our ability to adequately protect our proprietary rights; the possibility of adverse effects resulting from the expiration of issued patents; the possibility that we may be required to recognize impairment charges against goodwill, non-amortizable assets and other investments in the future; the possibility of increasing levels of excess and obsolete inventory; increases in our employee benefit costs could reduce our profitability; the possibility of work stoppages, union and work council campaigns, labor disputes and adverse effects related to changes in labor laws; the accuracy of our analysis of our potential asbestos-related exposure and insurance coverage; the fact that our stock price has historically been volatile and may not be indicative of future prices; changes in the availability and cost and quality of raw materials, labor, transportation and utilities; changes in environmental and other governmental regulation which could increase expenses and affect operating results; our ability to accurately predict reserve levels; our ability to obtain favorable credit terms with our customers and collect accounts receivable; our ability to service our debt; certain covenants in our debt documents could adversely restrict our financial and operating flexibility; fluctuations in foreign currency exchange rates; and changes in tax rates and exposure which may increase our tax liabilities. Such factors also apply to our joint ventures. We make no commitment to update any forward-looking statement or to disclose any facts, events, or circumstances after the date hereof that may affect the accuracy of any forward-looking statements, unless required by law. Additional information about certain factors that could cause actual results to differ from such forward-looking statements include, but are not limited to, those items described in Item 1A, Risk Factors, in this Form 10-K. Business Overview Company Background and Strategy We are a global enterprise that provides our customers with innovative solutions and industry leading products in a variety of markets, including portable communications, communications infrastructure, consumer electronics, mass transit, automotive, defense and clean energy. We generate revenues and cash flows through the development, manufacture, and distribution of specialty material-based products that are sold to multiple customers, primarily original equipment manufacturers (OEMs) and contract manufacturers that, in turn, produce component products that are sold to end-customers for use in various applications. As such, our business is highly dependent, although indirectly, on market demand for these end-user products. Our ability to forecast future sales growth is largely dependent on management's ability to anticipate changing market conditions and how our customers will react to these changing conditions. It is also highly limited due to the short lead times demanded by our customers and the dynamics of serving as a relatively small supplier in the overall supply chain for these end-user products. In addition, our sales represent a number of different products across a wide range of price points and distribution channels that do not always allow for meaningful quantitative analysis of changes in demand or price per unit with respect to the effect on sales and earnings. Strategically, our current focus is on three mega trends that have fueled growth of our Company: (1) continued growth of the internet and the variety of ways in which it can be accessed, (2) expansion of mass transit, and (3) further investment in clean technology. These trends and their related markets all require materials that perform to the highest standards, a characteristic which has been a key strength of our products over the years. We are also focused on growing our business both organically and through strategic acquisitions or technology investments that will add to or expand our product portfolio, as well as strengthen our presence in existing markets or expand into new markets. We will continue to focus on business opportunities and invest in expansion around the globe. Our vision is to be the leading innovative, growth oriented, and high technology materials solutions provider for our selective markets. To achieve this vision, we must have an organization that can cost effectively develop, produce and market products and services that provide clear advantages for our customers and markets. 2014 Executive Summary In 2014, Rogers saw strong demand in our megatrend markets: internet connectivity, mass transit and clean technology. More than 60% of our sales are in these categories, reinforcing our belief that we are focused on the right markets that have strong, sustainable global demand. Rogers' core management team is seeing the results of all the work that has gone into realigning the Corporation both internally and externally to better service our customers and markets. We are continuing to work to improve the Corporation and have launched significant projects targeted at improving our infrastructure, particularly our information systems and manufacturing planning capabilities. We are also looking for new ways to grow, both organically through a combination of new product launches, new market applications, and geographic expansion, as well as externally through targeted acquisitions and technology initiatives. We believe that the recent actions taken to transform Rogers will provide a solid base for us to achieve our strategic goals and to increase value for our shareholders. From a results perspective, we achieved net sales of $610.9 million in 2014, an increase of 13.7% from $537.5 million in 2013. This increase in 2014 was driven across all of our core businesses with net sales growth in the Printed Circuit Materials (PCM) operating segment of 30.2% from $184.9 million in 2013 to $240.9 million in 2014, net sales in the Power Electronics Solutions (PES) operating segment increasing 6.9% from $160.7 million in 2013 to $171.8 million in 2014, and net sales in High Performance Foams (HPF) increasing 3.3% from $168.1 million in 2013 to $173.7 million in 2014. At PCM, these increases were driven by growth in global telecommunications infrastructure capacity in wireless (3G & 4G) base stations and antenna systems, as well as other new application areas such as automotive safety radar systems. At PES, these increases were driven by increases in energy efficient motor drives, mass transit and vehicle electrification (x-by-wire) applications. At HPF, the increases were the result of general industrial, consumer comfort and impact protection, mass transit, and hybrid electric vehicles. Demand into the portable electronics (mobile internet devices and feature phones) applications was down and we expect continued challenges in this market as we move forward. From an operating results perspective, we achieved $80.4 million in operating income during 2014, a 63.2% improvement over the $49.3 million achieved in 2013. Operating results in 2014 and 2013 included approximately $7.7 million and $12.6 million of special charges, respectively. The 2014 special charges relate to the early payment of certain long term pension obligations, acquisition costs and impairment of our investment in Solicore. The 2013 special charges related to the impairment of an investment in Solicore (see Footnote 8 - Investment) and severance related charges. Excluding these charges, non-GAAP operating income improved as a percentage of sales by 290 basis points from 11.5% in 2013 to 14.4% in 2014. We also experienced strong improvement in gross margin, which increased from 34.9% in 2013 to 38.3% in 2014. This improvement was primarily the result of increased operating leverage on the incremental sales volume enhanced by improved operating efficiencies across our operating segments. Offsetting some of these favorable results was a 17.7% increase in selling and administrative expenses from $106.4 million in 2013 to $125.2 million in 2014. The drivers for this increase were incremental incentive and equity compensation costs, incremental expenditures in certain key strategic areas, severance costs and other cost increases. See "Results of Operations" below for further discussion. Going forward, we expect to experience continued sales growth in Rogers' applications for telecommunications, automotive safety systems, rail traction, hybrid all-electric vehicles (EV/HEV), energy efficient motor controls, automotive electrification and protective cushioning. We also believe that many opportunities for growth exist, particularly as we expand our presence across new markets and regions, as well as further diversify our product portfolio in the markets we serve today. Results of Continuing Operations The following table sets forth, for the periods indicated, selected operations data expressed as a percentage of net sales. 2014 vs. 2013 Net Sales Net sales in 2014 were $610.9 million, a 13.7% increase from $537.5 million in 2013. The increase in net sales in 2014 is attributable to volume increases in all of our operating segments. Net sales in the Printed Circuit Materials (PCM) operating segment experienced a 30.2% increase from $184.9 million in 2013 to $240.9 million in 2014, the Power Electronics Solutions (PES) operating segment achieved a 6.9% increase from $160.7 million in 2013 to $171.8 million in 2014, and the High Performance Foams (HPF) operating segment increased 3.3% from $168.1 million in 2013 to $173.7 million in 2014. See “Segment Sales and Operations” below for further discussion on segment performance. Gross Margin Gross margin increased by approximately 340 basis points from 34.9% in 2013 to 38.3% in 2014. Our 2013 results included approximately $0.9 million or 20 basis points of special charges related to relocation costs associated with the move of certain manufacturing operations from the Power Electronics Solutions manufacturing facility in Eschenbach, Germany to a lower cost facility in Hungary. The primary driver of the improvement in gross margin was the increased sales volume achieved during 2014, which contributed approximately 180 basis points to the improvement. The remaining net improvement of 140 basis points was attributable primarily to our ability to leverage our existing asset base through production efficiencies to absorb the increased sales volume. In addition, we continue to implement improvements in supply chain, product quality and procurement, which also favorably impacted margin performance. Selling and Administrative Expenses Selling and administrative (S&A) expenses were $125.2 million in 2014, an increase of 17.7% from $106.4 million in 2013. Our 2014 results included approximately $2.3 million of acquisition costs. Our 2013 results included approximately $1.3 million of special charges comprised of $0.6 million in costs related to the move of certain manufacturing operations from the Power Electronic Solutions manufacturing facility is Eschenbach, Germany to a lower cost facility in Hungary and $0.7 million of other severance related charges. Excluding these charges, non-GAAP selling and administrative expense increased $17.8 million. As a percentage of sales, non-GAAP selling and administrative expenses increased by 60 basis points from 19.5% in 2013 to 20.1% in 2014. The overall increase in non-GAAP expenses is due to a variety of factors, including $7.7 million of incremental incentive and equity compensation costs, $10.1 million for incremental expenditures in certain key strategic areas, such as sales and marketing, strategic planning, information technology and executive recruiting, as well as costs related to merit increases. Also contributing to the increased costs in 2014 were charges related to the CFO transition of $0.8 million, severance of $2.8 million, $1.3 million of incremental asbestos related liabilities and other cost increases of $2.1 million. These increases were offset by approximately $7.0 million in expense reductions related primarily to changes in our defined benefit pension plans initiated in 2013. Management is pursuing pension risk mitigation strategies which would decrease the financial volatility of the plan; however, it could also result in less expense savings in the future as the investment mix is shifted more heavily to fixed income securities from equity securities. Research and Development Expenses Research and development (R&D) expenses were $22.9 million in 2014, an increase of 6.0%, from $21.6 million in 2013. As a percentage of sales, R&D costs decreased from 4.0% in 2013 to 3.7% in 2014. The lower rate is due primarily to the significant increase in net sales. From a gross spending perspective, in the past year we have made concerted efforts to realign our R&D organization to better fit the future direction of the Company, including dedicating resources to focus on current product extensions and enhancements to meet our short term technology needs. We also are increasing investments that are targeted at developing new platforms and technologies focused on long term growth initiatives, as evidenced by our partnership with Northeastern University in Boston, Massachusetts. This partnership has resulted in the creation of the Rogers Innovation Center on its Burlington, Massachusetts campus. As a result, we expect to increase R&D expenditures as the Rogers Innovation Center ramps up, as our long term goal is to reinvest approximately 6% of net sales back into R&D activities. Restructuring and Impairment Charges Restructuring and impairment charges were $5.4 million in 2014 as compared to $10.4 million in 2013. In 2014, these charges were comprised primarily of the following: (i) $5.2 million related to the settlement of certain long term pension obligations and (ii) $ 0.2 million related to an impairment charge on an investment in Solicore, Inc. In 2013, these charges were comprised primarily of the following: (i) $4.6 million related to the impairment charge on the investment in Solicore, Inc., (ii) $4.2 million of severance and related charges as a result of additional streamlining initiatives as well as changes to the executive management team, and (iii) a $1.5 million curtailment charge related to the freezing of the defined benefit pension plans. Equity Income in Unconsolidated Joint Ventures Equity income in unconsolidated joint ventures was $4.1 million in 2014, a decrease of 4.7% from $4.3 million in 2013. The decline was primarily due to the depreciation of the Japanese Yen against the U.S. dollar of approximately 8.6% year over year. Other Income (Expense), Net Other income (expense), net was expense of $1.2 million in 2014 and 2013. Although the ending balance was the same year over year, there were changes in the activity. Our 2014 results included unfavorable commodity hedging transactions offset by lower commission payments to the joint ventures. Our 2013 results included approximately $0.7 million of unfavorable mark to market adjustments related to copper hedging contracts and approximately $0.3 million related to unfavorable foreign currency transaction adjustments. Interest Income (Expense), Net Interest income (expense), net, declined by 17.1% to $2.9 million of expense in 2014 from $3.5 million of expense in 2013. The decline is due primarily to lower interest expense on our debt facility, as we have paid down principal from $98.0 million at the beginning of 2013 to $60.0 million at the end of 2014. Income Tax Expense (Benefit) Our effective tax rate was 34.2% in 2014 and 23.0% in 2013. In 2014, our tax rate was adversely impacted by distribution of current year earnings from one of our foreign subsidiaries as well as acquisition costs. In both 2014 and 2013, our tax rate was favorably impacted by the tax benefit associated with the lapse of statute in accordance with applicable accounting guidance and foreign source income subject to tax at lower rates than income generated in the U.S. In 2013, the rate was favorably impacted by the tax benefit related to the lapse of statute in accordance with applicable accounting guidance, and foreign source income subject to tax at lower rates than income generated in the U.S. We currently have a $0.7 million net operating loss in one of our Chinese entities that will expire in 2018. We have a $0.1 million net operating loss carryforward in Japan, which will expire in 2023. We also have state net operating loss carryforwards ranging from $0.1 million to $16.2 million in various state taxing jurisdictions, which will begin to expire in 2015. We have approximately $7.0 million of credit carryforwards in Arizona, which will expire in 2015. We believe that it is more likely than not that the benefit from the China and state net operating loss carryforwards as well as our state credit carryforwards will not be realized. In recognition of this risk, we have provided a valuation allowance of $7.7 million relating to these carryforwards. If or when recognized, the tax benefits related to any reversal of the valuation allowance on deferred tax assets as of December 31, 2014, will be accounted for as follows: approximately $6.8 million will be recognized as a reduction of income tax expense and $0.9 million will be recorded as an increase in equity. Backlog The backlog of firm orders was $80.2 million at December 31, 2014, as compared to $50.5 million at December 31, 2013. The increase at the end of 2014 was primarily related to the Power Electronics Solutions and Printed Circuit Materials operating segments, which experienced an increase in backlog of $8.3 million and $18.9 million, respectively, at December 31, 2014 as compared to December 31, 2013. 2013 vs. 2012 Net Sales Net sales in 2013 were $537.5 million, a 7.8% increase from $498.8 million of sales in 2012. The increase in net sales in 2013 was primarily related to the significantly improved performance of the Power Electronics Solutions operating segment, which experienced a 19.7% increase in net sales from $134.3 million in 2012 to $160.7 million in 2013, and the Printed Circuit Materials operating segment, which achieved a 14.2% increase in net sales from $161.9 million in 2012 to $184.9 million in 2013. These increases were partially offset by a 6.3% decline in net sales in the High Performance Foams operating segment from $179.4 million in 2012 to $168.1 million in 2013. See “Segment Sales and Operations” below for further discussion on segment performance. Gross Margin Gross margin increased by approximately 310 basis points from 31.8% in 2012 to 34.9% in 2013. Our 2013 results included approximately $0.9 million or 20 basis points of special charges related to relocation costs associated with the move of certain manufacturing operations from the Power Electronics Solutions manufacturing facility in Eschenbach, Germany to a lower cost facility in Hungary. The primary driver of the improvement in gross margin was the increased sales volume achieved during 2013, which contributed approximately 70 basis points to the improvement, as well as the impact from streamlining activities, which contributed an additional 20 basis point improvement to our overall results. The remaining net improvement of 240 basis points is attributable primarily to efficiencies in the production process that enabled us to absorb lower cost, incremental manufacturing capacity through our existing manufacturing base while continuing to implement improvements in supply chain, product quality and procurement. Selling and Administrative Expenses Selling and administrative (S&A) expenses were $106.4 million in 2013, an increase of 6.7% from $99.7 million in 2012. 2013 results included approximately $1.3 million of special charges comprised of $0.6 million in costs related to the move of certain manufacturing operations from the Power Electronic Solutions manufacturing facility in Eschenbach, Germany to a lower cost facility in Hungary and $0.7 million of other severance related charges. Our 2012 results included approximately $5.8 million of special charges comprised primarily of a $2.9 million charge taken as a result of increasing the forecast period on asbestos related liabilities from 5 to 10 years during the fourth quarter of 2012, as well as a $2.0 million charge related to the settlement of a pension obligation with the former Chief Executive Officer of the Company. Excluding these charges, selling and administrative expense increased from $93.8 million in 2012 to $105.0 million in 2013. As a percentage of sales, excluding special charges, non-GAAP selling and administrative expenses increased from 18.8% in 2012 to 19.5% in 2013. The overall increase in expenses is due to a variety of factors, including $9.3 million of incentive and equity compensation costs, as there was no incentive compensation during 2012 due to the decline in results as compared to 2011, and $1.6 million of higher amortization expense related to Curamik intangible assets as the amortization expense is based on the expected future cash flows related to the respective assets, which results in some year to year volatility. These increases were partially offset by cost savings of approximately $5.7 million primarily related to changes in the defined benefit pension plans and the streamlining initiatives initiated in 2012 and 2013. The remaining net increase is primarily attributable to incremental expenditures in certain key strategic areas, such as sales and marketing, strategic planning, information technology and executive recruiting - expenditures all targeted at better positioning the Company for future growth. Research and Development Expenses Research and development (R&D) expenses were $21.6 million in 2013, an increase of 12.1% from $19.3 million in 2012. As a percentage of sales, R&D expenses were 4.0% in 2013 and 3.9% in 2012. The increase in R&D expenditures is consistent with our long term strategic plan of investing up to 6% of net sales back into R&D activities. In the past year, we have made concerted efforts to begin realigning our R&D organization to better fit the future direction of the Company, including dedicating resources to focus on current product extensions and enhancements to build our short term technology needs, as well as increasing investments directed at developing new platforms and technologies that are focused on long term growth initiatives, as evidenced by our partnership with Northeastern University in Boston, Massachusetts to create the Rogers Innovation Center on their campus. Restructuring and Impairment Charges Restructuring and impairment charges were $10.4 million in 2013 as compared to $14.1 million in 2012. In 2013, these charges were comprised primarily of the following: (i) $4.6 million related to the impairment charge on the investment in Solicore, Inc., (ii) $4.2 million of severance and related charges as a result of additional streamlining initiatives as well as changes to the executive management team, and (iii) a $1.5 million curtailment charge related to the freezing of the defined benefit pension plans. In 2012, these charges were comprised primarily of the following: (i) $7.1 million in severance related charges resulting from streamlining initiatives that took place throughout the year, including the early retirement program implemented in the first quarter of 2012; (ii) approximately $2.3 million related to the shut-down of the Bremen manufacturing facility in Germany and relocation of certain production to the manufacturing facility in Carol Stream, Illinois; and (iii) $3.8 million in severance related charges resulting from actions taken to move the final inspection operations of Curamik from Germany to Hungary. Equity Income in Unconsolidated Joint Ventures Equity income in unconsolidated joint ventures was $4.3 million in 2013, a decrease of 8.8% from $4.7 million in 2012. The decline was primarily due to the depreciation of the Japanese Yen against the U.S. dollar of approximately 22.2% year over year, as well as the generally softer demand across most of the joint venture end markets. Other Income (Expense), Net Other income (expense), net was expense of $1.2 million in 2013 as compared to expense of $0.2 million in 2012. Our 2013 results included approximately $0.7 million of unfavorable mark to market adjustments related to copper hedging contracts and approximately $0.3 million related to unfavorable foreign currency transaction adjustments. Our 2012 results included approximately $1.0 million of unfavorable foreign currency transaction adjustments, more than offset by a $1.7 million gain from the sale of certain assets at the Arizona and Bremen, Germany manufacturing facilities. Realized Gain (Loss) Realized investment gain (loss) represents the portion of the auction rate securities impairment that relates to credit losses and is required to be recorded in the consolidated statements of income (loss). There was no loss recognized in 2013 and a loss of $3.2 million recognized in 2012. The 2012 loss was a result of the liquidation of the full auction rate securities portfolio, which resulted in net cash proceeds of approximately $25.4 million. Interest Income (Expense), Net Interest income (expense), net was expense of $3.5 million in 2013 as compared to expense of $4.3 million in 2012. This expense relates to the interest expense on our long-term debt, as well as the interest expense on the long term obligation related to the leased Power Electronic Solutions manufacturing facility in Eschenbach, Germany. The overall decline in the expense was driven by the decline in long term debt during 2013 as we paid down the facilities by $20.5 million from $98.0 million at December 31, 2012 to $77.5 million at December 31, 2013. Income Tax Expense (Benefit) Our effective tax rate was 23.0% in 2013 and (205.2)% in 2012. In both 2013 and 2012, our tax rate was favorably impacted by the tax benefit associated with certain discrete rate items recorded during each year and also benefited from favorable tax rates on certain foreign business activity. In 2013, the rate was primarily impacted by the following items: (i) 5.3% benefit related to the lapse of statute in accordance with applicable accounting guidance; and (ii) 6.8% benefit related to foreign source income which is taxed at lower rates than income generated in the U.S. In 2012, the rate was primarily impacted by the following items: (i) 232.5% benefit related to the reversal of the valuation allowance on the U.S. deferred tax assets; and (ii) 16.1% benefit related to foreign source income which is taxed at lower rates than income generated in the U.S. In 2009, we established a valuation allowance against substantially all of our U.S. deferred tax assets as we concluded that we did not have sufficient evidence to support the position that these assets would be utilized in the future. This conclusion was reached primarily due to the presence of recent cumulative losses in the U.S. and upon consideration of all other available evidence, both positive and negative, using a “more likely than not standard” in accordance with applicable accounting guidance. As of the end of the third quarter of 2012, we concluded that a valuation allowance against these assets is no longer necessary as we are no longer in, nor are we expecting to be in, a cumulative loss in the foreseeable future. Also, in appropriate circumstances we have the opportunity to undertake a tax planning strategy to ensure that our deferred tax assets do not expire unutilized. This strategy is based upon our ability to make a tax election to capitalize certain expenses that will result in generating taxable income to allow us to utilize our deferred tax assets before they expire. We would undertake such a strategy to realize these deferred tax assets prior to expiration only if we determined it was reasonable, prudent, and feasible. This, along with other positive evidence, such as our recent history of positive taxable income, led us to conclude in 2012 that it is more likely than not that we will ultimately be able to realize our deferred tax assets. We had a $1.0 million net operating loss as of December 31, 2013 in one of our Chinese entities that will begin to expire in 2017. We believe that we will generate sufficient taxable income in China such that this carryforward should be fully realized. Backlog The backlog of firm orders was $50.5 million at December 31, 2013, as compared to $43.3 million at December 31, 2012. The increase at the end of 2013 was primarily related to the Power Electronics Solutions and Printed Circuit Materials operating segments, which experienced an increase in backlog of $3.6 million and $3.7 million, respectively, at December 31, 2013 as compared to December 31, 2012. Segment Sales and Operations Core Strategic Printed Circuit Materials The Printed Circuit Materials (PCM) operating segment is comprised of high frequency circuit material products used for making circuitry that receive, process and transmit high frequency communications signals, in a wide variety of markets and applications, including wireless communications, high reliability, and automotive, among others. 2014 vs. 2013 - Net sales in 2014 were $240.9 million, an increase of 30.2% from $184.9 million in 2013. The increase in net sales was due primarily to a 52.9% increase in orders for high frequency circuit materials to support wireless base station and antenna applications in connection with the global 4G/LTE infrastructure build-out, particularly in China. Further, demand in automotive safety radar applications for Advanced Driver Assistance Systems increased by 37.7% year over year as auto manufacturers continue to adopt this safety feature into their designs. These increases were partially offset by a 15.9% decline in net sales for certain applications in handheld devices for improved internet connectivity. Operating income improved by 132.4% from $18.8 million in 2013 to $43.7 million in 2014. As a percentage of net sales, operating income for 2014 was 18.1%, an increase from 10.2% in 2013. 2014 operating income includes approximately $2.9 million of special charges comprised of $1.9 million from the early payment of certain long term pension obligations, $0.9 million related to acquisition costs and $0.1 million related to the impairment of the Solicore investment. Our 2013 operating income included approximately $2.8 million of special charges comprised primarily of $1.0 million in severance charges and $1.6 million allocation related to the impairment of the Solicore investment. Excluding these charges, non-GAAP operating income increased by 115.7% from $21.6 million in 2013 to $46.6 million in 2014. As a percentage of sales, excluding the 2014 and 2013 special charges, 2014 operating income was 19.3%, a 760 basis point improvement as compared to the 11.7% achieved in 2013. This increase is due primarily to the increase in net sales as we were able to achieve this growth by utilizing our existing manufacturing capacity. Results were also favorably impacted by the continuous efforts targeted at manufacturing efficiency improvements. This increase was partially offset by $6.9 million of higher allocated selling and administrative expenses in 2014 compared to 2013. See the "Results of Operations" section above for a discussion of these costs. 2013 vs. 2012 - Net sales in 2013 were $184.9 million, an increase of 14.2% from $161.9 million in 2012. The increase in net sales was due primarily to strong demand for PCM materials in handheld devices for improved internet connectivity, which experienced a 176.9% increase in 2013 as compared to 2012, as manufacturers expanded the use of our materials in their devices in areas such as antennas. Demand in automotive radar applications for Advanced Driver Assistance Systems (ADAS) increased by 74.8% year over year as auto manufacturers continued to adopt this safety feature into their designs. We also experienced a 9.9% year over year increase in net sales for power amplifiers in the base station market driven by the continued global roll-out of 4G-LTE, particularly in China. Operating income improved to $18.8 million in 2013 as compared to $8.2 million in 2012. Our 2013 operating income included approximately $2.8 million of special charges comprised primarily of $1.0 million in severance charges and $1.6 million allocation related to the impairment of the Solicore investment. Our 2012 operating income included approximately $2.3 million of net special charges comprised primarily of $2.9 million in severance charges incurred as part of our overall streamlining initiatives, $0.6 million in charges related to pension settlement accounting (as further described in the "Selling and Administrative Expenses" section above), $0.9 million of allocated asbestos charges (as further described in in the "Selling and Administrative Expenses" section above) and $0.5 million of other special charges; partially offset by a one-time benefit of $2.1 million related to inventory valuation adjustments and $0.5 million related to an insurance reimbursement of a previously settled product liability claim. Excluding these special charges, operating income improved from $10.4 million in 2012 to $21.6 million in 2013. As a percentage of sales, excluding special charges, 2013 operating income was 11.7%, a 520 basis point improvement as compared to the 6.5% achieved in 2012. This significant improvement was driven by the strong volume increases achieved in this operating segment, as well as the overall improvement in operating leverage driven by the streamlining initiatives that began in 2012. High Performance Foams The High Performance Foams (HPF) operating segment is comprised of polyurethane and silicone foam products, which are sold into a wide variety of markets for various applications such as general industrial, portable electronics, consumer and transportation markets for gasketing, sealing, and cushioning applications. 2014 vs. 2013 - Net sales increased by 3.3% from $168.1 million in 2013 to $173.7 million in 2014. This increase in net sales was driven primarily due to higher demand in general industrial (5.5%), battery applications for hybrid electric vehicles (67.4%), consumer comfort and impact protection (13.4%), and mass transit (12.3%). High Performance Foams demand into the portable electronics (mobile internet devices and feature phones) applications was down 9.2% year over year and we expect continued challenges in this market as we move forward. Operating income increased by 3.6% from $22.3 million in 2013 to $23.1 million in 2014. As a percentage of net sales, operating income for both 2014 and 2013 was 13.3%. Our 2014 operating income includes approximately $2.0 million of special charges comprised of $1.3 million for the early payment of certain long term pension obligations and $0.6 million of acquisition costs. Our 2013 results included approximately $3.3 million of special charges comprised primarily of $1.5 million in severance charges and a $1.6 million allocation related to the impairment of the Solicore investment. Excluding these items, non-GAAP operating income declined by 2.3% from $25.7 million in 2013 to $25.1 million in 2014. As a percentage of net sales, excluding the 2014 and 2013 special charges, 2014 operating income was 14.4%, a 80 basis point decline as compared to the 15.2% achieved in 2013. This decline is primarily attributable to the increase of $4.7 million in allocated selling and administrative expenses incurred during 2014 and was partially offset by increased operating profit due to increased net sales. See the "Results of Operations" section above for a discussion of these costs. 2013 vs. 2012 - Net sales decreased by 6.3% from $179.4 million in 2012 to $168.1 million in 2013. This decline in net sales was driven primarily by a 12.7% decline in net sales into the mobile internet device market, as market dynamics negatively impacted volumes. Specifically, the introduction of smaller tablet devices, material utilization improvements by our customers, a shift in market share within our customer base, and the adoption of new technologies allowing thinner form factors all contributed to the declines in this rapidly changing market. The decrease was partially offset by a 1.4% increase into the consumer and general industrial markets, where demand remained strong for our foam products. Operating income declined by 13.2% from $25.7 million in 2012 to $22.3 million in 2013. Our 2013 results included approximately $3.3 million of special charges comprised primarily of $1.5 million in severance charges and a $1.6 million allocation related to the impairment of the Solicore investment. Our 2012 results included approximately $7.8 million of special charges, including $3.2 million related to the shutdown of the silicone foams manufacturing facility in Bremen, Germany, $2.2 million of net severance related charges as a result of our streamlining initiatives, $0.7 million in allocated pension settlement charges (as further described in the "Selling and Administrative Expenses" section above) and $1.0 million of allocated asbestos charges (as further described in the "Selling and Administrative Expenses" section above). Excluding these special charges, operating income decreased by approximately 23.4% from $33.5 million in 2012 to $25.7 million in 2013. As a percentage of sales, excluding special charges, 2013 operating income was 15.2%, a 350 basis point decline as compared to the 18.7% achieved in 2012. This decline was primarily attributable to the lower sales volumes in the mobile internet device market, partially offset by improved operating leverage as a result of the streamlining initiatives that began in 2012. Power Electronics Solutions The Power Electronics Solutions (PES) operating segment is comprised of two product lines - curamik® direct-bonded copper (DBC) substrates that are used primarily in the design of intelligent power management devices, such as IGBT (insulated gate bipolar transistor) modules that enable a wide range of products including highly efficient industrial motor drives, wind and solar energy converters and electrical systems in automobiles, and RO-LINX® busbars that are used primarily in power distribution systems products in mass transit and clean technology applications. 2014 vs. 2013 - Net sales increased by 6.9% from $160.7 million in 2013 to $171.8 million in 2014. This increase in net sales was led by an increase in demand in mass transit (14.9%), energy efficient motor control applications (16.2%) and vehicle electrification (x-by-wire) applications (26.8%). These increases more than offset weaker demand in laser diode (15.1%) and certain renewable energy applications (8.2%). Operating income increased by 390.9% from $1.1 million in 2013 to $5.4 million in 2014. As a percentage of net sales, operating income in 2014 was 3.1%, an increase from 0.7% in 2013. Our 2014 operating income includes approximately $2.8 million of special charges comprised of $1.9 million of the early payment of certain long term pension obligations and $0.9 million of acquisition costs. Our 2013 results included approximately $6.1 million of special charges comprised primarily of $3.8 million of severance related charges, a $1.2 million allocation related to the impairment of the Solicore investment, and $1.1 million related to the start-up of inspecting operations in Hungary. Excluding these items, non-GAAP operating income improved by 13.9% from $7.2 million in 2013 to $8.2 million in 2014. This improvement was the result of sales volume increases achieved in this operating segment and manufacturing efficiency improvements, partially offset by an increase of $7.6 million of higher allocated selling and administrative expenses incurred in 2014. See the "Results of Operations" section above for a discussion of these costs. 2013 vs. 2012 - Net sales increased by 19.7% from $134.3 million in 2012 to $160.7 million in 2013. This significant recovery in net sales was driven primarily by a 28.4% increase in net sales into clean technology applications with strength across a number of markets, including hybrid and electric vehicles (89.9% increase), solar and wind applications (38.9% increase), and industrial motor drives (9.6% increase). Our 2013 results highlighted the recovery we had been anticipating in this operating segment since the significant downturns experienced in 2012. Operating results improved from an operating loss of $12.1 million in 2012 to operating income of $1.1 million in 2013. Our 2013 results included approximately $6.1 million of special charges comprised primarily of $3.8 million of severance related charges, a $1.2 million allocation related to the impairment of the Solicore investment, and $1.1 million related to the start-up of inspecting operations in Hungary. Our 2012 results included approximately $9.2 million of special charges consisting primarily of $6.0 million of severance and related compensation charges, $0.8 million of allocated asbestos costs, and $0.7 million of charges related to the shutdown of manufacturing operations in North America. Excluding these charges, PES operating results improved from a loss of $2.8 million in 2012 to income of $7.2 million in 2013. As a percentage of sales, excluding special charges, 2013 operating income was 4.4%, a 650 basis point improvement as compared to the (2.1)% operating loss in 2012. These improvements were driven by the significant volume increases achieved in this operating segment, as well as the overall improvement in operating leverage driven by the streamlining initiatives that began in 2012. Other Our Other reportable segment consists of our elastomer rollers and float products, as well as the inverter distribution business. 2014 vs 2013 - Net sales increased by 3.5% from $23.7 million in 2013 to $24.5 million in 2014. The increase in net sales was due primarily to stronger demand for elastomer rollers and floats products, which increased 3.5% year over year. There was also stronger demand for inverters, which increased 3.0% year over year. Operating results improved by 15.5% from $7.1 million in operating profit in 2013 to $8.2 million in operating profit in 2014. Our 2013 results included approximately $0.4 million of special charges related primarily to this segment's allocated portion of the Solicore impairment charge and severance charges. The overall improvement in operating results in this segment was attributable primarily to the increase in volume and improved operational efficiencies. 2013 vs 2012 - Net sales increased by 2.4% from $23.2 million in 2012 to $23.7 million in 2013. The increase in net sales was due primarily to a 6.7% increase in net sales of elastomer component and float products, partially offset by a 25.7% decline in net sales of inverter products from our legacy Durel business. Operating results improved by 86.6% from $3.8 million in operating profit in 2012 to $7.1 million in operating profit in 2013. Our 2013 results included approximately $0.4 million of special charges related primarily to this segment's allocated portion of the Solicore impairment charge and severance charges. 2012 results included approximately $0.5 million of special charges related primarily to allocated severance and pension settlement related costs. Excluding these special charges, operating income improved from $4.3 million in 2012 to $7.4 million in 2013. As a percentage of sales, excluding special charges, 2013 operating income was 31.4%, a 1,300 basis point improvement as compared to the 18.4% achieved in 2012. This significant improvement was driven by the overall improvement in operating leverage driven by the streamlining initiatives that began in 2012. Joint Ventures Rogers INOAC Corporation (RIC) RIC, our joint venture with Japan-based INOAC Corporation, was established over 29 years ago and manufactures high performance PORON urethane foam materials in Japan. RIC's 2014 net sales declined by approximately 17.7% as compared to 2013. Approximately 8.6 percentage points of this decline relates to the depreciation of the Japanese Yen against the U.S. dollar as the currency value significantly changed during the period. Excluding the impact of the currency change, net sales declined by approximately 1.8% year over year primarily due to the continued weakness in the Japanese domestic and export markets, particularly LCD TV's, domestic mobile phones and general industrial applications. Sales decreased by 21.5% from 2012 to 2013. Approximately 17.2 percentage points of this decline relates to the depreciation of the Japanese Yen against the U.S. dollar as the currency value significantly changed during the period. Excluding the impact of the currency change, net sales declined by approximately 4.4% year over year primarily due to the continued weakness in the Japanese domestic and export markets, particularly LCD TV's, domestic mobile phones and general industrial applications. Rogers INOAC Suzhou Corporation (RIS) RIS, our joint venture agreement with INOAC Corporation for the purpose of manufacturing PORON urethane foam materials in China, began operations in 2004. Net sales increased by approximately 2.3% from 2013 to 2014 and decreased approximately 10.4% from 2012 to 2013. The increase from 2013 to 2014 was primarily related small market gains in mobile internet devices. The decline from 2012 to 2013 was primarily related to design changes in the mobile internet device market that negatively impacted volumes. Discontinued Operations In the fourth quarter of 2011, we made the strategic decision to end the operations of our Thermal Management Solutions operating segment. We had invested in its operations for the previous few years, but had difficulty gaining traction in the market and working through issues in the manufacturing process. Therefore, we determined that we would not achieve future success in this operation and chose to shut down operations rather than invest further. There was no activity for this segment in 2014 or 2013. In 2012 operating income of $0.1 million was reflected as discontinued operations in the accompanying consolidated statements of income (loss). Net sales associated with the discontinued operations for 2012 were $0.1 million. The tax related to the discontinued operations was de minimis for 2013 and 2012. In the second quarter of 2012, we decided to cease production of our non-woven composite materials operating segment located in Rogers, Connecticut. Sales of non-woven products had been steadily declining for several years and totaled approximately $5.3 million in 2012. Manufacturing operations ceased by the end of 2012 and last sales out of inventory occurred in the first quarter of 2013. In 2013, operating income of $0.1 million, net of tax, was reflected as discontinued operations in the accompanying consolidated statements of income (loss), net sales were $0.2 million, and tax related to the discontinued operation was $0.1 million. In 2012 an operating loss of $0.3 million, net of tax, was reflected as discontinued operations in the accompanying consolidated statements of income (loss). The tax related to the discontinued operations was $0.1 million in 2012. Product and Market Development Our research and development team is dedicated to growing our business by developing cost effective solutions that improve the performance of customers' products and by identifying business and technology acquisition opportunities to expand our market presence. Currently, R&D spend is approximately 4% of net sales, however, our long term strategic plan is to invest up to 6% in R&D activities as we work to grow the Company both organically and through external investments. Liquidity, Capital Resources and Financial Position We believe our ability to generate cash from operations to reinvest in our business is one of our fundamental strengths. We believe our existing sources of liquidity and cash flows expected to be generated from operations, together with available credit facilities, will be sufficient to fund our operations, capital expenditures, research and development efforts, and debt service commitments, as well as our other operating and investing needs, for at least the next twelve months and, we believe, well into the foreseeable future. We continue to have access to the remaining portion of the line of credit available under the Amended Credit Agreement (as defined in the Credit Facilities section which follows), as evidenced by our purchase of Arlon, LLC in the first quarter of 2015, for which we drew down our line of credit for approximately $125.0 million. We continually review and evaluate the adequacy of our cash flows, borrowing facilities and banking relationships to ensure that we have the appropriate access to cash to fund both near-term operating needs and long-term strategic initiatives. At December 31, 2014, cash and cash equivalents were $237.4 million as compared to $191.9 million at the end of 2013, an increase of $45.5 million, or approximately 23.7%. This increase was due primarily to strong cash generated from operations, in addition to $20.5 million received from stock option exercises and $3.8 million received in dividends from our unconsolidated joint ventures. These increases in cash were partially offset by cash outlays of $13.0 million in contributions to our defined benefit pension plan, $17.5 million of payments on our debt facility, and $28.8 million in capital expenditures. The following table illustrates the location of our cash and cash equivalents by our three major geographic areas as of the periods indicated: Cash held in certain foreign locations could be subject to additional taxes if we were to repatriate such amounts back to the U.S. Our current policy is that the historical earnings and cash in these locations will be permanently reinvested in those foreign locations. Net working capital was $311.6 million, $287.7 million and $221.7 million in 2014, 2013 and 2012, respectively. Significant changes in our balance sheet accounts from December 31, 2013 to December 31, 2014 were as follows: ◦ Goodwill decreased $10.5 million or 9.7% from $108.7 million at December 31, 2013 to $98.2 million at December 31, 2014. This decrease is primarily due to the decline in the value of the Euro currency against the United States dollar in the year 2014. There have been no impairments of goodwill during the year ended December 31, 2014. ◦ Other intangible assets decreased $10.9 million or 22.2% from $49.2 million at December 31, 2013 to $38.3 million at December 31, 2014. This decrease is primarily due to the decline in the value of the Euro currency against the United States dollar in the year 2014, coupled with the amortization of intangible assets. There have been no impairments of Other intangible assets during the year ended December 31, 2014. ◦ Overall, our debt position declined by $17.5 million from $77.5 million at December 31, 2013 to $60.0 million at December 31, 2014 due to payments made on the facilities during 2014. During 2014, $28.5 million of net cash was used for investing activities as compared to $17.0 million of net cash provided by investing activities in 2013 and $1.4 million of net cash used in investing activities in 2012. The investing activities in 2012 included liquidating our auction rate security portfolio which resulted in net proceeds of approximately $25.4 million. Capital expenditures were $28.8 million, $16.9 million and $23.8 million in 2014, 2013 and 2012, respectively. Net cash provided by financing activities was $1.9 million in 2014, $10.7 million provided by financing activities in 2013 and net cash used in financing activities was $8.5 million in 2012. Credit Facilities On July 13, 2011, we entered into an amended and restated $265.0 million secured five year credit agreement, which we amended in March 2012. This credit agreement (“Amended Credit Agreement”) is with (i) JPMorgan Chase Bank, N.A., as administrative agent; (ii) HSBC Bank USA, National Association; (iii) RBS Citizens, National Association; (iv) Fifth Third Bank; and (v) Citibank, N.A. JPMorgan Securities LLC and HSBC Bank USA, National Association acted as joint bookrunners and joint lead arrangers; HSBC Bank USA, National Association and RBS Citizens, National Association acted as co-syndication agents; and Fifth Third Bank and Citibank, N.A. acted as co-documentation agents. The Amended Credit Agreement amends and restates the credit agreement signed between the Company and the same banks on November 23, 2010 and increased our borrowing capacity from $165.0 million under the original agreement to $265.0 million under the Amended Credit Agreement. Key features of the Amended Credit Agreement, as compared to the November 23, 2010 credit agreement, include an increase in credit from $165.0 million to $265.0 million with the addition of a $100.0 million term loan; the extension of maturity from November 23, 2014 to July 13, 2016; a 25 basis point reduction in interest costs; an increase in the size of permitted acquisitions from $25.0 million to $100.0 million; and an increase in permitted additional indebtedness from $20.0 million to $120.0 million. The Amended Credit Agreement provides for the extension of credit in the form of a $100.0 million term loan (which refinances outstanding borrowings in the amount of $100.0 million from the existing revolving credit line), as further described below; and up to $165.0 million of revolving loans, in multiple currencies, at any time and from time to time until the maturity of the Amended Credit Agreement on July 13, 2016. We may borrow, pre-pay and re-borrow amounts under the $165.0 million revolving portion of the Amended Credit Agreement; however, with respect to the $100.0 million term loan portion, any principal amounts re-paid may not be re-borrowed. Borrowings may be used to finance working capital needs, for letters of credit and for general corporate purposes in the ordinary course of business, including the financing of permitted acquisitions (as defined in the Amended Credit Agreement). Borrowings under the Amended Credit Agreement bear interest based on one of two options. Alternate base rate loans bear interest that includes a base reference rate plus a spread of 75 - 150 basis points, depending on our leverage ratio. The base reference rate is the greater of the prime rate; federal funds effective rate plus 50 basis points; or adjusted London Interbank Offered Rate (“LIBOR”) plus 100 basis points. Euro-currency loans bear interest based on the adjusted LIBOR plus a spread of 175 - 250 basis points, depending on our leverage ratio. Our current borrowings are Euro-currency based. In addition to interest payable on the principal amount of indebtedness outstanding from time to time under the Amended Credit Agreement, the Company is required to pay a quarterly fee of 0.20% to 0.35% (based upon its leverage ratio) on the unused amount of the lenders’ commitments under the Amended Credit Agreement. In connection with the Amended Credit Agreement, we transferred borrowings in the amount of $100.0 million from the revolving credit line under the November 23, 2010 credit agreement to the term loan under the Amended Credit Agreement. The Amended Credit Agreement requires the mandatory quarterly repayment of principal on amounts borrowed under such term loan. Payments commenced on September 30, 2011, and are scheduled to be completed on June 30, 2016. The future principal payments under the Amended Credit Agreement are as follows: The Amended Credit Agreement is secured by many of the assets of Rogers and our World Properties, Inc., subsidiary, including but not limited to, receivables, equipment, intellectual property, inventory, stock in certain subsidiaries and real property. As part of the Amended Credit Agreement, we are restricted in our ability to perform certain actions, including, but not limited to, our ability to pay dividends, incur additional debt, sell certain assets, and make capital expenditures, with certain exceptions. Further, we are required to maintain certain financial covenant ratios, including (i) a leverage ratio of no more than 3.0 to 1.0 and (ii) a minimum fixed charge coverage ratio (FCCR). The FCCR requirements are detailed in the table below: The FCCR is the ratio between Adjusted Earnings Before Interest, Taxes, Depreciation and Amortization (EBITDA) and Consolidated Fixed Charges as defined in the Amended Credit Agreement, which measures our ability to cover the fixed charge obligations. The key components of Consolidated Fixed Charges are capital expenditures, scheduled debt payments, capital lease payments, rent and interest expenses. Several factors in the first quarter of 2012, including the status of the global economy and the fact that there were no mandatory term loan payments when the original ratio was established, led to an amendment to the covenant which temporarily reduced the FCCR. Fixed Charge metrics are detailed in the table below: As of December 31, 2014, we were in compliance with all of our covenants, as we achieved actual ratios of approximately 0.55 on the leverage ratio and 2.58 on the fixed charge coverage ratio. If an event of default occurs, the lenders may, among other things, terminate their commitments and declare all outstanding borrowings to be immediately due and payable together with accrued interest and fees. In connection with the establishment of the initial credit agreement in 2010, we capitalized approximately $1.6 million of debt issuance costs. We capitalized an additional $0.7 million of debt issuance costs in 2011 related to the Amended Credit Agreement. Also, in connection with the Amended Credit Agreement, we capitalized an additional $0.1 million of debt issuance costs in 2012. These costs are being amortized over the life of the Amended Credit Agreement, which will terminate in June 2016. We incurred amortization expense of $0.5 million for each of the years ended December 31, 2014, 2013 and 2012. At December 31, 2014, we have approximately $0.8 million of credit facility costs remaining to be amortized. In the first quarter of 2011, we made an initial draw on the line of credit of $145.0 million to fund the acquisition of Curamik. During 2014 and 2013, we made principal payments of $17.5 million and $20.5 million, respectively, on the outstanding debt. The 2013 payments included an $8.0 million payment on the revolving credit line, which paid the remaining balance of the revolving credit line. We are obligated to repay $35.0 million on the term loan obligation in 2015. As of December 31, 2014, the outstanding debt related to the Amended Credit Agreement consisted of $60.0 million of term loan debt. We have the option to pay part of or the entire amount at any time over the remaining life of the Amended Credit Agreement, with any balance due and payable at the agreement's expiration. In addition, as of December 31, 2014, we had a $1.4 million standby letter of credit (LOC) that was backed by the Amended Credit Agreement. No amounts were owed on the standby LOC as of December 31, 2014 or December 31, 2013. We also guarantee an interest rate swap related to the lease of the Curamik manufacturing facility in Eschenbach, Germany. The swap agreement is between the lessor, our Curamik subsidiary and a third party bank. We guarantee any liability related to the swap agreement in case of default by the lessor through the term of the swap until expiration in July 2016, or if we exercised the option to buy out the lease at June 30, 2013 as specified within the lease agreement. We did not exercise our option to buy out the lease at June 30, 2013. The swap is in a liability position with the bank at December 31, 2014, and has a fair value of $0.4 million. We have concluded that default by the lessor is not probable during the term of the swap; therefore, we believe the guarantee has no value. Capital Lease During the first quarter of 2011, we recorded a capital lease obligation related to the acquisition of Curamik for its primary manufacturing facility in Eschenbach, Germany. Under the terms of the leasing agreement, we had an option to purchase the property in either 2013 or upon the expiration of the lease in 2021 at a price which is the greater of (i) the then-current market value or (ii) the residual book value of the land including the buildings and installations thereon. We chose not to exercise the option to purchase the property that was available to us on June 30, 2013. The total obligation recorded for the lease as of December 31, 2014 and 2013 was $6.8 million and $8.0 million, respectively. Depreciation expense related to the capital lease was $0.4 million, $0.4 million and $0.4 million for the years ended December 31, 2014, 2013 and 2012, respectively. Accumulated depreciation as of December 31, 2014 and 2013 was $1.6 million and $1.2 million, respectively. These expenses were included as depreciation expense within Cost of Sales on our consolidated statements of income (loss). Interest expense related to the debt recorded on the capital lease was included in interest expense on the consolidated statements of income (loss). See “Interest” section below for further discussion. Interest We incurred interest expense on our outstanding debt of $1.8 million, $2.2 million and $2.9 million for each of the years ended December 31, 2014, 2013 and 2012, respectively. We incurred an unused commitment fee of approximately $0.4 million, for the years ended December 31, 2014, 2013 and 2012. In July 2012, we entered into an interest rate swap to hedge the variable interest rate on 65% of the term loan debt, then outstanding, effective July 2013. At December 31, 2014, our outstanding debt balance is only made up of the term loan debt which is $60.0 million. At December 31, 2014, the rate charged on this debt is the one month LIBOR of 0.1875% plus a spread of 1.75%. We also incurred interest expense on the capital lease of $0.5 million, $0.5 million and $0.6 million for the years ended December 31, 2014, 2013 and 2012, respectively. Cash paid for interest was $2.5 million, $3.1 million and $4.0 million for 2014, 2013 and 2012, respectively. Auction Rate Securities During the first quarter of 2012, we liquidated our auction rate securities portfolio, receiving net proceeds of $25.4 million on a stated par value of $29.5 million. As a result of this liquidation, we recognized a loss on the discount of the securities of $3.2 million (the remaining difference between the liquidation proceeds and par value of $0.9 million had previously been recognized as an impairment loss). Contractual Obligations The following table summarizes our significant contractual obligations as of December 31, 2014: (1) Estimated future interest payments are based on (1) rates that range from 0.16% to 1.51%, which take into consideration projected forward 1 Month LIBOR, (2) a leverage-based spread and (3) the related impact of the interest rate swap. Pension benefit payments, which amount to $187.9 million, are expected to be paid through the utilization of pension plan assets; retiree health and life insurance benefits, which amount to $9.8 million, are expected to be paid from operating cash flows. Other long-term liabilities, such as deferred taxes, unrecognized tax benefits and asbestos-related product liability reserves, have been excluded from the table due to the uncertainty of the timing of payments combined with the absence of historical trends to be used as a predictor for such payments. Effects of Inflation We do not believe that inflation had a material impact on our business, sales, or operating results during the periods presented. Off-Balance Sheet Arrangements We do not have any off-balance sheet arrangements that have, or are, in the opinion of management, reasonably likely to have, a current or future material effect on our financial condition or results of operations. Critical Accounting Policies Our Consolidated Financial Statements are prepared in accordance with U.S. generally accepted accounting principles, which require management to make estimates, judgments and assumptions that affect the amounts reported in the financial statements and accompanying notes. We base our estimates on historical experience and on various other assumptions that are believed to be reasonable under the circumstances and believe that appropriate reserves have been established based on reasonable methodologies and appropriate assumptions based on facts and circumstances that are known; however, actual results may differ from these estimates under different assumptions or conditions. An accounting policy is deemed to be critical if it requires an accounting estimate to be made based on assumptions that are highly judgmental and uncertain at the time the estimate is made, if different estimates could reasonably have been used, or if changes to those estimates are reasonably likely to periodically occur that could affect the amounts carried in the financial statements. These critical accounting policies are as follows: Revenue Recognition We recognize revenue when all of the following criteria are met: (1) we have entered into a binding agreement, (2) the product has shipped and title and risk of ownership have passed, (3) the sales price to the customer is fixed or determinable, and (4) collectability is reasonably assured. We recognize revenue based upon a determination that all criteria for revenue recognition have been met, which, based on the majority of our shipping terms, is considered to have occurred upon shipment of the finished product. Some shipping terms require the goods to be through customs or be received by the customer before title passes. In those instances, revenue is not recognized until either the customer has received the goods or they have passed through customs, depending on the circumstances. As appropriate, we record estimated reductions to revenue for customer returns and allowances and warranty claims. Provisions for such allowances are made at the time of sale and are typically derived from historical trends and other relevant information. Allowance for Doubtful Accounts The allowance for doubtful accounts is established to represent our best estimate of the net realizable value of the outstanding accounts receivable. The allowance for doubtful accounts is determined based on a variety of factors that affect the potential collectability of receivables, including length of time receivables are past due, customer credit ratings, financial stability of customers, specific one-time events and past customer history. In addition, in circumstances when we are made aware of a specific customer's inability to meet its financial obligations, a specific allowance is established. The majority of accounts are individually evaluated on a regular basis and appropriate reserves are established as deemed appropriate based on the criteria previously mentioned. The remainder of the reserve takes into consideration historical trends, market conditions and the composition of our customer base. The risk with this estimate is associated with failure to become aware of potential collectability issues related to specific accounts and thereby becoming exposed to potential unreserved losses. Historically, our estimates and assumptions around the allowance have been reasonably accurate and we have processes and controls in place to closely monitor customers and potential credit issues. Additionally, we have credit insurance on certain accounts that mitigates some of the risk of loss. Over the past three years, our allowance as a percentage of total receivables has ranged from 1.9% to 2.2%. A 50 basis point increase in our current year allowance to would increase our reserve by approximately $0.4 million. Inventory Valuation Inventories are stated at the lower of cost or market with costs determined primarily on a first-in first-out basis. We also maintain a reserve for excess, obsolete and slow-moving inventory that is primarily developed by utilizing both specific product identification and historical product demand as the basis for our analysis. Products and materials that are specifically identified as obsolete are fully reserved. In general, most products that have been held in inventory greater than one year are fully reserved unless there are mitigating circumstances, including forecasted sales or current orders for the product. The remainder of the allowance is based on our estimates and fluctuates with market conditions, design cycles and other economic factors. Risks associated with this allowance include unforeseen changes in business cycles that could affect the marketability of certain products and an unexpected decline in current production. We closely monitor the market place and related inventory levels and have historically maintained reasonably accurate allowance levels. In addition, we value certain inventories using the last-in, first-out (LIFO) method. Accordingly, a LIFO valuation reserve is calculated using the link chain index method and is maintained to properly value these inventories. Our obsolescence reserve has ranged from 10.0% to 11.4% of gross inventory over the last three years. A one hundred basis point increase to the December 31, 2014 obsolescence reserve would increase the reserve by approximately $1.0 million. Goodwill and Other Intangibles We have made acquisitions over the years that included the recognition of goodwill and other intangible assets. Goodwill and indefinite lived intangibles are tested for impairment annually or more frequently if events or changes in circumstances indicate the carrying value may have been impaired. Application of the goodwill impairment test requires significant judgment, including the identification of reporting units, assignment of assets and liabilities to reporting units, and determination of the fair value of each reporting unit. Determining the fair value of a reporting unit is subjective and requires the use of significant estimates and assumptions, including revenue growth rates and operating margins, discount rates, and future market conditions, among others. We test goodwill for impairment using a two-step process. The first step of the impairment test requires a comparison of the implied fair value of each of our reporting units to the respective carrying value. If the carrying value of a reporting unit is less than its implied fair value, no indication of impairment exists and a second step is not performed. If the carrying amount of a reporting unit is higher than its fair value, there is an indication that impairment may exist and a second step must be performed. In the second step, the impairment is computed by comparing the implied fair value of the reporting unit's goodwill with the carrying amount of the goodwill. If the carrying amount of the reporting unit's goodwill is greater than the implied fair value of its goodwill, an impairment loss must be recognized for the excess and charged to operations. In 2014, we estimated the fair value of our reporting units using an income approach based on the present value of future cash flows. We believe this approach yields the most appropriate evidence of fair value as our reporting units are not easily compared to other corporations involved in similar businesses. We further believe that the assumptions and rates used in our annual impairment test are reasonable, but inherently uncertain. We currently have three reporting units with goodwill and intangible assets - High Performance Foams, Curamik and the Elastomer Components Division (ECD) and the annual impairment test was performed in the fourth quarter of 2014 as has been our historical practice. The HPF, Curamik and ECD reporting units had allocated goodwill of approximately $23.6 million, $72.4 million and $2.2 million, respectively, at December 31, 2014. No impairment charges resulted from this analysis. The excess of fair value over carrying value for these reporting units was 318% for HPF, 85% for Curamik and 77% for ECD. From a sensitivity perspective, if the fair value of these reporting units declined by 10%, the fair value of the HPF reporting unit would exceed its carrying value by approximately 277%, the fair value of the Curamik reporting unit would exceed its carrying value by approximately 65%, and the fair value of the ECD reporting unit would exceed its carrying value by approximately 60%. These valuations are based on a five year discounted cash flow analysis, which utilized discount rates ranging from 13.0% for HPF and ECD to 15.5% for Curamik and a terminal year growth rate of 3% for all three reporting units. Intangible assets, such as purchased technology, customer relationships, and the like, are generally recorded in connection with a business acquisition. Values assigned to intangible assets are determined based on estimates and judgments regarding expectations of the success and life cycle of products and technology acquired and the value of the acquired businesses customer base. These assets are reviewed at least annually, or more frequently, if facts and circumstances surrounding such assets indicate a possible impairment of the asset exists. In 2014, there were no indicators of impairment on any of our other intangible assets. Long-Lived Assets We review property, plant and equipment, and other long-term assets, including investments, for impairment whenever events or changes in circumstances indicate the carrying value of assets may not be recoverable. Recoverability of these assets is measured by comparison of their carrying value to future undiscounted cash flows the assets are expected to generate over their remaining economic lives. If such assets are considered to be impaired, the impairment to be recognized in earnings equals the amount by which the carrying value of the assets exceeds their market value determined by either a quoted market price, if available, or a value determined by utilizing a discounted cash flow analysis. In the future, deterioration in our business could result in additional impairment charges. Evaluation of impairment of long-lived assets requires estimates of future operating results that are used in the preparation of the expected future undiscounted cash flows. Actual future operating results and the remaining economic lives of our long-lived assets could differ from the estimates used in assessing the recoverability of these assets. These differences could result in impairment charges, which could have a material adverse impact on our results of operations. In addition, in certain instances, assets may not be impaired but their estimated useful lives may decrease. In these situations, we amortize the remaining net book values over the revised useful lives. Environmental Contingencies We accrue for environmental investigation, remediation, operating and maintenance costs when it is probable that a liability has been incurred and the amount can be reasonably estimated. For environmental matters, the most likely cost to be incurred is accrued based on an evaluation of currently available facts with respect to each individual site, including existing technology, current laws and regulations and prior remediation experience. For sites with multiple potential responsible parties (PRPs), we consider our likely proportionate share of the anticipated remediation costs and the ability of the other parties to fulfill their obligations in establishing a provision for those costs. Where no amount within a range of estimates is more likely to occur than another, the low end of the range is accrued. When future liabilities are determined to be reimbursable by insurance coverage, an accrual is recorded for the potential liability and a receivable is recorded for the estimated insurance reimbursement amount. We are exposed to the uncertain nature inherent in such remediation and the possibility that initial estimates will not reflect the final outcome of a matter. Product Liability and Workers' Compensation Costs Workers' compensation liabilities in the U.S. are recognized for claims incurred (including claims incurred but not reported) and for changes in the status of individual case reserves. At the time a workers' compensation claim is filed, a liability is estimated to settle the claim and accrued at that time. The liability for workers' compensation claims is determined based on estimates of the nature and severity of the claims and based on analysis provided by third party administrators and by various state statutes and reserve requirements. We have developed our own trend factors based on our specific claims experience. In other countries where workers' compensation claims are applicable, we typically maintain insurance coverage with limited deductible payments. Because the liability is an estimate, the ultimate liability may be more or less than reported. For product liability claims, we typically maintain insurance coverage with reasonable deductible levels to protect us from potential exposures. Any liability associated with such claims is based on management's best estimate of the potential claim value, while insurance receivables associated with related claims are not recorded until verified by the insurance carrier. For asbestos related claims, we recognize projected asbestos liabilities and related insurance receivables, with any difference between the liability and related insurance receivable recognized as an expense in the consolidated statements of income (loss). In order to determine projected asbestos related liabilities, we have historically engaged National Economic Research Associates, Inc. (NERA), a consulting firm with expertise in the field of evaluating mass tort litigation asbestos bodily-injury claims. Further, in order to determine the projected insurance coverage on the asbestos liabilities, we have historically engaged Marsh USA, Inc., also known as Marsh Risk Consulting (Marsh), to develop these projections. Projecting future asbestos costs and related insurance coverage is subject to numerous variables that are extremely difficult to predict, including the number of claims that might be received, the type and severity of the disease alleged by each claimant, the long latency period associated with asbestos exposure, dismissal rates, costs of medical treatment, the financial resources of other companies that are co-defendants in claims, uncertainties surrounding the litigation process from jurisdiction to jurisdiction and from case to case, and the impact of potential changes in legislative or judicial standards, including potential tort reform. The models developed for determining the potential exposure and related insurance coverage were developed by outside consultants deemed to be experts in their respective fields with the forecast for asbestos related liabilities generated by NERA and the related insurance receivable projections developed by Marsh. The models contain numerous assumptions that significantly impact the results generated by the models. We believe the assumptions made are reasonable at the present time, but are subject to uncertainty based on the actual future outcome of our asbestos litigation. We determined that a ten-year projection period is now appropriate as we have experience in addressing asbestos related lawsuits over the last few years to use as a baseline to project the liability over ten years. However, we do not believe we have sufficient data to justify a longer projection period at this time. As of December 31, 2014, the estimated liability and estimated insurance recovery for the ten-year period through 2024 was $56.5 million and $53.0 million, respectively. Given the inherent uncertainty in making future projections, we plan to have the projections of current and future asbestos claims periodically re-examined, and we will update them further if needed based on our experience, changes in the underlying assumptions that formed the basis for NERA's and Marsh's models, and other relevant factors, such as changes in the tort system. There can be no assurance that our accrued asbestos liabilities will approximate our actual asbestos-related settlement and defense costs, or that our accrued insurance recoveries will be realized. We believe that it is reasonably possible that we will incur additional charges for our asbestos liabilities and defense costs in the future, which could exceed existing reserves, but cannot reasonably estimate such excess amounts at this time. Legal Contingencies From time to time we are a defendant in legal matters, including those involving environmental law and product liability (as discussed in more detail above). As required by U.S. GAAP, we determine whether an amount with respect to a loss contingency should be accrued by assessing whether a loss is deemed probable and the amount can be reasonably estimated. Separately, we would analyze any potential insurance proceeds that would be available to offset the claim amounts. Estimates of potential outcomes of these contingencies are developed in consultation with internal and external counsel. While this assessment is based upon all available information, litigation is inherently uncertain and the ultimate outcome of such litigation could be more or less than original estimates. Final resolution of such matters could materially affect our results of operations, cash flows and financial position. Pension and Other Postretirement Benefits We provide various defined benefit pension plans for our U.S. employees and sponsor three defined benefit health care plans and a life insurance plan. The costs and obligations associated with these plans are dependent upon various actuarial assumptions used in calculating such amounts. These assumptions include discount rates, long-term rates of return on plan assets, mortality rates, and other factors. The assumptions used were determined as follows: (i) the discount rate used is based on the PruCurve high quality corporate bond index, with comparisons against other similar indices; and (ii) the long-term rate of return on plan assets is determined based on historical portfolio results, market conditions and our expectations of future returns. We determine these assumptions based on consultation with outside actuaries and investment advisors. Any changes in these assumptions could have a significant impact on future recognized pension costs, assets and liabilities. The rates used to determine our costs and obligations under our pension and postretirement plans are disclosed in Note 9 of the Consolidated Financial Statements of this Form 10-K. Each assumption has different sensitivity characteristics. For the year ended December 31, 2014, a 25 basis point decrease in the discount rate would have increased our total pension expense by approximately $47,500. This number represents the aggregate increase in expense for the three pension plans: Employees' Pension Plan, Defined Benefit Pension Plan and the Restoration Plan. A 25 basis point decrease in the discount rate would increase the other post-employment benefits (OPEB) expense by about $8,200. A 25 basis point decrease in the expected return on assets would increase the total 2014 pension expense approximately $0.4 million. This number represents the aggregate increase in the expense for the two qualified pension plans. Since the OPEB and non-qualified plans are unfunded, those plans would not be impacted by this assumption change. Income Taxes We are subject to income taxes in the U.S. and in numerous foreign jurisdictions. We consider the undistributed earnings as of December 31, 2014 of substantially all of our foreign subsidiaries to be indefinitely reinvested and, accordingly, no U.S. income taxes have been provided thereon. If circumstances change and it becomes apparent that some, or all of the undistributed earnings as of December 31, 2014 will not be indefinitely reinvested, the provision for the tax consequences, if any, will be recorded in the period when circumstances change. Distributions out of current and future earnings are permissible to fund discretionary activities such as business acquisitions. However, when distributions are made, this could result in a higher effective tax rate. We have provided for potential liabilities due in various jurisdictions. In the ordinary course of global business, there are many transactions and calculations where the ultimate tax outcome is uncertain. Some of these uncertainties arise as a consequence of cost reimbursement arrangements among related entities. Although we believe our estimates are reasonable, no assurance can be given that the final tax outcome of these matters will not be different than that which is reflected in the historical income tax provisions and accruals. Such differences could have a material impact on our income tax provision and operating results in the period in which such determination is made. Deferred income taxes are determined based on the estimated future tax effects differences between the financial statement carrying amounts and the tax bases of existing assets and liabilities. Deferred tax assets are recognized to the extent that realization of those assets is considered to be more likely than not. A valuation allowance is established for deferred taxes when it is more likely than not that all or a portion of the deferred tax assets will not be realized. We record benefits for uncertain tax positions based on an assessment of whether it is more likely than not that the tax positions will be sustained by the taxing authorities. If this threshold is not met, no tax benefit of the uncertain position is recognized. If the threshold is met, we recognize the largest amount of the tax benefit that is more than 50 percent likely to be realized upon ultimate settlement with the related tax authority. We recognize interest and penalties related to unrecognized tax benefits within the income tax expense line in the accompanying consolidated statements of income (loss). Accrued interest and penalties are included within the related tax liability line in the consolidated statements of financial position. Stock-Based Compensation Stock-based compensation expense associated with stock options, time-based and performance-based restricted stock grants, deferred stock units, and related awards is recognized in the consolidated statements of income (loss). Determining the amount of stock-based compensation expense to be recorded requires us to develop estimates to be used in calculating the grant-date fair value of stock options. • Stock Options Historically, we have used stock options as part of our overall compensation plan for key employees. In recent years, we have not issued stock options and have shifted our equity award program towards time and performance based restricted stock awards. To value stock options, we calculate the grant-date fair values using the Black-Scholes valuation model. The use of valuation models requires us to make estimates for the following assumptions: Expected volatility - In determining expected volatility, we consider a number of factors, including historical volatility and implied volatility. Expected term - We use historical employee exercise data to estimate the expected term assumption for the Black-Scholes valuation model. Risk-free interest rate - We use the yield on zero-coupon U.S. Treasury securities for a period commensurate with the expected term assumption as the risk-free interest rate. Expected dividend yield - We do not currently pay dividends on our common stock; therefore, a dividend yield of 0% was used in the Black-Scholes model. The amount of stock-based compensation expense recognized during a period is based on the value of the portion of the awards that are ultimately expected to vest. Forfeitures are estimated at the time of grant and revised, if necessary, in subsequent periods if actual forfeitures differ from those estimates. The term “forfeitures” is distinct from “cancellations” or “expirations” and represents only the unvested portion of the surrendered option. Based on an analysis of our historical forfeitures, we have applied an annual forfeiture rate of 3% to all unvested stock-based awards as of December 31, 2014. The rate of 3% represents the portion that is expected to be forfeited each year over the vesting period. This analysis is re-evaluated annually and the forfeiture rate is adjusted as necessary. Ultimately, the actual expense recognized over the vesting period will only be for those awards that vest. • Performance-Based Restricted Stock In 2006, we began granting performance-based restricted stock awards to certain key executives. We currently have awards from 2012, 2013 and 2014 outstanding. These awards cliff vest at the end of a 3 year measurement period, except for 2012 awards to those individuals who are retirement eligible during the grant period, as such awards are subject to accelerated vesting as the grant is earned over the course of the vesting period (i.e. a pro-rata payout occurs based on the retirement date). Participants are eligible to be awarded shares ranging from 0% to 200% of the original award amount, based on certain defined performance measures. Compensation expense is recognized using the straight line method over the vesting period, unless the employee has an accelerated vesting schedule. The 2012 awards have three measurement criteria on which the final payout of the award is based - (i) the three year compounded annual growth rate (CAGR) of net sales, (ii) the three year CAGR of diluted earnings per share, and (iii) the three year average of each year's free cash flow as a percentage of net sales. In accordance with the applicable accounting literature, these measures are treated as performance conditions. The fair value of these awards is determined based on the market value of the underlying stock price at the grant date with cumulative compensation expense recognized to date being increased or decreased based on changes in the forecasted pay out percentages at the end of each reporting period. The 2013 and 2014 awards have two measurement criteria on which the final payout of the award is based - (i) the three year return on invested capital (ROIC) compared to that of a specified group of peer companies, and (ii) the three year total shareholder return (TSR) on the performance of our common stock as compared to that of a specified group of peer companies. In accordance with the applicable accounting literature, the ROIC portion of the award is considered a performance condition. As such, the fair value of the ROIC portion is determined based on the market value of the underlying stock price at the grant date with cumulative compensation expense recognized to date being increased or decreased based on changes in the forecasted pay out percentage at the end of each reporting period. The TSR portion of the awards is considered a market condition. As such, the fair value of these awards was determined on the date of grant using a Monte Carlo simulation valuation model with related compensation expense fixed on the grant date and expensed on a straight-line basis over the life of the awards that ultimately vest with no changes for the final projected payout of the award. The assumptions used in the Monte Carlo are as follows: Expected volatility - In determining expected volatility, we have considered a number of factors, including historical volatility. Expected term - We use the vesting period of the award to determine the expected term assumption for the Monte Carlo simulation valuation model. Risk-free interest rate - We use an implied "spot rate" yield on U.S. Treasury Constant Maturity rates as of the grant date for our assumption of the risk-free interest rate. Expected dividend yield - We do not currently pay dividends on our common stock; therefore, a dividend yield of 0% was used in the Monte Carlo simulation valuation model. • Time-Based Restricted Stock In 2011, we began granting time-based restricted stock awards to certain key executives and other key members of the Company’s management team. We currently have grants from 2011, 2012, 2013 and 2014 outstanding. The majority of the 2011 and 2012 grants cliff vest at the end of the three year vesting period. The majority of the 2013 and 2014 grants ratably vest on the first, second and third anniversaries of the original grant date. We recognize compensation expense on all of these awards on a straight-line basis over the vesting period. The fair value of the award is determined based on the market value of the underlying stock price at the grant date. • Deferred Stock Units We grant deferred stock units to non-management directors. These awards are fully vested on the date of grant and the related shares are generally issued on the 13th month anniversary of the grant date unless the individual elects to defer the receipt of these shares. Each deferred stock unit results in the issuance of one share of Rogers’ stock. The grant of deferred stock units is typically done annually in the second quarter of each year. The fair value of the award is determined based on the market value of the underlying stock price at the grant date.

<s>[INST] In the following discussion and analysis, we sometimes provide financial information that was not prepared in accordance with U.S. generally accepted accounting principles (GAAP). Management believes that this nonGAAP information provides meaningful supplemental information regarding the Company's performance by excluding certain expenses that are generally nonrecurring or otherwise may not be indicative of the core business operating results. In general, the Company believes that the additional nonGAAP financial information provided herein is useful to management and investors in assessing the Company's historical performance and for planning, forecasting and analyzing future periods. However, nonGAAP information has limitations as an analytical tool and should not be considered in isolation from, or solely as an alternative to, financial information prepared in accordance with GAAP. Any time we provide nonGAAP information in the following narrative we identify it as such and in close proximity provide the most directly comparable GAAP financial measure, as well as the information necessary to reconcile the two measures. Forward Looking Statements Certain statements in this Form 10K may constitute “forwardlooking statements” within the meaning of the Private Securities Litigation Reform Act of 1995. Such forwardlooking statements are based on management's expectations, estimates, projections and assumptions. Words such as “expects,” “anticipates,” “intends,” “believes,” “estimates,” “should,” “target,” “may,” “project,” “guidance,” and variations of such words and similar expressions are intended to identify such forwardlooking statements. Such forwardlooking statements involve known and unknown risks, uncertainties, and other factors that may cause our actual results or performance to be materially different from any future results or performance expressed or implied by such forwardlooking statements. Such factors include, but are not limited to, changing business, economic, and political conditions both in the United States and in foreign countries, particularly in light of the uncertain outlook for global economic growth, particularly in several of our key markets; increasing competition; any difficulties in integrating acquired businesses into our operations and the possibility that anticipated benefits of acquisitions and divestitures may not materialize as expected; delays or problems in completing planned operational enhancements to various facilities; our achieving less than anticipated benefits and/or incurring greater than anticipated costs relating to streamlining initiatives or that such initiatives may be delayed or not fully implemented due to operational, legal or other challenges; changes in product mix; the possibility that changes in technology or market requirements will reduce the demand for our products; the possibility of significant declines in our backlog; the possibility of breaches of our information technology infrastructure; the development and marketing of new products and manufacturing processes and the inherent risks associated with such efforts and the ability to identify and enter new markets; the outcome of current and future litigation; our ability to retain key personnel; our ability to adequately protect our proprietary rights; the possibility of adverse effects resulting from the expiration of issued patents; the possibility that we may be required to recognize impairment charges against goodwill, nonamortizable assets and other investments in the future; the possibility of increasing levels of excess and obsolete inventory; increases in our employee benefit costs could reduce our profitability; the possibility of work stoppages, union and work council campaigns, labor disputes and adverse effects related to changes in labor laws; the accuracy of our analysis of our potential asbestosrelated exposure and insurance coverage; the fact that our stock price has historically been volatile and may not be indicative of future prices; changes in the availability and cost and quality of raw materials, labor, transportation and utilities; changes in environmental and other governmental regulation which could increase expenses and affect operating results; our ability to accurately predict reserve levels; our ability to obtain favorable credit terms with our customers and collect accounts receivable; our ability to service our debt; certain covenants in our debt documents could adversely restrict our financial and operating flexibility; fluctuations in foreign currency exchange rates; and changes in tax rates and exposure which may increase our tax liabilities. Such factors also apply to our joint ventures. We make no commitment to update any forwardlooking statement or to disclose any facts, events, or circumstances after the date hereof that may affect the accuracy of any forwardlooking statements, unless required by law. Additional information about certain factors that could cause actual results to differ from such forwardlooking statements include, but are not limited to, those items described in Item 1A, Risk Factors [/INST] Negative. </s>

ROGERS CORP

2016-02-23

2015-12-31

Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations The following discussion and analysis of our financial condition and results of operations should be read together with the Selected Financial Data and our Consolidated Financial Statements and the related notes that appear elsewhere in this Form 10-K. In the following discussion and analysis, we sometimes provide financial information that was not prepared in accordance with U.S. generally accepted accounting principles (GAAP). Management believes that this non-GAAP information provides meaningful supplemental information regarding the Company's performance by excluding certain expenses that are generally non-recurring or otherwise may not be indicative of the core business operating results. In general, the Company believes that the additional non-GAAP financial information provided herein is useful to management and investors in assessing the Company's historical performance and for planning, forecasting and analyzing future periods. However, non-GAAP information has limitations as an analytical tool and should not be considered in isolation from, or solely as an alternative to, financial information prepared in accordance with GAAP. Any time we provide non-GAAP information in the following narrative we identify it as such and in close proximity provide the most directly comparable GAAP financial measure, as well as the information necessary to reconcile the two measures. Business Overview Rogers Corporation designs, develops, manufactures and sells high-quality and high-reliability engineered materials and components for mission critical applications. We operate principally three strategic business segments: Advanced Connectivity Solutions (ACS), Elastomeric Material Solutions (EMS) and Power Electronics Solutions (PES). We have a history of innovation and have established two Rogers Innovation Centers for our leading research and development activities, in Massachusetts and China. Our growth strategy is based upon the following principles: (1) market-driven organization, (2) innovation leadership, (3) synergistic mergers and acquisitions, and (4) operational excellence. As a market-driven organization, we are focused on three megatrends of expanding business opportunities: Internet Connectivity, Clean Energy and Safety & Protection. During 2015, we added the Safety & Protection megatrend in place of Mass Transit in response to the increase in demand for advanced driver assistance systems and growth in products focused on consumer impact protection, passenger safety and vibration management and flexible heater insulation. In January 2015, we completed the acquisition of Arlon LLC and its subsidiaries, other than Arlon India (Pvt) Limited (the acquired subsidiaries, collectively, Arlon), for an aggregate purchase price of approximately $157 million. Arlon manufactures high performance materials for the printed circuit board industry and silicone rubber-based materials. The acquisition of Arlon and its subsequent integration into our business segments have enabled us to increase scale and complement our existing product offerings, thus enhancing our ability to support our customers. The Arlon polyimide and thermoset laminate business, which was not integrated, was sold in December 2015. 2015 Executive Summary In 2015 as compared to 2014, our revenue increased 5.0% to $641.4 million, gross margin decreased 170 bps to 36.7%, and operating income decreased 6.1% to $76.3 million. The following key factors should be considered when reviewing our results of operations, financial condition and liquidity for the periods discussed: • Our revenue growth in 2015 was attributable primarily to our newly-acquired Arlon operations. The increase in net sales in 2015 was composed of an organic sales decrease of 6.9%, negative currency impact of 4.5%, offset by acquisition related growth of 16.4%. We believe our revenue decline is associated with the uncertain macro-economic conditions in China and Europe as well as the U.S. This situation has resulted in the delay of several key projects within the markets that we participate in, leading to weaker demand in certain applications across all three business segments. We expect to see a moderate recovery in sales going forward however we remain cautious as to the exact timing of the recovery. • Our operating income declined due to a variety of factors in 2015. We achieved $76.3 million in operating income during 2015, a 6.1% decline over the $81.2 million achieved in 2014. Operating results in 2015 and 2014 included approximately $11.2 million and $7.7 million of special charges, respectively. Contributing to the decline in operating income was the decline in gross margin. Gross margin declined due to the lower organic sales and the lower gross margin from the Arlon business; however, this decline was partially mitigated through operational excellence initiatives across our business units. Gross margin was 36.7% in 2015 as compared to 38.4% in 2014. • We are an innovation company and in 2015 spent approximately 4.3% of our revenues on research and development, an increase from 3.7% in 2014. Research and development (R&D) expenses were $27.6 million in 2015, an increase of 20.8%, from $22.9 million in 2014. The increased spending was due to increased investments that are targeted at developing new platforms and technologies, as evidenced by the recent creation of the Rogers Innovation Centers in Massachusetts and in Asia. Since 2013, we have made concerted efforts to realign our R&D organization to better fit the future direction of our Company, including dedicating resources to focus on current product extensions and enhancements to meet our short term technology needs. • We completed $40.0 million in share repurchases in 2015. These repurchases were part of a $100 million share repurchase program announced in August 2015. The repurchases were made at an average price of $54.97 per share. We initiated this program to mitigate potentially dilutive effects of stock options and shares of restricted stock granted by the Company, in addition to enhancing shareholder value. Further share repurchases under the program will be subject to management’s consideration of cash availability, including cash generation, as well as potential cash uses, including capital spending and other investments, and potential acquisitions. • We closed on the acquisition of Arlon in January of 2015. The Arlon business has been fully integrated into the ACS and EMS businesses, and contributed approximately $100.0 million in sales in 2015. Results of Continuing Operations The following table sets forth, for the periods indicated, selected operations data expressed as a percentage of net sales. 2015 vs. 2014 Net Sales Net sales increased by 5.0% in 2015 from 2014. The increase in net sales in 2015 was composed of an organic sales decrease of 6.9% and a negative currency impact of 4.5%, offset by Arlon acquisition related growth of 16.4%. The decline in organic sales was the result of a decline in all operating segments. The Advanced Connectivity Solutions (ACS) operating segment net sales increased 11.1%: organic sales decline of 11.4% and negative currency impact of 1.3%, which partially offset acquisition growth of 23.8%. The Elastomeric Material Solutions (EMS) operating segment net sales increased 4.2%: organic sales decline of 7.9% and negative currency impact of 1.8%, which partially offset acquisition growth of 13.8%. The Power Electronics Solutions (PES) operating segment net sales declined 12.5%: organic sales decline of 0.5% combined with a negative currency impact of 12.0%. See “Segment Sales and Operations” below for further discussion on segment performance. Gross Margin Gross margin as a percentage of net sales declined by 170 basis points to 36.7% in 2015 compared to 38.4% in 2014. Our 2015 results included approximately $1.8 million of purchase accounting related to the Arlon acquisition, of which, $1.6 million was the non-recurring fair value adjustment for inventory. The year over year decline was primarily the result of lower organic net sales and lower gross margin contribution related to the Arlon business. This was partially offset by improvements in supply chain, product quality and procurement, which favorably impacted margin performance. Selling, General and Administrative Expenses Selling, general and administrative (SG&A) expenses increased by 5.0% in 2015 compared with 2014. Our 2015 results included approximately $9.6 million of special charges comprised of $1.6 million of severance related charges, $4.8 million in integration expenses related to the Arlon acquisition and $3.2 million related to the establishment of an environmental reserve. Our 2014 results included approximately $2.3 million of acquisition costs. Excluding these special charges, SG&A expense decreased $1.1 million and as a percentage of sales, decreased by 110 basis points from 20.1% in 2014 to 19.0% in 2015. The decrease in expenses, excluding special charges, is due to a variety of factors, including $12.0 million of lower incentive and equity compensation costs, $1.1 million of lower costs related to asbestos related liabilities, $1.0 million of lower severance and lower operational spending and other discrete items incurred in 2014 of $2.2 million. Partially offsetting these amounts are increases in expenses due to a variety of factors, including $13.5 million of SG&A expenses related to the Arlon business (including $5.8 million of intangible amortization associated with the acquisition) and $1.8 million of defined benefit pension and retirement plan costs. Research and Development Expenses Research and development (R&D) expenses increased by 20.8% in 2015 compared with 2014. As a percentage of sales, R&D costs increased from 3.7% in 2014 to 4.3% in 2015. The overall increase is due to $1.8 million of expenses related to the Arlon business as well as an increase in investments that are targeted at developing new platforms and technologies focused on long term growth initiatives at our innovation centers in the U.S. and Asia. Equity Income in Unconsolidated Joint Ventures Equity income in unconsolidated joint ventures declined approximately 29.9% in 2015 from 2014. The decrease was due to lower demand, product mix and unfavorable currency exchange rate shifts. Interest Income (Expense), Net Interest income (expense), net, was higher expense by 52.1% in 2015 from 2014. The increase year over year was driven by the increase in long term debt associated with the Arlon acquisition, which occurred in January of 2015. Other Income (Expense), Net Other income (expense), net was higher expense of $7.3 million from 2014 to 2015. Our 2015 results included approximately $7.2 million of special charges comprised of $4.8 million of a loss on the sale of the Arlon specialty polyimide and epoxy-based laminates business and $2.4 million of receivables related to the tax indemnities that were reversed, which related to the release of uncertain tax positions. Income Tax Expense In 2015, the difference between the our effective tax rate and the statutory federal tax rate was favorably impacted by taxable income generated in countries with a lower tax rate to that of the United States, research and development credits, a tax benefit related to a change in the effective state rate and release of valuation allowance on certain state tax attributes. The rate was unfavorably impacted by reserves for uncertain tax positions, change to prior estimates and nondeductible expenses. The rate decreased from 2014 primarily due to a reduction in the level of repatriation of current foreign earnings, increased reversals of uncertain tax benefits and deferred state tax benefits due to the acquisition of Arlon, partially offset with a shift of earnings from low tax to high tax jurisdictions. Backlog Our backlog of firm orders was $63.3 million as of December 31, 2015, as compared to $77.0 million as of December 31, 2014. The decrease at the end of 2015 was primarily related to Power Electronics Solutions, Advanced Connectivity Solutions and our Other businesses, which experienced decreases in backlog of $7.3 million, $(9.1) million and , respectively. These declines were slightly offset by Elastomeric Material Solutions, which experienced an increase of $2.8 million in the backlog. Contributing to the year-over-year change in backlog were customer delivery improvements, which reduced customer ordering cycles, combined with general market conditions. Additionally, the 2015 backlog contains $7.4 million related to the Arlon businesses. The backlog of firm orders is expected to be filled within the next 12 months. 2014 vs. 2013 Net Sales (Dollars in thousands) Percent Change Net Sales $ 610,911 $ 537,482 13.7% Net sales in 2014 increased 13.7% from 2013. The increase in net sales in 2014 was attributable to volume increases in all of our operating segments. Net sales in the Advanced Connectivity Solutions (ACS) operating segment experienced a 30.2% increase from $184.9 million in 2013 to $240.9 million in 2014, the Power Electronics Solutions (PES) operating segment achieved a 6.9% increase from $160.7 million in 2013 to $171.8 million in 2014, and the Elastomeric Material Solutions (EMS) operating segment increased 3.3% from $168.1 million in 2013 to $173.7 million in 2014. See “Segment Sales and Operations” below for further discussion on segment performance. Gross Margin Gross margin increased by approximately 330 basis points from 35.1% in 2013 to 38.4% in 2014. Our 2013 results included approximately $0.9 million or 20 basis points of special charges related to relocation costs associated with the move of certain manufacturing operations from the Power Electronics Solutions manufacturing facility in Eschenbach, Germany to a lower cost facility in Hungary. The primary driver of the improvement in gross margin was the increased sales volume achieved during 2014, which contributed approximately 180 basis points to the improvement. The remaining net improvement of 150 basis points was attributable primarily to our ability to leverage our existing asset base through production efficiencies to absorb the increased sales volume. Selling, General and Administrative Expenses Selling, general and administrative (SG&A) expenses in 2014 increased 17.7% from 2013. Our 2014 results included approximately $2.3 million of acquisition costs. Our 2013 results included approximately $1.3 million of special charges comprised of $0.6 million in costs related to the move of certain manufacturing operations from the Power Electronic Solutions manufacturing facility is Eschenbach, Germany to a lower cost facility in Hungary and $0.7 million of other severance related charges. Excluding these charges, SG&A expense increased $17.8 million. As a percentage of sales, SG&A expenses increased by 70 basis points from 19.8% in 2013 to 20.5% in 2014. The overall increase in expenses was due to a variety of factors, including $7.7 million of incremental incentive and equity compensation costs, $10.1 million for incremental expenditures in certain key strategic areas, such as sales and marketing, strategic planning, information technology and executive recruiting, as well as costs related to merit increases. Also contributing to the increased costs in 2014 were charges related to the CFO transition of $0.8 million, severance of $2.8 million, $1.3 million of incremental asbestos related liabilities and other cost increases of $2.1 million. These increases were offset by approximately $7.0 million in expense reductions related primarily to changes in our defined benefit pension plans initiated in 2013. Research and Development Expenses Research and development (R&D) expenses in 2014 increased 5.7%, from 2013. As a percentage of sales, R&D costs decreased from 4.0% in 2013 to 3.7% in 2014. The lower rate was due primarily to the significant increase in net sales. From a gross spending perspective, in the past year we have made concerted efforts to realign our R&D organization to better fit the future direction of the Company, including dedicating resources to focus on current product extensions and enhancements to meet our short term technology needs. We also increased investments that were targeted at developing new platforms and technologies focused on long term growth initiatives, as evidenced by our partnership with Northeastern University in Boston, Massachusetts. This partnership has resulted in the creation of the Rogers Innovation Center on its Burlington, Massachusetts campus. Restructuring and Impairment Charges Restructuring and impairment charges decreased 48.0% in 2014 from 2013. In 2014, these charges were comprised primarily of the following: (i) $5.2 million related to the settlement of certain long term pension obligations and (ii) $ 0.2 million related to an impairment charge on an investment in BrightVolt, Inc. (formerly Solicore, Inc.). In 2013, these charges were comprised primarily of the following: (i) $4.6 million related to the impairment charge on the investment in BrightVolt, Inc., (ii) $4.2 million of severance and related charges as a result of additional streamlining initiatives as well as changes to the executive management team, and (iii) a $1.5 million curtailment charge related to the freezing of the defined benefit pension plans. Equity Income in Unconsolidated Joint Ventures Equity income in unconsolidated joint ventures decreased 4.7% in 2014 from 2013. The decline was primarily due to the depreciation of the Japanese Yen against the U.S. dollar of approximately 8.6% year over year. Interest Income (Expense), Net Interest income (expense), net, declined by 15.4% in 2014 from 2013. The decline was due primarily to lower interest expense on our debt facility, as we paid down principal from $98.0 million at the end of 2013 to $60.0 million at the end of 2014 Other Income (Expense), Net Other income (expense), net remained consistent in 2014 from 2013. Although the ending balance was the same year over year, there were changes in the activity. Our 2014 results included unfavorable commodity hedging transactions offset by lower commission payments to the joint ventures. Our 2013 results included approximately $0.7 million of unfavorable mark to market adjustments related to copper hedging contracts and approximately $0.3 million related to unfavorable foreign currency transaction adjustments. Income Tax Expense In 2014, the difference between the our effective tax rate and the statutory federal tax rate was favorably impacted by taxable income generated in countries with a lower tax rate to that of the United States and research and development credits. The rate was unfavorably impacted by reserves for uncertain tax positions, distributions of current year earnings from our foreign subsidiaries as well as nondeductible acquisition costs. The rate increased from 2013 primarily due to an increased level of repatriation of current foreign earnings which was done to facilitate the Arlon acquisition, mix of earnings, lower reversals of uncertain tax benefits and nondeductible acquisition costs. Backlog The backlog of firm orders was $77.0 million at December 31, 2014, as compared to $50.5 million at December 31, 2013. The increase at the end of 2014 was primarily related to the Power Electronics Solutions and Advanced Connectivity Solutions operating segments, which experienced an increase in backlog of $8.3 million and $18.9 million, respectively, at December 31, 2014 as compared to December 31, 2013. Segment Sales and Operations Core Strategic Advanced Connectivity Solutions The Advanced Connectivity Solutions (ACS) operating segment is comprised of high frequency circuit material products used for making circuitry that receives, processes and transmits high frequency communications signals, in a wide variety of markets and applications, including wireless communications, high reliability, and automotive, among others. 2015 vs. 2014 Net sales in this segment increased by 11.1% in 2015. Organic sales declined 11.4%, currency fluctuations decreased net sales by 1.3% and the acquisition of Arlon added 23.8% net sales growth as compared to the same period in the prior year. The year over year increase in net sales, including the acquisition, was driven by an increase in automotive radar applications for Advanced Drive Assistance Systems (33.4%) and aerospace and defense applications (54.4%) and the wireless telecom market (1.5%). These increases were partially offset by weaker demand in 4G LTE base stations, primarily in China (-25%). Operating income improved by 2.5% in 2015. As a percentage of net sales, operating income in 2015 was 16.9%, a 140 basis point decline as compared to the 18.3% reported in 2014. Our 2015 operating income included approximately $5.3 million of special charges comprised of $2.6 million of integration expenses related to the Arlon acquisition, $1.0 million of Arlon purchase accounting expenses related to the non-recurring fair value adjustment for inventory, a $1.4 million environmental charge and $0.4 million of severance related charges. Our 2014 operating income included approximately $2.9 million of special charges comprised of $1.9 million from the early payment of certain long term pension obligations, $0.9 million related to acquisition costs and $0.1 million related to the impairment of the BrightVolt investment (formerly Solicore). As a percentage of sales, excluding the 2015 and 2014 special charges, 2015 operating income was 18.8%, a 70 basis point decline as compared to the 19.5% achieved in 2014. This decline is primarily due to the lower organic net sales partially offset by the addition of the operating income from the acquisition, combined with favorable results from the continuous efforts targeted at manufacturing efficiency improvements and favorable inventory absorption. 2014 vs. 2013 Net sales in this segment increased 30.2% in 2014. The increase in net sales was due primarily to a 52.9% increase in orders for high frequency circuit materials to support wireless base station and antenna applications in connection with the global 4G/LTE infrastructure build-out, particularly in China. Further, demand in automotive safety radar applications for Advanced Driver Assistance Systems increased by 37.7% year over year as auto manufacturers continue to adopt this safety feature into their designs. These increases were partially offset by a 15.9% decline in net sales for certain applications in handheld devices for improved internet connectivity. Operating income improved by 130.4% in 2014. As a percentage of net sales, operating income for 2014 was 18.3%, an increase from 10.3% in 2013. 2014 operating income includes approximately $2.9 million of special charges comprised of $1.9 million from the early payment of certain long term pension obligations, $0.9 million related to acquisition costs and $0.1 million related to the impairment of the BrightVolt investment. Our 2013 operating income included approximately $2.8 million of special charges comprised primarily of $1.0 million in severance charges and $1.6 million allocation related to the impairment of the BrightVolt investment. Excluding these charges, operating income increased by 114.2% from $21.9 million in 2013 to $46.9 million in 2014. As a percentage of sales, excluding the 2014 and 2013 special charges, 2014 operating income was 19.5%, a 920 basis point improvement as compared to the 10.3% achieved in 2013. This increase was due primarily to the increase in net sales as we were able to achieve this growth by utilizing our existing manufacturing capacity. Results were also favorably impacted by the continuous efforts targeted at manufacturing efficiency improvements. This increase was partially offset by $6.9 million of higher allocated SG&A expenses in 2014 compared to 2013. Elastomeric Material Solutions The Elastomeric Material Solutions (EMS) operating segment is comprised of polyurethane and silicone foam products, which are sold into a wide variety of markets for various applications such as general industrial, portable electronics, consumer and transportation markets for gasketing, sealing, and cushioning applications. 2015 vs. 2014 Net sales in this segment increased by 4.2% in 2015. Organic sales declined 7.9%, currency fluctuations decreased net sales by 1.8% and the acquisition of Arlon added 13.8% of sales growth as compared to the prior year. The increase in net sales, including the acquisition, was driven by increased demand in mass transit (26.2%) and general industrial (26.1%) applications. Offsetting these increases, this operating segment experienced a decline in net sales into the portable electronics segment (mobile internet devices and feature phone applications) (-22.7%) and consumer applications (-11.0%). Operating income declined by 14.4% in 2015. As a percentage of net sales, the 2015 operating income was 11.0%, a 240 basis point decline as compared to the 13.4% reported in 2014. Our 2015 operating income includes approximately $3.2 million of special charges comprised of $1.6 million of integration expenses related to the Arlon acquisition, $0.5 million of Arlon purchase accounting expenses related to the non-recurring fair value adjustment for inventory, a $0.8 million environmental charge and $0.3 million of severance related charges. Our 2014 operating income includes approximately $2.0 million of special charges comprised of $1.3 million for the early payment of certain long term pension obligations and $0.6 million of acquisition costs. As a percentage of net sales, excluding the 2015 and 2014 special charges, 2015 operating income was 12.8%, a 180 basis point decline as compared to the 14.6% achieved in 2014. This decline is primarily due to the lower organic net sales partially offset by the addition of the operating income from the acquisition. 2014 vs. 2013 Net sales increased by 3.3% in 2014. This increase in net sales was driven primarily due to higher demand in general industrial (5.5%), battery applications for hybrid electric vehicles (67.4%), consumer comfort and impact protection (13.4%), and mass transit (12.3%). Elastomeric Material Solutions demand into the portable electronics (mobile internet devices and feature phones) applications was down 9.2% year over year. Operating income increased by 3.1% in 2014. As a percentage of net sales, operating income for both 2014 and 2013 was 13.4%. Our 2014 operating income includes approximately $2.0 million of special charges comprised of $1.3 million for the early payment of certain long term pension obligations and $0.6 million of acquisition costs. Our 2013 results included approximately $3.3 million of special charges comprised primarily of $1.5 million in severance charges and a $1.6 million allocation related to the impairment of the BrightVolt investment. Excluding these items, operating income declined by 2.7% from $26.0 million in 2013 to $25.3 million in 2014. As a percentage of net sales, excluding the 2014 and 2013 special charges, 2014 operating income was 14.6%, a 90 basis point decline as compared to the 15.5% achieved in 2013. This decline is primarily attributable to the increase of $4.7 million in allocated selling, general and administrative expenses incurred during 2014 and was partially offset by increased operating profit due to increased net sales. Power Electronics Solutions The Power Electronics Solutions (PES) operating segment is comprised of two product lines - curamik® direct-bonded copper (DBC) substrates that are used primarily in the design of intelligent power management devices, such as IGBT (insulated gate bipolar transistor) modules that enable a wide range of products including highly efficient industrial motor drives, wind and solar energy converters and electrical systems in automobiles, and RO-LINX® busbars that are used primarily in power distribution systems products in mass transit and clean technology applications. 2015 vs. 2014 Net sales in this segment decreased by 12.5% in 2015. Organic net sales declined 0.5% as compared to 2014. Net sales were unfavorably impacted by 12.0% due to currency fluctuations. The net sales decline was impacted by weaker demand in variable frequency motor drives (-19.1%), vehicle electrification (x-by-wire) (-25.2%) and certain renewable energy applications (-21.8%). These declines were partially offset by an increase in demand in electric vehicle applications (41.5%) and laser diode applications (11.5%). Operating income declined by 33.7% in 2015. As a percentage of net sales, the 2015 operating income was 2.5%, a 80 basis point decline as compared to the 3.3% reported in 2014. Our 2015 operating income included approximately $2.0 million of special charges comprised of $1.1 million of an environmental charge and $0.9 million of severance related charges. Our 2014 operating income includes approximately $2.8 million of special charges comprised of $1.9 million for the early payment of certain long term pension obligations and $0.9 million of acquisition costs. As a percentage of net sales, excluding the 2015 and 2014 special charges, 2015 operating income was 3.8%, a 110 basis point decline as compared to the 4.9% achieved in 2014. This decrease was due to the lower organic net sales as well as the unfavorable foreign currency exchange impact. 2014 vs. 2013 Net sales increased by 6.9% in 2014. This increase in net sales was led by an increase in demand in mass transit (14.9%), energy efficient motor control applications (16.2%) and vehicle electrification (x-by-wire) applications (26.8%). These increases more than offset weaker demand in laser diode (15.1%) and certain renewable energy applications (8.2%). Operating income increased by 338.5% in 2014. As a percentage of net sales, operating income in 2014 was 3.3%, an increase from 1.0% in 2013. Our 2014 operating income includes approximately $2.8 million of special charges comprised of $1.9 million of the early payment of certain long term pension obligations and $0.9 million of acquisition costs. Our 2013 results included approximately $6.1 million of special charges comprised primarily of $3.8 million of severance related charges, a $1.2 million allocation related to the impairment of the SG&A investment, and $1.1 million related to the start-up of inspecting operations in Hungary. Excluding these items, operating income improved by 14.9% from $7.4 million in 2013 to $8.5 million in 2014. This improvement was the result of sales volume increases achieved in this operating segment and manufacturing efficiency improvements, partially offset by an increase of $7.6 million of higher allocated selling, general and administrative expenses incurred in 2014. Other Our Other businesses consist of our elastomer rollers and float products, as well as the inverter distribution operations. Additionally, the Arlon acquisition added a business to this segment that manufactured specialty polyimide and epoxy-based laminates and bonding materials, which was sold in December 2015. 2015 vs 2014 Net sales increased by 73.7% in 2015. The acquisition of Arlon added 76.0% sales growth as compared to the same period in the prior year. Net sales were unfavorably impacted primarily by 2.2% due to currency fluctuations. Operating income decreased 10.0% in 2015. The decline is comprised of lower operating profit of $0.6 million due to lower organic sales volume, $0.6 million of integration expenses related to the Arlon acquisition, offset by the performance of the specialty polyimide and epoxy-based laminates and bonding materials business. 2014 vs 2013 Net sales increased by 3.5% in 2014. The increase in net sales was due primarily to stronger demand for elastomer rollers and floats products, which increased 3.5% year over year. There was also stronger demand for inverters, which increased 3.0% year over year. Operating results improved by 15.5% in 2014. Our 2013 results included approximately $0.4 million of special charges related primarily to this segment's allocated portion of severance charges and the BrightVolt impairment charge. The overall improvement in operating results in this segment was attributable primarily to the increase in volume and improved operational efficiencies. Joint Ventures Rogers INOAC Corporation (RIC) RIC, our joint venture with Japan-based INOAC Corporation, was established over 30 years ago and manufactures high performance PORON urethane foam materials in Japan. RIC's 2015 net sales decreased by approximately 13.5% from 2014 to 2015 and decreased by approximately 17.7% from 2013 to 2014. A portion of these decreases relates to the depreciation of the Japanese Yen against the U.S. dollar as the currency value significantly changed during these periods. Excluding the impact of the currency change, net sales declined year over year primarily due to the continued weakness in the Japanese domestic and export markets, particularly LCD TV's, domestic mobile phones and general industrial applications. Rogers INOAC Suzhou Corporation (RIS) RIS, our joint venture agreement with INOAC Corporation for the purpose of manufacturing PORON urethane foam materials in China, began operations in 2004. Net sales decreased by approximately 6.3% from 2014 to 2015 and increased approximately 2.3% from 2013 to 2014. The decrease from 2014 to 2015 was primarily related to declines in portable electronic devices. The increase from 2013 to 2014 was primarily related small market gains in mobile internet devices. Discontinued Operations In the second quarter of 2012, we decided to cease production of our non-woven composite materials operating segment located in Rogers, Connecticut. Manufacturing operations ceased by the end of 2012 and last sales out of inventory occurred in the first quarter of 2013. In 2013, operating income of $0.1 million, net of tax, was reflected as discontinued operations in the accompanying consolidated statements of operations, net sales were $0.2 million, and income tax related to the discontinued operation was $0.1 million. There was no impact from discontinued operations in 2014 or 2015. Product and Market Development Our research and development team is dedicated to growing our business by developing cost effective solutions that improve the performance of customers' products and by identifying business and technology acquisition opportunities to expand our market presence. Currently, R&D spend is approximately 4% of net sales. Liquidity, Capital Resources and Financial Position We believe our existing sources of liquidity and cash flows expected to be generated from operations, together with available credit facilities, will be sufficient to fund our operations, capital expenditures, research and development efforts, and debt service commitments, as well as our other operating and investing needs, for at least the next twelve months and, well into the foreseeable future. We continue to have access to the remaining portion of the line of credit available under the Amended Credit Agreement (as defined in the Credit Facilities section which follows), as evidenced by our purchase of Arlon, LLC in the first quarter of 2015, for which we drew down our line of credit for approximately $125.0 million. We continually review and evaluate the adequacy of our cash flows, borrowing facilities and banking relationships to ensure that we have the appropriate access to cash to fund both near-term operating needs and long-term strategic initiatives. At December 31, 2015, cash and cash equivalents were $204.6 million as compared to $237.4 million at the end of 2014, a decrease of $32.8 million, or approximately 13.8%. This decrease was due primarily to $33.4 million (net) being disbursed for the acquisition of Arlon, $40.0 million in share repurchases, $24.8 in capital expenditures, $7.7 million in a contribution to our defined benefit plans and $6.4 million in required debt payments, partially offset by strong cash generated from operations and the receipt of $7.0 million related to stock option exercises and $2.9 million of dividends from our joint ventures. The following table illustrates the location of our cash and cash equivalents by our three major geographic areas: U.S. income taxes have not been provided on $179.1 million of undistributed earnings of foreign subsidiaries since it is the Company’s intention to permanently reinvest such earnings or to distribute them only when it is tax efficient to do so. It is impracticable to estimate the total tax liability, if any, that would be created by the future distribution of these earnings. Net working capital was $350.0 million, $317.7 million and $293.6 million in 2015, 2014 and 2013, respectively. Significant changes in our balance sheet accounts from December 31, 2014 to December 31, 2015 were as follows: ◦ Goodwill increased $77.2 million or 78.6% from $98.2 million at December 31, 2014 to $175.4 million at December 31, 2015. This increase is primarily due to the acquisition of Arlon. There have been no impairments of goodwill during the year ended December 31, 2015. ◦ Other intangible assets increased $36.7 million or 95.8% from $38.3 million at December 31, 2014 to $75.0 million at December 31, 2015. This increase is primarily due to the acquisition of Arlon. There have been no impairments of Other intangible assets during the year ended December 31, 2015. ◦ Overall, our debt position increased by $118.6 million from $60.0 million at December 31, 2014 to $178.6 million at December 31, 2015 due to additional borrowings made to finance the acquisition of Arlon. ◦ Property, plant and equipment increased by $28.2 million or 18.8% from $150.4 million at December 31, 2014 to $178.6 million at December 31, 2015. The increase was primarily due to the acquisition of Arlon, which increased property, plant and equipment by $28.7 million. Contributing to the increase was capital expenditures of $24.8 million, which was substantially offset by depreciation expense of $20.1 million. During 2015, $180.3 million of net cash was used for investing activities as compared to $28.5 million in 2014 and $17.0 million in 2013. Investing activity for 2015 included the acquisition of Arlon, which used $158.4 million in investing cash. Capital expenditures were $24.8 million, $28.8 million and $16.9 million in 2015, 2014 and 2013, respectively. Net cash provided by financing activities was $83.0 million, $1.9 million and $10.7 million in 2015, 2014 and 2013, respectively. Financing activities in 2015 included borrowings of $125.0 million to finance the acquisition of Arlon, offset by $40.0 million of cash used for the share buyback program. Credit Facilities On June 18, 2015, we entered into a secured five year credit agreement (the "Amended Credit Agreement"). The Amended Credit Agreement amends and restates the credit agreement signed between the Company and the same banks on July 13, 2011 and increased our borrowing capacity from $265.0 million to $350.0 million, with an additional $50.0 million accordion feature. The Amended Credit Agreement provides (1) a $55.0 million term loan; (2) up to $295.0 million of revolving loans, with sublimits for multicurrency borrowings, letters of credit and swing-line notes; and (3) a $50.0 million expansion feature. Borrowings may be used to finance working capital needs, for letters of credit and for general corporate purposes in the ordinary course of business, including the financing of permitted acquisitions (as defined in the Amended Credit Agreement). Borrowings under the Amended Credit Agreement bear interest based on one of two options. Alternate base rate loans bear interest that includes a base reference rate plus a spread of 37.5 to 75.0 basis points, depending on our leverage ratio. The base reference rate is the greater of the prime rate; federal funds effective rate plus 50 basis points; or adjusted 1-month LIBOR plus 100 basis points. Euro-currency loans bear interest based on adjusted LIBOR plus a spread of 137.5 to 175.0 basis points, depending on our leverage ratio. In addition to interest payable on the principal amount of indebtedness outstanding from time to time under the Amended Credit Agreement, the Company is required to pay a quarterly fee of 0.20% to 0.30% (based upon our leverage ratio) of the unused amount of the lenders’ commitments under the Amended Credit Agreement. The Amended Credit Agreement contains customary representations, warranties, covenants, mandatory prepayments and events of default under which the Company's payment obligations may be accelerated. The financial covenants include requirements to maintain (1) a leverage ratio of no more than 3.25 to 1.00, subject to a one-time election to increase the maximum leverage ratio to 3.50 to 1.00 for one fiscal year in connection with a permitted acquisition, and (2) an interest coverage ratio ("ICR") of no less than 3.00 to 1.00. The ICR is the ratio determined as of the end of each of its fiscal quarters ending on and after September 30, 2015, of (i) Consolidated Earnings Before Interest, Taxes, Depreciation and Amortization (EBITDA) (as defined in the Amended Credit Agreement) minus the unfinanced portion of Consolidated Capital Expenditures to (ii) Consolidated Interest Expense paid in cash, in each case for the period of four consecutive fiscal quarters ending with the end of such fiscal quarter, all calculated for the Borrower and its subsidiaries on a consolidated basis. As of December 31, 2015, we were in compliance with all of the financial covenants in the Amended Credit Agreement, as we achieved actual ratios of approximately 1.47 to 1.00 on the leverage ratio and 23.82 to 1.00 on the ICR. The Amended Credit Agreement requires the mandatory quarterly repayment of principal on amounts borrowed under such term loan. Payments commenced on September 30, 2015, and are scheduled to be completed in June 2020. The aggregate mandatory principal payments due are as follows: All obligations under the Amended Credit Agreement are guaranteed by each of the Corporation’s existing and future material domestic subsidiaries, as defined in the Amended Credit Agreement (the “Guarantors”). The obligations are also secured by a Second Amended and Restated Pledge and Security Agreement, dated as of June 18, 2015, entered into by the Company and the Guarantors which grants to the administrative agent, for the benefit of the lenders, a security interest, subject to certain exceptions, in substantially all of the non-real estate assets of the Guarantors. All amounts borrowed or outstanding under the Amended Credit Agreement, with the exception of amounts borrowed under the term loan which are subject to quarterly principal payments, are due and mature on June 18, 2020, unless the commitments are terminated earlier either at the request of the Company or if certain events of default occur. In addition, as of December 31, 2015 we had a $1.2 million standby letter of credit (LOC) to guarantee Rogers workers compensation plans that were backed by the Amended Credit Agreement. No amounts were drawn on the LOC as of December 31, 2015 or 2014. The Amended Credit Agreement is secured by many of the assets of Rogers, including but not limited to, receivables, equipment, intellectual property, inventory, and stock in certain subsidiaries. Before entering into the Amended Credit Agreement, we had $0.5 million of remaining capitalized costs from the previous credit agreements. These costs will continue to be amortized over the life of the Amended Credit Agreement. In the second quarter of 2015, we capitalized an additional $1.8 million in connection with the Amended Credit Agreement. These costs will be amortized over the life of the Amended Credit Agreement, which will terminate in June 2020. We incurred amortization expense of $0.5 million in each of the years ended 2015, 2014 and 2013, respectively. At December 31, 2015, we have approximately $2.1 million of credit facility costs remaining to be amortized. We borrowed $125.0 million under the line of credit in the first quarter of 2015 to fund the acquisition of Arlon. During 2015 and 2014, we made principal payments of $6.4 million and $17.5 million, respectively, on the outstanding debt. The principal amount of this debt has been transferred to the new revolving credit line created in June of 2015. We are obligated to pay $3.4 million on this debt obligation in the next 12 months under the term loan. We incurred interest expense on our outstanding debt of $3.5 million, $1.8 million and $2.2 million for the years ended December 31, 2015, 2014 and 2013, respectively. We incurred an unused commitment fee of $0.3 million, $0.4 million and $0.5 million for the years ended December 31, 2015, 2014 and 2013, respectively. In July 2012, we entered into an interest rate swap to hedge the variable interest rate on our term loan debt. As of December 31, 2015, the remaining notional amount of the interest rate swap covers $16.2 million of our term loan debt and has a rate of 0.752%. At December 31, 2015, our outstanding debt balance is comprised of a term loan of $53.6 million and $125.0 million borrowed on the revolving line of credit. At December 31, 2015, the rate charged on this debt is the 1 month LIBOR at 0.4375% plus a spread of 1.500%. Capital Lease During the first quarter of 2011, we recorded a capital lease obligation related to the acquisition of Curamik for its primary manufacturing facility in Eschenbach, Germany. Under the terms of the leasing agreement, we had an option to purchase the property in either 2013 or upon the expiration of the lease in 2021 at a price which is the greater of (i) the then-current market value or (ii) the residual book value of the land including the buildings and installations thereon. We chose not to exercise the option to purchase the property that was available to us on June 30, 2013. The total obligation recorded for the lease as of December 31, 2015 and 2014 was $5.8 million and $6.8 million, respectively. Depreciation expense related to the capital lease was $0.3 million, $0.4 million and $0.4 million for the years ending December 31, 2015, 2014 and 2013, respectively. Accumulated depreciation as of December 31, 2015 and 2014 was $1.9 million and $1.6 million, respectively. These expenses are included as depreciation expense in Cost of Sales on our consolidated statements of operations. Interest expense related to the debt recorded on the capital lease is included in interest expense on the consolidated statements of operations. We also incurred interest expense on the capital lease of $0.4 million, $0.5 million and $0.5 million for the years ended December 31, 2015, 2014 and 2013, respectively. Cash paid for interest was $3.3 million, $2.5 million and $3.1 million for 2015, 2014 and 2013, respectively. Restriction on Payment of Dividends Pursuant to the Amended Credit Agreement, we cannot make a cash dividend payment if (i) a default or event of default has occurred and is continuing or will result from the cash dividend payment.We do not currently have any restrictions in our ability to pay dividends under our current, amended credit agreement, as no default of event of default has occurred. Contractual Obligations The following table summarizes our significant contractual obligations as of December 31, 2015: (1) Estimated future interest payments are based on (1) rates that range from 1.375% to 1.75%, which take into consideration projected forward 1 Month LIBOR and (2) a leverage-based spread. Unfunded pension benefit obligations, which amount to $11.4 million at December 31, 2015, are expected to be paid from operating cash flows and the timing of payments is not definitive. Retiree health and life insurance benefits, which amount to $2.7 million, are expected to be paid from operating cash flows. Other long-term liabilities, such as deferred taxes, unrecognized tax benefits and asbestos-related product liability reserves, have been excluded from the table due to the uncertainty of the timing of payments combined with the absence of historical trends to be used as a predictor for such payments. Effects of Inflation We do not believe that inflation had a material impact on our business, sales, or operating results during the periods presented. Off-Balance Sheet Arrangements We do not have any off-balance sheet arrangements that have, or are, in the opinion of management, reasonably likely to have, a current or future material effect on our financial condition or results of operations. Critical Accounting Policies Our Consolidated Financial Statements are prepared in accordance with U.S. generally accepted accounting principles, which require management to make estimates, judgments and assumptions that affect the amounts reported in the financial statements and accompanying notes. We base our estimates on historical experience and on various other assumptions that are believed to be reasonable under the circumstances and believe that appropriate reserves have been established based on reasonable methodologies and appropriate assumptions based on facts and circumstances that are known; however, actual results may differ from these estimates under different assumptions or conditions. An accounting policy is deemed to be critical if it requires an accounting estimate to be made based on assumptions that are highly judgmental and uncertain at the time the estimate is made, if different estimates could reasonably have been used, or if changes to those estimates are reasonably likely to periodically occur that could affect the amounts carried in the financial statements. These critical accounting policies are as follows: Revenue Recognition We recognize revenue when all of the following criteria are met: (1) we have entered into a binding agreement, (2) the product has shipped and title and risk of ownership have passed, (3) the sales price to the customer is fixed or determinable, and (4) collectability is reasonably assured. We recognize revenue based upon a determination that all criteria for revenue recognition have been met, which, based on the majority of our shipping terms, is considered to have occurred upon shipment of the finished product. Some shipping terms require the goods to be through customs or be received by the customer before title passes. In those instances, revenue is not recognized until either the customer has received the goods or they have passed through customs, depending on the circumstances. As appropriate, we record estimated reductions to revenue for customer returns and allowances and warranty claims. Provisions for such allowances are made at the time of sale and are typically derived from historical trends and other relevant information. Inventory Valuation Inventories are stated at the lower of cost or market with costs determined primarily on a first-in first-out basis. We also maintain a reserve for excess, obsolete and slow-moving inventory that is primarily developed by utilizing both specific product identification and historical product demand as the basis for our analysis. Products and materials that are specifically identified as obsolete are fully reserved. In general, most products that have been held in inventory greater than one year are fully reserved unless there are mitigating circumstances, including forecasted sales or current orders for the product. The remainder of the allowance is based on our estimates and fluctuates with market conditions, design cycles and other economic factors. Risks associated with this allowance include unforeseen changes in business cycles that could affect the marketability of certain products and an unexpected decline in current production. We closely monitor the marketplace and related inventory levels and have historically maintained reasonably accurate allowance levels. Our obsolescence reserve has ranged from 10.0% to 11.6% of gross inventory over the last three years. Goodwill and Other Intangibles We have made acquisitions over the years that included the recognition of goodwill and other intangible assets. Goodwill and indefinite lived intangibles are tested for impairment annually or more frequently if events or changes in circumstances indicate the carrying value may have been impaired. Application of the goodwill impairment test requires significant judgment, including the identification of reporting units, assignment of assets and liabilities to reporting units, and determination of the fair value of each reporting unit. Determining the fair value of a reporting unit is subjective and requires the use of significant estimates and assumptions, including revenue growth rates and operating margins, discount rates, and future market conditions, among others. We test goodwill for impairment using a two-step process. The first step of the impairment test requires a comparison of the implied fair value of each of our reporting units to the respective carrying value. If the carrying value of a reporting unit is less than its implied fair value, no indication of impairment exists and a second step is not performed. If the carrying amount of a reporting unit is higher than its fair value, there is an indication that impairment may exist and a second step must be performed. In the second step, the impairment is computed by comparing the implied fair value of the reporting unit's goodwill with the carrying amount of the goodwill. If the carrying amount of the reporting unit's goodwill is greater than the implied fair value of its goodwill, an impairment loss must be recognized for the excess and charged to operations. In 2015, we estimated the fair value of our reporting units using an income approach based on the present value of future cash flows. We believe this approach yields the most appropriate evidence of fair value as our reporting units are not easily compared to other corporations involved in similar businesses. We further believe that the assumptions and rates used in our annual impairment test are reasonable, but inherently uncertain. We currently have four reporting units with goodwill and intangible assets - Advanced Connectivity Solutions (ACS), Elastomeric Material Solutions (EMS), Curamik and the Elastomer Components Division (ECD) and the annual impairment test was performed in the fourth quarter of 2015 as has been our historical practice. The ACS, EMS, Curamik and ECD reporting units had allocated goodwill of approximately $51.9 million, $56.3 million, $65.0 million and $2.2 million, respectively, at December 31, 2015. No impairment charges resulted from this analysis. The excess of fair value over carrying value for these reporting units was 341.0% for ACS, 208.6% for EMS, 73.8% for Curamik and 232.3% for ECD. From a sensitivity perspective, if the fair value of these reporting units declined by 10%, the fair value of the ACS reporting unit would exceed its carrying value by approximately 300%, the fair value of the EMS reporting unit would exceed its carrying value by approximately 178%, the fair value of the Curamik reporting unit would exceed its carrying value by approximately 56%, and the fair value of the ECD reporting unit would exceed its carrying value by approximately 199%. These valuations are based on a five year discounted cash flow analysis, which utilized discount rates ranging from 12.0% for EMS and ECD to 15.3% for Curamik and a terminal year growth rate of 3% for all three reporting units. Intangible assets, such as purchased technology, customer relationships, and the like, are generally recorded in connection with a business acquisition. Values assigned to intangible assets are determined based on estimates and judgments regarding expectations of the success and life cycle of products and technology acquired and the value of the acquired businesses customer base. These assets are reviewed at least annually, or more frequently, if facts and circumstances surrounding such assets indicate a possible impairment of the asset exists. In 2015, there were no indicators of impairment on any of our other intangible assets. Product Liability For product liability claims, we typically maintain insurance coverage with reasonable deductible levels to protect us from potential exposures. Any liability associated with such claims is based on management's best estimate of the potential claim value, while insurance receivables associated with related claims are not recorded until verified by the insurance carrier. For asbestos related claims, we recognize projected asbestos liabilities and related insurance receivables, with any difference between the liability and related insurance receivable recognized as an expense in the consolidated statements of operations. In order to determine projected asbestos related liabilities, we have historically engaged National Economic Research Associates, Inc. (NERA), a consulting firm with expertise in the field of evaluating mass tort litigation asbestos bodily-injury claims. Further, in order to determine the projected insurance coverage on the asbestos liabilities, we have historically engaged Marsh USA, Inc., also known as Marsh Risk Consulting (Marsh), to develop these projections. Projecting future asbestos costs and related insurance coverage is subject to numerous variables that are extremely difficult to predict, including the number of claims that might be received, the type and severity of the disease alleged by each claimant, the long latency period associated with asbestos exposure, dismissal rates, costs of medical treatment, the financial resources of other companies that are co-defendants in claims, uncertainties surrounding the litigation process from jurisdiction to jurisdiction and from case to case, and the impact of potential changes in legislative or judicial standards, including potential tort reform. The models developed for determining the potential exposure and related insurance coverage were developed by outside consultants deemed to be experts in their respective fields with the forecast for asbestos related liabilities generated by NERA and the related insurance receivable projections developed by Marsh. The models contain numerous assumptions that significantly impact the results generated by the models. We believe the assumptions made are reasonable at the present time, but are subject to uncertainty based on the actual future outcome of our asbestos litigation. We determined that a ten-year projection period is appropriate as we have experience in addressing asbestos related lawsuits over the last few years to use as a baseline to project the liability over ten years. However, we do not believe we have sufficient data to justify a longer projection period at this time. As of December 31, 2015, the estimated liability and estimated insurance recovery for the ten-year period through 2025 was $56.6 million and $53.4 million, respectively. Given the inherent uncertainty in making future projections, we plan to have the projections of current and future asbestos claims periodically re-examined, and we will update them further if needed based on our experience, changes in the underlying assumptions that formed the basis for NERA's and Marsh's models, and other relevant factors, such as changes in the tort system. There can be no assurance that our accrued asbestos liabilities will approximate our actual asbestos-related settlement and defense costs, or that our accrued insurance recoveries will be realized. We believe that it is reasonably possible that we will incur additional charges for our asbestos liabilities and defense costs in the future, which could exceed existing reserves, but cannot reasonably estimate such excess amounts at this time. Pension and Other Postretirement Benefits We provide various defined benefit pension plans for our U.S. employees and sponsor three defined benefit health care plans and a life insurance plan. The costs and obligations associated with these plans are dependent upon various actuarial assumptions used in calculating such amounts. These assumptions include discount rates, long-term rates of return on plan assets, mortality rates, and other factors. The assumptions used were determined as follows: (i) the discount rate used is based on the PruCurve high quality corporate bond index, with comparisons against other similar indices; and (ii) the long-term rate of return on plan assets is determined based on historical portfolio results, market conditions and our expectations of future returns. We determine these assumptions based on consultation with outside actuaries and investment advisors. Any changes in these assumptions could have a significant impact on future recognized pension costs, assets and liabilities. The rates used to determine our costs and obligations under our pension and postretirement plans are disclosed in Note 10 to “Item 8 - Financial Statements and Supplementary Data”. Each assumption has different sensitivity characteristics. For the year ended December 31, 2015, a 25 basis point decrease in the discount rate would have increased our total pension expense by approximately $20,500. This number represents the aggregate increase in expense for the four pension plans: Employees' Pension Plan, Defined Benefit Pension Plan, Bear Pension Plan and the Restoration Plan. A 25 basis point decrease in the discount rate would decrease the other post-employment benefits (OPEB) expense by approximately $8,000. A 25 basis point decrease in the expected return on assets would increase the total 2015 pension expense approximately $0.4 million. This number represents the aggregate increase in the expense for the three qualified pension plans. Since the OPEB and non-qualified plans are unfunded, those plans would not be impacted by this assumption change. Income Taxes We are subject to income taxes in the U.S. and in numerous foreign jurisdictions. The Company accounts for income taxes following ASC 740 (Accounting for Income Taxes) recognizing deferred tax assets and liabilities using enacted tax rates for the effect of temporary differences between book and tax basis of recorded assets and liabilities. Deferred tax assets are reduced by a valuation allowance if it is more likely than not that some or all of a deferred tax asset will not be realized. U.S. income taxes have not been provided on $179.1 million of undistributed earnings of foreign subsidiaries since it is the Company’s intention to permanently reinvest such earnings or to distribute them only when it is tax efficient to do so. It is impracticable to estimate the total tax liability, if any, that would be created by the future distribution of these earnings. If circumstances change and it becomes apparent that some, or all of the undistributed earnings as of December 31, 2015 will not be indefinitely reinvested, the provision for the tax consequences, if any, will be recorded in the period when circumstances change. Distributions out of current and future earnings are permissible to fund discretionary activities such as business acquisitions. However, when distributions are made, this could result in a higher effective tax rate. We record benefits for uncertain tax positions based on an assessment of whether it is more likely than not that the tax positions will be sustained by the taxing authorities. If this threshold is not met, no tax benefit of the uncertain position is recognized. If the threshold is met, we recognize the largest amount of the tax benefit that is more than fifty percent likely to be realized upon ultimate settlement. We recognize interest and penalties within the income tax expense line in the accompanying consolidated statements of operations. Accrued interest and penalties are included within the related tax liability line in the consolidated statements of financial position. Stock-Based Compensation Stock-based compensation expense associated with stock options, time-based and performance-based restricted stock grants, deferred stock units, and related awards is recognized in the consolidated statements of operations. Determining the amount of stock-based compensation expense to be recorded requires us to develop estimates to be used in calculating the grant-date fair value of stock options. • Stock Options Historically, we have used stock options as part of our overall compensation plan for key employees. To value stock options, we calculated the grant-date fair values using the Black-Scholes valuation model. The use of valuation models requires us to make estimates for the following assumptions: Expected volatility - In determining expected volatility, we consider a number of factors, including historical volatility and implied volatility. Expected term - We use historical employee exercise data to estimate the expected term assumption for the Black-Scholes valuation model. Risk-free interest rate - We use the yield on zero-coupon U.S. Treasury securities for a period commensurate with the expected term assumption as the risk-free interest rate. Expected dividend yield - We do not currently pay dividends on our capital stock; therefore, a dividend yield of 0% was used in the Black-Scholes model. The amount of stock-based compensation expense recognized during a period is based on the value of the portion of the awards that are ultimately expected to vest. Forfeitures are estimated at the time of grant and revised, if necessary, in subsequent periods if actual forfeitures differ from those estimates. The term “forfeitures” is distinct from “cancellations” or “expirations” and represents only the unvested portion of the surrendered option. Based on an analysis of our historical forfeitures, we have applied an annual forfeiture rate of 3% to all unvested stock-based awards as of December 31, 2015. The rate of 3% represents the portion that is expected to be forfeited each year over the vesting period. This analysis is re-evaluated annually and the forfeiture rate is adjusted as necessary. Ultimately, the actual expense recognized over the vesting period will only be for those awards that vest. • Performance-Based Restricted Stock In 2006, we began granting performance-based restricted stock awards to certain key executives. We currently have awards from 2013, 2014 and 2015 outstanding. These awards cliff vest at the end of a 3 year measurement period to those individuals who are retirement eligible during the grant period, as such awards are subject to accelerated vesting as the grant is earned over the course of the vesting period (i.e. a pro-rata payout occurs based on the retirement date). Participants are eligible to be awarded shares ranging from 0% to 200% of the original award amount, based on certain defined performance measures. Compensation expense is recognized using the straight line method over the vesting period, unless the employee has an accelerated vesting schedule. The 2013, 2014 and 2015 awards have two measurement criteria on which the final payout of the award is based - (i) the three year return on invested capital (ROIC) compared to that of a specified group of peer companies, and (ii) the three year total shareholder return (TSR) on the performance of our capital stock as compared to that of a specified group of peer companies. In accordance with the applicable accounting literature, the ROIC portion of the award is considered a performance condition. As such, the fair value of the ROIC portion is determined based on the market value of the underlying stock price at the grant date with cumulative compensation expense recognized to date being increased or decreased based on changes in the forecasted pay out percentage at the end of each reporting period. The TSR portion of the awards is considered a market condition. As such, the fair value of these awards was determined on the date of grant using a Monte Carlo simulation valuation model with related compensation expense fixed on the grant date and expensed on a straight-line basis over the life of the awards that ultimately vest with no changes for the final projected payout of the award. The assumptions used in the Monte Carlo are as follows: Expected volatility - In determining expected volatility, we have considered a number of factors, including historical volatility. Expected term - We use the vesting period of the award to determine the expected term assumption for the Monte Carlo simulation valuation model. Risk-free interest rate - We use an implied "spot rate" yield on U.S. Treasury Constant Maturity rates as of the grant date for our assumption of the risk-free interest rate. Expected dividend yield - We do not currently pay dividends on our capital stock; therefore, a dividend yield of 0% was used in the Monte Carlo simulation valuation model. • Time-Based Restricted Stock In 2011, we began granting time-based restricted stock awards to certain key executives and other key members of the Company’s management team. We currently have grants from 2013, 2014 and 2015 outstanding. The majority of the 2013, 2014 and 2015 grants ratably vest on the first, second and third anniversaries of the original grant date. We recognize compensation expense on all of these awards on a straight-line basis over the vesting period. The fair value of the award is determined based on the market value of the underlying stock price at the grant date. • Deferred Stock Units We grant deferred stock units to non-management directors. These awards are fully vested on the date of grant and the related shares are generally issued on the 13th month anniversary of the grant date unless the individual elects to defer the receipt of these shares. Each deferred stock unit results in the issuance of one share of Rogers’ stock. The grant of deferred stock units is typically done annually in the second quarter of each year. The fair value of the award is determined based on the market value of the underlying stock price at the grant date.

<s>[INST] In the following discussion and analysis, we sometimes provide financial information that was not prepared in accordance with U.S. generally accepted accounting principles (GAAP). Management believes that this nonGAAP information provides meaningful supplemental information regarding the Company's performance by excluding certain expenses that are generally nonrecurring or otherwise may not be indicative of the core business operating results. In general, the Company believes that the additional nonGAAP financial information provided herein is useful to management and investors in assessing the Company's historical performance and for planning, forecasting and analyzing future periods. However, nonGAAP information has limitations as an analytical tool and should not be considered in isolation from, or solely as an alternative to, financial information prepared in accordance with GAAP. Any time we provide nonGAAP information in the following narrative we identify it as such and in close proximity provide the most directly comparable GAAP financial measure, as well as the information necessary to reconcile the two measures. Business Overview Rogers Corporation designs, develops, manufactures and sells highquality and highreliability engineered materials and components for mission critical applications. We operate principally three strategic business segments: Advanced Connectivity Solutions (ACS), Elastomeric Material Solutions (EMS) and Power Electronics Solutions (PES). We have a history of innovation and have established two Rogers Innovation Centers for our leading research and development activities, in Massachusetts and China. Our growth strategy is based upon the following principles: (1) marketdriven organization, (2) innovation leadership, (3) synergistic mergers and acquisitions, and (4) operational excellence. As a marketdriven organization, we are focused on three megatrends of expanding business opportunities: Internet Connectivity, Clean Energy and Safety & Protection. During 2015, we added the Safety & Protection megatrend in place of Mass Transit in response to the increase in demand for advanced driver assistance systems and growth in products focused on consumer impact protection, passenger safety and vibration management and flexible heater insulation. In January 2015, we completed the acquisition of Arlon LLC and its subsidiaries, other than Arlon India (Pvt) Limited (the acquired subsidiaries, collectively, Arlon), for an aggregate purchase price of approximately $157 million. Arlon manufactures high performance materials for the printed circuit board industry and silicone rubberbased materials. The acquisition of Arlon and its subsequent integration into our business segments have enabled us to increase scale and complement our existing product offerings, thus enhancing our ability to support our customers. The Arlon polyimide and thermoset laminate business, which was not integrated, was sold in December 2015. 2015 Executive Summary In 2015 as compared to 2014, our revenue increased 5.0% to $641.4 million, gross margin decreased 170 bps to 36.7%, and operating income decreased 6.1% to $76.3 million. The following key factors should be considered when reviewing our results of operations, financial condition and liquidity for the periods discussed: Our revenue growth in 2015 was attributable primarily to our newlyacquired Arlon operations. The increase in net sales in 2015 was composed of an organic sales decrease of 6.9%, negative currency impact of 4.5%, offset by acquisition related growth of 16.4%. We believe our revenue decline is associated with the uncertain macroeconomic conditions in China and Europe as well as the U.S. This situation has resulted in the delay of several key projects within the markets that we participate in, leading to weaker demand in certain applications across all three business segments. We expect to see a moderate recovery in sales going forward however we remain cautious as to the exact timing of the recovery. Our operating income declined due to a variety of factors in 2015. We achieved $76.3 million in operating income during 2015, a 6.1% decline over the $81.2 million achieved in 2014. Operating results in 2015 and 2014 included approximately $11.2 million and $7.7 million of special charges, respectively. Contributing to the decline in operating income was the decline in gross margin. Gross margin declined [/INST] Positive. </s>

ROGERS CORP

2017-02-21

2016-12-31

Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations The following discussion and analysis of our financial condition and results of operations should be read together with the Selected Financial Data and our Consolidated Financial Statements and the related notes that appear elsewhere in this Form 10-K. In the following discussion and analysis, we sometimes provide financial measures that were not prepared in accordance with U.S. generally accepted accounting principles (GAAP), such as adjusted selling, general and administrative expense as a percentage of net sales or adjusted operating income as a percentage of net sales. Management believes that these non-GAAP financial measures provide meaningful supplemental information regarding the Company’s performance by excluding certain expenses that are generally non-recurring or otherwise may not be indicative of the core business operating results. In general, the Company believes that the additional non-GAAP financial measures provided herein are useful to management and investors in analyzing trends in the Company’s business and planning and forecasting future periods. However, non-GAAP financial measures have limitations as an analytical tool and should not be considered in isolation from, or solely as an alternative to, financial information prepared in accordance with GAAP. Where we provide non-GAAP financial measures in the following narrative, we have identified the most directly comparable GAAP financial measures and provided the most directly comparable GAAP financial measure, as well as the information necessary to reconcile the two measures. Business Overview Rogers Corporation designs, develops, manufactures and sells high-quality and high-reliability engineered materials and components for mission critical applications. We operate principally three strategic business segments: Advanced Connectivity Solutions (ACS), Elastomeric Material Solutions (EMS) and Power Electronics Solutions (PES). We are currently headquartered in Rogers, Connecticut, but we plan to relocate our headquarters to Chandler, Arizona, where we have major business and manufacturing operations, during 2017. We have a history of innovation and have established two Rogers Innovation Centers for our leading research and development activities, in Massachusetts and Suzhou, China. Our growth strategy is based upon the following principles: (1) market-driven organization, (2) innovation leadership, (3) synergistic mergers and acquisitions, and (4) operational excellence. As a market-driven organization, we are focused on growth drivers, including, connectivity, clean energy, and safety and protection. In executing on our growth strategy, we have completed three strategic acquisitions: (1) in January 2017, we acquired the principal operating assets of Diversified Silicone Products, Inc. (DSP), a custom silicone product development and manufacturing business, serving a wide range of high reliability applications, (2) in November 2016, we acquired DeWAL Industries (DeWAL), a leading manufacturer of polytetrafluoroethylene and ultra-high molecular weight polyethylene films, pressure sensitive tapes and specialty products for the industrial, aerospace, automotive, and electronics markets, and (3) in January 2015, we acquired Arlon LLC and its subsidiaries, other than Arlon India (Pvt) Limited (the acquired subsidiaries, collectively, Arlon), a leading manufacturer of high performance materials for the printed circuit board industry and silicone rubber-based materials. 2016 Executive Summary In 2016 as compared to 2015, our net sales increased 2.3% to $656.3 million, gross margin increased 130 bps to 38.0%, and operating income increased 10.0% to $83.9 million. The following key factors should be considered when reviewing our results of operations, financial condition and liquidity for the periods discussed: • Our net sales increase in 2016 was attributable to sales increases in all of our strategic business segments, offset in part by a 2015 divestiture and a negative currency impact. Net sales in each of our strategic business segments increased (ACS: 3.8%, EMS: 12.3%; PES: 1.4%), while net sales in our Other segment declined 2.3% due to the 2015 divestiture of the non-core Arlon polyimide and thermoset business. Additionally, net sales in 2016 in each of our strategic business segments was negatively impacted by currency fluctuations. Net sales from DeWAL were approximately $5.4 million from the acquisition date through December 31, 2016. See “Segment Sales and Operations.” • Our gross margin improved 130 basis points and our operating margin increased 90 basis points in 2016 compared to 2015. Gross margin and operating margin were favorably impacted by the increase in net sales, combined with operational excellence initiatives across our business units. The increase in gross margin and operating margin were also driven by our divestiture of the lower margin Arlon polyimide and thermoset business during 2015. Operating results for 2016 included an increase of selling, general and administrative costs principally due to incentive compensation costs and costs associated with strategic projects. See “Results of Operations.” • Our net income was impacted by $12.4 million of additional tax expense associated with distributions from China subsidiaries and a change in assertion that earnings would be permanently reinvested. We historically treated foreign earnings in China as permanently reinvested; however, we changed our assertion due to changes in our business circumstances and our long-term business plan. This change resulted in payment of $6.3 million in withholding taxes and an accrual of $6.1 million of foreign deferred taxes that will become payable upon future distributions. As a consequence, our effective tax rate for 2016 increased to 41.3%. See “Results of Operations.” • We acquired DeWAL (in late 2016) and DSP (in early 2017), as we continue to execute on our synergistic acquisition strategy. Acquisitions are a core part of our growth strategy, and these particular acquisitions extend the product portfolio and technology capabilities of our EMS segment, with complementary high-end, high performance elastomeric materials. DeWAL is a leading manufacturer of polytetrafluoroethylene and ultra-high molecular weight polyethylene films, pressure sensitive tapes and specialty products for the industrial, aerospace, automotive, and electronics markets, and DSP is a custom silicone product development and manufacturing business, serving a wide range of high reliability applications. • We financed our recent acquisitions with borrowings under our revolving credit facility and cash. We borrowed $166.0 million under our credit facility during 2016 to finance part of the DeWAL and DSP acquisitions. As a result, outstanding borrowings under our credit facility increased to $241.2 million as of December 31, 2016. • We are an innovation company and in 2016 spent 4.4% of our net sales on research and development, an increase from 4.3% in 2015. Research and development (R&D) expenses were $28.6 million in 2016, an increase of 3.4% from $27.6 million in 2015. The increased spending was due to increased investments that are targeted at developing new platforms and technologies. We have made concerted efforts to realign our R&D organization to better fit the future direction of our Company, including dedicating resources to focus on current product extensions and enhancements to meet our short term technology needs. Results of Operations The following table sets forth, for the periods indicated, selected operations data expressed as a percentage of net sales. 2016 vs. 2015 Net Sales Net sales increased by 2.3% in 2016 from 2015, driven primarily by the ACS and EMS operating segments. The ACS operating segment net sales increased 3.8%, including a negative currency impact of 1.0%. The EMS operating segment net sales increased 12.3%, including a negative currency impact of 1.8%. The PES operating segment net sales increased 1.4%, including a negative currency impact of 0.9%. In total, the increase in net sales in 2016 included a negative currency impact of 1.2%. Sales in 2016 were also negatively impacted by 2.9% for the sales related to the non-core divestiture of the Arlon polyimide and thermoset laminate business, which was sold in December 2015. Gross Margin Gross margin as a percentage of net sales increased by 130 basis points to 38.0% in 2016 compared to 36.7% in 2015. In 2016, gross margin was favorably impacted by an increase in net sales and lower commodities pricing, combined with operational excellence initiatives across our business units and the divestiture of the lower margin Arlon polyimide and thermoset business in 2015. Our 2015 results included $1.6 million of expense for a non-recurring purchase accounting fair value adjustment for inventory related to the Arlon acquisition. Selling, General and Administrative Expenses Selling, general and administrative (SG&A) expenses increased by 3.7% in 2016 compared with 2015. Our 2016 results increased principally due to $7.7 million of incentive compensation due to the Company meeting performance incentive targets and $4.5 million of costs associated with non-acquisition related strategic projects. These increases were partially offset by cost savings from cost containment initiatives. Our 2016 results include $3.8 million of acquisition costs related to DeWAL and DSP and 2015 included $4.8 million in integration expenses related to the Arlon acquisition and $3.2 million related to the establishment of an environmental reserve. Research and Development Expenses Research and development (R&D) expenses increased by 3.4% in 2016 compared with 2015. As a percentage of sales, R&D costs increased from 4.3% in 2015 to 4.4% in 2016. The overall increase is due to continued investments that are targeted at developing new platforms and technologies focused on long-term growth initiatives at our innovation centers in the U.S. and Asia. Equity Income in Unconsolidated Joint Ventures Equity income in unconsolidated joint ventures increased 43.5% in 2016 from 2015. The increase was due to the appreciation of the Japanese Yen against the U.S. dollar, as the currency value significantly changed. Excluding the impact of the currency change, net sales increased due to higher demand primarily in the portable electronics market. Interest Income (Expense), Net Interest income (expense), net, was lower expense by 12.3% in 2016 from 2015. The decrease year over year was driven by $103.4 million of debt repayments in 2016 on borrowings incurred in January 2015 associated with the Arlon acquisition. Other Income (Expense), Net In 2015, our results included $4.8 million of a loss on the sale of the Arlon specialty polyimide and epoxy-based laminates business and $2.4 million of receivables related to the tax indemnities that were reversed, which related to the release of uncertain tax positions. Comparing 2016 to 2015, we recognized a net favorable impact of $1.5 million due to copper hedging transactions and a net unfavorable impact of $1.9 million due to foreign currency transactions. Additionally, in the third quarter of 2016, we had $0.8 million of expense for tax indemnity receivables that were reversed, which related to the release of uncertain tax positions, and in the first quarter of 2016, we recorded an additional loss related to the sale of the Arlon polyimide and thermoset laminate business of $0.2 million. Income Tax Expense Our effective tax rate for 2016 was 41.3% compared to 30.0% in 2015. The increase from 2015 is primarily related to withholding taxes on off-shore cash movements, a change to our assertion that certain foreign earnings are permanently reinvested and a change in the mix of earnings attributable to higher-taxing jurisdictions, offset by benefits associated with an increase in the reversal of reserves for uncertain tax positions. This increase was offset by the prior year being unfavorably impacted by adjustments related to finalization of 2014 income tax year returns. The prior year also included a benefit due to a change of the state tax rate as a result of a legal reorganization and release of valuation allowance on certain state tax attributes. Historically, our intention was to permanently reinvest the majority of our foreign earnings indefinitely or to distribute them only when it is tax efficient to do so. As a result of changes in business circumstances and our long-term business plan, with respect to offshore distributions, we modified our assertion of certain accumulated foreign subsidiary earnings considered permanently reinvested during 2016. This change resulted in accrual of a deferred tax liability of $6.1 million associated with distribution related foreign taxes on undistributed earnings of our Chinese subsidiaries that are no longer considered permanently reinvested. In the event that we distributed these funds to other offshore subsidiaries, these taxes would become due. In addition, we incurred $6.3 million of withholding taxes related to distributions from China. Backlog Our backlog of firm orders was $106.5 million as of December 31, 2016, as compared to $63.3 million as of December 31, 2015. ACS, EMS, PES, and Other operating segments experienced year over year increases in backlog of $13.2 million, $15.8 million, $13.8 million and $0.4 million, respectively. Contributing to the year over year change in backlog was an improvement in general market conditions. Additionally, the 2016 backlog contains $7.2 million related to the DeWAL business. The backlog of firm orders is expected to be filled within the next 12 months. 2015 vs. 2014 Net Sales Net sales increased by 5.0% in 2015 from 2014. The increase in net sales in 2015 was composed of an organic sales decrease of 6.9% and a negative currency impact of 4.5%, offset by Arlon acquisition related growth of 16.4%. The decline in organic sales was the result of a decline in all operating segments. The ACS operating segment net sales increased 11.1%: organic sales decline of 11.4% and negative currency impact of 1.3%, which partially offset acquisition growth of 23.8%. The EMS operating segment net sales increased 4.2%: organic sales decline of 7.9% and negative currency impact of 1.8%, which partially offset acquisition growth of 13.8%. The PES operating segment net sales declined 12.5%: organic sales decline of 0.5% combined with a negative currency impact of 12.0%. See “Segment Sales and Operations” below for further discussion on segment performance. Gross Margin Gross margin as a percentage of net sales declined by 170 basis points to 36.7% in 2015 compared to 38.4% in 2014. Our 2015 results included approximately $1.8 million of purchase accounting related to the Arlon acquisition, of which, $1.6 million was the non-recurring fair value adjustment for inventory. The year over year decline was primarily the result of lower organic net sales and lower gross margin contribution related to the Arlon business. This was partially offset by improvements in supply chain, product quality and procurement, which favorably impacted margin performance. Selling, General and Administrative Expenses Selling, general and administrative (SG&A) expenses increased by 5.0% in 2015 compared with 2014. As a percentage of net sales, selling, general and administrative expenses were 20.5% for each of 2015 and 2014. Our 2015 results included approximately $9.6 million of charges comprised of $1.6 million of severance related charges, $4.8 million in integration expenses related to the Arlon acquisition and $3.2 million related to the establishment of an environmental reserve. Our 2014 results included approximately $2.3 million of acquisition costs. Excluding the charges noted above, SG&A expense decreased $1.1 million and as a percentage of sales, decreased by 110 basis points from 20.1% in 2014 to 19.0% in 2015. The decrease in expenses, excluding these charges, is due to a variety of factors, including $12.0 million of lower incentive and equity compensation costs, $1.1 million of lower costs related to asbestos related liabilities, $1.0 million of lower severance and lower operational spending and other discrete items incurred in 2014 of $2.2 million. Partially offsetting these amounts are increases in expenses due to a variety of factors, including $13.5 million of SG&A expenses related to the Arlon business (including $5.8 million of intangible amortization associated with the acquisition) and $1.8 million of defined benefit pension and retirement plan costs. Research and Development Expenses Research and development (R&D) expenses increased by 20.8% in 2015 compared with 2014. As a percentage of sales, R&D costs increased from 3.7% in 2014 to 4.3% in 2015. The overall increase is due to $1.8 million of expenses related to the Arlon business as well as an increase in investments that are targeted at developing new platforms and technologies focused on long term growth initiatives at our innovation centers in the U.S. and Asia. Equity Income in Unconsolidated Joint Ventures Equity income in unconsolidated joint ventures declined approximately 29.9% in 2015 from 2014. The decrease was due to lower demand due to weakness in the Japanese domestic and export markets, particularly LCD TVs, domestic mobile phones and general industrial applications, change in product mix and unfavorable currency exchange rate shifts, including depreciation of the Japanese yen. Interest Income (Expense), Net Interest income (expense), net, was higher expense by 52.1% in 2015 from 2014. The increase year over year was driven by the increase in long term debt associated with the Arlon acquisition, which occurred in January of 2015. Other Income (Expense), Net Other income (expense), net was higher expense of $7.3 million from 2014 to 2015. Our 2015 results included charges of $4.8 million due to a loss on the sale of the Arlon specialty polyimide and epoxy-based laminates business and $2.4 million due to receivables related to tax indemnities that were reversed, which related to the release of uncertain tax positions. Income Tax Expense In 2015, the difference between the our effective tax rate and the statutory federal tax rate was favorably impacted by taxable income generated in countries with a lower tax rate to that of the United States, research and development credits, a tax benefit related to a change in the effective state rate and release of valuation allowance on certain state tax attributes. The rate was unfavorably impacted by reserves for uncertain tax positions, change to prior estimates and nondeductible expenses. The rate decreased from 2014 primarily due to a reduction in the level of repatriation of current foreign earnings, increased reversals of uncertain tax benefits and deferred state tax benefits due to the acquisition of Arlon, partially offset with a shift of earnings from low tax to high tax jurisdictions. Backlog Our backlog of firm orders was $63.3 million as of December 31, 2015, as compared to $77.0 million as of December 31, 2014. The decrease at the end of 2015 was primarily related to PES, ACS and our Other businesses, which experienced decreases in backlog of $7.3 million, $9.1 million and $0.1 million, respectively. These declines were slightly offset by EMS, which experienced an increase of $2.8 million in the backlog. Contributing to the year over year change in backlog were customer delivery improvements, which reduced customer ordering cycles, combined with general market conditions. Additionally, the 2015 backlog contains $7.4 million related to the Arlon businesses. Segment Sales and Operations Core Strategic Advanced Connectivity Solutions The ACS operating segment is comprised of high frequency circuit material products used for making circuitry that receives, processes and transmits high frequency communications signals, in a wide variety of markets and applications, including wireless communications, high reliability, wired infrastructure and automotive, among others. 2016 vs. 2015 Net sales in this segment increased by 3.8% in 2016 compared to 2015. Currency fluctuations decreased net sales by 1.0%. The increase in net sales is driven primarily by automotive radar applications for advanced driver assistance systems (23.1%) and aerospace and defense applications (8.7%) and other applications (30.0%), partially offset by a decline in the wireless telecom market (-3.5%) and lower demand in the satellite TV dish applications (-22.2%). Operating income declined by 2.6% in 2016 from 2015. As a percentage of net sales, 2016 operating income was 15.8%, a 110 basis point decrease as compared to the 16.9% reported in 2015. Operating income in 2016 was positively impacted by higher sales, however this increase was offset by unfavorable mix, unfavorable volume pricing and absorption, higher incentive compensation and additional corporate selling, general and administrative expense allocations. 2015 results included $5.3 million of charges comprised of $2.6 million of integration expenses related to the Arlon acquisition, $1.0 million of Arlon purchase accounting expenses related to the non-recurring fair value adjustment for inventory, $1.4 million of allocated environmental charge and $0.4 million of allocated severance related charges. 2015 vs. 2014 Net sales in this segment increased by 11.1% in 2015. Organic sales declined 11.4%, currency fluctuations decreased net sales by 1.3% and the acquisition of Arlon added 23.8% net sales growth as compared to the same period in the prior year. The year over year increase in net sales, including the acquisition, was driven by an increase in automotive radar applications for Advanced Drive Assistance Systems (33.4%) and aerospace and defense applications (54.4%) and the wireless telecom market (1.5%). These increases were partially offset by weaker demand in 4G LTE base stations, primarily in China (-25%). Operating income improved by 2.5% in 2015. As a percentage of net sales, operating income in 2015 was 16.9%, a 140 basis point decline as compared to the 18.3% reported in 2014. Our 2015 operating income included approximately $2.6 million of integration expenses related to the Arlon acquisition, $1.0 million of Arlon purchase accounting expenses related to the non-recurring fair value adjustment for inventory, a $1.4 million environmental charge and $0.4 million of severance related charges. Our 2014 operating income included approximately $1.9 million in charges from the early payment of certain long term pension obligations, $0.9 million in charges related to acquisition costs and $0.1 million in charges related to the impairment of the BrightVolt investment. As a percentage of sales, excluding the 2015 and 2014 charges noted above, 2015 operating income was 18.8%, a 70 basis point decline as compared to the 19.5% achieved in 2014. This decline is primarily due to the lower organic net sales partially offset by the addition of the operating income from the acquisition, combined with favorable results from the continuous efforts targeted at manufacturing efficiency improvements and favorable inventory absorption. Elastomeric Material Solutions The EMS operating segment is comprised of polyurethane and silicone foam products, which are sold into a wide variety of markets for various applications such as general industrial, portable electronics, consumer and transportation markets for gasketing, sealing, impact protection and cushioning applications. In November 2016, we completed an acquisition of DeWAL, a leading manufacturer of polytetrafluoroethylene, ultra-high molecular weight polyethylene films, pressure sensitive tapes and specialty products for the industrial, aerospace, automotive, and electronics markets. In January 2017, we acquired the principal operating assets of DSP, a custom silicone product development and manufacturing business, serving a wide range of high reliability applications. We are in the process of integrating DeWAL and DSP into our EMS segment. 2016 vs. 2015 Net sales in this segment increased by 12.3% in 2016 from 2015. Currency fluctuations decreased net sales by 1.8%. The increase in net sales was driven primarily by portable electronics applications (23.9%), automotive applications (41.4%) and general industrial (1.6%). These increases were partially offset by declines in demand in consumer applications (-15.2%) and mass transit applications (-1.9%). The results of DeWAL have been included in our consolidated financial statements only for the period subsequent to the completion of our acquisition. During this period, net sales attributable to DeWAL totaled $5.4 million. Operating income increased by 33.1% in 2016 from 2015. As a percentage of net sales, 2016 operating income was 13.1%, a 210 basis point increase as compared to the 11.0% reported in 2015. The increase in operating income in 2016 is primarily due to an increase in net sales, partially offset by corporate selling, general and administrative expense allocations and higher incentive compensation. 2016 results also include $3.8 million of acquisition costs related to the DeWAL and DSP acquisitions, along with $0.9 million of expenses related to the non-recurring fair value adjustment for DeWAL inventory. The results of DeWAL have been included in our consolidated financial statements only for the period subsequent to the completion of our acquisition. During this period, operating income attributable to DeWAL totaled $2.0 million. 2015 results included $3.2 million of charges comprised of $1.6 million of integration expenses related to the Arlon acquisition, $0.5 million of Arlon purchase accounting expenses related to the non-recurring fair value adjustment for inventory, $0.8 million of allocated environmental charge and $0.3 million of allocated severance related charges. 2015 vs. 2014 Net sales in this segment increased by 4.2% in 2015. Organic sales declined 7.9%, currency fluctuations decreased net sales by 1.8% and the acquisition of Arlon added 13.8% of sales growth as compared to the prior year. The increase in net sales, including the acquisition, was driven by increased demand in mass transit (26.2%) and general industrial (26.1%) applications. Offsetting these increases, this operating segment experienced a decline in net sales into the portable electronics segment (mobile internet devices and feature phone applications) (-22.7%) and consumer applications (-11.0%). Operating income declined by 14.4% in 2015. As a percentage of net sales, the 2015 operating income was 11.0%, a 240 basis point decline as compared to the 13.4% reported in 2014. Our 2015 operating income includes approximately $1.6 million of integration expenses related to the Arlon acquisition, $0.5 million of Arlon purchase accounting expenses related to the non-recurring fair value adjustment for inventory, a $0.8 million environmental charge and $0.3 million of severance related charges. Our 2014 operating income includes approximately $1.3 million in charges for the early payment of certain long term pension obligations and $0.6 million of acquisition costs. As a percentage of net sales, excluding the 2015 and 2014 charges noted above, 2015 operating income was 12.8%, a 180 basis point decline as compared to the 14.6% achieved in 2014. This decline is primarily due to the lower organic net sales partially offset by the addition of the operating income from the acquisition. Power Electronics Solutions The PES operating segment is comprised of two product lines - curamik® direct-bonded copper (DBC) substrates that are used primarily in the design of intelligent power management devices, such as IGBT (insulated gate bipolar transistor) modules that enable a wide range of products including highly efficient industrial motor drives, wind and solar energy converters and electrical systems in automobiles, and ROLINX® busbars that are used primarily in power distribution systems products in electric and hybrid electric vehicles and clean technology applications. 2016 vs. 2015 Net sales in this segment increased by 1.4% in 2016 from 2015. Currency fluctuations decreased net sales by 0.9%. The increase in net sales was driven by demand in electric and hybrid electric vehicles (15.6%), variable frequency motor drives (7.9%) and certain renewable energy applications (2.0%). These increased net sales were partially offset by lower demand in rail applications (-40.6%). Operating income increased 59.1% in 2016 from 2015. As a percentage of net sales, 2016 operating income was 3.9%, a 140 basis point increase as compared to the 2.5% reported in 2015. This increase is primarily due to operational efficiency programs and an increase in net sales partially offset by unfavorable product mix, increased incentive compensation and corporate selling, general and administrative expense allocations. 2015 included approximately $2.0 million of allocated charges comprised of $1.1 million of an environmental charge and $0.9 million of severance related charges. 2015 vs. 2014 Net sales in this segment decreased by 12.5% in 2015. Organic net sales declined 0.5% as compared to 2014. Net sales were unfavorably impacted by 12.0% due to currency fluctuations. The net sales decline was impacted by weaker demand in variable frequency motor drives (-19.1%), vehicle electrification (x-by-wire) (-25.2%) and certain renewable energy applications (-21.8%). These declines were partially offset by an increase in demand in electric vehicle applications (41.5%) and laser diode applications (11.5%). Operating income declined by 33.7% in 2015. As a percentage of net sales, the 2015 operating income was 2.5%, a 80 basis point decline as compared to the 3.3% reported in 2014. Our 2015 operating income included approximately $1.1 million of an environmental charge and $0.9 million of severance related charges. Our 2014 operating income includes approximately $1.9 million in charges for the early payment of certain long term pension obligations and $0.9 million of acquisition costs. As a percentage of net sales, excluding the 2015 and 2014 previously noted charges, 2015 operating income was 3.8%, a 110 basis point decline as compared to the 4.9% achieved in 2014. This decrease was due to the lower organic net sales as well as the unfavorable foreign currency exchange impact. Other Our Other segment consists of our elastomer rollers and floats business, as well as our inverter distribution business. Additionally, this segment included the acquired Arlon polymide and thermoset laminate business from January 2015 until it was sold in December 2015. 2016 vs 2015 Net sales decreased by 46.1% in 2016 from 2015, due principally to the impact of the divestiture of the Arlon polyimide and thermoset laminate business in December 2015. Net sales were unfavorably impacted by 1.4%, due to currency fluctuations. Operating income decreased 1.1% in the 2016 from 2015. The decline was primarily due to lower net sales partially offset by $0.6 million of integration expenses related to the Arlon acquisition that are included in 2015 results, which didn’t repeat in 2016. As a percentage of net sales, operating income increased to 31.9% in 2016 from 17.4% in 2015, due principally to the sale of the lower margin Arlon polyimide and thermoset laminate business. 2015 vs 2014 Net sales increased by 73.7% in 2015. The acquisition of Arlon added 76.0% sales growth as compared to the same period in the prior year. Net sales were unfavorably impacted primarily by 2.2% due to currency fluctuations. Operating income decreased 10.0% in 2015. The decline is comprised of lower operating profit of $0.6 million due to lower organic sales volume, $0.6 million of integration expenses related to the Arlon acquisition, offset by the performance of the specialty polyimide and epoxy-based laminates and bonding materials business. Product and Market Development Our research and development team is dedicated to growing our business by developing cost effective solutions that improve the performance of customers’ products and by identifying business and technology acquisition or development opportunities to expand our market presence. Currently, R&D spend is approximately 4.4% of net sales. Liquidity, Capital Resources and Financial Position We believe our existing sources of liquidity and cash flows expected to be generated from operations, together with available credit facilities, will be sufficient to fund our operations, capital expenditures, research and development efforts, and debt service commitments, as well as our other operating and investing needs, for at least the next twelve months. We regularly review and evaluate the adequacy of our cash flows, borrowing facilities and banking relationships to ensure that we have the appropriate access to cash to fund both near-term operating needs and long-term strategic initiatives. At December 31, 2016, cash and cash equivalents were $227.8 million as compared to $204.6 million at the end of 2015, an increase of $23.2 million, or approximately 11.3%. This increase was due primarily to strong cash from operations, proceeds from debt of $166.0 million, offset by $133.9 million (net) paid for the acquisition of DeWAL, $8.0 million in share repurchases, $18.1 million in capital expenditures and $103.8 million in debt and capital lease payments. We used the remaining cash proceeds from the drawdown on our credit facility, along with cash on hand, to fund the DSP acquisition in January 2017. The following table illustrates the location of our cash and cash equivalents by our three major geographic areas: Cash held in certain foreign locations could be subject to additional taxes if we distributed such amounts back to other offshore subsidiaries or repatriated them to the U.S. As a result of changes in our business circumstances and long-term business plan, we have changed our estimate of the amount of foreign subsidiary earnings considered permanently reinvested. Undistributed earnings of our Chinese subsidiaries are no longer considered indefinitely reinvested and may be distributed to other offshore subsidiaries. This change resulted in payment of $6.3 million in withholding taxes and accrual of $6.1 million of foreign deferred taxes during 2016 that will become payable upon future distributions. We have not changed our assertion during 2016 with respect to distributions of earnings that would require the accrual of U.S. income tax. Net working capital was $357.2 million, $350.0 million and $317.7 million as of December 31, 2016, 2015 and 2014, respectively. Significant changes in our balance sheet accounts from December 31, 2015 to December 31, 2016 were as follows: ◦ Accounts receivable increased $18.2 million or 17.9% from $101.4 million at December 31, 2015 to $119.6 million at December 31, 2016. The increase is primarily due to increased demand across all business units. ◦ Goodwill increased $33.0 million or 18.8% from $175.5 million at December 31, 2015 to $208.4 million at December 31, 2016. This increase is due to the acquisition of DeWAL. There were no impairments of goodwill during the year ended December 31, 2016. ◦ Other intangible assets increased $61.7 million or 82.2% from $75.0 million at December 31, 2015 to $136.7 million at December 31, 2016. This increase is due to the acquisition of DeWAL. There were no impairments of Other intangible assets during the year ended December 31, 2016. ◦ Overall, our debt position increased $63.0 million from $176.5 million at December 31, 2015 to $239.5 million at December 31, 2016. The increase is due to borrowings of $136.0 million to finance the DeWAL acquisition and an additional $30.0 million in borrowings to partially fund the DSP acquisition. These borrowings were offset by $103.8 million of debt repayments in 2016. Outstanding debt is presented on the consolidated statements of financial position net of debt issuance costs. During 2016, $151.8 million of net cash was used for investing activities as compared to $180.3 million in 2015 and $28.5 million in 2014. Investing activity for 2016 included the acquisition of DeWAL, which used $133.9 million in investing cash (net), compared to $158.4 million in investing cash (net) used for the Arlon acquisition in 2015. Capital expenditures were $18.1 million, $24.8 million and $28.8 million in 2016, 2015 and 2014, respectively. Net cash provided by financing activities was $57.9 million, $83.0 million and $1.9 million in 2016, 2015 and 2014, respectively. Financing activities in 2016 included borrowings of $166.0 million to finance acquisitions, offset by $103.8 million in debt and capital lease repayments and $8.0 million of cash used for the share buyback program. Credit Facilities • Second Amended Credit Agreement On June 18, 2015, we entered into a secured five year credit agreement with JPMorgan Chase Bank, N.A., as administrative agent, and the lenders party thereto (the “Second Amended Credit Agreement”). The Second Amended Credit Agreement provided (1) a $55.0 million term loan; (2) up to $295.0 million of revolving loans, with sublimits for multicurrency borrowings, letters of credit and swing-line notes; and (3) a $50.0 million expansion feature. Borrowings could be used to finance working capital needs, for letters of credit and for general corporate purposes in the ordinary course of business, including the financing of permitted acquisitions (as defined in the Second Amended Credit Agreement). In 2016, we borrowed $136.0 million under the line of credit to fund the acquisition of DeWAL and an additional $30.0 million to partially fund the acquisition of Diversified Silicone Products. We borrowed $125.0 million under the line of credit under our prior credit agreement in the first quarter of 2015 to fund the acquisition of Arlon, and this amount was refinanced under our Second Amended Credit Agreement in June 2015. During 2016 and 2015, we made principal payments of $103.4 million, and $6.4 million, respectively, on the outstanding debt. At December 31, 2016, our outstanding debt balance was comprised of a term loan of $50.2 million and $191.0 million borrowed on the revolving line of credit. In addition, as of December 31, 2016 and 2015, we had a $1.2 million standby letter of credit (LOC) to guarantee Rogers workers compensation plans that were backed by the Second Amended Credit Agreement. No amounts were drawn on the LOC as of December 31, 2016 or 2015. We incurred interest expense on our outstanding debt of $3.1 million, $3.5 million, and $1.8 million for the years ended December 31, 2016, 2015 and 2014, respectively. Cash paid for interest was $3.1 million, $3.3 million, and $2.5 million for 2016, 2015 and 2014, respectively. At December 31, 2016, the rate charged on our outstanding borrowings under the Second Amended Credit Agreement was the 1-month LIBOR at 0.6250% plus a spread of 1.375%. We also incurred an unused commitment fee of $0.4 million, $0.3 million, and $0.4 million for the years ended December 31, 2016, 2015 and 2014, respectively. The financial covenants in the Second Amended Credit Agreement included requirements to maintain (1) a leverage ratio of no more than 3.25 to 1.00, subject to a one-time election to increase the maximum leverage ratio to 3.50 to 1.00 for one fiscal year in connection with a permitted acquisition, and (2) an interest coverage ratio of no less than 3.00 to 1.00. As of December 31, 2016, we were in compliance with all of the financial covenants in the Second Amended Credit Agreement. The Second Amended Credit Agreement required mandatory quarterly repayment of principal on amounts borrowed under the term loan, and payment in full of outstanding borrowings by June 30, 2020, which are described in the Contractual Obligations table in this Item 7. All obligations under the Second Amended Credit Agreement were guaranteed by each of the Company’s existing and future material domestic subsidiaries, as defined in the Second Amended Credit Agreement (the “Previous Guarantors”). The obligations were also secured by a Second Amended and Restated Pledge and Security Agreement, dated as of June 18, 2015, entered into by the Company and the Previous Guarantors which granted to the administrative agent, for the benefit of the lenders, a security interest, subject to certain exceptions, in substantially all of the non-real estate assets of the Guarantors. These assets included, but were not limited to, receivables, equipment, intellectual property, inventory, and stock in certain subsidiaries. • Third Amended Credit Agreement On February 17, 2017, we entered into a secured five year credit agreement with JPMorgan Chase Bank, N.A., as administrative agent, and the lenders party thereto (the “Third Amended Credit Agreement”), which amended and restated the Second Amended Credit Agreement. The Third Amended Credit Agreement refinances the Second Amended Credit Agreement, eliminates the term loan under the Second Amended Credit Agreement, increases the principal amount of the revolving credit facility to up to $450.0 million borrowing capacity, with sublimits for multicurrency borrowings, letters of credit and swing-line notes, and provides an additional $175.0 million accordion feature. Borrowings may be used to finance working capital needs, for letters of credit and for general corporate purposes in the ordinary course of business, including the financing of permitted acquisitions (as defined in the Third Amended Credit Agreement). Borrowings under the Third Amended Credit Agreement can be made as alternate base rate loans or euro-currency loans. Alternate base rate loans bear interest that includes a base reference rate plus a spread of 37.5 to 75.0 basis points, depending on our leverage ratio. The base reference rate is the greater of the prime rate; federal funds effective rate (or the overnight bank funding rate, if greater) plus 50 basis points; or adjusted 1-month LIBOR plus 100 basis points. Euro-currency loans bear interest based on adjusted LIBOR plus a spread of 137.5 to 175.0 basis points, depending on our leverage ratio. In addition to interest payable on the principal amount of indebtedness outstanding from time to time under the Third Amended Credit Agreement, the Company is required to pay a quarterly fee of 20 to 30 basis points (based upon our leverage ratio) of the unused amount of the lenders’ commitments under the Third Amended Credit Agreement. The Third Amended Credit Agreement contains customary representations, warranties, covenants, mandatory prepayments and events of default under which the Company’s payment obligations may be accelerated. If an event of default occurs, the lenders may, among other things, terminate their commitments and declare all outstanding borrowings to be immediately due and payable together with accrued interest and fees. The financial covenants include requirements to maintain (1) a leverage ratio of no more than 3.25 to 1.00, subject to an election to increase the maximum leverage ratio to 3.50 to 1.00 for one fiscal year in connection with a permitted acquisition, and (2) an interest coverage ratio of no less than 3.00 to 1.00. All obligations under the Third Amended Credit Agreement are guaranteed by each of the Company’s existing and future material domestic subsidiaries, as defined in the Third Amended Credit Agreement (the “Guarantors”). The obligations are also secured by a Third Amended and Restated Pledge and Security Agreement, dated as of February 17, 2017, entered into by the Company and the Guarantors which grants to the administrative agent, for the benefit of the lenders, a security interest, subject to certain exceptions, in substantially all of the non-real estate assets of the Guarantors. These assets include, but are not limited to, receivables, equipment, intellectual property, inventory, and stock in certain subsidiaries. All revolving loans are due on the maturity date, February 17, 2022. We are not required to make any quarterly principal payments under the Third Amended Credit Agreement. Restriction on Payment of Dividends Our Third Amended Credit Agreement generally permits us to pay cash dividends to our shareholders, provided that (i) no default or event of default has occurred and is continuing or would result from the dividend payment and (ii) our leverage ratio does not exceed 2.75 to 1.00. If our leverage ratio exceeds 2.75 to 1.00, we may nonetheless make up to $20.0 million in restricted payments, including cash dividends, during the fiscal year, provided that no default or event of default has occurred and is continuing or would result from the payments. Our leverage ratio did not exceed 2.75 to 1.00 as of February 17, 2017. Contractual Obligations The following table summarizes our significant contractual obligations as of December 31, 2016. (1) This amount represents non-cancelable vendor purchase commitments. (2) As noted above in the description of our Third Amended Credit Agreement, we are no longer required to make quarterly principal payments on outstanding borrowings under our term loan. Accordingly, all outstanding borrowings under our credit facility are now due on February 17, 2022. (3) Estimated future interest payments are based on a leveraged based spread that ranges from 1.375% to 1.75%, plus projected forward 1-month LIBOR rates. Unfunded pension benefit obligations, which amount to $5.9 million at December 31, 2016, are expected to be paid from operating cash flows and the timing of payments is not definitive. Retiree health and life insurance benefits, which amount to $2.1 million, are expected to be paid from operating cash flows. Other long-term liabilities, such as deferred taxes, unrecognized tax benefits and asbestos-related product liability reserves, have been excluded from the table due to the uncertainty of the timing of payments combined with the absence of historical trends to be used as a predictor for such payments. Effects of Inflation We do not believe that inflation had a material impact on our business, sales, or operating results during the periods presented. Off-Balance Sheet Arrangements We do not have any off-balance sheet arrangements that have, or are, in the opinion of management, reasonably likely to have, a current or future material effect on our financial condition or results of operations. Critical Accounting Policies Our Consolidated Financial Statements are prepared in accordance with U.S. generally accepted accounting principles, which require management to make estimates, judgments and assumptions that affect the amounts reported in the financial statements and accompanying notes. We base our estimates on historical experience and on various other assumptions that are believed to be reasonable under the circumstances and believe that appropriate reserves have been established based on reasonable methodologies and appropriate assumptions based on facts and circumstances that are known; however, actual results may differ from these estimates under different assumptions or conditions. An accounting policy is deemed to be critical if it requires an accounting estimate to be made based on assumptions that are highly judgmental and uncertain at the time the estimate is made, if different estimates could reasonably have been used, or if changes to those estimates are reasonably likely to periodically occur that could affect the amounts carried in the financial statements. These critical accounting policies are as follows: Revenue Recognition We recognize revenue when all of the following criteria are met: (1) we have entered into a binding agreement, (2) the product has shipped and title and risk of ownership have passed, (3) the sales price to the customer is fixed or determinable, and (4) collectability is reasonably assured. We recognize revenue based upon a determination that all criteria for revenue recognition have been met, which, based on the majority of our shipping terms, is considered to have occurred upon shipment of the finished product. Some shipping terms require the goods to be through customs or be received by the customer before title passes. In those instances, revenue is not recognized until either the customer has received the goods or they have passed through customs, depending on the circumstances. As appropriate, we record estimated reductions to revenue for customer returns and allowances and warranty claims. Provisions for such allowances are made at the time of sale and are typically derived from historical trends and other relevant information. See further discussion in Note 19, “Recent Accounting Standards” to “Item 8 Financial Statements and Supplementary Data.” Inventory Valuation Inventories are stated at the lower of cost or market with costs determined primarily on a first-in first-out basis. We also maintain a reserve for excess, obsolete and slow-moving inventory that is primarily developed by utilizing both specific product identification and historical product demand as the basis for our analysis. Products and materials that are specifically identified as obsolete are fully reserved. In general, most products that have been held in inventory greater than one year are fully reserved unless there are mitigating circumstances, including forecasted sales or current orders for the product. The remainder of the allowance is based on our estimates and fluctuates with market conditions, design cycles and other economic factors. Risks associated with this allowance include unforeseen changes in business cycles that could affect the marketability of certain products and an unexpected decline in current production. We closely monitor the marketplace and related inventory levels and have historically maintained reasonably accurate allowance levels. Our obsolescence reserve has ranged from 11.0% to 14.2% of gross inventory over the last three years. Goodwill and Other Intangibles We have made acquisitions over the years that included the recognition of goodwill and other intangible assets. Goodwill and indefinite lived intangibles are tested for impairment annually or more frequently if events or changes in circumstances indicate the carrying value may have been impaired. Application of the goodwill impairment test requires significant judgment, including the identification of reporting units, assignment of assets and liabilities to reporting units, and determination of the fair value of each reporting unit. Determining the fair value of a reporting unit is subjective and requires the use of significant estimates and assumptions, including revenue growth rates and operating margins, discount rates, and future market conditions, among others. We test goodwill for impairment using a two-step process. The first step of the impairment test requires a comparison of the implied fair value of each of our reporting units to the respective carrying value. If the carrying value of a reporting unit is less than its implied fair value, no indication of impairment exists and a second step is not performed. If the carrying amount of a reporting unit is higher than its fair value, there is an indication that impairment may exist and a second step must be performed. In the second step, the impairment is computed by comparing the implied fair value of the reporting unit’s goodwill with the carrying amount of the goodwill. If the carrying amount of the reporting unit’s goodwill is greater than the implied fair value of its goodwill, an impairment loss must be recognized for the excess and charged to operations. In 2016, we estimated the fair value of our reporting units using an income approach based on the present value of future cash flows. We believe this approach yields the most appropriate evidence of fair value as our reporting units are not easily compared to other corporations involved in similar businesses. We further believe that the assumptions and rates used in our annual impairment test are reasonable, but inherently uncertain. We currently have four reporting units with goodwill: ACS, EMS, curamik® and the Elastomer Components Division (ECD). Consistent with historical practice, the annual impairment test on these reporting units was performed in the fourth quarter of 2016. No impairment charges resulted from this analysis. The excess of fair value over carrying value for ACS, EMS, curamik® and ECD was 281.6%, 76.0%, 75.8% and 225.7%, respectively. From a sensitivity perspective, if the fair value of each of these reporting units declined by 10%, the excess of fair value over carrying value for ACS, EMS, curamik® and ECD would be 243.4%, 58.4%, 58.2% and 193.1%, respectively. These valuations are based on a five year discounted cash flow analysis, which utilized discount rates ranging from 12.0% for ACS to 12.9% for curamik® and a terminal year growth rate of 3% for all four reporting units. The ACS, EMS, curamik® and ECD reporting units had allocated goodwill of approximately $51.7 million, $91.5 million, $63.0 million and $2.2 million, respectively, at December 31, 2016. Intangible assets, such as purchased technology, customer relationships, and the like, are generally recorded in connection with a business acquisition. Values assigned to intangible assets are determined based on estimates and judgments regarding expectations of the success and life cycle of products and technology acquired and the value of the acquired businesses customer base. These assets are reviewed at least annually if facts and circumstances surrounding such assets indicate a possible impairment of the asset exists. In 2016, there were no indicators of impairment on any of our other intangible assets. Product Liability For product liability claims, we typically maintain insurance coverage with reasonable deductible levels to protect us from potential exposures. Any liability associated with such claims is based on management’s best estimate of the potential claim value, while insurance receivables associated with related claims are not recorded until verified by the insurance carrier. For asbestos related claims, we recognize projected asbestos liabilities and related insurance receivables, with any difference between the liability and related insurance receivable recognized as an expense in the consolidated statements of operations. Projecting future asbestos costs and related insurance coverage is subject to numerous variables that are extremely difficult to predict, including the number of claims that might be received, the type and severity of the disease alleged by each claimant, the long latency period associated with asbestos exposure, dismissal rates, costs of medical treatment, the financial resources of other companies that are co-defendants in claims, uncertainties surrounding the litigation process from jurisdiction to jurisdiction and from case to case, and the impact of potential changes in legislative or judicial standards, including potential tort reform. We believe the assumptions used in our models for determining our potential exposure and related insurance coverage are reasonable at the present time, but such assumptions are inherently uncertain. We determined that a ten-year projection period is appropriate as we have experience in addressing asbestos related lawsuits over the last few years to use as a baseline to project the liability over ten years. However, we do not believe we have sufficient data to justify a longer projection period at this time. As of December 31, 2016, the estimated liability and estimated insurance recovery for the ten-year period through 2026 was $52.0 million and $48.4 million, respectively. Given the inherent uncertainty in making projections, we plan to re-examine periodically the projections of current and future asbestos claims, and we will update them if needed based on our experience, changes in the assumptions underlying our models, and other relevant factors, such as changes in the tort system. There can be no assurance that our accrued asbestos liabilities will approximate our actual asbestos-related settlement and defense costs, or that our accrued insurance recoveries will be realized. We believe that it is reasonably possible that we will incur additional charges for our asbestos liabilities and defense costs in the future, which could exceed existing reserves, but cannot reasonably estimate such excess amounts at this time. Pension and Other Postretirement Benefits We provide various defined benefit pension plans for our U.S. employees and sponsor three defined benefit health care plans and a life insurance plan. The costs and obligations associated with these plans are dependent upon various actuarial assumptions used in calculating such amounts. These assumptions include discount rates, long-term rates of return on plan assets, mortality rates, and other factors. The assumptions used were determined as follows: (i) the discount rate used is based on the PruCurve high quality corporate bond index, with comparisons against other similar indices; and (ii) the long-term rate of return on plan assets is determined based on historical portfolio results, market conditions and our expectations of future returns. We determine these assumptions based on consultation with outside actuaries and investment advisors. Any changes in these assumptions could have a significant impact on future recognized pension costs, assets and liabilities. The rates used to determine our costs and obligations under our pension and postretirement plans are disclosed in Note 10, “Pension Benefits and Retirement Health and Life Insurance Benefits” to “Item 8 - Financial Statements and Supplementary Data.” Each assumption has different sensitivity characteristics. For the year ended December 31, 2016, a 25 basis point decrease in the discount rate would have increased our total pension expense by approximately $17,500. This number represents the aggregate increase in expense for the four pension plans: Employees’ Pension Plan, Defined Benefit Pension Plan, Bear Pension Plan and the Restoration Plan. A 25 basis point decrease in the discount rate would increase the other post-employment benefits (OPEB) expense by approximately $3,000. A 25 basis point decrease in the expected return on assets would increase the total 2016 pension expense approximately $0.4 million. This number represents the aggregate increase in the expense for the three qualified pension plans. Since the OPEB and non-qualified plans are unfunded, those plans would not be impacted by this assumption change. Income Taxes We are subject to income taxes in the U.S. and in numerous foreign jurisdictions. The Company accounts for income taxes following ASC 740 (Accounting for Income Taxes) recognizing deferred tax assets and liabilities using enacted tax rates for the effect of temporary differences between book and tax basis of recorded assets and liabilities. Deferred tax assets are reduced by a valuation allowance if it is more likely than not that some or all of a deferred tax asset will not be realized. U.S. income taxes have not been provided on $210.9 million of undistributed earnings of foreign subsidiaries since it is the Company’s intention to permanently reinvest such earnings offshore or to repatriate them only when it is tax efficient to do so. It is impracticable to estimate the total tax liability, if any, that would be created by the future distribution of these earnings. If circumstances change and it becomes apparent that some, or all of these undistributed earnings as of December 31, 2016 will not be indefinitely reinvested, the provision for the tax consequences, if any, will be recorded in the period when circumstances change. As of each of December 31, 2016 and 2015, $1.1 million of U.S. income taxes had been provided on undistributed earnings of foreign subsidiaries that are not considered permanently reinvested. As a result of changes in business circumstances and our long-term business plan with respect to offshore distributions, we modified our assertion of certain accumulated foreign subsidiary earnings considered permanently reinvested. As of December 31, 2016, $6.1 million of deferred foreign taxes have been provided on undistributed earnings of our foreign subsidiaries that are not considered permanently reinvested. In the event that we distributed these funds to other offshore subsidiaries, these taxes would become due. In addition, we incurred $6.3 million of withholding taxes in 2016 related to distributions from China to lower tier, non-U.S. subsidiaries. Distributions out of current and future earnings are permissible to fund discretionary activities such as business acquisitions. However, when distributions are made, this could result in a higher effective tax rate. We record benefits for uncertain tax positions based on an assessment of whether it is more likely than not that the tax positions will be sustained by the taxing authorities. If this threshold is not met, no tax benefit of the uncertain position is recognized. If the threshold is met, we recognize the largest amount of the tax benefit that is more than fifty percent likely to be realized upon ultimate settlement. We recognize interest and penalties within the income tax expense line in the accompanying consolidated statements of operations. Accrued interest and penalties are included within the related tax liability line in the consolidated statements of financial position. Stock-Based Compensation Stock-based compensation expense associated with time-based and performance-based restricted stock units, deferred stock units, stock options and related awards is recognized in the consolidated statements of operations. Determining the amount of stock-based compensation expense to be recorded requires us to develop estimates to be used in calculating the grant-date fair value of stock-based compensation. The amount of stock-based compensation expense recognized during a period is based on the value of the portion of the awards that are ultimately expected to vest. Forfeitures are estimated at the time of grant and revised, if necessary, in subsequent periods if actual forfeitures differ from those estimates. The term “forfeitures” is distinct from “cancellations” or “expirations” and represents only the unvested portion of the surrendered option. Based on an analysis of our historical forfeitures, we have applied an annual forfeiture rate of 12% to all unvested stock-based awards as of December 31, 2016. The rate of 12% represents the portion that is expected to be forfeited each year over the vesting period. This analysis is re-evaluated annually and the forfeiture rate is adjusted as necessary. Ultimately, the actual expense recognized over the vesting period will only be for those awards that vest. • Performance-Based Restricted Stock Units Compensation expense related to our performance-based restricted stock units is recognized using the straight-line method over the vesting period. The outstanding 2014 and 2015 awards have two measurement criteria on which the final payout of the award is based - (i) the three year return on invested capital (ROIC) compared to that of a specified group of peer companies, and (ii) the three year total shareholder return (TSR) on the performance of our capital stock as compared to that of a specified group of peer companies. The outstanding 2016 awards have one measurement criteria, the three year total shareholder return (TSR) on the performance of our capital stock as compared to that of a specified group of peer companies. In accordance with the applicable accounting literature, the ROIC portion of the award is considered a performance condition. As such, the fair value of the ROIC portion is determined based on the market value of the underlying stock price at the grant date with cumulative compensation expense recognized to date being increased or decreased based on changes in the forecasted pay out percentage at the end of each reporting period. The TSR portion of the awards is considered a market condition. As such, the fair value of these awards was determined on the date of grant using a Monte Carlo simulation valuation model with related compensation expense fixed on the grant date and expensed on a straight-line basis over the life of the awards that ultimately vest with no changes for the final projected payout of the award. The assumptions used in the Monte Carlo are as follows: Expected volatility - In determining expected volatility, we have considered a number of factors, including historical volatility. Expected term - We use the vesting period of the award to determine the expected term assumption for the Monte Carlo simulation valuation model. Risk-free interest rate - We use an implied “spot rate” yield on U.S. Treasury Constant Maturity rates as of the grant date for our assumption of the risk-free interest rate. Expected dividend yield - We do not currently pay dividends on our capital stock; therefore, a dividend yield of 0% was used in the Monte Carlo simulation valuation model. • Time-Based Restricted Stock Units In 2011, we began granting time-based restricted stock units to certain key executives and other key members of the Company’s management team. We currently have grants from 2013, 2014, 2015 and 2016 outstanding. The majority of the grants ratably vest on the first, second and third anniversaries of the original grant date. We recognize compensation expense on all of these awards on a straight-line basis over the vesting period. The fair value of the award is determined based on the market value of the underlying stock price at the grant date. • Deferred Stock Units We grant deferred stock units to non-management directors. These awards are fully vested on the date of grant and the related shares are generally issued on the 13th month anniversary of the grant date unless the individual elects to defer the receipt of these shares. Each deferred stock unit results in the issuance of one share of Rogers’ stock. The grant of deferred stock units is typically done annually in the second quarter of each year. The fair value of the award is determined based on the market value of the underlying stock price at the grant date. • Stock Options Historically, we granted stock options to certain key executives and other key members of the Company’s management team and our last grant was in 2012. To value stock options, we calculated the grant-date fair values using the Black-Scholes valuation model. The use of valuation models required us to make estimates for the following assumptions: Expected volatility - In determining expected volatility, we consider a number of factors, including historical volatility and implied volatility. Expected term - We use historical employee exercise data to estimate the expected term assumption for the Black-Scholes valuation model. Risk-free interest rate - We use the yield on zero-coupon U.S. Treasury securities for a period commensurate with the expected term assumption as the risk-free interest rate. Expected dividend yield - We do not currently pay dividends on our capital stock; therefore, a dividend yield of 0% was used in the Black-Scholes model. The amount of stock-based compensation expense recognized during a period is based on the value of the portion of the awards that are ultimately expected to vest. Forfeitures are estimated at the time of grant and revised, if necessary, in subsequent periods if actual forfeitures differ from those estimates. The term “forfeitures” is distinct from “cancellations” or “expirations” and represents only the unvested portion of the surrendered option. Based on an analysis of our historical forfeitures, we have applied an annual forfeiture rate of 3% to all unvested stock-based awards as of December 31, 2016. The rate of 3% represents the portion that is expected to be forfeited each year over the vesting period. This analysis is re-evaluated annually and the forfeiture rate is adjusted as necessary. Ultimately, the actual expense recognized over the vesting period will only be for those awards that vest.

<s>[INST] In the following discussion and analysis, we sometimes provide financial measures that were not prepared in accordance with U.S. generally accepted accounting principles (GAAP), such as adjusted selling, general and administrative expense as a percentage of net sales or adjusted operating income as a percentage of net sales. Management believes that these nonGAAP financial measures provide meaningful supplemental information regarding the Company’s performance by excluding certain expenses that are generally nonrecurring or otherwise may not be indicative of the core business operating results. In general, the Company believes that the additional nonGAAP financial measures provided herein are useful to management and investors in analyzing trends in the Company’s business and planning and forecasting future periods. However, nonGAAP financial measures have limitations as an analytical tool and should not be considered in isolation from, or solely as an alternative to, financial information prepared in accordance with GAAP. Where we provide nonGAAP financial measures in the following narrative, we have identified the most directly comparable GAAP financial measures and provided the most directly comparable GAAP financial measure, as well as the information necessary to reconcile the two measures. Business Overview Rogers Corporation designs, develops, manufactures and sells highquality and highreliability engineered materials and components for mission critical applications. We operate principally three strategic business segments: Advanced Connectivity Solutions (ACS), Elastomeric Material Solutions (EMS) and Power Electronics Solutions (PES). We are currently headquartered in Rogers, Connecticut, but we plan to relocate our headquarters to Chandler, Arizona, where we have major business and manufacturing operations, during 2017. We have a history of innovation and have established two Rogers Innovation Centers for our leading research and development activities, in Massachusetts and Suzhou, China. Our growth strategy is based upon the following principles: (1) marketdriven organization, (2) innovation leadership, (3) synergistic mergers and acquisitions, and (4) operational excellence. As a marketdriven organization, we are focused on growth drivers, including, connectivity, clean energy, and safety and protection. In executing on our growth strategy, we have completed three strategic acquisitions: (1) in January 2017, we acquired the principal operating assets of Diversified Silicone Products, Inc. (DSP), a custom silicone product development and manufacturing business, serving a wide range of high reliability applications, (2) in November 2016, we acquired DeWAL Industries (DeWAL), a leading manufacturer of polytetrafluoroethylene and ultrahigh molecular weight polyethylene films, pressure sensitive tapes and specialty products for the industrial, aerospace, automotive, and electronics markets, and (3) in January 2015, we acquired Arlon LLC and its subsidiaries, other than Arlon India (Pvt) Limited (the acquired subsidiaries, collectively, Arlon), a leading manufacturer of high performance materials for the printed circuit board industry and silicone rubberbased materials. 2016 Executive Summary In 2016 as compared to 2015, our net sales increased 2.3% to $656.3 million, gross margin increased 130 bps to 38.0%, and operating income increased 10.0% to $83.9 million. The following key factors should be considered when reviewing our results of operations, financial condition and liquidity for the periods discussed: Our net sales increase in 2016 was attributable to sales increases in all of our strategic business segments, offset in part by a 2015 divestiture and a negative currency impact. Net sales in each of our strategic business segments increased (ACS: 3.8%, EMS: 12.3%; PES: 1.4%), while net sales in our Other segment declined 2.3% due to the 2015 divestiture of the noncore Arlon polyimide and thermoset business. Additionally, net sales in 2016 in each of our strategic business segments was negatively impacted by currency fluctuations. Net sales from DeWAL were approximately $5.4 million from the acquisition date through December 31, 2016. See “Segment Sales and Operations.” Our gross margin improved 1 [/INST] Positive. </s>

ROGERS CORP

2018-02-28

2017-12-31

Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations The following discussion and analysis of our financial condition and results of operations should be read together with the Selected Financial Data and our Consolidated Financial Statements and the related notes that appear elsewhere in this Form 10-K. In the following discussion and analysis, we sometimes provide financial information that was not prepared in accordance with U.S. generally accepted accounting principles (GAAP). Management believes that such non-GAAP financial measures can provide meaningful supplemental information regarding the Company’s performance by excluding certain expenses that are generally non-recurring or otherwise may not be indicative of the core business operating results. In general, the Company believes that any such additional non-GAAP financial information provided is useful to management and investors in assessing the Company’s historical performance and for planning, forecasting and analyzing future periods. However, non-GAAP financial measures have limitations as an analytical tool and should not be considered in isolation from, or solely as an alternative to, financial information prepared in accordance with GAAP. Any time we provide non-GAAP financial measures in the following narrative, we identify it as such and in close proximity provide the most directly comparable GAAP financial measure, as well as the information necessary to reconcile the two measures. Business Overview Rogers Corporation designs, develops, manufactures and sells high-quality and high-reliability engineered materials and components for mission critical applications. We operate principally three strategic operating segments: Advanced Connectivity Solutions (ACS), Elastomeric Material Solutions (EMS) and Power Electronics Solutions (PES). We have a history of innovation and have established Innovation Centers for our leading research and development activities in Chandler, Arizona, Burlington, Massachusetts, Eschenbach, Germany and Suzhou, China. We are headquartered in Chandler, Arizona. Our growth strategy is based upon the following principles: (1) market-driven organization, (2) innovation leadership, (3) synergistic mergers and acquisitions, and (4) operational excellence. As a market-driven organization, we are focused on growth drivers, including advanced mobility and advanced connectivity. More specifically, the key trends and markets that affect our business include the increased use of advanced driver assistance systems and adoption of electric and hybrid electric vehicles and new technology adoption in the telecom industry, including next generation wireless infrastructure. In addition to our focus on advanced mobility and advanced connectivity, we also sell into a variety of other end markets including renewable energy, aerospace and defense and diverse general industrial applications. Our sales and marketing approach is based on addressing these trends, while our strategy focuses on factors for success as a manufacturer of engineered materials and components: quality, service, cost, efficiency, innovation and technology. We have expanded our capabilities through organic investment and acquisitions and strive to ensure high quality solutions for our customers. We continue to review and re-align our manufacturing and engineering footprint in an effort to attain a leading competitive position globally. We have established or expanded our capabilities in various locations in support of our customers’ growth initiatives. We seek to enhance our operational and financial performance by investing in research and development, manufacturing and materials efficiencies, and new product initiatives that respond to the needs of our customers. We strive to evaluate operational and strategic alternatives to improve our business structure and align our business with the changing needs of our customers and major industry trends affecting our business. In executing on our growth strategy, we have completed three strategic acquisitions: (1) in January 2017, we acquired the principal operating assets of Diversified Silicone Products, Inc. (DSP), a custom silicone product development and manufacturing business, serving a wide range of high reliability applications, (2) in November 2016, we acquired DeWAL Industries LLC (DeWAL), a leading manufacturer of polytetrafluoroethylene and ultra-high molecular weight polyethylene films, pressure sensitive tapes and specialty products for the industrial, aerospace, automotive, and electronics markets, and (3) in January 2015, we acquired Arlon LLC and its subsidiaries, other than Arlon India (Pvt) Limited (the acquired entities, collectively, Arlon), a leading manufacturer of high performance materials for the printed circuit board industry and silicone rubber-based materials. 2017 Executive Summary In 2017 as compared to 2016, our net sales increased 25.1% to $821.0 million, gross margin increased 79 basis points to 38.8%, operating margin increased 315 basis points to 15.9% and operating income increased 56.0% to $130.8 million. The following key factors should be considered when reviewing our results of operations, financial condition and liquidity for the periods discussed: • Our net sales increase in 2017 was attributable to increases in net sales across all of our strategic operating segments, reflecting both growth attributable to our recent acquisitions and organic growth within each operating segment. Each of ACS, EMS and PES recorded net sales growth. ACS experienced continued growth in automotive radar applications, consumer electronics, and aerospace and defense, partially offset by lower demand in wireless infrastructure applications and satellite TV dish applications. EMS net sales increased primarily from the recent acquisitions of DeWAL and DSP, and from higher end-market demand from core markets, including automotive, mass transit, portable electronics, general industrial, and consumer products applications. PES saw strength across most of its traditional markets, including laser diode cooler applications, renewable energy, mass transit, electric and hybrid electric vehicles and variable frequency motor drives. See “Segment Sales and Operations.” • Our gross margin improved 79 basis points and our operating margin increased 315 basis points in 2017 compared to 2016 primarily as a result of increased demand and our operational excellence initiatives. Gross margin and operating margin were favorably impacted by the increase in net sales, combined with operational excellence initiatives across our operating segments including increased capacity utilization, operational process enhancements and automation, conversion of fixed cost structure to variable, benefits from low cost country manufacturing expansion, and synergies from the recent acquisitions of DeWAL and DSP. See “Results of Operations.” • We continue to execute on our synergistic acquisition strategy. The acquisitions of DeWAL and DSP, and their subsequent integration into our EMS operating segment, have enabled us to extend the product portfolio and technology capabilities with complementary high-end, high performance elastomeric materials. • During 2017, we refinanced our borrowings under our revolving credit facility and as a result of strong financial performance, we made discretionary principal payments of $110.2 million. Our outstanding borrowings under our credit facility decreased to $131.0 million as of December 31, 2017. • We are an innovation company and in 2017 spent 3.6% of our net sales on research and development. Research and development (R&D) expenses were $29.5 million in 2017, an increase of 3.4% from $28.6 million in 2016. The increased spending was due to continued investments that are targeted at developing new platforms and technologies. We have made concerted efforts to realign our R&D organization to better fit the future direction of our Company, including dedicating resources to focus on current product extensions and enhancements to meet our short-term and long-term technology needs. Results of Operations The following table sets forth, for the periods indicated, selected operations data expressed as a percentage of net sales. 2017 vs. 2016 Net Sales Net sales increased by 25.1% in 2017 compared to 2016. This increase was driven by the net sales from our recent acquisitions of DeWAL and DSP, as well as higher organic net sales in our three strategic operating segments (ACS, EMS and PES). The ACS operating segment had an increase in net sales of 8.4% due to higher end-market demand in automotive radar applications, consumer electronics, and aerospace and defense, partially offset by lower demand in wireless infrastructure applications and satellite TV dish applications. EMS net sales increased 53.9% primarily due to the recent acquisitions of DeWAL and DSP, and from higher end-market product demand from core markets, including automotive, mass transit, portable electronics, general industrial and consumer products applications. PES had increased net sales of 21.4% due to higher end-market demand in laser diode cooler applications, renewable energy, mass transit, electric and hybrid electric vehicles and variable frequency motor drives. Net sales were unfavorably impacted by 0.1% due to currency fluctuations primarily as a result of the depreciation in value of the Renminbi relative to the U.S. dollar, offset in part by appreciation in value of the Euro relative to the U.S. dollar. See “Segment Sales and Operations” below for further discussion on operating segment performance. Gross Margin Gross margin as a percentage of net sales increased by 79 basis points to 38.8% in 2017 compared to 38.0% in 2016. In 2017, gross margin was favorably impacted by an increase in net sales combined with operational excellence initiatives across our operating segments, including increased capacity utilization, operational process enhancements and automation, conversion of fixed cost structure to variable, benefits from low cost country manufacturing expansion, and synergies from the recent acquisitions of DeWAL and DSP. Selling, General and Administrative Expenses Selling, general and administrative (SG&A) expenses increased by 17.4% in 2017 compared to 2016, due principally to $6.1 million of additional equity and incentive compensation expense, $4.8 million of additional other intangible assets amortization and depreciation related to the acquisitions, $4.7 million of additional SG&A expenses from the operations of the acquired businesses, $3.6 million of additional sales and marketing costs, $1.3 million of corporate development activity costs, and $3.4 million for additional asbestos liability accruals. Our 2017 results also include $3.2 million of acquisition and integration costs related to DeWAL and DSP. SG&A decreased as a percent of net sales to 19.5% in 2017 compared to 20.8% in 2016 as a result of administrative cost containment activities. Research and Development Expenses Research and development (R&D) expenses increased by 3.4% in 2017 compared to 2016. The increase is due to continued investments that are targeted at developing new platforms and technologies focused on long-term growth initiatives at our Innovation Centers in the United States, Europe and Asia. As a percentage of sales, R&D costs decreased from 4.4% in 2016 to 3.6% in 2017 primarily due to sales growth increasing at a higher rate than the increase in R&D spend. Other Operating Expenses (Income) In the second quarter of 2017, we completed the physical relocation of our global headquarters from Rogers, Connecticut to Chandler, Arizona. We recorded $2.8 million of expense related to this project in 2017 compared to $0.7 million recorded in 2016. In the third quarter of 2017, we recognized a $0.3 million impairment charge related to our remaining investment in BrightVolt, Inc. (formerly known as Solicore, Inc.). As this investment does not relate to a specific operating segment, we allocated it ratably among the three operating segments. In the fourth quarter of 2017, we recognized a $0.5 million impairment charge related to the remaining net book value of an other intangible asset within our ROLINX® product line in our PES operating segment. In the first quarter of 2017, we completed the planned sale of a parcel of land in Belgium that had been classified as held for sale as of December 31, 2016 and recognized a gain on sale of approximately $0.9 million in operating income. Also in the third quarter of 2017, we completed the sale of a facility located in Belgium and recognized a gain on sale of approximately $4.4 million in operating income. Equity Income in Unconsolidated Joint Ventures Equity income in unconsolidated joint ventures increased 18.1% in 2017 from 2016. The increases were due to higher demand, primarily in the portable electronics market. Other Income (Expense), Net In 2017, the increase in other income (expense), net was attributable to gains in copper derivative transactions of approximately $1.9 million compared to gains of $0.5 million in 2016, as well as gains from foreign currency fluctuations of $0.8 million compared to losses of $1.8 million in 2016. In 2016, we also recorded an additional loss related to the sale of the Arlon polyimide and thermoset laminate business of $0.2 million, and $0.8 million of expense for tax indemnity receivables that were reversed due to the release of uncertain tax positions. Interest Expense, Net Interest expense, net, increased by 56.0% in 2017 from 2016. This increase was primarily due to higher outstanding borrowings on our credit facility in 2017 compared to 2016 due to borrowings to fund the acquisitions of DeWAL and DSP. As explained in “Liquidity, Capital Resources and Financial Position” below, we made discretionary principal payments of $110.2 million in 2017 to reduce our outstanding borrowings under our credit facility to $131.0 million as of December 31, 2017. Income Tax Expense Our effective tax rate for 2017 was 39.5%, including our provisional estimate of the impact of the recent significant tax reform in the United States (U.S. Tax Reform), compared to 41.3% in 2016. The 2017 rate decrease was primarily due to lower foreign tax impact on remitted and unremitted foreign earnings and profits, equity compensation excess tax deductions recognized in 2017 and increased international tax rate benefits due to earnings mix. This was substantially offset by our provisional estimate of the impact of U.S. Tax Reform, a decrease in reversal of reserves associated with uncertain tax positions and a change in valuation allowance associated with deferred tax assets that are capital in nature. See Note 13, “Income Taxes” to “Item 8 - Financial Statements and Supplementary Data” for additional information regarding U.S. Tax Reform. Excluding the impact of U.S. Tax Reform, our effective tax rate for 2017 was 29.2%. On December 22, 2017, Staff Accounting Bulletin No. 118 (SAB 118) was issued to address the application of US GAAP in situations when a registrant does not have the necessary information available, prepared, or analyzed (including computations) in reasonable detail to complete the accounting for certain income tax effects of the Act. In accordance with SAB 118, we have determined that the $1.7 million of the deferred tax expense recorded in connection with the remeasurement of certain deferred tax assets and liabilities and the $12.0 million of tax expense recorded in connection with the transition tax on the mandatory deemed repatriation of foreign earnings was a provisional amount and a reasonable estimate at December 31, 2017. Management will subject these estimates to further analysis related to certain matters, such as federal and state interpretations of U.S. Tax Reform, U.S. Treasury regulations, administrative interpretations or court decisions, a more detailed analysis of post-1986 undistributed foreign subsidiary earnings and profits (E&P) that may require further adjustments and changes to certain estimates, as well as potential correlative adjustments. Any subsequent adjustment to these amounts will be recorded to tax expense in the quarter of 2018 when the analysis is complete. See Note 13, “Income Taxes” to “Item 8 - Financial Statements and Supplementary Data” for additional information regarding U.S. Tax Reform. Backlog Our backlog of firm orders was $122.8 million as of December 31, 2017, compared to $106.5 million as of December 31, 2016. The ACS, PES and Other operating segments experienced year-over-year increases in backlog of $2.2 million, $13.8 million and $4.5 million, respectively while the EMS operating segment experienced a year-over-year decrease of $6.4 million. The increase in backlog for the ACS, PES and Other operating segments is primarily due to overall sales growth in 2017 compared to 2016, as well as increases in long-term buying patterns in the ACS operating segment, and favorable currency fluctuations in our PES operating segment. The decrease in backlog for the EMS operating segment is primarily due to an increase in order fulfillment during 2017 as compared to 2016. Additionally, the 2017 EMS backlog contains $2.1 million related to DSP. The backlog of firm orders is expected to be filled within the next 12 months. 2016 vs. 2015 Net Sales Net sales increased by 2.3% in 2016 from 2015, driven primarily by the ACS and EMS operating segments. The ACS operating segment net sales increased 3.8%, including a negative currency impact of 1.0%. The EMS operating segment net sales increased 12.3%, including a negative currency impact of 1.8%. The PES operating segment net sales increased 1.4%, including a negative currency impact of 0.9%. In total, the increase in net sales in 2016 included a negative currency impact of 1.2%. Additionally, sales in 2016 declined by 2.9% due to the non-core divestiture of the Arlon polyimide and thermoset laminate business, which was sold in December 2015. Gross Margin Gross margin as a percentage of net sales increased by 130 basis points to 38.0% in 2016 compared to 36.7% in 2015. In 2016, gross margin was favorably impacted by an increase in net sales and lower commodities pricing, combined with operational excellence initiatives across our business units and the divestiture of the lower margin Arlon polyimide and thermoset business in 2015. Our 2015 results included $1.6 million of expense for a non-recurring purchase accounting fair value adjustment for inventory related to the Arlon acquisition. Selling, General and Administrative Expenses Selling, general and administrative (SG&A) expenses increased by 3.7% in 2016 compared with 2015. Our 2016 results increased principally due to $7.7 million of incentive compensation due to the Company meeting performance incentive targets and $4.5 million of costs associated with non-acquisition related strategic projects. These increases were partially offset by cost savings from cost containment initiatives. Our 2016 results include $3.8 million of acquisition costs related to DeWAL and DSP and 2015 included $4.8 million in integration expenses related to the Arlon acquisition and $3.2 million related to the establishment of an environmental reserve. Research and Development Expenses Research and development (R&D) expenses increased by 3.4% in 2016 compared with 2015. As a percentage of sales, R&D costs increased from 4.3% in 2015 to 4.4% in 2016. The overall increase was due to continued investments that are targeted at developing new platforms and technologies focused on long-term growth initiatives at our Innovation Centers in the United States, Europe and Asia. Equity Income in Unconsolidated Joint Ventures Equity income in unconsolidated joint ventures increased 43.5% in 2016 from 2015. The increase was due to the appreciation of the Japanese Yen against the U.S. dollar, as the currency value significantly changed. Excluding the impact of the currency change, net sales increased due to higher demand primarily in the portable electronics market. Interest Expense, Net Interest expense, net, was lower expense by 12.3% in 2016 from 2015. The decrease year over year was driven by $103.4 million of debt repayments in 2016 on borrowings incurred in January 2015 associated with the Arlon acquisition. Other Income (Expense), Net In 2015, our results included $4.8 million of a loss on the sale of the Arlon specialty polyimide and epoxy-based laminates business and $2.4 million of receivables related to the tax indemnities that were reversed, which related to the release of uncertain tax positions. Comparing 2016 to 2015, we recognized a net favorable impact of $1.5 million due to copper hedging transactions and a net unfavorable impact of $1.9 million due to foreign currency transactions. Additionally, in the third quarter of 2016, we had $0.8 million of expense for tax indemnity receivables that were reversed, which related to the release of uncertain tax positions, and in the first quarter of 2016, we recorded an additional loss related to the sale of the Arlon polyimide and thermoset laminate business of $0.2 million. Income Tax Expense Our effective tax rate for 2016 was 41.3% compared to 30.0% in 2015. The increase from 2015 is primarily related to withholding taxes on off-shore cash movements, a change to our assertion that certain foreign earnings are permanently reinvested and a change in the mix of earnings attributable to higher-taxing jurisdictions, offset by benefits associated with an increase in the reversal of reserves for uncertain tax positions. This increase was offset by the prior year being unfavorably impacted by adjustments related to finalization of 2014 income tax year returns. The prior year also included a benefit due to a change of the state tax rate as a result of a legal reorganization and release of valuation allowance on certain state tax attributes. Historically, our intention was to permanently reinvest the majority of our foreign earnings indefinitely or to distribute them only when it is tax efficient to do so. As a result of certain internal restructuring transactions effectuated to more closely align our subsidiaries from an operational, legal and geographic perspective and improve management of financial resources, with respect to offshore distributions, we modified our assertion of certain accumulated foreign subsidiary earnings considered permanently reinvested during 2016. This change resulted in accrual of a deferred tax liability of $6.1 million associated with distribution related foreign taxes on undistributed earnings of our Chinese subsidiaries that are no longer considered permanently reinvested. In the event that we distributed these funds to other offshore subsidiaries, these taxes would become due. In addition, we incurred $6.3 million of withholding taxes related to distributions from China. Backlog Our backlog of firm orders was $106.5 million as of December 31, 2016, as compared to $63.3 million as of December 31, 2015. ACS, EMS, PES and Other operating segments experienced year over year increases in backlog of $13.2 million, $15.8 million, $13.8 million and $0.4 million, respectively. Contributing to the year over year change in backlog was an improvement in general market conditions. Additionally, the 2016 backlog contained $7.2 million related to the DeWAL business. Segment Sales and Operations Core Strategic Advanced Connectivity Solutions The ACS operating segment is comprised of high frequency circuit material products used for making circuitry that receives, processes and transmits high frequency communications signals, in a wide variety of markets and applications, including wireless communications, automotive, high reliability, wired infrastructure, aerospace and defense, and consumer applications, among others. 2017 vs. 2016 Net sales in this segment increased by 8.4% in 2017 compared to 2016. The increase in net sales is primarily driven by end market demand in automotive radar applications 48.3%, consumer electronics 38.3%, and aerospace and defense 8.8%, partially offset by lower demand in wireless infrastructure applications 5.0% and satellite TV dish applications 14.3%. Net sales were unfavorably impacted by 0.4% due to currency fluctuations, primarily as a result of the depreciation in value of the Renminbi relative to the U.S. dollar. Operating income improved by 27.8% in 2017 compared to 2016. As a percentage of net sales in 2017, operating income was 18.7%, a 280 basis point increase, compared to 15.8% in 2016. This increase is primarily due to higher net sales as well as lower costs from continued operational efficiencies and cost reduction initiatives. 2016 vs. 2015 Net sales in this segment increased by 3.8% in 2016 compared to 2015. Currency fluctuations decreased net sales by 1.0%. The increase in net sales is driven primarily by automotive radar applications for advanced driver assistance systems 23.1% and aerospace and defense applications 8.7% and other applications 30.0%, partially offset by a decline in the wireless telecom market 3.5% and lower demand in the satellite TV dish applications 22.2%. Operating income declined by 2.6% in 2016 from 2015. As a percentage of net sales, 2016 operating income was 15.8%, a 110 basis point decrease as compared to the 16.9% reported in 2015. Operating income in 2016 was positively impacted by higher sales, however this increase was offset by unfavorable mix, unfavorable volume pricing and absorption, higher incentive compensation and additional corporate selling, general and administrative expense allocations. 2015 results included $5.3 million of charges comprised of $2.6 million of integration expenses related to the Arlon acquisition, $1.0 million of Arlon purchase accounting expenses related to the non-recurring fair value adjustment for inventory, $1.4 million of allocated environmental charge and $0.4 million of allocated severance related charges. Elastomeric Material Solutions The EMS operating segment is comprised of polyurethane and silicone foam products, which are sold into a wide variety of applications and markets, including general industrial, portable electronics, automotive, mass transit and consumer applications. In November 2016, we completed the acquisition of DeWAL, a leading manufacturer of polytetrafluoroethylene, ultra-high molecular weight polyethylene films, pressure sensitive tapes and specialty products for the industrial, aerospace, automotive, and electronics markets. In January 2017, we acquired the principal operating assets of DSP, a custom silicone product development and manufacturing business, serving a wide range of high reliability applications. The integration of DeWAL and DSP into our EMS operating segment has enabled us to extend the product portfolio and technology capabilities with complementary high-end, high performance elastomeric materials. 2017 vs. 2016 Net sales in this segment increased 53.9% in 2017 compared to 2016. The increase in net sales was primarily driven by the acquisitions of DeWAL and DSP 38.8%, as well as an increase in organic net sales 15.1%. EMS experienced higher end-market demand in core markets including automotive 28.0%, mass transit 23.5%, portable electronics 22.6%, general industrial 13.6% and consumer products applications 8.1%. Net sales were unfavorably impacted by 0.4% due to currency fluctuations, primarily as a result of the depreciation in value of the Renminbi relative to the U.S. dollar, partially offset by the appreciation in value of the Korean Won and Euro relative to the U.S. dollar. Operating income improved 93.3% in 2017 compared to 2016. As a percentage of net sales, 2017 operating income was 16.4%, a 340 basis point increase compared to 13.1% in 2016. This increase is primarily due to higher net sales attributable to both acquisitions and organic growth, as well as lower costs from continued operational efficiencies. Operating income in 2017 included a $1.6 million charge to reflect a purchase accounting fair value adjustment for inventory related to the DeWAL and DSP acquisitions and $3.2 million of acquisition and integration costs. Operating income in 2017 also included increased other intangible assets amortization and depreciation expense of $4.9 million related to the DeWAL and DSP acquisitions. 2016 vs. 2015 Net sales in this segment increased by 12.3% in 2016 from 2015. Currency fluctuations decreased net sales by 1.8%. The increase in net sales was driven primarily by portable electronics applications 23.9%, automotive applications 41.4% and general industrial 1.6%. These increases were partially offset by declines in demand in consumer applications 15.2% and mass transit 1.9%. The results of DeWAL have been included in our consolidated financial statements only for the period subsequent to the completion of our acquisition. During this period, net sales attributable to DeWAL totaled $5.4 million. Operating income increased by 33.1% in 2016 from 2015. As a percentage of net sales, 2016 operating income was 13.1%, a 210 basis point increase as compared to the 11.0% reported in 2015. The increase in operating income in 2016 is primarily due to an increase in net sales, partially offset by corporate selling, general and administrative expense allocations and higher incentive compensation. 2016 results also include $3.8 million of acquisition costs related to the DeWAL and DSP acquisitions, along with $0.9 million of expenses related to the non-recurring fair value adjustment for DeWAL inventory. The results of DeWAL have been included in our consolidated financial statements only for the period subsequent to the completion of our acquisition. During this period, operating income attributable to DeWAL totaled $2.0 million. 2015 results included $3.2 million of charges comprised of $1.6 million of integration expenses related to the Arlon acquisition, $0.5 million of Arlon purchase accounting expenses related to the non-recurring fair value adjustment for inventory, $0.8 million of allocated environmental charge and $0.3 million of allocated severance related charges. Power Electronics Solutions The PES operating segment is comprised of two product lines - curamik® direct-bonded copper (DBC) substrates that are used primarily in the design of intelligent power management devices, such as IGBT (insulated gate bipolar transistor) modules that enable a wide range of products including highly efficient industrial motor drives, wind and solar energy converters and electrical systems in automobiles, and ROLINX® busbars that are used primarily in power distribution systems products in electric and hybrid electric vehicles and clean technology applications. 2017 vs. 2016 Net sales in this segment increased 21.4% in 2017 compared to 2016. The increase in net sales was driven by higher demand for laser diode cooler applications 44.6%, renewable energy 40.3%, mass transit 23.4%, electric and hybrid electric vehicles 18.5% and variable frequency motor drives 10.3%. Net sales were favorably impacted by 0.8% due to currency fluctuations primarily as a result of the appreciation in value of the Euro relative to the U.S. dollar, partially offset by the depreciation in value of the Renminbi relative to the U.S. dollar. Operating income increased 168.8% in 2017 compared to 2016. As a percentage of net sales, 2017 operating income was 8.7%, a 480 basis point increase as compared to 3.9% in 2016. This increase is primarily due to higher net sales and increased equipment utilization, supply chain volume discounts, and improved productivity from operational excellence initiatives, partially offset by a $0.5 million impairment charge related to the remaining net book value of an other intangible asset within our ROLINX® product line in our PES operating segment. 2016 vs. 2015 Net sales in this segment increased by 1.4% in 2016 from 2015. Currency fluctuations decreased net sales by 0.9%. The increase in net sales was driven by demand in electric and hybrid electric vehicles 15.6%, variable frequency motor drives 7.9% and certain renewable energy applications 2.0%. These increased net sales were partially offset by lower demand in rail applications 40.6%. Operating income increased 59.1% in 2016 from 2015. As a percentage of net sales, 2016 operating income was 3.9%, a 140 basis point increase as compared to the 2.5% reported in 2015. This increase is primarily due to operational efficiency programs and an increase in net sales partially offset by unfavorable product mix, increased incentive compensation and corporate selling, general and administrative expense allocations. 2015 included approximately $2.0 million of allocated charges comprised of $1.1 million of an environmental charge and $0.9 million of severance related charges. Other Our Other operating segment consists of our elastomer rollers and floats business, as well as our inverter distribution business. Additionally, this segment included the acquired Arlon polyimide and thermoset laminate business from January 2015 until it was sold in December 2015. 2017 vs 2016 Net sales decreased 2.8% in 2017 compared to 2016, primarily due to lower demand in global light vehicles, as well as a negative impact from currency fluctuations of 0.7% resulting from a depreciation in the value of the Renminbi relative to the U.S. dollar. Operating income in 2017 decreased by 2.4% compared to 2016 primarily due to lower net sales, partially offset by the impact of continuing operating efficiencies. 2016 vs 2015 Net sales decreased by 46.1% in 2016 from 2015, due principally to the impact of the divestiture of the Arlon polyimide and thermoset laminate business in December 2015. Net sales were unfavorably impacted by 1.4% due to currency fluctuations. Operating income decreased 1.1% in the 2016 from 2015. The decline was primarily due to lower net sales partially offset by $0.6 million of integration expenses related to the Arlon acquisition that are included in 2015 results, which didn’t repeat in 2016. As a percentage of net sales, operating income increased to 31.9% in 2016 from 17.4% in 2015, due principally to the sale of the lower margin Arlon polyimide and thermoset laminate business. Product and Market Development Our research and development team is dedicated to growing our business by developing cost effective solutions that improve the performance of customers’ products and by identifying business and technology acquisition or development opportunities to expand our market presence. Currently, R&D spend is approximately 3.6% of net sales. Liquidity, Capital Resources and Financial Position We believe our existing sources of liquidity and cash flows expected to be generated from operations, together with available credit facilities, will be sufficient to fund our operations, capital expenditures, research and development efforts, and debt service commitments, as well as our other operating and investing needs, for at least the next twelve months. We regularly review and evaluate the adequacy of our cash flows, borrowing facilities and banking relationships to ensure that we have the appropriate access to cash to fund both near-term operating needs and long-term strategic initiatives. At December 31, 2017, cash and cash equivalents were $181.2 million as compared to $227.8 million at the end of 2016, a decrease of $46.6 million, or approximately 20.5%. This decrease was primarily due to discretionary principal payments on our outstanding credit facility of $110.2 million during 2017, a payment of $60.2 million for the acquisition of DSP in January 2017, and $27.2 million in capital expenditures, partially offset by cash generated by operations. The following table illustrates the location of our cash and cash equivalents by our three major geographic areas: Approximately $145.5 million of cash and cash equivalents are held by non-U.S. subsidiaries. As a result of U.S. Tax Reform, these funds have been subjected to U.S. tax through the transition tax, but could be subject to additional taxes if they are redeployed outside of their country of origin. With the exception of certain of our Chinese subsidiaries, we have historically and continue to assert that foreign earnings are indefinitely reinvested. While we have not currently changed our assertion with respect to foreign earnings compared to prior years, we are currently evaluating the impact of U.S. Tax Reform on our global structure and any associated impacts it may have on our assertion on a go forward basis and as such have not included a provisional estimate of the impact. See Note 13, “Income Taxes,” to “Item 8 - Financial Statements and Supplementary Data” for additional information regarding U.S. Tax Reform. Net working capital was $340.7 million, $357.2 million and $350.0 million as of December 31, 2017, 2016 and 2015, respectively. Significant changes in our balance sheet accounts from December 31, 2016 to December 31, 2017 were as follows: ◦ Accounts receivable increased 17.5% to $140.6 million as of December 31, 2017, from $119.6 million at December 31, 2016. The increase was due primarily to higher net sales in 2017 resulting from our acquisitions of DeWAL in late 2016 and DSP in early 2017, as well as higher organic net sales in our three strategic operating segments. ◦ Inventory increased 23.5% to $112.6 million as of December 31, 2017, from $91.1 million at December 31, 2016. The increase is due primarily to a $9.1 million increase in raw materials and a $6.5 million increase in finished goods as a result of increased demand across all operating segments, partially offset by a $1.1 million decrease in work in process inventory due to lower demand of certain components in our EMS operating segment. The increase in inventory over the prior year also includes fluctuations in foreign currency transactions of $2.8 million. Additionally, inventory increased $3.5 million as of December 31, 2017 due to the acquisition of DSP in January 2017. ◦ Goodwill increased 13.8% to $237.1 million as of December 31, 2017, from $208.4 million at December 31, 2016. The increase is due primarily to the acquisition of DSP in January 2017. There were no impairments of goodwill during the year ended December 31, 2017. ◦ Other intangible assets increased 17.3% to $160.3 million as of December 31, 2017 from $136.7 million at December 31, 2016. This increase is due primarily to the acquisition of DSP in January 2017, partially offset by amortization of definite-lived other intangible assets and an impairment charge of $0.5 million during the year related to the remaining net book value of an other intangible asset within our ROLINX® product line in our PES operating segment. During 2017, $78.3 million of net cash was used for investing activities as compared to $151.8 million in 2016 and $180.3 million in 2015. Investing activities for 2017 included the acquisition of DSP, which used $60.2 million in investing cash (net), compared to $133.9 million in investing cash (net) used for the DeWAL acquisition in 2016. Capital expenditures were $27.2 million, $18.1 million and $24.8 million in 2017, 2016 and 2015, respectively. During 2018, we expect capital spending to be in the range of approximately $50.0 million to $60.0 million. We plan to fund the 2018 capital requirements with cash from operations. Net cash used in financing activities was $113.2 million in 2017, compared to $57.9 million and $83.0 million in 2016 and 2015, respectively. The increase is due primarily to the $110.2 million in payments on our outstanding credit facility and $0.5 million payments on capital leases during 2017. Financing activities in 2016 and 2015 included borrowings of $166.0 million and $125.0 million, respectively, to finance the acquisitions of DeWAL, DSP and Arlon. Credit Facilities On June 18, 2015, we entered into a secured five year credit agreement with JPMorgan Chase Bank, N.A, as administrative agent, and the lenders party thereto (the “Second Amended Credit Agreement”). The Second Amended Credit Agreement provided (1) a $55.0 million term loan; (2) up to $295.0 million of revolving loans, with sublimits for multicurrency borrowings, letters of credit and swing-line notes; and (3) a $50.0 million expansion feature. On February 17, 2017, we entered into a secured five-year credit agreement with JPMorgan Chase Bank, N.A., as administrative agent, and the lenders party thereto (the “Third Amended Credit Agreement”), which amended and restated the Second Amended Credit Agreement. The Third Amended Credit Agreement refinanced the Second Amended Credit Agreement, eliminated the term loan under the Second Amended Credit Agreement, and increased the principal amount of the revolving credit facility to up to $450.0 million borrowing capacity with sublimits for multicurrency borrowings, letters of credit and swing-line notes, and provided an additional $175.0 million accordion feature. All revolving loans under the Third Amended Credit Agreement are due on the maturity date, February 17, 2022. We are not required to make any quarterly principal payments under the Third Amended Credit Agreement. During 2017, we made discretionary principal payments of $110.2 million to reduce the amount outstanding on our credit facility. As of December 31, 2017, we had $131.0 million in outstanding borrowings under our credit facility. See Note 12, “Debt,” for additional information on the Third Amended Credit Agreement. Restriction on Payment of Dividends Our Third Amended Credit Agreement generally permits us to pay cash dividends to our shareholders, provided that (i) no default or event of default has occurred and is continuing or would result from the dividend payment and (ii) our leverage ratio does not exceed 2.75 to 1.00. If our leverage ratio exceeds 2.75 to 1.00, we may nonetheless make up to $20.0 million in restricted payments, including cash dividends, during the fiscal year, provided that no default or event of default has occurred and is continuing or would result from the payments. Our leverage ratio did not exceed 2.75 to 1.00 as of December 31, 2017. Contractual Obligations The following table summarizes our significant contractual obligations as of December 31, 2017. (1) This amount represents non-cancelable vendor purchase commitments. (2) As noted above in the description of our Third Amended Credit Agreement, we are no longer required to make quarterly principal payments on outstanding borrowings under our term loan. Accordingly, all outstanding borrowings under our credit facility are now due on February 17, 2022. (3) Estimated future interest payments are based on a leveraged based spread that ranges from 1.375% to 1.75%, plus projected forward 1-month LIBOR rates. Unfunded pension benefit obligations, which amount to $5.7 million at December 31, 2017, are expected to be paid from operating cash flows and the timing of payments is not definitive. Retiree health and life insurance benefits, which amount to $2.0 million, are expected to be paid from operating cash flows. Other long-term liabilities, such as deferred taxes, unrecognized tax benefits and asbestos-related product liability reserves, have been excluded from the table due to the uncertainty of the timing of payments combined with the absence of historical trends to be used as a predictor for such payments. Effects of Inflation We do not believe that inflation had a material impact on our business, sales, or operating results during the periods presented. Off-Balance Sheet Arrangements We do not have any off-balance sheet arrangements that have, or are, in the opinion of management, reasonably likely to have, a current or future material effect on our financial condition or results of operations. Critical Accounting Policies Our consolidated financial statements are prepared in accordance with U.S. generally accepted accounting principles, which require management to make estimates, judgments and assumptions that affect the amounts reported in the financial statements and accompanying notes. We base our estimates on historical experience and on various other assumptions that are believed to be reasonable under the circumstances and believe that appropriate reserves have been established based on reasonable methodologies and appropriate assumptions based on facts and circumstances that are known; however, actual results may differ from these estimates under different assumptions or conditions. An accounting policy is deemed to be critical if it requires an accounting estimate to be made based on assumptions that are highly judgmental and uncertain at the time the estimate is made, if different estimates could reasonably have been used, or if changes to those estimates are reasonably likely to periodically occur that could affect the amounts carried in the financial statements. These critical accounting policies are as follows: Revenue Recognition We recognize revenue when all of the following criteria are met: (1) we have entered into a binding agreement, (2) the product has shipped and title and risk of ownership have passed, (3) the sales price to the customer is fixed or determinable, and (4) collectability is reasonably assured. We recognize revenue based upon a determination that all criteria for revenue recognition have been met, which, based on the majority of our shipping terms, is considered to have occurred upon shipment of the finished product. Some shipping terms require the goods to be through customs or be received by the customer before title passes. In those instances, revenue is not recognized until either the customer has received the goods or they have passed through customs, depending on the circumstances. As appropriate, we record estimated reductions to revenue for customer returns and allowances and warranty claims. Provisions for such allowances are made at the time of sale and are typically derived from historical trends and other relevant information. See further discussion in Note 19, “Recent Accounting Standards” to “Item 8 - Financial Statements and Supplementary Data.” Inventory Valuation Inventories are stated at the lower of cost or net realizable value with costs determined primarily on a first-in first-out basis. We also maintain a reserve for excess, obsolete and slow-moving inventory that is primarily developed by utilizing both specific product identification and historical product demand as the basis for our analysis. Products and materials that are specifically identified as obsolete are fully reserved. In general, most products that have been held in inventory greater than one year are fully reserved unless there are mitigating circumstances, including forecasted sales or current orders for the product. The remainder of the allowance is based on our estimates and fluctuates with market conditions, design cycles and other economic factors. Risks associated with this allowance include unforeseen changes in business cycles that could affect the marketability of certain products and an unexpected decline in current production. We closely monitor the marketplace and related inventory levels and have historically maintained reasonably accurate allowance levels. Our obsolescence reserve has ranged from 10% to 14% of gross inventory over the last three years. Goodwill and Other Intangible Assets We have made acquisitions over the years that included the recognition of intangible assets. Intangible assets are classified into three categories: (1) goodwill; (2) other intangible assets with definite lives subject to amortization; and (3) other intangible assets with indefinite lives not subject to amortization. Other intangible assets can include items such as trademarks and trade names, licensed technology, customer relationships and covenants not to compete, among other things. Each definite-lived other intangible asset is amortized over its respective economic useful life using the economic attribution method. Goodwill is tested for impairment annually and between annual impairment tests if events or changes in circumstances indicate the carrying value may be impaired. If it is more likely than not that our goodwill is impaired, then we compare the estimated fair value of each of our reporting units to their respective carrying value. If a reporting unit’s carrying value is greater than its fair value, then an impairment is recognized for the excess and charged to operations. We currently have four reporting units with goodwill: ACS, EMS, curamik® and Elastomer Components Division (ECD). Consistent with historical practice, the annual impairment test on these reporting units was performed as of November 30, 2017. The application of the annual goodwill impairment test requires significant judgment, including the identification of reporting units, assignment of assets and liabilities to reporting units, and determination of the fair value of each reporting unit. Determining the fair value is subjective and requires the use of significant estimates and assumptions, including financial projections for net sales, gross margin and operating margin, discount rates, terminal year growth rates and future market conditions, among others. We estimated the fair value of our reporting units using an income approach based on the present value of future cash flows through a five year discounted cash flow analysis. The discounted cash flow analysis utilized the discount rates for each of the reporting units ranging from 11.0% for EMS to 12.3% for curamik®, and a terminal year growth rate of 3% for all four reporting units. We believe this approach yields the most appropriate evidence of fair value as our reporting units are not easily compared to other corporations involved in similar businesses. We further believe that the assumptions and rates used in our annual goodwill impairment test are reasonable, but inherently uncertain. There were no impairment charges resulting from our goodwill impairment analysis in 2017. The ACS, EMS, curamik® and ECD reporting units had allocated goodwill of approximately $51.7 million, $111.6 million, $71.6 million and $2.2 million, respectively, at December 31, 2017. Indefinite-lived other intangible assets are tested for impairment annually and between annual impairment tests if events or changes in circumstances indicate the carrying value may be impaired. If it is more likely than not that an indefinite-lived other intangible asset is impaired, then we compare the estimated fair value of that indefinite-lived other intangible asset to its respective carrying value. If an indefinite-lived other intangible asset’s carrying value is greater than its fair value, an impairment is recognized for the excess and charged to operations. The application of the annual indefinite-lived other intangible asset impairment test requires significant judgment, including the determination of fair value of each indefinite-lived other intangible asset. Fair value is primarily based on income approaches using discounted cash flow models, which have significant assumptions. Such assumptions are subject to variability from year to year and are directly impacted by global market conditions. There were no impairment charges resulting from our indefinite-lived other intangible assets impairment analysis in 2017. The curamik® reporting unit had an indefinite-lived other intangible asset of approximately $4.7 million at December 31, 2017. Definite-lived other intangible assets are tested for recoverability whenever events or changes in circumstances indicate the carrying value may not be recoverable. The recoverability test involves comparing the estimated sum of the undiscounted cash flows for each definite-lived other intangible asset to its respective carrying value. If a definite-lived other intangible asset’s carrying value is greater than the sum of its undiscounted cash flows, then the definite-lived other intangible asset’s carrying value is compared to its estimated fair value and an impairment charge is recognized for the excess and charged to operations. The application of the recoverability test requires significant judgment, including the identification of the asset group and determination of undiscounted cash flows and fair value of the underlying definite-lived other intangible asset. Determination of undiscounted cash flows requires the use of significant estimates and assumptions, including certain financial projections. Fair value is primarily based on income approaches using discounted cash flow models, which have significant assumptions. Such assumptions are subject to variability from year to year and are directly impacted by global market conditions. There were no impairment charges resulting from our definite-lived other intangible assets impairment analysis in 2017. The ACS, EMS and curamik® reporting units had definite-lived other intangible assets of approximately $11.1 million, $128.1 million and $16.4 million, respectively, at December 31, 2017. Product Liability For product liability claims, we typically maintain insurance coverage with reasonable deductible levels to protect us from potential exposures. Any liability associated with such claims is based on management’s best estimate of the potential claim value, while insurance receivables associated with related claims are not recorded until verified by the insurance carrier. For asbestos related claims, we recognize projected asbestos liabilities and related insurance receivables, with any difference between the liability and related insurance receivable recognized as an expense in the consolidated statements of operations. Projecting future asbestos costs and related insurance coverage is subject to numerous variables that are difficult to predict, including the number of claims that might be received, the type and severity of the disease alleged by each claimant, the long latency period associated with asbestos exposure, dismissal rates, costs of medical treatment, the financial resources of other companies that are co-defendants in claims, uncertainties surrounding the litigation process from jurisdiction to jurisdiction and from case to case, and the impact of potential changes in legislative or judicial standards, including potential tort reform. We believe the assumptions used in our models for determining our potential exposure and related insurance coverage are reasonable at the present time, but such assumptions are inherently uncertain. Prior to 2017, due to the inherent uncertainties of the projection process and our limited amount of settlement and claims history, we utilized a ten-year projection period, which we concluded was appropriate as we did not believe we had sufficient data to justify a longer projection period. During 2017, we reviewed the projections of our current and future asbestos claims, and determined it was appropriate to extend the liability projection period to cover all current and future claims through 2058. We based our conclusion on our history and experience with the claims data, the diminished volatility and consistency of observable claims data, the period of time that has elapsed since we stopped manufacturing products that contained encapsulated asbestos and an expectation of a downward trend in claims due to the average age of our claimants, which is approaching the average life expectancy. The year 2058 also represents the expected end of Rogers’ asbestos liability exposure and no further ongoing claims are expected past that date. As a result, we believe we are now able to make a reasonable estimate of the actuarially determined liability for current and future asbestos claims through 2058. As of December 31, 2017, the estimated liability and estimated insurance recovery for all current and future claims projected through 2058 was $76.2 million and $69.2 million, respectively. Given the inherent uncertainty in making projections, we plan to re-examine periodically the projections of current and future asbestos claims, and we will update them if needed based on our experience, changes in the assumptions underlying our models, and other relevant factors, such as changes in the tort system. There can be no assurance that our accrued asbestos liabilities will approximate our actual asbestos-related settlement and defense costs, or that our accrued insurance recoveries will be realized. We believe that it is reasonably possible that we may incur additional charges for our asbestos liabilities and defense costs in the future, which could exceed existing reserves and insurance recovery. Pension and Other Postretirement Benefits We provide various defined benefit pension plans for our U.S. employees and sponsor three defined benefit health care plans and a life insurance plan. The costs and obligations associated with these plans are dependent upon various actuarial assumptions used in calculating such amounts. These assumptions include discount rates, long-term rates of return on plan assets, mortality rates, and other factors. The assumptions used were determined as follows: (i) the discount rate used is based on the PruCurve high quality corporate bond index, with comparisons against other similar indices; and (ii) the long-term rate of return on plan assets is determined based on historical portfolio results, market conditions and our expectations of future returns. We determine these assumptions based on consultation with outside actuaries and investment advisors. Any changes in these assumptions could have a significant impact on future recognized pension costs, assets and liabilities. The rates used to determine our costs and obligations under our pension and postretirement plans are disclosed in Note 10, “Pension Benefits and Retirement Health and Life Insurance Benefits” to “Item 8 - Financial Statements and Supplementary Data.” Each assumption has different sensitivity characteristics. For the year ended December 31, 2017, a 25 basis point decrease in the discount rate would have increased our total pension expense by a de minimis amount. This number represents the aggregate increase in expense for the three pension plans: Employees’ Pension Plan, Defined Benefit Pension Plan and the Restoration Plan. A 25 basis point decrease in the discount rate would decrease the other post-employment benefits (OPEB) expense by a de minimis amount. A 25 basis point decrease in the expected return on assets would increase the total 2017 pension expense by approximately $0.4 million. This number represents the aggregate increase in the expense for the three qualified pension plans. Since the OPEB and non-qualified plans are unfunded, those plans would not be impacted by this assumption change. Income Taxes We are subject to income taxes in the U.S. and in numerous foreign jurisdictions. The Company accounts for income taxes following ASC 740 (Accounting for Income Taxes) recognizing deferred tax assets and liabilities using enacted tax rates for the effect of temporary differences between book and tax basis of recorded assets and liabilities. Deferred tax assets are reduced by a valuation allowance if it is more likely than not that some or all of a deferred tax asset will not be realized. As a result of U.S. Tax Reform, all post-1986 undistributed foreign subsidiary E&P as of December 31, 2017 have been subjected to U.S. tax through the transition tax. Our unremitted foreign earnings could be subject to additional taxes if they are redeployed outside of their country of origin. With the exception of certain of our Chinese subsidiaries, we have historically and continue to assert that foreign earnings are indefinitely reinvested. While we have not currently changed our assertion with respect to foreign earnings compared to prior years, we are currently evaluating the impact of U.S. Tax Reform on our global structure and any associated impacts it may have on our assertion on a go forward basis and as such have not included a provisional estimate of the impact. See Note 13, “Income Taxes,” to “Item 8 - Financial Statements and Supplementary Data” for additional information regarding U.S. Tax Reform. The U.S. Tax Reform Act includes two new U.S. tax base erosion provisions, the global intangible low-taxed income (GILTI) provisions and the base-erosion and anti-abuse tax (BEAT) provisions. The GILTI provisions require the Company to include in its U.S. income tax return foreign subsidiary earnings in excess of an allowable return on the foreign subsidiary's tangible assets. The Company has elected to account for GILTI tax in the period in which it is incurred, and therefore has not provided any deferred tax impacts of GILTI in its consolidated financial statements for the year ended December 31, 2017. The BEAT provisions in the Tax Reform Act eliminate the deduction of certain base-erosion payments made to related foreign corporations, and impose a minimum tax if greater than regular tax. Starting January 1, 2018, the Company will account for BEAT in the period in which it is incurred to the extent the Company is subject to it. We record benefits for uncertain tax positions based on an assessment of whether it is more likely than not that the tax positions will be sustained by the taxing authorities. If this threshold is not met, no tax benefit of the uncertain position is recognized. If the threshold is met, we recognize the largest amount of the tax benefit that is more than fifty percent likely to be realized upon ultimate settlement. We recognize interest and penalties within the income tax expense line in the accompanying consolidated statements of operations. Accrued interest and penalties are included within the related tax liability line in the consolidated statements of financial position. Equity Compensation Equity compensation expense associated with time-based and performance-based restricted stock units, deferred stock units, stock options and related awards is recognized in the consolidated statements of operations. Determining the amount of equity compensation expense to be recorded requires us to develop estimates to be used in calculating the grant-date fair value of equity compensation. Forfeiture Rate - We previously estimated the forfeiture rate based on historical experience and our expectations regarding future terminations. To the extent our actual forfeiture rate was different from our estimate, equity compensation expense was adjusted accordingly. In accordance with our adoption of ASU 2016-09, Improvements to Employee Share-Based Payment Accounting, on January 1, 2017, we now account for forfeitures as they occur. The adoption of this standard, with respect to treatment of forfeitures, did not have a material impact on our consolidated financial statements in the period of adoption. • Performance-Based Restricted Stock Units Compensation expense related to our performance-based restricted stock units is recognized using the straight-line method over the vesting period. We currently have awards from 2015, 2016 and 2017 outstanding. The outstanding 2015 awards have two measurement criteria on which the final payout of the award is based - (i) the three year return on invested capital (ROIC) compared to that of a specified group of peer companies, and (ii) the three year total shareholder return (TSR) on the performance of our capital stock as compared to that of a specified group of peer companies. The outstanding 2016 and 2017 awards have one measurement criteria, the three year total shareholder return (TSR) on the performance of our capital stock as compared to that of a specified group of peer companies. In accordance with the applicable accounting literature, the ROIC portion of the award is considered a performance condition. As such, the fair value of the ROIC portion is determined based on the market value of the underlying stock price at the grant date with cumulative compensation expense recognized to date being increased or decreased based on changes in the forecasted pay out percentage at the end of each reporting period. The TSR portion of the awards is considered a market condition. As such, the fair value of these awards was determined on the date of grant using a Monte Carlo simulation valuation model with related compensation expense fixed on the grant date and expensed on a straight-line basis over the life of the awards that ultimately vest with no changes for the final projected payout of the award. The assumptions used in the Monte Carlo are as follows: Expected volatility - In determining expected volatility, we have considered a number of factors, including historical volatility. Expected term - We use the vesting period of the award to determine the expected term assumption for the Monte Carlo simulation valuation model. Risk-free interest rate - We use an implied “spot rate” yield on U.S. Treasury Constant Maturity rates as of the grant date for our assumption of the risk-free interest rate. Expected dividend yield - We do not currently pay dividends on our capital stock; therefore, a dividend yield of 0% was used in the Monte Carlo simulation valuation model. • Time-Based Restricted Stock Units In 2011, we began granting time-based restricted stock units to certain key executives and other key members of the Company’s management team. We currently have grants from 2015, 2016 and 2017 outstanding. The majority of the grants ratably vest on the first, second and third anniversaries of the original grant date. We recognize compensation expense on all of these awards on a straight-line basis over the vesting period. The fair value of the award is determined based on the market value of the underlying stock price at the grant date. • Deferred Stock Units We grant deferred stock units to non-management directors. These awards are fully vested on the date of grant and the related shares are generally issued on the 13th month anniversary of the grant date unless the individual elects to defer the receipt of these shares. Each deferred stock unit results in the issuance of one share of Rogers’ stock. The grant of deferred stock units is typically done annually in the second quarter of each year. The fair value of the award is determined based on the market value of the underlying stock price at the grant date. • Stock Options Historically, we granted stock options to certain key executives and other key members of the Company’s management team and our last grant was in 2012. To value stock options, we calculated the grant-date fair values using the Black-Scholes valuation model. The use of valuation models required us to make estimates for the following assumptions: Expected volatility - In determining expected volatility, we consider a number of factors, including historical volatility and implied volatility. Expected term - We use historical employee exercise data to estimate the expected term assumption for the Black-Scholes valuation model. Risk-free interest rate - We use the yield on zero-coupon U.S. Treasury securities for a period commensurate with the expected term assumption as the risk-free interest rate. Expected dividend yield - We do not currently pay dividends on our capital stock; therefore, a dividend yield of 0% was used in the Black-Scholes model. Forfeiture Rate - We previously estimated the forfeiture rate based on historical experience and our expectations regarding future terminations. To the extent our actual forfeiture rate was different from our estimate, equity compensation expense was adjusted accordingly. In accordance with our adoption of ASU 2016-09, Improvements to Employee Share-Based Payment Accounting, on January 1, 2017, we now account for forfeitures as they occur. The adoption of this standard, with respect to treatment of forfeitures, did not have a material impact on our condensed consolidated financial statements in the period of adoption.

<s>[INST] In the following discussion and analysis, we sometimes provide financial information that was not prepared in accordance with U.S. generally accepted accounting principles (GAAP). Management believes that such nonGAAP financial measures can provide meaningful supplemental information regarding the Company’s performance by excluding certain expenses that are generally nonrecurring or otherwise may not be indicative of the core business operating results. In general, the Company believes that any such additional nonGAAP financial information provided is useful to management and investors in assessing the Company’s historical performance and for planning, forecasting and analyzing future periods. However, nonGAAP financial measures have limitations as an analytical tool and should not be considered in isolation from, or solely as an alternative to, financial information prepared in accordance with GAAP. Any time we provide nonGAAP financial measures in the following narrative, we identify it as such and in close proximity provide the most directly comparable GAAP financial measure, as well as the information necessary to reconcile the two measures. Business Overview Rogers Corporation designs, develops, manufactures and sells highquality and highreliability engineered materials and components for mission critical applications. We operate principally three strategic operating segments: Advanced Connectivity Solutions (ACS), Elastomeric Material Solutions (EMS) and Power Electronics Solutions (PES). We have a history of innovation and have established Innovation Centers for our leading research and development activities in Chandler, Arizona, Burlington, Massachusetts, Eschenbach, Germany and Suzhou, China. We are headquartered in Chandler, Arizona. Our growth strategy is based upon the following principles: (1) marketdriven organization, (2) innovation leadership, (3) synergistic mergers and acquisitions, and (4) operational excellence. As a marketdriven organization, we are focused on growth drivers, including advanced mobility and advanced connectivity. More specifically, the key trends and markets that affect our business include the increased use of advanced driver assistance systems and adoption of electric and hybrid electric vehicles and new technology adoption in the telecom industry, including next generation wireless infrastructure. In addition to our focus on advanced mobility and advanced connectivity, we also sell into a variety of other end markets including renewable energy, aerospace and defense and diverse general industrial applications. Our sales and marketing approach is based on addressing these trends, while our strategy focuses on factors for success as a manufacturer of engineered materials and components: quality, service, cost, efficiency, innovation and technology. We have expanded our capabilities through organic investment and acquisitions and strive to ensure high quality solutions for our customers. We continue to review and realign our manufacturing and engineering footprint in an effort to attain a leading competitive position globally. We have established or expanded our capabilities in various locations in support of our customers’ growth initiatives. We seek to enhance our operational and financial performance by investing in research and development, manufacturing and materials efficiencies, and new product initiatives that respond to the needs of our customers. We strive to evaluate operational and strategic alternatives to improve our business structure and align our business with the changing needs of our customers and major industry trends affecting our business. In executing on our growth strategy, we have completed three strategic acquisitions: (1) in January 2017, we acquired the principal operating assets of Diversified Silicone Products, Inc. (DSP), a custom silicone product development and manufacturing business, serving a wide range of high reliability applications, (2) in November 2016, we acquired DeWAL Industries LLC (DeWAL), a leading manufacturer of polytetrafluoroethylene and ultrahigh molecular weight polyethylene films, pressure sensitive tapes and specialty products for the industrial, aerospace, automotive, and electronics markets, and (3) in January 2015, we acquired Arlon LLC and its subsidiaries, other than Arlon India (Pvt) Limited (the acquired entities, collectively, Arlon), a leading manufacturer of high performance materials for the printed circuit board industry and silicone rubberbased materials. 2017 Executive Summary In 2017 as compared to 2016, our net sales increased 25.1% to $821.0 million, gross margin increased 79 basis points to 38.8%, operating margin increased 31 [/INST] Negative. </s>

ROGERS CORP

2019-02-21

2018-12-31

Item 7. Management’s Discussion and Analysis of Results of Operations and Financial Position The following discussion and analysis of our results of operations and financial position should be read together with the Selected Financial Data and our Consolidated Financial Statements and the related notes that appear elsewhere in this Form 10-K. Business Overview Rogers Corporation designs, develops, manufactures and sells high-quality and high-reliability engineered materials and components for mission critical applications. We operate three strategic operating segments: Advanced Connectivity Solutions (ACS), Elastomeric Material Solutions (EMS) and Power Electronics Solutions (PES). The remaining operations, which represent our non-core businesses, are reported in the Other operating segment. We have a history of innovation and have established Innovation Centers for our research and development activities in Chandler, Arizona; Burlington, Massachusetts; Eschenbach, Germany and Suzhou, China. We are headquartered in Chandler, Arizona. Growth Strategy and Recent Acquisitions Our growth strategy is based upon the following principles: (1) market-driven organization, (2) innovation leadership, (3) synergistic mergers and acquisitions, and (4) operational excellence. As a market-driven organization, we are focused on growth drivers, including advanced mobility and advanced connectivity. More specifically, the key trends currently affecting our business include the increasing use of advanced driver assistance systems and adoption of electric and hybrid electric vehicles in the automotive industry and new technology adoption in the telecommunications industry, including next generation wireless infrastructure. In addition to our focus on advanced mobility and advanced connectivity in the automotive and telecommunications industries, we sell into a variety of other end markets including renewable energy, consumer electronics, aerospace and defense and diverse general industrial applications. Our sales and marketing approach is based on addressing these trends, while our strategy focuses on factors for success as a manufacturer of engineered materials and components: quality, service, cost, efficiency, innovation and technology. We have expanded our capabilities through organic investment and acquisitions, and we strive to ensure high quality solutions for our customers. We continue to review and re-align our manufacturing and engineering footprint in an effort to attain a leading competitive position globally. We have established or expanded our capabilities in various locations in support of our customers’ growth initiatives. We seek to enhance our operational and financial performance by investing in research and development, manufacturing and materials efficiencies, and new product initiatives that respond to the needs of our customers. We strive to evaluate operational and strategic alternatives to improve our business structure and align our business with the changing needs of our customers and major industry trends affecting our business. In executing on our growth strategy, we have completed three strategic acquisitions in the last three fiscal years: (1) in July 2018, we acquired Griswold LLC (Griswold), a manufacturer of a wide range of high-performance engineered cellular elastomer and microcellular polyurethane products and solutions, (2) in January 2017, we acquired the principal operating assets of Diversified Silicone Products, Inc. (DSP), a custom silicone product development and manufacturing business serving a wide range of high reliability applications, and (3) in November 2016, we acquired DeWAL Industries LLC (DeWAL), a manufacturer of polytetrafluoroethylene and ultra-high molecular weight polyethylene films, pressure sensitive tapes and specialty products for the industrial, aerospace, automotive and electronics markets. Additionally, in August 2018, we acquired a production facility and related machinery and equipment located in Chandler Arizona from Isola USA Corp (Isola). 2018 Executive Summary In 2018 as compared to 2017, our net sales increased 7.1% to $879.1 million, gross margin decreased approximately 340 basis points to 35.4%, and operating income as a percentage of net sales decreased approximately 290 basis points to 12.8%. The following key factors should be considered when reviewing our results of operations, financial position and liquidity for the periods discussed: • Our net sales increase in 2018 was attributable to increases in net sales in our EMS and PES strategic operating segments. Net sales were favorably impacted by higher net sales in electric and hybrid electric vehicle and micro-channel cooler applications in our PES operating segment and higher net sales in portable electronics and automotive applications in our EMS operating segment, partially offset by lower net sales in wireless 4G LTE and portable electronics applications in our ACS operating segment. The increase in net sales was also driven in part by net sales of $13.7 million, or 1.7%, related to our acquisition of Griswold, as well as $15.5 million, or 1.9%, of favorable impacts from appreciation in value of the Euro and Renminbi relative to the U.S. dollar. The adoption of new accounting guidance for revenue recognition favorably impacted net sales in 2018 by $4.6 million, or 0.6%. • Our gross margin decreased approximately 340 basis points to 35.4% in 2018 from 38.8% in 2017. Gross margin was unfavorably impacted as a result of strategic investments in capacity optimization and infrastructure to support future growth initiatives, increased costs for raw materials, facility consolidation and new product launch, as well as unfavorable absorption of fixed costs. The adoption of new accounting guidance for revenue recognition favorably impacted gross margin in 2018 by $1.5 million, or 0.5%. • Our operating income decreased 12.7% to $112.7 million in 2018, as compared to $129.1 million in 2017. The decrease was primarily due to a decrease in gross margin, as well as a $2.4 million increase in selling, general & administrative (SG&A) expenses and a $3.5 million increase in research and development (R&D) expenses, furthered by a decrease in other operating income of $2.2 million. The increase in SG&A expenses was driven by increases in acquisition expenses as well as other intangible assets amortization related to Griswold. SG&A expenses decreased as a percentage of net sales from 19.7% in 2017 to 18.7% in 2018. The decrease in other operating income was primarily due to the $3.5 million of depreciation expense on leased assets netted against the $0.9 million of imputed income related to the Isola asset acquisition. • We are an innovation company, and in 2018 we continued our investment in R&D, with R&D expenses comprising 3.8% of net sales, an increase of approximately 20 basis points from 2017. R&D expenses were $33.1 million in 2018, as compared to $29.5 million in 2017. We have made concerted efforts to realign our R&D organization to better fit the expected future direction of our Company, including dedicating resources to focus on current product extensions and enhancements to meet our expected short-term and long-term technology needs. • We acquired Griswold in July 2018, as we continue to execute on our synergistic acquisition strategy. Acquisitions are a core part of our growth strategy, and the Griswold acquisition extends the product portfolio and technology capabilities of our EMS operating segment. We financed our acquisition of Griswold with $82.5 million in borrowings under our revolving credit facility. As a result, borrowings under our revolving credit facility increased in 2018. • In preparation for expected demand in advanced connectivity and advanced mobility, we acquired a production facility and related machinery and equipment from Isola in August 2018. We intend to use the purchased assets for capacity expansion within our ACS operating segment in contemplation of expected future demand from our 5G customers. We financed the asset acquisition with $43.4 million in cash on hand. Results of Operations The following table sets forth, for the periods indicated, selected operations data expressed as a percentage of net sales. 2018 vs. 2017 Net sales increased by 7.1% in 2018 compared to 2017. Our EMS and PES operating segments had net sales increases of 9.2% and 20.8%, respectively, while our ACS operating segment had a net sales decrease of 2.3%. The increase in net sales was favorably impacted by higher net sales in electric and hybrid electric vehicles and micro-channel cooler applications in our PES operating segment and higher net sales in portable electronics and automotive applications in our EMS operating segment, partially offset by lower net sales in wireless 4G LTE and portable electronics applications in our ACS operating segment. The increase in net sales was also driven in part by net sales of $13.7 million, or 1.7%, related to our acquisition of Griswold, as well as $15.5 million, or 1.9%, of favorable currency fluctuations due to the appreciation in value of the Euro and Renminbi relative to the U.S. dollar. The adoption of new accounting guidance for revenue recognition favorably impacted net sales in 2018 by $4.6 million, or 0.6%. For additional information regarding the impacts of adoption of new accounting guidance for revenue recognition, refer to “Note 16 - Revenue from Contracts with Customers,” as well as “Note 15 - Operating Segment and Geographic Information” to “Item 8. Financial Statements and Supplementary Data.” Gross margin as a percentage of net sales decreased approximately 340 basis points to 35.4% in 2018 compared to 38.8% in 2017. Gross margin in 2018 was unfavorably impacted by strategic investments in capacity optimization and infrastructure to support future growth initiatives, increased costs for raw materials, facility consolidation and new product launch, as well as unfavorable absorption of fixed costs. The adoption of new accounting guidance for revenue recognition favorably impacted gross margin in 2018 by $1.5 million, or 0.5%. SG&A expenses increased 1.5% in 2018 from 2017, due to a $2.0 million increase in other intangible assets amortization and a $0.5 million increase in acquisition expenses year-over-year. SG&A expenses were also unfavorably impacted by increases in sales and marketing investments to support future growth initiatives and other SG&A expenses, which were almost completely offset by decreases in total compensation and benefits. The total year-over-year increase in other SG&A expenses was favorably impacted by cost control initiatives executed in the fourth quarter. SG&A expenses decreased as a percentage of net sales to 18.7% in 2018 from 19.7% from 2017. R&D expenses increased 11.9% in 2018 from 2017 due to concerted efforts to realign our R&D organization to better fit the expected future direction of our Company, including dedicating resources to focus on current product extensions and enhancements to meet our expected short-term and long-term technology needs. R&D expenses increased as a percentage of net sales to 3.8% in 2018 from 3.6% from 2017. We incurred restructuring charges associated with the relocation of our global headquarters from Rogers, Connecticut to Chandler, Arizona and the consolidation of our Santa Fe Springs, California operations into the Company’s facilities in Carol Stream, Illinois and Bear, Delaware. We recognized $2.0 million and $0.6 million of restructuring charges associated with the facility consolidation and our global headquarters relocation, respectively, in 2018, and $2.8 million of restructuring charges related to the global headquarters relocation in 2017. We did not recognize any restructuring charges related to the facility consolidation in 2017. We estimate that approximately $0.5 million of additional costs related to the facility consolidation will be incurred in 2019. In 2018, we recognized $1.5 million in impairment charges on certain assets in connection with the Isola asset acquisition, which was allocated to our ACS operating segment. In 2017, we recognized a $0.3 million impairment charge related to our remaining investment in BrightVolt, Inc. and recognized a $0.5 million impairment charge related to the remaining net book value of an other intangible asset within our ROLINX® product line in our PES operating segment. The impairment of our remaining investment in BrightVolt, Inc. was allocated ratably among the three operating segments, while the impairment of the ROLINX® related other intangible asset was allocated to our PES operating segment. In 2018, we recognized lease income of approximately $0.9 million and related depreciation expense on leased assets of approximately $3.5 million in connection with the transitional leaseback of a portion of the facility and certain machinery and equipment acquired from Isola in August 2018. We recorded a gain from the settlement of antitrust litigation in the amount of $4.2 million, a gain of $0.7 million for the settlement of indemnity claims related to the DSP acquisition, income of $0.6 million from economic incentive grants related to the physical relocation of our global headquarters from Rogers, Connecticut to Chandler, Arizona and a gain on sale of property, plant and equipment of $0.2 million. In 2017, we recognized other operating income of $5.3 million as a result of the sales of a facility and a parcel of land located in Belgium. For additional information related to the year-over-year changes in other operating income (expense), refer to “Note 18 - Supplemental Financial Information” to “Item 8. Financial Statements and Supplementary Data.” Equity income in unconsolidated joint ventures increased 12.3% in 2018 from 2017 due to higher demand, primarily in portable electronics applications. Other income (expense), net decreased 119.8% in 2018 from 2017 due to declines in the value of our copper derivatives and foreign exchange contracts, as well as unfavorable changes in foreign currency transaction costs. Interest expense, net, increased by 8.1% in 2018 from 2017 due to higher interest rates, partially offset by a lower average outstanding balance on our revolving credit facility in 2018 compared to 2017. The lower average outstanding balance was a result of discretionary payments of $50.0 million and $60.0 million during the second and third quarters of 2017, respectively, to reduce our outstanding borrowings under our revolving credit facility, largely offset by new borrowings under our revolving credit facility during the third quarter of 2018 to fund our acquisition of Griswold and our voluntary pension contribution in connection with the proposed plan termination process. Our effective income tax rate for 2018 was 20.7% compared to 39.5% for 2017. The 2018 rate decrease was primarily due to a lower U.S. statutory tax rate in 2018 and the absence of the one-time impact from the enactment of the Tax Cuts and Jobs Act of 2017 (U.S. Tax Reform) in 2017, an increase in reversal of reserves associated with uncertain tax positions and lower foreign tax impact on remitted and unremitted foreign earnings and profits. On December 22, 2017, Staff Accounting Bulletin No. 118 (SAB 118) was issued to address the application of U.S. GAAP in situations when a registrant does not have the necessary information available, prepared, or analyzed (including computations) in reasonable detail to complete the accounting for certain income tax effects of the U.S. Tax Reform. December 22, 2018 marked the end of the measurement period for purposes of SAB 118. As such, we completed our analysis based on currently available legislative updates relating to the U.S. Tax Reform, as well as a more detailed analysis of the post-1986 undistributed earnings and profits that required further adjustment, resulting in a tax expense of $0.2 million in the fourth quarter of 2018 and a total tax expense of $0.2 million for the year ended December 31, 2018. The total tax expense included a $7.5 million benefit related to adjustments to the transition tax and a $7.7 million expense related to the establishment of a valuation allowance against deferred tax assets associated with carried over research and developments credits. There were no significant adjustments recorded with respect to finalization of the impact of the U.S. Tax Reform on state taxes and the remeasurement of certain deferred tax assets and liabilities. For additional information regarding U.S. Tax Reform, refer to “Note 14 - Income Taxes” to “Item 8. Financial Statements and Supplementary Data.” 2017 vs. 2016 Net sales increased by 25.1% in 2017 compared to 2016. This increase was driven by the net sales from our acquisitions of DeWAL and DSP, as well as higher organic net sales in our three strategic operating segments (ACS, EMS and PES). The ACS operating segment had an increase in net sales of 8.4% due to higher end-market demand in automotive radar, consumer electronics, and aerospace and defense applications, partially offset by lower demand in wireless infrastructure applications and satellite TV dish applications. EMS net sales increased 53.9% primarily due to the acquisitions of DeWAL and DSP, and from higher end-market product demand from core markets, including automotive, mass transit, portable electronics, general industrial and consumer products applications. PES had increased net sales of 21.4% due to higher end-market demand in laser diode cooler applications, renewable energy, mass transit, electric and hybrid electric vehicles and variable frequency motor drives. Net sales were unfavorably impacted by 0.1% due to currency fluctuations primarily as a result of the depreciation in value of the Renminbi relative to the U.S. dollar, offset in part by appreciation in value of the Euro relative to the U.S. dollar. Gross margin as a percentage of net sales increased by 79 basis points to 38.8% in 2017 compared to 38.0% in 2016. In 2017, gross margin was favorably impacted by an increase in net sales combined with operational excellence initiatives across our operating segments, including increased capacity utilization, operational process enhancements and automation, conversion of fixed cost structure to variable, benefits from low cost country manufacturing expansion, and synergies from the acquisitions of DeWAL and DSP. SG&A expenses increased by 16.1% in 2017 compared to 2016, due principally to $6.1 million of additional equity and incentive compensation expense, $4.8 million of additional other intangible assets amortization and depreciation related to the acquisitions, $4.7 million of additional SG&A expenses from the operations of the acquired businesses, $3.6 million of additional sales and marketing costs, $1.3 million of corporate development activity costs, and $3.4 million for additional asbestos liability accruals. Our 2017 results also included $3.2 million of acquisition and integration costs related to DeWAL and DSP. SG&A decreased as a percent of net sales to 19.7% in 2017 compared to 21.2% in 2016 as a result of administrative cost containment activities. R&D expenses increased by 3.4% in 2017 compared to 2016. The increase was due to continued investments that are targeted at developing new platforms and technologies focused on long-term growth initiatives at our Innovation Centers in the United States, Europe and Asia. As a percentage of sales, R&D costs decreased from 4.4% in 2016 to 3.6% in 2017 primarily due to sales growth increasing at a higher rate than the increase in R&D spend. In the second quarter of 2017, we completed the physical relocation of our global headquarters from Rogers, Connecticut to Chandler, Arizona. We recorded $2.8 million of expense related to this project in 2017 compared to $0.7 million recorded in 2016. In the third quarter of 2017, we recognized a $0.3 million impairment charge related to our remaining investment in BrightVolt, Inc. As this investment did not relate to a specific operating segment, we allocated it ratably among the three operating segments. In the fourth quarter of 2017, we recognized a $0.5 million impairment charge related to the remaining net book value of an other intangible asset within our ROLINX® product line in our PES operating segment. In the first quarter of 2017, we completed the planned sale of a parcel of land in Belgium that had been classified as held for sale as of December 31, 2016 and recognized a gain on sale of approximately $0.9 million in operating income. Also in the third quarter of 2017, we completed the sale of a facility located in Belgium and recognized a gain on sale of approximately $4.4 million in operating income. Equity income in unconsolidated joint ventures increased 18.1% in 2017 from 2016. The increase was due to higher demand, primarily in the portable electronics market. In 2017, the increase in other income (expense), net was attributable to gains in copper derivative transactions of approximately $1.9 million compared to gains of $0.5 million in 2016, as well as gains from foreign currency fluctuations of $0.8 million compared to losses of $1.8 million in 2016. In 2016, we also recorded an additional loss related to the sale of the Arlon polyimide and thermoset laminate business of $0.2 million, and $0.8 million of expense for tax indemnity receivables that were reversed due to the release of uncertain tax positions. Interest expense, net, increased by 56.0% in 2017 from 2016. This increase was primarily due to higher outstanding borrowings on our credit facility in 2017 compared to 2016 due to borrowings to fund the acquisitions of DeWAL and DSP. As explained in “Liquidity, Capital Resources and Financial Position” below, we made discretionary principal payments of $110.2 million in 2017 to reduce our outstanding borrowings under our credit facility to $131.0 million as of December 31, 2017. Our effective tax rate for 2017 was 39.5%, including our provisional estimate of the impact of the U.S. Tax Reform, compared to 41.3% in 2016. The 2017 rate decrease was primarily due to lower foreign tax impact on remitted and unremitted foreign earnings and profits, equity compensation excess tax deductions recognized in 2017 and increased international tax rate benefits due to earnings mix. This was substantially offset by our provisional estimate of the impact of U.S. Tax Reform, a decrease in reversal of reserves associated with uncertain tax positions and a change in valuation allowance associated with deferred tax assets that are capital in nature. For additional information regarding U.S. Tax Reform, refer to “Note 14 - Income Taxes” to “Item 8. Financial Statements and Supplementary Data.” On December 22, 2017, Staff Accounting Bulletin No. 118 (SAB 118) was issued to address the application of U.S. GAAP in situations when a registrant does not have the necessary information available, prepared, or analyzed (including computations) in reasonable detail to complete the accounting for certain income tax effects of the U.S. Tax Reform. In accordance with SAB 118, we determined that the $1.7 million of the deferred tax expense recorded in connection with the remeasurement of certain deferred tax assets and liabilities and the $12.0 million of tax expense recorded in connection with the transition tax on the mandatory deemed repatriation of foreign earnings was a provisional amount and a reasonable estimate at December 31, 2017. Under SAB 118, we completed our analysis based on currently available legislative updates relating to the U.S. Tax Reform, as well as a more detailed analysis of the post-1986 undistributed earnings and profits that required further adjustment, resulting in a tax expense of $0.2 million in the fourth quarter of 2018 and a total tax expense of $0.2 million for the year ended December 31, 2018. The total tax expense included a $7.5 million benefit related to adjustments to the transition tax and a $7.7 million expense related to the establishment of a valuation allowance against deferred tax assets associated with carried over research and developments credits. There were no significant adjustments recorded with respect to finalization of the impact of the U.S. Tax Reform on state taxes and the remeasurement of certain deferred tax assets and liabilities. For additional information regarding U.S. Tax Reform, refer to “Note 14 - Income Taxes” to “Item 8. Financial Statements and Supplementary Data.” Operating Segment Net Sales and Operating Income Advanced Connectivity Solutions 2018 vs. 2017 ACS net sales decreased by 2.3% in 2018 compared to 2017. The decrease in net sales was primarily driven by lower demand in wireless 4G LTE and portable electronics applications, partially offset by favorable currency fluctuations of $2.8 million, or 0.9%, due to the appreciation in value of the Euro and Renminbi relative to the U.S. dollar, as well as higher demand in automotive radar and aerospace and defense applications. The adoption of new accounting guidance for revenue recognition did not impact ACS net sales in 2018. Operating income decreased by 39.0% in 2018 compared to 2017. The decrease in operating income was due to lower net sales, increased costs for copper commodities and multi-site product qualification, including freight, lower capacity utilization due to process issues and machine downtime, as well as strategic investments in capacity optimization, infrastructure and sales and marketing to support future growth initiatives. Additionally, we recognized $1.5 million in impairment charges on certain assets in connection with the Isola asset acquisition. The adoption of new accounting guidance for revenue recognition did not impact ACS operating income in 2018. As a percentage of net sales, the 2018 operating income was 11.5%, an approximately 690 basis point decrease as compared to the 18.4% reported in 2017. 2017 vs. 2016 Net sales in this segment increased by 8.4% in 2017 compared to 2016. The increase in net sales was primarily driven by end market demand in automotive radar, consumer electronics and aerospace and defense applications, partially offset by lower demand in wireless infrastructure and satellite TV dish applications. Net sales were unfavorably impacted by 0.4% due to currency fluctuations, primarily as a result of the depreciation in value of the Renminbi relative to the U.S. dollar. Operating income improved by 30.5% in 2017 compared to 2016. As a percentage of net sales in 2017, operating income was 18.4%, a 310 basis point increase, compared to 15.3% in 2016. This increase was primarily due to higher net sales as well as lower costs from continued operational efficiencies and cost reduction initiatives. Elastomeric Material Solutions 2018 vs. 2017 EMS net sales increased by 9.2% in 2018 compared to 2017. The increase in net sales was primarily driven by net sales related to our acquisition of Griswold of $13.7 million, or 4.4%, higher demand in portable electronics and automotive applications, as well as favorable currency fluctuations of $3.5 million, or 1.1%, due to the appreciation in value of the Euro and Renminbi relative to the U.S. dollar. The adoption of new accounting guidance for revenue recognition favorably impacted EMS net sales in 2018 by $0.7 million, or 0.2%. Operating income increased by 3.1% in 2018 compared to 2017. The increase in operating income was primarily due to increased net sales related to our acquisition of Griswold and organic growth, a gain from the settlement of antitrust litigation of $4.2 million, discussed in “Note 18 - Supplemental Financial Information” to “Item 8. Financial Statements and Supplementary Data,” a gain of $0.7 million for the settlement of indemnity claims related to the DSP acquisition, as well as discretionary cost control. These increases in operating income were partially offset by increased costs for raw materials and facility consolidation, unfavorable absorption of fixed costs, strategic investments in sales and marketing to support future growth initiatives, as well as increases in other intangible assets amortization. The adoption of new accounting guidance for revenue recognition favorably impacted EMS operating income in 2018 by $0.2 million, or 0.4%. As a percentage of net sales, the 2018 operating income was 15.4%, an approximately 90 basis point decrease as compared to the 16.3% reported in 2017. 2017 vs. 2016 Net sales in this segment increased 53.9% in 2017 compared to 2016. The increase in net sales was primarily driven by the acquisitions of DeWAL and DSP, 38.8%, as well as an increase in organic net sales 15.1%. EMS experienced higher end-market demand in core markets including automotive, mass transit, portable electronics, general industrial and consumer products applications. Net sales were unfavorably impacted by 0.4% due to currency fluctuations, primarily as a result of the depreciation in value of the Renminbi relative to the U.S. dollar, partially offset by the appreciation in value of the Korean Won and Euro relative to the U.S. dollar. Operating income improved 96.7% in 2017 as compared to 2016. As a percentage of net sales, 2017 operating income was 16.3%, a 360 basis point increase compared to 12.7% in 2016. This increase was primarily due to higher net sales attributable to both acquisitions and organic growth, as well as lower costs from continued operational efficiencies. Operating income in 2017 included a $1.6 million charge to reflect a purchase accounting fair value adjustment for inventory related to the DeWAL and DSP acquisitions and $3.2 million of acquisition and integration costs. Operating income in 2017 also included increased other intangible assets amortization and depreciation expense of $4.9 million related to the DeWAL and DSP acquisitions. Power Electronics Solutions 2018 vs. 2017 PES net sales increased by 20.8% in 2018 compared to 2017. Net sales increased in electric and hybrid electric vehicles and micro-channel coolers applications, primarily due to higher demand. Net sales were also impacted by favorable currency fluctuations of $8.9 million, or 4.8%, due to the appreciation in value of the Euro and Renminbi relative to the U.S. dollar. The adoption of new accounting guidance for revenue recognition favorably impacted PES net sales in 2018 by $6.3 million, or 3.4%. Operating income increased 25.4% in 2018 compared to 2017. The adoption of new accounting guidance for revenue recognition favorably impacted PES operating income in 2018 by $2.0 million, or 12.8%. The increase in operating income was also due to increases in net sales from higher demand, partially offset by strategic investments in capacity optimization and sales and marketing to support future growth initiatives, a commercial settlement, increased costs for facility consolidation and new product launch, as well as process issues. As a percentage of net sales, the 2018 operating income was 8.8%, an approximately 30 basis point increase as compared to the 8.5% reported in 2017. 2017 vs. 2016 Net sales in this segment increased 21.4% in 2017 compared to 2016. The increase in net sales was driven by higher demand for laser diode coolers, renewable energy, mass transit, electric and hybrid electric vehicles and variable frequency motor drives applications. Net sales were favorably impacted by 0.8% due to currency fluctuations primarily as a result of the appreciation in value of the Euro relative to the U.S. dollar, partially offset by the depreciation in value of the Renminbi relative to the U.S. dollar. Operating income increased 199.6% in 2017 compared to 2016. As a percentage of net sales, 2017 operating income was 8.5%, a 510 basis point increase as compared to 3.4% in 2016. This increase was primarily due to higher net sales and increased equipment utilization, supply chain volume discounts, and improved productivity from operational excellence initiatives, partially offset by a $0.5 million impairment charge related to the remaining net book value of an other intangible asset within our ROLINX® product line in our PES operating segment. Other 2018 vs 2017 Net sales in this segment decreased by 9.4% in 2018 compared to 2017. The decrease in net sales was primarily driven by the adoption of new accounting guidance for revenue recognition, which resulted in a $2.4 million unfavorable impact, or 10.5%. Currency fluctuations had a $0.3 million favorable impact on net sales during 2018 due to the appreciation in value of the Euro and Renminbi relative to the U.S. dollar. Operating income decreased by 5.9% in 2018 compared to 2017. This decrease in operating income was primarily driven by lower net sales, partially offset by operational improvements and efficiency initiatives. Operating income in 2018 was unfavorably impacted by $0.7 million, or 10.5%, from the adoption of new accounting guidance for revenue recognition. As a percentage of net sales, the 2018 operating income was 33.3%, an approximately 130 basis point increase as compared to the 32.0% reported in the 2017. 2017 vs. 2016 Net sales decreased 2.8% in 2017 compared to 2016, primarily due to lower demand in global light vehicles, as well as a negative impact from currency fluctuations of 0.7% resulting from a depreciation in the value of the Renminbi relative to the U.S. dollar. Operating income in 2017 decreased by 2.4% compared to 2016 primarily due to lower net sales, partially offset by the impact of continuing operating efficiencies. Product and Market Development Our research and development team is dedicated to growing our business by developing cost effective solutions that improve the performance of customers’ products and by identifying business and technology acquisition or development opportunities to expand our market presence. Liquidity, Capital Resources and Financial Position We believe that our existing sources of liquidity and cash flows that are expected to be generated from our operations, together with our available credit facilities, will be sufficient to fund our operations, currently planned capital expenditures, research and development efforts and our debt service commitments, for at least the next 12 months. We regularly review and evaluate the adequacy of our cash flows, borrowing facilities and banking relationships seeking to ensure that we have the appropriate access to cash to fund both our near-term operating needs and our long-term strategic initiatives. The following table illustrates the location of our cash and cash equivalents by our three major geographic areas: Approximately $125.9 million of cash and cash equivalents were held by non-U.S. subsidiaries as of December 31, 2018. The Company did not make any changes in 2018 to its position on the permanent reinvestment of its earnings from foreign operations. With the exception of certain of our Chinese subsidiaries, we continue to assert that historical foreign earnings are indefinitely reinvested. Net working capital was $378.6 million, $340.7 million and $357.2 million as of December 31, 2018, 2017 and 2016, respectively. Significant changes in our statement of financial position accounts from December 31, 2017 to December 31, 2018 were as follows: • Accounts receivable, less allowance for doubtful accounts increased 2.9% to $144.6 million as of December 31, 2018, from $140.6 million as of December 31, 2017. The increase was primarily due to higher net sales at the end of 2018 compared to at the end of the 2017. • We recorded contract assets of $22.7 million as of December 31, 2018 related to the adoption of ASU 2014-09. For additional information, refer to “Note 16 - Revenue from Contracts with Customers” to “Item 8. Financial Statements and Supplementary Data.” • Inventories increased 17.8% to $132.6 million as of December 31, 2018, from $112.6 million as of December 31, 2017, as a result of our acquisition of Griswold, additional purchases as a result of changes in vendor allocations, supplier transition, safety stock replenishment and raw material cost increases, partially offset by the impact from the adoption of new accounting guidance for revenue recognition. For additional information regarding the impact of the new revenue recognition adoption, refer to “Note 16 - Revenue from Contracts with Customers” to “Item 8. Financial Statements and Supplementary Data.” • Accrued employee benefits and compensation decreased to $30.5 million as of December 31, 2018, from $39.4 million as of December 31, 2017. This decrease is primarily due to incentive compensation payouts of $18.2 million that occurred during 2018, partially offset by $5.8 million of accruals for projected incentive compensation payouts for the 2018 performance year. • Goodwill increased 11.7% to $264.9 million as of December 31, 2018, from $237.1 million as of December 31, 2017, primarily due to the acquisition of Griswold in July 2018. • Other intangible assets, net of amortization, increased 10.4% to $177.0 million as of December 31, 2018, from $160.3 million as of December 31, 2017, primarily due to the acquisition of Griswold in July 2018. As of December 31, 2018, cash and cash equivalents were $167.7 million as compared to $181.2 million as of December 31, 2017, a decrease of $13.4 million, or 7.4%. This decrease was primarily due to $78.0 million paid for the Griswold acquisition, net of cash acquired, $47.1 million in capital expenditures, $43.4 million paid for the Isola asset acquisition, and $25.4 million in pension and other postretirement benefits contributions, along with $6.6 million in tax payments related to net share settlement of equity awards, $5.0 million of principal payments made on our outstanding borrowings on our revolving credit facility and $3.0 million in repurchases of capital stock. This activity was partially offset by proceeds of $102.5 million from additional borrowings under our revolving credit facility, of which $82.5 million and $20.0 million were used to fund the Griswold acquisition and the voluntary pension plan contribution, respectively, and by cash flows generated by operations. In 2017, cash and cash equivalents decreased $46.6 million, primarily due to $110.2 million of principal payments made on our outstanding borrowings on our revolving credit facility, $60.2 million cash paid for the DSP acquisition, net of cash acquired and $27.2 million in capital expenditures, partially offset by cash flows generated by operations. In 2016, cash and cash equivalents increased $23.2 million, primarily due to proceeds of $166.0 million from borrowings under our revolving credit facility and cash flows generated by operations, partially offset by $133.9 million of cash paid for the DeWAL acquisition, net of cash acquired, $100.0 million of principal payments made on our outstanding borrowings under our revolving credit facility and $18.1 million in capital expenditures. Revolving Credit Facility On February 17, 2017, we entered into a secured five year credit agreement with JPMorgan Chase Bank, N.A., as administrative agent, and the lenders party thereto (the Third Amended Credit Agreement), which amended and restated the Second Amended Credit Agreement. The Third Amended Credit Agreement refinanced the Second Amended Credit Agreement, eliminated the term loan under the Second Amended Credit Agreement, increased the principal amount of our revolving credit facility to up to $450.0 million of borrowing capacity, with sublimits for multicurrency borrowings, letters of credit and swing-line notes, and provided an additional $175.0 million accordion feature. All revolving loans under the Third Amended Credit Agreement are due on the maturity date, February 17, 2022. We are not required to make any quarterly principal payments under the Third Amended Credit Agreement. During 2018, 2017 and 2016, we made discretionary principal payments of $5.0 million, $110.2 million and $100.0 million, respectively on the outstanding borrowings under our revolving credit facility. As of December 31, 2018, we had $228.5 million in outstanding borrowings under our revolving credit facility. For additional information regarding the Third Amended Credit Agreement, refer to “Note 11 - Debt and Capital Leases” to “Item 8. Financial Statements and Supplementary Data.” Restriction on Payment of Dividends Our Third Amended Credit Agreement generally permits us to pay cash dividends to our shareholders, provided that (i) no default or event of default has occurred and is continuing or would result from the dividend payment and (ii) our leverage ratio does not exceed 2.75 to 1.00. If our leverage ratio exceeds 2.75 to 1.00, we may nonetheless make up to $20.0 million in restricted payments, including cash dividends, during the fiscal year, provided that no default or event of default has occurred and is continuing or would result from the payments. Our leverage ratio did not exceed 2.75 to 1.00 as of December 31, 2018. Contractual Obligations The following table summarizes our significant contractual obligations as of December 31, 2018. (1) This amount represents non-cancelable vendor purchase commitments. (2) All outstanding borrowings under our revolving credit facility are due on February 17, 2022. (3) Estimated future interest payments are based on a leverage ratio based spread that ranges from 1.375% to 1.75%, plus projected forward 1-month LIBOR rates, and have been adjusted for the impact of the floating to fixed rate interest rate swap on $75.0 million of the outstanding borrowings under our revolving credit facility. For additional information, refer to “Note 3 - Hedging Transactions and Derivative Financial Instruments” to “Item 8. Financial Statements and Supplementary Data.” Unfunded pension benefit obligations, which amount to $0.2 million as of December 31, 2018, are expected to be paid from operating cash flows and the timing of payments is not definitive. Retiree health and life insurance benefits, which amount to $1.9 million, are expected to be paid from operating cash flows. Other long-term liabilities, such as deferred taxes, unrecognized tax benefits and asbestos-related product liability reserves, have been excluded from the table due to the uncertainty of the timing of payments combined with the absence of historical trends to be used as a predictor for such payments. Effects of Inflation We do not believe that inflation had a material impact on our business, net sales, or operating results during the periods presented. Off-Balance Sheet Arrangements We do not have any off-balance sheet arrangements that have, or are, in the opinion of management, reasonably likely to have, a current or future material effect on our results of operations or financial position. Critical Accounting Estimates Our consolidated financial statements are prepared in accordance with U.S. generally accepted accounting principles, which require management to make estimates, judgments and assumptions that affect the amounts reported in the financial statements and accompanying notes. We base our estimates on historical experience and on various other assumptions that are believed to be reasonable under the circumstances and believe that appropriate reserves have been established based on reasonable methodologies and appropriate assumptions based on facts and circumstances that are known; however, actual results may differ from these estimates under different assumptions or conditions. An accounting policy is deemed to be critical if it requires an accounting estimate to be made based on assumptions that are highly judgmental and uncertain at the time the estimate is made, if different estimates could reasonably have been used, or if changes to those estimates are reasonably likely to periodically occur that could affect the amounts carried in the financial statements. A summary of our critical accounting estimates is presented below: Inventory Valuation Inventories are stated at the lower of cost or net realizable value with costs determined primarily on a first-in first-out basis. We also maintain a reserve for excess, obsolete and slow-moving inventory that is primarily developed by utilizing both specific product identification and historical product demand as the basis for our analysis. Products and materials that are specifically identified as obsolete are fully reserved. In general, most products that have been held in inventory greater than one year are fully reserved unless there are mitigating circumstances, including forecasted sales or current orders for the product. The remainder of the allowance is based on our estimates and fluctuates with market conditions, design cycles and other economic factors. Risks associated with this allowance include unforeseen changes in business cycles that could affect the marketability of certain products and an unexpected decline in current production. We closely monitor the marketplace and related inventory levels and have historically maintained reasonably accurate allowance levels. Our obsolescence reserve has ranged from 9% to 14% of gross inventory over the last three years. Goodwill and Other Intangible Assets We have made acquisitions over the years that included the recognition of intangible assets. Intangible assets are classified into three categories: (1) goodwill; (2) other intangible assets with definite lives subject to amortization; and (3) other intangible assets with indefinite lives not subject to amortization. Other intangible assets can include items such as trademarks and trade names, licensed technology, customer relationships and covenants not to compete, among other things. Each definite-lived other intangible asset is amortized over its respective economic useful life using the economic attribution method. Goodwill is tested for impairment annually and between annual impairment tests if events or changes in circumstances indicate the carrying value may be impaired. If it is more likely than not that our goodwill is impaired, then we compare the estimated fair value of each of our reporting units to their respective carrying value. If a reporting unit’s carrying value is greater than its fair value, then an impairment is recognized for the excess and charged to operations. We currently have four reporting units with goodwill: ACS, EMS, curamik® and Elastomer Components Division (ECD). Consistent with historical practice, the annual impairment test on these reporting units was performed as of November 30, 2018. The application of the annual goodwill impairment test requires significant judgment, including the identification of reporting units, assignment of assets and liabilities to reporting units and determination of the fair value of each reporting unit. Determining the fair value is subjective and requires the use of significant estimates and assumptions, including financial projections for net sales, gross margin and operating margin, discount rates, terminal year growth rates and future market conditions, among others. We estimated the fair value of our reporting units using an income approach based on the present value of future cash flows through a five year discounted cash flow analysis. The discounted cash flow analysis utilized the discount rates for each of the reporting units ranging from 11.3% for EMS to 12.9% for ECD, and terminal year growth rates ranging from 4.9% for curamik® to 5.9% for ACS. We believe this approach yields the most appropriate evidence of fair value as our reporting units are not easily compared to other corporations involved in similar businesses. We further believe that the assumptions and rates used in our annual goodwill impairment test are reasonable, but inherently uncertain. There were no impairment charges resulting from our goodwill impairment analysis for the year ended December 31, 2018. Our ACS, EMS, curamik® and ECD reporting units had allocated goodwill of approximately $51.7 million, $142.6 million, $68.4 million and $2.2 million respectively, as of December 31, 2018. Indefinite-lived other intangible assets are tested for impairment annually and between annual impairment tests if events or changes in circumstances indicate the carrying value may be impaired. If it is more likely than not that an indefinite-lived other intangible asset is impaired, then we compare the estimated fair value of that indefinite-lived other intangible asset to its respective carrying value. If an indefinite-lived other intangible asset’s carrying value is greater than its fair value, then an impairment charge is recognized for the excess and charged to operations. The application of the annual indefinite-lived other intangible asset impairment test requires significant judgment, including the determination of fair value of each indefinite-lived other intangible asset. Fair value is primarily based on income approaches using discounted cash flow models, which have significant assumptions. Such assumptions are subject to variability from year to year and are directly impacted by global market conditions. There were no impairment charges resulting from our indefinite-lived other intangible assets impairment analysis for the year ended December 31, 2018. Our curamik® reporting unit had an indefinite-lived other intangible asset of approximately $4.5 million as of December 31, 2018. Definite-lived other intangible assets are tested for recoverability whenever events or changes in circumstances indicate the carrying value may not be recoverable. The recoverability test involves comparing the estimated sum of the undiscounted cash flows for each definite-lived other intangible asset to its respective carrying value. If a definite-lived other intangible asset’s carrying value is greater than the sum of its undiscounted cash flows, then the definite-lived other intangible asset’s carrying value is compared to its estimated fair value and an impairment charge is recognized for the excess and charged to operations. The application of the recoverability test requires significant judgment, including the identification of the asset group and determination of undiscounted cash flows and fair value of the underlying definite-lived other intangible asset. Determination of undiscounted cash flows requires the use of significant estimates and assumptions, including certain financial projections. Fair value is primarily based on income approaches using discounted cash flow models, which have significant assumptions. Such assumptions are subject to variability from year to year and are directly impacted by global market conditions. There were no impairment charges resulting from our definite-lived other intangible assets impairment analysis for the year ended December 31, 2018. Our ACS, EMS and curamik® reporting units had definite-lived other intangible assets of approximately $7.9 million, $152.2 million and $12.4 million, respectively, as of December 31, 2018. Product Liabilities We endeavor to maintain insurance coverage with reasonable deductible levels to protect us from potential exposures to product liability claims. Any liability associated with such claims is based on management’s best estimate of the potential claim value, while insurance receivables associated with related claims are not recorded until verified by the insurance carrier. For asbestos-related claims, we recognize projected asbestos liabilities and related insurance receivables, with any difference between the liability and related insurance receivable recognized as an expense in the consolidated statements of operations. Our estimates of asbestos-related contingent liabilities and related insurance receivables are based on an independent actuarial analysis and an independent insurance usage analysis prepared annually by third parties. The actuarial analysis contains numerous assumptions, including number of claims that might be received, the type and severity of the disease alleged by each claimant, the long latency period associated with asbestos exposure, dismissal rates, average settlement costs, average defense costs, costs of medical treatment, the financial resources of other companies that are co-defendants in claims, uncertainties surrounding the litigation process from jurisdiction to jurisdiction and from case to case, and the impact of potential changes in legislative or judicial standards, including potential tort reform. Furthermore, any predictions with respect to these assumptions are subject to even greater uncertainty as the projection period lengthens. The insurance usage analysis considers, among other things, applicable deductibles, retentions and policy limits, the solvency and historical payment experience of various insurance carriers, the likelihood of recovery as estimated by external legal counsel and existing insurance settlements. The liability projection period covers all current and future claims through 2058, which represents the expected end of our asbestos liability exposure with no further ongoing claims expected beyond that date. This conclusion was based on our history and experience with the claims data, the diminished volatility and consistency of observable claims data, the period of time that has elapsed since we stopped manufacturing products that contained encapsulated asbestos and an expected downward trend in claims due to the average age of our claimants, which is approaching the average life expectancy. There can be no assurance that our accrued asbestos liabilities will approximate our actual asbestos-related settlement and defense costs, or that our accrued insurance recoveries will be realized. We believe that it is reasonably possible that we may incur additional charges for our asbestos liabilities and defense costs in the future, that could exceed existing reserves and insurance recovery. We plan to continue to vigorously defend ourselves and believe we have substantial unutilized insurance coverage to mitigate future costs related to this matter. We review our asbestos-related projections annually in the fourth quarter of each year unless facts and circumstances materially change during the year, at which time we would analyze these projections. We believe the assumptions made on the potential exposure and expected insurance coverage are reasonable at the present time, but are subject to uncertainty based on the actual future outcome of our asbestos litigation. As of December 31, 2018, the estimated liability and estimated insurance recovery for all current and future claims projected through 2058 was $70.3 million and $63.8 million, respectively. Revenue Recognition Recognition of revenue occurs when a customer obtains control of promised goods or services in an amount that reflects the consideration to which the providing entity expects to be entitled in exchange for those goods or services. We recognize revenue when all of the following criteria are met: (1) we have entered into a binding agreement, (2) the performance obligations have been identified, (3) the transaction price to the customer has been determined, (4) the transaction price has been allocated to the performance obligations in the contract, and (5) the performance obligations have been satisfied. The majority of our shipping terms permit us to recognize revenue at point of shipment. Some shipping terms require the goods to be through customs or be received by the customer before title passes. In those instances, revenue is not recognized until either the customer has received the goods or they have passed through customs, depending on the circumstances. Shipping and handling costs are treated as fulfillment costs. Sales tax or value added tax (VAT) are excluded from the measurement of the transaction price. The Company manufactures some products to customer specifications which are customized to such a degree that it is unlikely that another entity would purchase these products or that we could modify these products for another customer. These products are deemed to have no alternative use to the Company whereby we have an enforceable right to payment evidenced by contractual termination clauses. In accordance with ASC 606, for those circumstances we recognize revenue on an over-time basis. Revenue recognition does not occur until the product meets the definition of “no alternative use” and therefore, items that have not yet reached that point in the production process are not included in the population of items with over-time revenue recognition. As appropriate, we record estimated reductions to revenue for customer returns, allowances, and warranty claims. Provisions for such reductions are made at the time of sale and are typically derived from historical trends and other relevant information. Pension and Other Postretirement Benefits We provide various defined benefit pension plans for our U.S. employees and sponsor three defined benefit health care plans and a life insurance plan. The costs and obligations associated with these plans are dependent upon various actuarial assumptions used in calculating such amounts. These assumptions include discount rates, long-term rates of return on plan assets, mortality rates, and other factors. The assumptions used were determined as follows: (i) the discount rate used is based on the PruCurve high quality corporate bond index, with comparisons against other similar indices; and (ii) the long-term rate of return on plan assets is determined based on historical portfolio results, market conditions and our expectations of future returns. We determine these assumptions based on consultation with outside actuaries and investment advisors. Any changes in these assumptions could have a significant impact on future recognized pension costs, assets and liabilities. The rates used to determine our costs and obligations under our pension and postretirement plans are disclosed in “Note 12 - Pension, Other Postretirement Benefits and Employee Savings and Investment Plans” to “Item 8. Financial Statements and Supplementary Data.” Each assumption has different sensitivity characteristics. For the year ended December 31, 2018, a 25 basis point decrease in the discount rate would have increased our pension expense for Rogers Corporation Employees’ Pension Plan (the Union Plan), the Rogers Corporation Defined Benefit Pension Plan (following its merger with the Hourly Employees Pension Plan of Arlon LLC, Microwave Material and Silicone Technologies Divisions, Bear, Delaware (the Merged Plan)), and the Rogers Corporation Amended and Restated Pension Restoration Plan and the Rogers Corporation Amended and Restated Pension Restoration Plan (the Nonqualified Plans) by a de minimis amount. A 25 basis point decrease in the discount rate would have decreased the other post-employment benefits (OPEB) expense by a de minimis amount. A 25 basis point decrease in the expected return on assets would have increased the total 2018 pension expense for the Union Plan and the Merged Plan by approximately $0.4 million. Since the OPEB and Nonqualified Plans are unfunded, those plans would not be impacted by this assumption change. Equity Compensation Determining the amount of equity compensation expense to be recorded requires us to develop estimates to be used in calculating the grant-date fair value of performance-based restricted stock units. Performance-Based Restricted Stock Units As of December 31, 2018, we had performance-based restricted stock units from 2018, 2017 and 2016 outstanding. These awards generally cliff vest at the end of a three year measurement period. However, employees whose employment terminates during the measurement period due to death, disability, or, in certain cases, retirement may receive a pro-rata payout based on the number of days they were employed during the measurement period. Participants are eligible to be awarded shares ranging from 0% to 200% of the original award amount, based on certain defined performance measures. The 2018, 2017 and 2016 awards have one measurement criteria: the three year total shareholder return (TSR) on the performance of our capital stock as compared to that of a specified group of peer companies. The TSR measurement criteria of the awards is considered a market condition. As such, the fair value of this measurement criteria was determined on the grant date using a Monte Carlo simulation valuation model. We recognize compensation expense on all of these awards on a straight-line basis over the vesting period with no changes for final projected payout of the awards. We account for forfeitures as they occur. Below were the assumptions used in the Monte Carlo calculation on the respective grant dates for awards granted in 2018 and 2017: Expected volatility - In determining expected volatility, we have considered a number of factors, including historical volatility. Expected term - We use the measurement period of the award to determine the expected term assumption for the Monte Carlo simulation valuation model. Risk-free interest rate - We use an implied “spot rate” yield on U.S. Treasury Constant Maturity rates as of the grant date for our assumption of the risk-free interest rate. Expected dividend yield - We do not currently pay dividends on our capital stock; therefore, a dividend yield of 0% was used in the Monte Carlo simulation valuation model.

<s>[INST] Business Overview Rogers Corporation designs, develops, manufactures and sells highquality and highreliability engineered materials and components for mission critical applications. We operate three strategic operating segments: Advanced Connectivity Solutions (ACS), Elastomeric Material Solutions (EMS) and Power Electronics Solutions (PES). The remaining operations, which represent our noncore businesses, are reported in the Other operating segment. We have a history of innovation and have established Innovation Centers for our research and development activities in Chandler, Arizona; Burlington, Massachusetts; Eschenbach, Germany and Suzhou, China. We are headquartered in Chandler, Arizona. Growth Strategy and Recent Acquisitions Our growth strategy is based upon the following principles: (1) marketdriven organization, (2) innovation leadership, (3) synergistic mergers and acquisitions, and (4) operational excellence. As a marketdriven organization, we are focused on growth drivers, including advanced mobility and advanced connectivity. More specifically, the key trends currently affecting our business include the increasing use of advanced driver assistance systems and adoption of electric and hybrid electric vehicles in the automotive industry and new technology adoption in the telecommunications industry, including next generation wireless infrastructure. In addition to our focus on advanced mobility and advanced connectivity in the automotive and telecommunications industries, we sell into a variety of other end markets including renewable energy, consumer electronics, aerospace and defense and diverse general industrial applications. Our sales and marketing approach is based on addressing these trends, while our strategy focuses on factors for success as a manufacturer of engineered materials and components: quality, service, cost, efficiency, innovation and technology. We have expanded our capabilities through organic investment and acquisitions, and we strive to ensure high quality solutions for our customers. We continue to review and realign our manufacturing and engineering footprint in an effort to attain a leading competitive position globally. We have established or expanded our capabilities in various locations in support of our customers’ growth initiatives. We seek to enhance our operational and financial performance by investing in research and development, manufacturing and materials efficiencies, and new product initiatives that respond to the needs of our customers. We strive to evaluate operational and strategic alternatives to improve our business structure and align our business with the changing needs of our customers and major industry trends affecting our business. In executing on our growth strategy, we have completed three strategic acquisitions in the last three fiscal years: (1) in July 2018, we acquired Griswold LLC (Griswold), a manufacturer of a wide range of highperformance engineered cellular elastomer and microcellular polyurethane products and solutions, (2) in January 2017, we acquired the principal operating assets of Diversified Silicone Products, Inc. (DSP), a custom silicone product development and manufacturing business serving a wide range of high reliability applications, and (3) in November 2016, we acquired DeWAL Industries LLC (DeWAL), a manufacturer of polytetrafluoroethylene and ultrahigh molecular weight polyethylene films, pressure sensitive tapes and specialty products for the industrial, aerospace, automotive and electronics markets. Additionally, in August 2018, we acquired a production facility and related machinery and equipment located in Chandler Arizona from Isola USA Corp (Isola). 2018 Executive Summary In 2018 as compared to 2017, our net sales increased 7.1% to $879.1 million, gross margin decreased approximately 340 basis points to 35.4%, and operating income as a percentage of net sales decreased approximately 290 basis points to 12.8%. The following key factors should be considered when reviewing our results of operations, financial position and liquidity for the periods discussed: Our net sales increase in 2018 was attributable to increases in net sales in our EMS and PES strategic operating segments. Net sales were favorably impacted by higher net sales in electric and hybrid electric vehicle and microchannel cooler applications in our PES operating segment and higher net sales in portable electronics and automotive applications in our EMS operating segment, partially offset by lower net sales in wireless 4G LTE and [/INST] Positive. </s>

ROGERS CORP

2020-02-21

2019-12-31

Item 7. Management’s Discussion and Analysis of Results of Operations and Financial Position The following discussion and analysis of our results of operations and financial position should be read together with our consolidated financial statements and accompanying notes, which are contained in “Item 8. Financial Statements and Supplementary Data,” as well as “Item 6. Selected Financial Data.” The discussion of the comparison of our 2018 and 2017 results was previously presented in the Management’s Discussion & Analysis in Part II, Item 7 of the Company’s Annual Report on Form 10-K filed with the SEC on February 21, 2019, and has been omitted from this section pursuant to Instruction 1 to Item 303(a) of Regulation S-K. Business Overview Rogers Corporation designs, develops, manufactures and sells high-performance and high-reliability engineered materials and components to meet our customers’ demanding challenges. We operate three strategic operating segments: Advanced Connectivity Solutions (ACS), Elastomeric Material Solutions (EMS) and Power Electronics Solutions (PES). The remaining operations, which represent our non-core businesses, are reported in the Other operating segment. We have a history of innovation and have established Innovation Centers for our research and development activities in Chandler, Arizona; Burlington, Massachusetts; Eschenbach, Germany; and Suzhou, China. We are headquartered in Chandler, Arizona. Growth Strategy and Recent Acquisitions Our growth strategy is based upon the following principles: (1) market-driven organization, (2) innovation leadership, (3) synergistic mergers and acquisitions, and (4) operational excellence. As a market-driven organization, we are focused on growth drivers, including advanced mobility and advanced connectivity. More specifically, the key trends currently affecting our business include the increasing use of advanced driver assistance systems (ADAS) and increasing electrification of vehicles, including electric and hybrid electric vehicles (EV/HEV), in the automotive industry and new technology adoption in the telecommunications industry, including next generation wireless infrastructure. In addition to our focus on advanced mobility and advanced connectivity in the automotive and telecommunications industries, we sell into a variety of other markets including general industrial, portable electronics, connected devices, aerospace and defense, mass transit and renewable energy. Our sales and marketing approach is based on addressing these trends, while our strategy focuses on factors for success as a manufacturer of engineered materials and components: performance, quality, service, cost, efficiency, innovation and technology. We have expanded our capabilities through organic investment and acquisitions and strive to ensure high quality solutions for our customers. We continue to review and re-align our manufacturing and engineering footprint in an effort to attain a leading competitive position globally. We have established or expanded our capabilities in various locations in support of our customers’ growth initiatives. We seek to enhance our operational and financial performance by investing in research and development, manufacturing and materials efficiencies, and new product initiatives that respond to the needs of our customers. We strive to evaluate operational and strategic alternatives to improve our business structure and align our business with the changing needs of our customers and major industry trends affecting our business. In executing on our growth strategy, we have completed the following strategic acquisitions in the last two fiscal years: (1) in July 2018, we acquired Griswold LLC (Griswold), a manufacturer of a wide range of high-performance engineered cellular elastomer and microcellular polyurethane products and solutions and (2) in August 2018, we acquired a production facility and related machinery and equipment located in Chandler, Arizona from Isola USA Corp (Isola). Results of Operations The following table sets forth, for the periods indicated, selected operations data expressed as a percentage of net sales. Net Sales and Gross Margin Net sales increased by 2.2% in 2019 compared to 2018. Our ACS and EMS operating segments had net sales increases of 7.6% and 5.9%, respectively, partially offset by a net sales decrease in our PES operating segment of 11.1%. The increase in net sales was primarily driven by higher net sales in 5G wireless infrastructure in our ACS operating segment and the $15.0 million of net sales in the first half of the year related to Griswold, which we acquired in July 2018. Net sales were also favorably impacted by higher net sales in the aerospace and defense market in our ACS operating segment, higher net sales in the portable electronics market in our EMS operating segment and higher net sales in the mass transit and power semiconductor substrate EV/HEV markets in our PES operating segment, partially offset by lower net sales in the general industrial, vehicle electrification, ROLINX® EV/HEV power interconnects and renewable energy markets in our PES operating segment, lower net sales in 4G wireless infrastructure in our ACS operating segment and lower net sales in the general industrial market in our EMS operating segment. Net sales were unfavorably impacted by the effects of trade tensions in 2019. Net sales were additionally unfavorably impacted by $20.9 million, or 2.4%, due to the depreciation in value of the euro, Chinese renminbi and South Korean won relative to the U.S. dollar. Gross margin as a percentage of net sales decreased approximately 40 basis points to 35.0% in 2019 compared to 35.4% in 2018. Gross margin in 2019 was negatively impacted by lower volumes, unfavorable absorption of fixed costs, lower productivity and higher fixed overhead costs in our PES operating segment, as well as an increase in tariffs and duties in our ACS and EMS operating segments. This was partially offset by higher volumes, favorable product mix and productivity improvements in our ACS and EMS operating segments, as well as the resolution of certain process issues that had negatively impacted gross margin in 2018. Selling, General and Administrative Expenses SG&A expenses increased 2.8% in 2019 from 2018, primarily due to a $7.0 million increase in total compensation and benefits, a $1.2 million increase in other intangible assets amortization, most of which was related to our acquisition of Griswold, a $1.0 million increase in asbestos-related charges and a $0.8 million increase in environmental charges. This was partially offset by a $2.7 million decrease in professional service costs, a $1.5 million decrease in depreciation expense and a $1.1 million decrease in travel and entertainment expenses. Research and Development Expenses R&D expenses decreased 4.2% in 2019 from 2018, primarily due to the timing of new product initiatives and lower compensation and benefits costs due to a lower average headcount during 2019. Restructuring and Impairment Charges and Other Operating (Income) Expense, Net We recognized impairment charges of $1.5 million in both 2019 and 2018 primarily relating to certain assets in connection with the Isola asset acquisition, which were allocated to our ACS operating segment. We incurred restructuring charges associated with the relocation of our global headquarters from Rogers, Connecticut to Chandler, Arizona and the consolidation of our Santa Fe Springs, California operations into our facilities in Carol Stream, Illinois and Bear, Delaware. In 2019, we recognized $0.9 million of restructuring charges associated with the facility consolidation. In 2018, we recognized $2.0 million and $0.6 million of restructuring charges associated with facility consolidation and the global headquarters relocation, respectively. Other operating (income) expense, net decreased by $4.0 million in 2019 from 2018. In 2019 and 2018, we recognized lease income of $1.0 million and $0.9 million, respectively, and related depreciation expense on leased assets of $1.9 million and $3.5 million, respectively, in connection with the transitional leaseback of a portion of the facility and certain machinery and equipment acquired from Isola. In 2018, we recorded a gain from the settlement of antitrust litigation in the amount of $4.2 million and recognized income of $0.6 million from economic incentive grants related to the physical relocation of our global headquarters from Rogers, Connecticut to Chandler. Additionally, we recorded a gain of $0.7 million in both 2019 and 2018 for the settlement of indemnity claims related to the Isola asset acquisition and the DSP acquisition, respectively. Equity Income in Unconsolidated Joint Ventures As of December 31, 2019, we had two unconsolidated joint ventures, each 50% owned: Rogers INOAC Corporation (RIC) and Rogers INOAC Suzhou Corporation (RIS). Equity income in those unconsolidated joint ventures decreased 3.3% in 2019 from 2018 due to lower net sales for RIC and RIS in the portable electronics and automotive markets. Pension Settlement Charges and Other Income (Expense), Net In 2019, we recorded a $53.2 million non-cash pre-tax settlement charge in connection with the termination of the Rogers Corporation Defined Benefit Pension Plan (following its merger with the Hourly Employees Pension Plan of Arlon LLC, Microwave Material and Silicone Technologies Divisions, Bear, Delaware (collectively, the Merged Plan)). We expect to incur an additional non-cash pre-tax settlement charge in connection with the remaining settlement efforts of the Merged Plan of approximately $0.7 million during the first half of 2020. For additional information, refer to Note 11 - Pension Benefits, Other Postretirement Benefits and Employee Savings and Investment Plan to “Item 8. Financial Statements and Supplementary Data.” Other income (expense), net improved to a net expense of $0.6 million in 2019 compared to a net expense of $1.0 million in 2018 due to favorable impacts from our copper derivatives contracts, partially offset by higher costs associated with our defined benefit plans and unfavorable impacts from our foreign currency transactions, including foreign currency derivatives. Interest Expense, Net Interest expense, net, increased by 3.6% in 2019 from 2018 due to a higher average outstanding revolving credit facility balance as well as a higher weighted average interest rate on our revolving credit facility in 2019 compared to 2018, partially offset by an increase in interest income year-over-year. The higher average outstanding balance on our revolving credit facility was a result of $102.5 million of new borrowing under our revolving credit facility during the third quarter of 2018 to fund the acquisition of Griswold and our voluntary pension contribution in connection with the proposed plan termination process. This was partially offset by $105.5 million of discretionary principal payments on our revolving credit facility in 2019, the majority of which occurred in the second and third quarters of 2019. Income Tax Expense Our effective income tax rate for 2019 was 14.2% compared to 20.7% for 2018. The 2019 rate decrease was due to the beneficial impact of changes in valuation allowance against deferred tax assets associated with carried over research and development credits, excess tax deductions on stock-based compensation, and the international provisions from the U.S. tax reform enacted in 2017. This decrease was partially offset by a disproportionate tax impact from the non-cash settlement charge in connection with the termination of the Merged Plan, increase in taxes associated with the repatriation of foreign earnings, and increase in current accruals of reserves for uncertain tax positions. Operating Segment Net Sales and Operating Income Advanced Connectivity Solutions ACS net sales increased by 7.6% in 2019 compared to 2018. The increase in net sales was primarily driven by higher net sales in 5G wireless infrastructure and aerospace and defense markets, partially offset by lower net sale in 4G wireless infrastructure. Net sales were unfavorably impacted by the effects of trade tensions in 2019. Net sales were additionally unfavorably impacted by $6.1 million, or 2.1%, due to the depreciation in value of the Chinese renminbi and euro relative to the U.S. dollar. Operating income increased by 43.8% in 2019 from 2018. The increase in operating income was primarily due to higher net sales, favorable product mix, productivity improvements and the resolution of certain process issues that had negatively impacted gross margin in 2018, partially offset by an increase in tariffs and duties. As a percentage of net sales, operating income in 2019 was 15.4%, an approximately 390 basis point increase as compared to 11.5% in 2018. Elastomeric Material Solutions EMS net sales increased by 5.9% in 2019 compared to 2018. The increase in net sales was primarily due to the $15.0 million of net sales in the first half of the year related to Griswold, which we acquired in July 2018, as well as higher net sales in the portable electronics market, partially offset by lower net sales in the general industrial market. Net sales were unfavorably impacted by the effects of trade tensions in 2019. Net sales were additionally unfavorably impacted by $5.9 million, or 1.7%, due to the depreciation in value of the Chinese renminbi, South Korean won and euro relative to the U.S. dollar. Operating income increased by 8.7% in 2019 from 2018. The increase in operating income was primarily due to higher net sales, favorable product mix, productivity improvements and a reduction in facility consolidation costs, partially offset by the non-recurring $4.2 million gain from the settlement of antitrust litigation in 2018 and an increase in tariffs and duties. As a percentage of net sales, operating income in 2019 was 15.8%, an approximately 40 basis point increase as compared to 15.4% in 2018. Power Electronics Solutions PES net sales decreased by 11.1% in 2019 compared to 2018. The decrease in net sales was primarily driven by lower net sales in the general industrial, vehicle electrification, ROLINX® EV/HEV power interconnects and renewable energy markets, partially offset by higher net sales in the mass transit and power semiconductor substrate EV/HEV markets. Net sales were impacted by unfavorable currency fluctuations of $8.4 million, or 3.8%, due to the depreciation in value of the euro and Chinese renminbi relative to the U.S. dollar. Operating income decreased by 107.3% in 2019 from 2018. The decrease in operating income was primarily due to lower net sales, unfavorable absorption of fixed overhead costs, lower productivity and higher fixed overhead expenses. As a percentage of net sales, PES had an operating loss of 0.7% in 2019, an approximately 950 basis point decrease as compared to operating income of 8.8% in 2018. Other Net sales in this segment increased by 6.4% in 2019 from 2018. The increase in net sales was primarily driven by higher net sales for our NITROPHYL® floats product line and a last-time buy in the Durel business. Net sales were impacted by unfavorable currency fluctuations of $0.5 million, or 2.4%, due to the depreciation in value of the Chinese renminbi relative to the U.S. dollar. Operating income decreased by 8.2% in 2019 from 2018. The decrease in operating income was primarily due to unfavorable absorption of fixed overhead costs and unfavorable product mix, partially offset by higher net sales. As a percentage of net sales, operating income in 2019 was 28.7%, an approximately 460 basis point decrease as compared to 33.3% in 2018. Product and Market Development Our research and development team is dedicated to growing our business by developing cost effective solutions that improve the performance of customers’ products and by identifying business and technology acquisition or development opportunities to expand our market presence. Liquidity, Capital Resources and Financial Position We believe that our existing sources of liquidity and cash flows that are expected to be generated from our operations, together with our available credit facilities, will be sufficient to fund our operations, currently planned capital expenditures, research and development efforts and our debt service commitments, for at least the next 12 months. We regularly review and evaluate the adequacy of our cash flows, borrowing facilities and banking relationships, seeking to ensure that we have the appropriate access to cash to fund both our near-term operating needs and our long-term strategic initiatives. The following table illustrates the location of our cash and cash equivalents by our three major geographic areas: Approximately $127.5 million of our cash and cash equivalents were held by non-U.S. subsidiaries as of December 31, 2019. We did not make any changes in 2019 to our position on the permanent reinvestment of our historical earnings from foreign operations. With the exception of certain of our Chinese subsidiaries, where a substantial portion of our Asia cash and cash equivalents are held, we continue to assert that historical foreign earnings are indefinitely reinvested. Net working capital was $363.9 million and $378.6 million as of December 31, 2019 and 2018, respectively. Significant changes in our statement of financial position accounts from December 31, 2018 to December 31, 2019 were as follows: • Accounts receivable, net decreased 15.4% to $122.3 million as of December 31, 2019, from $144.6 million as of December 31, 2018. The decrease was primarily due to lower net sales at the end of 2019 compared to at the end of the 2018, as well as a reduction in our income taxes receivable year-over-year. • Contract assets decreased 1.2% to $22.5 million as of December 31, 2019, from $22.7 million as of December 31, 2018, mainly attributable to the decrease in no alternative use inventory for which we have the right to payment in our PES operating segment. • Inventories increased 0.2% to $132.9 million as of December 31, 2019, from $132.6 million as of December 31, 2018, primarily driven by higher raw material purchases for long lead times in our ACS and PES operating segments during the third quarter of 2019 in anticipation of demand increases through the first half of 2020, almost entirely offset by inventory reduction efforts in our EMS operating segment. In 2019, cash and cash equivalents decreased $0.9 million, primarily due to $105.5 million of principal payments made on our outstanding borrowings on our revolving credit facility, $51.6 million in capital expenditures, as well as $7.6 million in tax payments related to net share settlement of equity awards, almost entirely offset by cash flows generated by operations. In 2018, cash and cash equivalents decreased $13.4 million, primarily due to the $78.0 million paid for the Griswold acquisition, net of cash acquired, $47.1 million in capital expenditures, $43.4 million paid for the Isola asset acquisition, and $25.4 million in pension and other postretirement benefits contributions, along with $6.6 million in tax payments related to net share settlement of equity awards, $5.0 million of principal payments made on our outstanding borrowings on our revolving credit facility and $3.0 million in repurchases of capital stock. This activity was partially offset by proceeds of $102.5 million from additional borrowings under our revolving credit facility, of which $82.5 million and $20.0 million were used to fund the Griswold acquisition and the voluntary pension plan contribution, respectively, and by cash flows generated by operations. In 2020, we expect capital spending to be in the range of approximately $40.0 million to $45.0 million, which we plan to fund with cash from operations. Revolving Credit Facility In February 2017, we entered into a secured five year credit agreement with JPMorgan Chase Bank, N.A., as administrative agent, and the lenders party thereto (the Third Amended Credit Agreement), which amended and restated the Second Amended Credit Agreement. The Third Amended Credit Agreement refinanced the Second Amended Credit Agreement, eliminated the term loan under the Second Amended Credit Agreement, increased the principal amount of our revolving credit facility to up to $450.0 million of borrowing capacity, with sublimits for multicurrency borrowings, letters of credit and swing-line notes, and provided an additional $175.0 million accordion feature. All revolving loans under the Third Amended Credit Agreement are due on the maturity date, February 17, 2022. We are not required to make any quarterly principal payments under the Third Amended Credit Agreement. In 2019 and 2018, we made discretionary principal payments of $105.5 million and $5.0 million, respectively, on the outstanding borrowings under our revolving credit facility. As of December 31, 2019, we had $123.0 million in outstanding borrowings under our revolving credit facility. For additional information regarding the Third Amended Credit Agreement, refer to “Note 9 - Debt” to “Item 8. Financial Statements and Supplementary Data.” Restriction on Payment of Dividends The Third Amended Credit Agreement generally permits us to pay cash dividends to our shareholders, provided that (i) no default or event of default has occurred and is continuing or would result from the dividend payment and (ii) our leverage ratio does not exceed 2.75 to 1.00. If our leverage ratio exceeds 2.75 to 1.00, we may nonetheless make up to $20.0 million in restricted payments, including cash dividends, during the fiscal year, provided that no default or event of default has occurred and is continuing or would result from the payments. Our leverage ratio did not exceed 2.75 to 1.00 as of December 31, 2019. Contractual Obligations The following table summarizes our contractual obligations as of December 31, 2019. (1) This amount represents non-cancelable vendor purchase commitments. (2) All outstanding borrowings under our revolving credit facility are due on February 17, 2022. (3) Estimated future interest payments are based on a leverage ratio based spread that ranges from 1.375% to 1.75%, plus projected forward 1-month LIBOR rates, and have been adjusted for the impact of the floating to fixed rate interest rate swap on $75.0 million of the outstanding borrowings under our revolving credit facility. For additional information, refer to “Note 3 - Hedging Transactions and Derivative Financial Instruments” to “Item 8. Financial Statements and Supplementary Data.” Actual future interest payments could differ from those set forth here due to the expected phase-out of LIBOR by the end of 2021. Other postretirement benefits, which amount to $1.6 million, are expected to be paid from operating cash flows. Other long-term liabilities, such as deferred taxes, unrecognized tax benefits and asbestos-related product liability reserves, have been excluded from the table due to the uncertainty of the timing of payments combined with the absence of historical trends to be used as a predictor for such payments. Effects of Inflation We do not believe that inflation had a material impact on our business, net sales, or operating results during the periods presented. Off-Balance Sheet Arrangements We do not have any off-balance sheet arrangements that have, or are, in the opinion of management, reasonably likely to have, a current or future material effect on our results of operations or financial position. Critical Accounting Estimates Our consolidated financial statements are prepared in accordance with U.S. generally accepted accounting principles, which require management to make estimates, judgments and assumptions that affect the amounts reported in the financial statements and accompanying notes. We base our estimates on historical experience and on various other assumptions that are believed to be reasonable under the circumstances and believe that appropriate reserves have been established using on reasonable methodologies and appropriate assumptions based on facts and circumstances that are known; however, actual results may differ from these estimates under different assumptions or conditions. Certain accounting policies may require a choice between acceptable accounting methods or may require substantial judgment or estimation in their application. A summary of our critical accounting estimates is presented below: Inventory Valuation Inventories are stated at the lower of cost or net realizable value with costs determined primarily on a first-in first-out basis. We also maintain a reserve for excess, obsolete and slow-moving inventory that is primarily developed by utilizing both specific product identification and historical product demand as the basis for our analysis. Products and materials that are specifically identified as obsolete are fully reserved. In general, most products that have been held in inventory greater than one year are fully reserved unless there are mitigating circumstances, including forecasted sales or current orders for the product. The remainder of the allowance is based on our estimates and fluctuates with market conditions, design cycles and other economic factors. Risks associated with this allowance include unforeseen changes in business cycles that could affect the marketability of certain products and an unexpected decline in current production. We closely monitor the marketplace and related inventory levels and have historically maintained reasonably accurate allowance levels. Our obsolescence reserve has ranged from 9% to 12% of gross inventory over the last three fiscal years. Goodwill and Other Intangible Assets We have made acquisitions over the years that included the recognition of intangible assets. Intangible assets are classified into three categories: (1) goodwill; (2) other intangible assets with definite lives subject to amortization; and (3) other intangible assets with indefinite lives not subject to amortization. Other intangible assets can include items such as trademarks and trade names, licensed technology, customer relationships and covenants not to compete, among other things. Each definite-lived other intangible asset is amortized over its respective economic useful life using the economic attribution method. Goodwill is tested for impairment annually and between annual impairment tests if events or changes in circumstances indicate the carrying value may be impaired. If it is more likely than not that our goodwill is impaired, then we compare the estimated fair value of each of our reporting units to its respective carrying value. If a reporting unit’s carrying value is greater than its fair value, then an impairment is recognized for the excess and charged to operations. We currently have four reporting units with goodwill: ACS, EMS, curamik® and Elastomer Components Division (ECD). Consistent with historical practice, the annual impairment test on these reporting units was performed as of November 30, 2019. The application of the annual goodwill impairment test requires significant judgment, including the identification of reporting units, assignment of assets and liabilities to reporting units and determination of the fair value of each reporting unit. Determining the fair value is subjective and requires the use of significant estimates and assumptions, including financial projections for net sales, gross margin and operating margin, discount rates, terminal growth rates and future market conditions, among others. We estimated the fair value of our reporting units using an income approach based on the present value of future cash flows through a five year discounted cash flow analysis. The discounted cash flow analysis utilized the discount rates for each of the reporting units ranging from 10.3% for EMS to 11.9% for ACS, and terminal growth rates ranging from 3.3% for curamik® to 4.6% for ACS. We believe this approach yields the most appropriate evidence of fair value as our reporting units are not easily compared to other corporations involved in similar businesses. We further believe that the assumptions and rates used in our annual goodwill impairment test are reasonable, but inherently uncertain. There were no impairment charges resulting from our goodwill impairment analysis for the year ended December 31, 2019. Our ACS, EMS, curamik® and ECD reporting units had allocated goodwill of $51.7 million, $142.0 million, $67.0 million and $2.2 million respectively, as of December 31, 2019. Indefinite-lived other intangible assets are tested for impairment annually and between annual impairment tests if events or changes in circumstances indicate the carrying value may be impaired. If it is more likely than not that an indefinite-lived other intangible asset is impaired, then we compare the estimated fair value of that indefinite-lived other intangible asset to its respective carrying value. If an indefinite-lived other intangible asset’s carrying value is greater than its fair value, then an impairment charge is recognized for the excess and charged to operations. Consistent with historical practice, the annual impairment test on these reporting units was performed as of November 30, 2019. The application of the annual indefinite-lived other intangible asset impairment test requires significant judgment, including the determination of fair value of each indefinite-lived other intangible asset. Fair value is primarily based on income approaches using discounted cash flow models, which have significant assumptions. Such assumptions are subject to variability from year to year and are directly impacted by global market conditions. There were no impairment charges resulting from our indefinite-lived other intangible assets impairment analysis for the year ended December 31, 2019. Our curamik® reporting unit had an indefinite-lived other intangible asset of $4.4 million as of December 31, 2019. Definite-lived other intangible assets are tested for recoverability whenever events or changes in circumstances indicate the carrying value may not be recoverable. The recoverability test involves comparing the estimated sum of the undiscounted cash flows for each definite-lived other intangible asset to its respective carrying value. If a definite-lived other intangible asset’s carrying value is greater than the sum of its undiscounted cash flows, then the definite-lived other intangible asset’s carrying value is compared to its estimated fair value and an impairment charge is recognized for the excess and charged to operations. The application of the recoverability test requires significant judgment, including the identification of the asset group and determination of undiscounted cash flows and fair value of the underlying definite-lived other intangible asset. Determination of undiscounted cash flows requires the use of significant estimates and assumptions, including certain financial projections. Fair value is primarily based on income approaches using discounted cash flow models, which have significant assumptions. Such assumptions are subject to variability from year to year and are directly impacted by global market conditions. There were no impairment charges resulting from our definite-lived other intangible assets impairment analysis for the year ended December 31, 2019. Our ACS, EMS and curamik® reporting units had definite-lived other intangible assets of $4.7 million, $140.4 million and $9.5 million, respectively, as of December 31, 2019. Product Liabilities We endeavor to maintain insurance coverage with reasonable deductible levels to protect us from potential exposures to product liability claims. Any liability associated with such claims is based on management’s best estimate of the potential claim value, while insurance receivables associated with related claims are not recorded until verified by the insurance carrier. For asbestos-related claims, we recognize projected asbestos liabilities and related insurance receivables, with any difference between the liability and related insurance receivable recognized as an expense in the consolidated statements of operations. Our estimates of asbestos-related contingent liabilities and related insurance receivables are based on an independent actuarial analysis and an independent insurance usage analysis prepared annually by third parties. The actuarial analysis contains numerous assumptions, including number of claims that might be received, the type and severity of the disease alleged by each claimant, the long latency period associated with asbestos exposure, dismissal rates, average indemnity costs, average defense costs, costs of medical treatment, the financial resources of other companies that are co-defendants in claims, uncertainties surrounding the litigation process from jurisdiction to jurisdiction and from case to case, and the impact of potential changes in legislative or judicial standards, including potential tort reform. Furthermore, any predictions with respect to these assumptions are subject to even greater uncertainty as the projection period lengthens. The insurance usage analysis considers, among other things, applicable deductibles, retentions and policy limits, the solvency and historical payment experience of various insurance carriers, the likelihood of recovery as estimated by external legal counsel and existing insurance settlements. The liability projection period covers all current and future indemnity and defense costs through 2064, which represents the expected end of our asbestos liability exposure with no further ongoing claims expected beyond that date. This conclusion was based on our history and experience with the claims data, the diminished volatility and consistency of observable claims data, the period of time that has elapsed since we stopped manufacturing products that contained encapsulated asbestos and an expected downward trend in claims due to the average age of our claimants, which is approaching the average life expectancy. Our accrued asbestos liabilities may not approximate our actual asbestos-related indemnity and defense costs, and our accrued insurance recoveries may not be realized. We believe it is reasonably possible that we may incur additional charges for our asbestos liabilities and defense costs in the future that could exceed existing reserves and insurance recoveries. We plan to continue to vigorously defend ourselves and believe we have substantial unutilized insurance coverage to mitigate future costs related to this matter. We review our asbestos-related projections annually in the fourth quarter of each year unless facts and circumstances materially change during the year, at which time we would analyze these projections. We believe the assumptions made on the potential exposure and expected insurance coverage are reasonable at the present time, but are subject to uncertainty based on the actual future outcome of our asbestos litigation. As of December 31, 2019, the estimated liabilities and estimated insurance recoveries for all current and future indemnity and defense costs projected through 2064 were $85.9 million and $78.3 million, respectively. Revenue Recognition Recognition of revenue occurs when a customer obtains control of promised goods or services in an amount that reflects the consideration to which the providing entity expects to be entitled in exchange for those goods or services. We recognize revenue when all of the following criteria are met: (1) we have entered into a binding agreement, (2) the performance obligations have been identified, (3) the transaction price to the customer has been determined, (4) the transaction price has been allocated to the performance obligations in the contract, and (5) the performance obligations have been satisfied. The majority of our shipping terms permit us to recognize revenue at point of shipment. Some shipping terms require the goods to be cleared through customs or be received by the customer before title passes. In those instances, revenue is not recognized until either the customer has received the goods or they have passed through customs, depending on the circumstances. Shipping and handling costs are treated as fulfillment costs. Sales tax or value added tax (VAT) are excluded from the measurement of the transaction price. The Company manufactures some products to customer specifications which are customized to such a degree that it is unlikely that another entity would purchase these products or that we could modify these products for another customer. These products are deemed to have no alternative use to the Company whereby we have an enforceable right to payment evidenced by contractual termination clauses. In accordance with ASC 606, for those circumstances we recognize revenue on an over-time basis. Revenue recognition does not occur until the product meets the definition of “no alternative use” and therefore, items that have not yet reached that point in the production process are not included in the population of items with over-time revenue recognition. As appropriate, we record estimated reductions to revenue for customer returns, allowances, and warranty claims. Provisions for such reductions are made at the time of sale and are typically derived from historical trends and other relevant information. Pension and Other Postretirement Benefits We provide various defined benefit pension plans for our U.S. employees and we sponsor multiple fully insured or self-funded medical plans and fully insured life insurance plans for retirees. The costs and obligations associated with these plans are dependent upon various actuarial assumptions used in calculating such amounts. These assumptions include discount rates, long-term rates of return on plan assets, mortality rates and other factors. The assumptions used were determined as follows: (i) the discount rate used is based on the PruCurve bond index, with comparisons against other similar indices; and (ii) the long-term rate of return on plan assets is determined based on historical portfolio results, market conditions and our expectations of future returns. We determine these assumptions based on consultation with outside actuaries and investment advisors. Any changes in these assumptions could have a significant impact on future recognized pension costs, assets and liabilities. The rates used to determine our costs and obligations under our pension and postretirement plans are disclosed in “Note 11 - Pension Benefits, Other Postretirement Benefits and Employee Savings and Investment Plan” to “Item 8. Financial Statements and Supplementary Data.” Each assumption has different sensitivity characteristics. For the year ended December 31, 2019, a 25 basis point decrease in the discount rate would have increased our pension expense for Rogers Corporation Employees’ Pension Plan (the Union Plan) and the Merged Plan by a de minimis amount. A 25 basis point decrease in the discount rate would have decreased the other postretirement benefits expense by a de minimis amount. A 25 basis point decrease in the expected return on assets would have increased the total 2019 pension expense for the Union Plan and the Merged Plan by a de minimis amount. As the other postretirement benefit plans are unfunded, they would not be impacted by this assumption change. Equity Compensation Determining the amount of equity compensation expense to be recorded requires us to develop estimates to be used in calculating the grant-date fair value of performance-based restricted stock units. Performance-Based Restricted Stock Units As of December 31, 2019, we had performance-based restricted stock units from 2019, 2018 and 2017 outstanding. These awards generally cliff vest at the end of a three-year measurement period. However, employees whose employment terminates during the measurement period due to death, disability, or, in certain cases, retirement may receive a pro-rata payout based on the number of days they were employed during the measurement period. Participants are eligible to be awarded shares ranging from 0% to 200% of the original award amount, based on certain defined performance measures. The 2019, 2018 and 2017 awards have one measurement criteria: the three-year total shareholder return (TSR) on the performance of our capital stock as compared to that of a specified group of peer companies. The TSR measurement criteria of the awards is considered a market condition. As such, the fair value of this measurement criteria was determined on the grant date using a Monte Carlo simulation valuation model. We recognize compensation expense on all of these awards on a straight-line basis over the vesting period with no changes for final projected payout of the awards. We account for forfeitures as they occur. Below were the assumptions used in the Monte Carlo calculation for each material award granted in 2019, 2018 and 2017: Expected volatility - In determining expected volatility, we have considered a number of factors, including historical volatility. Expected term - We use the measurement period of the award to determine the expected term assumption for the Monte Carlo simulation valuation model. Risk-free interest rate - We use an implied “spot rate” yield on U.S. Treasury Constant Maturity rates as of the grant date for our assumption of the risk-free interest rate. Expected dividend yield - We do not currently pay dividends on our capital stock; therefore, a dividend yield of 0% was used in the Monte Carlo simulation valuation model.

<s>[INST] The discussion of the comparison of our 2018 and 2017 results was previously presented in the Management’s Discussion & Analysis in Part II, Item 7 of the Company’s Annual Report on Form 10K filed with the SEC on February 21, 2019, and has been omitted from this section pursuant to Instruction 1 to Item 303(a) of Regulation SK. Business Overview Rogers Corporation designs, develops, manufactures and sells highperformance and highreliability engineered materials and components to meet our customers’ demanding challenges. We operate three strategic operating segments: Advanced Connectivity Solutions (ACS), Elastomeric Material Solutions (EMS) and Power Electronics Solutions (PES). The remaining operations, which represent our noncore businesses, are reported in the Other operating segment. We have a history of innovation and have established Innovation Centers for our research and development activities in Chandler, Arizona; Burlington, Massachusetts; Eschenbach, Germany; and Suzhou, China. We are headquartered in Chandler, Arizona. Growth Strategy and Recent Acquisitions Our growth strategy is based upon the following principles: (1) marketdriven organization, (2) innovation leadership, (3) synergistic mergers and acquisitions, and (4) operational excellence. As a marketdriven organization, we are focused on growth drivers, including advanced mobility and advanced connectivity. More specifically, the key trends currently affecting our business include the increasing use of advanced driver assistance systems (ADAS) and increasing electrification of vehicles, including electric and hybrid electric vehicles (EV/HEV), in the automotive industry and new technology adoption in the telecommunications industry, including next generation wireless infrastructure. In addition to our focus on advanced mobility and advanced connectivity in the automotive and telecommunications industries, we sell into a variety of other markets including general industrial, portable electronics, connected devices, aerospace and defense, mass transit and renewable energy. Our sales and marketing approach is based on addressing these trends, while our strategy focuses on factors for success as a manufacturer of engineered materials and components: performance, quality, service, cost, efficiency, innovation and technology. We have expanded our capabilities through organic investment and acquisitions and strive to ensure high quality solutions for our customers. We continue to review and realign our manufacturing and engineering footprint in an effort to attain a leading competitive position globally. We have established or expanded our capabilities in various locations in support of our customers’ growth initiatives. We seek to enhance our operational and financial performance by investing in research and development, manufacturing and materials efficiencies, and new product initiatives that respond to the needs of our customers. We strive to evaluate operational and strategic alternatives to improve our business structure and align our business with the changing needs of our customers and major industry trends affecting our business. In executing on our growth strategy, we have completed the following strategic acquisitions in the last two fiscal years: (1) in July 2018, we acquired Griswold LLC (Griswold), a manufacturer of a wide range of highperformance engineered cellular elastomer and microcellular polyurethane products and solutions and (2) in August 2018, we acquired a production facility and related machinery and equipment located in Chandler, Arizona from Isola USA Corp (Isola). Results of Operations The following table sets forth, for the periods indicated, selected operations data expressed as a percentage of net sales. Net Sales and Gross Margin Net sales increased by 2.2% in 2019 compared to 2018. Our ACS and EMS operating segments had net sales increases of 7.6% and 5.9%, respectively, partially offset by a net sales decrease in our PES operating segment of 11.1%. The increase in net sales was primarily driven by higher net sales in 5G wireless infrastructure in our ACS operating segment and the $15.0 million of net sales in the first half of the year related to Griswold, which we acquired in July 2018. Net sales were also favorably impacted by higher net sales in the aerospace and defense market in our ACS operating segment, higher net sales in the portable electronics market in our [/INST] Positive. </s>

WHIRLPOOL CORP /DE/

2015-02-26

2014-12-31

ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS This Management Discussion and Analysis should be read in connection with the Consolidated Financial Statements, Notes to the Consolidated Financial Statements and Selected Financial Data included in this Form 10-K. Certain references to particular information in the Notes to the Consolidated Financial Statements are made to assist readers. ABOUT WHIRLPOOL Whirlpool Corporation (“Whirlpool”) is the number one major appliance manufacturer in the world with net sales of approximately $20 billion and net earnings available to Whirlpool of $650 million in 2014. We are a leading producer of major home appliances in North America, Latin America and Europe, and have a significant presence throughout China and India. We have received worldwide recognition for accomplishments in a variety of business and social efforts, including leadership, diversity, innovative product design, business ethics, social responsibility and community involvement. We conduct our business through four reportable segments, which we define based on geography. Our reportable segments consist of North America, Latin America, EMEA (Europe, Middle East and Africa) and Asia. Our customer base includes large, sophisticated trade customers who have many choices and demand competitive products, services and prices. The major home appliance industry operates in an intensely competitive environment, reflecting the impact of both new and established global competitors, including Asian and European manufacturers. The charts below summarize the balance of net sales by reportable segment for 2014, 2013 and 2012, respectively: We monitor country-specific economic factors such as gross domestic product, unemployment, consumer confidence, retail trends, housing starts and completions, sales of existing homes and mortgage interest rates as key indicators of industry demand. In addition to profitability, we also focus on country, brand, product and channel sales when assessing and forecasting financial results. Our leading portfolio of brands includes Whirlpool, Maytag, KitchenAid, Embraco, Brastemp, Consul and Indesit, each of which generates annual revenues in excess of $1 billion. Our global branded consumer products strategy is to introduce innovative new products, increase brand customer loyalty, expand our presence outside the United States, enhance our trade management platform, improve total cost and quality by expanding and leveraging our global operating platform and, where appropriate, make strategic acquisitions and investments. As we grow revenues in our core products, our strategy is to extend our business by offering products and services that are dependent on and related to our core business and expand into adjacent products, such as Affresh cleaners and Gladiator GarageWorks, through businesses that leverage our core competencies and business infrastructure. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - (CONTINUED) OVERVIEW Whirlpool delivered a strong year of business operating performance as evidenced by record revenues and strong margins, while driving product introductions, ongoing productivity and delivering restructuring benefits. We have continued to build a global platform that will drive future growth and strong value creation, further accelerated through the completion of two acquisitions during 2014 in China and Europe. We have great opportunities for growth as demand in the U.S. continued to recover and we are very well positioned to capitalize when growth returns to emerging markets such as Brazil, China, India and Russia. We continue to accelerate our investments in product and brand innovation which will benefit our end consumers, while driving revenue growth in those areas that expand and extend our core appliance business. We believe that continued execution of our business priorities and a focus on long-term growth will allow the Company to adapt to changes in the macroeconomic environment and maintain our position as the world's leading global manufacturer and marketer of major home appliances. RESULTS OF OPERATIONS The following table summarizes the consolidated results of operations: nm: not meaningful Consolidated Net Sales The following tables summarize units sold and consolidated net sales by operating segment: MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - (CONTINUED) Consolidated net sales increased 5.9% compared to 2013 primarily due to favorable product price/mix, higher unit shipments and the benefit of the acquisitions partially offset by the unfavorable impact of foreign currency and lower BEFIEX credits. Excluding the impact of foreign currency and BEFIEX credits, consolidated net sales increased 8.4% compared to 2013. Consolidated net sales for 2013 increased 3.4% compared to 2012 primarily due to higher unit shipments and BEFIEX credits, partially offset by the unfavorable impact of foreign currency and changes in product price/mix. Excluding the impact of foreign currency and BEFIEX credits, consolidated net sales for 2013 increased 4.4% compared to 2012. We provide the percentage change in net sales, excluding the impact of foreign currency and BEFIEX credits, as a supplement to the change in net sales as determined by U.S. generally accepted accounting principles ("GAAP") to provide stockholders with a clearer basis to assess Whirlpool's results over time. This measure is considered a non-GAAP financial measure and is calculated by translating the current period net sales excluding BEFIEX credits, in functional currency, to U.S. dollars using the prior-year period's exchange rate compared to the prior-year period net sales excluding BEFIEX credits. Significant regional trends were as follows: • North America net sales increased 4.5% compared to 2013 primarily due to a 3.8% increase in units sold and favorable product price/mix, partially offset by foreign currency. North America net sales for 2013 increased 5.7% compared to 2012 primarily due to a 6.6% increase in units sold, partially offset by changes in product mix and foreign currency. • Latin America net sales decreased 4.9% compared to 2013 primarily due to a 4.5% decrease in units sold from the impact of the World Cup and presidential elections in 2014, lower BEFIEX credits and unfavorable foreign currency, partially offset by favorable product price/mix. Excluding the impact of foreign currency and BEFIEX credits, Latin America net sales increased 2.5% in 2014. Latin America net sales for 2013 decreased 0.5% compared to 2012 primarily due to the unfavorable impact of foreign currency, partially offset by a 6.2% increase in units sold and higher BEFIEX credits. Excluding the impact of foreign currency and BEFIEX credits, Latin America net sales increased 4.1% in 2013. We recognized approximately $14 million, $109 million and $37 million of BEFIEX credits in 2014, 2013 and 2012, respectively. As of December 31, 2014, approximately $48 million of future cash monetization remained for court awarded fees, which is not expected to be payable for several years. For additional information regarding BEFIEX credits, see Notes 7 and 12 of the Notes to the Consolidated Financial Statements. • EMEA net sales increased 29.1% compared to 2013, primarily due to a 32.2% increase in units sold primarily due to the acquisition of Indesit, partially offset by unfavorable product price/mix and foreign currency. Excluding the impact of foreign currency, net sales increased 29.6%. In 2013 EMEA net sales increased 5.2% compared to 2012, primarily due to the favorable impact of foreign currency and a 3.1% increase in units sold. Excluding the impact of foreign currency, net sales increased 1.8%. • Asia net sales increased 1.2% compared to 2013 primarily due to the acquisition of Hefei Sanyo, partially offset by foreign currency, product transition costs and unfavorable product price/mix. Excluding the impact of foreign currency, Asia net sales increased 4.1%. Asia net sales for 2013 decreased 4.8% compared to 2012 primarily due to the unfavorable impact of foreign currency and a 2.7% decrease in units sold, partially offset by favorable product price/mix. Excluding the impact of foreign currency, Asia net sales decreased 1.1%. Gross Margin The table below summarizes gross margin percentages by region: The consolidated gross margin percentage decreased 50 basis points to 17.1% compared to 2013, primarily due to higher material costs, expenses related to the acquisitions, foreign currency and lower BEFIEX credits, partially offset by productivity and restructuring benefits. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - (CONTINUED) Significant regional trends were as follows: • North America gross margin decreased compared to 2013 primarily due to the impact of product transitions, partially offset by productivity. North America gross margin for 2013 increased compared to 2012 primarily due to productivity and cost and capacity reduction initiatives, partially offset by a 2012 curtailment gain in a postretirement benefit plan that did not recur in 2013. • Latin America gross margin decreased compared to 2013 primarily due to lower BEFIEX credits, higher material costs and unfavorable foreign currency, partially offset by higher product price/mix. During 2013, Latin America gross margin increased compared to 2012 primarily due to favorable product price/mix, productivity and BEFIEX credits, partially offset by higher material costs. • EMEA gross margin increased compared to 2013 primarily due to increased productivity, the acquisition of Indesit, and restructuring benefits, partially offset by unfavorable product price/mix and foreign currency. During 2013, EMEA gross margin increased compared to 2012 primarily due to increased productivity and benefits from restructuring initiatives, partially offset by higher material costs. • Asia gross margin decreased in 2014 when compared to the prior year, primarily due to expenses related to the acquisition of Hefei Sanyo in 2014, foreign currency and unfavorable material costs, partially offset by favorable product price/mix, productivity and the benefits of the acquisition. Asia gross margin increased in 2013 when compared to the prior year primarily due to favorable product price/mix and productivity, partially offset by the unfavorable impacts of higher material costs and foreign currency. Selling, General and Administrative The following table summarizes selling, general and administrative expenses as a percentage of sales by region: Consolidated selling, general and administrative expenses in 2014 reflect acquisition-related costs and investment expenses compared to 2013 and have increased as a percent of consolidated net sales due to those expenses. Selling, general and administrative expenses as a percent of consolidated net sales in 2013 remained flat compared to 2012, primarily due to leverage on increased sales. Restructuring During the fourth quarter 2011, the Company committed to restructuring plans (the "2011 Plan") to expand our operating margins and improve our earnings through substantial cost and capacity reductions, primarily within our North America and EMEA operating segments. All actions related to the 2011 Plan have been announced and are now substantially complete. Over $40 million in costs related to actions authorized under the 2011 Plan were recognized during 2014. During 2014, the Company announced the following restructuring plans: (a) the closure of a microwave oven manufacturing facility and other organizational efficiency actions in EMEA and Latin America, and (b) organizational integration activities in China, in anticipation of the Hefei Sanyo transaction. These plans resulted in charges of approximately $90 million in 2014, with completion expected by the end of 2015, related to employee termination costs, non-cash asset impairment costs, and facility exit costs. We incurred restructuring charges of $136 million, $196 million, and $237 million for the years ended December 31, 2014, 2013 and 2012, respectively. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - (CONTINUED) For the full year 2015, we may incur up to $300 million of restructuring charges, which will result in substantial cost reductions. Additional information about restructuring activities can be found in Note 11 of the Notes to the Consolidated Financial Statements. Interest and Sundry Income (Expense) Interest and sundry income (expense) decreased $13 million compared to 2013, primarily driven by lower charges related to Embraco antitrust matters and a Brazilian government settlement occurring in 2013. During 2013, interest and sundry income (expense) increased $43 million compared to 2012, primarily driven by charges related to Embraco antitrust matters, a Brazilian government settlement and acquisition-related investment expenses. For additional information about the Embraco antitrust matters, the Brazilian collection dispute, and the Brazilian government settlement, see Note 7 of the Notes to the Consolidated Financial Statements. For additional information about the acquisitions of Hefei Sanyo and Indesit, see Note 2 of the Notes to the Consolidated Financial Statements. Interest Expense Interest expense decreased $12 million compared to 2013, primarily due to lower interest rates which were offset by higher average debt levels. The increase in average debt is related to the funding and assumed debt related to our two acquisitions in 2014 (See Note 2 to the Consolidated Financial Statements). During 2013, interest expense decreased $22 million compared to 2012, primarily due to lower interest rates. Income Taxes Income tax expense was $189 million, $68 million, and $133 million in 2014, 2013 and 2012, respectively. The increase in tax expense in 2014 compared to 2013 is primarily due to the absence of the United States energy tax credits that were recognized in 2013. The decrease in tax expense in 2013 compared to 2012 is primarily due to United States energy tax credits recognized, partially offset by higher pre-tax earnings. The "American Taxpayer Relief Act of 2012," signed in January 2013, reinstated the energy tax credit for 2012 and 2013, and resulted in a tax credit benefit related to the production of qualifying appliances in 2012 and 2013 in the combined amount of $126 million, all of which was recognized in 2013. For additional information about our consolidated tax provision, see Note 12 of the Notes to the Consolidated Financial Statements. The following table summarizes the difference between income tax expense at the United States statutory rate of 35% and the income tax expense at effective worldwide tax rates for the respective periods: MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - (CONTINUED) FORWARD-LOOKING PERSPECTIVE We currently estimate earnings per diluted share and industry demand for 2015 to be within the following ranges: For the full-year 2015, we expect to generate free cash flow between $700 million and $800 million, including restructuring cash outlays of up to $250 million, capital spending of $800 million to $850 million and U.S. pension contributions of approximately $80 million. The table below reconciles projected 2015 cash provided by operating activities determined in accordance with GAAP to free cash flow, a non-GAAP measure. Management believes that free cash flow provides stockholders with a relevant measure of liquidity and a useful basis for assessing Whirlpool’s ability to fund its activities and obligations. There are limitations to using non-GAAP financial measures, including the difficulty associated with comparing companies that use similarly named non-GAAP measures whose calculations may differ from our calculations. We define free cash flow as cash provided by continuing operations less capital expenditures and including proceeds from the sale of assets/businesses, and changes in restricted cash. The change in restricted cash relates to the private placement funds paid by Whirlpool to acquire majority control of Hefei Sanyo and which are used to fund capital and technical resources to enhance Hefei Sanyo’s research and development and working capital. The projections above are based on many estimates and are inherently subject to change based on future decisions made by management and the Board of Directors of Whirlpool, and significant economic, competitive and other uncertainties and contingencies. FINANCIAL CONDITION AND LIQUIDITY Our objective is to finance our business through operating cash flow and the appropriate mix of long-term and short-term debt. By diversifying the maturity structure, we avoid concentrations of debt, reducing liquidity risk. We have varying needs for short-term working capital financing as a result of the nature of our business. We regularly review our capital structure and liquidity priorities, which include funding the business through capital and engineering spending to support innovation and productivity initiatives, funding our pension plan and term debt liabilities, providing return to shareholders and potential acquisitions. On October 14, 2014, we completed our acquisition from Fineldo S.p.A. and certain members of the Merloni family (the "Family") a number of shares that, when combined with a prior purchase, totaled 66.8% of the voting stock of Indesit for an aggregate purchase price, including the prior purchase, of €758 million (approximately $965 million at the dates of purchase), without adjustment. The Company funded the aggregate purchase price for the shares constituting a majority interest that we purchased in October 2014 through the issuance of an aggregate principal amount of $650 million in senior notes on November 4, 2014. Whirlpool launched a mandatory tender offer for all remaining outstanding shares of Indesit in accordance with Italian law which was completed on November 28, 2014 at a cost of €344 million (approximately $429 million at the date of purchase). MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - (CONTINUED) On December 3, 2014 we acquired the remaining shares for €32 million (approximately $40 million at the date of the purchase) to obtain 100% ownership. Additional information about the transaction can be found in Note 2 of the Notes to the Consolidated Financial Statements. In addition, we assumed $99 million of bank guarantees through our acquisition of Indesit as of December 31, 2014. On October 24, 2014, Whirlpool’s wholly-owned Chinese subsidiary completed its acquisition of a 51% equity stake in Hefei Sanyo, through two transactions, for an aggregate purchase price of RMB 3.4 billion (approximately $551 million at the dates of purchase). The Company funded the total consideration for the shares with cash on hand. The cash paid for the private placement portion of the transaction is considered restricted cash, which will be used to fund capital and technical resources to enhance Hefei Sanyo’s research and development and working capital. Additional information about the transaction can be found in Note 2 of the Notes to the Consolidated Financial Statements. Our short term potential uses of liquidity include funding our ongoing capital spending, restructuring activities, funding pension plans and returns to shareholders. We also have $234 million of term debt maturing in the next twelve months. We monitor the credit ratings and market indicators of credit risk of our lending, depository, and derivative counterparty banks regularly. In addition, we diversify our deposits and investments in short term cash equivalents to limit the concentration of exposure by counterparty. We continue to review customer conditions across the Eurozone. As of December 31, 2014, we had €78 million (approximately $94 million as of December 31, 2014) in outstanding trade receivables and short-term and long-term notes due to us associated with Alno AG, a long-standing European customer. Approximately €39 million (approximately $47 million as of December 31, 2014) of the outstanding receivables were overdue as of December 31, 2014. In the fourth quarter of 2014, Whirlpool and Alno entered into an agreement to revise the previous standstill agreement to amend the payment terms of the overdue trade receivables. The new agreement cured the violation of the prior agreement and Alno’s full overdue balance remains due in full by the end of the first quarter of 2016. Our exposure includes not only the outstanding receivables but also the potential risks of an Alno bankruptcy and impacts to our distribution process. Alno is proceeding to secure additional financing to improve its financial position. In March 2014, Whirlpool sold approximately 7.4 million shares held in Alno AG for approximately $5 million. This transaction resulted in the conversion of our investment from the equity method of accounting to an available for sale investment due to our less than 20% overall investment in Alno AG. As of December 31, 2014, we had $1.0 billion of cash and equivalents on hand, of which $0.9 billion was held outside of the United States. Our intent is to permanently reinvest these funds outside of the United States and our current plans do not demonstrate a need to repatriate these funds to fund our U.S. operations. However, if these funds were repatriated, we would then be required to accrue and pay applicable U.S. taxes (subject to an adjustment for foreign tax credits) and withholding taxes payable to various countries. Sources and Uses of Cash We met our cash needs during 2014 through cash flows from operations, cash and equivalents, and financing arrangements. Our cash and equivalents at December 31, 2014 decreased $354 million compared to the same period in 2013. Significant drivers of changes in our cash and equivalents balance during 2014 are discussed below: Cash Flow Summary MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - (CONTINUED) Cash Flows from Operating Activities The increase in cash provided by operating activities during 2014 reflects strong cash earnings and working capital improvements partially offset by $125 million to fund our United States qualified pension plans. The timing of cash flows from operations varies significantly within a quarter primarily due to changes in production levels, sales patterns, promotional programs, funding requirements as well as receivable and payment terms. Dependent on timing of cash flows, the location of cash balances, as well as the liquidity requirements of each country, external sources of funding are used to support working capital requirements throughout the year. Due to the variables discussed above, cash flow from operations during the year may significantly exceed our quarter and year-end balances. We offer our suppliers access to third party payables processors. Independent of Whirlpool, the processors allow suppliers to sell their receivables to financial institutions at the discretion of only the supplier and the financial institution. We have no economic interest in the sale of these receivables and no direct financial relationship with the financial institutions concerning these services. All of our obligations, including amounts due, remain to our suppliers as stated in our supplier agreements. As of December 31, 2014 and 2013, approximately $1.6 billion and $1.3 billion, respectively, are outstanding under the programs with participating financial institutions. Cash Flows from Investing Activities Cash used in investing activities of $2.5 billion during 2014 increased $1.9 billion from 2013, primarily driven by the acquisitions of Hefei Sanyo and Indesit and higher capital investment to support new product innovations. Cash used in investing activities of $582 million during 2013 increased $88 million from 2012, primarily driven by higher capital investment to support new product innovations. Cash Flows from Financing Activities Cash provided by financing activities during 2014 increased compared to 2013 primarily due to the funding required to complete the acquisitions of Hefei Sanyo and Indesit, partially offset by lower share repurchase activity. Cash used in financing activities during 2013 increased compared to 2012 primarily due to the resumption of our share repurchase program and higher cash dividends, partially offset by increased proceeds from the issuance of common stock associated with stock option exercises. Financing Arrangements On September 26, 2014, we entered into a Second Amended and Restated Long-Term Credit Agreement (the “Long-Term Facility”). The Long-Term Facility amends, restates and extends the borrowers’ prior five-year credit facility, which was scheduled to mature on June 28, 2016. The Long-Term Facility increases the existing $1.7 billion facility to an aggregate amount of $2.0 billion, with an option to increase the total amount to up to $2.5 billion by exercise of an accordion feature. The Long-Term Facility has a maturity date of September 26, 2019. The Long-Term Facility includes a letter of credit sublimit of $200 million. The Long-Term Facility decreases the interest and fee rates payable with respect to the Long-Term Facility based on our debt rating as follows: (1) the spread over LIBOR is 1.250%; (2) the spread over prime is 0.250%; and (3) the unused commitment fee is 0.15%, as of the effective date of the Long-Term Facility. We had no borrowings outstanding under the Long-Term Facility at December 31, 2014 or the prior five-year credit facility at December 31, 2013. On September 26, 2014, we entered into a Short-Term Credit Agreement (the “364-Day Facility” and together with the Long-Term Facility, the “Facilities”). The 364-Day Facility is a revolving credit facility in an aggregate amount of $1.0 billion. The 364-Day Facility has a maturity date of September 25, 2015. The interest and fee rates payable with respect to the 364-Day Facility based on our debt rating are as follows: (1) the spread over LIBOR is 1.250%; (2) the spread over prime is 0.250%; and (3) the unused commitment fee is 0.125%, as of the effective date of the 364-Day Facility. We had no borrowings outstanding under the 364-Day Facility at December 31, 2014. The Facilities contain customary covenants and warranties including, among other things, a rolling twelve month maximum leverage ratio limited to 3.25 to 1.0 for each fiscal quarter and a rolling twelve month interest coverage ratio required to be greater than or equal to 3.0 to 1.0 for each fiscal quarter. In addition, the covenants limit our ability to (or to permit any subsidiaries to), subject to various exceptions and limitations: (i) merge with other companies; (ii) create liens on our property; (iii) incur debt or off-balance sheet obligations at the subsidiary level; (iv) enter into transactions with affiliates, except on an arms-length basis; (v) enter into agreements restricting the payment of subsidiary dividends or restricting the making of loans or repayment of debt by subsidiaries; and (vi) enter into agreements restricting the creation of liens on our assets. We were in compliance with financial covenant requirements at December 31, 2014 and December 31, 2013. We have paid lenders under the Facilities an up-front fee of approximately $3 million. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - (CONTINUED) We have committed credit facilities in Brazil, which provide borrowings up to 1.1 billion Brazilian reais (approximately $429 million as of December 31, 2014) maturing at various times from 2015 to 2017. The credit facilities contain no financial covenants and we had no borrowings outstanding under these credit facilities at December 31, 2014 and 2013. In the fourth quarter of 2014, we acquired a committed credit facility in Italy as a result of the Indesit acquisition, which provides borrowings up to €350 million (approximately $424 million as of December 31, 2014) maturing July 29, 2016. As described in the credit agreement included as an exhibit to this Form 10-K, the credit facility contains covenants which state the guarantor, Indesit, will not permit (1) the ratio of Consolidated Net Borrowings as of any Year-End Determination Date to Consolidated earnings before income taxes, depreciation and amortization, for the twelve month period ended on such Year-End Determination Date to exceed 3.00 to 1; (2) the ratio of Consolidated Net Borrowings as of any Semi Annual Determination Date to Consolidated EBITDA for the twelve month period ended on such Semi Annual Determination Date to exceed 4.00 to 1; and (3) the ratio of Consolidated EBITDA to Consolidated Net Interest for the twelve month period ending on any Determination Date to be less than 3.5 to 1. We were in compliance with financial covenant requirements at December 31, 2014. We had no borrowings outstanding under this credit facility at December 31, 2014. On February 25, 2014, we completed a debt offering of $250 million principal amount of 1.35% notes due in 2017, $250 million principal amount of 2.40% notes due in 2019, and $300 million principal amount of 4.00% notes due in 2024. On May 1, 2014, $500 million of 8.60% notes matured and were repaid. On August 15, 2014, $100 million of 6.45% notes matured and were repaid. On November 4, 2014, we completed a debt offering of $300 million principal amount of 1.65% notes due in 2017 and $350 million principal amount of 3.70% notes due in 2025. These notes contain covenants that limit our ability to incur certain liens or enter into certain sale and lease-back transactions. In addition, if we experience a specific kind of change of control, we are required to make an offer to purchase all of the notes at a purchase price of 101% of the principal amount thereof, plus accrued and unpaid interest. During 2013 we completed a debt offering comprised of $250 million principal amount of 3.70% notes due in 2023 and $250 million principal amount of 5.15% notes due in 2043. These notes contain covenants that limit our ability to incur certain liens or enter into certain sale and lease-back transactions. In addition, if we experience a specific kind of change of control, we are required to make an offer to purchase all of the notes at a purchase price of 101% of the principal amount thereof, plus accrued and unpaid interest. For additional information about our financing arrangements, see Note 6 of the Notes to the Consolidated Financial Statements. 401(k) Defined Contribution Plan During January 2012, we began contributing company stock to fund the company match and automatic company contributions, equal to up to 7% of employees' eligible pay, in our 401(k) defined contribution plan covering all U.S. employees. We contributed $49 million of company stock to our 401(k) defined contribution plan during 2012. We resumed funding the company match and automatic contribution in cash during the fourth quarter 2012. Repurchase Program On April 14, 2014, our Board of Directors authorized a new share repurchase program of up to $500 million. Share repurchases are made from time to time on the open market as conditions warrant. The program does not obligate us to repurchase any of our shares. We repurchased 165,900 shares at an aggregate purchase price of approximately $25 million through December 31, 2014. At December 31, 2014, there were approximately $475 million in remaining funds authorized under this program. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - (CONTINUED) CONTRACTUAL OBLIGATIONS AND FORWARD-LOOKING CASH REQUIREMENTS The following table summarizes our expected cash outflows resulting from financial contracts and commitments: (1) Interest payments related to long-term debt are included in the table above. For additional information about our financing arrangements, see Note 6 of the Notes to the Consolidated Financial Statements. (2) Purchase obligations include our “take-or-pay” contracts with materials vendors and minimum payment obligations to other suppliers. (3) Represents payments agreed to under a Brazil government settlement program. See Note 7 of the Notes to the Consolidated Financial Statements for additional information. (4) Represents the minimum contributions required by law estimated based on current interest rates, asset return assumptions, legislative requirements and other actuarial assumptions at December 31, 2014. Management may elect to contribute amounts in addition to those required by law. See Note 13 of the Notes to the Consolidated Financial Statements for additional information. (5) Represents required contributions to our foreign funded pension plans only. See Note 13 of the Notes to the Consolidated Financial Statements for additional information. (6) Represents our portion of expected benefit payments under our retiree healthcare plans. (7) For additional information regarding legal settlements, see Note 7 of the Notes to the Consolidated Financial Statements. (8) This table does not include short-term credit facility and commercial paper borrowings. For additional information about short-term borrowings, see Note 6 of the Notes to the Consolidated Financial Statements. This table does not include future anticipated income tax settlements; see Note 12 of the Notes to the Consolidated Financial Statements. HEFEI SANYO ACQUISITION On August 12, 2013, Whirlpool's wholly-owned subsidiary, Whirlpool China, reached agreements to acquire a 51% equity stake in a leading home appliances manufacturer, Hefei Sanyo, a joint stock company whose shares are listed and traded on the Shanghai Stock Exchange. This transaction was completed on October 24, 2014. Hefei Sanyo has been renamed to "Whirlpool China Co., Ltd." The aggregate purchase price was RMB 3.4 billion (approximately $551 million at the dates of purchase). The Company funded the total consideration for the shares with cash on hand. The cash paid for the private placement portion of the transaction is considered restricted cash, which will be used to fund capital and technical resources to enhance Hefei Sanyo’s research and development and working capital. We expect the acquisition will accelerate Whirlpool’s profitable growth in the Chinese appliance market. During 2014, Whirlpool began integrating the manufacturing, administrative, supply chain and technology operations of Hefei Sanyo. The results of Hefei Sanyo’s operations have been included in the Consolidated Financial Statements beginning October 24, 2014. Hefei Sanyo has an established and broad distribution network that includes more than 30,000 outlets throughout China. Their significant presence in rural areas complements Whirlpool’s presence in China’s higher-tier cities. With this acquisition, Whirlpool also gains manufacturing scale and a competitive cost structure in the city of Hefei. The ability to consolidate operations offers strong synergies as Whirlpool will provide extensive technical, marketing and product development, combined with Hefei Sanyo’s sales execution and operational strengths, to support the next phase of development in the advancement of Hefei Sanyo as an important global production and research and development center for the home appliance sector. Further discussion of this transaction can be found in Note 2 of the Notes to the Consolidated Financial Statements. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - (CONTINUED) INDESIT ACQUISITION On December 3, 2014, Whirlpool purchased all remaining shares of Indesit (aside from a minority interest that was purchased in the third quarter of 2014) and Indesit delisted from the Electronic Stock Market organized and managed by Borsa Italiana S.p.A. Total consideration paid for Indesit was $1.4 billion in aggregate net of cash acquired. The Company funded the aggregate purchase price for the shares constituting a majority interest that we purchased in October 2014 through borrowings under our credit facility, and repaid a portion of such borrowings through the issuance of an aggregate principal amount of $650 million in senior notes on November 4, 2014. We funded the aggregate purchase price for the tender offer and remaining shares through borrowings under our credit facility and through borrowings under our commercial paper programs, and intend to repay such borrowings in the future through public debt financing. The acquisition builds our market position and will enable sustainable growth in EMEA. During 2015, Whirlpool expects to integrate the manufacturing, administrative, supply chain and technology operations of Indesit. The results of Indesit’s operations have been included in the Consolidated Financial Statements beginning October 14, 2014. Further discussion of this transaction can be found in Note 2 of the Notes to the Consolidated Financial Statements. OFF-BALANCE SHEET ARRANGEMENTS We have guarantee arrangements in a Brazilian subsidiary. As a standard business practice in Brazil, the subsidiary guarantees customer lines of credit at commercial banks to support purchases, following its normal credit policies. If a customer were to default on its line of credit with the bank, our subsidiary would be required to satisfy the obligation with the bank and the receivable would revert back to the subsidiary. As of December 31, 2014 and 2013, the guaranteed amounts totaled $492 million and $485 million, respectively. Our subsidiary insures against credit risk for these guarantees, under normal operating conditions, through policies purchased from high-quality underwriters. In addition, we assumed $1.2 billion of corporate guarantees through our acquisition of Indesit as of December 31, 2014. We had no losses associated with these guarantees in 2014 or 2013. We have guaranteed a $45 million five year revolving credit facility between certain financial institutions and a not-for-profit entity in connection with a community and economic development project (“Harbor Shores”). The credit facility, which originated in 2008, was amended in 2014 by Harbor Shores and reduced to $45 million, was refinanced in December 2012 and we renewed our guarantee through 2017. The fair value of the guarantee was nominal. The purpose of Harbor Shores is to stimulate employment and growth in the areas of Benton Harbor and St. Joseph, Michigan. In the event of default, we must satisfy the guarantee of the credit facility up to the amount borrowed at the date of default. In the ordinary course of business, we enter into agreements with financial institutions to issue bank guarantees, letters of credit and surety bonds. These agreements are primarily associated with unresolved tax matters in Brazil, as is customary under local regulations, and governmental obligations related to certain employee benefit arrangements. As of December 31, 2014 and 2013, we had approximately $401 million and $404 million outstanding under these agreements, respectively. CRITICAL ACCOUNTING POLICIES AND ESTIMATES The preparation of financial statements in conformity with generally accepted accounting principles in the United States (GAAP) requires management to make certain estimates and assumptions. We periodically evaluate these estimates and assumptions, which are based on historical experience, changes in the business environment and other factors that management believes to be reasonable under the circumstances. Actual results may differ materially from these estimates. Pension and Other Postretirement Benefits Accounting for pensions and other postretirement benefits involves estimating the costs of future benefits and attributing the cost over the employee’s expected period of employment. The determination of our obligation and expense for these costs requires the use of certain assumptions. Those assumptions include the discount rate, expected long-term rate of return on plan assets, life expectancy, and health care cost trend rates. These assumptions are subject to change based on interest rates on high quality bonds, stock and bond markets and medical cost inflation, respectively. Actual results that differ from our assumptions are accumulated and amortized over future periods and therefore, generally affect our recognized expense and accrued liability in such future periods. While we believe that our assumptions are appropriate given current economic conditions and actual experience, significant differences in results or significant changes in our assumptions may materially affect our pension and other postretirement benefit obligations and related future expense. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - (CONTINUED) Our pension and other postretirement benefit obligations at December 31, 2014 and preliminary retirement benefit costs for 2015 were prepared using the assumptions that were determined at December 31, 2014. The following table summarizes the sensitivity of our December 31, 2014 retirement obligations and 2015 retirement benefit costs of our United States plans to changes in the key assumptions used to determine those results: * Projected benefit obligation (PBO) for pension plans and accumulated postretirement benefit obligation (APBO) for other postretirement benefit plans. These sensitivities may not be appropriate to use for other years’ financial results. Furthermore, the impact of assumption changes outside of the ranges shown above may not be approximated by using the above results. For additional information about our pension and other postretirement benefit obligations, see Note 13 of the Notes to the Consolidated Financial Statements. Income Taxes We estimate our income taxes in each of the taxing jurisdictions in which we operate. This involves estimating actual current tax expense together with assessing any temporary differences resulting from the different treatment of certain items, such as the timing for recognizing expenses, for tax and accounting purposes. These differences may result in deferred tax assets or liabilities, which are included in our Consolidated Balance Sheets. We are required to assess the likelihood that deferred tax assets, which include net operating loss carryforwards, foreign tax credits and deductible temporary differences, are expected to be realizable in future years. Realization of our net operating loss and foreign tax credit deferred tax assets is supported by specific tax planning strategies and, where possible, considers projections of future profitability. If recovery is not more likely than not, we provide a valuation allowance based on estimates of future taxable income in the various taxing jurisdictions, and the amount of deferred taxes that are ultimately realizable. If future taxable income is lower than expected or if tax planning strategies are not available as anticipated, we may record additional valuation allowances through income tax expense in the period such determination is made. Likewise, if we determine that we are able to realize our deferred tax assets in the future in excess of net recorded amounts, an adjustment to the deferred tax asset will benefit income tax expense in the period such determination is made. As of December 31, 2014 and 2013, we had total deferred tax assets of $3.2 billion and $3.0 billion, respectively, net of valuation allowances of $308 million and $186 million, respectively. Our income tax benefit or expense has fluctuated considerably over the last five years from a tax benefit of $436 million in 2011 to the current year tax expense of $189 million and has been influenced primarily by U.S. energy tax credits, audit settlements and adjustments, tax planning strategies, enacted legislation, and dispersion of global income. Future changes in the effective tax rate will be subject to several factors including, remaining BEFIEX credits, business profitability, tax planning strategies, and enacted tax laws. In addition, we operate within multiple taxing jurisdictions and are subject to audit in these jurisdictions. These audits can involve complex issues, which may require an extended period of time to resolve. For additional information about income taxes, see Notes 1, 7 and 12 of the Notes to the Consolidated Financial Statements. BEFIEX Credits In previous years, our Brazilian operations earned tax credits under the Brazilian government’s export incentive program (BEFIEX). These credits reduced Brazilian federal excise taxes on domestic sales, resulting in an increase in the operations’ recorded net sales. As of December 31, 2014, all BEFIEX credits that were available to be monetized had been monetized. For additional information regarding BEFIEX credits, see Note 7 of the Notes to the Consolidated Financial Statements. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - (CONTINUED) Warranty Obligations The estimation of warranty obligations is determined in the same period that revenue from the sale of the related products is recognized. The warranty obligation is based on historical experience and represents our best estimate of expected costs at the time products are sold. Warranty accruals are adjusted for known or anticipated warranty claims as new information becomes available. New product launches require a greater use of judgment in developing estimates until historical experience becomes available. Future events and circumstances could materially change our estimates and require adjustments to the warranty obligations. For additional information about warranty obligations, see Note 7 of the Notes to the Consolidated Financial Statements. Goodwill and Intangibles Certain business acquisitions have resulted in the recording of goodwill and trademark assets. Upon acquisition, the purchase price is first allocated to identifiable assets and liabilities, including trademark assets, based on estimated fair value, with any remaining purchase price recorded as goodwill. Most trademarks and goodwill are considered indefinite lived intangible assets and as such are not amortized. At December 31, 2014, we had goodwill of $2.8 billion. Goodwill increased by $1.1 billion in 2014 due to the acquisitions of Hefei Sanyo and Indesit. There have been no changes to our reporting units or allocations of goodwill by reporting units except for goodwill resulting from the acquisitions. We have trademark assets in our North America, EMEA and Asia operating segments with a carrying value of approximately $1.5 billion, $629 million, and $42 million respectively, as of December 31, 2014. We perform our annual impairment assessment for goodwill and other indefinite-lived intangible assets as of October 1st and more frequently if indicators of impairment exist. Goodwill Valuations We evaluate goodwill using a qualitative assessment to determine whether it is more likely than not that the fair value of any reporting unit is less than its carrying amount. If we determine that the fair value of the reporting unit may be less than its carrying amount, we evaluate goodwill using a two-step impairment test. Otherwise, we conclude that no impairment is indicated and we do not perform the two-step impairment test. In 2014, this assessment was performed for the NAR and LAR operating segments, as impairment indicators do not exist for goodwill acquired in 2014. In conducting a qualitative assessment, the Company analyzes a variety of events or factors that may influence the fair value of the reporting unit, including, but not limited to: the results of prior quantitative tests performed; changes in the carrying amount of the reporting unit; actual and projected operating results; relevant market data for both the company and its peer companies; industry outlooks; macroeconomic conditions; liquidity; changes in key personnel; and the Company's competitive position. Significant judgment is used to evaluate the totality of these events and factors to make the determination of whether it is more likely than not that the fair value of the reporting unit is less than its carrying value. If the qualitative assessment concludes that the two-step impairment test is necessary, we first compare the book value of a reporting unit, including goodwill, with its fair value. The fair value is estimated based on a market approach and a discounted cash flow analysis, also known as the income approach, and is reconciled back to the current market capitalization for Whirlpool to ensure that the implied control premium is reasonable. If the book value of a reporting unit exceeds its fair value, we perform the second step to estimate an implied fair value of the reporting unit’s goodwill by allocating the fair value of the reporting unit to all of the assets and liabilities other than goodwill (including any unrecognized intangible assets). The difference between the total fair value of the reporting unit and the fair value of all the assets and liabilities other than goodwill is the implied fair value of that goodwill. The amount of impairment loss is equal to the excess of the book value of the goodwill over the implied fair value of that goodwill. Evaluating Goodwill - Results and Significant Assumptions Based on the favorable results of the qualitative assessment conducted on October 1, 2014, there was no goodwill impairment charge recorded in 2014. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - (CONTINUED) For our North America reporting unit, our qualitative assessment included a review of the events and factors outlined above. Our last quantitative test was performed in 2011. Significant weight was provided to the following factors, as we determined that these items have the most significant impact on the fair value of this reporting unit. • Operating profit margins remain strong for the third consecutive year at 10.1% in 2014 compared to 10.5% and 8.8% in 2013 and 2012, respectively. Margins have been driven by higher net sales, ongoing cost productivity, the benefit of cost and capacity-reduction initiatives, as well as our continued ability to deliver innovative and consumer relevant products to the marketplace. The improvement in operating margins compared to the prior quantitative assessment performed in 2011 provides significant positive evidence for the qualitative assessment. • We experienced a 125 basis point decrease in the discount rate from our last quantitative assessment performed in 2011, primarily driven by a decrease in the risk free rate and a decline in our company specific risk premium. The decrease in the company specific risk premium is driven largely by the structural improvement in our operating model delivered through successful execution of our cost and capacity reductions and implementation of previously announced cost-based price increases since 2011. The decrease in the discount rate provides significant positive evidence for the qualitative assessment. The implied increases to the fair value of our North America reporting unit noted above are further supported by an increase in our overall market capitalization of approximately $11 billion, or approximately 280%, as of October 1, 2014, compared to the prior quantitative assessment in 2011. This increase is largely attributable to the improved operating performance of the North America reporting unit. Intangible Valuations We evaluate certain indefinite-lived intangibles using a qualitative assessment to determine whether it is more likely than not that the fair value of the indefinite lived intangible asset is less than its carrying amount. If we determine that the fair value may be less than its carrying amount, the fair value of the trademark is estimated and compared to its carrying value to determine if an impairment exists. Otherwise, we conclude that no impairment is indicated and we do not perform the quantitative test. When the qualitative assessment is not utilized and a quantitative test is performed, we estimate the fair value of these intangible assets using the relief-from-royalty method, which requires assumptions related to projected revenues from our annual long-range plan; assumed royalty rates that could be payable if we did not own the trademark; and a discount rate based on our weighted average cost of capital. We recognize an impairment loss when the estimated fair value of the indefinite-lived intangible asset is less than its carrying value. Evaluating Trademarks - Results and Significant Assumptions We performed a qualitative assessment for one trademark, with a value of approximately $18 million. Our prior quantitative test performed in 2011 indicated that the fair value for this trademark exceeded its respective carrying value by approximately 400%. Based on the qualitative assessment conducted on October 1, 2014, we concluded that it was more likely than not that the fair value of this trademark was greater than its respective carrying value, therefore no impairment was recorded. Based on the results of our impairment test performed as of October 1, 2014, impairment of two trademarks was determined to exist, primarily driven by a change in our brand strategy in EMEA as a result of the acquisition of Indesit and resulted in a charge of approximately $12 million. The fair values of all other trademarks tested exceed their carrying values by more than 10% with the exception of one North American trademark. The fair value of this trademark exceeded its carrying value of approximately $1 billion by 5%. The fair value of this trademark was lower in 2014, as a result of extended transitions to deliver product innovation in North America. We invested significantly in this trademark in 2014 and are on track to deliver these new products in 2015. In performing the quantitative test, significant assumptions used in our relief from royalty model as of October 1, 2014 included revenue growth rates, assumed royalty rates and the discount rate, which are discussed further below. • Revenue growth rates relate to projected revenues from our annual long range plan and vary from brand to brand. Adverse changes in the operating environment for the appliance industry or our inability to grow revenues at the forecasted rates may result in a future impairment charge. We performed a sensitivity analysis on our estimated fair value noting that a 10% reduction of forecasted revenues would result in an impairment of approximately $56 million. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - (CONTINUED) • In determining royalty rates for the valuation of our trademarks, we considered factors that affect the intrinsic royalty rates that would hypothetically be paid for the use of the trademark. The most significant factors in determining the intrinsic royalty rates include the overall role and importance of the trademarks in the particular industry, the profitability of the products utilizing the trademarks, and the position of the trademarked products in a given market segment. Based on this analysis, we determined royalty rates of 2% to 3% for our value brands, 3.5% to 4% for our mass market brands and 6% for our super premium brand. We performed a sensitivity analysis on our estimated fair value noting that a 100 basis point reduction of the royalty rates for each brand would result in an impairment of approximately $175 million. • In developing discount rates for the valuation of our trademarks, we used the industry average weighted average cost of capital as the base, adjusted for the higher relative level of risks associated with doing business in other countries, as applicable, as well as the higher relative levels of risks associated with intangible assets. Based on this analysis, we determined discount rates ranging from 8.5% to 10.25%. We performed a sensitivity analysis on our estimated fair value noting that an increase in the discount rates used for the valuation of 100 basis points would result in an impairment of approximately $100 million. Many of the factors used in assessing fair value are outside the control of management and it is reasonably likely that assumptions and estimates can change in future periods. These changes can result in future impairments. For additional information about goodwill and intangible valuations, see Note 3 of the Notes to the Consolidated Financial Statements. ISSUED BUT NOT YET EFFECTIVE ACCOUNTING PRONOUNCEMENTS In May 2014, the FASB issued ASU No. 2014-09, "Revenue from Contracts with Customers (Topic 606)", which supersedes the revenue recognition requirements in ASC 605, Revenue Recognition. This ASU is based on the principle that revenue is recognized to depict the transfer of goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services. The ASU also requires additional disclosure about the nature, amount, timing and uncertainty of revenue and cash flows arising from customer contracts, including significant judgments and changes in judgments and assets recognized from costs incurred to obtain or fulfill a contract. This pronouncement is effective for annual reporting periods beginning after December 15, 2016, including interim periods within that reporting period and is to be applied using one of two retrospective application methods, with early application not permitted. We have not yet determined the potential effects on the Consolidated Condensed Financial Statements, if any. All other issued but not yet effective accounting pronouncements are not expected to have a material effect on our Consolidated Financial Statements. OTHER MATTERS Embraco Antitrust Matters Beginning in February 2009, our compressor business headquartered in Brazil ("Embraco") was notified of antitrust investigations of the global compressor industry by government authorities in various jurisdictions. Embraco has resolved government investigations in various jurisdictions as well as all related civil lawsuits in the United States. Embraco also has resolved certain other claims and certain claims remain pending. Additional lawsuits could be filed. At December 31, 2014, $25 million remains accrued, with installment payments of $21 million, plus interest, remaining to be made to government authorities at various times through 2015. We continue to defend these actions and take other steps to minimize our potential exposure. The final outcome and impact of these matters, and any related claims and investigations that may be brought in the future are subject to many variables, and cannot be predicted. We establish accruals only for those matters where we determine that a loss is probable and the amount of loss can be reasonably estimated. While it is currently not possible to reasonably estimate the aggregate amount of costs which we may incur in connection with these matters, such costs could have a material adverse effect on our financial position, liquidity, or results of operations in any particular reporting period. BEFIEX Credits and Other Tax Matters In previous years, our Brazilian operations earned tax credits under the Brazilian government’s export incentive program (BEFIEX). These credits reduced Brazilian federal excise taxes on domestic sales, resulting in an increase in the operations’ recorded net sales, as the credits are monetized. We monetized $14 million, $109 million and $37 million of export credits in 2014, 2013 and 2012, respectively. We began recognizing BEFIEX credits in accordance with prior favorable court decisions allowing for the credits to be recognized. We recognized export credits as they were monetized. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - (CONTINUED) In December 2013, the Brazilian government reinstituted the monetary adjustment index applicable to BEFIEX credits that existed prior to July 2009, when the Brazilian government required companies to apply a different monetary adjustment index to BEFIEX credits. As of December 31, 2014, no BEFIEX credits deemed to be available prior to this action remained to be monetized. Whether use of the reinstituted index should be given retroactive effect for the July 2009 to December 2013 period is currently being reviewed by the Brazilian courts. If the reinstituted index is given retroactive effect, we would be entitled to recognize additional credits. The outcome and timing of the Brazilian court decisions remains uncertain. Our Brazilian operations have received governmental assessments related to claims for income and social contribution taxes associated with BEFIEX credits monetized from 2000 through 2002 and 2007 through 2011. We do not believe BEFIEX export credits are subject to income or social contribution taxes. We are disputing these tax matters in various courts and intend to vigorously defend our positions. We have not provided for income or social contribution taxes on these export credits, and based on the opinions of tax and legal advisors, we have not accrued any amount related to these assessments as of December 31, 2014. The total amount of outstanding tax assessments received for income and social contribution taxes relating to the BEFIEX credits, including interest and penalties, is approximately 1.4 billion Brazilian reais (approximately $533 million as of December 31, 2014). Relying on existing Brazilian legal precedent, in 2003 and 2004, we recognized tax credits in an aggregate amount of $26 million, adjusted for currency, on the purchase of raw materials used in production (“IPI tax credits”). The Brazilian tax authority subsequently challenged the recording of IPI tax credits. No credits have been recognized since 2004. In 2009, we entered into a Brazilian government program which provided extended payment terms and reduced penalties and interest to encourage tax payers to resolve this and certain other disputed tax credit amounts. As permitted by the program, we elected to settle certain debts through the use of other existing tax credits and recorded charges of approximately $34 million in 2009 associated with these matters. In July 2012, the Brazilian revenue authority notified us that a portion of our proposed settlement was rejected and we received tax assessments of 204 million Brazilian reais (approximately $78 million as of December 31, 2014), reflecting interest and penalties to date. We are disputing these assessments and we intend to vigorously defend our position. Based on the opinion of our tax and legal advisors, we have not recorded an additional reserve related to these matters. In 2001, Brazil adopted a law making the profits of controlled foreign corporations of Brazilian entities subject to income and social contribution tax regardless of whether the profits were repatriated ("CFC Tax"). Our Brazilian subsidiary, along with other corporations, challenged tax assessments on foreign profits on constitutionality and other grounds. In April 2013, the Brazilian Supreme Court ruled in our case, finding that the law is constitutional, but remanding the case to a lower court for consideration of other arguments raised in our appeal, including the existence of tax treaties with jurisdictions in which controlled foreign corporations are domiciled. As of December 31, 2014, our potential exposure for income and social contribution taxes relating to profits of controlled foreign corporations, including interest and penalties and net of expected foreign tax credits, is approximately 178 million Brazilian reais (approximately $67 million as of December 31, 2014). We believe these assessments are without merit and we intend to continue to vigorously dispute them. Based on the opinion of our tax and legal advisors, we have not accrued any amount related to these assessments as of December 31, 2014. In December 2013, we entered into a Brazilian government program to settle long standing disputes. Participation in the program removed uncertainty related to 16 assessments that were previously under dispute and significantly reduces potential penalties and interest associated with these matters. Our participation will result in total payments including principal, interest, and penalties of 75 million Brazilian reais (approximately $28 million as of December 31, 2014), paid in 30 monthly installments from December 2013. In addition to the IPI tax credit and CFC Tax matters noted above, we are currently disputing other assessments issued by the Brazilian tax authorities related to non-income and income tax matters, including for the monetization of BEFIEX credits and other BEFIEX matters, which are at various stages of review in numerous administrative and judicial proceedings. In accordance with our accounting policies, we routinely assess these matters and, when necessary, record our best estimate of a loss. We believe these tax assessments are without merit and are vigorously defending our positions. Litigation is inherently unpredictable and the conclusion of these matters may take many years to ultimately resolve, during which time the amounts related to these assessments will continue to be increased by monetary adjustments at the Selic rate, which is the benchmark rate set by the Brazilian Central Bank. Accordingly, it is possible that an unfavorable outcome in these proceedings could have a material adverse effect on our financial position, liquidity, or results of operations in any particular reporting period. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - (CONTINUED) Other Litigation We are currently defending against numerous lawsuits pending in federal and state courts in the United States relating to certain of our front load washing machines. Some of these lawsuits have been certified for treatment as class actions. The complaints in these lawsuits generally allege violations of state consumer fraud acts, unjust enrichment, product liability claims and breach of warranty. The complaints generally seek compensatory, consequential and punitive damages. We believe these suits are without merit and are vigorously defending them. Given the preliminary stage of many of these proceedings, the Company cannot reasonably estimate a possible range of loss, if any, at this time. The resolution of one or more of these matters could have a material adverse effect on our Consolidated Financial Statements. In addition, we are currently defending a number of other lawsuits in federal and state courts in the United States related to the manufacturing and sale of our products which include class action allegations. These lawsuits allege claims which include breach of contract, breach of warranty, product liability claims, fraud, violation of federal and state consumer protection acts and negligence. We do not have insurance coverage for class action lawsuits. We are also involved in various other legal actions in the United States and other jurisdictions around the world arising in the normal course of business, for which insurance coverage may or may not be available depending on the nature of the action. We dispute the merits of these suits and actions, and intend to vigorously defend them. Management believes, based upon its current knowledge, after taking into consideration legal counsel's evaluation of such suits and actions, and after taking into account current litigation accruals, that the outcome of these matters currently pending against Whirlpool should not have a material adverse effect, if any, on our Consolidated Financial Statements. Other Matters In 2013, the French Competition Authority commenced an investigation of appliance manufacturers and retailers in France. The investigation includes 11 manufacturers, including the Whirlpool and Indesit operations in France. Although it is currently not possible to assess the impact, if any, this matter may have on our Consolidated Financial Statements, the resolution of this matter could have a material adverse effect on our financial position, liquidity, or results of operations in any particular reporting period. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - (CONTINUED) FORWARD-LOOKING STATEMENTS The Private Securities Litigation Reform Act of 1995 provides a safe harbor for forward-looking statements made by us or on our behalf. Certain statements contained in this annual report, including those within the forward-looking perspective section within this Management's Discussion and Analysis, and other written and oral statements made from time to time by us or on our behalf do not relate strictly to historical or current facts and may contain forward-looking statements that reflect our current views with respect to future events and financial performance. As such, they are considered “forward-looking statements” which provide current expectations or forecasts of future events. Such statements can be identified by the use of terminology such as “may,” “could,” “will,” “should,” “possible,” “plan,” “predict,” “forecast,” “potential,” “anticipate,” “estimate,” “expect,” “project,” “intend,” “believe,” “may impact,” “on track,” and similar words or expressions. Our forward-looking statements generally relate to our growth strategies, financial results, product development, and sales efforts. These forward-looking statements should be considered with the understanding that such statements involve a variety of risks and uncertainties, known and unknown, and may be affected by inaccurate assumptions. Consequently, no forward-looking statement can be guaranteed and actual results may vary materially. This document contains forward-looking statements about Whirlpool Corporation and its consolidated subsidiaries (“Whirlpool”) that speak only as of this date. Whirlpool disclaims any obligation to update these statements. Forward-looking statements in this document may include, but are not limited to, statements regarding expected earnings per share, cash flow, productivity and raw material prices. Many risks, contingencies and uncertainties could cause actual results to differ materially from Whirlpool's forward-looking statements. Among these factors are: (1) intense competition in the home appliance industry reflecting the impact of both new and established global competitors, including Asian and European manufacturers; (2) acquisition and investment-related risk, including risk associated with our acquisitions of Hefei Sanyo and Indesit, and risk associated with our increased presence in emerging markets; (3) Whirlpool's ability to continue its relationship with significant trade customers and the ability of these trade customers to maintain or increase market share; (4) risks related to our international operations, including changes in foreign regulations, regulatory compliance and disruptions arising from natural disasters or terrorist attacks; (5) fluctuations in the cost of key materials (including steel, plastic, resins, copper and aluminum) and components and the ability of Whirlpool to offset cost increases; (6) the ability of Whirlpool to manage foreign currency fluctuations; (7) litigation, tax, and legal compliance risk and costs, especially costs which may be materially different from the amount we expect to incur or have accrued for; (8) the effects and costs of governmental investigations or related actions by third parties; (9) changes in the legal and regulatory environment including environmental and health and safety regulations; (10) Whirlpool's ability to maintain its reputation and brand image; (11) the ability of Whirlpool to achieve its business plans, productivity improvements, cost control, price increases, leveraging of its global operating platform, and acceleration of the rate of innovation; (12) information technology system failures and data security breaches; (13) product liability and product recall costs; (14) inventory and other asset risk; (15) changes in economic conditions which affect demand for our products, including the strength of the building industry and the level of interest rates; (16) the ability of suppliers of critical parts, components and manufacturing equipment to deliver sufficient quantities to Whirlpool in a timely and cost-effective manner; (17) the uncertain global economy; (18) our ability to attract, develop and retain executives and other qualified employees; (19) the impact of labor relations; (20) Whirlpool's ability to obtain and protect intellectual property rights; and (21) health care cost trends, regulatory changes and variations between results and estimates that could increase future funding obligations for pension and postretirement benefit plans. We undertake no obligation to update any forward-looking statement, and investors are advised to review disclosures in our filings with the SEC. It is not possible to foresee or identify all factors that could cause actual results to differ from expected or historic results. Therefore, investors should not consider the foregoing factors to be an exhaustive statement of all risks, uncertainties, or factors that could potentially cause actual results to differ from forward-looking statements. Additional information concerning these and other factors can be found in “Risk Factors” in Item 1A of this report. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - (CONTINUED)

<s>[INST] RESULTS OF OPERATIONS This Management Discussion and Analysis should be read in connection with the Consolidated Financial Statements, Notes to the Consolidated Financial Statements and Selected Financial Data included in this Form 10K. Certain references to particular information in the Notes to the Consolidated Financial Statements are made to assist readers. ABOUT WHIRLPOOL Whirlpool Corporation (“Whirlpool”) is the number one major appliance manufacturer in the world with net sales of approximately $20 billion and net earnings available to Whirlpool of $650 million in 2014. We are a leading producer of major home appliances in North America, Latin America and Europe, and have a significant presence throughout China and India. We have received worldwide recognition for accomplishments in a variety of business and social efforts, including leadership, diversity, innovative product design, business ethics, social responsibility and community involvement. We conduct our business through four reportable segments, which we define based on geography. Our reportable segments consist of North America, Latin America, EMEA (Europe, Middle East and Africa) and Asia. Our customer base includes large, sophisticated trade customers who have many choices and demand competitive products, services and prices. The major home appliance industry operates in an intensely competitive environment, reflecting the impact of both new and established global competitors, including Asian and European manufacturers. The charts below summarize the balance of net sales by reportable segment for 2014, 2013 and 2012, respectively: We monitor countryspecific economic factors such as gross domestic product, unemployment, consumer confidence, retail trends, housing starts and completions, sales of existing homes and mortgage interest rates as key indicators of industry demand. In addition to profitability, we also focus on country, brand, product and channel sales when assessing and forecasting financial results. Our leading portfolio of brands includes Whirlpool, Maytag, KitchenAid, Embraco, Brastemp, Consul and Indesit, each of which generates annual revenues in excess of $1 billion. Our global branded consumer products strategy is to introduce innovative new products, increase brand customer loyalty, expand our presence outside the United States, enhance our trade management platform, improve total cost and quality by expanding and leveraging our global operating platform and, where appropriate, make strategic acquisitions and investments. As we grow revenues in our core products, our strategy is to extend our business by offering products and services that are dependent on and related to our core business and expand into adjacent products, such as Affresh cleaners and Gladiator GarageWorks, through businesses that leverage our core competencies and business infrastructure. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (CONTINUED) OVERVIEW Whirlpool delivered a strong year of business operating performance as evidenced by record revenues and strong margins, while driving product introductions, ongoing productivity and delivering restructuring benefits. We have continued to build a global platform that will drive future growth and strong value creation, further accelerated through the completion of two acquisitions during 2014 in China and Europe. We have great opportunities for growth as demand in the U.S. continued to recover and we are very well positioned to capitalize when growth returns to emerging markets such as Brazil, China, India and Russia. We continue to accelerate our investments in product and brand innovation which will benefit our end consumers, while driving revenue growth in those areas that expand and extend our core appliance business. We believe that continued execution of our business priorities and a focus on longterm growth will allow the Company to adapt to changes in the macroeconomic environment and maintain our position as the world's leading global manufacturer and marketer of major home appliances. RESULTS OF OPERATIONS The following table summarizes the consolidated results of operations: nm: not meaningful Consolidated Net Sales The following tables summarize units sold and consolidated net sales by operating segment: MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (CONTINUED) Consolidated net sales increased 5.9% compared to [/INST] Negative. </s>

WHIRLPOOL CORP /DE/

2016-02-16

2015-12-31

ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS This Management Discussion and Analysis should be read in connection with the Consolidated Financial Statements, Notes to the Consolidated Financial Statements and Selected Financial Data included in this Form 10-K. Certain references to particular information in the Notes to the Consolidated Financial Statements are made to assist readers. ABOUT WHIRLPOOL Whirlpool Corporation (“Whirlpool”) is the number one major appliance manufacturer in the world with net sales of approximately $21 billion and net earnings available to Whirlpool of $783 million in 2015. We are a leading producer of major home appliances in North America, Latin America and Europe, and have a significant presence throughout China and India. We have received worldwide recognition for accomplishments in a variety of business and social efforts, including leadership, diversity, innovative product design, business ethics, social responsibility and community involvement. We conduct our business through four reportable segments, which we define based on geography. Our reportable segments consist of North America, Latin America, EMEA (Europe, Middle East and Africa) and Asia. Our customer base includes large, sophisticated trade customers who have many choices and demand competitive products, services and prices. The major home appliance industry operates in an intensely competitive environment, reflecting the impact of both new and established global competitors, including Asian and European manufacturers. The charts below summarize the balance of net sales by reportable segment for 2015, 2014 and 2013, respectively: We monitor country-specific economic factors such as gross domestic product, unemployment, consumer confidence, retail trends, housing starts and completions, sales of existing homes and mortgage interest rates as key indicators of industry demand. In addition to profitability, we also focus on country, brand, product and channel sales when assessing and forecasting financial results. Our leading portfolio of brands includes Whirlpool, Maytag, KitchenAid, Embraco, Brastemp, Consul and Indesit, each of which generated annual revenues in excess of $1 billion. Our global branded consumer products strategy is to introduce innovative new products, increase brand customer loyalty, expand our presence outside the United States, enhance our trade management platform, improve total cost and quality by expanding and leveraging our global operating platform and, where appropriate, make strategic acquisitions and investments. As we grow revenues in our core products, our strategy is to extend our business by offering products and services that are dependent on and related to our core business and expand into adjacent products, such as Affresh cleaners and Gladiator GarageWorks, through businesses that leverage our core competencies and business infrastructure. OVERVIEW Whirlpool delivered strong results in 2015, driving revenue growth, margin expansion and strong cash generation by leveraging our industry leading brand portfolio and innovative new products within our core appliance and adjacent businesses. We achieved these results through strong focus and decisive action plans in a global environment that saw rapid emerging markets demand decline and strengthening of U.S. dollar against most global currencies. Over the past year, we made moves to reshape our global operating footprint, respond to shifts in the operating environment and invest in our brands and products. We made substantial progress toward integrating Indesit in Europe and Hefei Sanyo in China, our 2014 acquisitions, that create leading MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - (CONTINUED) positions as a western company, in those markets. We have great opportunities for growth as demand in the U.S. continues to recover and we are very well positioned to capitalize when growth returns to emerging markets such as Brazil, China, and Russia. We believe that continued execution of our business priorities and a focus on long-term growth will allow the Company to adapt to changes in the macroeconomic environment and continue to create shareholder value. RESULTS OF OPERATIONS The following table summarizes the consolidated results of operations: nm: not meaningful Consolidated Net Sales The following tables summarize units sold and consolidated net sales by operating segment: nm: not meaningful Consolidated net sales increased 5.1% compared to 2014 primarily driven by increased volume due to acquisitions and favorable product price/mix, partially offset by the unfavorable impact of foreign currency and a weakened demand environment in emerging markets. Excluding the impact of foreign currency, consolidated net sales increased 18.1% compared to 2014. Consolidated net sales for 2014 increased 5.9% compared to 2013 primarily due to favorable product price/mix, increased volume due to acquisitions, partially offset by the unfavorable impact of foreign currency and lower BEFIEX credits. Excluding the impact of foreign currency and BEFIEX credits, consolidated net sales for 2014 increased 8.4% compared to 2013. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - (CONTINUED) We provide the percentage change in net sales, excluding the impact of foreign currency and BEFIEX credits, as a supplement to the change in net sales as determined by U.S. generally accepted accounting principles ("GAAP") to provide stockholders with a clearer basis to assess Whirlpool's results over time. This measure is considered a non-GAAP financial measure and is calculated by translating the current period net sales excluding BEFIEX credits, in functional currency, to U.S. dollars using the prior-year period's exchange rate compared to the prior-year period net sales excluding BEFIEX credits. Significant regional trends were as follows: • North America net sales increased 0.9% compared to 2014 primarily due to a 1.4% increase in units sold and favorable product price/mix, partially offset by foreign currency. Excluding the impact of foreign currency, net sales increased 3.2% in 2015. North America net sales for 2014 increased 4.5% compared to 2013 primarily due to a 3.8% increase in units sold and favorable product/price mix, partially offset by foreign currency. Excluding the impact of foreign currency, net sales increased 5.1% in 2014. • EMEA net sales increased 43.4% compared to 2014, primarily due to a 59.7% increase in units sold due to the acquisition of Indesit and favorable product mix, partially offset by unfavorable foreign currency. Excluding the impact of foreign currency, net sales increased 75.3% in 2015. In 2014 EMEA net sales increased 29.1% compared to 2013, primarily due to a 32.2% increase in units sold due to the acquisition of Indesit, partially offset by unfavorable product/price mix and foreign currency. Excluding the impact of foreign currency, net sales increased 29.6% in 2014. • Latin America net sales decreased 28.5% compared to 2014 primarily due to a 21.3% decrease in units sold and unfavorable foreign currency, partially offset by favorable product mix. Excluding the impact of foreign currency, Latin America net sales decreased 5.9% in 2015. Latin America net sales for 2014 decreased 4.9% compared to 2013 primarily due to a 4.5% decrease in units sold, lower BEFIEX credits and unfavorable foreign currency, partially offset by favorable product price/mix. Excluding the impact of foreign currency and BEFIEX credits, Latin America net sales increased 2.5% in 2014. We recognized approximately $0, $14 million and $109 million of BEFIEX credits in 2015, 2014 and 2013, respectively. As of December 31, 2015, approximately $34 million of future cash monetization remained for court awarded fees, which is not expected to be payable for several years. For additional information regarding BEFIEX credits, see Notes 7 and 12 of the Notes to the Consolidated Financial Statements. • Asia net sales increased 73.6% compared to 2014 primarily due to the acquisition of Hefei Sanyo. Excluding the impact of foreign currency, Asia net sales increased 78.3% in 2015. Asia net sales for 2014 increased 1.2% compared to 2013 primarily due to the acquisition of Hefei Sanyo, partially offset by foreign currency, product transition costs and unfavorable product price/mix. Excluding the impact of foreign currency, Asia net sales increased 4.1% in 2014. Gross Margin The table below summarizes gross margin percentages by region: The consolidated gross margin percentage increased 60 basis points to 17.7% compared to 2014, primarily due to ongoing cost productivity, favorable product price/mix, acquisition synergies and capacity optimization initiatives, partially offset by foreign currency. Significant regional trends were as follows: • North America gross margin increased compared to 2014 primarily due to ongoing cost productivity and recognition of postretirement-benefit curtailment gains, partially offset by unfavorable foreign currency. North America gross margin for 2014 decreased compared to 2013 primarily due to the impact of product transitions, partially offset by productivity. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - (CONTINUED) • EMEA gross margin was flat compared to 2014 primarily due to benefits from the Indesit acquisition, favorable product price/mix, ongoing cost productivity, and capacity optimization initiatives, partially offset by unfavorable foreign currency, legacy Indesit product corrective action costs and increased investments in marketing, technology and products. During 2014, EMEA gross margin increased compared to 2013 primarily due to increased productivity, acquisition synergies and restructuring benefits, partially offset by unfavorable product price/mix and unfavorable foreign currency. • Latin America gross margin decreased compared to 2014 primarily due to unfavorable foreign currency and the weakened demand environment in Brazil, partially offset by higher product price/mix. During 2014, Latin America gross margin decreased compared to 2013 primarily due to lower BEFIEX credits, higher material costs and unfavorable foreign currency, partially offset by higher product price/mix. • Asia gross margin increased in 2015 when compared to 2014, primarily due to acquisition synergies, partially offset by increased investments in marketing, technology and products. During 2014, Asia gross margin decreased compared to 2013 primarily due to expenses related to the acquisition of Hefei Sanyo, foreign currency and unfavorable material costs, partially offset by favorable product price/mix, productivity and acquisition synergies. Selling, General and Administrative The following table summarizes selling, general and administrative expenses as a percentage of sales by region: Consolidated selling, general and administrative expenses as a percent of consolidated net sales in 2015 remained flat compared to 2014 reflecting the favorable impact of acquisition synergies, partially offset by foreign currency. Selling, general and administrative expenses as a percent of consolidated net sales in 2014 increased compared to 2013, reflecting acquisition-related costs and investment expenses. Restructuring During 2014 and the twelve months ended December 31, 2015, we announced the following restructuring plans: (a) the closure of a microwave oven manufacturing facility and other organizational efficiency actions in EMEA and Latin America, (b) organizational integration activities in China and Europe to support the integration of the acquisitions of Hefei Sanyo, which we have since renamed Whirlpool (China) Co., Ltd. ("Whirlpool China") and Indesit, and (c) the closure of a research and development facility in Germany in 2016. In the second quarter of 2015, we committed to a restructuring plan to integrate our Italian legacy operations with those of Indesit. The industrial restructuring plan, which was approved by the relevant labor unions in July 2015 and signed by the Italian government in August 2015, provides for the closure or repurposing of certain manufacturing facilities and headcount reductions at other facilities. In addition, the restructuring plan provides for headcount reductions in the salaried employee workforce. We estimate that we will incur up to €179 million (approximately $194 million as of December 31, 2015) in employee-related costs, €25 million (approximately $27 million as of December 31, 2015) in asset impairment costs, and €37 million (approximately $40 million as of December 31, 2015) in other associated costs in connection with these actions. Completion of these plans is expected by the end of 2018. We estimate €209 million (approximately $227 million as of December 31, 2015) of the estimated €241 million total cost will result in future cash expenditures. We incurred restructuring charges of $201 million, $136 million, and $196 million for the years ended December 31, 2015, 2014 and 2013, respectively. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - (CONTINUED) For the full year 2016, we expect to incur up to $200 million of restructuring charges, which will result in ongoing substantial cost reductions. Additional information about restructuring activities can be found in Note 11 of the Notes to the Consolidated Financial Statements. Interest and Sundry Income (Expense) Interest and sundry income (expense) decreased $53 million compared to 2014, primarily due to a $64 million gain related to a business investment in Brazil during the second quarter of 2015, and previous year investment expenses related to the Hefei Sanyo and Indesit acquisitions during 2014, partially offset by impact from foreign currency. During 2014, interest and sundry income (expense) decreased $13 million compared to 2013, primarily driven by lower charges related to Embraco antitrust matters and a Brazilian government settlement occurring in 2013. For additional information about the Embraco antitrust matters and the Brazilian government settlement, see Note 7 of the Notes to the Consolidated Financial Statements. For additional information about the acquisitions of Hefei Sanyo and Indesit, see Note 2 of the Notes to the Consolidated Financial Statements. Interest Expense Interest expense was unchanged compared to 2014. This was a result of higher average long-term debt balances, offset by lower average interest rates on long-term debt. During 2014, interest expense decreased $12 million compared to 2013, primarily due to lower interest rates. Income Taxes Income tax expense was $209 million, $189 million, and $68 million in 2015, 2014 and 2013, respectively. The increase in tax expense in 2015 compared to 2014 is primarily due to higher pre-tax earnings, partially offset by a lower effective tax rate. The increase in tax expense in 2014 compared to 2013 is primarily due to the absence of United States energy tax credits recognized in 2013. The "American Taxpayer Relief Act of 2012," signed in January 2013, reinstated the energy tax credit for 2012 and 2013, and resulted in a tax credit benefit related to the production of qualifying appliances in 2012 and 2013 in the combined amount of $126 million, all of which was recognized in 2013. For additional information about our consolidated tax provision, see Note 12 of the Notes to the Consolidated Financial Statements. The following table summarizes the difference between income tax expense at the United States statutory rate of 35% and the income tax expense at effective worldwide tax rates for the respective periods: MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - (CONTINUED) FORWARD-LOOKING PERSPECTIVE We currently estimate earnings per diluted share and industry demand for 2016 to be within the following ranges: (1) Primarily reflects industry demand in Brazil. For the full-year 2016, we expect to generate free cash flow between $700 million and $800 million, including restructuring cash outlays of up to $200 million, capital expenditures of $700 million to $750 million and EMEA legacy product warranty costs of $155 million. The table below reconciles projected 2016 cash provided by operating activities determined in accordance with GAAP to free cash flow, a non-GAAP measure. Management believes that free cash flow provides stockholders with a relevant measure of liquidity and a useful basis for assessing Whirlpool’s ability to fund its activities and obligations. There are limitations to using non-GAAP financial measures, including the difficulty associated with comparing companies that use similarly named non-GAAP measures whose calculations may differ from our calculations. We define free cash flow as cash provided by continuing operations less capital expenditures and including proceeds from the sale of assets/businesses, and changes in restricted cash. The change in restricted cash relates to the private placement funds paid by Whirlpool to acquire majority control of Hefei Sanyo in 2014 and which are used to fund capital and technical resources to enhance Whirlpool China’s research and development and working capital. The projections above are based on many estimates and are inherently subject to change based on future decisions made by management and the Board of Directors of Whirlpool, and significant economic, competitive and other uncertainties and contingencies. FINANCIAL CONDITION AND LIQUIDITY Our objective is to finance our business through operating cash flow and the appropriate mix of long-term and short-term debt. By diversifying the maturity structure, we avoid concentrations of debt, reducing liquidity risk. We have varying needs for short-term working capital financing as a result of the nature of our business. We regularly review our capital structure and liquidity priorities, which include funding the business through capital and engineering spending to support innovation and productivity initiatives, funding our pension plan and term debt liabilities, providing return to shareholders and potential acquisitions. On October 24, 2014, Whirlpool's wholly-owned subsidiary completed its acquisition of a 51% equity stake in Whirlpool China. The aggregate purchase price for the transaction was RMB 3.4 billion (approximately $551 million at the dates of purchase for each step of the transaction). The Company funded the total consideration for the shares with cash on hand. The cash paid for the private placement step of the transaction is considered restricted cash, which is used to fund capital and technical resources to enhance Whirlpool China’s research and development and working capital. Additional information about the transaction can be found in Note 2 of the Notes to the Consolidated Financial Statements. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - (CONTINUED) In July 2015, Whirlpool China suspended trading of its stock pursuant to listing rules of the Shanghai Stock Exchange in connection with its response to a notification from China's securities regulatory agency to all listed companies aimed at addressing volatility in China's securities market. In December 2015, Whirlpool China resumed trading of its stock in accordance with relevant Chinese laws and the Shanghai Stock Exchange's listing rules. On December 3, 2014, Whirlpool completed the final step in its acquisition of Indesit. Total consideration paid for Indesit was €1.1 billion (approximately $1.4 billion at the dates of purchase of each step in the transaction) in aggregate net of cash acquired. The Company funded the aggregate purchase price for Indesit through borrowings under its credit facility and commercial paper programs, and repaid a portion of such borrowings through the issuance of an aggregate principal amount of $650 million in senior notes on November 4, 2014 and an aggregate principal amount of €500 million (approximately $525 million as of the date of issuance) in senior notes on March 12, 2015. Additional information about the transaction can be found in Note 2 of the Notes to the Consolidated Financial Statements. Our short term potential uses of liquidity include funding our ongoing capital spending, restructuring activities, funding pension plans and returns to shareholders. We also have $508 million of term debt maturing in the next twelve months. We monitor the credit ratings and market indicators of credit risk of our lending, depository, and derivative counterparty banks regularly. In addition, we diversify our deposits and investments in short term cash equivalents to limit the concentration of exposure by counterparty. We continue to monitor general financial instability and uncertainty globally. As of December 31, 2015, the only country where we had cash or cash equivalents greater than 1% of our consolidated assets was China, which represented 1.9%. In addition, we did not have any third-party accounts receivable greater than 1% of our consolidated assets in any single country outside of North America, with the exception of Italy, which represented 1.5%. We also continue to review customer conditions across the Eurozone. As of December 31, 2015, we had €79 million (approximately $86 million as of December 31, 2015) in outstanding trade receivables and short-term and long-term notes due to us associated with Alno AG, a long-standing European customer. Approximately €33 million (approximately $36 million as of December 31, 2015) of the outstanding receivables were overdue as of December 31, 2015. In the fourth quarter of 2014, Whirlpool and Alno entered into an agreement to revise the previous standstill agreement to amend the payment terms of the overdue trade receivables. The new agreement cured the violation of the prior agreement and Alno's overdue balance remains due in full by the end of the fourth quarter of 2016. Our exposure includes not only the outstanding receivables but also the potential risks of an Alno bankruptcy and impacts to our distribution process. Alno is proceeding to secure additional financing to improve its financial position. In 2014, Whirlpool sold shares held in Alno AG, which resulted in the conversion of our investment from the equity method of accounting to an available for sale investment due to our less than 20% overall investment in Alno AG. The Company had cash and cash equivalents of $772 million at December 31, 2015, of which $726 million was held by subsidiaries in foreign countries. For each of its foreign subsidiaries, the Company makes an assertion regarding the amount of earnings intended for permanent reinvestment, with the balance available to be repatriated to the United States. The cash held by foreign subsidiaries for permanent reinvestment is generally used to finance the subsidiaries' operational activities and future foreign investments. Our intent is to permanently reinvest these funds outside of the United States and our current plans do not demonstrate a need to repatriate these funds to fund our U.S. operations. However, if these funds were repatriated, then we would be required to accrue and pay applicable United States taxes (subject to an adjustment for foreign tax credits) and withholding taxes payable to various countries. The repatriation could result in an adjustment to the tax liability after considering available foreign tax credits and other tax attributes. It is not practicable to estimate the amount of the deferred tax liability associated with these unremitted earnings due to the complexity of its hypothetical calculation. Sources and Uses of Cash We met our cash needs during 2015 through cash flows from operations, cash and cash equivalents, and financing arrangements. Our cash and cash equivalents at December 31, 2015 decreased $254 million compared to the same period in 2014. Significant drivers of changes in our cash and cash equivalents balance during 2015 are discussed below: MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - (CONTINUED) Cash Flow Summary Cash Flows from Operating Activities The decrease in cash provided by operating activities during 2015 reflects strong cash earnings, partially offset by changes in working capital and $72 million to fund our United States qualified pension plans. The timing of cash flows from operations varies significantly throughout the year primarily due to changes in production levels, sales patterns, promotional programs, funding requirements as well as receivable and payment terms. Depending on timing of cash flows, the location of cash balances, as well as the liquidity requirements of each country, external sources of funding are used to support working capital requirements. Cash Flows from Investing Activities Changes in cash used in investing activities primarily reflect capital investments in each year, and the acquisitions of Indesit and Hefei Sanyo in 2014. Cash Flows from Financing Activities Cash used in financing activities during 2015 primarily reflects share repurchase activity under our new share repurchase program. Cash provided by financing activities during 2014 primarily reflect funding required to complete the acquisitions of Hefei Sanyo and Indesit. Cash used in financing activities during 2013 primarily reflects share repurchase activity under our previous share repurchase program. Financing Arrangements We have committed credit facilities in Brazil, which provide borrowings up to 1.0 billion Brazilian reais (approximately $256 million as of December 31, 2015) maturing at various times from 2016 to 2017. The credit facilities contain no financial covenants and we had no borrowings outstanding under these credit facilities at December 31, 2015 and 2014. On September 25, 2015, we entered into an Amended and Restated Short-Term Credit Agreement (the “Amended 364-Day Facility”). The Amended 364-Day Facility has a maturity date of September 23, 2016, aggregate borrowing capacity of $500 million and amends and restates in its entirety the Short-Term Credit Agreement entered into on September 26, 2014 (the “Original 364-Day Facility”). Collectively, the $500 million Amended 364-Day Facility, a €250 million European facility added in July 2015 and the existing $2.0 billion long-term credit facility provide total committed credit facilities of approximately $2.8 billion (the “Facilities”), which is fundamentally unchanged from the $3.0 billion in committed credit facilities available as of December 31, 2014. The resulting Facilities are sufficient, more geographically diverse, and better reflect our growing global operations. The interest and fee rates payable with respect to the Amended 364-Day Facility based on our current debt rating are unchanged from the Original 364-Day Facility and are as follows: (1) the spread over LIBOR is 1.250%; (2) the spread over prime is 0.250%; and (3) the unused commitment fee is 0.125%, as of the date hereof. The Amended 364-Day Facility contains customary covenants and warranties including, among other things, a rolling twelve month maximum leverage ratio limited to 3.25 to 1.0 for each fiscal quarter and a rolling twelve month interest coverage ratio required to be greater than or equal to 3.0 to 1.0 for each fiscal quarter. In addition, the covenants limit our ability to (or to permit any subsidiaries to), subject to various exceptions and limitations: (i) merge with other companies; (ii) create liens on its property; (iii) incur debt or off-balance sheet obligations at the subsidiary level; (iv) enter into transactions with affiliates, except on an arms-length basis; (v) enter into agreements restricting the payment of subsidiary dividends or restricting the making of loans or repayment of debt by subsidiaries; and (vi) enter into agreements restricting the creation of liens on its assets. We are in compliance with financial covenant requirements at December 31, 2015 and 2014. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - (CONTINUED) On September 26, 2014, we entered into a Second Amended and Restated Long-Term Credit Agreement (the “Long-Term Facility”). The Long-Term Facility amends, restates and extends the Company's prior five-year credit facility, which was scheduled to mature on June 28, 2016. The Long-Term Facility increased the prior $1.7 billion facility to an aggregate amount of $2.0 billion, with an option to increase the total amount to up to $2.5 billion by exercise of an accordion feature. The Long-Term Facility has a maturity date of September 26, 2019. The Long-Term Facility includes a letter of credit sublimit of $200 million. The interest and fee rates payable with respect to the Long-Term Facility based on our debt rating are as follows: (1) the spread over LIBOR is 1.250%; (2) the spread over prime is 0.250%; and (3) the unused commitment fee is 0.15%, as of the effective date of the Long-Term Facility. We had no borrowings outstanding under the Amended 364-Day Facility or the Long-Term Facility at December 31, 2015 or 2014, respectively. On May 15, 2015, $200 million of 5.00% notes matured and were repaid. On March 12, 2015, we completed a debt offering of €500 million (approximately $525 million as of the date of issuance) principal amount of 0.625% notes due in 2020. The notes contain covenants that limit our ability to incur certain liens or enter into certain sale and lease-back transactions. In addition, if we experience a specific kind of change of control, we are required to make an offer to purchase all of the notes at a purchase price of 101% of the principal amount thereof, plus accrued and unpaid interest. The notes are registered under the Securities Act of 1933, as amended, pursuant to our Registration Statement on Form S-3 (File No. 333-181339) filed with the Securities and Exchange Commission (the “Commission”) on May 11, 2012. On February 25, 2014, we completed a debt offering of $250 million principal amount of 1.35% notes due in 2017, $250 million principal amount of 2.40% notes due in 2019, and $300 million principal amount of 4.00% notes due in 2024. On May 1, 2014, $500 million of 8.60% notes matured and were repaid. On August 15, 2014, $100 million of 6.45% notes matured and were repaid. On November 4, 2014, we completed a debt offering of $300 million principal amount of 1.65% notes due in 2017 and $350 million principal amount of 3.70% notes due in 2025. These notes contain covenants that limit our ability to incur certain liens or enter into certain sale and lease-back transactions. In addition, if we experience a specific kind of change of control, we are required to make an offer to purchase all of the notes at a purchase price of 101% of the principal amount thereof, plus accrued and unpaid interest. In the fourth quarter of 2014, we assumed €300 million principal amount of 4.5% guaranteed notes due on April 26, 2018 from the Indesit acquisition. During the first quarter of 2015, holders of the notes passed a resolution which amended the terms and conditions of the notes so that they are better aligned to the terms and conditions of notes and bonds issued by Whirlpool Corporation. As a result of the passage of the resolution, Whirlpool has agreed to be a guarantor of the notes. These notes contain covenants that limit our ability to incur certain liens or enter into certain sale and lease-back transactions. In addition, if we experience a specific kind of change of control, we are required to make an offer to purchase all of the notes at a purchase price of 101% of the principal amount thereof, plus accrued and unpaid interest. For additional information about our financing arrangements, see Note 6 of the Notes to the Consolidated Financial Statements. Dividends In April 2015, our Board of Directors approved a 20% increase in our quarterly dividend on our common stock to 90 cents per share from 75 cents per share. Repurchase Program On April 14, 2014, our Board of Directors authorized a new share repurchase program of up to $500 million. Share repurchases are made from time to time on the open market as conditions warrant. The program does not obligate us to repurchase any of our shares. For the years ended December 31, 2015 and 2014, we repurchased 1,505,299 shares at an aggregate purchase price of approximately $250 million and 165,900 shares at an aggregate purchase price of approximately $25 million. At December 31, 2015, there were approximately $225 million in remaining funds authorized under this program. Supplier Financing We offer our suppliers access to third party payables processors. Independent of Whirlpool, the processors allow suppliers to sell their receivables to financial institutions at the discretion of only the supplier and the financial institution. We have no economic interest in the sale of these receivables and no direct financial relationship with the financial institutions concerning these services. All of our obligations, including amounts due, remain to our suppliers as stated in our supplier MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - (CONTINUED) agreements. As of December 31, 2015 and 2014, approximately $1.2 billion and $1.6 billion, respectively, are outstanding under the programs with participating financial institutions. CONTRACTUAL OBLIGATIONS AND FORWARD-LOOKING CASH REQUIREMENTS The following table summarizes our expected cash outflows resulting from financial contracts and commitments: (1) Interest payments related to long-term debt are included in the table above. For additional information about our financing arrangements, see Note 6 of the Notes to the Consolidated Financial Statements. (2) Purchase obligations include our “take-or-pay” contracts with materials vendors and minimum payment obligations to other suppliers. (3) Represents payments agreed to under a Brazil government settlement program. See Note 7 of the Notes to the Consolidated Financial Statements for additional information. (4) Represents the minimum contributions required for foreign and domestic pension plans based on current interest rates, asset return assumptions, legislative requirements and other actuarial assumptions at December 31, 2015. Management may elect to contribute amounts in addition to those required by law. See Note 13 of the Notes to the Consolidated Financial Statements for additional information. (5) Represents our portion of expected benefit payments under our retiree healthcare plans. (6) For additional information regarding legal settlements, see Note 7 of the Notes to the Consolidated Financial Statements. (7) This table does not include short-term credit facility and commercial paper borrowings. For additional information about short-term borrowings, see Note 6 of the Notes to the Consolidated Financial Statements. This table does not include future anticipated income tax settlements; see Note 12 of the Notes to the Consolidated Financial Statements. WHIRLPOOL CHINA ACQUISITION On August 12, 2013, Whirlpool's wholly-owned subsidiary, Whirlpool China, reached agreements to acquire a 51% equity stake in a leading home appliances manufacturer, Hefei Sanyo, a joint stock company whose shares are listed and traded on the Shanghai Stock Exchange. This transaction was completed on October 24, 2014. Hefei Sanyo has since been renamed to "Whirlpool China Co., Ltd." The aggregate purchase price was RMB 3.4 billion (approximately $551 million at the dates of purchase). The Company funded the total consideration for the shares with cash on hand. The cash paid for the private placement portion of the transaction is considered restricted cash, which will be used to fund capital and technical resources to enhance Whirlpool China’s research and development and working capital. We expect the acquisition will accelerate Whirlpool’s profitable growth in the Chinese appliance market. During 2014, Whirlpool began integrating the manufacturing, administrative, supply chain and technology operations of Hefei Sanyo. The results of Hefei Sanyo’s operations have been included in the Consolidated Financial Statements beginning October 24, 2014. Hefei Sanyo has an established and broad distribution network that includes more than 30,000 outlets throughout China. Their significant presence in rural areas complements Whirlpool’s presence in China’s higher-tier cities. With this acquisition, Whirlpool also gains manufacturing scale and a competitive cost structure in the city of Hefei. The ability to consolidate operations offers strong synergies as Whirlpool will provide extensive technical, marketing and product development, combined with Hefei Sanyo’s sales execution and operational strengths, to support the next phase of development in the advancement of Whirlpool China as an important global production and research and development center for the home appliance sector. Further discussion of this transaction can be found in Note 2 of the Notes to the Consolidated Financial Statements. INDESIT ACQUISITION On December 3, 2014, Whirlpool completed the final step in its acquisition of Indesit. Total consideration paid for Indesit was €1.1 billion (approximately $1.4 billion at the dates of purchase of each step in the transaction) in aggregate net of cash MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - (CONTINUED) acquired. The Company funded the aggregate purchase price for Indesit through borrowings under its credit facility and commercial paper programs, and repaid a portion of such borrowings through the issuance of an aggregate principal amount of $650 million in senior notes on November 4, 2014 and an aggregate principal amount of €500 million (approximately $525 million as of the date of issuance) in senior notes on March 12, 2015. Additional information about the transaction can be found in Note 2 of the Notes to the Consolidated Financial Statements. The acquisition builds our market position and will enable growth in EMEA. The results of Indesit’s operations have been included in the Consolidated Financial Statements beginning October 14, 2014. Further discussion of this transaction can be found in Note 2 of the Notes to the Consolidated Financial Statements. OFF-BALANCE SHEET ARRANGEMENTS We have guarantee arrangements in a Brazilian subsidiary. As a standard business practice in Brazil, the subsidiary guarantees customer lines of credit at commercial banks to support purchases following its normal credit policies. If a customer were to default on its line of credit with the bank, our subsidiary would be required to satisfy the obligation with the bank and the receivable would revert back to the subsidiary. At December 31, 2015 and December 31, 2014, the guaranteed amounts totaled $260 million and $492 million, respectively. Our subsidiary insures against credit risk for these guarantees, under normal operating conditions, through policies purchased from high-quality underwriters. We had no losses associated with these guarantees in 2015 or 2014. We have guaranteed a $43 million five-year revolving credit facility between certain financial institutions and a not-for-profit entity in connection with a community and economic development project (“Harbor Shores”). The credit facility, which originated in 2008, was amended in 2015 by Harbor Shores and reduced to $43 million, was refinanced in December 2012 and we renewed our guarantee through 2017. The fair value of the guarantee is nominal. The purpose of Harbor Shores is to stimulate employment and growth in the areas of Benton Harbor and St. Joseph, Michigan. In the event of default, we must satisfy the guarantee of the credit facility up to the amount borrowed at the date of default. In the ordinary course of business, we enter into agreements with financial institutions to issue bank guarantees, letters of credit and surety bonds. These agreements are primarily associated with unresolved tax matters in Brazil, as is customary under local regulations, and governmental obligations related to certain employee benefit arrangements. As of December 31, 2015 and 2014, we had approximately $290 million and $401 million outstanding under these agreements, respectively. CRITICAL ACCOUNTING POLICIES AND ESTIMATES The preparation of financial statements in conformity with generally accepted accounting principles in the United States (GAAP) requires management to make certain estimates and assumptions. We periodically evaluate these estimates and assumptions, which are based on historical experience, changes in the business environment and other factors that management believes to be reasonable under the circumstances. Actual results may differ materially from these estimates. Pension and Other Postretirement Benefits Accounting for pensions and other postretirement benefits involves estimating the costs of future benefits and attributing the cost over the employee’s expected period of employment. The determination of our obligation and expense for these costs requires the use of certain assumptions. Those assumptions include the discount rate, expected long-term rate of return on plan assets, life expectancy, and health care cost trend rates. These assumptions are subject to change based on interest rates on high quality bonds, stock and bond markets and medical cost inflation, respectively. Actual results that differ from our assumptions are accumulated and amortized over future periods and therefore, generally affect our recognized expense and accrued liability in such future periods. While we believe that our assumptions are appropriate given current economic conditions and actual experience, significant differences in results or significant changes in our assumptions may materially affect our pension and other postretirement benefit obligations and related future expense. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - (CONTINUED) Our pension and other postretirement benefit obligations at December 31, 2015 and preliminary retirement benefit costs for 2016 were prepared using the assumptions that were determined as of December 31, 2015. The following table summarizes the sensitivity of our December 31, 2015 retirement obligations and 2016 retirement benefit costs of our United States plans to changes in the key assumptions used to determine those results: * Projected benefit obligation (PBO) for pension plans and accumulated postretirement benefit obligation (APBO) for other postretirement benefit plans. These sensitivities may not be appropriate to use for other years’ financial results. Furthermore, the impact of assumption changes outside of the ranges shown above may not be approximated by using the above results. For additional information about our pension and other postretirement benefit obligations, see Note 13 of the Notes to the Consolidated Financial Statements. Income Taxes We estimate our income taxes in each of the taxing jurisdictions in which we operate. This involves estimating actual current tax expense together with assessing any temporary differences resulting from the different treatment of certain items, such as the timing for recognizing expenses, for tax and accounting purposes. These differences may result in deferred tax assets or liabilities, which are included in our Consolidated Balance Sheets. We are required to assess the likelihood that deferred tax assets, which include net operating loss carryforwards, foreign tax credits and deductible temporary differences, that are expected to be realizable in future years. Realization of our net operating loss and foreign tax credit deferred tax assets is supported by specific tax planning strategies and, where possible, considers projections of future profitability. If recovery is not more likely than not, we provide a valuation allowance based on estimates of future taxable income in the various taxing jurisdictions, and the amount of deferred taxes that are ultimately realizable. If future taxable income is lower than expected or if tax planning strategies are not available as anticipated, we may record additional valuation allowances through income tax expense in the period such determination is made. Likewise, if we determine that we are able to realize our deferred tax assets in the future in excess of net recorded amounts, an adjustment to the deferred tax asset will benefit income tax expense in the period such determination is made. As of December 31, 2015 and 2014, we had total deferred tax assets of $3.3 billion and $3.2 billion, respectively, net of valuation allowances of $286 million and $308 million, respectively. Our income tax benefit or expense has fluctuated considerably over the last five years from a tax benefit of $436 million in 2011 to the current year tax expense of $209 million and has been influenced primarily by U.S. energy tax credits, audit settlements and adjustments, tax planning strategies, enacted legislation, and dispersion of global income. Future changes in the effective tax rate will be subject to several factors including, remaining BEFIEX credits, business profitability, tax planning strategies, and enacted tax laws. In addition, we operate within multiple taxing jurisdictions and are subject to audit in these jurisdictions. These audits can involve complex issues, which may require an extended period of time to resolve. For additional information about income taxes, see Notes 1, 7 and 12 of the Notes to the Consolidated Financial Statements. BEFIEX Credits In previous years, our Brazilian operations earned tax credits under the Brazilian government’s export incentive program (BEFIEX). These credits reduced Brazilian federal excise taxes on domestic sales, resulting in an increase in the operations’ recorded net sales. As of December 31, 2015, all BEFIEX credits that were available to be monetized had been monetized. For additional information regarding BEFIEX credits, see Note 7 of the Notes to the Consolidated Financial Statements. Legacy Product Corrective Action Reserves In the normal course of business, we engage in investigations of potential quality and safety issues. As part of our ongoing effort to deliver quality products to consumers, we are currently investigating a limited number of potential quality and safety issues globally. As necessary, we undertake to effect repair or replacement of appliances in the event that an investigation leads to the conclusion that such action is warranted. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - (CONTINUED) As part of that process, in 2015, Whirlpool engaged in thorough investigations of incident reports associated with two of its dryer production platforms developed by Indesit. These dryer production platforms were developed by Indesit prior to Whirlpool's acquisition of Indesit in October 2014. This led to Indesit reporting the issue to regulatory authorities for consideration. These discussions determined that corrective action of the affected dryers was required. Whirlpool has implemented modifications at the point of manufacture to ensure that dryers produced after October 2015 are not affected by this issue. An outreach and service campaign is underway to modify dryers that have already been sold. Such dryers were manufactured between April 2004 and October 2015 and sold in the UK and other countries in the EMEA region under the Hotpoint (Whirlpool ownership of the Hotpoint brand in EMEA and Asia Pacific regions is not affiliated with the Hotpoint brand sold in the Americas) and Indesit brand names, as well as various other brands owned by other manufacturers, distributors and retailers whose products Indesit produced. In September 2015, we recorded a liability related to the corrective action. We estimate the most probable pre-tax and after tax cost of the corrective action to be €245 million and €196 million respectively (approximately $274 million and $219 million respectively, as of September 30, 2015) based on certain tax deductibility assumptions. Approximately 90% of the affected units were manufactured by Indesit prior to its acquisition by the Company in October 2014. Accordingly, we increased the warranty liability as a purchase accounting adjustment in the opening balance sheet with a corresponding increase to goodwill of €210 million (approximately $235 million as of September 30, 2015). During 2015, we recognized expenses of $39 million related to legacy product corrective action on the heritage Indesit product in Europe. The establishment of this liability is based on several assumptions such as customer response rate, consumer options, field repair costs, inventory repair costs, and timing of tax deductibility. Our experience with respect to these factors may cause our actual costs to differ significantly from our estimated costs. In addition, we intend to seek indemnity under the terms of the Indesit acquisition agreements. Any amounts we recover from the seller would reduce our net costs. We expect the corrective action affecting these dryers to have future cash expenditures in 2016 of approximately $155 million with the remaining cash expenditures occurring in 2017. For additional information about the Indesit corrective action, see Note 7 of the Notes to the Consolidated Financial Statements. Warranty Obligations The estimation of warranty obligations is determined in the same period that revenue from the sale of the related products is recognized. The warranty obligation is based on historical experience and represents our best estimate of expected costs at the time products are sold. Warranty accruals are adjusted for known or anticipated warranty claims as new information becomes available. New product launches require a greater use of judgment in developing estimates until historical experience becomes available. Future events and circumstances could materially change our estimates and require adjustments to the warranty obligations. For additional information about warranty obligations, see Note 7 of the Notes to the Consolidated Financial Statements. Goodwill and Intangibles Certain business acquisitions have resulted in the recording of goodwill and trademark assets. Upon acquisition, the purchase price is first allocated to identifiable assets and liabilities, including trademark assets, based on estimated fair value, with any remaining purchase price recorded as goodwill. Most trademarks and goodwill are considered indefinite-life intangible assets and as such, are not amortized. At December 31, 2015, we had goodwill of approximately $3.0 billion. There have been no changes to our reporting units or allocations of goodwill by reporting units except for goodwill resulting from the acquisitions and changes in purchase price allocations, or the impact of foreign currency. We have trademark assets in our North America, EMEA and Asia operating segments with a total carrying value of approximately $2.7 billion as of December 31, 2015. We perform our annual impairment assessment for goodwill and other indefinite-life intangible assets as of October 1st and more frequently if indicators of impairment exist. In 2015, the Company elected to perform a quantitative analysis using a discounted cash flow model and other valuation techniques, to evaluate goodwill and other indefinite-life intangible assets. Many of the factors used in assessing fair values are outside the control of management and it is reasonably likely that assumptions and estimates can change in future periods. These changes can result in future impairments. Goodwill Valuations In performing a quantitative assessment, we estimate fair value using the best information available to us, including market information and discounted cash flow projections also referred to as the income approach. The income approach uses operating MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - (CONTINUED) segments projection of estimated operating results and cash flows that are discounted using a weighted-average cost of capital that is determined based on current market conditions. The projection uses management’s best estimates of economic and market conditions over the projected period including growth rates in sales, costs and number of units, estimates of future expected changes in operating margins and cash expenditures. Other estimates and assumptions include terminal value growth rates, future estimates of capital expenditures and changes in future working capital requirements. The estimated fair value of each operating segment is compared to their respective carrying values. Sensitivity analyses were performed around these assumptions in order to assess the reasonableness of the assumptions and the resulting estimated fair values. Additionally we validate our estimates of fair value under the income approach by comparing the values to fair value estimates using a market approach. A market approach estimates fair value by applying cash flow multiples to the reporting unit’s operating performance. The multiples are derived from comparable publicly traded companies with similar operating and investment characteristics of the reporting units. We consider the implied control premium and conclude whether the implied control premium is reasonable based on other recent market transactions. If actual results are not consistent with managements’ estimate and assumptions, goodwill may be overstated and a charge against net income would be required, which would adversely affect the Company’s financial statements. Based on the results of our quantitative assessment conducted on October 1, 2015, the fair values of Whirlpool's operating segments continue to exceed their respective carrying values. The range by which the excess fair value of our operating segments' goodwill exceeded their respective carrying values was 12% to 108%. Intangible Valuations When performing a quantitative assessment, we estimate the fair value of these intangible assets using the relief-from-royalty method, which requires assumptions related to projected revenues from our annual long-range plan; assumed royalty rates that could be payable if we did not own the trademark; and a discount rate based on our weighted average cost of capital. If the estimated fair value of the indefinite-lived intangible asset is less than its carrying value, we would recognize an impairment loss. Two trademarks acquired in fourth quarter of 2014 have fair values that exceed their carrying values by less than 10%. The fair values of all other trademarks exceeded their carrying values by more than 10% with the exception of one North American trademark. The fair value of this North American trademark exceeded its carrying value of approximately $1 billion by 5% in 2014 and 2015. We expect revenue trends for this brand to improve as we continue to execute specific brand investments and product development plans. Our assessment indicates no impairment as of December 31, 2015. We performed a sensitivity analysis on our estimated fair value noting that a 10% reduction of forecasted revenues, a 50 basis point reduction in royalty rate, or a 50 basis point increase in discount rate would result in an impairment of approximately $51 million, $80 million or $22 million respectively. If actual results are not consistent with managements’ estimate and assumptions, indefinite-life intangible assets may be overstated and a charge against net income would be required, which would adversely affect the Company’s financial statements. Based on the results of our quantitative assessment performed as of October 1, 2014, impairment of two trademarks was determined to exist, primarily driven by a change in our brand strategy in EMEA as a result of the acquisition of Indesit and resulted in a charge of approximately $12 million in 2014. For additional information about goodwill and intangible valuations, see Note 3 of the Notes to the Consolidated Financial Statements. ISSUED BUT NOT YET EFFECTIVE ACCOUNTING PRONOUNCEMENTS In May 2014, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update (“ASU”) No. 2014-09, "Revenue from Contracts with Customers (Topic 606)", which supersedes the revenue recognition requirements in ASC 605, Revenue Recognition. This ASU is based on the principle that revenue is recognized to depict the transfer of goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services. The ASU also requires additional disclosure about the nature, amount, timing and uncertainty of revenue and cash flows arising from customer contracts, including significant judgments and changes in judgments and assets recognized from costs incurred to obtain or fulfill a contract. The FASB has approved a one year deferral of this standard, and this pronouncement is now effective for annual reporting periods beginning after December 15, 2017, including interim periods within that reporting period and is to be applied using one of two retrospective application methods, with early application permitted for annual reporting periods beginning after December 15, 2016. While we have not completed our impact analysis, we do not expect the adoption to have a material impact on our Consolidated Financial Statements, and do not plan to elect early adoption of the standard. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - (CONTINUED) In April 2015, FASB issued ASU No. 2015-03, Interest - "Imputation of Interest (Subtopic 835-30): Simplifying the Presentation of Debt Issuance Costs". The guidance requires debt issuance costs related to a recognized debt liability be presented on the balance sheet as a direct deduction from the carrying amount of that debt liability, consistent with the presentation for debt discounts. The recognition and measurement guidance for debt issuance costs are not affected by the amendments in this ASU. In August 2015, the FASB issued ASU No. 2015-15, Interest-Imputation of Interest (Subtopic 835-30): Presentation and Subsequent Measurement of Debt Issuance Costs Associated with Line-of-Credit Arrangements - Amendments to SEC Paragraphs Pursuant to Staff Announcements at the June 2015 EITF Meeting. ASU 2015-15 amends Subtopic 835-30 to include that the SEC would not object to the deferral and presentation of debt issuance costs as an asset and subsequent amortization of debt issuance costs over the term of the line-of-credit arrangement, whether or not there are any outstanding borrowings on the line-of-credit arrangement. This guidance is effective for fiscal years and interim periods within those years beginning after December 15, 2015, and must be applied on a retrospective basis with early adoption permitted. The adoption is not expected to have a material impact on our Consolidated Financial Statements. In July 2015, the FASB issued ASU No. 2015-12, "Plan Accounting-Defined Benefit Pension Plans (Topic 960), Defined Contribution Pension Plans (Topic 962) Health and Welfare Benefit Plans (Topic 965)". There are three parts to the ASU that aim to simplify the accounting and presentation of plan accounting. Part I of this ASU requires fully benefit-responsive investment contracts to be measured at contract value instead of the current fair value measurement. Part II of this ASU requires investments (both participant-directed and nonparticipant-directed investments) of employee benefit plans be grouped only by general type, eliminating the need to disaggregate the investments in multiple ways. Part III of this ASU provides a similar measurement date practical expedient for employee benefit plans as available in ASU No. 2015-04, which allows employers to measure defined benefit plan assets on a month-end date that is nearest to the year’s fiscal year-end when the fiscal period does not coincide with a month-end. Parts I and II of the new guidance should be applied on a retrospective basis. Part III of the new guidance should be applied on a prospective basis. This ASU is effective for fiscal years beginning after December 15, 2015, and for interim periods within those fiscal years. The adoption is not expected to have a material impact on our Consolidated Financial Statements. In July 2015, the FASB issued ASU No. 2015-11, "Simplifying the Measurement of Inventory", which amends ASC 330, Inventory. This ASU simplifies the subsequent measurement of inventory by using only the lower of cost and net realizable value. The ASU does not apply to inventory measured using last-in, first-out method. This guidance is effective for fiscal years and interim periods within those years beginning after December 15, 2016, and must be applied on a retrospective basis with early adoption permitted. The adoption is not expected to have a material impact on our Consolidated Financial Statements. In November 2015, FASB issued ASU No. 2015-17, "Income Taxes (Topic 740) - Balance Sheet Classification of Deferred Taxes", which supersedes the guidance in Topic 740, Income Taxes, that requires an entity to separate deferred tax liabilities and assets into a current amount and noncurrent amount in a classified statement of financial position. The amendment requires entities that present a classified balance sheet to classify all deferred tax liabilities and assets as a noncurrent amount. This guidance is effective for fiscal years and interim periods within those years beginning after December 15, 2016, and may be early adopted on a prospective basis or on a retrospective basis to all periods presented. We have not yet determined the potential effects from this pronouncement on our Consolidated Financial Statements. All other issued but not yet effective accounting pronouncements are not expected to have a material effect on our Consolidated Financial Statements. OTHER MATTERS Embraco Antitrust Matters Beginning in February 2009, our compressor business headquartered in Brazil ("Embraco") was notified of antitrust investigations of the global compressor industry by government authorities in various jurisdictions. Embraco has resolved government investigations in various jurisdictions as well as all related civil lawsuits in the United States. Embraco has also resolved certain other claims and certain claims remain pending. Additional lawsuits could be filed. At December 31, 2015, $10 million remains accrued, with installment payments of $8 million, plus interest, due at various times through 2016. We continue to defend these actions and take other steps to minimize our potential exposure. The final outcome and impact of these matters, and any related claims and investigations that may be brought in the future are subject to many variables, and cannot be predicted. We establish accruals only for those matters where we determine that a loss is probable and the amount of loss can be reasonably estimated. While it is currently not possible to reasonably estimate the aggregate amount of costs which we may incur in connection with these matters, such costs could have a material adverse effect on our financial position, liquidity, or results of operations in any particular reporting period. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - (CONTINUED) BEFIEX Credits and Other Brazil Tax Matters In previous years, our Brazilian operations earned tax credits under the Brazilian government’s export incentive program (BEFIEX). These credits reduced Brazilian federal excise taxes on domestic sales, resulting in an increase in the operations’ recorded net sales, as the credits were monetized. We did not monetize any BEFIEX credits during the year ended December 31, 2015. We monetized $14 million and $109 million of BEFIEX credits during the years ended December 31, 2014 and 2013. We began recognizing BEFIEX credits in accordance with prior favorable court decisions allowing for the credits to be recognized. We recognized export credits as they were monetized. In December 2013, the Brazilian government reinstituted the monetary adjustment index applicable to BEFIEX credits that existed prior to July 2009, when the Brazilian government required companies to apply a different monetary adjustment index to BEFIEX credits. As of December 31, 2015, no BEFIEX credits deemed to be available prior to this action remained to be monetized. Whether use of the reinstituted index should be given retroactive effect for the July 2009 to December 2013 period has been subject to review by the Brazilian courts. If the reinstituted index is given retroactive effect, we would be entitled to recognize additional credits. We are awaiting the resolution of additional proceedings on the retroactive effect of the reinstituted index. Our Brazilian operations have received governmental assessments related to claims for income and social contribution taxes associated with BEFIEX credits monetized from 2000 through 2002 and 2007 through 2011. We do not believe BEFIEX export credits are subject to income or social contribution taxes. We are disputing these tax matters in various courts and intend to vigorously defend our positions. We have not provided for income or social contribution taxes on these export credits, and based on the opinions of tax and legal advisors, we have not accrued any amount related to these assessments as of December 31, 2015. The total amount of outstanding tax assessments received for income and social contribution taxes relating to the BEFIEX credits, including interest and penalties, is approximately 1.5 billion Brazilian reais (approximately $395 million as of December 31, 2015). Relying on existing Brazilian legal precedent, in 2003 and 2004, we recognized tax credits in an aggregate amount of $26 million, adjusted for currency, on the purchase of raw materials used in production (“IPI tax credits”). The Brazilian tax authority subsequently challenged the recording of IPI tax credits. No credits have been recognized since 2004. In 2009, we entered into a Brazilian government program which provided extended payment terms and reduced penalties and interest to encourage tax payers to resolve this and certain other disputed tax credit amounts. As permitted by the program, we elected to settle certain debts through the use of other existing tax credits and recorded charges of approximately $34 million in 2009 associated with these matters. In July 2012, the Brazilian revenue authority notified us that a portion of our proposed settlement was rejected and we received tax assessments of 219 million Brazilian reais (approximately $56 million as of December 31, 2015), reflecting interest and penalties to date. We are disputing these assessments and we intend to vigorously defend our position. Based on the opinion of our tax and legal advisors, we have not recorded an additional reserve related to these matters. In 2001, Brazil adopted a law making the profits of controlled foreign corporations of Brazilian entities subject to income and social contribution tax regardless of whether the profits were repatriated ("CFC Tax"). Our Brazilian subsidiary, along with other corporations, challenged tax assessments on foreign profits on constitutionality and other grounds. In April 2013, the Brazilian Supreme Court ruled on one of our cases, finding that the law is constitutional, but remanding the case to a lower court for consideration of other arguments raised in our appeal, including the existence of tax treaties with jurisdictions in which controlled foreign corporations are domiciled. As of December 31, 2015, our potential exposure for income and social contribution taxes relating to profits of controlled foreign corporations, including interest and penalties and net of expected foreign tax credits, is approximately 161 million Brazilian reais (approximately $41 million as of December 31, 2015). We believe these assessments are without merit and we intend to continue to vigorously dispute them. Based on the opinion of our tax and legal advisors, we have not accrued any amount related to these assessments as of December 31, 2015. In December 2013, we entered into a Brazilian government program to settle long standing disputes. Participation in the program removed uncertainty related to 16 assessments that were previously under dispute and significantly reduces potential penalties and interest associated with these matters. Our participation will result in total payments including principal, interest, and penalties of 75 million Brazilian reais, to be paid in 30 monthly installments, which began in December 2013. There was a nominal amount of outstanding principal, interest, and penalties at December 31, 2015, the payments for which we will complete during 2016. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - (CONTINUED) In addition to the IPI tax credit and CFC Tax matters noted above, we are currently disputing other assessments issued by the Brazilian tax authorities related to non-income and income tax matters, including for the monetization of BEFIEX credits and other matters, which are at various stages of review in numerous administrative and judicial proceedings. Sessions of trial of the Brazilian administrative council of tax appeals, or CARF, have resumed after having been suspended for several months while changes in CARF procedures and staffing were implemented. The amounts related to these assessments will continue to be increased by monetary adjustments at the Selic rate, which is the benchmark rate set by the Brazilian Central Bank. In accordance with our accounting policies, we routinely assess these matters and, when necessary, record our best estimate of a loss. We believe these tax assessments are without merit and are vigorously defending our positions. Litigation is inherently unpredictable and the conclusion of these matters may take many years to ultimately resolve. Accordingly, it is possible that an unfavorable outcome in these proceedings could have a material adverse effect on our financial position, liquidity, or results of operations in any particular reporting period. Other Litigation We have vigorously defended against numerous lawsuits pending in the United States relating to certain of our front load washing machines. We have reached preliminary agreement on a settlement that will resolve all such class action lawsuits. The settlement has been accounted for in interest and sundry income (expense) in the fourth quarter of 2015. The settlement requires court approval in order to be finalized, and we are proceeding through the court process to request such approval. In addition, we are currently vigorously defending a number of other lawsuits in federal and state courts in the United States related to the manufacturing and sale of our products which include class action allegations, and may become involved in similar actions in other jurisdictions. These lawsuits allege claims which include negligence, breach of contract, breach of warranty, product liability and safety claims, fraud, and violation of federal and state regulations, including consumer protection acts. We do not have insurance coverage for class action lawsuits. We are also involved in various other legal actions in the United States and other jurisdictions around the world arising in the normal course of business, for which insurance coverage may or may not be available depending on the nature of the action. We dispute the merits of these suits and actions, and intend to vigorously defend them. Management believes, based upon its current knowledge, after taking into consideration legal counsel's evaluation of such suits and actions, and after taking into account current litigation accruals, that the outcome of these matters currently pending against Whirlpool should not have a material adverse effect, if any, on our financial position, liquidity, or results of operations. Other Matters In 2013, the French Competition Authority commenced an investigation of appliance manufacturers and retailers in France. The investigation includes 11 manufacturers, including the Whirlpool and Indesit operations in France. Although it is currently not possible to assess the impact, if any, this matter may have on our Consolidated Financial Statements, the resolution of this matter could have a material adverse effect on our financial position, liquidity, or results of operations in any particular reporting period. Antidumping Petition On December 16, 2015, we submitted a petition requesting that the U.S. Department of Commerce and the United States International Trade Commission initiate antidumping investigations regarding large residential washers from China sold by Samsung and LG into the United States. The purpose of this petition, similar to the petitions we filed in December 2011 regarding large residential washers from South Korea and Mexico, is to establish conditions of fair competition in the United States that will support significant investment and innovation in the production of large residential washers in the United States and the U.S. jobs created by that production. This petition is the result of our continual monitoring of the large residential washer landscape, which highlighted that Samsung and LG have continued to dump washers into the United States following the conclusion of our earlier case in 2013. The Whirlpool washers affected by the imports subject in this case are made in Clyde, Ohio. There are several steps in the process of the antidumping investigation. We expect a preliminary determination of the amount of dumping in July 2016. The preliminary determination will be followed by several other steps leading to a final decision from the U.S. Department of Commerce and the U.S. International Trade Commission, which we expect in January 2017. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - (CONTINUED) FORWARD-LOOKING STATEMENTS The Private Securities Litigation Reform Act of 1995 provides a safe harbor for forward-looking statements made by us or on our behalf. Certain statements contained in this annual report, including those within the forward-looking perspective section within this Management's Discussion and Analysis, and other written and oral statements made from time to time by us or on our behalf do not relate strictly to historical or current facts and may contain forward-looking statements that reflect our current views with respect to future events and financial performance. As such, they are considered “forward-looking statements” which provide current expectations or forecasts of future events. Such statements can be identified by the use of terminology such as “may,” “could,” “will,” “should,” “possible,” “plan,” “predict,” “forecast,” “potential,” “anticipate,” “estimate,” “expect,” “project,” “intend,” “believe,” “may impact,” “on track,” and similar words or expressions. Our forward-looking statements generally relate to our growth strategies, financial results, product development, and sales efforts. These forward-looking statements should be considered with the understanding that such statements involve a variety of risks and uncertainties, known and unknown, and may be affected by inaccurate assumptions. Consequently, no forward-looking statement can be guaranteed and actual results may vary materially. This document contains forward-looking statements about Whirlpool Corporation and its consolidated subsidiaries (“Whirlpool”) that speak only as of this date. Whirlpool disclaims any obligation to update these statements. Forward-looking statements in this document may include, but are not limited to, statements regarding expected earnings per share, cash flow, productivity and raw material prices. Many risks, contingencies and uncertainties could cause actual results to differ materially from Whirlpool's forward-looking statements. Among these factors are: (1) intense competition in the home appliance industry reflecting the impact of both new and established global competitors, including Asian and European manufacturers; (2) acquisition and investment-related risk, including risk associated with our acquisitions of Hefei Sanyo and Indesit, and risk associated with our increased presence in emerging markets; (3) Whirlpool's ability to continue its relationship with significant trade customers and the ability of these trade customers to maintain or increase market share; (4) risks related to our international operations, including changes in foreign regulations, regulatory compliance and disruptions arising from natural disasters or terrorist attacks; (5) fluctuations in the cost of key materials (including steel, plastic, resins, copper and aluminum) and components and the ability of Whirlpool to offset cost increases; (6) the ability of Whirlpool to manage foreign currency fluctuations; (7) litigation, tax, and legal compliance risk and costs, especially costs which may be materially different from the amount we expect to incur or have accrued for; (8) the effects and costs of governmental investigations or related actions by third parties; (9) changes in the legal and regulatory environment including environmental and health and safety regulations; (10) Whirlpool's ability to maintain its reputation and brand image; (11) the ability of Whirlpool to achieve its business plans, productivity improvements, cost control, price increases, leveraging of its global operating platform, and acceleration of the rate of innovation; (12) information technology system failures and data security breaches; (13) product liability and product recall costs; (14) inventory and other asset risk; (15) the uncertain global economy and changes in economic conditions which affect demand for our products; (16) the ability of suppliers of critical parts, components and manufacturing equipment to deliver sufficient quantities to Whirlpool in a timely and cost-effective manner; (17) our ability to attract, develop and retain executives and other qualified employees; (18) the impact of labor relations; (19) Whirlpool's ability to obtain and protect intellectual property rights; and (20) health care cost trends, regulatory changes and variations between results and estimates that could increase future funding obligations for pension and postretirement benefit plans. We undertake no obligation to update any forward-looking statement, and investors are advised to review disclosures in our filings with the SEC. It is not possible to foresee or identify all factors that could cause actual results to differ from expected or historic results. Therefore, investors should not consider the foregoing factors to be an exhaustive statement of all risks, uncertainties, or factors that could potentially cause actual results to differ from forward-looking statements. Additional information concerning these and other factors can be found in “Risk Factors” in Item 1A of this report.

<s>[INST] RESULTS OF OPERATIONS This Management Discussion and Analysis should be read in connection with the Consolidated Financial Statements, Notes to the Consolidated Financial Statements and Selected Financial Data included in this Form 10K. Certain references to particular information in the Notes to the Consolidated Financial Statements are made to assist readers. ABOUT WHIRLPOOL Whirlpool Corporation (“Whirlpool”) is the number one major appliance manufacturer in the world with net sales of approximately $21 billion and net earnings available to Whirlpool of $783 million in 2015. We are a leading producer of major home appliances in North America, Latin America and Europe, and have a significant presence throughout China and India. We have received worldwide recognition for accomplishments in a variety of business and social efforts, including leadership, diversity, innovative product design, business ethics, social responsibility and community involvement. We conduct our business through four reportable segments, which we define based on geography. Our reportable segments consist of North America, Latin America, EMEA (Europe, Middle East and Africa) and Asia. Our customer base includes large, sophisticated trade customers who have many choices and demand competitive products, services and prices. The major home appliance industry operates in an intensely competitive environment, reflecting the impact of both new and established global competitors, including Asian and European manufacturers. The charts below summarize the balance of net sales by reportable segment for 2015, 2014 and 2013, respectively: We monitor countryspecific economic factors such as gross domestic product, unemployment, consumer confidence, retail trends, housing starts and completions, sales of existing homes and mortgage interest rates as key indicators of industry demand. In addition to profitability, we also focus on country, brand, product and channel sales when assessing and forecasting financial results. Our leading portfolio of brands includes Whirlpool, Maytag, KitchenAid, Embraco, Brastemp, Consul and Indesit, each of which generated annual revenues in excess of $1 billion. Our global branded consumer products strategy is to introduce innovative new products, increase brand customer loyalty, expand our presence outside the United States, enhance our trade management platform, improve total cost and quality by expanding and leveraging our global operating platform and, where appropriate, make strategic acquisitions and investments. As we grow revenues in our core products, our strategy is to extend our business by offering products and services that are dependent on and related to our core business and expand into adjacent products, such as Affresh cleaners and Gladiator GarageWorks, through businesses that leverage our core competencies and business infrastructure. OVERVIEW Whirlpool delivered strong results in 2015, driving revenue growth, margin expansion and strong cash generation by leveraging our industry leading brand portfolio and innovative new products within our core appliance and adjacent businesses. We achieved these results through strong focus and decisive action plans in a global environment that saw rapid emerging markets demand decline and strengthening of U.S. dollar against most global currencies. Over the past year, we made moves to reshape our global operating footprint, respond to shifts in the operating environment and invest in our brands and products. We made substantial progress toward integrating Indesit in Europe and Hefei Sanyo in China, our 2014 acquisitions, that create leading MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (CONTINUED) positions as a western company, in those markets. We have great opportunities for growth as demand in the U.S. continues to recover and we are very well positioned to capitalize when growth returns to emerging markets such as Brazil, China, and Russia. We believe that continued execution of our business priorities and a focus on longterm growth will allow the Company to adapt to changes in the macroeconomic environment and continue to create shareholder value. RESULTS OF OPERATIONS The following table summarizes the consolidated results of operations: nm: not meaningful Consolidated Net Sales The following tables summarize units sold and consolidated net sales by operating segment: nm: not meaningful Consolidated net sales increased 5.1% compared to 2 [/INST] Positive. </s>

WHIRLPOOL CORP /DE/

2017-02-13

2016-12-31

ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS This Management Discussion and Analysis should be read in connection with the Consolidated Financial Statements, Notes to the Consolidated Financial Statements and Selected Financial Data included in this Form 10-K. Certain references to particular information in the Notes to the Consolidated Financial Statements are made to assist readers. ABOUT WHIRLPOOL Whirlpool is the number one major appliance manufacturer in the world with net sales of approximately $21 billion in 2016. We are a leading producer of major home appliances in North America, Europe and Latin America, and have a significant presence throughout China and India. We have received worldwide recognition for accomplishments in a variety of business and social efforts, including leadership, diversity, innovative product design, business ethics, social responsibility and community involvement. We conduct our business through four reportable segments, which we define based on geography. Our reportable segments consist of North America, EMEA, Latin America and Asia. Our customer base includes large, sophisticated trade customers who have many choices and demand competitive products, services and prices. The major home appliance industry operates in an intensely competitive environment, reflecting the impact of both new and established global competitors, including Asian and European manufacturers. The charts below summarize the balance of net sales by reportable segment for 2016, 2015 and 2014, respectively: We monitor country-specific economic factors such as gross domestic product, unemployment, consumer confidence, retail trends, housing starts and completions, sales of existing homes and mortgage interest rates as key indicators of industry demand. In addition to profitability, we also focus on country, brand, product and channel sales when assessing and forecasting financial results. Our leading portfolio of brands includes Whirlpool, Maytag, KitchenAid, Embraco, Brastemp, Consul and Indesit. Our global branded consumer products strategy is to introduce innovative new products, increase brand customer loyalty, expand our presence outside the United States, enhance our trade management platform, improve total cost and quality by expanding and leveraging our global operating platform and, where appropriate, make strategic acquisitions and investments. As we grow revenues in our core products, our strategy is to extend our business by offering products and services that are dependent on and related to our core business and expand into adjacent products, such as Affresh cleaners and Gladiator GarageWorks, through businesses that leverage our core competencies and business infrastructure. OVERVIEW During 2016, we had another year of strong performance for Whirlpool Corporation, as we delivered record results through strong operational execution and decisive actions to adjust to changes in global markets. Over the last few years, macroeconomic volatility has been a factor in many of the countries where we operate. We continued to experience volatility during 2016. The Brexit decision in June had a negative impact on British currency and demand, while uncertainty in emerging markets generated additional currency and demand weakness, especially in Brazil, Russia and China. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - (CONTINUED) These challenges, along with a further strengthening U.S. dollar, had a combined negative impact of approximately $600 million in revenue and $2 per share of earnings. Our earnings growth and strong cash generation enabled us to create long-term shareholder value through the execution of our balanced capital allocation approach. We invested in our innovation pipeline through $660 million in capital expenditures while increasing our dividend by 11% and repurchasing $525 million in common stock. These investments continue to be supported by a strong balance sheet, an increased capacity to invest and the confidence that our operating plans will deliver extraordinary levels of shareholder value both now and in the future. Our long-term value creation framework is built upon the strong foundation we have in place: our industry-leading brand portfolio and robust product innovation pipeline, supported by our best cost global operating platform and executed by our exceptional employees throughout the world. We will measure these value-creation components by focusing on the following key metrics: • Deliver 3 to 5 percent annual organic net sales growth across our global footprint • Grow earnings per share by 10 to 15 percent annually • Expand EBIT margins to 10 percent plus by 2020 through strong cost productivity programs and further leveraging our strong brands and innovative new products • Generate free cash flow of 5 to 6 percent of net sales by 2018, which represents over 85 percent earnings to free cash conversion We remain confident in our ability to effectively manage our business regardless of the operating environment and expect to continue delivering long-term value for all of our shareholders. RESULTS OF OPERATIONS The following table summarizes the consolidated results of operations: Consolidated Net Sales The following charts summarize units sold and consolidated net sales by operating segment: MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - (CONTINUED) MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - (CONTINUED) Consolidated net sales decreased 0.8% compared to 2015 primarily driven by unfavorable impacts from foreign currency and product price/mix, partially offset by higher unit volumes. Excluding the impact of foreign currency, consolidated net sales increased 1.6% compared to 2015. Consolidated net sales for 2015 increased 5.1% compared to 2014 primarily driven by increased volume due to acquisitions and favorable product price/mix, partially offset by the unfavorable impact of foreign currency and a weakened demand environment in emerging markets. Excluding the impact of foreign currency and BEFIEX in 2014, consolidated net sales for 2015 increased 18.1% compared to 2014. We provide the percentage change in net sales, excluding the impact of foreign currency and BEFIEX, as a supplement to the change in net sales as determined by U.S. generally accepted accounting principles ("GAAP") to provide stockholders with a clearer basis to assess Whirlpool's results over time. This measure is considered a non-GAAP financial measure and is calculated by translating the current period net sales in functional currency, to U.S. dollars using the prior-year's exchange rate compared to the prior-year period net sales and BEFIEX. Significant regional trends were as follows: • North America net sales increased 3.9% compared to 2015 primarily due to a 7.7% increase in units sold, partially offset by unfavorable impacts from product price/mix and foreign currency. Excluding the impact of foreign currency, net sales increased 5.0% in 2016. North America net sales for 2015 increased 0.9% compared to 2014 primarily due to a 1.4% increase in units sold and favorable product/price mix, partially offset by foreign currency. Excluding the impact of foreign currency, net sales increased 3.2% in 2015. • EMEA net sales decreased 8.1% compared to 2015, primarily due to unfavorable impacts from foreign currency, product price/mix, and a 1.9% decrease in units sold. Excluding the impact of foreign currency, net sales decreased 4.3% in 2016. EMEA net sales for 2015 increased 43.4% compared to 2014, primarily due to a 59.7% increase in units sold due to the acquisition of Indesit and favorable product mix, partially offset by unfavorable foreign currency. Excluding the impact of foreign currency, net sales increased 75.3% in 2015. • Latin America net sales decreased 4.7% compared to 2015 primarily due to a 11.5% decrease in units sold and unfavorable impacts from foreign currency, partially offset by favorable product price/mix. Excluding the impact of foreign currency, Latin America net sales decreased 1.5% in 2016. Latin America net sales for 2015 decreased 28.5% compared to 2014 primarily due to a 21.3% decrease in units sold and unfavorable foreign currency, partially offset by favorable product mix. Excluding the impact of foreign currency and BEFIEX, Latin America net sales decreased 5.9% in 2015. • Asia net sales increased 0.5% compared to 2015 primarily due to a 12.3% increase in units sold, partially offset by unfavorable impacts from product price/mix and foreign currency. Excluding the impact of foreign currency, Asia net sales increased 5.4% in 2016. Asia net sales for 2015 increased 73.6% compared to 2014 primarily due to a 78.8% increase in units sold driven by the acquisition of Hefei Sanyo. Excluding the impact of foreign currency, Asia net sales increased 78.3% in 2015. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - (CONTINUED) Gross Margin The chart below summarizes gross margin percentages by operating segment: The consolidated gross margin percentage increased by 10 basis points to 17.8% compared to 2015, primarily due to ongoing cost productivity and acquisition synergies, unit volume growth, and benefits from cost and capacity-reduction initiatives, partially offset by the unfavorable impacts from product price/mix and foreign currency. Significant regional trends were as follows: • North America gross margin percentage decreased compared to 2015 primarily due to unfavorable product price/mix, recognition of postretirement-benefit curtailment gains in 2015, and foreign currency, partially offset by unit volume growth and ongoing cost productivity. North America gross margin for 2015 increased compared to 2014 primarily due to ongoing cost productivity and recognition of postretirement-benefit curtailment gains, partially offset by unfavorable foreign currency. • EMEA gross margin percentage increased compared to 2015 primarily due to favorable impacts from acquisition synergies, partially offset by unfavorable impacts from foreign currency, product price/mix, unit volume declines, and acquisition-related integration costs. During 2015, EMEA gross margin was flat compared to 2014 primarily due to benefits from the Indesit acquisition, favorable product price/mix, ongoing cost productivity, and capacity optimization initiatives, offset by unfavorable foreign currency, legacy Indesit product corrective action costs and increased investments in marketing, technology and products. • Latin America gross margin percentage increased compared to 2015 primarily due to favorable product price/mix and benefits from cost and capacity reduction initiatives, partially offset by unit volume declines due to the weakened demand environment in Brazil. During 2015, Latin America gross margin decreased compared to 2014 primarily due to unfavorable foreign currency and the weakened demand environment in Brazil, partially offset by higher product price/mix. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - (CONTINUED) • Asia gross margin percentage decreased in 2016, compared to 2015, primarily due to unfavorable product price/mix and increased investments in marketing, technology and products, partially offset by unit volume growth and benefits from ongoing cost productivity. During 2015, Asia gross margin increased compared to 2014 primarily due to acquisition synergies, partially offset by increased investments in marketing, technology and products. Selling, General and Administrative The following table summarizes selling, general and administrative expenses as a percentage of sales by operating segment: Consolidated selling, general and administrative expenses as a percent of consolidated net sales in 2016 and 2015, compared to the previous years, reflect the favorable impact of acquisition synergies, partially offset by foreign currency. Restructuring We incurred restructuring charges of $173 million, $201 million, and $136 million for the years ended December 31, 2016, 2015 and 2014, respectively. For the full year 2017, we expect to incur up to $200 million of restructuring charges, which will result in ongoing substantial cost reductions. Additional information about restructuring activities can be found in Note 10 of the Notes to the Consolidated Financial Statements. Interest and Sundry (Income) Expense Interest and sundry (income) expense decreased $10 million compared to 2015, primarily due to amounts received pursuant to an agreement, reached in the fourth quarter of 2016, with the seller of Indesit to recover a portion of our acquisition related costs. During 2015, interest and sundry (income) expense decreased $53 million compared to 2014, primarily due to a $64 million gain related to a business investment in Brazil during 2015 and previous year investment expenses related to the Hefei Sanyo and Indesit acquisitions, partially offset by impact from foreign currency. For additional information about the Embraco antitrust matters and legacy product warranty cost, see Note 6 of the Notes to the Consolidated Financial Statements. For additional information about the acquisitions of Hefei Sanyo and Indesit, see the Financial Condition and Liquidity section of Management's Discussion and Analysis. Interest Expense Interest expense decreased by $4 million compared to 2015. This was a result of lower average interest rates on long-term debt, offset by higher average long-term debt balances. During 2015, interest expense was unchanged compared to 2014. This was a result of higher average long-term debt balances, offset by lower average interest rates on long-term debt. Income Taxes Income tax expenses were $186 million, $209 million, and $189 million in 2016, 2015 and 2014, respectively. The decrease in tax expense in 2016 compared to 2015 is primarily due to favorable audits and settlements and tax planning resulting in valuation allowance releases, partially offset by higher pre-tax earnings. The increase in tax expense in 2015 compared to 2014 is primarily due to higher pre-tax earnings, partially offset by a lower effective tax rate. For additional information about our consolidated tax provision, see Note 11 of the Notes to the Consolidated Financial Statements. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - (CONTINUED) FORWARD-LOOKING PERSPECTIVE Earnings per diluted share presented below are net of tax, while each adjustment is presented on a pre-tax basis. The aggregate income tax impact of the taxable components of each adjustment is presented in the income tax impact line item at our anticipated 2017 full-year tax rate of 22%. We currently estimate earnings per diluted share and industry demand for 2017 to be within the following ranges: (1) Reflects industry demand in the United States. (2) Reflects industry demand in Brazil. For the full-year 2017, we expect to generate cash from operating activities of $1.7 billion to $1.75 billion and free cash flow of approximately $1 billion, including primarily acquisition related restructuring cash outlays of up to $165 million, legacy product warranty and liability costs of $69 million, pension contributions of $42 million and, with respect to free cash flow, capital expenditures of $700 million to $750 million. The table below reconciles projected 2017 cash provided by operating activities determined in accordance with GAAP to free cash flow, a non-GAAP measure. Management believes that free cash flow provides stockholders with a relevant measure of liquidity and a useful basis for assessing Whirlpool’s ability to fund its activities and obligations. There are limitations to using non-GAAP financial measures, including the difficulty associated with comparing companies that use similarly named non-GAAP measures whose calculations may differ from our calculations. We define free cash flow as cash provided by continuing operations less capital expenditures and including proceeds from the sale of assets/businesses, and changes in restricted cash. The change in restricted cash relates to the private placement funds paid by Whirlpool to acquire majority control of Hefei Sanyo in 2014 and which are used to fund capital expenditures and technical resources to enhance Whirlpool China’s research and development and working capital, as required by the terms of the Hefei Sanyo acquisition made in October 2014. (1) Financial guidance on a GAAP basis for cash provided by (used in) financing activities and cash provided by (used in) investing activities has not been provided because in order to prepare any such estimate or projection, the Company would need to rely on market factors and certain other conditions and assumptions that are outside of its control. The projections above are based on many estimates and are inherently subject to change based on future decisions made by management and the Board of Directors of Whirlpool, and significant economic, competitive and other uncertainties and contingencies. FINANCIAL CONDITION AND LIQUIDITY Our objective is to finance our business through operating cash flow and the appropriate mix of long-term and short-term debt. By diversifying the maturity structure, we avoid concentrations of debt, reducing liquidity risk. We have varying needs for short-term working capital financing as a result of the nature of our business. We regularly review our capital structure and liquidity priorities, which include funding the business through capital and engineering spending to support innovation and productivity initiatives, funding our pension plan and term debt liabilities, providing return to shareholders and potential acquisitions. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - (CONTINUED) Our short term potential uses of liquidity include funding our ongoing capital spending, restructuring activities, funding pension plans and returns to shareholders. We also have $560 million of term debt maturing in the next twelve months, and are currently evaluating our options in connection with this maturing debt, which may include repayment through refinancing, through free cash flow generation, or cash on hand. We monitor the credit ratings and market indicators of credit risk of our lending, depository, and derivative counterparty banks regularly, and take certain action to manage credit risk. We diversify our deposits and investments in short term cash equivalents to limit the concentration of exposure by counterparty. As of December 31, 2016, the only country where we had cash or cash equivalents greater than 1% of our consolidated assets was China, which represented 2.4%. In addition, we did not have any third-party accounts receivable greater than 1% of our consolidated assets in any single country outside of North America, with the exceptions of Italy, China, and Brazil which represented 1.0%, 1.0%, and 1.3% respectively. We continue to monitor general financial instability and uncertainty globally. As of December 31, 2016, we had €67 million (approximately $71 million as of December 31, 2016) in outstanding trade receivables and short-term and long-term notes due to us associated with Alno AG, a long-standing European customer. Approximately €49 million (approximately $51 million as of December 31, 2016) of the outstanding receivables were overdue as of December 31, 2016. Our exposure includes not only the outstanding receivables but also the potential risks of an Alno AG bankruptcy and impacts to our distribution process. We believe our reserves related to these outstanding receivables are sufficient. In the fourth quarter of 2016, Whirlpool sold its remaining investment of approximately 10.6 million shares in Alno AG for approximately €5 million (approximately $6 million). We continue to monitor customer financial conditions globally. The Company had cash and cash equivalents of approximately $1.1 billion at December 31, 2016, of which approximately $1.0 billion was held by subsidiaries in foreign countries. For each of its foreign subsidiaries, the Company makes an assertion regarding the amount of earnings intended for permanent reinvestment, with the balance available to be repatriated to the United States. The cash held by foreign subsidiaries for permanent reinvestment is generally used to finance the subsidiaries' operational activities and future foreign investments. Our intent is to permanently reinvest these funds outside of the United States and our current plans do not demonstrate a need to repatriate these funds to fund our U.S. operations. However, if these funds were repatriated, then we would be required to accrue and pay applicable United States taxes (subject to an adjustment for foreign tax credits) and withholding taxes payable to various countries. The repatriation could result in an adjustment to the tax liability after considering available foreign tax credits and other tax attributes. It is not practicable to estimate the amount of the deferred tax liability associated with these unremitted earnings due to the complexity of its hypothetical calculation. Sources and Uses of Cash We met our cash needs during 2016 through cash flows from operations, cash and cash equivalents, and financing arrangements. Our cash and cash equivalents at December 31, 2016 increased $313 million compared to the same period in 2015. The following table summarizes the net increase (decrease) in cash and cash equivalents for the periods presented. Significant drivers of changes in our cash and cash equivalents balance during 2016 are discussed below: Cash Flow Summary MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - (CONTINUED) Cash Flows from Operating Activities The decrease in cash provided by operating activities during 2016 reflects strong cash earnings and effective credit management, more than offset by cash expenditures related to the legacy product corrective action. The timing of cash flows from operations varies significantly throughout the year primarily due to changes in production levels, sales patterns, promotional programs, funding requirements, credit management, as well as receivable and payment terms. Depending on the timing of cash flows, the location of cash balances, as well as the liquidity requirements of each country, external sources of funding are used to support working capital requirements. Cash Flows from Investing Activities Changes in cash used in investing activities during 2016 primarily reflect a reduction in capital expenditures and investment in related businesses, partially offset by increased proceeds from the sale of business assets. In June 2016, Whirlpool China Co., Ltd. (“Whirlpool China”), our majority-owned indirect subsidiary, entered into an agreement to return land use rights for land now occupied by two Whirlpool China plants in Hefei, China to a division of the Hefei municipal government. The aggregate price for the return of land use rights was approximately RMB 687 million (approximately $103 million as of June 27, 2016). Whirlpool China received RMB 280 million (approximately $42 million as of June 27, 2016) of the aggregate return price on June 27, 2016 with the remainder to be paid in installments in 2017 and 2018. The remaining balance is RMB 407 million (approximately $59 million as of December 31, 2016). Cash Flows from Financing Activities Cash used in financing activities during 2016 primarily reflects share repurchase activity and repayments of long-term debt. Cash used in financing activities during 2015 primarily reflects share repurchase activity under our share repurchase program. Cash provided by financing activities during 2014 primarily reflects funding required to complete the acquisitions of Hefei Sanyo and Indesit. Whirlpool Subsidiary Share Repurchase On July 12, 2016, Whirlpool S.A. (“WHR SA”) and Brasmotor S.A. (“BMT”), both majority-owned indirect subsidiaries of Whirlpool Corporation, issued public announcements in Brazil reporting that Whirlpool do Brasil Ltda., the controlling shareholder of both WHR SA and BMT, intended to acquire the outstanding common and preferred shares of WHR SA and BMT by means of tender offers for the publicly-held shares. At that time, Whirlpool do Brasil Ltda. and other Whirlpool entities held 99.20% of the common and 95.68% of the preferred shares of WHR SA and 99.40% of the common and 93.55% of the preferred shares of BMT. The tender offers were launched in November 2016 and concluded in December 2016. The offer for BMT was successful and will result in the acquisition of 100% of the shares of BMT after the squeeze-out of the remaining minority shareholders. The cost related to this offer was approximately $25 million as of December 2016. The squeeze-out was completed in January 2017, bringing the total cost to approximately $31 million. The WHR SA tender offer was abandoned because the minimum number of interested minority shareholders was not obtained. Financing Arrangements On July 15, 2016, $244 million of 7.75% notes matured and were repaid. On June 15, 2016, $250 million of 6.50% notes matured and were repaid. On May 23, 2016, we completed a debt offering of $500 million principal amount of 4.50% notes due in 2046. The notes contain covenants that limit our ability to incur certain liens or enter into certain sale and lease-back transactions. In addition, if we experience a specific kind of change of control, we are required to make an offer to purchase all of the notes at a purchase price of 101% of the principal amount thereof, plus accrued and unpaid interest. The notes are registered under the Securities Act of 1933, as amended, pursuant to our Registration Statement on Form S-3 (File No. 333-203704) filed with the Securities and Exchange Commission on April 29, 2015. On November 2, 2016, Whirlpool Finance Luxembourg S.à. r.l., an indirect, wholly-owned finance subsidiary of Whirlpool Corporation, completed a debt offering of €500 million (approximately $555 million as of the date of issuance) principal amount of 1.250% notes due in 2026. The Company has fully and unconditionally guaranteed these notes. The notes contain covenants that limit Whirlpool Corporation's ability to incur certain liens or enter into certain sale and lease-back transactions. In addition, if we experience a specific kind of change of control, we are required to make an offer to purchase all of the notes at a purchase price of 101% of the principal amount thereof, plus accrued and unpaid interest. The notes are registered under the Securities Act MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - (CONTINUED) of 1933, as amended, pursuant to our Registration Statement on Form S-3 (File No.333-203704-1) filed with the Securities and Exchange Commission on October 25, 2016 The Company had a total committed credit facilities of approximately $3.1 billion as of December 31, 2016, which is fundamentally unchanged from the committed credit facilitates as of December 31, 2015. The facilities are more geographically diverse and reflect the Company’s growing global operations. The Company believes these facilities are sufficient to support its global operations. We had no borrowings outstanding under the committed credit facilities at December 31, 2016 and 2015, respectively. For additional information about our financing arrangements, see Note 5 of the Notes to the Consolidated Financial Statements. WHIRLPOOL CHINA ACQUISITION On August 12, 2013, Whirlpool's wholly-owned subsidiary, Whirlpool (China) Investment Co., Ltd., reached agreements to acquire a 51% equity stake in Hefei Sanyo, a joint stock company whose shares are listed and traded on the Shanghai Stock Exchange. This transaction was completed on October 24, 2014. Hefei Sanyo has since been renamed to "Whirlpool China Co., Ltd." The aggregate purchase price was RMB 3.4 billion (approximately $551 million at the dates of purchase). The Company funded the total consideration for the shares with cash on hand. The cash paid for the private placement portion of the transaction is considered restricted cash, which is used to fund capital expenditures and technical resources to enhance Whirlpool China’s research and development and working capital, as required by the terms of the Hefei Sanyo acquisition made in October 2014. We expect the acquisition will accelerate Whirlpool's profitable growth in China. During 2014, Whirlpool began integrating the manufacturing, administrative, supply chain and technology operations of Hefei Sanyo. The results of Hefei Sanyo’s operations have been included in the Consolidated Financial Statements beginning October 24, 2014. Hefei Sanyo has an established and broad distribution network that includes a very large number of distribution outlets throughout China. Its significant presence in rural areas complements Whirlpool’s presence in China’s higher-tier cities. With this acquisition, Whirlpool also gained manufacturing scale and a competitive cost structure in the city of Hefei. The ability to consolidate operations offers strong synergies as Whirlpool will provide extensive technical, marketing and product development, combined with Hefei Sanyo’s sales execution and operational strengths, to support the next phase of development in the advancement of Whirlpool China as an important global production and research and development center for the home appliance sector. INDESIT ACQUISITION On December 3, 2014, Whirlpool completed the final step in its acquisition of Indesit. Total consideration paid for Indesit was €1.1 billion (approximately $1.4 billion at the dates of purchase of each step in the transaction) in aggregate net of cash acquired. The Company funded the aggregate purchase price for Indesit through borrowings under its credit facility and commercial paper programs, and repaid a portion of such borrowings through the issuance of an aggregate principal amount of $650 million in senior notes on November 4, 2014 and an aggregate principal amount of €500 million (approximately $525 million as of the date of issuance) in senior notes on March 12, 2015. This transaction has built Whirlpool’s market position within Europe, and we believe will continue to enable sustainable growth given the complementary market positions, product offerings and distribution channels of Whirlpool and Indesit throughout Europe. We expect efficiencies in R&D, capital spending and value chain costs, as well as operational scale with increased volume and the ability to more effectively integrate our product platforms. The results of Indesit’s operations have been included in the Consolidated Financial Statements beginning October 14, 2014. Dividends In April 2016, our Board of Directors approved an 11% increase in our quarterly dividend on our common stock to $1 per share from 90 cents per share. Repurchase Program For additional information about our repurchase program, see Note 8 of the Notes to the Consolidated Financial Statements. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - (CONTINUED) CONTRACTUAL OBLIGATIONS AND FORWARD-LOOKING CASH REQUIREMENTS The following table summarizes our expected cash outflows resulting from financial contracts and commitments: (1) Interest payments related to long-term debt are included in the table above. For additional information about our financing arrangements, see Note 5 of the Notes to the Consolidated Financial Statements. (2) Purchase obligations include our “take-or-pay” contracts with materials vendors and minimum payment obligations to other suppliers. (3) Represents the minimum contributions required for foreign and domestic pension plans based on current interest rates, asset return assumptions, legislative requirements and other actuarial assumptions at December 31, 2016. Management may elect to contribute amounts in addition to those required by law. See Note 12 of the Notes to the Consolidated Financial Statements for additional information. (4) Represents our portion of expected benefit payments under our retiree healthcare plans. (5) For additional information regarding legal settlements, see Note 6 of the Notes to the Consolidated Financial Statements. (6) This table does not include credit facility and commercial paper borrowings. For additional information about short-term borrowings, see Note 5 of the Notes to the Consolidated Financial Statements. This table does not include future anticipated income tax settlements; see Note 11 of the Notes to the Consolidated Financial Statements. OFF-BALANCE SHEET ARRANGEMENTS We have guarantee arrangements in a Brazilian subsidiary. As a standard business practice in Brazil, the subsidiary guarantees customer lines of credit at commercial banks to support purchases following its normal credit policies. If a customer were to default on its line of credit with the bank, our subsidiary would be required to satisfy the obligation with the bank and the receivable would revert back to the subsidiary. At December 31, 2016 and December 31, 2015, the guaranteed amounts totaled $258 million and $260 million, respectively. The fair value of these guarantees were nominal at December 31, 2016 and December 31, 2015. Our subsidiary insures against credit risk for these guarantees, under normal operating conditions, through policies purchased from high-quality underwriters. We had no losses associated with these guarantees in 2016 or 2015. We have guaranteed a $40 million five-year revolving credit facility between certain financial institutions and a not-for-profit entity in connection with a community and economic development project (“Harbor Shores”). The credit facility, which originated in 2008, was refinanced in December 2012 and we renewed our guarantee through 2017. It was also amended in 2015 and reduced from $43 million to $40 million by Harbor Shores in 2016. The fair value of this guarantee was nominal at December 31, 2016 and December 31, 2015. The purpose of Harbor Shores is to stimulate employment and growth in the areas of Benton Harbor and St. Joseph, Michigan. In the event of default, we must satisfy the guarantee of the credit facility up to the amount borrowed at the date of default. In the ordinary course of business, we enter into agreements with financial institutions to issue bank guarantees, letters of credit and surety bonds. These agreements are primarily associated with unresolved tax matters in Brazil, as is customary under local regulations, and governmental obligations related to certain employee benefit arrangements. As of December 31, 2016 and 2015, we had approximately $327 million and $290 million outstanding under these agreements, respectively. CRITICAL ACCOUNTING POLICIES AND ESTIMATES The preparation of financial statements in conformity with generally accepted accounting principles in the United States (GAAP) requires management to make certain estimates and assumptions. We periodically evaluate these estimates and assumptions, which are based on historical experience, changes in the business environment and other factors that management believes to be reasonable under the circumstances. Actual results may differ materially from these estimates. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - (CONTINUED) Pension and Other Postretirement Benefits Accounting for pensions and other postretirement benefits involves estimating the costs of future benefits and attributing the cost over the employee’s expected period of employment. The determination of our obligation and expense for these costs requires the use of certain assumptions. Those key assumptions include the discount rate, expected long-term rate of return on plan assets, life expectancy, and health care cost trend rates. These assumptions are subject to change based on interest rates on high quality bonds, stock and bond markets and medical cost inflation, respectively. Actual results that differ from our assumptions are accumulated and amortized over future periods and therefore, generally affect our recognized expense and accrued liability in such future periods. While we believe that our assumptions are appropriate given current economic conditions and actual experience, significant differences in results or significant changes in our assumptions may materially affect our pension and other postretirement benefit obligations and related future expense. Our pension and other postretirement benefit obligations at December 31, 2016 and preliminary retirement benefit costs for 2017 were prepared using the assumptions that were determined as of December 31, 2016. The following table summarizes the sensitivity of our December 31, 2016 retirement obligations and 2017 retirement benefit costs of our United States plans to changes in the key assumptions used to determine those results: * Projected benefit obligation (PBO) for pension plans and accumulated postretirement benefit obligation (APBO) for other postretirement benefit plans. These sensitivities may not be appropriate to use for other years’ financial results. Furthermore, the impact of assumption changes outside of the ranges shown above may not be approximated by using the above results. For additional information about our pension and other postretirement benefit obligations, see Note 12 of the Notes to the Consolidated Financial Statements. Income Taxes We estimate our income taxes in each of the taxing jurisdictions in which we operate. This involves estimating actual current tax expense together with assessing any temporary differences resulting from the different treatment of certain items, such as the timing for recognizing expenses, for tax and accounting purposes. These differences may result in deferred tax assets or liabilities, which are included in our Consolidated Balance Sheets. We are required to assess the likelihood that deferred tax assets, which include net operating loss carryforwards, foreign tax credits and deductible temporary differences, that are expected to be realizable in future years. Realization of our net operating loss and foreign tax credit deferred tax assets is supported by specific tax planning strategies and, where possible, considers projections of future profitability. If recovery is not more likely than not, we provide a valuation allowance based on estimates of future taxable income in the various taxing jurisdictions, and the amount of deferred taxes that are ultimately realizable. If future taxable income is lower than expected or if tax planning strategies are not available as anticipated, we may record additional valuation allowances through income tax expense in the period such determination is made. Likewise, if we determine that we are able to realize our deferred tax assets in the future in excess of net recorded amounts, an adjustment to the deferred tax asset will benefit income tax expense in the period such determination is made. As of December 31, 2016 and 2015, we had total deferred tax assets of $3.2 billion and $3.3 billion, respectively, net of valuation allowances of $150 million and $286 million, respectively. Our income tax expense has fluctuated considerably over the last five years from $133 million in 2012 to $186 million in the current year. The tax expense has been influenced primarily by U.S. energy tax credits, foreign tax credits, audit settlements and adjustments, tax planning strategies, enacted legislation, and dispersion of global income. Future changes in the effective tax rate will be subject to several factors, including business profitability, tax planning strategies, and enacted tax laws. In addition, we operate within multiple taxing jurisdictions and are subject to audit in these jurisdictions. These audits can involve complex issues, which may require an extended period of time to resolve. For additional information about income taxes, see Notes 1, 6 and 11 of the Notes to the Consolidated Financial Statements. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - (CONTINUED) Legacy Product Corrective Action Reserves In the normal course of business, we engage in investigations of potential quality and safety issues. As part of our ongoing effort to deliver quality products to consumers, we are currently investigating a limited number of potential quality and safety issues globally. As necessary, we undertake to effect repair or replacement of appliances in the event that an investigation leads to the conclusion that such action is warranted. As part of that process, in 2015, Whirlpool engaged in thorough investigations of incident reports associated with two of its dryer production platforms developed by Indesit. These dryer production platforms were developed prior to Whirlpool's acquisition of Indesit in October 2014. This led to Indesit reporting the issue to regulatory authorities for consideration. These discussions determined that corrective action of the affected dryers was required. Whirlpool has implemented modifications at the point of manufacture to ensure that dryers produced after October 2015 are not affected by this issue. An outreach and service campaign is underway to modify dryers that have already been sold. Such dryers were manufactured between April 2004 and October 2015 and sold in the UK and other countries in the EMEA region under the Hotpoint* and Indesit brand names, as well as various other brands owned by other manufacturers, distributors and retailers whose products Indesit produced. As of December 31, 2016, Whirlpool had $162 million of cash expenditures related to the corrective action. We expect the corrective action affecting these dryers to have future cash expenditures in 2017 of $69 million. For additional information about the legacy product corrective action, see Note 6 of the Notes to the Consolidated Financial Statements. Warranty Obligations The estimation of warranty obligations is determined in the same period that revenue from the sale of the related products is recognized. The warranty obligation is based on historical experience and represents our best estimate of expected costs at the time products are sold. Warranty accruals are adjusted for known or anticipated warranty claims as new information becomes available. New product launches require a greater use of judgment in developing estimates until historical experience becomes available. Future events and circumstances could materially change our estimates and require adjustments to the warranty obligations. For additional information about warranty obligations, see Note 6 of the Notes to the Consolidated Financial Statements. Goodwill and Other Intangibles Certain business acquisitions have resulted in the recording of goodwill and trademark assets. Upon acquisition, the purchase price is first allocated to identifiable assets and liabilities, including trademark assets, based on estimated fair value, with any remaining purchase price recorded as goodwill. Primarily, Whirlpool's trademarks and goodwill are considered indefinite-life intangible assets and as such, are not amortized. At December 31, 2016, we had goodwill of approximately $3.0 billion. There have been no changes to our reporting units or allocations of goodwill by reporting units except for the impact of foreign currency. We primarily have trademark assets in our North America, EMEA and Asia operating segments with a total carrying value of approximately $2.6 billion as of December 31, 2016. We perform our annual impairment assessment for goodwill and other indefinite-life intangible assets as of October 1st and more frequently if indicators of impairment exist. In 2016, the Company primarily elected to perform a quantitative analysis using a discounted cash flow model and other valuation techniques, to evaluate goodwill and certain indefinite-life intangible assets. Goodwill Valuations In performing a quantitative assessment, we estimate each reporting units' fair value using the income approach. The income approach uses operating segments projection of estimated operating results and cash flows that are discounted using a weighted-average cost of capital that is determined based on current market conditions. The projection uses management’s best estimates of economic and market conditions over the projected period including growth rates in sales, costs and number of units, estimates of future expected changes in operating margins and cash expenditures. Other estimates and assumptions include terminal value growth rates, future estimates of capital expenditures and changes in future working capital requirements. The estimated fair value of each operating segment is compared to their respective carrying values. *Whirlpool ownership of the Hotpoint brand in the EMEA and Asia Pacific regions is not affiliated with the Hotpoint brand sold in the Americas MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - (CONTINUED) Additionally we validate our estimates of fair value under the income approach by comparing the values of fair value estimates using a market approach. A market approach estimates fair value by applying cash flow multiples to the reporting unit’s operating performance. The multiples are derived from comparable publicly traded companies with similar operating and investment characteristics of the reporting units. We consider the implied control premium and conclude whether the implied control premium is reasonable based on other recent market transactions. If actual results are not consistent with managements’ estimate and assumptions, goodwill may be overstated and a charge against net income would be required, which would adversely affect the Company’s financial statements. Based on the results of our quantitative assessment conducted on October 1, 2016, the fair values of Whirlpool's reporting units continue to exceed their respective carrying values. The range by which the excess fair value of our reporting units' goodwill exceeded their respective carrying values was 4% to 142%. The EMEA reporting unit has excess fair value of 4%. During the fourth quarter 2014, Whirlpool acquired Indesit, resulting in substantially all of the goodwill included in this reporting unit. The range by which the excess fair value of our remaining reporting units' goodwill exceeded their respective carrying values was 70% to 142%. Other Intangible Valuations In performing a quantitative assessment of indefinite life intangible assets other than goodwill, primarily trademarks, we estimate the fair value of these intangible assets using the relief-from-royalty method, which requires assumptions related to projected revenues from our annual long-range plan; assumed royalty rates that could be payable if we did not own the trademark; and a discount rate based on our weighted average cost of capital. If the estimated fair value of the indefinite-lived intangible asset is less than its carrying value, we would recognize an impairment loss. Three trademarks acquired in fourth quarter of 2014 have fair values that exceed their carrying values by less than 10%. The fair values of all other trademarks exceeded their carrying values by more than 10% with the exception of one North American trademark. The fair value of this North American trademark exceeded its carrying value of approximately $1 billion by 6% in 2016 and 5% in 2015. We expect revenue trends for this brand to improve as we continue to execute specific brand investments and product development plans. Additionally, we performed a sensitivity analysis on our estimated fair value noting that a 10% reduction of forecasted revenues, a 50 basis point decrease in royalty rate, or a 50 basis point increase in discount rate would result in an impairment ranging from approximately $22 million to $78 million. If actual results are not consistent with management's estimate and assumptions, trademarks or other indefinite-life intangible assets may be overstated and a charge against net income would be required, which would adversely affect the Company’s financial results of operations. Based on the results of our quantitative assessment performed as of October 1, 2014, impairment of two trademarks was determined to exist, primarily driven by a change in our brand strategy in EMEA as a result of the acquisition of Indesit and resulted in a charge of approximately $12 million in 2014. Our assessment indicates no impairment of any trademarks as of December 31, 2016. For additional information about goodwill and intangible valuations, see Note 2 of the Notes to the Consolidated Financial Statements. ISSUED BUT NOT YET EFFECTIVE ACCOUNTING PRONOUNCEMENTS Additional information regarding recently issued accounting pronouncements can be found in Note 1 of the Notes to the Consolidated Financial Statements. OTHER MATTERS For information regarding certain of our loss contingencies/litigation, see Note 6 of the Consolidated Financial Statements. Antidumping Petition In December 2015, we filed a petition with the U.S. Department of Commerce (DOC) and the United States International Trade Commission (ITC) to address Samsung and LG dumping large residential washers from China. The petition was filed to MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - (CONTINUED) restore fair competition in the United States that will support significant investment in the production of large residential washers and the creation of U.S. jobs. The Whirlpool washers affected by the imports subject in this case are made in Clyde, Ohio. In December 2016, the DOC issued a final determination that Samsung and LG violated U.S. and international trade laws by dumping washers from China into the U.S. As part of the final determination, the DOC also announced certain antidumping margins for Samsung and LG. In January 2017, the ITC voted unanimously that Samsung and LG's dumping had caused material injury to the U.S. washer industry. As in the case of our December 2011 petition, the DOC and ITC decisions will be followed by administrative review procedures and possible appeals over the next several years. Post-Retirement Benefit Litigation For information regarding post-retirement benefit litigation, see Note 12 of the Consolidated Financial Statements. FORWARD-LOOKING STATEMENTS The Private Securities Litigation Reform Act of 1995 provides a safe harbor for forward-looking statements made by us or on our behalf. Certain statements contained in this annual report, including those within the forward-looking perspective section within this Management's Discussion and Analysis, and other written and oral statements made from time to time by us or on our behalf do not relate strictly to historical or current facts and may contain forward-looking statements that reflect our current views with respect to future events and financial performance. As such, they are considered “forward-looking statements” which provide current expectations or forecasts of future events. Such statements can be identified by the use of terminology such as “may,” “could,” “will,” “should,” “possible,” “plan,” “predict,” “forecast,” “potential,” “anticipate,” “estimate,” “expect,” “project,” “intend,” “believe,” “may impact,” “on track,” and similar words or expressions. Our forward-looking statements generally relate to our growth strategies, financial results, product development, and sales efforts. These forward-looking statements should be considered with the understanding that such statements involve a variety of risks and uncertainties, known and unknown, and may be affected by inaccurate assumptions. Consequently, no forward-looking statement can be guaranteed and actual results may vary materially. This document contains forward-looking statements about Whirlpool Corporation and its consolidated subsidiaries (“Whirlpool”) that speak only as of this date. Whirlpool disclaims any obligation to update these statements. Forward-looking statements in this document may include, but are not limited to, statements regarding expected earnings per share, cash flow, productivity and raw material prices. Many risks, contingencies and uncertainties could cause actual results to differ materially from Whirlpool's forward-looking statements. Among these factors are: (1) intense competition in the home appliance industry reflecting the impact of both new and established global competitors, including Asian and European manufacturers; (2) Whirlpool's ability to maintain or increase sales to significant trade customers and the ability of these trade customers to maintain or increase market share; (3) Whirlpool's ability to maintain its reputation and brand image; (4) the ability of Whirlpool to achieve its business plans, productivity improvements, and cost control objectives, and to leverage its global operating platform, and accelerate the rate of innovation; (5) Whirlpool's ability to obtain and protect intellectual property rights; (6) acquisition and investment-related risks, including risks associated with our past acquisitions, and risks associated with our increased presence in emerging markets; (7) risks related to our international operations, including changes in foreign regulations, regulatory compliance and disruptions arising from political, legal and economic instability; (8) information technology system failures, data security breaches, network disruptions, and cybersecurity attacks; (9) product liability and product recall costs; (10) the ability of suppliers of critical parts, components and manufacturing equipment to deliver sufficient quantities to Whirlpool in a timely and cost-effective manner; (11) our ability to attract, develop and retain executives and other qualified employees; (12) the impact of labor relations; (13) fluctuations in the cost of key materials (including steel, resins, copper and aluminum) and components and the ability of Whirlpool to offset cost increases; (14) Whirlpool’s ability to manage foreign currency fluctuations; (15) inventory and other asset risk; (16) the uncertain global economy and changes in economic conditions which affect demand for our products; (17) health care cost trends, regulatory changes and variations between results and estimates that could increase future funding obligations for pension and postretirement benefit plans; (18) litigation, tax, and legal compliance risk and costs, especially if materially different from the amount we expect to incur or have accrued for, and any disruptions caused by the same; (19) the effects and costs of governmental investigations or related actions by third parties; and (20) changes in the legal and regulatory environment including environmental, health and safety regulations. We undertake no obligation to update any forward-looking statement, and investors are advised to review disclosures in our filings with the SEC. It is not possible to foresee or identify all factors that could cause actual results to differ from expected or historic results. Therefore, investors should not consider the foregoing factors to be an exhaustive statement of all risks, uncertainties, or factors that could potentially cause actual results to differ from forward-looking statements. Additional information concerning these and other factors can be found in “Risk Factors” in Item 1A of this report.

<s>[INST] RESULTS OF OPERATIONS This Management Discussion and Analysis should be read in connection with the Consolidated Financial Statements, Notes to the Consolidated Financial Statements and Selected Financial Data included in this Form 10K. Certain references to particular information in the Notes to the Consolidated Financial Statements are made to assist readers. ABOUT WHIRLPOOL Whirlpool is the number one major appliance manufacturer in the world with net sales of approximately $21 billion in 2016. We are a leading producer of major home appliances in North America, Europe and Latin America, and have a significant presence throughout China and India. We have received worldwide recognition for accomplishments in a variety of business and social efforts, including leadership, diversity, innovative product design, business ethics, social responsibility and community involvement. We conduct our business through four reportable segments, which we define based on geography. Our reportable segments consist of North America, EMEA, Latin America and Asia. Our customer base includes large, sophisticated trade customers who have many choices and demand competitive products, services and prices. The major home appliance industry operates in an intensely competitive environment, reflecting the impact of both new and established global competitors, including Asian and European manufacturers. The charts below summarize the balance of net sales by reportable segment for 2016, 2015 and 2014, respectively: We monitor countryspecific economic factors such as gross domestic product, unemployment, consumer confidence, retail trends, housing starts and completions, sales of existing homes and mortgage interest rates as key indicators of industry demand. In addition to profitability, we also focus on country, brand, product and channel sales when assessing and forecasting financial results. Our leading portfolio of brands includes Whirlpool, Maytag, KitchenAid, Embraco, Brastemp, Consul and Indesit. Our global branded consumer products strategy is to introduce innovative new products, increase brand customer loyalty, expand our presence outside the United States, enhance our trade management platform, improve total cost and quality by expanding and leveraging our global operating platform and, where appropriate, make strategic acquisitions and investments. As we grow revenues in our core products, our strategy is to extend our business by offering products and services that are dependent on and related to our core business and expand into adjacent products, such as Affresh cleaners and Gladiator GarageWorks, through businesses that leverage our core competencies and business infrastructure. OVERVIEW During 2016, we had another year of strong performance for Whirlpool Corporation, as we delivered record results through strong operational execution and decisive actions to adjust to changes in global markets. Over the last few years, macroeconomic volatility has been a factor in many of the countries where we operate. We continued to experience volatility during 2016. The Brexit decision in June had a negative impact on British currency and demand, while uncertainty in emerging markets generated additional currency and demand weakness, especially in Brazil, Russia and China. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (CONTINUED) These challenges, along with a further strengthening U.S. dollar, had a combined negative impact of approximately $600 million in revenue and $2 per share of earnings. Our earnings growth and strong cash generation enabled us to create longterm shareholder value through the execution of our balanced capital allocation approach. We invested in our innovation pipeline through $660 million in capital expenditures while increasing our dividend by 11% and repurchasing $525 million in common stock. These investments continue to be supported by a strong balance sheet, an increased capacity to invest and the confidence that our operating plans will deliver extraordinary levels of shareholder value both now and in the future. Our longterm value creation framework is built upon the strong foundation we have in place: our industryleading brand portfolio and robust product innovation pipeline, supported by our best cost global operating platform and executed by our exceptional employees throughout the world. We will measure these valuecreation components by focusing on the following key metrics: Deliver 3 to 5 percent annual organic net sales growth across our global footprint Grow earnings per share by [/INST] Negative. </s>

ALEXANDERS INC

2015-02-17

2014-12-31

ITEM 7. management’s discussion and analysis of financial condition and results of operations Overview Alexander’s, Inc. (NYSE: ALX) is a real estate investment trust (“REIT”), incorporated in Delaware, engaged in leasing, managing, developing and redeveloping its properties. All references to “we,” “us,” “our,” “Company,” and “Alexander’s”, refer to Alexander’s, Inc. and its consolidated subsidiaries. We are managed by, and our properties are leased and developed by, Vornado Realty Trust (“Vornado”) (NYSE: VNO). We have six properties in the greater New York City metropolitan area. We compete with a large number of property owners and developers. Our success depends upon, among other factors, trends of the world, national and local economies, the financial condition and operating results of current and prospective tenants and customers, the availability and cost of capital, construction and renovation costs, taxes, governmental regulations, legislation, population trends, zoning laws, and our ability to lease, sublease or sell our properties, at profitable levels. Our success is also subject to our ability to refinance existing debt on acceptable terms as it comes due. Year Ended December 31, 2014 Financial Results Summary Net income attributable to common stockholders for the year ended December 31, 2014 was $67,925,000, or $13.29 per diluted share, compared to $56,915,000, or $11.14 per diluted share for the year ended December 31, 2013. Net income attributable to common stockholders includes income from discontinued operations (Kings Plaza) of $529,000, or $0.10 per diluted share for the year ended December 31, 2014, compared to $2,252,000, or $0.44 per diluted share for the year ended December 31, 2013. Funds from operations attributable to common stockholders (“FFO”) for the year ended December 31, 2014 was $96,980,000, or $18.98 per diluted share, compared to $85,717,000, or $16.78 per diluted share for the prior year. FFO includes FFO from discontinued operations (Kings Plaza) of $529,000, or $0.10 per diluted share for the year ended December 31, 2014, compared to $2,252,000, or $0.44 per diluted share for the prior year. Quarter Ended December 31, 2014 Financial Results Summary Net income attributable to common stockholders for the quarter ended December 31, 2014 was $18,161,000, or $3.55 per diluted share, compared to $15,790,000, or $3.09 per diluted share for the quarter ended December 31, 2013. Net income attributable to common stockholders includes income from discontinued operations (Kings Plaza) of $529,000, or $0.10 per diluted share for the quarter ended December 31, 2014, compared to $2,252,000, or $0.44 per diluted share for the quarter ended December 31, 2013. FFO for the quarter ended December 31, 2014 was $25,508,000, or $4.99 per diluted share, compared to $23,015,000, or $4.50 per diluted share for the prior year’s quarter. FFO includes FFO from discontinued operations (Kings Plaza) of $529,000, or $0.10 per diluted share for the quarter ended December 31, 2014, compared to $2,252,000, or $0.44 per diluted share for the prior year’s quarter. Overview - continued Square Footage, Occupancy and Leasing Activity As of December 31, 2014 and 2013, our portfolio was comprised of six properties aggregating 2,178,000 square feet that had occupancy rates of 99.7% and 99.4%, respectively. In the year ended December 31, 2014 we leased 7,977 square feet with an average initial rent of $83.62 per square foot and a weighted average lease term of 14.6 years. Significant Tenants Bloomberg L.P. (“Bloomberg”) accounted for $91,109,000, $88,164,000 and $86,468,000, or 45% of our total revenues in each of the years ended December 31, 2014, 2013 and 2012, respectively. No other tenant accounted for more than 10% of our total revenues in any of the last three years. If we were to lose Bloomberg as a tenant, or if Bloomberg were to fail or become unable to perform its obligations under its lease, it would adversely affect our results of operations and financial condition. We receive and evaluate certain confidential financial information and metrics from Bloomberg on a semi-annual basis. In addition, we access and evaluate financial information regarding Bloomberg from private sources, as well as publicly available data. In October 2014, Bloomberg exercised its option to extend leases that were scheduled to expire in December 2015 covering 188,608 square feet of office space at our 731 Lexington Avenue property for a term of 5 years. We are currently in negotiations with Bloomberg to determine the rental rate for the extension period. Financing On February 28, 2014, we completed a $300,000,000 refinancing of the office portion of 731 Lexington Avenue. The interest-only loan is at LIBOR plus 0.95% (1.11% at December 31, 2014) and matures in March 2017, with four one-year extension options. The proceeds of the new loan and existing cash were used to repay the existing loan and closing costs. In connection herewith, we purchased an interest rate cap with a notional amount of $300,000,000 that caps LIBOR at a rate of 6.0%. Critical Accounting Policies and Estimates Our financial statements are prepared in conformity with accounting principles generally accepted in the United States of America (“GAAP”), which requires us to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting periods. Actual results could differ from those estimates. Set forth below is a summary of our accounting policies that we believe are critical to the preparation of our consolidated financial statements. This summary should be read in conjunction with a more complete discussion of our accounting policies included in Note 2 to the consolidated financial statements in this Annual Report on Form 10-K. Real Estate Real estate is carried at cost, net of accumulated depreciation and amortization. As of December 31, 2014 and 2013, the carrying amount of our real estate, net of accumulated depreciation and amortization, was $783,902,000 and $734,201,000, respectively. Maintenance and repairs are expensed as incurred. Depreciation requires an estimate by management of the useful life of each property and improvement as well as an allocation of the costs associated with a property to its various components. If we do not allocate these costs appropriately or incorrectly estimate the useful lives of our real estate, depreciation expense may be misstated. As real estate is undergoing development activities, all property operating expenses directly associated with and attributable to, the development and construction of a project, including interest expense, are capitalized to the cost of the real property to the extent that we believe such costs are recoverable through the value of the property. The capitalization period begins when development activities are underway and ends when the project is substantially complete. General and administrative costs are expensed as incurred. Critical Accounting Policies and Estimates - continued Our properties and related intangible assets, including properties to be developed in the future and currently under development, are individually reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of the assets may not be recoverable. An impairment exists when the carrying amount of an asset exceeds the sum of the undiscounted cash flows expected to result from the use and eventual disposition of the asset. Estimates of future cash flows are based on our current plans, intended holding periods and available market information at the time the analyses are prepared. For our development properties, estimates of future cash flows also include all future expenditures necessary to develop the asset, including interest payments that will be capitalized as part of the cost of the asset. An impairment loss is recognized only if the carrying amount of the asset is not recoverable and is measured based on the excess of the property’s carrying amount over its estimated fair value. If our estimates of future cash flows, anticipated holding periods, or fair values change, based on market conditions or otherwise, our evaluation of impairment charges may be different and such differences could be material to our consolidated financial statements. Estimates of future cash flows are subjective and are based, in part, on assumptions regarding future occupancy, rental rates and capital requirements that could differ materially from actual results. Plans to hold properties over longer periods decrease the likelihood of recording impairment losses. Allowance for Doubtful Accounts We periodically evaluate the collectibility of amounts due from tenants, including the receivable arising from the straight-lining of rents, and maintain an allowance for doubtful accounts ($1,544,000 and $1,993,000 as of December 31, 2014 and 2013, respectively) for estimated losses resulting from the inability of tenants to make required payments under the lease agreements. We exercise judgment in establishing these allowances and consider payment history and current credit status in developing these estimates. These estimates may differ from actual results, which could be material to our consolidated financial statements. Revenue Recognition We have the following revenue sources and revenue recognition policies: · Base Rent - revenue arising from tenant leases. These rents are recognized over the non-cancelable term of the related leases on a straight-line basis, which includes the effects of rent steps and free rent abatements under the leases. We commence rental revenue recognition when the tenant takes possession of the leased space and the leased space is substantially ready for its intended use. In addition, in circumstances where we provide a tenant improvement allowance for improvements that are owned by the tenant, we recognize the allowance as a reduction of rental revenue on a straight-line basis over the term of the lease. · Percentage Rent - revenue arising from retail tenant leases that is contingent upon the sales of tenants exceeding defined thresholds. These rents are recognized only after the contingency has been removed (i.e., when tenant sales thresholds have been achieved). · Expense Reimbursements - revenue arising from tenant leases which provide for the recovery of all or a portion of the operating expenses and real estate taxes of the respective properties. This revenue is accrued in the same periods as the expenses are incurred. · Parking income - revenue arising from the rental of parking space at our properties. This income is recognized as cash is received. Before we recognize revenue, we assess, among other things, its collectibility. If our assessment of the collectibility of revenue changes, the impact on our consolidated financial statements could be material. Income Taxes We operate in a manner intended to enable us to continue to qualify as a Real Estate Investment Trust (“REIT”) under Sections 856 - 860 of the Internal Revenue Code of 1986, as amended (the “Code”). In order to maintain our qualification as a REIT under the Code, we must distribute at least 90% of our taxable income to stockholders each year. We distribute to our stockholders 100% of our taxable income and therefore, no provision for Federal income taxes is required. If we fail to distribute the required amount of income to our stockholders, or fail to meet other REIT requirements, we may fail to qualify as a REIT, which may result in substantial adverse tax consequences. Results of Operations - Year Ended December 31, 2014 compared to December 31, 2013 Property Rentals Property rentals were $136,628,000 in the year ended December 31, 2014, compared to $135,908,000 in the prior year, an increase of $720,000. This increase was primarily due to higher parking revenues. Expense Reimbursements Tenant expense reimbursements were $64,186,000 in the year ended December 31, 2014, compared to $60,551,000 in the prior year, an increase of $3,635,000. This increase was primarily due to higher real estate taxes. Operating Expenses Operating expenses were $69,897,000 in the year ended December 31, 2014, compared to $64,930,000 in the prior year, an increase of $4,967,000. This increase was primarily comprised of higher real estate taxes of $3,536,000 and higher non-reimbursable operating expenses of $1,860,000. Depreciation and Amortization Depreciation and amortization was $29,196,000 in the year ended December 31, 2014, compared to $28,987,000 in the prior year, an increase of $209,000. General and Administrative Expenses General and administrative expenses were $5,032,000 in the year ended December 31, 2014, compared to $5,026,000 in the prior year, an increase of $6,000. Interest and Other Income, net Interest and other income, net was $2,434,000 in the year ended December 31, 2014, compared to $1,527,000 in the prior year, an increase of $907,000. This increase was primarily due to lease termination income of $800,000. Interest and Debt Expense Interest and debt expense was $32,068,000 in the year ended December 31, 2014, compared to $44,540,000 in the prior year, a decrease of $12,472,000. This decrease was primarily due to savings resulting from the refinancing of the office portion of 731 Lexington Avenue. Income Tax Benefit Income tax benefit was $341,000 in the year ended December 31, 2014, compared to $160,000 in the prior year, an increase of $181,000. This increase resulted from a larger reversal of tax liabilities in the current year as compared to the prior year. These liabilities were reversed as a result of the expiration of the applicable statute of limitations. Income from Discontinued Operations Income from discontinued operations was $529,000 in the year ended December 31, 2014, compared to $2,252,000 in the year ended December 31, 2013, a decrease of $1,723,000. Income for the current and prior year primarily represent the reversal of previously accrued liabilities related to Kings Plaza which was sold in November 2012. Results of Operations - Year Ended December 31, 2013 compared to December 31, 2012 Property Rentals Property rentals were $135,908,000 in the year ended December 31, 2013, compared to $134,847,000 in the year ended December 31, 2012, an increase of $1,061,000. This increase was primarily due to higher occupancy. Expense Reimbursements Tenant expense reimbursements were $60,551,000 in the year ended December 31, 2013, compared to $56,465,000 in the year ended December 31, 2012, an increase of $4,086,000. This increase was primarily due to higher real estate taxes and reimbursable operating expenses. Operating Expenses Operating expenses were $64,930,000 in the year ended December 31, 2013, compared to $61,755,000 in the year ended December 31, 2012, an increase of $3,175,000. This increase was primarily comprised of higher (i) real estate taxes of $3,991,000 and (ii) reimbursable operating expenses of $512,000, partially offset by (iii) lower bad debt expense of $1,362,000. Depreciation and Amortization Depreciation and amortization was $28,987,000 in the year ended December 31, 2013, compared to $28,815,000 in the year ended December 31, 2012, an increase of $172,000. General and Administrative Expenses General and administrative expenses were $5,026,000 in the year ended December 31, 2013, compared to $5,162,000 in the year ended December 31, 2012, a decrease of $136,000. Interest and Other Income, net Interest and other income, net was $1,527,000 in the year ended December 31, 2013, compared to $177,000 in the year ended December 31, 2012, an increase of $1,350,000. This increase was primarily due to dividend income in the current year on the Macerich common shares that we received in connection with the sale of Kings Plaza in November 2012. Interest and Debt Expense Interest and debt expense was $44,540,000 in the year ended December 31, 2013, compared to $45,652,000 in the year ended December 31, 2012, a decrease of $1,112,000. This decrease was primarily due to lower average debt balances. Income Tax Benefit (Expense) In the year ended December 31, 2013, we had an income tax benefit of $160,000, compared to an income tax expense of $64,000 in the year ended December 31, 2012, a decrease in expense of $224,000. This decrease resulted from a reduction of our estimated income tax liability due to the expiration of the applicable statute of limitations. Income from Discontinued Operations Income from discontinued operations was $2,252,000 in the year ended December 31, 2013, compared to $624,952,000 in the year ended December 31, 2012, a decrease of $622,700,000. Income for the year ended December 31, 2013 represents the reversal of previously accrued liabilities related to Kings Plaza. Income for the year ended December 31, 2012 is comprised of a $599,628,000 net gain on sale of Kings Plaza and $25,324,000 of income from the operations of the property prior to its sale in November 2012. Net Income Attributable to the Noncontrolling Interest Net income attributable to the noncontrolling interest was $606,000 in the year ended December 31, 2012, and represents our venture partner’s 75% pro-rata share of the net income from the Kings Plaza energy plant joint venture, which was sold together with Kings Plaza in November 2012. Related Party Transactions Vornado Steven Roth is the Chairman of our Board of Directors and Chief Executive Officer, the Managing General Partner of Interstate Properties (“Interstate”), a New Jersey general partnership, and the Chairman of the Board of Trustees and Chief Executive Officer of Vornado. At December 31, 2014, Mr. Roth, Interstate and its other two general partners, David Mandelbaum and Russell B. Wight, Jr. (who are also directors of the Company and trustees of Vornado) owned, in the aggregate, 26.3% of our outstanding common stock, in addition to the 2.1% they indirectly own through Vornado. Joseph Macnow, our Executive Vice President and Chief Financial Officer, is the Executive Vice President - Finance and Chief Administrative Officer of Vornado. Stephen W. Theriot, our Assistant Treasurer, is the Chief Financial Officer of Vornando. At December 31, 2014, Vornado owned 32.4% of our outstanding common stock. We are managed by, and our properties are leased and developed by, Vornado, pursuant to various agreements, which expire in March of each year and are automatically renewable. These agreements are described in Note 3 - Related Party Transactions, to our consolidated financial statements in this Annual Report on Form 10-K. Liquidity and Capital Resources Property rental income is our primary source of cash flow and is dependent on a number of factors including the occupancy level and rental rates of our properties, as well as our tenants’ ability to pay their rents. Our properties provide us with a relatively consistent stream of cash flow that enables us to pay our operating expenses, interest expense, recurring capital expenditures and cash dividends to stockholders. Other sources of liquidity to fund cash requirements include our existing cash, proceeds from financings, including mortgage or construction loans secured by our properties and proceeds from asset sales. We anticipate that cash flows from continuing operations over the next twelve months, together with existing cash balances, will be adequate to fund our business operations, cash dividends to stockholders, debt amortization, recurring capital expenditures and development expenditures related to the Rego Park II apartment tower. Dividends On January 21, 2015, we increased our regular quarterly dividend to $3.50 per share (a new indicated annual rate of $14.00 per share). The new dividend, if continued for all of 2015, would require us to pay out approximately $71,600,000. Development Project We are in the process of constructing an apartment tower above our Rego II shopping center, containing 312 units aggregating 255,000 square feet, which is expected to be completed in 2015. The estimated cost of this project is approximately $125,000,000, of which $73,327,000 has been incurred as of December 31, 2014. There can be no assurance that the project will be completed, or completed on schedule or within budget. Financing Activities and Contractual Obligations Below is a summary of our outstanding debt and maturities as of December 31, 2014. We intend to refinance our maturing debt as it comes due. Below is a summary of our contractual obligations and commitments as of December 31, 2014. Liquidity and Capital Resources - continued Commitments and Contingencies Insurance We maintain general liability insurance with limits of $300,000,000 per occurrence and all-risk property and rental value insurance coverage with limits of $1.7 billion per occurrence, including coverage for acts of terrorism, with sub-limits for certain perils such as floods and earthquakes on each of our properties. Fifty Ninth Street Insurance Company, LLC (“FNSIC”), our wholly owned consolidated subsidiary, acts as a direct insurer for coverage for acts of terrorism, including nuclear, biological, chemical and radiological (“NBCR”) acts, as defined by the Terrorism Risk Insurance Program Reauthorization Act, which expires in December 2020. Coverage for acts of terrorism (including NBCR acts) is up to $1.7 billion per occurrence and in the aggregate. Coverage for acts of terrorism (excluding NBCR acts) is fully reinsured by third party insurance companies with no exposure to FNSIC. For NBCR acts, FNSIC is responsible for a $275,000 deductible and 15% of the balance (16% effective January 1, 2016) of a covered loss, and the Federal government is responsible for the remaining 85% (84% effective January 1, 2016) of a covered loss. We are ultimately responsible for any loss incurred by FNSIC. We continue to monitor the state of the insurance market and the scope and costs of coverage for acts of terrorism. However, we cannot anticipate what coverage will be available on commercially reasonable terms in the future. We are responsible for deductibles and losses in excess of our insurance coverage, which could be material. Our mortgage loans are non-recourse to us, except for $75,000,000 of the $320,000,000 mortgage on the retail portion of our 731 Lexington Avenue property, in the event of a substantial casualty, as defined. Our mortgage loans contain customary covenants requiring us to maintain insurance. Although we believe that we have adequate insurance coverage for purposes of these agreements, we may not be able to obtain an equivalent amount of coverage at reasonable costs in the future. If lenders insist on greater coverage than we are able to obtain, it could adversely affect our ability to finance our properties. Litigation Rego Park I On June 24, 2014, Sears Roebuck and Co. (“Sears”) filed a lawsuit in the Supreme Court of the State of New York against Vornado and us (and certain of our subsidiaries) with regard to space that Sears leases at our Rego Park I property. Sears alleges that the defendants are liable for harm Sears has suffered as a result of (a) water intrusions into the premises Sears leases, (b) two fires in February 2014 that caused damages to those premises, and (c) alleged violations of the Americans with Disabilities Act in the premises’ parking garage. Sears asserts various causes of actions for damages and seeks to compel compliance with landlord’s obligations to repair the premises and to provide security, and to compel us to abate a nuisance that Sears claims was a cause of the water intrusions into its premises. In addition to injunctive relief, Sears seeks, among other things, damages of not less than $4 million and future damages it estimates will not be less than $25 million. We intend to defend the claims vigorously; the amount or range of reasonable possible losses, if any, cannot be estimated. Paramus In 2001, we leased 30.3 acres of land located in Paramus, New Jersey to IKEA Property, Inc. The lease has a purchase option in 2021 for $75,000,000. The property is encumbered by a $68,000,000 interest-only mortgage loan with a fixed rate of 2.90%, which matures in October 2018. The annual triple-net rent is the sum of $700,000 plus the amount of debt service on the mortgage loan. If the purchase option is exercised, we will receive net cash proceeds of approximately $7,000,000 and recognize a gain on sale of land of approximately $60,000,000. If the purchase option is not exercised, the triple-net rent for the last 20 years would include debt service sufficient to fully amortize $68,000,000 over the remaining 20-year lease term. Other There are various legal actions against us in the ordinary course of business. In our opinion, the outcome of such matters in the aggregate will not have a material effect on our financial condition, results of operations or cash flows. Liquidity and Capital Resources - continued Cash Flows Cash and cash equivalents were $227,815,000 at December 31, 2014, compared to $347,718,000 at December 31, 2013, a decrease of $119,903,000. This decrease resulted from $87,870,000 of net cash used in financing activities and $81,520,000 of net cash used in investing activities, partially offset by $49,487,000 of net cash provided by operating activities. Our consolidated outstanding debt was $1,032,780,000 at December 31, 2014, a $17,179,000 decrease from the balance at December 31, 2013. Year Ended December 31, 2014 Net cash provided by operating activities of $49,487,000 was comprised of net income of $67,925,000 and $29,355,000 of adjustments for non-cash items, partially offset by $47,793,000 for the net change in operating assets and liabilities. The adjustments for non-cash items were primarily comprised of depreciation and amortization of $31,919,000, partially offset by straight-lining of rental income of $2,538,000. The change in operating assets and liabilities was primarily due to the payment of accrued leasing commissions to Vornado of $40,353,000. Net cash used in investing activities of $81,520,000 was primarily comprised of $61,964,000 of construction in progress and real estate additions, primarily related to the development of our Rego Park II Apartment Tower, and purchases of short-term investments of $24,998,000. Net cash used in financing activities of $87,870,000 was primarily comprised of (i) debt repayments of $317,179,000 (primarily repayment of the loan on the office portion of 731 Lexington Avenue) and (ii) dividends paid on common stock of $66,436,000, partially offset by (iii) $300,000,000 of proceeds from the refinancing of the office portion of 731 Lexington Avenue. Year Ended December 31, 2013 Cash and cash equivalents were $347,718,000 at December 31, 2013, compared to $353,396,000 at December 31, 2012, a decrease of $5,678,000. This decrease resulted from $72,241,000 of net cash used in financing activities and $7,320,000 of net cash used in investing activities, partially offset by $73,883,000 of net cash provided by operating activities. Net cash provided by operating activities of $73,883,000 was comprised of net income of $56,915,000 and $27,876,000 of adjustments for non-cash items, partially offset by $10,908,000 for the net change in operating assets and liabilities. The adjustments for non-cash items were primarily comprised of depreciation and amortization of $31,395,000, partially offset by straight-lining of rental income of $3,707,000. Net cash used in investing activities of $7,320,000 was primarily comprised of $7,671,000 of construction in progress and real estate additions. Net cash used in financing activities of $72,241,000 was primarily comprised of dividends paid on common stock of $56,197,000 and debt repayments of $15,957,000. Liquidity and Capital Resources - continued Year Ended December 31, 2012 Cash and cash equivalents were $353,396,000 at December 31, 2012, compared to $506,619,000 at December 31, 2011, a decrease of $153,223,000. This decrease resulted from $973,007,000 of net cash used in financing activities, partially offset by $710,077,000 of net cash provided by investing activities and $109,707,000 of net cash provided by operating activities. Net cash provided by operating activities was $109,707,000, of which $34,896,000 was related to discontinued operations. Net cash provided by operating activities was comprised of net income of $674,993,000, and $2,154,000 for the net change in operating assets and liabilities, partially offset by $567,440,000 of adjustments for non-cash items. The adjustments for non-cash items were primarily comprised of a net gain on the sale of real estate of $599,628,000 and straight-lining of rental income of $4,475,000, partially offset by depreciation and amortization of $36,363,000. Net cash provided by investing activities of $710,077,000 was comprised of (i) net proceeds from the sale of real estate of $714,054,000 (excluding $30,000,000 of stock consideration) and (ii) proceeds from maturing short-term investments of $5,000,000, partially offset by (iii) $7,351,000 of construction in progress and real estate additions, primarily related to our Rego Park II property and (iv) an increase in restricted cash of $1,626,000. Net cash used in financing activities of $973,007,000 was primarily comprised of (i) dividends paid on common stock of $699,791,000, which included a special dividend of $623,178,000 to distribute the tax gain on the sale of Kings Plaza, (ii) repayment of the Kings Plaza debt of $250,000,000 upon the sale of the property, (iii) debt repayments of $15,016,000 and (iv) a payment of $7,800,000 to acquire the noncontrolling interest in the Kings Plaza energy plant joint venture, which was sold with the mall. Funds from Operations (“FFO”) FFO is computed in accordance with the definition adopted by the Board of Governors of the National Association of Real Estate Investment Trusts (“NAREIT”). NAREIT defines FFO as GAAP net income or loss adjusted to exclude net gains from sales of depreciated real estate assets, real estate impairment losses, depreciation and amortization expense from real estate assets, extraordinary items and other specified non-cash items, including the pro rata share of such adjustments of unconsolidated subsidiaries. FFO and FFO per diluted share are used by management, investors and analysts to facilitate meaningful comparisons of operating performance between periods and among our peers because it excludes the effect of real estate depreciation and amortization and net gains on sales, which are based on historical costs and implicitly assume that the value of real estate diminishes predictably over time, rather than fluctuating based on existing market conditions. FFO does not represent cash generated from operating activities and is not necessarily indicative of cash available to fund cash requirements and should not be considered as an alternative to net income as a performance measure or cash flow as a liquidity measure. FFO may not be comparable to similarly titled measures employed by other companies. A reconciliation of our net income to FFO is provided below. FFO attributable to common stockholders for the year ended December 31, 2014 was $96,980,000, or $18.98 per diluted share, compared to $85,717,000, or $16.78 per diluted share for the prior year. FFO attributable to common stockholders includes FFO from discontinued operations (Kings Plaza) of $529,000, or $0.10 per diluted share for the year ended December 31, 2014, compared to $2,252,000, or $0.44 per diluted share for the prior year. FFO attributable to common stockholders for the quarter ended December 31, 2014 was $25,508,000, or $4.99 per diluted share, compared to $23,015,000, or $4.50 per diluted share for the prior year’s quarter. FFO attributable to common stockholders includes FFO from discontinued operations (Kings Plaza) of $529,000, or $0.10 per diluted share for the quarter ended December 31, 2014, compared to $2,252,000, or $0.44 per diluted share for the prior year’s quarter. The following table reconciles our net income to FFO:

<s>[INST] Alexander’s, Inc. (NYSE: ALX) is a real estate investment trust (“REIT”), incorporated in Delaware, engaged in leasing, managing, developing and redeveloping its properties. All references to “we,” “us,” “our,” “Company,” and “Alexander’s”, refer to Alexander’s, Inc. and its consolidated subsidiaries. We are managed by, and our properties are leased and developed by, Vornado Realty Trust (“Vornado”) (NYSE: VNO). We have six properties in the greater New York City metropolitan area. We compete with a large number of property owners and developers. Our success depends upon, among other factors, trends of the world, national and local economies, the financial condition and operating results of current and prospective tenants and customers, the availability and cost of capital, construction and renovation costs, taxes, governmental regulations, legislation, population trends, zoning laws, and our ability to lease, sublease or sell our properties, at profitable levels. Our success is also subject to our ability to refinance existing debt on acceptable terms as it comes due. Year Ended December 31, 2014 Financial Results Summary Net income attributable to common stockholders for the year ended December 31, 2014 was $67,925,000, or $13.29 per diluted share, compared to $56,915,000, or $11.14 per diluted share for the year ended December 31, 2013. Net income attributable to common stockholders includes income from discontinued operations (Kings Plaza) of $529,000, or $0.10 per diluted share for the year ended December 31, 2014, compared to $2,252,000, or $0.44 per diluted share for the year ended December 31, 2013. Funds from operations attributable to common stockholders (“FFO”) for the year ended December 31, 2014 was $96,980,000, or $18.98 per diluted share, compared to $85,717,000, or $16.78 per diluted share for the prior year. FFO includes FFO from discontinued operations (Kings Plaza) of $529,000, or $0.10 per diluted share for the year ended December 31, 2014, compared to $2,252,000, or $0.44 per diluted share for the prior year. Quarter Ended December 31, 2014 Financial Results Summary Net income attributable to common stockholders for the quarter ended December 31, 2014 was $18,161,000, or $3.55 per diluted share, compared to $15,790,000, or $3.09 per diluted share for the quarter ended December 31, 2013. Net income attributable to common stockholders includes income from discontinued operations (Kings Plaza) of $529,000, or $0.10 per diluted share for the quarter ended December 31, 2014, compared to $2,252,000, or $0.44 per diluted share for the quarter ended December 31, 2013. FFO for the quarter ended December 31, 2014 was $25,508,000, or $4.99 per diluted share, compared to $23,015,000, or $4.50 per diluted share for the prior year’s quarter. FFO includes FFO from discontinued operations (Kings Plaza) of $529,000, or $0.10 per diluted share for the quarter ended December 31, 2014, compared to $2,252,000, or $0.44 per diluted share for the prior year’s quarter. Overview continued [/INST] Negative. </s>

ALEXANDERS INC

2016-02-16

2015-12-31

ITEM 7. management’s discussion and analysis of financial condition and results of operations Overview Alexander’s, Inc. (NYSE: ALX) is a real estate investment trust (“REIT”), incorporated in Delaware, engaged in leasing, managing, developing and redeveloping its properties. All references to “we,” “us,” “our,” “Company,” and “Alexander’s”, refer to Alexander’s, Inc. and its consolidated subsidiaries. We are managed by, and our properties are leased and developed by, Vornado Realty Trust (“Vornado”) (NYSE: VNO). We have seven properties in the greater New York City metropolitan area. We compete with a large number of property owners and developers. Our success depends upon, among other factors, trends of the global, national and local economies, the financial condition and operating results of current and prospective tenants and customers, the availability and cost of capital, construction and renovation costs, taxes, governmental regulations, legislation, population and employment trends, zoning laws, and our ability to lease, sublease or sell our properties, at profitable levels. Our success is also subject to our ability to refinance existing debt on acceptable terms as it comes due. Year Ended December 31, 2015 Financial Results Summary Net income for the year ended December 31, 2015 was $76,907,000, or $15.04 per diluted share, compared to $67,925,000, or $13.29 per diluted share for the year ended December 31, 2014. Funds from operations (“FFO”) for the year ended December 31, 2015 was $107,648,000, or $21.06 per diluted share, compared to $96,980,000, or $18.98 per diluted share for the year ended December 31, 2014. Quarter Ended December 31, 2015 Financial Results Summary Net income for the quarter ended December 31, 2015 was $23,572,000, or $4.61 per diluted share, compared to $18,161,000, or $3.55 per diluted share for the quarter ended December 31, 2014. FFO for the quarter ended December 31, 2015 was $31,730,000, or $6.21 per diluted share, compared to $25,508,000, or $4.99 per diluted share for the quarter ended December 31, 2014. Overview - continued Square Footage, Occupancy and Leasing Activity As of December 31, 2015 our portfolio was comprised of seven properties aggregating 2,437,000 square feet. As of December 31, 2015, our office and retail properties had an occupancy rate of 99.7% and the Alexander apartment tower had an occupancy rate of 25.6%. Significant Tenants Bloomberg L.P. (“Bloomberg”) accounted for $94,468,000, $91,109,000 and $88,164,000, or approximately 45% of our total revenues in each of the years ended December 31, 2015, 2014 and 2013, respectively. No other tenant accounted for more than 10% of our total revenues. If we were to lose Bloomberg as a tenant, or if Bloomberg were to be unable to fulfill its obligations under its lease, it would adversely affect our results of operations and financial condition. In order to assist us in our continuing assessment of Bloomberg’s creditworthiness, we receive certain confidential financial information and metrics from Bloomberg. In addition, we access and evaluate financial information regarding Bloomberg from other private sources, as well as publicly available data. In October 2014, Bloomberg exercised its option to extend leases that were scheduled to expire in December 2015 for a term of five years, covering 192,000 square feet of office space at our 731 Lexington Avenue property. In January 2016, we entered into a lease amendment with Bloomberg which extends the lease term related to this space to be coterminous with the other 697,000 square feet of office space leased by Bloomberg through February 2029, with a ten-year extension option. In connection with the lease amendment, Bloomberg provided a $200,000,000 letter of credit, which amount may be reduced in certain circumstances. We may draw on this letter of credit subject to certain terms of the lease amendment, including an event of default by Bloomberg. Financing In August 2015, we completed a $350,000,000 refinancing of the retail portion of 731 Lexington Avenue. The interest-only loan is at LIBOR plus 1.40% (1.67% as of December 31, 2015) and matures in August 2020, with two one-year extension options. Critical Accounting Policies and Estimates Our financial statements are prepared in conformity with accounting principles generally accepted in the United States of America (“GAAP”), which requires us to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting periods. Actual results could differ from those estimates. Set forth below is a summary of our accounting policies that we believe are critical to the preparation of our consolidated financial statements. This summary should be read in conjunction with a more complete discussion of our accounting policies included in Note 2 to the consolidated financial statements in this Annual Report on Form 10-K. Real Estate Real estate is carried at cost, net of accumulated depreciation and amortization. As of December 31, 2015 and 2014, the carrying amount of our real estate, net of accumulated depreciation and amortization, was $803,939,000 and $783,902,000, respectively. Maintenance and repairs are expensed as incurred. Depreciation requires an estimate by management of the useful life of each property and improvement as well as an allocation of the costs associated with a property to its various components. If we do not allocate these costs appropriately or incorrectly estimate the useful lives of our real estate, depreciation expense may be misstated. We capitalize all property operating expenses directly associated with and attributable to, the development and construction of a project, including interest expense. The capitalization period begins when development activities are underway and ends when it is determined that the asset is substantially complete and ready for its intended use, which is typically evidenced by the receipt of a temporary certificate of occupancy. General and administrative costs are expensed as incurred. Critical Accounting Policies and Estimates - continued Our properties and related intangible assets, including properties to be developed in the future and currently under development, are individually reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of the assets may not be recoverable. An impairment exists when the carrying amount of an asset exceeds the sum of the undiscounted cash flows expected to result from the use and eventual disposition of the asset. Estimates of future cash flows are based on our current plans, intended holding periods and available market information at the time the analyses are prepared. For our development properties, estimates of future cash flows also include all future expenditures necessary to develop the asset, including interest payments that will be capitalized as part of the cost of the asset. An impairment loss is recognized only if the carrying amount of the asset is not recoverable and is measured based on the excess of the property’s carrying amount over its estimated fair value. If our estimates of future cash flows, anticipated holding periods, or fair values change, based on market conditions or otherwise, our evaluation of impairment charges may be different and such differences could be material to our consolidated financial statements. Estimates of future cash flows are subjective and are based, in part, on assumptions regarding future occupancy, rental rates and capital requirements that could differ materially from actual results. Plans to hold properties over longer periods decrease the likelihood of recording impairment losses. Allowance for Doubtful Accounts We periodically evaluate the collectibility of amounts due from tenants, including the receivable arising from the straight-lining of rents, and maintain an allowance for doubtful accounts ($918,000 and $1,544,000 as of December 31, 2015 and 2014, respectively) for estimated losses resulting from the inability of tenants to make required payments under the lease agreements. We exercise judgment in establishing these allowances and consider payment history and current credit status in developing these estimates. These estimates may differ from actual results, which could be material to our consolidated financial statements. Revenue Recognition We have the following revenue sources and revenue recognition policies: · Base Rent - revenue arising from tenant leases. These rents are recognized over the non-cancelable term of the related leases on a straight-line basis, which includes the effects of rent steps and free rent abatements under the leases. We commence rental revenue recognition when the tenant takes possession of the leased space and the leased space is substantially ready for its intended use. In addition, in circumstances where we provide a tenant improvement allowance for improvements that are owned by the tenant, we recognize the allowance as a reduction of rental revenue on a straight-line basis over the term of the lease. · Percentage Rent - revenue arising from retail tenant leases that is contingent upon the sales of tenants exceeding defined thresholds. These rents are recognized only after the contingency has been removed (i.e., when tenant sales thresholds have been achieved). · Expense Reimbursements - revenue arising from tenant leases which provide for the recovery of all or a portion of the operating expenses and real estate taxes of the respective properties. This revenue is accrued in the same periods as the expenses are incurred. · Parking income - revenue arising from the rental of parking space at our properties. This income is recognized as cash is received. Before we recognize revenue, we assess, among other things, its collectibility. If our assessment of the collectibility of revenue changes, the impact on our consolidated financial statements could be material. Income Taxes We operate in a manner intended to enable us to continue to qualify as a REIT under Sections 856 - 860 of the Internal Revenue Code of 1986, as amended (the “Code”). In order to maintain our qualification as a REIT under the Code, we must distribute at least 90% of our taxable income to stockholders each year. We distribute to our stockholders 100% of our taxable income and therefore, no provision for Federal income taxes is required. If we fail to distribute the required amount of income to our stockholders, or fail to meet other REIT requirements, we may fail to qualify as a REIT, which may result in substantial adverse tax consequences. Results of Operations - Year Ended December 31, 2015 compared to December 31, 2014 Property Rentals Property rentals were $138,688,000 in the year ended December 31, 2015, compared to $136,628,000 in the prior year, an increase of $2,060,000. This increase was primarily due to higher straight-line rental income of $979,000 at our 731 Lexington Avenue property resulting from the extensions of two of Bloomberg’s leases in October 2014 that were scheduled to expire in December 2015. In addition, there was higher straight-line rental income of $524,000 from a new tenant at our Rego Park II property and rental income of $364,000 from leasing activity at The Alexander apartment tower, of which 93% was placed in service during the second half of 2015. Expense Reimbursements Tenant expense reimbursements were $69,227,000 in the year ended December 31, 2015, compared to $64,186,000 in the prior year, an increase of $5,041,000. This increase was primarily due to higher reimbursable real estate taxes and higher reimbursable operating expenses. Operating Expenses Operating expenses were $76,218,000 in the year ended December 31, 2015, compared to $69,897,000 in the prior year, an increase of $6,321,000. This increase was due to (i) higher real estate taxes of $4,438,000; (ii) higher reimbursable operating expenses of $1,904,000; and (iii) higher operating expenses of $1,565,000 related to The Alexander apartment tower; partially offset by (iv) lower bad debt expense of $1,019,000 and lower non-reimbursable expenses of $567,000. Depreciation and Amortization Depreciation and amortization was $31,086,000 in the year ended December 31, 2015, compared to $29,196,000 in the prior year, an increase of $1,890,000. This increase was primarily due to depreciation related to the portion of The Alexander apartment tower that was placed in service during the second half of 2015. General and Administrative Expenses General and administrative expenses were $5,406,000 in the year ended December 31, 2015, compared to $5,032,000 in the prior year, an increase of $374,000. This increase was primarily due to higher stock-based compensation expense as a result of deferred stock units granted to a newly appointed member of our Board of Directors during the second quarter of 2015, comprised of an initial award of $150,000 and a $56,000 annual award. Interest and Other Income, net Interest and other income, net was $5,949,000 in the year ended December 31, 2015, compared to $2,434,000 in the prior year, an increase of $3,515,000. This increase was primarily due to (i) $2,141,000 of dividend income from our investment in common shares of Macerich and (ii) $2,100,000 of income in connection with a settlement agreement with a former bankrupt tenant at our Rego Park I property, partially offset by (iii) lease termination income of $800,000 in the prior year. Interest and Debt Expense Interest and debt expense was $24,239,000 in the year ended December 31, 2015, compared to $32,068,000 in the prior year, a decrease of $7,829,000. This decrease was primarily due to (i) savings of $4,160,000 resulting from the refinancing of the retail portion of 731 Lexington Avenue on August 5, 2015 at LIBOR plus 1.40%, or 1.67% as of December 31, 2015 (the prior loan had a fixed rate of 4.93%); (ii) savings of $2,081,000 resulting from the refinancing of the office portion of 731 Lexington Avenue on February 28, 2014 at LIBOR plus 0.95%, or 1.28% as of December 31, 2015 (the prior loan had a fixed rate of 5.33%); and (iii) higher capitalized interest costs of $883,000 during the current year related to the development of The Alexander apartment tower. Income Taxes Income tax expense was $8,000 in the year ended December 31, 2015, compared to an income tax benefit of $341,000 in the prior year. The income tax benefit in the prior year resulted from a reversal of tax liabilities after the expiration of the applicable statute of limitations. Income from Discontinued Operations Income from discontinued operations was $529,000 in the year ended December 31, 2014, representing the reversal of previously accrued liabilities related to Kings Plaza, which was sold in November 2012. Results of Operations - Year Ended December 31, 2014 compared to December 31, 2013 Property Rentals Property rentals were $136,628,000 in the year ended December 31, 2014, compared to $135,908,000 in the prior, an increase of $720,000. This increase was primarily due to higher parking revenues. Expense Reimbursements Tenant expense reimbursements were $64,186,000 in the year ended December 31, 2014, compared to $60,551,000 in the year ended December 31, 2013, an increase of $3,635,000. This increase was primarily due to higher real estate taxes. Operating Expenses Operating expenses were $69,897,000 in the year ended December 31, 2014, compared to $64,930,000 in the prior year, an increase of $4,967,000. This increase was primarily comprised of higher real estate taxes of $3,536,000 and higher non-reimbursable operating expenses of $1,860,000. Depreciation and Amortization Depreciation and amortization was $29,196,000 in the year ended December 31, 2014, compared to $28,987,000 in the prior year, an increase of $209,000. General and Administrative Expenses General and administrative expenses were $5,032,000 in the year ended December 31, 2014, compared to $5,026,000 in the prior year, an increase of $6,000. Interest and Other Income, net Interest and other income, net was $2,434,000 in the year ended December 31, 2014, compared to $1,527,000 in the prior year, an increase of $907,000. This increase was primarily due to lease termination income of $800,000. Interest and Debt Expense Interest and debt expense was $32,068,000 in the year ended December 31, 2014, compared to $44,540,000 in the prior year, a decrease of $12,472,000. This decrease was primarily due to savings resulting from the refinancing of the office portion of 731 Lexington Avenue. Income Tax Benefit Income tax benefit was $341,000 in the year ended December 31, 2014, compared to $160,000 in the prior year, an increase of $181,000. This increase resulted from a larger reversal of tax liabilities in 2014 as compared to 2013. These liabilities were reversed as a result of the expiration of the applicable statute of limitations. Income from Discontinued Operations Income from discontinued operations was $529,000 in the year ended December 31, 2014, compared to $2,252,000 in the year ended December 31, 2013, a decrease of $1,723,000. Income for 2014 and 2013 primarily represents the reversal of previously accrued liabilities related to Kings Plaza which was sold in November 2012. Related Party Transactions Vornado Steven Roth is the Chairman of our Board of Directors and Chief Executive Officer, the Managing General Partner of Interstate Properties (“Interstate”), a New Jersey general partnership, and the Chairman of the Board of Trustees and Chief Executive Officer of Vornado. As of December 31, 2015, Mr. Roth, Interstate and its other two general partners, David Mandelbaum and Russell B. Wight, Jr. (who are also directors of the Company and trustees of Vornado) owned, in the aggregate, 26.3% of our outstanding common stock, in addition to the 2.2% they indirectly own through Vornado. Joseph Macnow, our Executive Vice President and Chief Financial Officer, is the Executive Vice President - Finance and Chief Administrative Officer of Vornado. Stephen W. Theriot, our Assistant Treasurer, is the Chief Financial Officer of Vornando. As of December 31, 2015, Vornado owned 32.4% of our outstanding common stock. We are managed by, and our properties are leased and developed by, Vornado, pursuant to various agreements, which expire in March of each year and are automatically renewable. These agreements are described in Note 3 - Related Party Transactions, to our consolidated financial statements in this Annual Report on Form 10-K. Liquidity and Capital Resources Property rental income is our primary source of cash flow and is dependent on a number of factors including the occupancy level and rental rates of our properties, as well as our tenants’ ability to pay their rents. Our properties provide us with a relatively consistent stream of cash flow that enables us to pay our operating expenses, interest expense, recurring capital expenditures and cash dividends to stockholders. Other sources of liquidity to fund cash requirements include our existing cash, proceeds from financings, including mortgage or construction loans secured by our properties and proceeds from asset sales. We anticipate that cash flows from continuing operations over the next twelve months, together with existing cash balances, will be adequate to fund our business operations, cash dividends to stockholders, debt amortization, recurring capital expenditures and development expenditures related to The Alexander apartment tower. Dividends On January 20, 2016, we increased our regular quarterly dividend to $4.00 per share (a new indicated annual rate of $16.00 per share). The new dividend, if continued for all of 2016, would require us to pay out approximately $82,000,000. The Alexander Apartment Tower The Alexander apartment tower, located above our Rego Park II shopping center, contains 312 units aggregating 255,000 square feet. The estimated cost of this project is approximately $125,000,000, of which $118,540,000 (including a development fee payable to Vornado) has been incurred as of December 31, 2015. We expect to incur the remaining costs during the first quarter of 2016. In December 2015, we received an updated TCO covering approximately 93% of the apartment tower where construction has been substantially completed, and accordingly 93% has been placed in service. We expect to receive the TCO for the remaining 7% in 2016. During the year ended December 31, 2015, we leased 84 of the 312 units. We expect to reach stabilized occupancy in 2017. Financing Activities and Contractual Obligations Below is a summary of our outstanding debt and maturities as of December 31, 2015. We intend to refinance our maturing debt as it comes due. Below is a summary of our contractual obligations and commitments as of December 31, 2015. Liquidity and Capital Resources - continued Commitments and Contingencies Insurance We maintain general liability insurance with limits of $300,000,000 per occurrence and per property, and all-risk property and rental value insurance coverage with limits of $1.7 billion per occurrence, including coverage for acts of terrorism, with sub-limits for certain perils such as floods and earthquakes on each of our properties. Fifty Ninth Street Insurance Company, LLC (“FNSIC”), our wholly owned consolidated subsidiary, acts as a direct insurer for coverage for acts of terrorism, including nuclear, biological, chemical and radiological (“NBCR”) acts, as defined by the Terrorism Risk Insurance Program Reauthorization Act, which expires in December 2020. Coverage for acts of terrorism (including NBCR acts) is up to $1.7 billion per occurrence and in the aggregate. Coverage for acts of terrorism (excluding NBCR acts) is fully reinsured by third party insurance companies with no exposure to FNSIC. For NBCR acts, FNSIC is responsible for a $275,000 deductible ($348,000 effective January 1, 2016) and 15% of the balance (16% effective January 1, 2016) of a covered loss, and the Federal government is responsible for the remaining 85% (84% effective January 1, 2016) of a covered loss. We are ultimately responsible for any loss incurred by FNSIC. We continue to monitor the state of the insurance market and the scope and costs of coverage for acts of terrorism. However, we cannot anticipate what coverage will be available on commercially reasonable terms in the future. We are responsible for deductibles and losses in excess of our insurance coverage, which could be material. Our mortgage loans are non-recourse to us and contain customary covenants requiring us to maintain insurance. Although we believe that we have adequate insurance coverage for purposes of these agreements, we may not be able to obtain an equivalent amount of coverage at reasonable costs in the future. If lenders insist on greater coverage than we are able to obtain, it could adversely affect our ability to finance our properties. Rego Park I Litigation On June 24, 2014, Sears Roebuck and Co. (“Sears”) filed a lawsuit in the Supreme Court of the State of New York against Vornado and us (and certain of our subsidiaries) with regard to space that Sears leases at our Rego Park I property. Sears alleges that the defendants are liable for harm Sears has suffered as a result of (a) water intrusions into the premises, (b) two fires in February 2014 that caused damages to those premises, and (c) alleged violations of the Americans with Disabilities Act in the premises’ parking garage. Sears asserts various causes of actions for damages and seeks to compel compliance with landlord’s obligations to repair the premises and to provide security, and to compel us to abate a nuisance that Sears claims was a cause of the water intrusions into its premises. In addition to injunctive relief, Sears seeks, among other things, damages of not less than $4 million and future damages it estimates will not be less than $25 million. We intend to defend the claims vigorously. The amount or range of reasonable possible losses, if any, cannot be estimated. Paramus In 2001, we leased 30.3 acres of land located in Paramus, New Jersey to IKEA Property, Inc. The lease has a purchase option in 2021 for $75,000,000. The property is encumbered by a $68,000,000 interest-only mortgage loan with a fixed rate of 2.90%, which matures in October 2018. The annual triple-net rent is the sum of $700,000 plus the amount of debt service on the mortgage loan. If the purchase option is exercised, we will receive net cash proceeds of approximately $7,000,000 and recognize a gain on sale of land of approximately $60,000,000. If the purchase option is not exercised, the triple-net rent for the last 20 years would include debt service sufficient to fully amortize $68,000,000 over the remaining 20-year lease term. Letters of Credit Approximately $2,074,000 of standby letters of credit were outstanding as of December 31, 2015. Other In October 2015, the New York City Department of Finance (“NYC DOF”) issued a Notice of Determination to us assessing an additional $20,300,000 of transfer taxes (including interest and penalties) in connection with the sale of Kings Plaza in November 2012. We believe that the NYC DOF’s claim is without merit and intend to vigorously contest this assessment. We have determined that the likelihood of a loss related to this issue is not probable and, after consultation with legal counsel, that the outcome of this assessment is not expected to have a material adverse effect on our financial position, results of operations or cash flows. Liquidity and Capital Resources - continued Other - Continued In October 2015, we entered into a settlement agreement with a former bankrupt tenant at our Rego Park I property. During the fourth quarter of 2015, we received approximately $2,100,000 from the bankruptcy estate, which is included as “interest and other income, net” in our consolidated statement of income for the year ended December 31, 2015. There are various other legal actions against us in the ordinary course of business. In our opinion, the outcome of such matters in the aggregate will not have a material effect on our financial position, results of operations or cash flows. Cash Flows Cash and cash equivalents were $259,349,000 at December 31, 2015, compared to $227,815,000 at December 31, 2014, an increase of $31,534,000. This increase resulted from (i) $106,201,000 of net cash provided by operating activities partially offset by (ii) $48,839,000 of net cash used in financing activities and (iii) $25,828,000 of net cash used in investing activities. Year Ended December 31, 2015 Net cash provided by operating activities of $106,201,000 was comprised of net income of $76,907,000 and $32,853,000 of adjustments for non-cash items, partially offset by $3,559,000 for the net change in operating assets and liabilities. The adjustments for non-cash items were primarily comprised of depreciation and amortization of $33,671,000, partially offset by straight-lining of rental income of $1,418,000. Net cash used in investing activities of $25,828,000 was primarily comprised of construction in progress and real estate additions of $50,121,000 (primarily related to The Alexander apartment tower) partially offset by proceeds of $24,998,000 from short-term investments that matured during the second quarter of 2015. Net cash used in financing activities of $48,839,000 was primarily comprised of (i) debt repayments of $323,193,000 (primarily repayment of the prior loan on the retail portion of 731 Lexington Avenue) and (ii) dividends paid of $71,571,000, partially offset by (iii) $350,000,000 of proceeds from the refinancing of the retail portion of 731 Lexington Avenue in August 2015. Year Ended December 31, 2014 Net cash provided by operating activities of $49,487,000 was comprised of net income of $67,925,000 and $29,355,000 of adjustments for non-cash items, partially offset by $47,793,000 for the net change in operating assets and liabilities. The adjustments for non-cash items were primarily comprised of depreciation and amortization of $31,919,000, partially offset by straight-lining of rental income of $2,538,000. The change in operating assets and liabilities was primarily due to the payment of accrued leasing commissions to Vornado of $40,353,000. Net cash used in investing activities of $81,520,000 was primarily comprised of $61,964,000 of construction in progress and real estate additions, primarily related to the development of The Alexander apartment tower, and purchases of short-term investments of $24,998,000. Net cash used in financing activities of $87,870,000 was primarily comprised of (i) debt repayments of $317,179,000 (primarily repayment of the loan on the office portion of 731 Lexington Avenue) and (ii) dividends paid on common stock of $66,436,000, partially offset by (iii) $300,000,000 of proceeds from the refinancing of the office portion of 731 Lexington Avenue. Liquidity and Capital Resources - continued Year Ended December 31, 2013 Net cash provided by operating activities of $73,883,000 was comprised of net income of $56,915,000 and $27,876,000 of adjustments for non-cash items, partially offset by $10,908,000 for the net change in operating assets and liabilities. The adjustments for non-cash items were primarily comprised of depreciation and amortization of $31,395,000, partially offset by straight-lining of rental income of $3,707,000. Net cash used in investing activities of $7,320,000 was primarily comprised of $7,671,000 of construction in progress and real estate additions. Net cash used in financing activities of $72,241,000 was primarily comprised of dividends paid on common stock of $56,197,000 and debt repayments of $15,957,000. Funds from Operations (“FFO”) FFO is computed in accordance with the definition adopted by the Board of Governors of the National Association of Real Estate Investment Trusts (“NAREIT”). NAREIT defines FFO as GAAP net income or loss adjusted to exclude net gains from sales of depreciated real estate assets, real estate impairment losses, depreciation and amortization expense from real estate assets and other specified non-cash items, including the pro rata share of such adjustments of unconsolidated subsidiaries. FFO and FFO per diluted share are used by management, investors and analysts to facilitate meaningful comparisons of operating performance between periods and among our peers because it excludes the effect of real estate depreciation and amortization and net gains on sales, which are based on historical costs and implicitly assume that the value of real estate diminishes predictably over time, rather than fluctuating based on existing market conditions. FFO does not represent cash generated from operating activities and is not necessarily indicative of cash available to fund cash requirements and should not be considered as an alternative to net income as a performance measure or cash flow as a liquidity measure. FFO may not be comparable to similarly titled measures employed by other companies. A reconciliation of our net income to FFO is provided below. FFO for the year ended December 31, 2015 was $107,648,000, or $21.06 per diluted share, compared to $96,980,000, or $18.98 per diluted share for the prior year. FFO for the quarter ended December 31, 2015 was $31,730,000, or $6.21 per diluted share, compared to $25,508,000, or $4.99 per diluted share for the prior year’s quarter. The following table reconciles our net income to FFO:

<s>[INST] Alexander’s, Inc. (NYSE: ALX) is a real estate investment trust (“REIT”), incorporated in Delaware, engaged in leasing, managing, developing and redeveloping its properties. All references to “we,” “us,” “our,” “Company,” and “Alexander’s”, refer to Alexander’s, Inc. and its consolidated subsidiaries. We are managed by, and our properties are leased and developed by, Vornado Realty Trust (“Vornado”) (NYSE: VNO). We have seven properties in the greater New York City metropolitan area. We compete with a large number of property owners and developers. Our success depends upon, among other factors, trends of the global, national and local economies, the financial condition and operating results of current and prospective tenants and customers, the availability and cost of capital, construction and renovation costs, taxes, governmental regulations, legislation, population and employment trends, zoning laws, and our ability to lease, sublease or sell our properties, at profitable levels. Our success is also subject to our ability to refinance existing debt on acceptable terms as it comes due. Year Ended December 31, 2015 Financial Results Summary Net income for the year ended December 31, 2015 was $76,907,000, or $15.04 per diluted share, compared to $67,925,000, or $13.29 per diluted share for the year ended December 31, 2014. Funds from operations (“FFO”) for the year ended December 31, 2015 was $107,648,000, or $21.06 per diluted share, compared to $96,980,000, or $18.98 per diluted share for the year ended December 31, 2014. Quarter Ended December 31, 2015 Financial Results Summary Net income for the quarter ended December 31, 2015 was $23,572,000, or $4.61 per diluted share, compared to $18,161,000, or $3.55 per diluted share for the quarter ended December 31, 2014. FFO for the quarter ended December 31, 2015 was $31,730,000, or $6.21 per diluted share, compared to $25,508,000, or $4.99 per diluted share for the quarter ended December 31, 2014. Overview continued Square Footage, Occupancy and Leasing Activity As of December 31, 2015 our portfolio was comprised of seven properties aggregating 2,437,000 square feet. As of December 31, 2015, our office and retail properties had an occupancy rate of 99.7% and the Alexander apartment tower had an occupancy rate of 25.6%. Significant Tenants Bloomberg L.P. (“Bloomberg”) accounted for $94,468,000, $91,109,000 and $88,164,000, or approximately 45% of our total revenues in each of the years ended December 31, 2015, 2014 and 2013, respectively. No other tenant accounted for more than 10% of our total revenues. If we were to lose Bloomberg as a tenant, or if Bloomberg were to be unable to fulfill its obligations under its lease, it would adversely affect our results of operations and financial condition. In order to assist us in our continuing assessment of Bloomberg’s creditworthiness, we receive certain confidential financial information and metrics from Bloomberg. In addition, we access and evaluate financial information regarding Bloomberg from other private sources, as well as publicly available data. In October 2014, Bloomberg exercised its option to extend leases that were scheduled to expire in December 201 [/INST] Positive. </s>

ALEXANDERS INC

2017-02-13

2016-12-31

ITEM 7. management’s discussion and analysis of financial condition and results of operations Overview Alexander’s, Inc. (NYSE: ALX) is a real estate investment trust (“REIT”), incorporated in Delaware, engaged in leasing, managing, developing and redeveloping its properties. All references to “we,” “us,” “our,” “Company,” and “Alexander’s”, refer to Alexander’s, Inc. and its consolidated subsidiaries. We are managed by, and our properties are leased and developed by, Vornado Realty Trust (“Vornado”) (NYSE: VNO). We have seven properties in the greater New York City metropolitan area. We compete with a large number of property owners and developers. Our success depends upon, among other factors, trends of the global, national and local economies, the financial condition and operating results of current and prospective tenants and customers, the availability and cost of capital, construction and renovation costs, taxes, governmental regulations, legislation, population and employment trends, zoning laws, and our ability to lease, sublease or sell our properties, at profitable levels. Our success is also subject to our ability to refinance existing debt on acceptable terms as it comes due. Year Ended December 31, 2016 Financial Results Summary Net income for the year ended December 31, 2016 was $86,477,000, or $16.91 per diluted share, compared to $76,907,000, or $15.04 per diluted share for the year ended December 31, 2015. Funds from operations (“FFO”) for the year ended December 31, 2016 was $119,780,000, or $23.42 per diluted share, compared to $107,648,000, or $21.06 per diluted share for the year ended December 31, 2015. Quarter Ended December 31, 2016 Financial Results Summary Net income for the quarter ended December 31, 2016 was $21,655,000, or $4.23 per diluted share, compared to $23,572,000, or $4.61 per diluted share for the quarter ended December 31, 2015. FFO for the quarter ended December 31, 2016 was $29,582,000, or $5.78 per diluted share, compared to $31,730,000, or $6.21 per diluted share for the quarter ended December 31, 2015. Net income and FFO for the quarter ended December 31, 2015 included $3,911,000, or $0.77 per diluted share from a special dividend from an investment in marketable securities and higher income from bankruptcy recoveries. Overview - continued Square Footage, Occupancy and Leasing Activity As of December 31, 2016 our portfolio was comprised of seven properties aggregating 2,437,000 square feet. As of December 31, 2016, our properties had an occupancy rate of 99.8%. Significant Tenants Bloomberg accounted for $104,590,000, $94,468,000 and $91,109,000, representing approximately 46%, 45% and 45% of our total revenues in each of the years ended December 31, 2016, 2015 and 2014, respectively. No other tenant accounted for more than 10% of our total revenues. If we were to lose Bloomberg as a tenant, or if Bloomberg were to be unable to fulfill its obligations under its lease, it would adversely affect our results of operations and financial condition. In order to assist us in our continuing assessment of Bloomberg’s creditworthiness, we receive certain confidential financial information and metrics from Bloomberg. In addition, we access and evaluate financial information regarding Bloomberg from other private sources, as well as publicly available data. In January 2016, we entered into a lease amendment with Bloomberg which extends the lease term related to 192,000 square feet of office space at our 731 Lexington Avenue property to be coterminous with the other 697,000 square feet of office space leased by Bloomberg through February 2029, with a ten-year extension option. In connection with the lease amendment, Bloomberg provided a $200,000,000 letter of credit, which amount may be reduced in certain circumstances. We may draw on this letter of credit subject to certain terms of the lease amendment, including an event of default by Bloomberg. Financing In March 2016 we completed a two-year extension of the 100% cash collateralized loan with a balance of $78,246,000 as of December 31, 2016. The loan bears interest at 0.35%, is prepayable at any time without penalty and matures in March 2018. Critical Accounting Policies and Estimates Our financial statements are prepared in conformity with accounting principles generally accepted in the United States of America (“GAAP”), which requires us to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting periods. Actual results could differ from those estimates. Set forth below is a summary of our accounting policies that we believe are critical to the preparation of our consolidated financial statements. This summary should be read in conjunction with a more complete discussion of our accounting policies included in Note 2 - Summary of Significant Accounting Policies, to the consolidated financial statements in this Annual Report on Form 10-K. Real Estate Real estate is carried at cost, net of accumulated depreciation and amortization. As of December 31, 2016 and 2015, the carrying amount of our real estate, net of accumulated depreciation and amortization, was $780,814,000 and $803,939,000, respectively. Maintenance and repairs are expensed as incurred. Depreciation requires an estimate by management of the useful life of each property and improvement as well as an allocation of the costs associated with a property to its various components. If we do not allocate these costs appropriately or incorrectly estimate the useful lives of our real estate, depreciation expense may be misstated. We capitalize all property operating expenses directly associated with and attributable to, the development and construction of a project, including interest expense. The capitalization period begins when development activities are underway and ends when it is determined that the asset is substantially complete and ready for its intended use, which is typically evidenced by the receipt of a temporary certificate of occupancy. General and administrative costs are expensed as incurred. Critical Accounting Policies and Estimates - continued Our properties and related intangible assets, including properties to be developed in the future and currently under development, are individually reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of the assets may not be recoverable. An impairment exists when the carrying amount of an asset exceeds the sum of the undiscounted cash flows expected to result from the use and eventual disposition of the asset. Estimates of future cash flows are based on our current plans, intended holding periods and available market information at the time the analyses are prepared. For our development properties, estimates of future cash flows also include all future expenditures necessary to develop the asset, including interest payments that will be capitalized as part of the cost of the asset. An impairment loss is recognized only if the carrying amount of the asset is not recoverable and is measured based on the excess of the property’s carrying amount over its estimated fair value. If our estimates of future cash flows, anticipated holding periods, or fair values change, based on market conditions or otherwise, our evaluation of impairment charges may be different and such differences could be material to our consolidated financial statements. Estimates of future cash flows are subjective and are based, in part, on assumptions regarding future occupancy, rental rates and capital requirements that could differ materially from actual results. Plans to hold properties over longer periods decrease the likelihood of recording impairment losses. Allowance for Doubtful Accounts We periodically evaluate the collectibility of amounts due from tenants, including the receivable arising from the straight-lining of rents, and maintain an allowance for doubtful accounts ($1,473,000 and $918,000 as of December 31, 2016 and 2015, respectively) for estimated losses resulting from the inability of tenants to make required payments under the lease agreements. We exercise judgment in establishing these allowances and consider payment history and current credit status in developing these estimates. These estimates may differ from actual results, which could be material to our consolidated financial statements. Revenue Recognition We have the following revenue sources and revenue recognition policies: · Base Rent - revenue arising from tenant leases. These rents are recognized over the non-cancelable term of the related leases on a straight-line basis, which includes the effects of rent steps and free rent abatements under the leases. We commence rental revenue recognition when the tenant takes possession of the leased space and the leased space is substantially ready for its intended use. In addition, in circumstances where we provide a tenant improvement allowance for improvements that are owned by the tenant, we recognize the allowance as a reduction of rental revenue on a straight-line basis over the term of the lease. · Percentage Rent - revenue arising from retail tenant leases that is contingent upon the sales of tenants exceeding defined thresholds. These rents are recognized only after the contingency has been removed (i.e., when tenant sales thresholds have been achieved). · Expense Reimbursements - revenue arising from tenant leases which provide for the recovery of all or a portion of the operating expenses and real estate taxes of the respective properties. This revenue is recognized in the same periods as the expenses are incurred. · Parking income - revenue arising from the rental of parking space at our properties. This income is recognized as the service is provided. Before we recognize revenue, we assess, among other things, its collectibility. If our assessment of the collectibility of revenue changes, the impact on our consolidated financial statements could be material. Income Taxes We operate in a manner intended to enable us to continue to qualify as a REIT under Sections 856 - 860 of the Internal Revenue Code of 1986, as amended (the “Code”). In order to maintain our qualification as a REIT under the Code, we must distribute at least 90% of our taxable income to stockholders each year. We distribute to our stockholders 100% of our taxable income and therefore, no provision for Federal income taxes is required. If we fail to distribute the required amount of income to our stockholders, or fail to meet other REIT requirements, we may fail to qualify as a REIT, which may result in substantial adverse tax consequences. Results of Operations - Year Ended December 31, 2016 compared to December 31, 2015 Property Rentals Property rentals were $151,444,000 in the year ended December 31, 2016, compared to $138,688,000 in the prior year, an increase of $12,756,000. This increase was primarily due to (i) rental income of $7,271,000 from The Alexander apartment tower, which was placed in service in phases beginning July 2015, (ii) higher rental income of $3,366,000 from the January 2016 lease amendment with Bloomberg at 731 Lexington Avenue and (iii) income of $2,257,000 resulting from a tenant lease termination at our Rego Park II property. Expense Reimbursements Tenant expense reimbursements were $75,492,000 in the year ended December 31, 2016, compared to $69,227,000 in the prior year, an increase of $6,265,000. This increase was primarily due to (i) higher recoveries of real estate taxes and operating expenses from Bloomberg at 731 Lexington Avenue as a result of the January 2016 lease amendment, which converted 192,000 square feet from a gross basis to a net rent basis and (ii) higher reimbursable real estate taxes, partially offset by (iii) lower reimbursable operating expenses. Operating Expenses Operating expenses were $82,232,000 in the year ended December 31, 2016, compared to $76,218,000 in the prior year, an increase of $6,014,000. This increase was primarily due to (i) higher operating expenses of $2,494,000 related to The Alexander apartment tower, which was placed in service in phases beginning July 2015, (ii) higher reimbursable real estate taxes of $3,703,000 and (iii) higher bad debt expense of $871,000, partially offset by (iv) lower reimbursable operating expenses of $1,068,000. Depreciation and Amortization Depreciation and amortization was $33,807,000 in the year ended December 31, 2016, compared to $31,086,000 in the prior year, an increase of $2,721,000. This increase was primarily due to additional depreciation related to The Alexander apartment tower, which was placed in service in phases beginning July 2015. General and Administrative Expenses General and administrative expenses were $5,436,000 in the year ended December 31, 2016, compared to $5,406,000 in the prior year, an increase of $30,000. Interest and Other Income, net Interest and other income, net was $3,305,000 in the year ended December 31, 2016, compared to $5,949,000 in the prior year, a decrease of $2,644,000. This decrease was primarily due to $2,141,000 from a special dividend from our investment in common shares of Macerich in 2015 and lower income of $1,275,000 in connection with bankruptcy recoveries. Interest and Debt Expense Interest and debt expense was $22,241,000 in the year ended December 31, 2016, compared to $24,239,000 in the prior year, a decrease of $1,998,000. This decrease was primarily due to savings of $5,631,000 resulting from the refinancing of the retail portion of 731 Lexington Avenue on August 5, 2015 at LIBOR plus 1.40%, or 2.05% as of December 31, 2016 (the prior loan had a fixed rate of 4.93%); partially offset by lower capitalized interest of $1,486,000 as a result of completing the development of The Alexander apartment tower and higher average LIBOR of $2,066,000. Income Taxes Income tax expense was $48,000 in the year ended December 31, 2016, compared to $8,000 in the prior year. Results of Operations - Year Ended December 31, 2015 compared to December 31, 2014 Property Rentals Property rentals were $138,688,000 in the year ended December 31, 2015, compared to $136,628,000 in the prior year, an increase of $2,060,000. This increase was primarily due to higher straight-line rental income of $979,000 at our 731 Lexington Avenue property resulting from the extensions of two of Bloomberg’s leases in October 2014 that were scheduled to expire in December 2015. In addition, there was higher straight-line rental income of $524,000 from a new tenant at our Rego Park II property and rental income of $364,000 from leasing activity at The Alexander apartment tower, which was placed in service in phases beginning July 2015. Expense Reimbursements Tenant expense reimbursements were $69,227,000 in the year ended December 31, 2015, compared to $64,186,000 in the prior year, an increase of $5,041,000. This increase was primarily due to higher reimbursable real estate taxes and higher reimbursable operating expenses. Operating Expenses Operating expenses were $76,218,000 in the year ended December 31, 2015, compared to $69,897,000 in the prior year, an increase of $6,321,000. This increase was due to (i) higher real estate taxes of $4,438,000; (ii) higher reimbursable operating expenses of $1,904,000; and (iii) higher operating expenses of $1,565,000 related to The Alexander apartment tower, which was placed in service in phases beginning July 2015, partially offset by (iv) lower bad debt expense of $1,019,000 and lower non-reimbursable expenses of $567,000. Depreciation and Amortization Depreciation and amortization was $31,086,000 in the year ended December 31, 2015, compared to $29,196,000 in the prior year, an increase of $1,890,000. This increase was primarily due to depreciation related to The Alexander apartment tower, which was placed in service in phases beginning July 2015. General and Administrative Expenses General and administrative expenses were $5,406,000 in the year ended December 31, 2015, compared to $5,032,000 in the prior year, an increase of $374,000. This increase was primarily due to higher stock-based compensation expense as a result of deferred stock units granted to a newly appointed member of our Board of Directors during the second quarter of 2015, comprised of an initial award of $150,000 and a $56,000 annual award. Interest and Other Income, net Interest and other income, net was $5,949,000 in the year ended December 31, 2015, compared to $2,434,000 in the prior year, an increase of $3,515,000. This increase was primarily due to (i) $2,141,000 from a special dividend from our investment in common shares of Macerich and (ii) $2,100,000 of income in connection with bankruptcy recoveries, partially offset by (iii) lease termination income of $800,000 in the prior year. Interest and Debt Expense Interest and debt expense was $24,239,000 in the year ended December 31, 2015, compared to $32,068,000 in the prior year, a decrease of $7,829,000. This decrease was primarily due to (i) savings of $4,160,000 resulting from the refinancing of the retail portion of 731 Lexington Avenue on August 5, 2015 at LIBOR plus 1.40%, or 1.67% as of December 31, 2015 (the prior loan had a fixed rate of 4.93%); (ii) savings of $2,081,000 resulting from the refinancing of the office portion of 731 Lexington Avenue on February 28, 2014 at LIBOR plus 0.95%, or 1.28% as of December 31, 2015 (the prior loan had a fixed rate of 5.33%); and (iii) higher capitalized interest costs of $883,000 during the current year related to the development of The Alexander apartment tower. Income Taxes Income tax expense was $8,000 in the year ended December 31, 2015, compared to an income tax benefit of $341,000 in the prior year. The income tax benefit in the prior year resulted from a reversal of tax liabilities after the expiration of the applicable statute of limitations. Income from Discontinued Operations Income from discontinued operations was $529,000 in the year ended December 31, 2014, representing the reversal of previously accrued liabilities related to Kings Plaza Regional Shopping Center (“Kings Plaza”), which was sold in 2012. Related Party Transactions Vornado Steven Roth is the Chairman of our Board of Directors and Chief Executive Officer, the Managing General Partner of Interstate Properties (“Interstate”), a New Jersey general partnership, and the Chairman of the Board of Trustees and Chief Executive Officer of Vornado. As of December 31, 2016, Mr. Roth, Interstate and its other two general partners, David Mandelbaum and Russell B. Wight, Jr. (who are also directors of the Company and trustees of Vornado) owned, in the aggregate, 26.3% of our outstanding common stock, in addition to the 2.2% they indirectly own through Vornado. Joseph Macnow, our Executive Vice President and Chief Financial Officer, is the Executive Vice President - Finance and Chief Administrative Officer of Vornado. Stephen W. Theriot, our Assistant Treasurer, is the Chief Financial Officer of Vornado. As of December 31, 2016, Vornado owned 32.4% of our outstanding common stock. We are managed by, and our properties are leased and developed by, Vornado, pursuant to various agreements, which expire in March of each year and are automatically renewable. These agreements are described in Note 3 - Related Party Transactions, to our consolidated financial statements in this Annual Report on Form 10-K. Toys “R” Us (“Toys”) As of December 31, 2016, our affiliate, Vornado owned 32.5% of Toys. Toys leases approximately 47,000 square feet of retail space at our Rego Park II shopping center. Joseph Macnow, our Executive Vice President and Chief Financial Officer, and Vornado’s Executive Vice President - Finance and Chief Administrative Officer and Wendy A. Silverstein, a member of our Board of Directors, represent Vornado as members of Toys’ Board of Directors. During the year ended December 31, 2016, we recognized $2,675,000 of revenue related to the space leased by Toys. Liquidity and Capital Resources Property rental income is our primary source of cash flow and is dependent on a number of factors including the occupancy level and rental rates of our properties, as well as our tenants’ ability to pay their rents. Our properties provide us with a relatively consistent stream of cash flow that enables us to pay our operating expenses, interest expense, recurring capital expenditures and cash dividends to stockholders. Other sources of liquidity to fund cash requirements include our existing cash, proceeds from financings, including mortgage or construction loans secured by our properties and proceeds from asset sales. We anticipate that cash flows from continuing operations over the next twelve months, together with existing cash balances, will be adequate to fund our business operations, cash dividends to stockholders, debt amortization and capital expenditures. Dividends On January 18, 2017, we increased our regular quarterly dividend to $4.25 per share (a new indicated annual rate of $17.00 per share). The new dividend, if continued for all of 2017, would require us to pay out approximately $86,900,000. Financing Activities and Contractual Obligations Below is a summary of our outstanding debt and maturities as of December 31, 2016. We intend to refinance our maturing debt as it comes due. Below is a summary of our contractual obligations and commitments as of December 31, 2016. Liquidity and Capital Resources - continued Commitments and Contingencies Insurance We maintain general liability insurance with limits of $300,000,000 per occurrence and per property, and all-risk property and rental value insurance coverage with limits of $1.7 billion per occurrence, including coverage for acts of terrorism, with sub-limits for certain perils such as floods and earthquakes on each of our properties. Fifty Ninth Street Insurance Company, LLC (“FNSIC”), our wholly owned consolidated subsidiary, acts as a direct insurer for coverage for acts of terrorism, including nuclear, biological, chemical and radiological (“NBCR”) acts, as defined by the Terrorism Risk Insurance Program Reauthorization Act, which expires in December 2020. Coverage for acts of terrorism (including NBCR acts) is up to $1.7 billion per occurrence and in the aggregate. Coverage for acts of terrorism (excluding NBCR acts) is fully reinsured by third party insurance companies and the Federal government with no exposure to FNSIC. For NBCR acts, FNSIC is responsible for a $348,000 deductible ($293,000 effective January 1, 2017) and 16% of the balance (17% effective January 1, 2017) of a covered loss, and the Federal government is responsible for the remaining 84% (83% effective January 1, 2017) of a covered loss. We are ultimately responsible for any loss incurred by FNSIC. We continue to monitor the state of the insurance market and the scope and costs of coverage for acts of terrorism. However, we cannot anticipate what coverage will be available on commercially reasonable terms in the future. We are responsible for deductibles and losses in excess of our insurance coverage, which could be material. Our mortgage loans are non-recourse to us and contain customary covenants requiring us to maintain insurance. Although we believe that we have adequate insurance coverage for purposes of these agreements, we may not be able to obtain an equivalent amount of coverage at reasonable costs in the future. If lenders insist on greater coverage than we are able to obtain, it could adversely affect our ability to finance our properties. Rego Park I Litigation On June 24, 2014, Sears filed a lawsuit in the Supreme Court of the State of New York against Vornado and us (and certain of our subsidiaries) with regard to space that Sears leases at our Rego Park I property alleging that the defendants are liable for harm Sears has suffered as a result of (a) water intrusions into the premises, (b) two fires in February 2014 that caused damages to those premises, and (c) alleged violations of the Americans with Disabilities Act in the premises’ parking garage. Sears asserted various causes of actions for damages and sought to compel compliance with landlord’s obligations to repair the premises and to provide security, and to compel us to abate a nuisance that Sears claims was a cause of the water intrusions into its premises. In addition to injunctive relief, Sears sought, among other things, damages of not less than $4 million and future damages it estimated would not be less than $25 million. In March 2016, Sears withdrew its claim for future damages leaving a remaining claim for property damages, which we estimate to be approximately $650,000 based on information provided by Sears. We intend to defend the remaining claim vigorously. The amount or range of reasonable possible losses, if any, is not expected to be greater than $650,000. Paramus In 2001, we leased 30.3 acres of land located in Paramus, New Jersey to IKEA Property, Inc. The lease has a purchase option in 2021 for $75,000,000. The property is encumbered by a $68,000,000 interest-only mortgage loan with a fixed rate of 2.90%, which matures in October 2018. The annual triple-net rent is the sum of $700,000 plus the amount of debt service on the mortgage loan. If the purchase option is exercised, we will receive net cash proceeds of approximately $7,000,000 and recognize a gain on sale of land of approximately $60,000,000. If the purchase option is not exercised, the triple-net rent for the last 20 years would include debt service sufficient to fully amortize $68,000,000 over the remaining 20-year lease term. Letters of Credit Approximately $2,074,000 of standby letters of credit were outstanding as of December 31, 2016. Other In October 2015, the New York City Department of Finance (“NYC DOF”) issued a Notice of Determination to us assessing an additional $21,300,000 of transfer taxes (including interest and penalties as of December 31, 2016) in connection with the sale of Kings Plaza in 2012. We believe that the NYC DOF’s claim is without merit and intend to vigorously contest this assessment. We have determined that the likelihood of a loss related to this issue is not probable and, after consultation with legal counsel, that the outcome of this assessment is not expected to have a material adverse effect on our financial position, results of operations or cash flows. Liquidity and Capital Resources - continued Other - Continued During the years ended December 31, 2016 and 2015, we received approximately $825,000 and $2,100,000 from bankruptcy recoveries, respectively, which is included as “interest and other income, net” in our consolidated statements of income. There are various other legal actions against us in the ordinary course of business. In our opinion, the outcome of such matters in the aggregate will not have a material effect on our financial position, results of operations or cash flows. Cash Flows Cash and cash equivalents were $288,926,000 at December 31, 2016, compared to $259,349,000 at December 31, 2015, an increase of $29,577,000. This increase resulted from (i) $130,820,000 of net cash provided by operating activities, partially offset by (ii) $85,292,000 of net cash used in financing activities and (iii) $15,951,000 of net cash used in investing activities. Year Ended December 31, 2016 Net cash provided by operating activities of $130,820,000 was comprised of net income of $86,477,000, adjustments for non-cash items of $39,171,000, and the net change in operating assets and liabilities of $5,172,000. The adjustments for non-cash items were primarily comprised of depreciation and amortization (including amortization of debt issuance costs) of $36,374,000 and straight-lining of rental income of $2,347,000. Net cash used in investing activities of $15,951,000 was primarily comprised of construction in progress and real estate additions of $15,506,000 (primarily related to The Alexander apartment tower), including the payment of a development fee to Vornado of $5,784,000. Net cash used in financing activities of $85,292,000 was primarily comprised of dividends paid of $81,822,000. Year Ended December 31, 2015 Net cash provided by operating activities of $106,201,000 was comprised of net income of $76,907,000 and adjustments for non-cash items of $32,853,000, partially offset by the net change in operating assets and liabilities of $3,559,000. The adjustments for non-cash items were primarily comprised of depreciation and amortization of $33,671,000, partially offset by straight-lining of rental income of $1,418,000. Net cash used in investing activities of $25,828,000 was primarily comprised of construction in progress and real estate additions of $50,121,000 (primarily related to The Alexander apartment tower) partially offset by proceeds of $24,998,000 from short-term investments that matured during the second quarter of 2015. Net cash used in financing activities of $48,839,000 was primarily comprised of (i) debt repayments of $323,193,000 (primarily repayment of the prior loan on the retail portion of 731 Lexington Avenue) and (ii) dividends paid of $71,571,000, partially offset by (iii) $350,000,000 of proceeds from the refinancing of the retail portion of 731 Lexington Avenue in August 2015. Liquidity and Capital Resources - continued Year Ended December 31, 2014 Net cash provided by operating activities of $49,487,000 was comprised of net income of $67,925,000 and adjustments for non-cash items of $29,355,000, partially offset by the net change in operating assets and liabilities of $47,793,000. The adjustments for non-cash items were primarily comprised of depreciation and amortization of $31,919,000, partially offset by straight-lining of rental income of $2,538,000. The change in operating assets and liabilities was primarily due to the payment of accrued leasing commissions to Vornado of $40,353,000. Net cash used in investing activities of $81,520,000 was primarily comprised of $61,964,000 of construction in progress and real estate additions, primarily related to the development of The Alexander apartment tower, and purchases of short-term investments of $24,998,000. Net cash used in financing activities of $87,870,000 was primarily comprised of (i) debt repayments of $317,179,000 (primarily repayment of the loan on the office portion of 731 Lexington Avenue) and (ii) dividends paid on common stock of $66,436,000, partially offset by (iii) $300,000,000 of proceeds from the refinancing of the office portion of 731 Lexington Avenue. Funds from Operations (“FFO”) FFO is computed in accordance with the definition adopted by the Board of Governors of NAREIT. NAREIT defines FFO as GAAP net income or loss adjusted to exclude net gains from sales of depreciated real estate assets, real estate impairment losses, depreciation and amortization expense from real estate assets and other specified non-cash items, including the pro rata share of such adjustments of unconsolidated subsidiaries. FFO and FFO per diluted share are used by management, investors and analysts to facilitate meaningful comparisons of operating performance between periods and among our peers because it excludes the effect of real estate depreciation and amortization and net gains on sales, which are based on historical costs and implicitly assume that the value of real estate diminishes predictably over time, rather than fluctuating based on existing market conditions. FFO does not represent cash generated from operating activities and is not necessarily indicative of cash available to fund cash requirements and should not be considered as an alternative to net income as a performance measure or cash flow as a liquidity measure. FFO may not be comparable to similarly titled measures employed by other companies. The following table reconciles our net income to FFO:

<s>[INST] We compete with a large number of property owners and developers. Our success depends upon, among other factors, trends of the global, national and local economies, the financial condition and operating results of current and prospective tenants and customers, the availability and cost of capital, construction and renovation costs, taxes, governmental regulations, legislation, population and employment trends, zoning laws, and our ability to lease, sublease or sell our properties, at profitable levels. Our success is also subject to our ability to refinance existing debt on acceptable terms as it comes due. Year Ended December 31, 2016 Financial Results Summary Net income for the year ended December 31, 2016 was $86,477,000, or $16.91 per diluted share, compared to $76,907,000, or $15.04 per diluted share for the year ended December 31, 2015. Funds from operations (“FFO”) for the year ended December 31, 2016 was $119,780,000, or $23.42 per diluted share, compared to $107,648,000, or $21.06 per diluted share for the year ended December 31, 2015. Quarter Ended December 31, 2016 Financial Results Summary Net income for the quarter ended December 31, 2016 was $21,655,000, or $4.23 per diluted share, compared to $23,572,000, or $4.61 per diluted share for the quarter ended December 31, 2015. FFO for the quarter ended December 31, 2016 was $29,582,000, or $5.78 per diluted share, compared to $31,730,000, or $6.21 per diluted share for the quarter ended December 31, 2015. Net income and FFO for the quarter ended December 31, 2015 included $3,911,000, or $0.77 per diluted share from a special dividend from an investment in marketable securities and higher income from bankruptcy recoveries. Overview continued Square Footage, Occupancy and Leasing Activity As of December 31, 2016 our portfolio was comprised of seven properties aggregating 2,437,000 square feet. As of December 31, 2016, our properties had an occupancy rate of 99.8%. Significant Tenants Bloomberg accounted for $104,590,000, $94,468,000 and $91,109,000, representing approximately 46%, 45% and 45% of our total revenues in each of the years ended December 31, 2016, 2015 and 2014, respectively. No other tenant accounted for more than 10% of our total revenues. If we were to lose Bloomberg as a tenant, or if Bloomberg were to be unable to fulfill its obligations under its lease, it would adversely affect our results of operations and financial condition. In order to assist us in our continuing assessment of Bloomberg’s creditworthiness, we receive certain confidential financial information and metrics from Bloomberg. In addition, we access and evaluate financial information regarding Bloomberg from other private sources, as well as publicly available data. In January 2016, we entered into a lease amendment with Bloomberg which extends the lease term related to 192,000 square feet of office space at our 731 Lexington Avenue property to be coterminous with the other 697,000 square feet of office space leased by Bloomberg through February 2029, with a tenyear extension option. In connection with the lease amendment, Bloomberg provided a $200,000,000 letter of credit, which amount [/INST] Negative. </s>

ALEXANDERS INC

2018-02-12

2017-12-31

ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Overview Alexander’s, Inc. (NYSE: ALX) is a real estate investment trust (“REIT”), incorporated in Delaware, engaged in leasing, managing, developing and redeveloping its properties. All references to “we,” “us,” “our,” “Company” and “Alexander’s” refer to Alexander’s, Inc. and its consolidated subsidiaries. We are managed by, and our properties are leased and developed by, Vornado Realty Trust (“Vornado”) (NYSE: VNO). We have seven properties in the greater New York City metropolitan area. We compete with a large number of property owners and developers. Our success depends upon, among other factors, trends of the global, national and local economies, the financial condition and operating results of current and prospective tenants and customers, the availability and cost of capital, construction and renovation costs, taxes, governmental regulations, legislation, population and employment trends, zoning laws, and our ability to lease, sublease or sell our properties, at profitable levels. Our success is also subject to our ability to refinance existing debt on acceptable terms as it comes due. Year Ended December 31, 2017 Financial Results Summary Net income for the year ended December 31, 2017 was $80,509,000, or $15.74 per diluted share, compared to $86,477,000, or $16.91 per diluted share for the year ended December 31, 2016. Funds from operations (“FFO”) (non-GAAP) for the year ended December 31, 2017 was $114,908,000, or $22.46 per diluted share, compared to $119,780,000, or $23.42 per diluted share for the year ended December 31, 2016. Net income for the year ended December 31, 2017 included additional depreciation and amortization of tenant improvements and deferred leasing costs of $2,444,000, or $0.48 per diluted share, resulting from a tenant lease termination at our 731 Lexington Avenue property. Net income and FFO (non-GAAP) for the year ended December 31, 2016 included rental income of $2,257,000, or $0.44 per diluted share, resulting from a tenant lease termination at our Rego Park II property. Net income for the year ended December 31, 2016 also included additional depreciation and amortization of tenant improvements and deferred leasing costs of $1,077,000, or $0.21 per diluted share, related to the tenant lease termination at our Rego Park II property. Quarter Ended December 31, 2017 Financial Results Summary Net income for the quarter ended December 31, 2017 was $17,883,000, or $3.50 per diluted share, compared to $21,655,000, or $4.23 per diluted share for the quarter ended December 31, 2016. FFO (non-GAAP) for the quarter ended December 31, 2017 was $28,062,000, or $5.49 per diluted share, compared to $29,582,000, or $5.78 per diluted share for the quarter ended December 31, 2016. Net income for the quarter ended December 31, 2017 included additional depreciation and amortization of tenant improvements and deferred leasing costs of $2,184,000, or $0.43 per diluted share, resulting from a tenant lease termination at our 731 Lexington Avenue property. Square Footage, Occupancy and Leasing Activity As of December 31, 2017 our portfolio was comprised of seven properties aggregating 2,437,000 square feet. As of December 31, 2017, our properties had an occupancy rate of 99.3%. Tenant Matters On April 4, 2017, Sears closed its 195,000 square foot store at our Rego Park I property. Annual revenue from Sears is approximately $10,600,000, under a lease which expires in March 2021. In its 2016 annual report on Form 10-K, Sears indicated that substantial doubt exists related to its ability to continue as a going concern. There are $3,865,000 of receivables arising from the straight-lining of rent and $406,000 of unamortized deferred leasing costs on our consolidated balance sheet related to the Sears lease as of December 31, 2017 which we will continue to assess for recoverability. On September 18, 2017, Toys, which leases 47,000 square feet of retail space at our Rego Park II shopping center ($2,600,000 of annual revenue) filed for Chapter 11 bankruptcy relief. There are $694,000 of tenant improvements, $257,000 of unamortized deferred leasing costs and $544,000 of receivables arising from the straight-lining of rent on our consolidated balance sheet related to the Toys lease as of December 31, 2017. Overview - continued On September 19, 2017, the bankruptcy court approved the terms of an order stipulation between Le Cirque, a restaurant operator which leases 13,000 square feet at our 731 Lexington Avenue property (approximately $1,200,000 of annual revenue), and the Company which terminated the lease on January 5, 2018 (original lease expiration was May 2021). As a result, we began accelerating depreciation and amortization of approximately $2,780,000 of tenant improvements and deferred leasing costs over the new lease term, of which approximately $2,650,000 was recognized in the year ended December 31, 2017 and approximately $130,000 will be recognized in the quarter ending March 31, 2018. Rego Park II Loan Participation On July 28, 2017, we entered into a participation and servicing agreement with the lender on our Rego Park II shopping center loan, which matures on November 30, 2018. We invested $200,000,000 to participate in the loan and are entitled to interest at LIBOR plus 1.60% (3.17% as of December 31, 2017). Financing On June 1, 2017, we completed a $500,000,000 refinancing of the office portion of 731 Lexington Avenue. The interest-only loan is at LIBOR plus 0.90% (2.38% as of December 31, 2017) and matures in June 2020, with four one-year extension options. In connection therewith, we purchased an interest rate cap with a notional amount of $500,000,000 that caps LIBOR at a rate of 6.0%. The property was previously encumbered by a $300,000,000 interest-only mortgage at LIBOR plus 0.95% which was scheduled to mature in March 2021. Significant Tenant Bloomberg accounted for revenue of $105,224,000, $104,590,000 and $94,468,000 in the years ended December 31, 2017, 2016 and 2015, respectively, representing approximately 46%, 46% and 45% of our total revenues in each year, respectively. No other tenant accounted for more than 10% of our total revenues. If we were to lose Bloomberg as a tenant, or if Bloomberg were to be unable to fulfill its obligations under its lease, it would adversely affect our results of operations and financial condition. In order to assist us in our continuing assessment of Bloomberg’s creditworthiness, we receive certain confidential financial information and metrics from Bloomberg. In addition, we access and evaluate financial information regarding Bloomberg from other private sources, as well as publicly available data. Critical Accounting Policies and Estimates Our financial statements are prepared in conformity with accounting principles generally accepted in the United States of America (“GAAP”), which requires us to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting periods. Actual results could differ from those estimates. Set forth below is a summary of our accounting policies that we believe are critical to the preparation of our consolidated financial statements. This summary should be read in conjunction with a more complete discussion of our accounting policies included in Note 2 - Summary of Significant Accounting Policies, to the consolidated financial statements in this Annual Report on Form 10-K. Real Estate Real estate is carried at cost, net of accumulated depreciation and amortization. As of December 31, 2017 and 2016, the carrying amount of our real estate, net of accumulated depreciation and amortization, was $754,324,000 and $780,814,000, respectively. Maintenance and repairs are expensed as incurred. Depreciation requires an estimate by management of the useful life of each property and improvement as well as an allocation of the costs associated with a property to its various components. If we do not allocate these costs appropriately or incorrectly estimate the useful lives of our real estate, depreciation expense may be misstated. We capitalize all property operating expenses directly associated with and attributable to, the development and construction of a project, including interest expense. The capitalization period begins when development activities are underway and ends when it is determined that the asset is substantially complete and ready for its intended use, which is typically evidenced by the receipt of a temporary certificate of occupancy. General and administrative costs are expensed as incurred. Critical Accounting Policies and Estimates - continued Our properties and related intangible assets, including properties to be developed in the future, are individually reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of the assets may not be recoverable. An impairment exists when the carrying amount of an asset exceeds the sum of the undiscounted cash flows expected to result from the use and eventual disposition of the asset. Estimates of future cash flows are based on our current plans, intended holding periods and available market information at the time the analyses are prepared. For our development properties, estimates of future cash flows also include all future expenditures necessary to develop the asset, including interest payments that will be capitalized as part of the cost of the asset. An impairment loss is recognized only if the carrying amount of the asset is not recoverable and is measured based on the excess of the property’s carrying amount over its estimated fair value. If our estimates of future cash flows, anticipated holding periods, or fair values change, based on market conditions or otherwise, our evaluation of impairment charges may be different and such differences could be material to our consolidated financial statements. Estimates of future cash flows are subjective and are based, in part, on assumptions regarding future occupancy, rental rates and capital requirements that could differ materially from actual results. Plans to hold properties over longer periods decrease the likelihood of recording impairment losses. Allowance for Doubtful Accounts We periodically evaluate the collectibility of amounts due from tenants, including the receivable arising from the straight-lining of rents, and maintain an allowance for doubtful accounts ($1,501,000 and $1,473,000 as of December 31, 2017 and 2016, respectively) for estimated losses resulting from the inability of tenants to make required payments under the lease agreements. We exercise judgment in establishing these allowances and consider payment history and current credit status in developing these estimates. These estimates may differ from actual results, which could be material to our consolidated financial statements. Revenue Recognition We have the following revenue sources and revenue recognition policies: • Base Rent - revenue arising from tenant leases. These rents are recognized over the non-cancelable term of the related leases on a straight-line basis, which includes the effects of rent steps and free rent abatements under the leases. We commence rental revenue recognition when the tenant takes possession of the leased space and the leased space is substantially ready for its intended use. In addition, in circumstances where we provide a tenant improvement allowance for improvements that are owned by the tenant, we recognize the allowance as a reduction of rental revenue on a straight-line basis over the term of the lease; • Percentage Rent - revenue arising from retail tenant leases that is contingent upon the sales of tenants exceeding defined thresholds. These rents are recognized only after the contingency has been removed (i.e., when tenant sales thresholds have been achieved); • Expense Reimbursements - revenue arising from tenant leases which provide for the recovery of all or a portion of the operating expenses and real estate taxes of the respective properties. This revenue is recognized in the same periods as the expenses are incurred; • Parking income - revenue arising from the rental of parking space at our properties. This income is recognized as the service is provided. Before we recognize revenue, we assess, among other things, its collectibility. If our assessment of the collectibility of revenue changes, the impact on our consolidated financial statements could be material. Income Taxes We operate in a manner intended to enable us to continue to qualify as a REIT under Sections 856 - 860 of the Internal Revenue Code of 1986, as amended (the “Code”). In order to maintain our qualification as a REIT under the Code, we must distribute at least 90% of our taxable income to stockholders each year. We distribute to our stockholders 100% of our taxable income and therefore, no provision for Federal income taxes is required. If we fail to distribute the required amount of income to our stockholders, or fail to meet other REIT requirements, we may fail to qualify as a REIT, which may result in substantial adverse tax consequences. Results of Operations - Year Ended December 31, 2017 compared to December 31, 2016 Property Rentals Property rentals were $152,857,000 in the year ended December 31, 2017, compared to $151,444,000 in the prior year, an increase of $1,413,000. This increase was primarily due to higher rental income of $3,730,000 from The Alexander apartment tower, which was placed in service in phases beginning July 2015 and leased up to stabilization in September 2016, partially offset by income of $2,257,000 in 2016 resulting from a tenant lease termination at our Rego Park II property. Expense Reimbursements Tenant expense reimbursements were $77,717,000 in the year ended December 31, 2017, compared to $75,492,000 in the prior year, an increase of $2,225,000. This increase was primarily due to higher reimbursable real estate taxes and higher reimbursable operating expenses. Operating Expenses Operating expenses were $85,127,000 in the year ended December 31, 2017, compared to $82,232,000 in the prior year, an increase of $2,895,000. This increase was primarily due to (i) higher real estate taxes of $3,267,000 and (ii) higher reimbursable operating expenses of $903,000, partially offset by (iii) lower marketing costs for The Alexander apartment tower of $1,098,000 and (iv) lower bad debt expense of $504,000. Depreciation and Amortization Depreciation and amortization was $34,925,000 in the year ended December 31, 2017, compared to $33,807,000 in the prior year, an increase of $1,118,000. This increase was primarily due to additional depreciation and amortization of tenant improvements and deferred leasing costs of $2,444,000 related to a tenant lease termination at our 731 Lexington Avenue property in September 2017, partially offset by additional depreciation and amortization of tenant improvements and deferred leasing costs of $1,077,000 in 2016 related to a tenant lease termination at our Rego Park II property. General and Administrative Expenses General and administrative expenses were $5,252,000 in the year ended December 31, 2017, compared to $5,436,000 in the prior year, a decrease of $184,000. This decrease was primarily due to lower director’s fees and stock-based compensation expense as a result of having one less member on our Board of Directors in 2017. Interest and Other Income, net Interest and other income, net was $6,716,000 in the year ended December 31, 2017, compared to $3,305,000 in the prior year, an increase of $3,411,000. This increase was primarily due to higher interest income of (i) $2,453,000 from the Rego Park II loan participation, (ii) $1,418,000 from an increase in the average interest rates and (iii) $216,000 from an increase in the average investment balances, partially offset by (iv) lower income of $429,000 in connection with bankruptcy recoveries and (v) income of $367,000 in the prior year from a cost reimbursement settlement with a retail tenant at our 731 Lexington Avenue property. Interest and Debt Expense Interest and debt expense was $31,474,000 in the year ended December 31, 2017, compared to $22,241,000 in the prior year, an increase of $9,233,000. This increase was primarily due to higher interest expense of (i) $5,289,000 due to an increase in average LIBOR, (ii) $2,658,000 resulting from the refinancing of the office portion of 731 Lexington Avenue on June 1, 2017 for $500,000,000 at LIBOR plus 0.90% (previously a $300,000,000 loan at LIBOR plus 0.95%) and (iii) $1,188,000 of higher amortization of debt issuance costs. Income Taxes Income tax expense was $3,000 in the year ended December 31, 2017, compared to $48,000 in the prior year. Results of Operations - Year Ended December 31, 2016 compared to December 31, 2015 Property Rentals Property rentals were $151,444,000 in the year ended December 31, 2016, compared to $138,688,000 in the prior year, an increase of $12,756,000. This increase was primarily due to (i) rental income of $7,271,000 from The Alexander apartment tower, which was placed in service in phases beginning July 2015 and leased up to stabilization in September 2016, (ii) higher rental income of $3,366,000 from the January 2016 lease amendment with Bloomberg at 731 Lexington Avenue and (iii) income of $2,257,000 resulting from a tenant lease termination at our Rego Park II property in June 2016. Expense Reimbursements Tenant expense reimbursements were $75,492,000 in the year ended December 31, 2016, compared to $69,227,000 in the prior year, an increase of $6,265,000. This increase was primarily due to (i) higher recoveries of real estate taxes and operating expenses from Bloomberg at 731 Lexington Avenue as a result of the January 2016 lease amendment, which converted 192,000 square feet from a gross basis to a net rent basis and (ii) higher reimbursable real estate taxes, partially offset by (iii) lower reimbursable operating expenses. Operating Expenses Operating expenses were $82,232,000 in the year ended December 31, 2016, compared to $76,218,000 in the prior year, an increase of $6,014,000. This increase was primarily due to (i) higher operating expenses of $2,494,000 related to The Alexander apartment tower, which was placed in service in phases beginning July 2015 and leased up to stabilization in September 2016, (ii) higher reimbursable real estate taxes of $3,703,000 and (iii) higher bad debt expense of $871,000, partially offset by (iv) lower reimbursable operating expenses of $1,068,000. Depreciation and Amortization Depreciation and amortization was $33,807,000 in the year ended December 31, 2016, compared to $31,086,000 in the prior year, an increase of $2,721,000. This increase was primarily due to additional depreciation related to The Alexander apartment tower, which was placed in service in phases beginning July 2015. General and Administrative Expenses General and administrative expenses were $5,436,000 in the year ended December 31, 2016, compared to $5,406,000 in the prior year, an increase of $30,000. Interest and Other Income, net Interest and other income, net was $3,305,000 in the year ended December 31, 2016, compared to $5,949,000 in the prior year, a decrease of $2,644,000. This decrease was primarily due to $2,141,000 from a special dividend from our investment in common shares of Macerich in 2015 and lower income of $1,275,000 in connection with bankruptcy recoveries. Interest and Debt Expense Interest and debt expense was $22,241,000 in the year ended December 31, 2016, compared to $24,239,000 in the prior year, a decrease of $1,998,000. This decrease was primarily due to savings of $5,631,000 resulting from the refinancing of the retail portion of 731 Lexington Avenue on August 5, 2015 at LIBOR plus 1.40%, or 2.05% as of December 31, 2016 (the prior loan had a fixed rate of 4.93%); partially offset by lower capitalized interest of $1,486,000 as a result of completing the development of The Alexander apartment tower, which was placed in service in phases beginning July 2015 and $2,066,000 due to an increase in average LIBOR. Income Taxes Income tax expense was $48,000 in the year ended December 31, 2016, compared to $8,000 in the prior year. Related Party Transactions Vornado Steven Roth is the Chairman of our Board of Directors and Chief Executive Officer, the Managing General Partner of Interstate Properties (“Interstate”), a New Jersey general partnership, and the Chairman of the Board of Trustees and Chief Executive Officer of Vornado. As of December 31, 2017, Mr. Roth, Interstate and its other two general partners, David Mandelbaum and Russell B. Wight, Jr. (who are also directors of the Company and trustees of Vornado) owned, in the aggregate, 26.2% of our outstanding common stock, in addition to the 2.3% they indirectly own through Vornado. Joseph Macnow, our Treasurer, is the Executive Vice President - Chief Financial Officer and Chief Administrative Officer of Vornado. Matthew Iocco, our Chief Financial Officer, is the Executive Vice President - Chief Accounting Officer of Vornado. As of December 31, 2017, Vornado owned 32.4% of our outstanding common stock. We are managed by, and our properties are leased and developed by, Vornado, pursuant to various agreements, which expire in March of each year and are automatically renewable. These agreements are described in Note 4 - Related Party Transactions, to our consolidated financial statements in this Annual Report on Form 10-K. Toys Our affiliate, Vornado, owns 32.5% of Toys. Joseph Macnow, Vornado’s Executive Vice President - Chief Financial Officer and Chief Administrative Officer and Wendy A. Silverstein, a member of our Board of Directors, represent Vornado as members of Toys’ Board of Directors. Toys leases 47,000 square feet of retail space at our Rego Park II shopping center ($2,600,000 of annual revenue). On September 18, 2017, Toys filed for Chapter 11 bankruptcy relief. There are $694,000 of tenant improvements, $257,000 of unamortized deferred leasing costs and $544,000 of receivables arising from the straight-lining of rent on our consolidated balance sheet related to the Toys lease as of December 31, 2017. Liquidity and Capital Resources Property rental income is our primary source of cash flow and is dependent on a number of factors including the occupancy level and rental rates of our properties, as well as our tenants’ ability to pay their rents. Our properties provide us with a relatively consistent stream of cash flow that enables us to pay our operating expenses, interest expense, recurring capital expenditures and cash dividends to stockholders. Other sources of liquidity to fund cash requirements include our existing cash, proceeds from financings, including mortgage or construction loans secured by our properties and proceeds from asset sales. We anticipate that cash flows from continuing operations over the next twelve months, together with existing cash balances, will be adequate to fund our business operations, cash dividends to stockholders, debt amortization and capital expenditures. Dividends On January 17, 2018, we increased our regular quarterly dividend to $4.50 per share (a new indicated annual rate of $18.00 per share). The new dividend, when declared by the Board of Directors for all of 2018, will require us to pay out approximately $92,100,000. Rego Park II Loan Participation On July 28, 2017, we entered into a participation and servicing agreement with the lender on our Rego Park II shopping center loan, which matures on November 30, 2018. We invested $200,000,000 to participate in the loan and are entitled to interest at LIBOR plus 1.60% (3.17% as of December 31, 2017). Financing Activities and Contractual Obligations On June 1, 2017, we completed a $500,000,000 refinancing of the office portion of 731 Lexington Avenue. The interest-only loan is at LIBOR plus 0.90% and matures in June 2020, with four one-year extension options. In connection therewith, we purchased an interest rate cap with a notional amount of $500,000,000 that caps LIBOR at a rate of 6.0%. The property was previously encumbered by a $300,000,000 interest-only mortgage at LIBOR plus 0.95% which was scheduled to mature in March 2021. Liquidity and Capital Resources - continued Below is a summary of our outstanding debt and maturities as of December 31, 2017. We may refinance our maturing debt as it comes due or choose to repay it. Below is a summary of our contractual obligations and commitments as of December 31, 2017. Commitments and Contingencies Insurance We maintain general liability insurance with limits of $300,000,000 per occurrence and per property, and all-risk property and rental value insurance coverage with limits of $1.7 billion per occurrence, including coverage for acts of terrorism, with sub-limits for certain perils such as floods and earthquakes on each of our properties. Fifty Ninth Street Insurance Company, LLC (“FNSIC”), our wholly owned consolidated subsidiary, acts as a direct insurer for coverage for acts of terrorism, including nuclear, biological, chemical and radiological (“NBCR”) acts, as defined by the Terrorism Risk Insurance Program Reauthorization Act, which expires in December 2020. Coverage for acts of terrorism (including NBCR acts) is up to $1.7 billion per occurrence and in the aggregate. Coverage for acts of terrorism (excluding NBCR acts) is fully reinsured by third party insurance companies and the Federal government with no exposure to FNSIC. For NBCR acts, FNSIC is responsible for a $293,000 deductible ($306,000 effective January 1, 2018) and 17% of the balance (18% effective January 1, 2018) of a covered loss, and the Federal government is responsible for the remaining 83% (82% effective January 1, 2018) of a covered loss. We are ultimately responsible for any loss incurred by FNSIC. Liquidity and Capital Resources - continued We continue to monitor the state of the insurance market and the scope and costs of coverage for acts of terrorism. However, we cannot anticipate what coverage will be available on commercially reasonable terms in the future. We are responsible for deductibles and losses in excess of our insurance coverage, which could be material. Our mortgage loans are non-recourse to us and contain customary covenants requiring us to maintain insurance. Although we believe that we have adequate insurance coverage for purposes of these agreements, we may not be able to obtain an equivalent amount of coverage at reasonable costs in the future. Further, if lenders insist on greater coverage than we are able to obtain, it could adversely affect our ability to finance our properties. Rego Park I Litigation In June 2014, Sears filed a lawsuit in the Supreme Court of the State of New York against Vornado and us (and certain of our subsidiaries) with regard to space that Sears leases at our Rego Park I property alleging that the defendants are liable for harm that Sears has suffered as a result of (a) water intrusions into the premises, (b) two fires in February 2014 that caused damages to those premises, and (c) alleged violations of the Americans with Disabilities Act in the premises’ parking garage. Sears asserted various causes of actions for damages and sought to compel compliance with landlord’s obligations to repair the premises and to provide security, and to compel us to abate a nuisance that Sears claims was a cause of the water intrusions into its premises. In addition to injunctive relief, Sears sought, among other things, damages of not less than $4 million and future damages it estimated would not be less than $25 million. In March 2016, Sears withdrew its claim for future damages leaving a remaining claim for property damages, which we estimate to be approximately $650,000 based on information provided by Sears. We intend to defend the remaining claim vigorously. The amount or range of reasonable possible losses, if any, is not expected to be greater than $650,000. Paramus In 2001, we leased 30.3 acres of land located in Paramus, New Jersey to IKEA Property, Inc. The lease has a purchase option in 2021 for $75,000,000. The property is encumbered by a $68,000,000 interest-only mortgage loan with a fixed rate of 2.90%, which matures on October 5, 2018. The annual triple-net rent is the sum of $700,000 plus the amount of debt service on the mortgage loan. If the purchase option is exercised, we will receive net cash proceeds of approximately $7,000,000 and recognize a gain on sale of land of approximately $60,000,000. If the purchase option is not exercised, the triple-net rent for the last 20 years would include debt service sufficient to fully amortize $68,000,000 over the remaining 20-year lease term. Letters of Credit Approximately $1,474,000 of standby letters of credit were outstanding as of December 31, 2017. Other In October 2015, the New York City Department of Finance (“NYC DOF”) issued a Notice of Determination to us assessing an additional $22,910,000 of transfer taxes (including interest and penalties as of December 31, 2017) in connection with the sale of Kings Plaza Regional Shopping Center in November 2012. We believe that the NYC DOF’s claim is without merit and intend to vigorously contest this assessment. We have determined that the likelihood of a loss related to this issue is not probable and, after consultation with legal counsel, that the outcome of this assessment is not expected to have a material adverse effect on our financial position, results of operations or cash flows. We received approximately $396,000, $825,000 and $2,100,000 from bankruptcy recoveries during the years ended December 31, 2017, 2016 and 2015, respectively, which is included as “interest and other income, net” in our consolidated statements of income. There are various other legal actions against us in the ordinary course of business. In our opinion, the outcome of such matters in the aggregate will not have a material effect on our financial position, results of operations or cash flows. Liquidity and Capital Resources - continued Cash Flows for the Year Ended December 31, 2017 Cash and cash equivalents and restricted cash were $393,279,000 at December 31, 2017, compared to $374,678,000 at December 31, 2016, an increase of $18,601,000. This increase resulted from (i) $123,426,000 of net cash provided by operating activities, and (ii) $97,146,000 of net cash provided by financing activities, partially offset by (iii) $201,971,000 of net cash used in investing activities. Net cash provided by operating activities of $123,426,000 was comprised of net income of $80,509,000 and adjustments for non-cash items of $43,372,000, partially offset by the net change in operating assets and liabilities of $455,000. The adjustments for non-cash items were primarily comprised of depreciation and amortization (including amortization of debt issuance costs) of $38,681,000 and straight-lining of rental income of $4,297,000. Net cash provided by financing activities of $97,146,000 was primarily comprised of (i) $500,000,000 of proceeds from the refinancing of the office portion of 731 Lexington Avenue, partially offset by (ii) debt repayments of $303,707,000 (primarily the repayment of the former loan on the office portion of 731 Lexington Avenue) and (iii) dividends paid of $86,961,000. Net cash used in investing activities of $201,971,000 was primarily comprised of the Rego Park II loan participation payment of $200,000,000 and construction in progress and real estate additions of $3,434,000. Cash Flows for the Year Ended December 31, 2016 Cash and cash equivalents and restricted cash were $374,678,000 at December 31, 2016, compared to $344,656,000 at December 31, 2015, an increase of $30,022,000. This increase resulted from (i) $130,820,000 of net cash provided by operating activities, partially offset by (ii) $85,292,000 of net cash used in financing activities and (iii) $15,506,000 of net cash used in investing activities. Net cash provided by operating activities of $130,820,000 was comprised of net income of $86,477,000, adjustments for non-cash items of $39,171,000, and the net change in operating assets and liabilities of $5,172,000. The adjustments for non-cash items were primarily comprised of depreciation and amortization (including amortization of debt issuance costs) of $36,374,000 and straight-lining of rental income of $2,347,000. Net cash used in financing activities of $85,292,000 was primarily comprised of dividends paid of $81,822,000. Net cash used in investing activities of $15,506,000 was comprised of construction in progress and real estate additions of $15,506,000 (primarily related to The Alexander apartment tower), including the payment of a development fee to Vornado of $5,784,000. Cash Flows for the Year Ended December 31, 2015 Cash and cash equivalents and restricted cash were $344,656,000 at December 31, 2015, compared to $312,417,000 at December 31, 2014, an increase of $32,239,000. This increase resulted from (i) $106,201,000 of net cash provided by operating activities, partially offset by (ii) $48,839,000 of net cash used in financing activities and (iii) $25,123,000 of net cash used in investing activities. Net cash provided by operating activities of $106,201,000 was comprised of net income of $76,907,000 and adjustments for non-cash items of $32,853,000, partially offset by the net change in operating assets and liabilities of $3,559,000. The adjustments for non-cash items were primarily comprised of depreciation and amortization of $33,671,000, partially offset by straight-lining of rental income of $1,418,000. Net cash used in financing activities of $48,839,000 was primarily comprised of (i) debt repayments of $323,193,000 (primarily repayment of the prior loan on the retail portion of 731 Lexington Avenue) and (ii) dividends paid of $71,571,000, partially offset by (iii) $350,000,000 of proceeds from the refinancing of the retail portion of 731 Lexington Avenue in August 2015. Net cash used in investing activities of $25,123,000 was comprised of construction in progress and real estate additions of $50,121,000 (primarily related to The Alexander apartment tower) partially offset by proceeds of $24,998,000 from short-term investments that matured during the second quarter of 2015. Funds from Operations (“FFO”) (non-GAAP) FFO is computed in accordance with the definition adopted by the Board of Governors of NAREIT. NAREIT defines FFO as GAAP net income or loss adjusted to exclude net gains from sales of depreciated real estate assets, real estate impairment losses, depreciation and amortization expense from real estate assets and other specified non-cash items, including the pro rata share of such adjustments of unconsolidated subsidiaries. FFO and FFO per diluted share are used by management, investors and analysts to facilitate meaningful comparisons of operating performance between periods and among our peers because it excludes the effect of real estate depreciation and amortization and net gains on sales, which are based on historical costs and implicitly assume that the value of real estate diminishes predictably over time, rather than fluctuating based on existing market conditions. FFO does not represent cash generated from operating activities and is not necessarily indicative of cash available to fund cash requirements and should not be considered as an alternative to net income as a performance measure or cash flow as a liquidity measure. FFO may not be comparable to similarly titled measures employed by other companies. The following table reconciles our net income to FFO (non-GAAP):

<s>[INST] Alexander’s, Inc. (NYSE: ALX) is a real estate investment trust (“REIT”), incorporated in Delaware, engaged in leasing, managing, developing and redeveloping its properties. All references to “we,” “us,” “our,” “Company” and “Alexander’s” refer to Alexander’s, Inc. and its consolidated subsidiaries. We are managed by, and our properties are leased and developed by, Vornado Realty Trust (“Vornado”) (NYSE: VNO). We have seven properties in the greater New York City metropolitan area. We compete with a large number of property owners and developers. Our success depends upon, among other factors, trends of the global, national and local economies, the financial condition and operating results of current and prospective tenants and customers, the availability and cost of capital, construction and renovation costs, taxes, governmental regulations, legislation, population and employment trends, zoning laws, and our ability to lease, sublease or sell our properties, at profitable levels. Our success is also subject to our ability to refinance existing debt on acceptable terms as it comes due. Year Ended December 31, 2017 Financial Results Summary Net income for the year ended December 31, 2017 was $80,509,000, or $15.74 per diluted share, compared to $86,477,000, or $16.91 per diluted share for the year ended December 31, 2016. Funds from operations (“FFO”) (nonGAAP) for the year ended December 31, 2017 was $114,908,000, or $22.46 per diluted share, compared to $119,780,000, or $23.42 per diluted share for the year ended December 31, 2016. Net income for the year ended December 31, 2017 included additional depreciation and amortization of tenant improvements and deferred leasing costs of $2,444,000, or $0.48 per diluted share, resulting from a tenant lease termination at our 731 Lexington Avenue property. Net income and FFO (nonGAAP) for the year ended December 31, 2016 included rental income of $2,257,000, or $0.44 per diluted share, resulting from a tenant lease termination at our Rego Park II property. Net income for the year ended December 31, 2016 also included additional depreciation and amortization of tenant improvements and deferred leasing costs of $1,077,000, or $0.21 per diluted share, related to the tenant lease termination at our Rego Park II property. Quarter Ended December 31, 2017 Financial Results Summary Net income for the quarter ended December 31, 2017 was $17,883,000, or $3.50 per diluted share, compared to $21,655,000, or $4.23 per diluted share for the quarter ended December 31, 2016. FFO (nonGAAP) for the quarter ended December 31, 2017 was $28,062,000, or $5.49 per diluted share, compared to $29,582,000, or $5.78 per diluted share for the quarter ended December 31, 2016. Net income for the quarter ended December 31, 2017 included additional depreciation and amortization of tenant improvements and deferred leasing costs of $2,184,000, or $0.43 per diluted share, resulting from a tenant lease termination at our 731 Lexington Avenue property. Square Footage, Occupancy and Leasing Activity As of December 31, 2017 our portfolio was comprised of seven properties aggregating 2,437,000 square feet. As of December 31, [/INST] Positive. </s>

ALEXANDERS INC

2019-02-11

2018-12-31

ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Overview Alexander’s, Inc. (NYSE: ALX) is a real estate investment trust (“REIT”), incorporated in Delaware, engaged in leasing, managing, developing and redeveloping its properties. All references to “we,” “us,” “our,” “Company” and “Alexander’s” refer to Alexander’s, Inc. and its consolidated subsidiaries. We are managed by, and our properties are leased and developed by, Vornado Realty Trust (“Vornado”) (NYSE: VNO). We have seven properties in the greater New York City metropolitan area. We compete with a large number of property owners and developers. Our success depends upon, among other factors, trends of the global, national and local economies, the financial condition and operating results of current and prospective tenants and customers, the availability and cost of capital, construction and renovation costs, taxes, governmental regulations, legislation, population and employment trends, zoning laws, and our ability to lease, sublease or sell our properties, at profitable levels. Our success is also subject to our ability to refinance existing debt on acceptable terms as it comes due. Year Ended December 31, 2018 Financial Results Summary Net income for the year ended December 31, 2018 was $32,844,000 or $6.42 per diluted share, compared to $80,509,000, or $15.74 per diluted share for the year ended December 31, 2017. Net income for the year ended December 31, 2018 included (i) $23,797,000, or $4.65 per diluted share, of expense for potential additional New York City real property transfer taxes on the 2012 sale of Kings Plaza Regional Shopping Center (“Kings Plaza”) which is being contested and (ii) $11,990,000, or $2.34 per diluted share, from the decrease in the fair value of marketable securities resulting from a new GAAP accounting standard effective January 1, 2018. Previously, changes in the fair value of marketable securities were recognized through “accumulated other comprehensive (loss) income” on our consolidated balance sheets and did not impact our consolidated statements of income. Funds from operations (“FFO”) (non-GAAP) for the year ended December 31, 2018 was $77,429,000, or $15.13 per diluted share, compared to $114,908,000, or $22.46 per diluted share for the year ended December 31, 2017. FFO (non-GAAP) for the year ended December 31, 2018 included $23,797,000, or $4.65 per diluted share, of expense for the contested Kings Plaza transfer taxes. Quarter Ended December 31, 2018 Financial Results Summary Net income for the quarter ended December 31, 2018 was $9,971,000, or $1.95 per diluted share, compared to $17,883,000, or $3.50 per diluted share for the quarter ended December 31, 2017. Net income for the quarter ended December 31, 2018 included $6,429,000, or $1.26 per diluted share, from the decrease in the fair value of marketable securities. FFO (non-GAAP) for the quarter ended December 31, 2018 was $24,158,000, or $4.72 per diluted share, compared to $28,062,000, or $5.49 per diluted share for the quarter ended December 31, 2017. Square Footage, Occupancy and Leasing Activity As of December 31, 2018, our portfolio was comprised of seven properties aggregating 2,437,000 square feet. As of December 31, 2018, our properties had an occupancy rate of 91.4%. Overview - continued Real Property Transfer Tax Litigation In 2012, we sold Kings Plaza and paid real property transfer taxes to New York City in connection with the sale. In 2015, the New York City Department of Finance (“NYC DOF”) issued a Notice of Determination to us assessing an additional New York City real property transfer tax amount, including interest, which we are contesting. In 2014, in a case with similar facts, the NYC DOF issued a Notice of Determination to a Vornado joint venture assessing an additional New York City real property transfer tax amount, including interest. In January 2017, a New York City administrative law judge made a determination upholding the Vornado joint venture’s position that such additional real property transfer taxes were not due. On February 16, 2018, the New York City Tax Appeals Tribunal (the “Tribunal”) overturned the January 2017 determination. The Vornado joint venture is appealing the Tribunal’s decision to the Appellate Division of the Supreme Court of the State of New York which is scheduled to be heard in the first half of 2019. In 2018, based on the precedent of the Tribunal’s decision, we recorded an expense for the potential additional real property transfer taxes of $23,797,000 ($15,874,000 of real property transfer tax and $7,923,000 of interest) and paid this amount in order to stop the interest from accruing. Our case is on hold pending the outcome of the Vornado joint venture’s appeal. Tenant Matters On April 4, 2017, Sears closed its 195,000 square foot store at our Rego Park I shopping center ($10,300,000 of annual revenue). On October 15, 2018, Sears filed for Chapter 11 bankruptcy relief and rejected its lease. Consequently, we wrote off the remaining balance of the Sears receivable arising from the straight-lining of rent of $2,973,000 during the year ended December 31, 2018. In addition, we accelerated depreciation and amortization of the remaining balance of $312,000 of deferred leasing costs during the year ended December 31, 2018. On September 18, 2017, Toys filed for Chapter 11 bankruptcy relief. On June 30, 2018, Toys rejected its 47,000 square foot lease at our Rego Park II shopping center ($2,600,000 of annual revenue) and possession of the space was returned to us. Consequently, we accelerated depreciation and amortization of the remaining balances of $588,000 of tenant improvements and $215,000 of deferred leasing costs during the year ended December 31, 2018. We also wrote off the Toys receivable arising from the straight-lining of rent of $500,000 during the year ended December 31, 2018. On January 10, 2019, Kohl’s announced that it plans to close and sublease its 133,000 square foot store at our Rego Park II shopping center; Kohl’s remains obligated to us under its lease which expires in January 2031. Financing On October 3, 2018, we extended our mortgage loan on our Paramus property. The $68,000,000 interest-only loan has a fixed rate of 4.72% and matures in October 2021. Previously the loan bore interest at a fixed rate of 2.90%. The tenant pays all of the interest on this mortgage loan as part of its rent. On December 12, 2018, we completed a $252,544,000 refinancing of our Rego Park II shopping center. The interest-only loan is at LIBOR plus 1.35% (3.87% as of December 31, 2018) and matures in December 2025. The previous loan bore interest at LIBOR plus 1.85% and was scheduled to mature in January 2019. As of December 31, 2018, we hold a $195,708,000 participation in the mortgage loan, earning interest at LIBOR plus 1.35%. The participation in the previous mortgage loan earned interest at LIBOR plus 1.60%. Significant Tenant Bloomberg accounted for revenue of $107,356,000, $105,224,000 and $104,590,000 in the years ended December 31, 2018, 2017 and 2016, respectively, representing approximately 46% of our total revenues in each year. No other tenant accounted for more than 10% of our total revenues. If we were to lose Bloomberg as a tenant, or if Bloomberg were to be unable to fulfill its obligations under its lease, it would adversely affect our results of operations and financial condition. In order to assist us in our continuing assessment of Bloomberg’s creditworthiness, we receive certain confidential financial information and metrics from Bloomberg. In addition, we access and evaluate financial information regarding Bloomberg from other private sources, as well as publicly available data. Critical Accounting Policies and Estimates Our financial statements are prepared in conformity with accounting principles generally accepted in the United States of America (“GAAP”), which requires us to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting periods. Actual results could differ from those estimates. Set forth below is a summary of our accounting policies that we believe are critical to the preparation of our consolidated financial statements. This summary should be read in conjunction with a more complete discussion of our accounting policies included in Note 2 - Summary of Significant Accounting Policies, to the consolidated financial statements in this Annual Report on Form 10-K. Real Estate Real estate is carried at cost, net of accumulated depreciation and amortization. As of December 31, 2018 and 2017, the carrying amount of our real estate, net of accumulated depreciation and amortization, was $730,270,000 and $754,324,000, respectively. Maintenance and repairs are expensed as incurred. Depreciation requires an estimate by management of the useful life of each property and improvement as well as an allocation of the costs associated with a property to its various components. If we do not allocate these costs appropriately or incorrectly estimate the useful lives of our real estate, depreciation expense may be misstated. We capitalize all property operating expenses directly associated with and attributable to, the development and construction of a project, including interest expense. The capitalization period begins when development activities are underway and ends when it is determined that the asset is substantially complete and ready for its intended use, which is typically evidenced by the receipt of a temporary certificate of occupancy. General and administrative costs are expensed as incurred. Our properties and related intangible assets, including properties to be developed in the future, are individually reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of the assets may not be recoverable. An impairment exists when the carrying amount of an asset exceeds the sum of the undiscounted cash flows expected to result from the use and eventual disposition of the asset. Estimates of future cash flows are based on our current plans, intended holding periods and available market information at the time the analyses are prepared. For our development properties, estimates of future cash flows also include all future expenditures necessary to develop the asset, including interest payments that will be capitalized as part of the cost of the asset. An impairment loss is recognized only if the carrying amount of the asset is not recoverable and is measured based on the excess of the property’s carrying amount over its estimated fair value. If our estimates of future cash flows, anticipated holding periods, or fair values change, based on market conditions or otherwise, our evaluation of impairment charges may be different and such differences could be material to our consolidated financial statements. Estimates of future cash flows are subjective and are based, in part, on assumptions regarding future occupancy, rental rates and capital requirements that could differ materially from actual results. Plans to hold properties over longer periods decrease the likelihood of recording impairment losses. Allowance for Doubtful Accounts We periodically evaluate the collectibility of amounts due from tenants, including the receivable arising from the straight-lining of rents, and maintain an allowance for doubtful accounts ($671,000 and $1,501,000 as of December 31, 2018 and 2017, respectively) for estimated losses resulting from the inability of tenants to make required payments under the lease agreements. We exercise judgment in establishing these allowances and consider payment history and current credit status in developing these estimates. These estimates may differ from actual results, which could be material to our consolidated financial statements. Critical Accounting Policies and Estimates - continued Revenue Recognition Our revenues consist of property rentals and expense reimbursements. We have the following revenue sources and revenue recognition policies: • Base Rent is revenue arising from tenant leases. These rents are recognized over the non-cancelable term of the related leases on a straight-line basis, which includes the effects of rent steps and rent abatements. We commence rental revenue recognition when the tenant takes possession of the leased space and the leased space is substantially ready for its intended use. In addition, in circumstances where we provide a tenant improvement allowance for improvements that are owned by the tenant, we recognize the allowance as a reduction of rental revenue on a straight-line basis over the term of the lease. • Percentage Rent is revenue arising from retail tenant leases that is contingent upon the sales of tenants exceeding defined thresholds. These rents are recognized only after the contingency has been removed (i.e., when tenant sales thresholds have been achieved). • Parking Revenue arising from the rental of parking space at our properties. This income is recognized as the services are provided. • Operating Expense Reimbursements is revenue arising from tenant leases which provide for the recovery of all or a portion of the operating expenses and real estate taxes of our properties. Revenue is recognized in the same period as the related expenses are incurred. • Tenant Services is revenue arising from sub-metered electric, elevator and other services provided to tenants at their request. This revenue is recognized as the services are transferred. Before we recognize revenue, we assess, among other things, its collectibility. If our assessment of the collectibility of revenue changes, the impact on our consolidated financial statements could be material. Income Taxes We operate in a manner intended to enable us to continue to qualify as a REIT under Sections 856 - 860 of the Internal Revenue Code of 1986, as amended (the “Code”). In order to maintain our qualification as a REIT under the Code, we must distribute at least 90% of our taxable income to stockholders each year. We distribute to our stockholders 100% of our taxable income and therefore, no provision for Federal income taxes is required. If we fail to distribute the required amount of income to our stockholders, or fail to meet other REIT requirements, we may fail to qualify as a REIT, which may result in substantial adverse tax consequences. Results of Operations - Year Ended December 31, 2018 compared to December 31, 2017 Property Rentals Property rentals were $152,795,000 in the year ended December 31, 2018, compared to $152,857,000 in the prior year, a decrease of $62,000. This decrease was primarily due to lower revenue from Sears at our Rego Park I property and Toys at our Rego Park II property, partially offset by higher revenue from a new restaurant tenant at our 731 Lexington Avenue property. Expense Reimbursements Tenant expense reimbursements were $80,030,000 in the year ended December 31, 2018, compared to $77,717,000 in the prior year, an increase of $2,313,000. This increase was primarily due to higher real estate taxes and higher operating expenses. Operating Expenses Operating expenses were $93,775,000 in the year ended December 31, 2018, compared to $85,127,000 in the prior year, an increase of $8,648,000. This increase was primarily due to (i) higher bad debt expense of $4,406,000, (ii) higher real estate taxes of $2,180,000 and (iii) higher operating expenses of $1,664,000. Depreciation and Amortization Depreciation and amortization was $33,089,000 in the year ended December 31, 2018, compared to $34,925,000 in the prior year, a decrease of $1,836,000. This decrease was primarily due to additional depreciation and amortization of tenant improvements and deferred leasing costs of $2,444,000 related to a tenant lease termination at our 731 Lexington Avenue property in 2017. General and Administrative Expenses General and administrative expenses were $5,339,000 in the year ended December 31, 2018, compared to $5,252,000 in the prior year, an increase of $87,000. Interest and Other Income, net Interest and other income, net was $12,546,000 in the year ended December 31, 2018, compared to $6,716,000 in the prior year, an increase of $5,830,000. This increase was primarily due to (i) $4,673,000 of higher interest income from the Rego Park II loan participation entered into in July 2017 and (ii) $3,693,000 of higher interest income due to an increase in average interest rates, partially offset by (iii) $1,600,000 of expense from a litigation settlement and (iv) $760,000 of lower interest income due to lower average investment balances. Interest and Debt Expense Interest and debt expense was $44,533,000 in the year ended December 31, 2018, compared to $31,474,000 in the prior year, an increase of $13,059,000. This increase was primarily due to (i) $8,482,000 resulting from an increase in average LIBOR, (ii) $2,620,000 resulting from the refinancing of the office portion of 731 Lexington Avenue on June 1, 2017 for $500,000,000 at LIBOR plus 0.90% (previously a $300,000,000 loan at LIBOR plus 0.95%) and (iii) $1,641,000 of higher amortization of debt issuance costs. Change in Fair Value of Marketable Securities Change in fair value of marketable securities was an expense of $11,990,000 in the year ended December 31, 2018, resulting from Macerich’s closing share prices of $43.28 and $65.68 as of December 31, 2018 and 2017, respectively, on 535,265 shares owned. See Note 5 - Marketable Securities, to our consolidated financial statements in this Annual Report on Form 10-K. Income Taxes Income tax expense was $4,000 in the year ended December 31, 2018, compared to $3,000 in the prior year. Loss from Discontinued Operations Loss from discontinued operations was $23,797,000 in the year ended December 31, 2018. The loss was due to a payment of potential additional real property transfer taxes from the 2012 sale of Kings Plaza which is being contested. See Note 6 - Discontinued Operations, to our consolidated financial statements in this Annual Report on Form 10-K. Results of Operations - Year Ended December 31, 2017 compared to December 31, 2016 Property Rentals Property rentals were $152,857,000 in the year ended December 31, 2017, compared to $151,444,000 in the prior year, an increase of $1,413,000. This increase was primarily due to higher rental income of $3,730,000 from The Alexander apartment tower, which was placed in service in phases beginning July 2015 and leased up to stabilization in September 2016, partially offset by income of $2,257,000 in 2016 resulting from a tenant lease termination at our Rego Park II property. Expense Reimbursements Tenant expense reimbursements were $77,717,000 in the year ended December 31, 2017, compared to $75,492,000 in the prior year, an increase of $2,225,000. This increase was primarily due to higher real estate taxes and higher operating expenses. Operating Expenses Operating expenses were $85,127,000 in the year ended December 31, 2017, compared to $82,232,000 in the prior year, an increase of $2,895,000. This increase was primarily due to (i) higher real estate taxes of $3,267,000 and (ii) higher operating expenses of $903,000, partially offset by (iii) lower marketing costs for The Alexander apartment tower of $1,098,000 and (iv) lower bad debt expense of $504,000. Depreciation and Amortization Depreciation and amortization was $34,925,000 in the year ended December 31, 2017, compared to $33,807,000 in the prior year, an increase of $1,118,000. This increase was primarily due to additional depreciation and amortization of tenant improvements and deferred leasing costs of $2,444,000 related to a tenant lease termination at our 731 Lexington Avenue property in 2017, partially offset by additional depreciation and amortization of tenant improvements and deferred leasing costs of $1,077,000 in 2016 related to a tenant lease termination at our Rego Park II property. General and Administrative Expenses General and administrative expenses were $5,252,000 in the year ended December 31, 2017, compared to $5,436,000 in the prior year, a decrease of $184,000. This decrease was primarily due to lower director’s fees and stock-based compensation expense as a result of having one less member on our Board of Directors in 2017. Interest and Other Income, net Interest and other income, net was $6,716,000 in the year ended December 31, 2017, compared to $3,305,000 in the prior year, an increase of $3,411,000. This increase was primarily due to higher interest income of (i) $2,453,000 from the Rego Park II loan participation, (ii) $1,418,000 from an increase in the average interest rates and (iii) $216,000 from an increase in the average investment balances, partially offset by (iv) lower income of $429,000 in connection with bankruptcy recoveries and (v) income of $367,000 in 2016 from a cost reimbursement settlement with a retail tenant at our 731 Lexington Avenue property. Interest and Debt Expense Interest and debt expense was $31,474,000 in the year ended December 31, 2017, compared to $22,241,000 in the prior year, an increase of $9,233,000. This increase was primarily due to (i) $5,289,000 resulting from an increase in average LIBOR, (ii) $2,658,000 resulting from the refinancing of the office portion of 731 Lexington Avenue on June 1, 2017 for $500,000,000 at LIBOR plus 0.90% (previously a $300,000,000 loan at LIBOR plus 0.95%) and (iii) $1,188,000 of higher amortization of debt issuance costs. Income Taxes Income tax expense was $3,000 in the year ended December 31, 2017, compared to $48,000 in the prior year. Related Party Transactions Vornado As of December 31, 2018, Vornado owned 32.4% of our outstanding common stock. We are managed by, and our properties are leased and developed by, Vornado, pursuant to various agreements, which expire in March of each year and are automatically renewable. These agreements are described in Note 4 - Related Party Transactions, to our consolidated financial statements in this Annual Report on Form 10-K. Steven Roth is the Chairman of our Board of Directors and Chief Executive Officer, the Managing General Partner of Interstate Properties (“Interstate”), a New Jersey general partnership, and the Chairman of the Board of Trustees and Chief Executive Officer of Vornado. As of December 31, 2018, Mr. Roth, Interstate and its other two general partners, David Mandelbaum and Russell B. Wight, Jr. (who are also directors of the Company and trustees of Vornado) owned, in the aggregate, 26.2% of our outstanding common stock, in addition to the 2.3% they indirectly own through Vornado. Joseph Macnow, our Treasurer, is the Executive Vice President - Chief Financial Officer and Chief Administrative Officer of Vornado. Matthew Iocco, our Chief Financial Officer, is the Executive Vice President - Chief Accounting Officer of Vornado. Toys Our affiliate, Vornado, owned 32.5% of Toys as of December 31, 2018. On February 1, 2019, in connection with the Toys Chapter 11 bankruptcy, the plan of reorganization for Toys was declared effective and Vornado’s ownership in Toys was canceled and Toys’ Board of Directors was dissolved. Joseph Macnow, Vornado’s Executive Vice President and Chief Financial Officer and Wendy A. Silverstein, a member of our Board of Directors, represented Vornado as members of Toys’ Board of Directors. Also in connection with the Toys Chapter 11 bankruptcy, Toys rejected its 47,000 square foot lease at our Rego Park II shopping center ($2,600,000 of annual revenue) effective June 30, 2018 and possession of the space was returned to us. Consequently, we accelerated depreciation and amortization of the remaining balances of $588,000 of tenant improvements and $215,000 of deferred leasing costs during the year ended December 31, 2018. We also wrote off the Toys receivable arising from the straight-lining of rent of $500,000 during the year ended December 31, 2018. Liquidity and Capital Resources Property rental income is our primary source of cash flow and is dependent on a number of factors including the occupancy level and rental rates of our properties, as well as our tenants’ ability to pay their rents. Our properties provide us with a relatively consistent stream of cash flow that enables us to pay our operating expenses, interest expense, recurring capital expenditures and cash dividends to stockholders. Other sources of liquidity to fund cash requirements include our existing cash, proceeds from financings, including mortgage or construction loans secured by our properties and proceeds from asset sales. We anticipate that cash flows from continuing operations over the next twelve months, together with existing cash balances, will be adequate to fund our business operations, cash dividends to stockholders, debt amortization and capital expenditures. Dividends On January 16, 2019, we set our regular quarterly dividend to $4.50 per share (an indicated annual rate of $18.00 per share). The dividend, when declared by the Board of Directors for all of 2019, will require us to pay out approximately $92,100,000. Financing Activities and Contractual Obligations On June 1, 2017, we completed a $500,000,000 refinancing of the office portion of 731 Lexington Avenue. The interest-only loan is at LIBOR plus 0.90% (3.36% as of December 31, 2018) and matures in June 2020, with four one-year extension options. In connection therewith, we purchased an interest rate cap with a notional amount of $500,000,000 that caps LIBOR at a rate of 6.0%. The property was previously encumbered by a $300,000,000 interest-only mortgage at LIBOR plus 0.95% which was scheduled to mature in March 2021. On October 3, 2018, we extended our mortgage loan on our Paramus property. The $68,000,000 interest-only loan has a fixed rate of 4.72% and matures in October 2021. Previously the loan bore interest at a fixed rate of 2.90%. The tenant pays all of the interest on this mortgage loan as part of its rent. Liquidity and Capital Resources - continued On December 12, 2018, we completed a $252,544,000 refinancing of our Rego Park II shopping center. The interest-only loan is at LIBOR plus 1.35% (3.87% as of December 31, 2018) and matures in December 2025. The previous loan bore interest at LIBOR plus 1.85% and was scheduled to mature in January 2019. As of December 31, 2018, we hold a $195,708,000 participation in the mortgage loan, earning interest at LIBOR plus 1.35%. The participation in the previous mortgage loan earned interest at LIBOR plus 1.60%. Below is a summary of our outstanding debt and maturities as of December 31, 2018. We may refinance our maturing debt as it comes due or choose to repay it. Below is a summary of our contractual obligations and commitments as of December 31, 2018. Commitments and Contingencies Insurance We maintain general liability insurance with limits of $300,000,000 per occurrence and per property, and all-risk property and rental value insurance coverage with limits of $1.7 billion per occurrence, including coverage for acts of terrorism, with sub-limits for certain perils such as floods and earthquakes on each of our properties. Fifty Ninth Street Insurance Company, LLC (“FNSIC”), our wholly owned consolidated subsidiary, acts as a direct insurer for coverage for acts of terrorism, including nuclear, biological, chemical and radiological (“NBCR”) acts, as defined by the Terrorism Risk Insurance Program Reauthorization Act, which expires in December 2020. Coverage for acts of terrorism (including NBCR acts) is up to $1.7 billion per occurrence and in the aggregate. Coverage for acts of terrorism (excluding NBCR acts) is fully reinsured by third party insurance companies and the Federal government with no exposure to FNSIC. For NBCR acts, FNSIC is responsible for a $323,000 deductible and 19% of the balance of a covered loss, and the Federal government is responsible for the remaining 81% of a covered loss. We are ultimately responsible for any loss incurred by FNSIC. Liquidity and Capital Resources - continued We continue to monitor the state of the insurance market and the scope and costs of coverage for acts of terrorism or other events. However, we cannot anticipate what coverage will be available on commercially reasonable terms in the future. We are responsible for uninsured losses and for deductibles and losses in excess of our insurance coverage, which could be material. Our mortgage loans are non-recourse to us and contain customary covenants requiring us to maintain insurance. Although we believe that we have adequate insurance coverage for purposes of these agreements, we may not be able to obtain an equivalent amount of coverage at reasonable costs in the future. Further, if lenders insist on greater coverage than we are able to obtain, it could adversely affect our ability to finance or refinance our properties. Rego Park I Litigation In June 2014, Sears filed a lawsuit in the Supreme Court of the State of New York against Vornado and us (and certain of our subsidiaries) with regard to space that Sears leased at our Rego Park I property alleging that the defendants are liable for harm that Sears has suffered as a result of (a) water intrusions into the premises, (b) two fires in February 2014 that caused damages to those premises, and (c) alleged violations of the Americans with Disabilities Act in the premises’ parking garage. Sears asserted various causes of actions for damages and sought to compel compliance with landlord’s obligations to repair the premises and to provide security, and to compel us to abate a nuisance that Sears claims was a cause of the water intrusions into its premises. In addition to injunctive relief, Sears sought, among other things, damages of not less than $4 million and future damages it estimated would not be less than $25 million. In March 2016, Sears withdrew its claim for future damages leaving a remaining claim for property damages, which we estimate to be approximately $650,000 based on information provided by Sears. We intend to defend the remaining claim vigorously. The amount or range of reasonable possible losses, if any, is not expected to be greater than $650,000. On October 15, 2018, Sears filed for Chapter 11 bankruptcy relief resulting in an automatic stay of this case. Paramus In 2001, we leased 30.3 acres of land located in Paramus, New Jersey to IKEA Property, Inc. The lease has a purchase option in 2021 for $75,000,000. The property is encumbered by a $68,000,000 interest-only mortgage loan with a fixed rate of 4.72%, which matures in October 2021. The annual triple-net rent is the sum of $700,000 plus the amount of interest on the mortgage loan. If the purchase option is exercised, we will receive net cash proceeds of approximately $7,000,000 and recognize a gain on sale of land of approximately $60,000,000. If the purchase option is not exercised, the triple-net rent for the last 20 years would include debt service sufficient to fully amortize $68,000,000 over the remaining 20-year lease term. Letters of Credit Approximately $1,030,000 of standby letters of credit were outstanding as of December 31, 2018. Other We received $165,000, $396,000 and $825,000 from bankruptcy recoveries during the years ended December 31, 2018, 2017 and 2016, respectively, which is included as “interest and other income, net” in our consolidated statements of income. There are various other legal actions against us in the ordinary course of business. In our opinion, the outcome of such matters in the aggregate will not have a material effect on our financial position, results of operations or cash flows. Liquidity and Capital Resources - continued Cash Flows for the Year Ended December 31, 2018 Cash and cash equivalents and restricted cash were $289,495,000 at December 31, 2018, compared to $393,279,000 at December 31, 2017, a decrease of $103,784,000. This decrease resulted from (i) $176,185,000 of net cash used in financing activities and (ii) $1,137,000 of net cash used in investing activities, partially offset by (iii) $73,538,000 of net cash provided by operating activities. Net cash used in financing activities of $176,185,000 was primarily comprised of net debt repayments of $81,896,000 (primarily the refinancing and subsequent repayment of the mortgage loan on our Rego Park I shopping center) and dividends paid of $92,100,000. Net cash used in investing activities of $1,137,000 was comprised of construction in progress and real estate additions of $3,966,000, partially offset by repayment of Rego Park II loan participation of $2,829,000. Net cash provided by operating activities of $73,538,000 was comprised of (i) net income of $32,844,000 and (ii) adjustments for non-cash items of $56,807,000, partially offset by (iii) the net change in operating assets and liabilities of $16,113,000. The adjustments for non-cash items were comprised of (i) depreciation and amortization (including amortization of debt issuance costs) of $38,499,000, (ii) the change in fair value of marketable securities of $11,990,000, (iii) straight-lining of rental income of $5,924,000 and (iv) stock-based compensation expense of $394,000. Cash Flows for the Year Ended December 31, 2017 Cash and cash equivalents and restricted cash were $393,279,000 at December 31, 2017, compared to $374,678,000 at December 31, 2016, an increase of $18,601,000. This increase resulted from (i) $123,426,000 of net cash provided by operating activities and (ii) $97,146,000 of net cash provided by financing activities, partially offset by (iii) $201,971,000 of net cash used in investing activities. Net cash provided by operating activities of $123,426,000 was comprised of (i) net income of $80,509,000 and (ii) adjustments for non-cash items of $43,372,000, partially offset by (iii) the net change in operating assets and liabilities of $455,000. The adjustments for non-cash items were comprised of (i) depreciation and amortization (including amortization of debt issuance costs) of $38,681,000, (ii) straight-lining of rental income of $4,297,000 and (iii) stock-based compensation expense of $394,000. Net cash provided by financing activities of $97,146,000 was primarily comprised of (i) $500,000,000 of proceeds from the refinancing of the office portion of 731 Lexington Avenue, partially offset by (ii) debt repayments of $303,707,000 (primarily the repayment of the former loan on the office portion of 731 Lexington Avenue) and (iii) dividends paid of $86,961,000. Net cash used in investing activities of $201,971,000 was comprised of (i) Rego Park II loan participation of $200,000,000 and (ii) construction in progress and real estate additions of $3,434,000, partially offset by (iii) principal repayment proceeds from the Rego Park II loan participation of $1,463,000. Cash Flows for the Year Ended December 31, 2016 Cash and cash equivalents and restricted cash were $374,678,000 at December 31, 2016, compared to $344,656,000 at December 31, 2015, an increase of $30,022,000. This increase resulted from (i) $130,820,000 of net cash provided by operating activities, partially offset by (ii) $85,292,000 of net cash used in financing activities and (iii) $15,506,000 of net cash used in investing activities. Net cash provided by operating activities of $130,820,000 was comprised of (i) net income of $86,477,000, (ii) adjustments for non-cash items of $39,171,000, and (iii) the net change in operating assets and liabilities of $5,172,000. The adjustments for non-cash items were comprised of (i) depreciation and amortization (including amortization of debt issuance costs) of $36,374,000, (ii) straight-lining of rental income of $2,347,000 and (iii) stock-based compensation expense of $450,000. Net cash used in financing activities of $85,292,000 was primarily comprised of dividends paid of $81,822,000. Net cash used in investing activities of $15,506,000 was comprised of construction in progress and real estate additions of $15,506,000 (primarily related to The Alexander apartment tower), including the payment of a development fee to Vornado of $5,784,000. Funds from Operations (“FFO”) (non-GAAP) FFO is computed in accordance with the December 2018 restated definition adopted by the Board of Governors of NAREIT. NAREIT defines FFO as GAAP net income or loss adjusted to exclude net gains from sales of depreciable real estate assets, real estate impairment losses, depreciation and amortization expense from real estate assets and other specified items, including the pro rata share of such adjustments of unconsolidated subsidiaries. FFO and FFO per diluted share are used by management, investors and analysts to facilitate meaningful comparisons of operating performance between periods and among our peers because it excludes the effect of real estate depreciation and amortization and net gains on sales, which are based on historical costs and implicitly assume that the value of real estate diminishes predictably over time, rather than fluctuating based on existing market conditions. FFO does not represent cash generated from operating activities and is not necessarily indicative of cash available to fund cash requirements and should not be considered as an alternative to net income as a performance measure or cash flow as a liquidity measure. FFO may not be comparable to similarly titled measures employed by other companies. A reconciliation of our net income to FFO is provided below. In accordance with the NAREIT December 2018 restated definition of FFO, we have elected to exclude the mark-to-market adjustments of marketable securities from the calculation of FFO. Our FFO for the nine months ended September 30, 2018 has been adjusted to exclude the $5,561,000, or $1.08 per diluted share, from the decrease in fair value of marketable securities previously reported. Net income for the year and quarter ended December 31, 2018 included $11,990,000, or $2.34 per diluted share, and $6,429,000, or $1.26 per diluted share, respectively, from the decrease in fair value of marketable securities. FFO (non-GAAP) for the years and quarters ended December 31, 2018 and 2017 FFO (non-GAAP) for the year ended December 31, 2018 was $77,429,000, or $15.13 per diluted share, compared to $114,908,000, or $22.46 per diluted share for the year ended December 31, 2017. FFO (non-GAAP) for the year ended December 31, 2018 included $23,797,000, or $4.65 per diluted share, of expense for the potential additional New York City real property transfer taxes on the 2012 sale of Kings Plaza which is being contested. FFO (non-GAAP) for the quarter ended December 31, 2018 was $24,158,000, or $4.72 per diluted share, compared to $28,062,000, or $5.49 per diluted share for the quarter ended December 31, 2017. The following table reconciles our net income to FFO (non-GAAP):

<s>[INST] Alexander’s, Inc. (NYSE: ALX) is a real estate investment trust (“REIT”), incorporated in Delaware, engaged in leasing, managing, developing and redeveloping its properties. All references to “we,” “us,” “our,” “Company” and “Alexander’s” refer to Alexander’s, Inc. and its consolidated subsidiaries. We are managed by, and our properties are leased and developed by, Vornado Realty Trust (“Vornado”) (NYSE: VNO). We have seven properties in the greater New York City metropolitan area. We compete with a large number of property owners and developers. Our success depends upon, among other factors, trends of the global, national and local economies, the financial condition and operating results of current and prospective tenants and customers, the availability and cost of capital, construction and renovation costs, taxes, governmental regulations, legislation, population and employment trends, zoning laws, and our ability to lease, sublease or sell our properties, at profitable levels. Our success is also subject to our ability to refinance existing debt on acceptable terms as it comes due. Year Ended December 31, 2018 Financial Results Summary Net income for the year ended December 31, 2018 was $32,844,000 or $6.42 per diluted share, compared to $80,509,000, or $15.74 per diluted share for the year ended December 31, 2017. Net income for the year ended December 31, 2018 included (i) $23,797,000, or $4.65 per diluted share, of expense for potential additional New York City real property transfer taxes on the 2012 sale of Kings Plaza Regional Shopping Center (“Kings Plaza”) which is being contested and (ii) $11,990,000, or $2.34 per diluted share, from the decrease in the fair value of marketable securities resulting from a new GAAP accounting standard effective January 1, 2018. Previously, changes in the fair value of marketable securities were recognized through “accumulated other comprehensive (loss) income” on our consolidated balance sheets and did not impact our consolidated statements of income. Funds from operations (“FFO”) (nonGAAP) for the year ended December 31, 2018 was $77,429,000, or $15.13 per diluted share, compared to $114,908,000, or $22.46 per diluted share for the year ended December 31, 2017. FFO (nonGAAP) for the year ended December 31, 2018 included $23,797,000, or $4.65 per diluted share, of expense for the contested Kings Plaza transfer taxes. Quarter Ended December 31, 2018 Financial Results Summary Net income for the quarter ended December 31, 2018 was $9,971,000, or $1.95 per diluted share, compared to $17,883,000, or $3.50 per diluted share for the quarter ended December 31, 2017. Net income for the quarter ended December 31, 2018 included $6,429,000, or $1.26 per diluted share, from the decrease in the fair value of marketable securities. FFO (nonGAAP) for the quarter ended December 31, 2018 was $24,158,000, or $4.72 per diluted share, compared to $28,062,000, or $5.49 per diluted share for the quarter ended December 31, 2017. Square Footage, Occupancy and Leasing Activity As of December 31, 2018, our portfolio was comprised of seven properties aggregating 2,437,000 square feet. As [/INST] Negative. </s>

ALEXANDERS INC

2020-02-18

2019-12-31

ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Overview Alexander’s, Inc. (NYSE: ALX) is a real estate investment trust (“REIT”), incorporated in Delaware, engaged in leasing, managing, developing and redeveloping its properties. All references to “we,” “us,” “our,” “Company” and “Alexander’s” refer to Alexander’s, Inc. and its consolidated subsidiaries. We are managed by, and our properties are leased and developed by, Vornado Realty Trust (“Vornado”) (NYSE: VNO). We have seven properties in the greater New York City metropolitan area. We compete with a large number of property owners and developers. Our success depends upon, among other factors, trends of the global, national and local economies, the financial condition and operating results of current and prospective tenants and customers, the availability and cost of capital, construction and renovation costs, taxes, governmental regulations, legislation, population and employment trends, zoning laws, and our ability to lease, sublease or sell our properties, at profitable levels. Our success is also subject to our ability to refinance existing debt on acceptable terms as it comes due. Year Ended December 31, 2019 Financial Results Summary Net income for the year ended December 31, 2019 was $60,075,000 or $11.74 per diluted share, compared to $32,844,000, or $6.42 per diluted share for the year ended December 31, 2018. Net income for the year ended December 31, 2018 included $23,797,000, or $4.65 per diluted share, of expense for potential additional New York City real property transfer taxes on the 2012 sale of Kings Plaza Regional Shopping Center (“Kings Plaza”). Funds from operations (“FFO”) (non-GAAP) for the year ended December 31, 2019 was $99,670,000, or $19.47 per diluted share, compared to $77,429,000, or $15.13 per diluted share for the year ended December 31, 2018. FFO (non-GAAP) for the year ended December 31, 2018 included $23,797,000, or $4.65 per diluted share, of expense for the Kings Plaza transfer taxes. Quarter Ended December 31, 2019 Financial Results Summary Net income for the quarter ended December 31, 2019 was $14,434,000, or $2.82 per diluted share, compared to $9,971,000, or $1.95 per diluted share for the quarter ended December 31, 2018. FFO (non-GAAP) for the quarter ended December 31, 2019 was $24,626,000, or $4.81 per diluted share, compared to $24,158,000, or $4.72 per diluted share for the quarter ended December 31, 2018. Square Footage, Occupancy and Leasing Activity As of December 31, 2019, our portfolio was comprised of seven properties aggregating 2,449,000 square feet, of which 2,230,000 square feet was in service and 219,000 square feet (primarily the former Sears space at our Rego Park I shopping center) was out of service due to redevelopment. The in service square feet was 96.5% occupied as of December 31, 2019. On September 23, 2019, we entered into a 10-year lease agreement with IKEA for 113,000 square feet at our Rego Park I shopping center, replacing a significant portion of the space formerly occupied by Sears. IKEA has the option to terminate this lease after the fifth year of the lease term subject to payment to us of the lesser of $10,000,000 or the amount of rent due under the remaining term. Financing On October 3, 2018, we extended our mortgage loan on our Paramus property. The $68,000,000 interest-only loan has a fixed rate of 4.72% and matures in October 2021. Previously the loan bore interest at a fixed rate of 2.90%. The tenant pays all of the interest on this mortgage loan as part of its rent. On December 12, 2018, we completed a refinancing of our Rego Park II shopping center in the amount of $252,544,000. The interest-only loan is at LIBOR plus 1.35% (3.15% as of December 31, 2019) and matures in December 2025. As of December 31, 2019, we have a participation in the mortgage in the amount of $195,708,000 which for GAAP purposes is netted against the mortgage balance. Therefore, the balance sheet amount of the mortgage loan is $56,836,000. On February 14, 2020, we reduced our participation in the mortgage loan to $50,000,000 and received cash proceeds of approximately $145,000,000. Overview - continued Significant Tenant Bloomberg accounted for revenue of $109,113,000, $107,356,000, and $105,224,000 in the years ended December 31, 2019, 2018 and 2017, respectively, representing approximately 48%, 46% and 46% of our total revenues in each year, respectively. No other tenant accounted for more than 10% of our total revenues. If we were to lose Bloomberg as a tenant, or if Bloomberg were to be unable to fulfill its obligations under its lease, it would adversely affect our results of operations and financial condition. In order to assist us in our continuing assessment of Bloomberg’s creditworthiness, we receive certain confidential financial information and metrics from Bloomberg. In addition, we access and evaluate financial information regarding Bloomberg from other private sources, as well as publicly available data. On June 28, 2019, we entered into a lease agreement with Bloomberg for an additional 49,000 square feet at our 731 Lexington Avenue property. Critical Accounting Policies and Estimates Our financial statements are prepared in conformity with accounting principles generally accepted in the United States of America (“GAAP”), which requires us to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting periods. Actual results could differ from those estimates. Set forth below is a summary of our accounting policies that we believe are critical to the preparation of our consolidated financial statements. This summary should be read in conjunction with a more complete discussion of our accounting policies included in Note 2 - Summary of Significant Accounting Policies, to the consolidated financial statements in this Annual Report on Form 10-K. Real Estate Real estate is carried at cost, net of accumulated depreciation and amortization. As of December 31, 2019 and 2018, the carrying amount of our real estate, net of accumulated depreciation and amortization, was $716,843,000 and $730,270,000, respectively. Maintenance and repairs are expensed as incurred. Depreciation requires an estimate by management of the useful life of each property and improvement as well as an allocation of the costs associated with a property to its various components. If we do not allocate these costs appropriately or incorrectly estimate the useful lives of our real estate, depreciation expense may be misstated. We capitalize all property operating expenses directly associated with and attributable to, the development and construction of a project, including interest expense. The capitalization period begins when development activities are underway and ends when it is determined that the asset is substantially complete and ready for its intended use, which is typically evidenced by the receipt of a temporary certificate of occupancy. General and administrative costs are expensed as incurred. Our properties, including properties to be developed in the future, are individually reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of the assets may not be recoverable. An impairment exists when the carrying amount of an asset exceeds the sum of the undiscounted cash flows expected to result from the use and eventual disposition of the asset, including an estimated terminal value calculated using an appropriate capitalization rate. Estimates of future cash flows are based on our current plans, intended holding periods and available market information at the time the analyses are prepared. For our development properties, estimates of future cash flows also include all future expenditures necessary to develop the asset, including interest payments that will be capitalized as part of the cost of the asset. An impairment loss is recognized only if the carrying amount of the asset is not recoverable and is measured based on the excess of the property’s carrying amount over its estimated fair value. If our estimates of future cash flows, anticipated holding periods, or fair values change, based on market conditions or otherwise, our evaluation of impairment charges may be different and such differences could be material to our consolidated financial statements. Estimates of future cash flows are subjective and are based, in part, on assumptions regarding future occupancy, rental rates and capital requirements that could differ materially from actual results. Plans to hold properties over longer periods decrease the likelihood of recording impairment losses. Critical Accounting Policies and Estimates - continued Revenue Recognition Our rental revenues include revenues from the leasing of space to tenants at our properties and revenues from parking and tenant services. We have the following revenue recognition policies: • Lease revenues from the leasing of space to tenants at our properties. Revenues derived from base rent are recognized over the non-cancelable term of the related leases on a straight-line basis which includes the effects of rent steps and rent abatements. We commence rental revenue recognition when the underlying asset is available for use by the lessee. In addition, in circumstances where we provide a tenant improvement allowance for improvements that are owned by the tenant, we recognize the allowance as a reduction of rental revenue on a straight-line basis over the term of the lease. Revenues derived from the reimbursement of real estate taxes, insurance expenses and common area maintenance expenses are generally recognized in the same period as the related expenses are incurred. As lessor, we have elected to combine the lease components (base and variable rent), non-lease components (reimbursements of common area maintenance expenses) and reimbursement of real estate taxes and insurance expenses from our operating lease agreements and account for the components as a single lease component in accordance with ASC Topic 842, Leases (“ASC 842”). • Parking revenue arising from the rental of parking spaces at our properties. This income is recognized as the services are transferred in accordance with ASC Topic 606, Revenue from Contracts with Customers (“ASC 606”). • Tenant services is revenue arising from sub-metered electric, elevator and other services provided to tenants at their request. This revenue is recognized as the services are transferred in accordance with ASC 606. Income Taxes We operate in a manner intended to enable us to continue to qualify as a REIT under Sections 856 - 860 of the Internal Revenue Code of 1986, as amended (the “Code”). In order to maintain our qualification as a REIT under the Code, we must distribute at least 90% of our taxable income to stockholders each year. We distribute to our stockholders 100% of our taxable income and therefore, no provision for Federal income taxes is required. If we fail to distribute the required amount of income to our stockholders, or fail to meet other REIT requirements, we may fail to qualify as a REIT, which may result in substantial adverse tax consequences. Results of Operations - Year Ended December 31, 2019 compared to December 31, 2018 Rental Revenues Rental revenues were $226,350,000 in the year ended December 31, 2019, compared to $232,825,000 in the prior year, a decrease of $6,475,000. This decrease was primarily due to the Sears vacancy effective October 2018 at our Rego Park I property. Operating Expenses Operating expenses were $89,738,000 in the year ended December 31, 2019, compared to $93,775,000 in the prior year, a decrease of $4,037,000. This decrease was primarily due to bad debt expense in the prior year of $4,459,000, primarily due to the Sears bankruptcy and lease termination. Depreciation and Amortization Depreciation and amortization was $31,351,000 in the year ended December 31, 2019, compared to $33,089,000 in the prior year, a decrease of $1,738,000. This decrease was primarily due to acceleration of depreciation and amortization in the prior year related to the Toys “R” Us, Inc. (“Toys”) bankruptcy and lease termination at our Rego Park II property. General and Administrative Expenses General and administrative expenses were $5,772,000 in the year ended December 31, 2019, compared to $5,343,000 in the prior year, an increase of $429,000. This increase was primarily due to higher professional fees. Interest and Other Income, net Interest and other income, net was $8,244,000 in the year ended December 31, 2019, compared to $12,546,000 in the prior year, a decrease of $4,302,000. This decrease was primarily due to (i) $7,126,000 of interest income in the prior year from our Rego Park II loan participation (on December 12, 2018, we refinanced our $252,544,000 Rego Park II shopping center mortgage loan and GAAP required that our $195,708,000 loan participation be treated as an extinguishment of debt), partially offset by (ii) $1,364,000 of higher interest income due to an increase in average interest rates and (iii) $1,600,000 of expense in the prior year from a litigation settlement. Interest and Debt Expense Interest and debt expense was $38,901,000 in the year ended December 31, 2019, compared to $44,533,000 in the prior year, a decrease of $5,632,000. This decrease was primarily due to $7,178,000 of lower interest expense due to the refinancing of our Rego Park II shopping center loan, partially offset by $1,810,000 of higher interest expense resulting from an increase in average interest rates. Change in Fair Value of Marketable Securities Change in fair value of marketable securities was an expense of $8,757,000 in the year ended December 31, 2019, resulting from Macerich’s closing share prices of $26.92 and $43.28 as of December 31, 2019 and 2018, respectively, on 535,265 shares owned. Change in fair value of marketable securities was an expense of $11,990,000 in the prior year, resulting from Macerich’s closing share prices of $43.28 and $65.68 as of December 31, 2018 and 2017, respectively. Loss from Discontinued Operations Loss from discontinued operations was $23,797,000 in the year ended December 31, 2018. The loss was due to an expense for potential additional real property transfer taxes from the 2012 sale of Kings Plaza. See Note 6 - Discontinued Operations, to our consolidated financial statements in this Annual Report on Form 10-K. Results of Operations - Year Ended December 31, 2018 compared to December 31, 2017 Rental Revenues Rental revenues were $232,825,000 in the year ended December 31, 2018, compared to $230,574,000 in the prior year, an increase of $2,251,000. This increase was primarily due to (i) higher revenue from a new restaurant tenant at our 731 Lexington property and (ii) higher expense reimbursements, partially offset by (iii) lower revenue from Sears at our Rego Park I property and Toys at our Rego Park II property. Operating Expenses Operating expenses were $93,775,000 in the year ended December 31, 2018, compared to $85,127,000 in the prior year, an increase of $8,648,000. This increase was primarily due to (i) higher bad debt expense of $4,406,000, (ii) higher real estate taxes of $2,180,000 and (iii) higher operating expenses of $1,664,000. Depreciation and Amortization Depreciation and amortization was $33,089,000 in the year ended December 31, 2018, compared to $34,925,000 in the prior year, a decrease of $1,836,000. This decrease was primarily due to additional depreciation and amortization of tenant improvements and deferred leasing costs of $2,444,000 related to a tenant lease termination at our 731 Lexington Avenue property in 2017. General and Administrative Expenses General and administrative expenses were $5,343,000 in the year ended December 31, 2018, compared to $5,255,000 in the prior year, an increase of $88,000. Interest and Other Income, net Interest and other income, net was $12,546,000 in the year ended December 31, 2018, compared to $6,716,000 in the prior year, an increase of $5,830,000. This increase was primarily due to (i) $4,673,000 of higher interest income from the Rego Park II loan participation entered into in July 2017 and (ii) $3,693,000 of higher interest income due to an increase in average interest rates, partially offset by (iii) $1,600,000 of expense in 2018 from a litigation settlement and (iv) $760,000 of lower interest income due to lower average investment balances. Interest and Debt Expense Interest and debt expense was $44,533,000 in the year ended December 31, 2018, compared to $31,474,000 in the prior year, an increase of $13,059,000. This increase was primarily due to (i) $8,482,000 resulting from an increase in average interest rates, (ii) $2,620,000 resulting from the refinancing of the office portion of 731 Lexington Avenue on June 1, 2017 for $500,000,000 at LIBOR plus 0.90% (previously a $300,000,000 loan at LIBOR plus 0.95%) and (iii) $1,641,000 of higher amortization of debt issuance costs. Change in Fair Value of Marketable Securities Change in fair value of marketable securities was an expense of $11,990,000 in the year ended December 31, 2018, resulting from Macerich’s closing share prices of $43.28 and $65.68 as of December 31, 2018 and 2017, respectively, on 535,265 shares owned. Loss from Discontinued Operations Loss from discontinued operations was $23,797,000 in the year ended December 31, 2018. The loss was due to an expense for potential additional real property transfer taxes from the 2012 sale of Kings Plaza. See Note 6 - Discontinued Operations, to our consolidated financial statements in this Annual Report on Form 10-K. Related Party Transactions Vornado As of December 31, 2019, Vornado owned 32.4% of our outstanding common stock. We are managed by, and our properties are leased and developed by, Vornado, pursuant to various agreements, which expire in March of each year and are automatically renewable. These agreements are described in Note 4 - Related Party Transactions, to our consolidated financial statements in this Annual Report on Form 10-K. Steven Roth is the Chairman of our Board of Directors and Chief Executive Officer, the Managing General Partner of Interstate Properties (“Interstate”), a New Jersey general partnership, and the Chairman of the Board of Trustees and Chief Executive Officer of Vornado. As of December 31, 2019, Mr. Roth, Interstate and its other two general partners, David Mandelbaum and Russell B. Wight, Jr. (who are also directors of the Company and trustees of Vornado) owned, in the aggregate, 26.1% of our outstanding common stock, in addition to the 2.3% they indirectly own through Vornado. Joseph Macnow, our Treasurer, is the Executive Vice President - Chief Financial Officer and Chief Administrative Officer of Vornado. Matthew Iocco, our Chief Financial Officer, is the Executive Vice President - Chief Accounting Officer of Vornado. Toys Our affiliate, Vornado, owned 32.5% of Toys as of December 31, 2018. On February 1, 2019, in connection with the Toys Chapter 11 bankruptcy, the plan of reorganization for Toys was declared effective and Vornado’s ownership in Toys was canceled and Toys’ Board of Directors was dissolved. Joseph Macnow, Vornado’s Executive Vice President and Chief Financial Officer and Wendy A. Silverstein, a member of our Board of Directors, represented Vornado as members of Toys’ Board of Directors. Also in connection with the Toys Chapter 11 bankruptcy, Toys rejected its 47,000 square foot lease at our Rego Park II shopping center ($2,600,000 of annual revenue) effective June 30, 2018 and possession of the space was returned to us. Liquidity and Capital Resources Property rental income is our primary source of cash flow and is dependent on a number of factors including the occupancy level and rental rates of our properties, as well as our tenants’ ability to pay their rents. Our properties provide us with a relatively consistent stream of cash flow that enables us to pay our operating expenses, interest expense, recurring capital expenditures and cash dividends to stockholders. Other sources of liquidity to fund cash requirements include our existing cash, proceeds from financings, including mortgage or construction loans secured by our properties and proceeds from asset sales. We anticipate that cash flows from continuing operations over the next twelve months, together with existing cash balances, will be adequate to fund our business operations, cash dividends to stockholders and capital expenditures. Dividends On January 15, 2020, we set our regular quarterly dividend to $4.50 per share (an indicated annual rate of $18.00 per share). The dividend, if declared by the Board of Directors for all of 2020, would require us to pay out approximately $92,100,000. Financing Activities and Contractual Obligations On October 3, 2018, we extended our mortgage loan on our Paramus property. The $68,000,000 interest-only loan has a fixed rate of 4.72% and matures in October 2021. Previously the loan bore interest at a fixed rate of 2.90%. The tenant pays all of the interest on this mortgage loan as part of its rent. On December 12, 2018, we completed a refinancing of our Rego Park II shopping center in the amount of $252,544,000. The interest-only loan is at LIBOR plus 1.35% (3.15% as of December 31, 2019) and matures in December 2025. As of December 31, 2019, we have a participation in the mortgage in the amount of $195,708,000 which for GAAP purposes is netted against the mortgage balance. Therefore, the balance sheet amount of the mortgage loan is $56,836,000. On February 14, 2020, we reduced our participation in the mortgage loan to $50,000,000 and received cash proceeds of approximately $145,000,000. Liquidity and Capital Resources - continued Below is a summary of our outstanding debt and maturities as of December 31, 2019. We may refinance our maturing debt as it comes due or choose to repay it. Below is a summary of our contractual obligations and commitments as of December 31, 2019. Commitments and Contingencies Insurance We maintain general liability insurance with limits of $300,000,000 per occurrence and per property, and all-risk property and rental value insurance coverage with limits of $1.7 billion per occurrence, including coverage for acts of terrorism, with sub-limits for certain perils such as floods and earthquakes on each of our properties. Fifty Ninth Street Insurance Company, LLC (“FNSIC”), our wholly owned consolidated subsidiary, acts as a direct insurer for coverage for acts of terrorism, including nuclear, biological, chemical and radiological (“NBCR”) acts, as defined by the Terrorism Risk Insurance Act of 2002, as amended to date and which has been extended through December 2027. Coverage for acts of terrorism (including NBCR acts) is up to $1.7 billion per occurrence and in the aggregate. Coverage for acts of terrorism (excluding NBCR acts) is fully reinsured by third party insurance companies and the Federal government with no exposure to FNSIC. For NBCR acts, FNSIC is responsible for a $268,000 deductible and 20% of the balance of a covered loss, and the Federal government is responsible for the remaining 80% of a covered loss. We are ultimately responsible for any loss incurred by FNSIC. Liquidity and Capital Resources - continued We continue to monitor the state of the insurance market and the scope and costs of coverage for acts of terrorism or other events. However, we cannot anticipate what coverage will be available on commercially reasonable terms in the future. We are responsible for uninsured losses and for deductibles and losses in excess of our insurance coverage, which could be material. Our mortgage loans are non-recourse to us and contain customary covenants requiring us to maintain insurance. Although we believe that we have adequate insurance coverage for purposes of these agreements, we may not be able to obtain an equivalent amount of coverage at reasonable costs in the future. Further, if lenders insist on greater coverage than we are able to obtain, it could adversely affect our ability to finance or refinance our properties. Paramus In 2001, we leased 30.3 acres of land located in Paramus, New Jersey to IKEA. The lease has a purchase option in 2021 for $75,000,000. The property is encumbered by a $68,000,000 interest-only mortgage loan with a fixed rate of 4.72%, which matures in October 2021. The annual triple-net rent is the sum of $700,000 plus the amount of interest on the mortgage loan. If the purchase option is exercised, we will receive net cash proceeds of approximately $7,000,000 and recognize a gain on sale of land of approximately $60,000,000. If the purchase option is not exercised, the triple-net rent for the last 20 years would include debt service sufficient to fully amortize $68,000,000 over the remaining 20-year lease term. Rego Park I Litigation In June 2014, Sears filed a lawsuit in the Supreme Court of the State of New York against Vornado and us (and certain of our subsidiaries) with regard to space that Sears leased at our Rego Park I property alleging that the defendants are liable for harm that Sears has suffered as a result of (a) water intrusions into the premises, (b) two fires in February 2014 that caused damages to those premises, and (c) alleged violations of the Americans with Disabilities Act in the premises’ parking garage. Sears asserted various causes of actions for damages and sought to compel compliance with landlord’s obligations to repair the premises and to provide security, and to compel us to abate a nuisance that Sears claims was a cause of the water intrusions into its premises. In addition to injunctive relief, Sears sought, among other things, damages of not less than $4,000,000 and future damages it estimated would not be less than $25,000,000. In March 2016, Sears withdrew its claim for future damages leaving a remaining claim for property damages, which we estimate to be approximately $650,000 based on information provided by Sears. We intend to defend the remaining claim vigorously. The amount or range of reasonable possible losses, if any, is not expected to be greater than $650,000. On October 15, 2018, Sears filed for Chapter 11 bankruptcy relief resulting in an automatic stay of this case. Tenant Matter On April 13, 2019, Kohl’s closed its 133,000 square foot store at our Rego Park II shopping center. On January 24, 2020, Kohl’s subleased its store to At Home and remains obligated under its lease which expires in January 2031. Letters of Credit Approximately $1,030,000 of standby letters of credit were issued and outstanding as of December 31, 2019. Other There are various other legal actions against us in the ordinary course of business. In our opinion, the outcome of such matters in the aggregate will not have a material effect on our financial position, results of operations or cash flows. Liquidity and Capital Resources - continued Cash Flows for the Year Ended December 31, 2019 Cash and cash equivalents and restricted cash were $313,977,000 at December 31, 2019, compared to $289,495,000 at December 31, 2018, an increase of $24,482,000. This increase resulted from (i) $126,070,000 of net cash provided by operating activities, partially offset by (ii) $92,139,000 of net cash used in financing activities and (iii) $9,449,000 of net cash used in investing activities. Net cash provided by operating activities of $126,070,000 was comprised of (i) net income of $60,075,000, (ii) adjustments for non-cash items of $48,079,000 and (iii) the net change in operating assets and liabilities of $17,916,000. The adjustments for non-cash items were comprised of (i) depreciation and amortization (including amortization of debt issuance costs) of $36,515,000, (ii) the change in fair value of marketable securities of $8,757,000, (iii) straight-lining of rental income of $2,413,000 and (iv) stock-based compensation expense of $394,000. Net cash used in financing activities was primarily comprised of dividends paid of $92,124,000. Net cash used in investing activities was comprised of construction in progress and real estate additions of $9,449,000. Cash Flows for the Year Ended December 31, 2018 Cash and cash equivalents and restricted cash were $289,495,000 at December 31, 2018, compared to $393,279,000 at December 31, 2017, a decrease of $103,784,000. This decrease resulted from (i) $176,185,000 of net cash used in financing activities and (ii) $1,137,000 of net cash used in investing activities, partially offset by (iii) $73,538,000 of net cash provided by operating activities. Net cash used in financing activities of $176,185,000 was primarily comprised of net debt repayments of $81,896,000 (primarily the refinancing and subsequent repayment of the mortgage loan on our Rego Park I shopping center) and dividends paid of $92,100,000. Net cash used in investing activities of $1,137,000 was comprised of construction in progress and real estate additions of $3,966,000, partially offset by repayment of Rego Park II loan participation of $2,829,000. Net cash provided by operating activities of $73,538,000 was comprised of (i) net income of $32,844,000 and (ii) adjustments for non-cash items of $56,807,000, partially offset by (iii) the net change in operating assets and liabilities of $16,113,000. The adjustments for non-cash items were comprised of (i) depreciation and amortization (including amortization of debt issuance costs) of $38,499,000, (ii) the change in fair value of marketable securities of $11,990,000, (iii) straight-lining of rental income of $5,924,000 and (iv) stock-based compensation expense of $394,000. Cash Flows for the Year Ended December 31, 2017 Cash and cash equivalents and restricted cash were $393,279,000 at December 31, 2017, compared to $374,678,000 at December 31, 2016, an increase of $18,601,000. This increase resulted from (i) $123,426,000 of net cash provided by operating activities and (ii) $97,146,000 of net cash provided by financing activities, partially offset by (iii) $201,971,000 of net cash used in investing activities. Net cash provided by operating activities of $123,426,000 was comprised of (i) net income of $80,509,000 and (ii) adjustments for non-cash items of $43,372,000, partially offset by (iii) the net change in operating assets and liabilities of $455,000. The adjustments for non-cash items were comprised of (i) depreciation and amortization (including amortization of debt issuance costs) of $38,681,000, (ii) straight-lining of rental income of $4,297,000 and (iii) stock-based compensation expense of $394,000. Net cash provided by financing activities of $97,146,000 was primarily comprised of (i) $500,000,000 of proceeds from the refinancing of the office portion of 731 Lexington Avenue, partially offset by (ii) debt repayments of $303,707,000 (primarily the repayment of the former loan on the office portion of 731 Lexington Avenue) and (iii) dividends paid of $86,961,000. Net cash used in investing activities of $201,971,000 was comprised of (i) Rego Park II loan participation of $200,000,000 and (ii) construction in progress and real estate additions of $3,434,000, partially offset by (iii) principal repayment proceeds from the Rego Park II loan participation of $1,463,000. Funds from Operations (“FFO”) (non-GAAP) FFO is computed in accordance with the December 2018 restated definition adopted by the Board of Governors of the National Association of Real Estate Investment Trusts (“NAREIT”). NAREIT defines FFO as GAAP net income or loss adjusted to exclude net gains from sales of depreciable real estate assets, real estate impairment losses, depreciation and amortization expense from real estate assets and other specified items, including the pro rata share of such adjustments of unconsolidated subsidiaries. FFO and FFO per diluted share are used by management, investors and analysts to facilitate meaningful comparisons of operating performance between periods and among our peers because it excludes the effect of real estate depreciation and amortization and net gains on sales, which are based on historical costs and implicitly assume that the value of real estate diminishes predictably over time, rather than fluctuating based on existing market conditions. FFO does not represent cash generated from operating activities and is not necessarily indicative of cash available to fund cash requirements and should not be considered as an alternative to net income as a performance measure or cash flow as a liquidity measure. FFO may not be comparable to similarly titled measures employed by other companies. A reconciliation of our net income to FFO is provided below. FFO (non-GAAP) for the years and quarters ended December 31, 2019 and 2018 FFO (non-GAAP) for the year ended December 31, 2019 was $99,670,000, or $19.47 per diluted share, compared to $77,429,000, or $15.13 per diluted share for the year ended December 31, 2018. FFO (non-GAAP) for the year ended December 31, 2018 included $23,797,000, or $4.65 per diluted share, of expense for the potential additional New York City real property transfer taxes on the 2012 sale of Kings Plaza. FFO (non-GAAP) for the quarter ended December 31, 2019 was $24,626,000, or $4.81 per diluted share, compared to $24,158,000, or $4.72 per diluted share for the quarter ended December 31, 2018. The following table reconciles our net income to FFO (non-GAAP):

<s>[INST] Alexander’s, Inc. (NYSE: ALX) is a real estate investment trust (“REIT”), incorporated in Delaware, engaged in leasing, managing, developing and redeveloping its properties. All references to “we,” “us,” “our,” “Company” and “Alexander’s” refer to Alexander’s, Inc. and its consolidated subsidiaries. We are managed by, and our properties are leased and developed by, Vornado Realty Trust (“Vornado”) (NYSE: VNO). We have seven properties in the greater New York City metropolitan area. We compete with a large number of property owners and developers. Our success depends upon, among other factors, trends of the global, national and local economies, the financial condition and operating results of current and prospective tenants and customers, the availability and cost of capital, construction and renovation costs, taxes, governmental regulations, legislation, population and employment trends, zoning laws, and our ability to lease, sublease or sell our properties, at profitable levels. Our success is also subject to our ability to refinance existing debt on acceptable terms as it comes due. Year Ended December 31, 2019 Financial Results Summary Net income for the year ended December 31, 2019 was $60,075,000 or $11.74 per diluted share, compared to $32,844,000, or $6.42 per diluted share for the year ended December 31, 2018. Net income for the year ended December 31, 2018 included $23,797,000, or $4.65 per diluted share, of expense for potential additional New York City real property transfer taxes on the 2012 sale of Kings Plaza Regional Shopping Center (“Kings Plaza”). Funds from operations (“FFO”) (nonGAAP) for the year ended December 31, 2019 was $99,670,000, or $19.47 per diluted share, compared to $77,429,000, or $15.13 per diluted share for the year ended December 31, 2018. FFO (nonGAAP) for the year ended December 31, 2018 included $23,797,000, or $4.65 per diluted share, of expense for the Kings Plaza transfer taxes. Quarter Ended December 31, 2019 Financial Results Summary Net income for the quarter ended December 31, 2019 was $14,434,000, or $2.82 per diluted share, compared to $9,971,000, or $1.95 per diluted share for the quarter ended December 31, 2018. FFO (nonGAAP) for the quarter ended December 31, 2019 was $24,626,000, or $4.81 per diluted share, compared to $24,158,000, or $4.72 per diluted share for the quarter ended December 31, 2018. Square Footage, Occupancy and Leasing Activity As of December 31, 2019, our portfolio was comprised of seven properties aggregating 2,449,000 square feet, of which 2,230,000 square feet was in service and 219,000 square feet (primarily the former Sears space at our Rego Park I shopping center) was out of service due to redevelopment. The in service square feet was 96.5% occupied as of December 31, 2019. On September 23, 2019, we entered into a 10year lease agreement with IKEA for 113,000 square feet at our Rego Park I shopping center, replacing a significant portion of the space formerly occupied by Sears. IKEA has the option to terminate this lease after the fifth year of the lease term subject to payment to us of the lesser of $ [/INST] Negative. </s>

SENSIENT TECHNOLOGIES CORP

2016-02-25

2015-12-31

Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operation. OVERVIEW Sensient Technologies Corporation (the “Company”) is a global developer, manufacturer and supplier of flavor and fragrance systems for the food, beverage, personal care and household-products industries. In addition, the Company is a developer, manufacturer and supplier of colors for businesses worldwide. The Company provides natural and synthetic color systems for use in foods, beverages and pharmaceuticals; colors and other ingredients for cosmetics, pharmaceuticals and specialty inks; and technical colors for industrial applications. The Company has three reporting segments: the Flavors & Fragrances segment; the Color segment; and the Asia Pacific segment. The Company’s 2015 diluted earnings per share from continuing operations were $2.32 in 2015 and $1.67 in 2014. Included in the 2015 and 2014 results, were $43.6 million and $90.6 million, respectively, of restructuring and other costs, or 73 cents per share and $1.34 per share, respectively. Adjusted diluted earnings per share, which exclude these restructuring and other costs, were $3.05 in 2015 and $3.02 in 2014 (see discussion below regarding Non-GAAP Financial Measures and the Company’s Restructuring Activities). In 2015, the Company continued a series of strategic initiatives to increase shareholder value. The Company’s restructuring activities continue to eliminate underperforming businesses and consolidate manufacturing operations. The Company continued to pay an uninterrupted since 1962 quarterly cash dividend and increased the quarterly dividend by 2 cents per share from 25 cents to 27 cents per share, or $1.08 per share on an annualized basis, in 2015. Furthermore, the Company repurchased $176.6 million of Company stock in 2015, which is in addition to the $137.2 million repurchased in 2014. Additional information on the results is included below. RESULTS OF CONTINUING OPERATIONS 2015 vs. 2014 Revenue Sensient’s revenue was $1.4 billion in both 2015 and 2014. The impact of foreign exchange rates reduced consolidated revenue by 7.4% in 2015. Gross Profit The Company’s gross margin was 33.0% in 2015 and 33.7% in 2014. Included in the cost of products sold are $6.1 million and $1.9 million of restructuring costs for 2015 and 2014, respectively. The decrease in the gross margin is primarily due to the lower volumes in the Color segment’s specialty inks business and higher restructuring costs. Restructuring costs reduced gross margin by 50 basis points and 20 basis points in 2015 and 2014, respectively. Selling and Administrative Expenses Selling and administrative expense as a percent of revenue was 20.9% in 2015 and 24.7% in 2014. Restructuring and other costs of $37.5 million and $88.6 million for 2015 and 2014, respectively, were included in selling and administrative expense. The decrease in selling and administrative expense as a percent of revenue is primarily a result of the decrease in restructuring and other costs, and lower corporate expenses, primarily a reduction of performance based executive compensation costs of $6.8 million. Restructuring and other costs increased selling and administrative expense as a percent of revenue by 270 basis points and 610 basis points in 2015 and 2014, respectively. Operating Income Operating income was $166.3 million in 2015 and $130.7 million in 2014. Operating margins increased to 12.1% in 2015 from 9.0% in 2014. Restructuring and other costs reduced operating margins by 320 basis points and 630 basis points in 2015 and 2014, respectively. Additional information on segment results can be found in the Segment Information section. Interest Expense Interest expense was $16.9 million in 2015 and $16.1 million in 2014. The increase in expense was primarily due to the increase in average debt outstanding which was partially offset by the lower average interest rates. Income Taxes The effective income tax rate was 28.2% in 2015 and 28.6% in 2014. The effective tax rates in both 2015 and 2014 were impacted by changes in estimates associated with the finalization of prior year tax items, audit settlements, mix of foreign earnings and restructuring costs. In total, net impact of the discrete items and restructuring costs reduced the effective income tax rate by 2.4% for 2015 and had no net impact on the rate in 2014. Index Acquisition On June 29, 2015, the Company completed the acquisition of the business and net assets of Xennia Technology Ltd. (“Xennia”) for $8.4 million. The Xennia business has been integrated with the specialty inks business in the Color segment. The Company acquired goodwill and intangibles of approximately $6.2 million and has incurred acquisition related costs of $0.8 million, which are included in the Corporate & Other segment. Restructuring The Company incurred restructuring costs in both continuing and discontinued operations. The discussion in this note relates to the combination of both continuing and discontinued operations unless otherwise noted. Restructuring costs related to discontinued operations are recorded in discontinued operations within the Company’s Consolidated Statements of Earnings and are discussed in more detail in Note 13, Discontinued Operations. In March of 2014, the Company announced that it was initiating a restructuring plan (2014 Restructuring Plan or “Plan”) to eliminate underperforming operations, consolidate manufacturing facilities and improve efficiencies within the Company. The Company determined that it had redundant manufacturing capabilities in both North America and Europe and that it could lower costs and operate more efficiently by consolidating into fewer facilities. Eight facilities were identified for consolidation in the Flavors & Fragrances segment, four in North America and four in Europe. To date, closures have been announced in Indianapolis, Indiana, United States; Cornwall, Mississauga and Halton Hills, Canada; Bremen, Germany; and Milan, Italy. The Company also discontinued one of the businesses in the Color segment, located near Leipzig, Germany, because it did not fit with the Company’s long term strategic plan and it had generated losses for several years. In 2015, the Company identified additional opportunities to consolidate manufacturing operations at one of the Color segment’s facilities in Europe and eliminate additional positions in the European Flavors & Fragrances businesses. Based on this Plan, the Company determined that certain long-lived assets associated with the underperforming operations were impaired. The Company reduced the carrying amounts of these assets to their aggregate respective fair values which were determined based on independent market valuations. The fair values of the remaining long-lived assets are estimated to be approximately $19 million, which includes certain of the land, buildings and equipment in the assets held for sale, noted below. Also certain machinery and equipment has been identified to be disposed of at the time of the facility closures and the associated depreciation for these assets has been accelerated. The Company recorded long-lived asset impairments, including the impairment charges and accelerated depreciation of $14.5 million and $70.2 million, during the years ended December 31, 2015 and 2014, respectively. Since initiating the Plan, the Company has recorded $84.7 million of long-lived asset impairments, including the impairment charges and accelerated depreciation. In addition, certain intangible assets, inventory and other current assets were also determined to be impaired and were written down. The Company has also incurred employee separation and other restructuring costs as a result of this Plan. The Company expects to reduce headcount by approximately 400 positions at the affected facilities, primarily in the Flavors & Fragrances segment, related to direct and indirect labor at manufacturing sites. As of December 31, 2015, approximately 220 positions have been eliminated as a result of this Plan. As a part of the Plan, the Company anticipates selling its European Natural Ingredients business, a business in the Flavors & Fragrances segment, in 2016. This business has two facilities, located in Marchais, France and Elburg, the Netherlands, which will be included in the expected sale. The European Natural Ingredients business has not generated significant profits for several years and it does not fit with the Company’s long-term strategic plan. In connection with the anticipated sale of the European Natural Ingredients business, the Company has recorded an impairment charge of $2.0 million in 2015, reducing the carrying value of the long-lived assets for this business to zero. An estimate of the fair value of this business, less cost to sell, was determined to be lower than its carrying value. The difference between the fair value and its carrying value exceeded the existing net book value of the long-lived assets. Upon completion of the sale, the Company expects to recognize an additional non-cash loss of approximately $12.0 million. The Company has recorded assets held for sale of land, buildings and equipment of $9.6 million related to the 2014 Restructuring Plan, and inventory, receivables and other assets of $21.4 million related to the anticipated sale of the European Natural Ingredients business. The Company also has $4.1 million of liabilities held for sale related to the anticipated sale of the European Natural Ingredients business. The Company recorded total restructuring costs of $42.8 million and $98.4 million in the years ended December 31, 2015 and 2014, respectively, in accordance with GAAP and based on an internal review of the affected facilities and consultation with legal and other advisors. Since initiating the 2014 Restructuring Plan, the Company has incurred $141 million of restructuring costs through December 31, 2015. The Company expects to incur approximately $16 million of additional restructuring costs by the end of 2016. Index The Company expects that the closure and sale of these operations will significantly lower the Company's operating costs over the next few years. Upon initiating the Plan, the Company estimated the annual cost reductions to be approximately $30 million, when fully implemented. The U.S. dollar has strengthened considerably since the initiation of the Plan, and based on the current exchange rates, the dollar value of the same cost savings would now be approximately $22 million. In 2015, the Company identified additional cost savings opportunities and as a result of these actions the current estimate of annual cost savings is approximately $27 million. The Company has already realized approximately $12 million of these cost savings, with approximately $3 million realized in 2014 and an additional $9 million in 2015. The Company expects to realize approximately $6 million to $7 million of incremental savings in 2016 and the remaining savings in 2017. The Company has also implemented price increases to further mitigate the impact of foreign currency movements. In connection with the 2014 Restructuring Plan, the Company approved a plan to dispose of a certain business within the Color segment. Production ceased in 2014 and the business met the criteria to be reported as a discontinued operation. The pre-tax loss from discontinued operations, which includes restructuring costs, was not material in 2015 and $11.5 million in 2014. NON-GAAP FINANCIAL MEASURES Within the following tables, the Company reports certain non-GAAP financial measures, including: (1) adjusted operating income, adjusted net earnings and adjusted diluted EPS from continuing operations (which exclude restructuring costs, acquisition related costs, and costs related to the 2014 proxy contest) and (2) percentage changes in revenue, operating income, diluted EPS, adjusted operating income, and adjusted diluted EPS on a local currency basis which eliminates the effects that result from translating its international operations into U.S. dollars. The Company has included each of these non-GAAP measures in order to provide additional information regarding our underlying operating results and comparable year-over-year performance. Such information is supplemental to information presented in accordance with GAAP and is not intended to represent a presentation in accordance with GAAP. These non-GAAP measures should not be considered in isolation. Rather, they should be considered together with GAAP measures and the rest of the information included in this report. Management internally reviews each of these non-GAAP measures to evaluate performance on a comparative period-to-period basis and to gain additional insight into underlying operating and performance trends, and the Company believes the information can be beneficial to investors for the same purposes. These non-GAAP measures may not be comparable to similarly titled measures used by other companies. (1) “Other” consists of acquisition related costs incurred in 2015 and proxy contest costs incurred in 2014. The Company incurred $0.8 million of acquisition related costs in 2015 and $3.2 million of proxy contest costs in 2014. Index The following table summarizes the percentage change in the 2015 results compared to the 2014 results in the respective financial measures. SEGMENT INFORMATION The Company determines its operating segments based on information utilized by its chief operating decision maker to allocate resources and assess performance. Segment performance is evaluated on operating income of the respective business units before restructuring charges which are reported in the Corporate & Other segment. The Company’s reportable segments consist of the Flavors & Fragrances, Color, and Asia Pacific segments. The Asia Pacific segment, which was previously reported in the Corporate & Other segment, meets the quantitative thresholds outlined in Accounting Standards Codification (ASC) 280, Segment Reporting, to be reported separately as of December 31, 2015. The results of operations for the Company’s businesses in Central and South America have been included in the Flavors & Fragrances segment, beginning in 2015. Previously, they had been reported in the Corporate & Other segment. In addition, the Flavors & Fragrances and Color segments have reassigned customer accounts and revised cost allocations amongst the businesses within their respective segments, resulting in changes in the underlying components of segment revenue and segment operating income. All prior year results have been restated to reflect each of these changes. Flavors & Fragrances Revenue for the Flavors & Fragrances segment was $819.0 million in 2015 and $851.5 million in 2014, a decrease of 3.8%. Foreign exchange rates reduced revenue 6.7% in 2015. The decrease in revenue was primarily due to lower revenue in Europe ($31.8 million) and Latin America ($2.6 million) partially offset by higher revenue in North America ($1.8 million). The lower revenue in Europe was primarily a result of the impact of unfavorable foreign exchange rates ($40.9 million) partially offset by higher selling prices ($6.9 million) and volumes ($2.3 million). The lower revenue in Latin America was a result of the impact of unfavorable exchange rates ($6.3 million) partially offset by higher selling prices ($2.9 million) and volumes ($0.8 million). The higher revenue in North America was primarily a result of higher selling prices ($13.2 million) partially offset by the impact of unfavorable exchange rates ($9.7 million) and volumes ($1.8 million). Gross margin increased 20 basis points to 27.1% in 2015 from 26.9% in 2014. The increase was primarily due to the impact of higher selling prices, product mix and savings associated with the 2014 Restructuring Plan partially offset by higher raw material costs. Segment operating income for the Flavors & Fragrances segment was $121.9 million in 2015 and $120.9 million in 2014, an increase of 0.8%. Foreign exchange rates reduced segment operating income by 2.9% in 2015. The higher segment operating income was primarily a result of higher segment operating income in Europe ($2.3 million) and lower segment operating income in North America ($1.2 million). The higher operating income in Europe was primarily due to higher selling prices ($6.9 million), product mix ($4.3 million) and savings associated with the Restructuring Plan ($2.0 million) partially offset by higher raw material costs ($7.0 million), manufacturing and other costs ($3.6 million) and unfavorable exchange rates ($0.3 million). The lower operating income in North America was primarily due to higher raw material costs ($14.3 million), higher production and other costs ($3.5 million), unfavorable exchange rates ($1.8 million) and unfavorable product mix ($1.6 million) partially offset by higher selling prices ($13.2 million), savings associated with the 2014 Restructuring Plan ($5.1 million) and volumes ($1.7 million). Segment operating margin increased 70 basis points in 2015 to 14.9% from 14.2% in 2014. Index Color Revenue for the Color segment was $470.9 million in 2015 and $509.3 million in 2014, a decrease of 7.5%. Foreign exchange rates reduced segment revenue 8.9% in 2015. The decrease in revenue was primarily due to lower revenue in non-food colors ($30.2 million) and food and beverage colors ($8.2 million). The lower revenue in non-food colors was primarily due to the impact of unfavorable exchange rates ($18.1 million), lower volumes ($13.6 million), primarily specialty inks, and lower selling prices ($5.1 million) partially offset by higher volumes resulting from the Xennia acquisition ($6.6 million). The lower revenue in food and beverage colors was primarily due to the impact of unfavorable exchange rates ($27.4 million), partially offset by higher selling prices ($13.1 million) and volumes ($6.1 million), which includes approximately $4 million from a one-off fourth quarter sale of natural colors. Gross margin for the Color segment decreased 130 basis points to 40.3% in 2015 from 41.6% in 2014. The decrease was primarily due to the impact of the lower volumes, primarily specialty inks, and higher raw material costs, partially offset by higher selling prices and product mix. Segment operating income for the Color segment was $94.8 million in 2015 and $114.0 million in 2014, a decrease of 16.9%. Foreign exchange rates reduced segment operating income by 8.8% in 2015. The lower segment operating income was due to lower non-food colors ($20.0 million) partially offset by higher food and beverage colors ($0.8 million). The lower operating income for non-food colors was primarily due to lower volumes ($8.0 million), primarily specialty inks, unfavorable exchange rates ($4.9 million), lower selling prices ($5.1 million) and higher manufacturing and other costs ($6.1 million) partially offset by favorable product mix ($3.9 million). The higher operating income for food and beverage colors was primarily due to the higher selling prices ($13.1 million), and higher volumes ($3.2 million), which includes approximately $2 million from a one-off fourth quarter sale of natural colors, partially offset by higher raw material costs ($10.6 million) and unfavorable exchange rates ($5.2 million). Segment operating margin was 20.1% in 2015 and 22.4% in 2014. Asia Pacific Revenue for the Asia Pacific segment was $130.6 million in 2015 and $133.3 million in 2014, a decrease of 2.1%. Foreign exchange rates reduced segment revenue by 6.4% in 2015. Higher volumes ($5.2 million) and selling prices ($0.8 million) were offset by unfavorable exchange rates ($8.6 million). Gross margin for the Asia Pacific segment increased 60 basis points to 37.5% in 2015 from 36.9% in 2014. The increase was primarily due to the higher selling prices and favorable product mix. Segment operating income for the Asia Pacific segment was $25.5 million in 2015 and $25.1 million in 2014, an increase of 1.5%. Foreign exchange rates reduced segment operating income by 5.1% in 2015. The higher segment operating income was a result of the higher volumes ($1.9 million), product mix ($1.1 million) and selling prices ($0.8 million) partially offset by the impact of unfavorable exchange rates ($1.3 million) and higher manufacturing and other costs ($2.1 million). Segment operating margin was 19.5% in 2015 and 18.8% in 2014. Corporate & Other The Corporate & Other expenses were $75.8 million in 2015 and $129.4 million in 2014, a decrease of 41.4%, primarily due to lower restructuring costs and lower costs for performance based compensation. The Company evaluates segment performance before restructuring costs, and reports all of the restructuring and other costs in the Corporate & Other segment. Restructuring and other costs were $43.6 million and $90.6 million in 2015 and 2014, respectively. RESULTS OF CONTINUING OPERATIONS 2014 vs. 2013 Revenue Sensient’s revenue was approximately $1.4 billion in 2014 and $1.5 billion in 2013. The impact of foreign exchange rates reduced consolidated revenue by 1.1% in 2014. Gross Profit The Company’s gross margin was 33.7% in 2014 and 32.5% in 2013. The increase in gross margin is primarily due to an increase in selling prices. Restructuring costs reduced gross margin 20 basis points and 10 basis points in 2014 and 2013, respectively. Selling and Administrative Expense Selling and administrative expense as a percent of revenue was 24.7% in 2014 compared to 20.6% in 2013. The increase in selling and administrative expenses during 2014 was attributable to the increase in restructuring costs of $88.6 million recorded in 2014 compared to $30.0 million recorded in 2013. Restructuring and other costs increased selling and administrative expenses as a percent of revenue by 610 basis points and 200 basis points in 2014 and 2013, respectively. Index Operating Income Operating income was $130.7 million in 2014 compared to $173.8 million in 2013. The decrease in operating income was primarily attributable to the increase in restructuring costs in 2014 compared to 2013. Operating margins decreased 290 basis points to 9.0% in 2015 from 11.9% in 2014. Restructuring and other costs reduced operating margins by 630 basis points and 220 basis points in 2014 and 2013, respectively. Additional information on segment results can be found in the Segment Information section. Interest Expense Interest expense was $16.1 million in both 2014 and 2013. The decrease in average interest rates offset the higher average outstanding debt balance. Income Taxes The effective income tax rate was 28.6% in 2014 and 27.5% in 2013. The effective tax rates for both 2014 and 2013 were affected by discrete items, including the favorable resolution of prior years’ tax matters and restructuring costs. In total, the discrete items and the impact of restructuring costs had no impact on the effective tax rate for 2014 and reduced the effective tax rate by 2.0% in 2013. Restructuring Activities In 2014, the Company announced that it was initiating its 2014 Restructuring Plan. The Company recorded $98.4 million of restructuring costs in 2014. For further information on the 2014 Restructuring Plan, see the discussion on pages 15 and 16 of Management’s Discussion and Analysis of Operations and Financial Condition. In 2013, the Company successfully completed its 2013 restructuring program related to relocating the Flavors & Fragrances segment headquarters to Chicago, and generating operating efficiencies across all segments of the Company by consolidating multiple facilities throughout Europe and North America. The Company recorded total costs of $31.7 million in 2013 related to the 2013 restructuring program. The plan resulted in the reduction of global headcount of approximately 280 employees performing various functions. Management estimates that operating costs were reduced by approximately $12 million and $7 million as of December 31, 2014 and 2013, respectively. NON-GAAP FINANCIAL MEASURES Within the following tables, the Company reports certain non-GAAP financial measures, including: (1) adjusted operating income, adjusted net earnings and adjusted diluted EPS from continuing operations (which exclude restructuring costs, and costs related to the 2014 proxy contest) and (2) percentage changes in revenue, operating income, diluted EPS, adjusted operating income, and adjusted diluted EPS on a local currency basis which eliminates the effects that result from translating its international operations into U.S. dollars. The Company has included each of these non-GAAP measures in order to provide additional information regarding our underlying operating results and comparable year-over-year performance. Such information is supplemental to information presented in accordance with GAAP and is not intended to represent a presentation in accordance with GAAP. These non-GAAP measures should not be considered in isolation. Rather, they should be considered together with GAAP measures and the rest of the information included in this report. Management internally reviews each of these non-GAAP measures to evaluate performance on a comparative period-to-period basis and to gain additional insight into underlying operating and performance trends, and the Company believes the information can be beneficial to investors for the same purposes. These non-GAAP measures may not be comparable to similarly titled measures used by other companies. Index (1) “Other” consists of $3.2 million of proxy contest costs incurred in 2014. The following table summarizes the percentage change in the 2014 results compared to the 2013 results in the respective financial measures. SEGMENT INFORMATION The Company’s reportable segments consist of the Flavors & Fragrances, Color, and Asia Pacific segments. The Asia Pacific segment, which was previously reported in the Corporate & Other segment, meets the quantitative thresholds outlined in ASC 280, Segment Reporting, to be reported separately as of December 31, 2015. The results of operations for the Company’s businesses in Central and South America have been included in the Flavors & Fragrances segment, beginning in 2015. Previously, they had been reported in the Corporate & Other segment. In addition, the Flavors & Fragrances and Color segments have reassigned customer accounts and revised cost allocations amongst the businesses within their respective segments, resulting in changes in the underlying components of segment revenue and segment operating income. All prior year results have been restated to reflect each of these changes. Flavors & Fragrances Revenue for the Flavors & Fragrances segment was $851.5 million in 2014 and $880.6 million in 2013, a decrease of 3.3%. Foreign exchange rates decreased revenue by 0.6% in 2014. The decrease in revenue was primarily due to lower revenue in North America ($29.4 million) and Latin America ($1.2 million) partially offset by higher revenue in Europe ($1.6 million). The lower revenue in North America is primarily due to lower volumes ($41.6 million), mainly lower natural ingredient volumes, and unfavorable exchange rates ($5.8 million) partially offset by higher selling prices ($18.0 million). The lower revenue in Latin America was primarily due to unfavorable exchange rates ($1.7 million) and lower volumes ($0.9 million) partially offset by higher selling prices ($1.4 million). The higher revenue in Europe was primarily due to favorable foreign exchange rates ($2.5 million) partially offset by unfavorable volumes ($0.9 million). Index Gross margin increased 130 basis points to 26.9% in 2014 from 25.6% in 2013. The increase was primarily due to the impact of higher selling prices partially offset by the lower volumes. Segment operating income for the Flavors & Fragrances segment was $120.9 million in 2014 and $121.8 million in 2013, a decrease of 0.8%. Foreign exchange rates reduced segment operating income by 0.7%. Higher profit in Latin America ($0.7 million) was offset by lower profit in North America ($0.7 million) and Europe ($0.9 million). The higher profit in Latin America was primarily due to higher selling prices ($1.4 million) partially offset by unfavorable exchange rates ($0.3 million) and other items ($0.4 million). The lower profit in North America was primarily due to lower volumes ($11.6 million), mainly natural ingredients, higher manufacturing and other costs ($8.6 million) and unfavorable exchange rates ($1.0 million) partially offset by higher selling prices ($18.0 million), product mix ($1.0 million) and savings associated with the restructuring program ($1.5 million). The lower profit in Europe was primarily due to higher employee costs ($4.4 million) partially offset by favorable raw material costs ($1.7 million), manufacturing and other costs ($1.4 million) and exchange rates ($0.5 million). Segment operating margin for the Flavors & Fragrances segment was 14.2% and 13.8% in 2014 and 2013, respectively. Color Revenue for the Color segment was $509.3 million in 2014 and $496.3 million in 2013, an increase of 2.6%. Foreign exchange rates reduced revenue by 1.1% in 2014. The increase in revenue was primarily due to higher sales of non-food colors ($12.4 million) and food and beverage colors ($0.6 million). The higher sales of non-food colors was primarily due to higher volumes ($12.4 million) and the higher sales of food and beverage colors was primarily due to higher selling prices ($6.5 million) partially offset by unfavorable exchange rates ($5.0 million) and lower volumes ($1.0 million). Gross margin for the Color segment increased 70 basis points to 41.6% in 2014 from 40.9% in 2013. The increase was primarily due to the impact of higher selling prices and the higher volumes. Segment operating income for the Color segment was $114.0 million in 2014 and $107.2 million in 2013, an increase of 6.3%. Foreign exchange rates decreased segment operating income by 0.7% in 2014. The increase was primarily due to non-food colors ($5.4 million) and food and beverage colors ($1.4 million). The higher profit for non-food colors was primarily due to the higher volumes and favorable product mix ($10.5 million) partially offset by higher salaries and wages ($3.0 million) and raw material costs ($2.1 million). The higher profit for food and beverage colors was primarily due to higher selling prices ($6.5 million) partially offset by higher raw material costs ($1.6 million), lower volumes and mix ($1.1 million), higher manufacturing and other costs ($1.3 million) and higher salaries and wages ($1.1 million). Segment operating margin for the Color segment increased 80 basis points to 22.4% in 2014 from 21.6% in 2013. Asia Pacific Revenue for the Asia Pacific segment was $133.3 million in 2014 and $132.6 million in 2013, an increase of 0.5%. Foreign exchange rates reduced revenue by 3.3% in 2014. The higher revenue was primarily due to higher volumes ($3.7 million) and selling prices ($1.3 million) partially offset by unfavorable exchange rates ($4.3 million). Gross margin for the Asia Pacific segment increased 10 basis points to 36.9% in 2014 from 36.8% in 2013. The increase was primarily due to the higher volumes and selling prices. Segment operating income for the Asia Pacific segment was $25.1 million in 2014 and $22.2 million in 2013, an increase of 13.4%. Foreign exchange rates reduced segment operating income by 2.8% in 2014. The higher profit was primarily a result of the higher volumes ($1.7 million), selling prices ($1.3 million) and lower other costs ($0.5 million) partially offset by the impact of unfavorable exchange rates ($0.6 million). Segment operating margin was 18.8% in 2014 and 16.7% in 2013. Corporate & Other Corporate & Other expenses were $129.4 million in 2014 and $77.4 million in 2013, an increase of 67.1%. The Company evaluates segment performance before restructuring costs, and reports all of the restructuring and other costs in the Corporate & Other segment. Restructuring and other costs were $90.6 million and $31.7 million in 2014 and 2013, respectively. The increased Corporate & Other costs in 2014 are due to the higher restructuring costs, offset by lower expenses for executive compensation. LIQUIDITY AND FINANCIAL POSITION Financial Condition The Company’s financial position remains strong. The Company entered into an amendment to its credit agreement in November 2015, to increase and extend the maturity of its credit facility. The amended facility consists of a $170 million term loan and a $350 million revolving loan agreement, and it replaces the $450 million credit facility that that Company entered into in October 2014. The Company also issued new fixed rate notes of €67 million in November 2015. Proceeds from the new term loan and the sale of notes were used to refinance existing debt. Index The Company expects its cash flow from operations, the new debt agreements and its existing debt capacity can be used to meet future cash requirements for operations, capital expenditures, dividend payments, acquisitions and stock repurchases. The impact of inflation on both the Company’s financial position and its results of operations has been minimal and is not expected to significantly affect 2016 results. Cash Flows from Operating Activities Net cash provided by operating activities was $128.1 million in 2015, $189.2 million in 2014 and $153.6 million in 2013. Operating cash flow provided the primary source of funds for operating needs, capital expenditures, shareholder dividends, acquisitions, and some share repurchases. The decrease in net cash provided by operating activities in 2015 is primarily due to the impact of foreign currency, higher payments of restructuring costs, and higher receivable balances. The increase in net cash provided by operating activities in 2014 was primarily due to higher earnings and working capital reductions in the second half of 2014. Cash Flows from Investing Activities Net cash used in investing activities was $75.8 million in 2015, $79.1 million in 2014 and $98.2 million in 2013. Capital expenditures were $79.9 million in 2015, $79.4 million in 2014 and $104.2 million in 2013. Cash Flows from Financing Activities Net cash used in financing activities was $50.1 million in 2015, $98.6 million in 2014 and $48.2 million in 2013. The Company had a net increase in debt of $174.6 million in 2015, a net increase in debt of $85.8 million in 2014 and a net decrease in debt of $3.7 million in 2013. In 2015, Sensient purchased $176.6 million of Company stock which settled before December 31, 2015, and purchased $137.2 million in 2014 of Company stock which settled before December 31, 2014. There were no purchases of Company stock in 2013. The Company has paid uninterrupted quarterly cash dividends since commencing public trading in its stock in 1962. In the third quarter of 2015, the Company increased its quarterly dividend from 25 cents per share to 27 cents per share. Dividends paid per share were $1.04 in 2015, 98 cents in 2014 and 91 cents in 2013. Total dividends paid were $48.1 million, $47.9 million and $45.5 million in 2015, 2014, and 2013, respectively. ISSUER PURCHASES OF EQUITY SECURITIES Sensient purchased 2.7 million shares of Company stock in 2015 for a total cost of $178.0 million and 2.5 million shares of Company stock in 2014 for a total cost of $138.3 million. There were no purchases of Company stock in 2013. In July 2014, the Board approved a share repurchase program under which the Company was authorized to repurchase five million shares of Company stock in addition to amounts remaining from a prior Board authorization. As of December 31, 2015, 2.1 million shares were available to be repurchased under existing authorizations. The Company’s share repurchase program has no expiration date. CRITICAL ACCOUNTING POLICIES In preparing the financial statements in accordance with accounting principles generally accepted in the U.S., management is required to make estimates and assumptions that have an impact on the asset, liability, revenue and expense amounts reported. These estimates can also affect supplemental information disclosures of the Company, including information about contingencies, risk and financial condition. The Company believes, given current facts and circumstances, that its estimates and assumptions are reasonable, adhere to accounting principles generally accepted in the U.S. and are consistently applied. Inherent in the nature of an estimate or assumption is the fact that actual results may differ from estimates and estimates may vary as new facts and circumstances arise. The Company makes routine estimates and judgments in determining the net realizable value of accounts receivable, inventories, property, plant and equipment, and prepaid expenses. Management believes the Company’s most critical accounting estimates and assumptions are in the following areas: Revenue Recognition The Company recognizes revenue (net of estimated discounts, allowances and returns) when title passes, the customer is obligated to pay the Company and the Company has no remaining obligations. Such recognition typically corresponds with the shipment of goods. Goodwill Valuation The Company reviews the carrying value of goodwill annually utilizing several valuation methodologies, including a discounted cash flow model. The Company completed its annual goodwill impairment test under ASC 350, Intangibles - Goodwill and Other, in the third quarter of 2015. In conducting its annual test for impairment, the Company performed a qualitative assessment of its previously calculated fair values for each of its reporting units and compared each of these values to the net book value of each reporting unit. Fair value is estimated using both a discounted cash flow analysis and an analysis of comparable company market values. If the fair value of a reporting unit exceeds its net book value, no impairment exists. The Company has three reporting units that had goodwill recorded and were tested for impairment. All three reporting units had fair values that were over 100% above their respective net book values. Changes in estimates of future cash flows caused by items such as unforeseen events or changes in market conditions could negatively affect the reporting units’ fair value and result in an impairment charge. Index Income Taxes The Company estimates its income tax expense in each of the taxing jurisdictions in which it operates. The Company is subject to a tax audit in each of these jurisdictions, which could result in changes to the estimated tax expense. The amount of these changes would vary by jurisdiction and would be recorded when probable and estimable. These changes could impact the Company’s financial statements. Management has recorded valuation allowances to reduce the Company’s deferred tax assets to the amount that is more likely than not to be realized. Examples of deferred tax assets include deductions, net operating losses and tax credits that the Company believes will reduce its future tax payments. In assessing the future realization of these assets, management has considered future taxable income and ongoing tax planning strategies. An adjustment to the recorded valuation allowance as a result of changes in facts or circumstances could result in a significant change in the Company’s tax expense. The Company does not provide for deferred taxes on unremitted earnings of foreign subsidiaries which are considered to be invested indefinitely. Inventories Inventories are stated at the lower of cost or market. Cost is determined using the first-in, first-out (“FIFO”) method with the exception of certain locations of the Flavors & Fragrances Group where cost is determined using a weighted average method. Market is determined on the basis of estimated realizable values. Cost includes direct materials, direct labor and manufacturing overhead. The Company estimates any required write-downs for inventory obsolescence by examining inventories on a quarterly basis to determine if there are any damaged items or slow moving products in which the carrying values could exceed net realizable value. Inventory write-downs are recorded as the difference between the cost of inventory and its estimated market value. While significant judgment is involved in determining the net realizable value of inventory, the Company believes that inventory is appropriately stated at the lower of cost of market. Commitments and Contingencies The Company is subject to litigation and other legal proceedings arising in the ordinary course of its businesses or arising under provisions related to the protection of the environment. Estimating liabilities and costs associated with these matters requires the judgment of management, who rely in part on information from Company legal counsel. When it is probable that the Company has incurred a liability associated with claims or pending or threatened litigation matters and the Company’s exposure is reasonably estimable, the Company records a charge against earnings. The Company recognizes related insurance reimbursement when receipt is deemed probable. The Company’s estimate of liabilities and related insurance recoveries may change as further facts and circumstances become known. CONTRACTUAL OBLIGATIONS The Company is subject to certain contractual obligations, including long-term debt, operating leases, manufacturing purchases and pension benefit obligations. The Company had unrecognized tax benefits of $6.1 million as of December 31, 2015. However, the Company cannot make a reasonably reliable estimate of the period of potential cash settlement of the liabilities and, therefore, has not included unrecognized tax benefits in the following table of significant contractual obligations as of December 31, 2015. PAYMENTS DUE BY PERIOD NEW PRONOUNCEMENTS In November 2015, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update (“ASU”) No. 2015-17, Balance Sheet Classification of Deferred Taxes, which will require entities to present deferred tax assets and deferred tax liabilities as noncurrent in a classified balance sheet. The ASU simplifies the current guidance, which requires entities to separately present deferred tax assets and deferred tax liabilities as current and noncurrent in a classified balance sheet. This guidance is effective for interim and annual periods beginning after December 31, 2016, with early adoption permitted. We are currently evaluating the expected impact of this standard, and do not expect it to be material to our financial statements. Index In September 2015, the FASB issued ASU 2015-16, Simplifying the Accounting for Measurement-Period Adjustments, which requires the acquirer in a business combination to recognize adjustments to provisional amounts that are identified during the measurement period in the reporting period in which the adjustment amounts are determined. The financial statements should contain the effect on earnings of changes in depreciation, amortization or other income effects calculated as if the accounting had been completed at the acquisition date. This guidance is effective for interim and annual periods beginning after December 15, 2015, with early adoption permitted. The impact of this standard will not have a significant impact on the Company’s financial statements. In July 2015, the FASB issued ASU No. 2015-11, Simplifying the Measurement of Inventory. Under this guidance, inventory that is accounted for using the first-in, first-out or average cost method shall be measured at the lower of cost or net realizable value, as opposed to the lower of cost or market measurement under current guidance. This guidance is effective for interim and annual periods beginning after December 15, 2016, with early adoption permitted. This new guidance is required to be retrospectively applied to all prior periods. We are currently evaluating the expected impact of this standard. In July 2015, the FASB affirmed its proposed one-year deferral of the effective date for ASU No. 2014-09, Revenue from Contracts with Customers. Under this proposal, the requirements of the new standard are effective for interim and annual periods beginning after December 15, 2017. The proposal also permits entities to adopt the standard for interim and annual reporting periods beginning after December 15, 2016. We are currently evaluating the expected impact of this standard. In April 2015, the FASB issued ASU No. 2015-03, Simplifying the Presentation of Debt Issuance Costs, which requires debt issuance costs to be presented in the balance sheet as a direct deduction from the carrying amount of the associated debt liability. Also, on August 18, 2015, the FASB issued ASU 2015-15, Presentation and Subsequent Measurement of Debt Issuance Costs Associated with Line-of-Credit Arrangements, to clarify that the SEC staff would not object to deferring and presenting debt issuance costs as an asset and subsequently amortizing deferred debt issuance costs ratably over the term of the line-of-credit arrangement. This guidance is effective for interim and annual periods beginning after December 15, 2015, with early adoption permitted. This new guidance is required to be retrospectively applied to all prior periods. The impact of this standard will not have a significant impact on the Company’s financial statements. OFF-BALANCE SHEET ARRANGEMENTS The Company had no off-balance sheet arrangements as of December 31, 2015.

<s>[INST] Sensient Technologies Corporation (the “Company”) is a global developer, manufacturer and supplier of flavor and fragrance systems for the food, beverage, personal care and householdproducts industries. In addition, the Company is a developer, manufacturer and supplier of colors for businesses worldwide. The Company provides natural and synthetic color systems for use in foods, beverages and pharmaceuticals; colors and other ingredients for cosmetics, pharmaceuticals and specialty inks; and technical colors for industrial applications. The Company has three reporting segments: the Flavors & Fragrances segment; the Color segment; and the Asia Pacific segment. The Company’s 2015 diluted earnings per share from continuing operations were $2.32 in 2015 and $1.67 in 2014. Included in the 2015 and 2014 results, were $43.6 million and $90.6 million, respectively, of restructuring and other costs, or 73 cents per share and $1.34 per share, respectively. Adjusted diluted earnings per share, which exclude these restructuring and other costs, were $3.05 in 2015 and $3.02 in 2014 (see discussion below regarding NonGAAP Financial Measures and the Company’s Restructuring Activities). In 2015, the Company continued a series of strategic initiatives to increase shareholder value. The Company’s restructuring activities continue to eliminate underperforming businesses and consolidate manufacturing operations. The Company continued to pay an uninterrupted since 1962 quarterly cash dividend and increased the quarterly dividend by 2 cents per share from 25 cents to 27 cents per share, or $1.08 per share on an annualized basis, in 2015. Furthermore, the Company repurchased $176.6 million of Company stock in 2015, which is in addition to the $137.2 million repurchased in 2014. Additional information on the results is included below. RESULTS OF CONTINUING OPERATIONS 2015 vs. 2014 Revenue Sensient’s revenue was $1.4 billion in both 2015 and 2014. The impact of foreign exchange rates reduced consolidated revenue by 7.4% in 2015. Gross Profit The Company’s gross margin was 33.0% in 2015 and 33.7% in 2014. Included in the cost of products sold are $6.1 million and $1.9 million of restructuring costs for 2015 and 2014, respectively. The decrease in the gross margin is primarily due to the lower volumes in the Color segment’s specialty inks business and higher restructuring costs. Restructuring costs reduced gross margin by 50 basis points and 20 basis points in 2015 and 2014, respectively. Selling and Administrative Expenses Selling and administrative expense as a percent of revenue was 20.9% in 2015 and 24.7% in 2014. Restructuring and other costs of $37.5 million and $88.6 million for 2015 and 2014, respectively, were included in selling and administrative expense. The decrease in selling and administrative expense as a percent of revenue is primarily a result of the decrease in restructuring and other costs, and lower corporate expenses, primarily a reduction of performance based executive compensation costs of $6.8 million. Restructuring and other costs increased selling and administrative expense as a percent of revenue by 270 basis points and 610 basis points in 2015 and 2014, respectively. Operating Income Operating income was $166.3 million in 2015 and $130.7 million in 2014. Operating margins increased to 12.1% in 2015 from 9.0% in 2014. Restructuring and other costs reduced operating margins by 320 basis points and [/INST] Positive. </s>

SENSIENT TECHNOLOGIES CORP

2017-02-23

2016-12-31

Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operation. OVERVIEW Sensient Technologies Corporation (the “Company”) is a global developer, manufacturer and supplier of flavor and fragrance systems for the food, beverage, personal care and household-products industries. In addition, the Company is a developer, manufacturer and supplier of colors for businesses worldwide. The Company provides natural and synthetic color systems for use in foods, beverages and pharmaceuticals; colors and other ingredients for cosmetics, pharmaceuticals and specialty inks; and technical colors for industrial applications. The Company’s three reportable segments are the Flavors & Fragrances Group and the Color Group, which are managed on a product-and-services basis, and the Asia Pacific Group, which is managed on a geographic basis. The Company’s corporate expenses and restructuring and other costs are included in the “Corporate & Other” category. The Company’s 2016 diluted earnings per share from continuing operations were $2.74 in 2016 and $2.32 in 2015. Included in the 2016 and 2015 results, were $26.1 million and $43.6 million, respectively, of restructuring and other costs, or 47 cents per share and 73 cents per share, respectively. Adjusted diluted earnings per share, which exclude these restructuring and other costs, were $3.21 in 2016 and $3.05 in 2015 (see discussion below regarding Non-GAAP Financial Measures and the Company’s Restructuring Activities and Divestiture). The Company’s net cash provided by operating activities was $222.5 million in 2016, an increase from the $128.0 million reported in 2015. The Company’s total debt decreased to $603 million as of December 31, 2016, from $634.2 million as of December 31, 2015. Since 1962, the Company has continued without interruption to pay a quarterly cash dividend. In 2016, the Company increased the quarterly dividend by 3 cents per share from 27 cents to 30 cents per share, or $1.20 per share on an annualized basis. In addition, the Company repurchased $50.1 million of Company stock in 2016, which is in addition to the $176.6 million repurchased in 2015. Additional information on the results is included below. RESULTS OF CONTINUING OPERATIONS 2016 vs. 2015 Revenue Sensient’s revenue was approximately $1.4 billion in both 2016 and 2015. The impact of foreign exchange rates reduced consolidated revenue by 2% in 2016. Gross Profit The Company’s gross margin was 34.4% in 2016 and 33.0% in 2015. Included in the cost of products sold are $2.1 million and $6.1 million of restructuring costs for 2016 and 2015, respectively. The increase in the gross margin is primarily a result of higher selling prices and volumes, mainly in the Color segment, savings associated with the 2014 Restructuring Plan ($7.9 million) and reduced restructuring costs, partially offset by higher raw material costs and manufacturing costs. Restructuring costs reduced gross margin by 10 basis points and 50 basis points in 2016 and 2015, respectively. Selling and Administrative Expenses Selling and administrative expense as a percent of revenue was 21.0% in 2016 and 20.9% in 2015. Restructuring and other costs of $24.0 million and $37.5 million for 2016 and 2015, respectively, were included in selling and administrative expense. Selling and administrative expense as a percent of revenue in 2016 were comparable to 2015 as a result of higher performance based executive compensation ($7.6 million) and professional fees ($6.2 million), partially offset by lower restructuring and other costs ($13.5 million). Restructuring and other costs increased selling and administrative expense as a percent of revenue by 180 basis points and 270 basis points in 2016 and 2015, respectively. Operating Income Operating income was $185.6 million in 2016 and $166.3 million in 2015. Operating margins increased to 13.4% in 2016 from 12.1% in 2015. Restructuring and other costs reduced operating margins by 190 basis points and 320 basis points in 2016 and 2015, respectively. Additional information on segment results can be found in the Segment Information section. Interest Expense Interest expense was $18.3 million in 2016 and $16.9 million in 2015. The increase in expense was primarily due to the increase in average debt outstanding, which was partially offset by lower average interest rates. Index Income Taxes The effective income tax rate was 26.5% in 2016 and 28.2% in 2015. The effective tax rates in both 2016 and 2015 were impacted by audit settlements, mix of foreign earnings and restructuring and other costs. The effective tax rate in 2015 was also impacted by changes in estimates associated with the finalization of prior year tax items. In total, the net impact of these discrete items and restructuring and other costs reduced the effective income tax rate by 1.2% for 2016 and 2.4% for 2015. Restructuring The Company incurred restructuring costs in both continuing and discontinued operations. The discussion in this note relates to the combination of both continuing and discontinued operations unless otherwise noted. Restructuring costs related to discontinued operations are recorded in discontinued operations within the Company’s Consolidated Statements of Earnings and are discussed in more detail in Note 14, Discontinued Operations. In March 2014, the Company announced that it was initiating a restructuring plan (“2014 Restructuring Plan” or “Plan”) to eliminate underperforming operations, consolidate manufacturing facilities and improve efficiencies within the Company. The Company determined that it had redundant manufacturing capabilities in both North America and Europe and that it could lower costs and operate more efficiently by consolidating into fewer facilities. Eight facilities were identified for consolidation in the Flavors & Fragrances segment, four in North America and four in Europe. To date, closures have been announced in Indianapolis, Indiana, United States; Cornwall, Mississauga and Halton Hills, Canada; Bremen, Germany; and Milan, Italy. The Company also plans to sell its two European Natural Ingredients facilities, as discussed below. In addition, the Company discontinued one of the businesses in the Color segment, located near Leipzig, Germany, because it did not fit with the Company’s long-term strategic plan and it had generated losses for several years. In 2015, the Company identified additional opportunities to consolidate manufacturing operations at one of the Color segment’s facilities in Europe and eliminate additional positions in the European Flavors & Fragrances businesses. Based on this Plan, the Company determined that certain long-lived assets associated with the underperforming operations were impaired. The Company reduced the carrying amounts of these assets to their aggregate respective fair values, which were determined based on independent market valuations. The fair values of the remaining long-lived assets are estimated to be approximately $14 million, which includes certain of the land, buildings and equipment in the assets held for sale, as noted below. Also, certain machinery and equipment has been identified to be disposed of at the time of the facility closures and the associated depreciation for these assets has been accelerated. The Company recorded long-lived asset impairments, including the impairment charges and accelerated depreciation of $1.9 million, $14.5 million and $70.2 million during the years ended December 31, 2016, 2015 and 2014, respectively. Since initiating the Plan, the Company has recorded $87 million of long-lived asset impairments, including the impairment charges and accelerated depreciation. In addition, certain intangible assets, inventory and other current assets were also determined to be impaired and were written down. The Company has also incurred employee separation and other restructuring costs as a result of this Plan. The Company anticipates that it will reduce headcount by approximately 400 positions at the affected facilities, primarily in the Flavors & Fragrances segment, related to direct and indirect labor at manufacturing sites. As of December 31, 2016, 300 positions had been eliminated as a result of this Plan. As mentioned above, the Company plans to sell its European Natural Ingredients business, a business in the Flavors & Fragrances segment. This business has two facilities, located in Marchais, France, and Elburg, the Netherlands. The European Natural Ingredients business has not generated significant profits for several years and it does not fit with the Company’s long-term strategic plan. The Company is currently working to sell this business and anticipates selling the business within the next year. Upon the completion of a sale of this business, the Company anticipates recognizing an additional non-cash loss of approximately $20 million. As of December 31, 2016, the Company has recorded assets held for sale of land, buildings and equipment of $7.2 million related to the 2014 Restructuring Plan. In addition, $19.5 million of inventory, receivables and other assets are included in assets held for sale related to the anticipated sale of the European Natural Ingredients business. The Company also has $3.8 million of liabilities held for sale related to the anticipated sale of the European Natural Ingredients business. The Company recorded total restructuring costs of $11.1 million, $42.8 million and $98.4 million in the years ended December 31, 2016, 2015 and 2014, respectively, in accordance with GAAP and based on an internal review of the affected facilities and consultation with legal and other advisors. Since initiating the 2014 Restructuring Plan, the Company has incurred $95 million of non-cash related restructuring costs and $57 million of cash related restructuring costs for a total of $152 million of restructuring costs through December 31, 2016. The Company expects to incur approximately $20 million of additional non-cash related restructuring costs and $2 million of additional cash related restructuring costs for a total of $22 million of additional restructuring costs, by the end of 2017. Index The Company expects that the closure and sale of these operations will significantly lower the Company’s operating costs over the next few years. Upon initiating the Plan, the Company estimated the annual cost reductions to be approximately $30 million, when fully implemented. The U.S. dollar has strengthened considerably since the initiation of the Plan, and as a result the dollar value of the cost savings has been reduced. In 2015, the Company identified additional cost savings opportunities, and as a result of these actions, the current estimate of annual cost savings is approximately $27 million. The Company has also implemented price increases to further mitigate the impact of foreign currency movements. Since initiating the Plan, the Company has realized total savings of approximately $22 million as of December 31, 2016, of which $9.1 million was recognized in 2016. The remaining savings are expected to be realized in 2017. The Company intends to continue to optimize production at the consolidating sites after the completion of the restructuring activities. In connection with the 2014 Restructuring Plan, the Company approved a plan to dispose of a certain business, located near Leipzig, Germany, within the Color segment. Production ceased in 2014 and the business met the criteria to be reported as a discontinued operation. In 2016, the facility and remaining assets were sold for a gain of $0.2 million. In addition, the entity was liquidated resulting in a reclassification of the cumulative translation adjustment related to that entity of $3.3 million into net earnings. Divestiture In 2016, the Board of Directors authorized management to explore strategic alternatives for a production facility and certain related business lines within the Flavors & Fragrances segment in Strasbourg, France. As of December 31, 2016, the Company has recorded assets held for sale of inventory and other assets of $14.8 million and $1.5 million of liabilities held for sale related to the sale. In addition, the Company recorded a non-cash impairment charge of $10.8 million during 2016, in selling and administrative expense, reducing the carrying value of the long-lived assets for this facility to zero. An estimate of the fair value of this business less cost to sell was determined to be lower than its carrying value. The difference between the fair value and its carrying value exceeded the existing net book value of the long-lived assets. In addition, the Company incurred $0.7 million of outside professional fees and other related costs as a result of the then anticipated divestiture. On January 6, 2017, the Company completed the sale of this facility and certain related business lines for approximately $12.5 million. As a result, in the Company’s first quarter 2017 consolidated condensed financial statements, the Company will recognize an additional non-cash loss of approximately $6 million. Index NON-GAAP FINANCIAL MEASURES Within the following tables, the Company reports certain non-GAAP financial measures, including: (1) adjusted operating income, adjusted net earnings and adjusted diluted EPS from continuing operations (which exclude restructuring and other costs) and (2) percentage changes in revenue, operating income, diluted EPS, adjusted operating income and adjusted diluted EPS on a local currency basis (which eliminate the effects that result from translating its international operations into U.S. dollars). The other costs in 2016 are for the divestiture related costs discussed under “Divestiture” above, and the other costs in 2015 are acquisition related costs. The Company has included each of these non-GAAP measures in order to provide additional information regarding our underlying operating results and comparable year-over-year performance. Such information is supplemental to information presented in accordance with GAAP and is not intended to represent a presentation in accordance with GAAP. These non-GAAP measures should not be considered in isolation. Rather, they should be considered together with GAAP measures and the rest of the information included in this report. Management internally reviews each of these non-GAAP measures to evaluate performance on a comparative period-to-period basis and to gain additional insight into underlying operating and performance trends, and the Company believes the information can be beneficial to investors for the same purposes. These non-GAAP measures may not be comparable to similarly titled measures used by other companies. (1) The other costs in 2016 are for the divestiture related costs discussed under “Divestiture” above and the other costs in 2015 are acquisition related costs. The following table summarizes the percentage change in the 2016 results compared to the 2015 results in the respective financial measures. (1) Refer to table above for a reconciliation of these non-GAAP measures Index SEGMENT INFORMATION The Company determines its operating segments based on information utilized by its chief operating decision maker to allocate resources and assess performance. Segment performance is evaluated on operating income of the respective business units before restructuring and other costs, which are reported in Corporate & Other, interest expense and income taxes. The Company’s reportable segments consist of the Flavors & Fragrances, Color and Asia Pacific segments. Beginning in the first quarter of 2016, the results of operations for the Company’s color business in China, South Korea and Japan, which were previously reported in the Asia Pacific segment, are now reported in the Color segment. All prior year results have been restated to reflect each of these changes. Flavors & Fragrances Revenue for the Flavors & Fragrances segment was $795.3 million in 2016 and $819.0 million in 2015, a decrease of 2.9%. Foreign exchange rates reduced revenue by 1.8% in 2016. The decrease in revenue was primarily due to lower revenue in North America ($13.3 million), Europe ($9.9 million) and Latin America ($0.6 million). The lower revenue in North America was primarily due to lower volumes ($29.0 million) and the unfavorable impact of exchange rates ($2.2 million) partially offset by higher selling prices ($18.0 million). The lower revenue in Europe was primarily a result of the unfavorable impact of exchange rates ($7.2 million) and lower volumes ($4.4 million), partially offset by higher selling prices ($1.7 million). The lower revenue in Latin America was primarily due to the unfavorable impact of exchange rates ($5.6 million) partially offset by higher selling prices ($2.6 million) and volumes ($2.4 million). Gross margin increased 40 basis points to 27.5% in 2016 from 27.1% in 2015. The increase was primarily due to the impact of higher selling prices and savings associated with the 2014 Restructuring Plan partially offset by higher raw material costs and lower volume and product mix. Segment operating income for the Flavors & Fragrances segment was $123.5 million in 2016, and $121.9 million in 2015, an increase of 1.4%. Foreign exchange rates reduced segment operating income by 1.7% in 2016. The higher segment operating income was primarily a result of higher segment operating income in North America ($5.8 million) partially offset by lower segment operating income in Europe ($3.4 million) and lower segment operating income in Latin America ($0.8 million). The higher operating income in North America was primarily due to higher selling prices ($18.0 million), savings associated with the Restructuring Plan ($4.4 million), lower manufacturing and other costs ($3.1 million) and profit on the sale of an import right ($2.2 million) partially offset by higher raw material costs ($9.8 million), volume and product mix ($11.6 million) and unfavorable exchange rates ($0.4 million). The lower operating income in Europe was primarily due to higher manufacturing and other costs ($9.9 million), volume and product mix ($0.3 million) and the unfavorable impact of exchange rates ($0.3 million) partially offset by savings associated with the 2014 Restructuring Plan ($3.8 million), higher selling prices ($1.7 million) and lower raw material costs ($1.6 million). The lower operating income in Latin America was primarily due to higher raw material costs ($2.6 million), higher manufacturing and other costs ($1.9 million) and the unfavorable impact of exchange rates ($1.2 million) partially offset by higher selling prices ($2.6 million) and volume and product mix ($2.3 million). Segment operating margin increased 60 basis points in 2016 to 15.5% from 14.9% in 2015. Color Revenue for the Color segment was $502.1 million in 2016, and $480.0 million in 2015, an increase of 4.6%. Foreign exchange rates reduced segment revenue by 2.9% in 2016. The increase in revenue was primarily due to higher revenue in non-food colors ($22.0 million) and food and beverage colors ($0.2 million). The higher revenue in non-food colors was primarily due to higher volumes ($27.5 million), primarily in cosmetic colors and specialty inks, partially offset by the unfavorable impact of exchange rates ($3.7 million) and lower selling prices ($1.9 million). The higher revenue in food and beverage colors was primarily due to higher selling prices ($8.8 million) and volumes ($1.3 million) partially offset by the impact of unfavorable exchange rates ($10.0 million). Gross margin for the Color segment increased 140 basis points to 41.9% in 2016 from 40.5% in 2015. The increase was primarily due to higher volumes and product mix, selling prices and lower manufacturing costs partially offset by the unfavorable impact of exchange rates and higher raw material costs. Segment operating income for the Color segment was $104.8 million in 2016 and $96.6 million in 2015, an increase of 8.5%. Foreign exchange rates reduced segment operating income by 2.5% in 2016. The higher segment operating income was due to higher non-food colors ($7.2 million) and food and beverage colors ($1.0 million). The higher operating income for non-food colors was primarily due to volume and product mix ($14.3 million), partially offset by higher manufacturing and other costs ($4.2 million), lower selling prices ($1.9 million), higher raw material costs ($0.6 million) and the unfavorable impact of exchange rates ($0.6 million). The higher profit for food and beverage colors is primarily due to higher selling prices ($8.8 million), volume and product mix ($2.8 million) and savings associated with the 2014 Restructuring Plan ($0.5 million), partially offset by higher raw material costs ($4.8 million), manufacturing and other costs ($4.6 million) and the unfavorable impact of exchange rates ($1.8 million). Segment operating margin was 20.9% in 2016 and 20.1% in 2015. Index Asia Pacific Revenue for the Asia Pacific segment was $127.5 million in 2016, and $116.7 million in 2015, an increase of 9.3%. Foreign exchange rates reduced segment revenue by 1.3% in 2016. The higher segment revenue was due to higher volumes ($9.6 million) and selling prices ($2.9 million) partially offset by the unfavorable impact of exchange rates ($1.7 million). Gross margin for the Asia Pacific segment decreased 10 basis points to 37.7% in 2016 from 37.8% in 2015. The decrease was primarily due to higher manufacturing costs and raw material costs partially offset by higher selling prices and volumes and product mix. Segment operating income for the Asia Pacific segment was $25.2 million in 2016 and $23.7 million in 2015, an increase of 6.2%. Foreign exchange rates reduced segment operating income by 1.9% in 2016. The higher segment operating income was a result of volume and product mix ($4.5 million) and higher selling prices ($2.9 million), partially offset by higher manufacturing and other costs ($5.2 million), raw material costs ($0.2 million) and the unfavorable impact of exchange rates ($0.5 million). Segment operating margin was 19.7% in 2016 and 20.3% in 2015. Corporate & Other The Corporate & Other expenses were $67.9 million in 2016 and $75.8 million in 2015, a decrease of 10.5%, primarily due to lower restructuring and other costs ($17.5 million) partially offset by higher performance based executive compensation ($7.6 million) and professional services ($3.5 million). The Company evaluates segment performance before restructuring and other costs, and reports all of the restructuring and other costs in Corporate & Other. Restructuring and other costs were $26.1 million and $43.6 million in 2016 and 2015, respectively. RESULTS OF CONTINUING OPERATIONS 2015 vs. 2014 Revenue Sensient’s revenue was $1.4 billion in both 2015 and 2014. The impact of foreign exchange rates reduced consolidated revenue by 7.4% in 2015. Gross Profit The Company’s gross margin was 33.0% in 2015 and 33.7% in 2014. Included in the cost of products sold are $6.1 million and $1.9 million of restructuring costs for 2015 and 2014, respectively. The decrease in the gross margin is primarily due to the lower volumes in the Color segment’s specialty inks business and higher restructuring costs. Restructuring costs reduced gross margin by 50 basis points and 20 basis points in 2015 and 2014, respectively. Selling and Administrative Expenses Selling and administrative expense as a percent of revenue was 20.9% in 2015 and 24.7% in 2014. Restructuring and other costs of $37.5 million and $88.6 million for 2015 and 2014, respectively, were included in selling and administrative expense. The decrease in selling and administrative expense as a percent of revenue is primarily a result of the decrease in restructuring and other costs, and lower corporate expenses, primarily a reduction of performance based executive compensation costs of $6.8 million. Restructuring and other costs increased selling and administrative expense as a percent of revenue by 270 basis points and 610 basis points in 2015 and 2014, respectively. Operating Income Operating income was $166.3 million in 2015 and $130.7 million in 2014. Operating margins increased to 12.1% in 2015 from 9.0% in 2014. Restructuring and other costs reduced operating margins by 320 basis points and 630 basis points in 2015 and 2014, respectively. Additional information on segment results can be found in the Segment Information section. Interest Expense Interest expense was $16.9 million in 2015 and $16.1 million in 2014. The increase in expense was primarily due to the increase in average debt outstanding which was partially offset by the lower average interest rates. Income Taxes The effective income tax rate was 28.2% in 2015 and 28.6% in 2014. The effective tax rates in both 2015 and 2014 were impacted by changes in estimates associated with the finalization of prior year tax items, audit settlements, mix of foreign earnings and restructuring costs. In total, net impact of the discrete items and restructuring costs reduced the effective income tax rate by 2.4% for 2015 and had no net impact on the rate in 2014. Index Acquisition On June 29, 2015, the Company completed the acquisition of the business and net assets of Xennia Technology Ltd. (“Xennia”) for $8.4 million. The Xennia business has been integrated with the specialty inks business in the Color segment. The Company acquired goodwill and intangibles of approximately $6.2 million and has incurred acquisition related costs of $0.8 million, which are included in Corporate & Other. Restructuring In 2014, the Company announced that it was initiating its 2014 Restructuring Plan. The Company recorded $42.8 million and $98.4 million of restructuring costs in 2015 and 2014, respectively. For further information on the 2014 Restructuring Plan, see the discussion on pages 18 and 19 of Management’s Discussion and Analysis of Operations and Financial Condition. NON-GAAP FINANCIAL MEASURES Within the following tables, the Company reports certain non-GAAP financial measures, including: (1) adjusted operating income, adjusted net earnings and adjusted diluted EPS from continuing operations (which exclude restructuring and other costs) and (2) percentage changes in revenue, operating income, diluted EPS, adjusted operating income and adjusted diluted EPS on a local currency basis which eliminates the effects that result from translating its international operations into U.S. dollars. The other costs in 2015 are acquisition related costs, and the other costs in 2014 are for the 2014 proxy contest. The Company has included each of these non-GAAP measures in order to provide additional information regarding our underlying operating results and comparable year-over-year performance. Such information is supplemental to information presented in accordance with GAAP and is not intended to represent a presentation in accordance with GAAP. These non-GAAP measures should not be considered in isolation. Rather, they should be considered together with GAAP measures and the rest of the information included in this report. Management internally reviews each of these non-GAAP measures to evaluate performance on a comparative period-to-period basis and to gain additional insight into underlying operating and performance trends, and the Company believes the information can be beneficial to investors for the same purposes. These non-GAAP measures may not be comparable to similarly titled measures used by other companies. (1) The other costs in 2015 are acquisition related costs, and the other costs in 2014 are for the 2014 proxy contest. Index The following table summarizes the percentage change in the 2015 results compared to the 2014 results in the respective financial measures. (1) Refer to table above for a reconciliation of these non-GAAP measures SEGMENT INFORMATION The Company determines its operating segments based on information utilized by its chief operating decision maker to allocate resources and assess performance. Segment performance is evaluated on operating income of the respective business units before restructuring charges, which are reported in Corporate & Other. The Company’s reportable segments consist of the Flavors & Fragrances, Color and Asia Pacific segments. Beginning in the first quarter of 2016, the results of operations for the Company’s color business in China, South Korea and Japan which were, previously reported in the Asia Pacific segment, are now reported in the Color segment. All prior year results have been restated to reflect each of these changes. Flavors & Fragrances Revenue for the Flavors & Fragrances segment was $819.0 million in 2015 and $851.5 million in 2014, a decrease of 3.8%. Foreign exchange rates reduced revenue 6.7% in 2015. The decrease in revenue was primarily due to lower revenue in Europe ($31.8 million) and Latin America ($2.6 million) partially offset by higher revenue in North America ($1.8 million). The lower revenue in Europe was primarily a result of the impact of unfavorable foreign exchange rates ($40.9 million) partially offset by higher selling prices ($6.9 million) and volumes ($2.3 million). The lower revenue in Latin America was a result of the impact of unfavorable exchange rates ($6.3 million) partially offset by higher selling prices ($2.9 million) and volumes ($0.8 million). The higher revenue in North America was primarily a result of higher selling prices ($13.2 million) partially offset by the impact of unfavorable exchange rates ($9.7 million) and volumes ($1.8 million). Gross margin increased 20 basis points to 27.1% in 2015 from 26.9% in 2014. The increase was primarily due to the impact of higher selling prices, product mix and savings associated with the 2014 Restructuring Plan partially offset by higher raw material costs. Segment operating income for the Flavors & Fragrances segment was $121.9 million in 2015 and $120.9 million in 2014, an increase of 0.8%. Foreign exchange rates reduced segment operating income by 2.9% in 2015. The higher segment operating income was primarily a result of higher segment operating income in Europe ($2.3 million) and lower segment operating income in North America ($1.2 million). The higher operating income in Europe was primarily due to higher selling prices ($6.9 million), product mix ($4.3 million) and savings associated with the Restructuring Plan ($2.2 million) partially offset by higher raw material costs ($7.0 million), manufacturing and other costs ($3.8 million) and unfavorable exchange rates ($0.3 million). The lower operating income in North America was primarily due to higher raw material costs ($14.3 million), higher manufacturing and other costs ($3.6 million), unfavorable exchange rates ($1.8 million) and unfavorable product mix ($2.0 million) partially offset by higher selling prices ($13.2 million), savings associated with the 2014 Restructuring Plan ($5.7 million) and volumes ($1.7 million). Segment operating margin increased 70 basis points in 2015 to 14.9% from 14.2% in 2014. Index Color Revenue for the Color segment was $480.0 million in 2015 and $519.6 million in 2014, a decrease of 7.6%. Foreign exchange rates reduced segment revenue 8.8% in 2015. The decrease in revenue was primarily due to lower revenue in non-food colors ($30.1 million) and food and beverage colors ($9.5 million). The lower revenue in non-food colors was primarily due to the impact of unfavorable exchange rates ($18.2 million), lower volumes ($13.4 million), primarily specialty inks, and lower selling prices ($5.1 million) partially offset by higher volumes resulting from the Xennia acquisition ($6.6 million). The lower revenue in food and beverage colors was primarily due to the impact of unfavorable exchange rates ($27.2 million), partially offset by higher selling prices ($13.1 million) and volumes ($4.6 million), which includes approximately $4 million from a one-off fourth quarter sale of natural colors. Gross margin for the Color segment decreased 130 basis points to 40.5% in 2015 from 41.8% in 2014. The decrease was primarily due to the impact of the lower volumes, primarily specialty inks, and higher raw material costs, partially offset by higher selling prices and product mix. Segment operating income for the Color segment was $96.6 million in 2015 and $116.2 million in 2014, a decrease of 16.9%. Foreign exchange rates reduced segment operating income by 8.6% in 2015. The lower segment operating income was due to lower non-food colors ($20.0 million) partially offset by higher food and beverage colors ($0.4 million). The lower operating income for non-food colors was primarily due to volume and product mix ($5.6 million), primarily specialty inks, unfavorable exchange rates ($4.8 million), lower selling prices ($5.1 million) and higher manufacturing and other costs ($4.5 million). The higher operating income for food and beverage colors was primarily due to the higher selling prices ($13.1 million), and volumes and product mix ($3.2 million), which includes approximately $2 million from a one-off fourth quarter sale of natural colors, partially offset by higher raw material costs ($10.6 million) and unfavorable exchange rates ($5.2 million). Segment operating margin was 20.1% in 2015 and 22.4% in 2014. Asia Pacific Revenue for the Asia Pacific segment was $116.7 million in 2015 and $118.3 million in 2014, a decrease of 1.3%. Foreign exchange rates reduced segment revenue by 7.0% in 2015. Higher volumes ($5.9 million) and selling prices ($0.9 million) were offset by unfavorable exchange rates ($8.4 million). Gross margin for the Asia Pacific segment increased 60 basis points to 37.8% in 2015 from 37.2% in 2014. The increase was primarily due to the higher selling prices and favorable product mix. Segment operating income for the Asia Pacific segment was $23.7 million in 2015 and $22.9 million in 2014, an increase of 3.4%. Foreign exchange rates reduced segment operating income by 5.6% in 2015. The higher segment operating income was a result of volume and product mix ($5.5 million) and selling prices ($0.9 million) partially offset by the impact of unfavorable exchange rates ($1.3 million) and higher manufacturing and other costs ($4.0 million). Segment operating margin was 20.3% in 2015 and 19.4% in 2014. Corporate & Other The Corporate & Other expenses were $75.8 million in 2015 and $129.4 million in 2014, a decrease of 41.4%, primarily due to lower restructuring and other costs and lower costs for performance based compensation. The Company evaluates segment performance before restructuring costs, and reports all of the restructuring and other costs in Corporate & Other. Restructuring and other costs were $43.6 million and $90.6 million in 2015 and 2014, respectively Index LIQUIDITY AND FINANCIAL POSITION Financial Condition The Company’s financial position remains strong. The Company is in compliance with its loan covenants calculated in accordance with applicable agreements as of December 31, 2016. In the fourth quarter of 2016, the Company entered into an accounts receivable securitization program, whereby the Company sold certain trade receivables, which were removed from the Company’s consolidated balance sheet, for $40 million. The proceeds received from this program, are included in cash flows from operating activities in the Condensed Consolidated Statements of Cash Flows for the twelve months ended December 31, 2016, see Note 8, Securitization, for additional information. The Company expects its cash flow from operations and its existing debt capacity can be used to meet anticipated future cash requirements for operations, capital expenditures, dividend payments, acquisitions and stock repurchases. The impact of inflation on both the Company’s financial position and its results of operations has been minimal and is not expected to significantly affect 2017 results. Cash Flows from Operating Activities Net cash provided by operating activities was $222.5 million in 2016, $128.0 million in 2015 and $189.2 million in 2014. Operating cash flow provided the primary source of funds for operating needs, capital expenditures, shareholder dividends, acquisitions, and share repurchases. The increase in net cash provided by operating activities in 2016 is primarily due to increased cash earnings, favorable changes in working capital and the impact of the accounts receivable securitization program mentioned above. The decrease in net cash provided by operating activities in 2015 is primarily due to the impact of foreign currency, higher payments of restructuring costs and higher receivable balances. Cash Flows from Investing Activities Net cash used in investing activities was $75.2 million in 2016, $75.8 million in 2015 and $79.1 million in 2014. Capital expenditures were $81.2 million in 2016, $79.9 million in 2015 and $79.4 million in 2014. Cash Flows from Financing Activities Net cash used in financing activities was $128.0 million in 2016, $50.1 million in 2015 and $98.6 million in 2014. The Company had a net decrease in debt of $24.5 million in 2016, a net increase in debt of $174.6 million in 2015 and a net increase in debt of $85.8 million in 2014. Sensient purchased $50.1 million, $176.6 million and $137.2 million of Company stock, which settled in 2016, 2015 and 2014, respectively. The Company has paid uninterrupted quarterly cash dividends since commencing public trading in its stock in 1962. In the fourth quarter of 2016, the Company increased its quarterly dividend from 27 cents per share to 30 cents per share. Dividends paid per share were $1.11 in 2016, $1.04 cents in 2015 and 98 cents in 2014. Total dividends paid were $49.6 million, $48.1 million and $47.9 million in 2016, 2015 and 2014, respectively. ISSUER PURCHASES OF EQUITY SECURITIES Sensient purchased 0.7 million shares of Company stock in 2016 for a total cost of $47.5 million, 2.7 million shares of Company stock in 2015 for a total cost of $178.0 million and 2.5 million shares of Company stock in 2014 for a total cost of $138.3 million. In July 2014, the Board approved a share repurchase program under which the Company was authorized to repurchase five million shares of Company stock in addition to amounts remaining from a prior Board authorization. As of December 31, 2016, 1.4 million shares were available to be repurchased under existing authorizations. The Company’s share repurchase program has no expiration date. CRITICAL ACCOUNTING POLICIES In preparing the financial statements in accordance with accounting principles generally accepted in the U.S., management is required to make estimates and assumptions that have an impact on the asset, liability, revenue and expense amounts reported. These estimates can also affect supplemental information disclosures of the Company, including information about contingencies, risk and financial condition. The Company believes, given current facts and circumstances, that its estimates and assumptions are reasonable, adhere to accounting principles generally accepted in the U.S. and are consistently applied. Inherent in the nature of an estimate or assumption is the fact that actual results may differ from estimates and estimates may vary as new facts and circumstances arise. The Company makes routine estimates and judgments in determining the net realizable value of accounts receivable, inventories, property, plant and equipment, and prepaid expenses. Management believes the Company’s most critical accounting estimates and assumptions are in the following areas: Revenue Recognition The Company recognizes revenue (net of estimated discounts, allowances and returns) when title passes, the customer is obligated to pay the Company and the Company has no remaining obligations. Such recognition typically corresponds with the shipment of goods. Goodwill Valuation The Company reviews the carrying value of goodwill annually utilizing several valuation methodologies, including a discounted cash flow model. The Company completed its annual goodwill impairment test under Accounting Standards Codification (ASC) 350, Intangibles - Goodwill and Other, in the third quarter of 2016. In conducting its annual test for impairment, the Company performed a quantitative assessment of the fair values for each of its reporting units and compared each of these values to the net book value of each reporting unit. Fair value is estimated using both a discounted cash flow analysis and an analysis of comparable company market values. If the fair value of a reporting unit exceeds its net book value, no impairment exists. The Company’s three reporting units each had goodwill recorded and were tested for impairment. All three reporting units had fair values that were over 100% above their respective net book values. Changes in estimates of future cash flows caused by items such as unforeseen events or changes in market conditions could negatively affect the reporting units’ fair value and result in an impairment charge. Index Income Taxes The Company estimates its income tax expense in each of the taxing jurisdictions in which it operates. The Company is subject to a tax audit in each of these jurisdictions, which could result in changes to the estimated tax expense. The amount of these changes would vary by jurisdiction and would be recorded when probable and estimable. These changes could impact the Company’s financial statements. Management has recorded valuation allowances to reduce the Company’s deferred tax assets to the amount that is more likely than not to be realized. Examples of deferred tax assets include deductions, net operating losses and tax credits that the Company believes will reduce its future tax payments. In assessing the future realization of these assets, management has considered future taxable income and ongoing tax planning strategies. An adjustment to the recorded valuation allowance as a result of changes in facts or circumstances could result in a significant change in the Company’s tax expense. The Company does not provide for deferred taxes on unremitted earnings of foreign subsidiaries, which are considered to be invested indefinitely. Inventories Inventories are stated at the lower of cost or market. Cost is determined using the first-in, first-out (“FIFO”) method with the exception of certain locations of the Flavors & Fragrances Group where cost is determined using a weighted average method. Market is determined on the basis of estimated realizable values. Cost includes direct materials, direct labor and manufacturing overhead. The Company estimates any required write-downs for inventory obsolescence by examining inventories on a quarterly basis to determine if there are any damaged items or slow moving products in which the carrying values could exceed net realizable value. Inventory write-downs are recorded as the difference between the cost of inventory and its estimated market value. While significant judgment is involved in determining the net realizable value of inventory, the Company believes that inventory is appropriately stated at the lower of cost of market. Commitments and Contingencies The Company is subject to litigation and other legal proceedings arising in the ordinary course of its businesses or arising under applicable laws and regulations. Estimating liabilities and costs associated with these matters requires the judgment of management, who rely in part on information from Company legal counsel. When it is probable that the Company has incurred a liability associated with claims or pending or threatened litigation matters and the Company’s exposure is reasonably estimable, the Company records a charge against earnings. The Company recognizes related insurance reimbursement when receipt is deemed probable. The Company’s estimate of liabilities and related insurance recoveries may change as further facts and circumstances become known. Index CONTRACTUAL OBLIGATIONS The Company is subject to certain contractual obligations, including long-term debt, operating leases, manufacturing purchases and pension benefit obligations. The Company had unrecognized tax benefits of $3.3 million as of December 31, 2016. However, the Company cannot make a reasonably reliable estimate of the period of potential cash settlement of the liabilities and, therefore, has not included unrecognized tax benefits in the following table of significant contractual obligations as of December 31, 2016. PAYMENTS DUE BY PERIOD NEW PRONOUNCEMENTS In November 2015, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update (“ASU”) No. 2015-17, Balance Sheet Classification of Deferred Taxes, which requires entities to present deferred tax assets and deferred tax liabilities as noncurrent in a classified balance sheet. The ASU simplifies the current guidance, which requires entities to separately present deferred tax assets and deferred tax liabilities as current and noncurrent in a classified balance sheet. This guidance is effective for interim and annual periods beginning after December 31, 2016, with early adoption permitted. The guidance can be applied retrospectively or prospectively. The Company retrospectively applied the guidance to all prior periods. The Company adopted this ASU in the first quarter of 2016. As a result, the Company reclassified $17.1 million of current deferred tax assets to Deferred Tax Asset Noncurrent as of December 31, 2015. The Company also reclassified $7.3 million of current deferred tax assets to Deferred Tax Liability Noncurrent as of December 31, 2015. In April 2015, the FASB issued ASU No. 2015-03, Simplifying the Presentation of Debt Issuance Costs, which requires debt issuance costs to be presented in the balance sheet as a direct deduction from the carrying amount of the associated debt liability. Also, on August 18, 2015, the FASB issued ASU 2015-15, Presentation and Subsequent Measurement of Debt Issuance Costs Associated with Line-of-Credit Arrangements, to clarify that the SEC staff would not object to deferring and presenting debt issuance costs as an asset and subsequently amortizing deferred debt issuance costs ratably over the term of the line-of-credit arrangement. This guidance is effective for interim and annual periods beginning after December 15, 2015. The guidance is required to be retrospectively applied to all prior periods. The Company adopted these ASUs in the first quarter of 2016. As a result, the Company reclassified $0.4 million of debt fees from Other Assets to Long Term Debt as of December 31, 2015. The Company’s debt fees associated with the Company’s revolving loan agreement remain classified in Other Assets. In July 2015, the FASB affirmed its proposed one-year deferral of the effective date for ASU No. 2014-09, Revenue from Contracts with Customers. Under this proposal, the requirements of the new standard are effective for interim and annual periods beginning after December 15, 2017. The proposal also permits entities to adopt the standard for interim and annual reporting periods beginning after December 15, 2016. The Company has begun to review the impact of this standard on the Company’s financial statements. The Company currently recognizes revenue (net of estimated discounts, allowances and returns) when title to goods passes, the customer is obliged to pay the Company and the Company has no remaining obligations. Such recognition typically corresponds with the shipment of goods. The Company has created a project team to review this new standard in relationship to its existing contracts and other relevant documents across all of the Company’s operating segments. The Company plans to incorporate this new standard using the Full Retrospective transition method. The Company will continue to evaluate the impact of this standard on the Company’s consolidated financial statements. In July 2015, the FASB issued ASU No. 2015-11, Simplifying the Measurement of Inventory. Under this guidance, inventory that is accounted for using first-in, first-out or average cost method shall be measured at the lower of cost or net realizable value, as opposed to the lower of cost or market measurement under current guidance. This guidance is effective for interim and annual periods beginning after December 15, 2016, with early adoption permitted. This new guidance is required to be retrospectively applied to all prior periods. We are currently evaluating the expected impact of this standard. In February 2016, the FASB issued ASU No. 2016-02, Leases, which requires lessees to recognize the lease assets and lease liabilities that arise from leases on the balance sheet and to disclose qualitative and quantitative information about lease transactions. This guidance is effective for fiscal years beginning after December 15, 2018, including interim periods within those fiscal years. The Company is currently evaluating the expected impact of this standard. In March 2016, the FASB issued ASU No. 2016-09, Improvements to Employee Share-Based Payment Accounting, which simplifies several aspects of the accounting for employee share-based payment transactions, primarily the accounting for the associated income taxes. This guidance is effective for annual and interim periods beginning after December 15, 2016, with early adoption permitted. The Company adopted this ASU in the fourth quarter of 2016 and it did not have a material impact on its consolidated financial statements. Index OFF-BALANCE SHEET ARRANGEMENTS In the fourth quarter of 2016, the Company entered into an accounts receivable securitization program with a commitment size of $40 million, whereby transactions under the program are accounted for as sales of trade receivables in accordance with ASC Topic 860, Transfers and Servicing, and removed from the Company’s consolidated balance sheet. See Note 8, Accounts Receivable Securitization, for more information. Index

<s>[INST] OVERVIEW Sensient Technologies Corporation (the “Company”) is a global developer, manufacturer and supplier of flavor and fragrance systems for the food, beverage, personal care and householdproducts industries. In addition, the Company is a developer, manufacturer and supplier of colors for businesses worldwide. The Company provides natural and synthetic color systems for use in foods, beverages and pharmaceuticals; colors and other ingredients for cosmetics, pharmaceuticals and specialty inks; and technical colors for industrial applications. The Company’s three reportable segments are the Flavors & Fragrances Group and the Color Group, which are managed on a productandservices basis, and the Asia Pacific Group, which is managed on a geographic basis. The Company’s corporate expenses and restructuring and other costs are included in the “Corporate & Other” category. The Company’s 2016 diluted earnings per share from continuing operations were $2.74 in 2016 and $2.32 in 2015. Included in the 2016 and 2015 results, were $26.1 million and $43.6 million, respectively, of restructuring and other costs, or 47 cents per share and 73 cents per share, respectively. Adjusted diluted earnings per share, which exclude these restructuring and other costs, were $3.21 in 2016 and $3.05 in 2015 (see discussion below regarding NonGAAP Financial Measures and the Company’s Restructuring Activities and Divestiture). The Company’s net cash provided by operating activities was $222.5 million in 2016, an increase from the $128.0 million reported in 2015. The Company’s total debt decreased to $603 million as of December 31, 2016, from $634.2 million as of December 31, 2015. Since 1962, the Company has continued without interruption to pay a quarterly cash dividend. In 2016, the Company increased the quarterly dividend by 3 cents per share from 27 cents to 30 cents per share, or $1.20 per share on an annualized basis. In addition, the Company repurchased $50.1 million of Company stock in 2016, which is in addition to the $176.6 million repurchased in 2015. Additional information on the results is included below. RESULTS OF CONTINUING OPERATIONS 2016 vs. 2015 Revenue Sensient’s revenue was approximately $1.4 billion in both 2016 and 2015. The impact of foreign exchange rates reduced consolidated revenue by 2% in 2016. Gross Profit The Company’s gross margin was 34.4% in 2016 and 33.0% in 2015. Included in the cost of products sold are $2.1 million and $6.1 million of restructuring costs for 2016 and 2015, respectively. The increase in the gross margin is primarily a result of higher selling prices and volumes, mainly in the Color segment, savings associated with the 2014 Restructuring Plan ($7.9 million) and reduced restructuring costs, partially offset by higher raw material costs and manufacturing costs. Restructuring costs reduced gross margin by 10 basis points and 50 basis points in 2016 and 2015, respectively. Selling and Administrative Expenses Selling and administrative expense as a percent of revenue was 21.0% in 2016 and 20.9% in 2015. Restructuring and other costs of $24.0 million and $37.5 million for 2016 and 2015, respectively, were included in selling and administrative expense. Selling and administrative expense as a percent of revenue in 2016 were comparable to 2015 as a result of higher performance based executive compensation ($7.6 million) and professional fees ($ [/INST] Positive. </s>

SENSIENT TECHNOLOGIES CORP

2018-02-23

2017-12-31

Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operation. OVERVIEW Sensient Technologies Corporation (the “Company”) is a global developer, manufacturer, and supplier of flavor and fragrance systems for the food, beverage, personal care, and household-products industries. The Company is also a leading developer, manufacturer, and supplier of colors for businesses worldwide. The Company provides natural and synthetic color systems for use in foods, beverages, pharmaceuticals and nutraceuticals; colors, inks and other ingredients for cosmetics, pharmaceuticals, nutraceuticals and digital printing; and technical colors for industrial applications. The Company’s three reportable segments are the Flavors & Fragrances Group and the Color Group, which are managed on a product basis, and the Asia Pacific Group, which is managed on a geographic basis. The Company’s corporate expenses and restructuring and other costs are included in the “Corporate & Other” category. The Company’s diluted earnings per share from continuing operations were $2.03 in 2017 and $2.74 in 2016. Included in the 2017 and 2016 results, were $48.1 million, or $0.96 per share, and $26.1 million, or $0.47 per share, respectively, of restructuring and other costs. Included in the 2017 results, were $18.4 million of provisional tax expense related to the enactment of the Tax Cuts and Jobs Act (“2017 Tax Legislation”) in the fourth quarter of 2017, equating to an impact of 42 cents per share. Adjusted diluted earnings per share, which exclude these restructuring and other costs as well as the impact of the 2017 Tax Legislation, were $3.42 in 2017 and $3.21 in 2016 (see discussion below regarding non-GAAP financial measures and the Company’s restructuring activities, divestiture and income taxes). Since 1962, the Company has paid without interruption a quarterly cash dividend. In 2017, the Company increased the quarterly dividend by 3 cents per share from 30 cents to 33 cents per share, or $1.32 per share on an annualized basis. In addition, the Company repurchased $87.2 million of Company stock in 2017, which is in addition to the $50.1 million repurchased in 2016. Additional information on the results is included below. RESULTS OF CONTINUING OPERATIONS 2017 vs. 2016 Revenue Sensient’s revenue was approximately $1.4 billion in both 2017 and 2016. Gross Profit The Company’s gross margin was 34.9% in 2017 and 34.4% in 2016. Included in the cost of products sold are $2.9 million and $2.1 million of restructuring costs for 2017 and 2016, respectively. The increase in the gross margin is primarily a result of higher selling prices and the favorable impact of the divestitures (See Note 12, Restructuring Charges, and Note 14, Divestitures), partially offset by higher raw material and manufacturing costs. Restructuring costs reduced gross margin by 20 basis points and 10 basis points in 2017 and 2016, respectively. Index Selling and Administrative Expenses Selling and administrative expense as a percent of revenue was 22.6% in 2017 and 21.0% in 2016, respectively. Restructuring and other costs of $45.2 million and $24.0 million for 2017 and 2016, respectively, were included in selling and administrative expense. Selling and administrative expense as a percent of revenue were higher in 2017 than 2016 primarily as a result of higher restructuring and other costs, partially offset by lower performance based executive compensation and professional fees. Restructuring and other costs increased selling and administrative expense as a percent of revenue by 330 basis points and 180 basis points in 2017 and 2016, respectively. Operating Income Operating income was $167.8 million in 2017 and $185.6 million in 2016. Operating margins were 12.3% in 2017 and 13.4% in 2016. Restructuring and other costs reduced operating margins by 350 basis points and 190 basis points in 2017 and 2016, respectively. Additional information on segment results can be found in the Segment Information section. Interest Expense Interest expense was $19.4 million in 2017 and $18.3 million in 2016. The increase in expense was primarily due to the increase in average debt outstanding. Income Taxes The effective income tax rate was 39.6% in 2017 and 26.5% in 2016. The effective tax rates in both 2017 and 2016 were impacted by restructuring and other activities, changes in estimates associated with the finalization of prior year foreign and domestic tax items, audit settlements, adjustments to valuation allowances and mix of foreign earnings. The effective tax rate in 2017 was also impacted by the limited tax deductibility of losses (See Note 12, Restructuring Charges) and the result of the cumulative foreign currency effect related to certain repatriation transactions. On December 22, 2017, the U.S. enacted the Tax Cuts and Jobs Act (the “Act”). The Act, which is also commonly referred to as “2017 Tax Legislation”, significantly changes U.S. corporate income tax laws by reducing the U.S. corporate income tax rate to 21% beginning in 2018 and creating a territorial tax system with a one-time mandatory tax on previously deferred foreign earnings of U.S. subsidiaries. As a result, the Company recorded a net charge of $18.4 million during the fourth quarter of 2017. This amount consists of reassessing the U.S. deferred tax assets and liabilities based on the lower corporate income tax rate, adjustments to the Company’s foreign tax credit carryover, and the one-time mandatory tax on previously deferred foreign earnings of U.S. subsidiaries. Although the Company believes that $18.4 million is a reasonable estimate of the current year impact of the 2017 Tax Legislation, it should be considered a provisional estimate. The Company expects additional guidance on the 2017 Tax Legislation in 2018, and will finalize certain tax positions when it files its 2017 U.S. tax return. The ultimate impact could differ from these provisional amounts, possibly materially, due to additional guidance, changes in interpretation, additional analysis, and assumptions the Company has made. Any adjustments to the provisional estimate will be reported in income tax expense in the reporting period in which any such adjustments are determined, which will be no later than the fourth quarter of 2018. The 2018 effective income tax rate is estimated to be between 24% and 25%, before any discrete items. Restructuring The Company incurred restructuring costs in both continuing and discontinued operations. The discussion here relates to the combination of both continuing and discontinued operations unless otherwise noted. Restructuring costs related to discontinued operations are recorded in discontinued operations within the Company’s Consolidated Condensed Statements of Earnings and are discussed in Note 13, Discontinued Operations, in more detail. Index Between March 2014 and 2017, the Company executed a restructuring plan (“2014 Restructuring Plan” or “Plan”) to eliminate underperforming operations, consolidate manufacturing facilities, and improve efficiencies within the Company. The Company determined that it had redundant manufacturing capabilities in both North America and Europe and that it could lower costs and operate more efficiently by consolidating into fewer facilities. Eight facilities were identified for consolidation in the Flavors & Fragrances segment, four in North America and four in Europe. Closures have been completed in Indianapolis, Indiana, United States; Cornwall, Mississauga, and Halton Hills, Canada; Bremen, Germany; and Milan, Italy. As part of the Plan, the Company eventually sold its European Natural Ingredients business, including its facilities in Elburg, the Netherlands, and Marchais, France, as discussed below. In addition, the Company discontinued one of the businesses in the Color segment, located near Leipzig, Germany, because it did not fit with the Company’s long-term strategic plan and it had generated losses for several years. In 2015, the Company identified additional opportunities to consolidate manufacturing operations at one of the Color segment’s facilities in Europe and to eliminate additional positions in the European Flavors & Fragrances businesses. The Company has completed all of the above-mentioned activities and closures, as of December 31, 2017. Based on this Plan, the Company determined that certain long-lived assets associated with the underperforming operations were impaired. The Company reduced the carrying amounts of these assets to their aggregate respective fair values, which were determined based on independent market valuations. Also, certain machinery and equipment was identified to be disposed of at the time of the facility closures and the associated depreciation for these assets has been accelerated. The Company recorded long-lived asset impairments, including the impairment charges and accelerated depreciation of $2.2 million, $1.9 million, and $14.5 million during the years ended December 31, 2017, 2016, and 2015, respectively. Since initiating the Plan, the Company has recorded $89 million of long-lived asset impairments, including the impairment charges and accelerated depreciation. In addition, certain intangible assets, inventory, and other current assets were also determined to be impaired and were written down. The Company has also incurred employee separation and other restructuring costs as a result of this Plan. The Company has eliminated headcount related to direct and indirect labor at manufacturing sites by approximately 400 positions at the affected facilities, primarily in the Flavors & Fragrances segment. In connection with the 2014 Restructuring Plan, the Company approved a plan to dispose of a certain business, located near Leipzig, Germany, within the Color segment. Production ceased in 2014 and the business met the criteria to be reported as a discontinued operation. In 2016, the facility and remaining assets were sold and the entity was liquidated. During the three months ended March 31, 2017, the Company sold its European Natural Ingredients business (also known as the European Dehydrated Vegetable business), a business in the Flavors & Fragrances segment. This business had two facilities, located in Marchais, France, and Elburg, the Netherlands. As part of the 2014 Restructuring Plan, the Company had concluded that the European Natural Ingredients business had not generated significant profits for several years and did not fit with the Company’s long-term strategic plan. The Company completed the sale of this business on March 27, 2017, for a de minimis amount and has recognized a non-cash loss of approximately $21.6 million. As of December 31, 2017, the Company has recorded assets held for sale of land, buildings, and equipment of $2 million related to the 2014 Restructuring Plan. In accordance with GAAP, the Company recorded total restructuring costs of $36.5 million, $11.1 million, and $42.8 million for the years ended December 31, 2017, 2016, and 2015, respectively. Since initiating the 2014 Restructuring Plan, the Company has incurred $189 million of restructuring costs as of December 31, 2017. The Company does not expect any restructuring costs in 2018. Since initiating the Plan, the Company has realized total savings of approximately $22 million as of December 31, 2017. In 2017, the Company realized a de minimis amount of savings, but expects additional savings of approximately $4 million to $5 million in 2018. Expected savings have shifted from 2017 to 2018 primarily due to the delay in closing the Indianapolis facility. The Company continues its efforts to optimize production at the consolidated sites. Divestiture In 2016, the Company’s Board of Directors authorized management to explore strategic alternatives for a facility and certain related business lines within the Flavors & Fragrances segment in Strasbourg, France. In 2016, the Company recorded a non-cash impairment charge of $10.8 million, in selling and administrative expense, reducing the carrying value of the long-lived assets for this facility to zero. An estimate of the fair value of this business less cost to sell was determined to be lower than its carrying value. The difference between the fair value and its carrying value exceeded the existing net book value of the long-lived assets. In addition, the Company incurred $0.7 million of outside professional fees and other related costs in 2016, as a result of the then anticipated divestiture. On January 6, 2017, the Company completed the sale of this facility and certain related business lines for approximately $12.5 million. At that time, the Company recognized an additional non-cash loss of approximately $11.0 million during the three months ended March 31, 2017. In addition, an additional non-cash loss of approximately $0.6 million was recognized during the three months ended June 30, 2017. The additional non-cash losses in 2017 were primarily due to changes in the estimates related to working capital balances. Index NON-GAAP FINANCIAL MEASURES Within the following tables, the Company reports certain non-GAAP financial measures, including: (1) adjusted operating income, adjusted net earnings, and adjusted diluted EPS from continuing operations (which exclude restructuring and other costs as well as the impact of the Tax Cuts and Jobs Act (“2017 Tax Legislation”)) and (2) percentage changes in revenue, operating income, diluted EPS, adjusted operating income, and adjusted diluted EPS on a local currency basis (which eliminate the effects that result from translating its international operations into U.S. dollars). The other costs in 2017 and 2016 are divestiture related costs, discussed under “Divestiture” above. The Company has included each of these non-GAAP measures in order to provide additional information regarding our underlying operating results and comparable year-over-year performance. Such information is supplemental to information presented in accordance with GAAP and is not intended to represent a presentation in accordance with GAAP. These non-GAAP measures should not be considered in isolation. Rather, they should be considered together with GAAP measures and the rest of the information included in this report. Management internally reviews each of these non-GAAP measures to evaluate performance on a comparative period-to-period basis and to gain additional insight into underlying operating and performance trends. The Company believes that this information can be beneficial to investors for the same purposes. These non-GAAP measures may not be comparable to similarly titled measures used by other companies. (1) The other costs in 2017 and 2016 are for the divestiture related costs discussed under “Divestiture” above. Note: Earnings per share calculations may not foot due to rounding differences. Index The following table summarizes the percentage change in the 2017 results compared to the 2016 results in the respective financial measures. (1) Refer to table above for a reconciliation of these non-GAAP measures. SEGMENT INFORMATION The Company determines its operating segments based on information utilized by its chief operating decision maker to allocate resources and assess performance. Segment performance is evaluated on operating income before restructuring and other costs (which are reported in Corporate & Other), interest expense, and income taxes. The Company’s reportable segments consist of the Flavors & Fragrances, Color, and Asia Pacific segments. Beginning in the first quarter of 2017, the results of operations for certain of the Company’s cosmetic and fragrance businesses in the Asia Pacific segment are now reported in the Color segment and Flavors & Fragrances segment, respectively. In addition, the Color segment reassigned customer accounts and revised cost allocations amongst the businesses within their segment resulting in changes in the underlying components of segment revenue and segment operating income. The results for 2016 have been restated to reflect these changes. Flavors & Fragrances Revenue for the Flavors & Fragrances segment was $746.9 million in 2017 and $795.8 million in 2016, a decrease of 6.1%. Foreign exchange did not have a material impact on revenue. The decrease in revenue was primarily due to lower revenue in Europe ($27.2 million) and North America ($22.5 million). The lower revenue in Europe was primarily due to the divestitures ($24.4 million) and lower volumes ($6.5 million), partially offset by higher selling prices ($4.4 million). The lower revenue in North America was primarily due to lower volumes ($36.3 million), partially offset by higher selling prices ($13.2 million). Gross margin increased 60 basis points to 28.2% in 2017 from 27.6% in 2016. The increase was primarily due to the impact of higher selling prices and the impact of the divestitures, partially offset by higher manufacturing and other costs and lower volume and product mix. Segment operating income for the Flavors & Fragrances segment was $114.3 million in 2017, and $124.1 million in 2016. The lower segment operating income was primarily a result of lower segment operating income in North America ($9.0 million). The lower operating income in North America was primarily due to unfavorable volume and product mix ($11.7 million), higher manufacturing and other costs ($6.7 million), and higher raw material costs ($3.1 million), partially offset by higher selling prices ($13.2 million). Segment operating margin was 15.3% in 2017 and 15.6% in 2016. Color Revenue for the Color segment was $526.4 million in 2017, and $504.1 million in 2016, an increase of 4.4%. The increase in revenue was primarily due to higher revenue in non-food colors ($21.8 million). The higher revenue in non-food colors was primarily due to higher volumes ($18.1 million), primarily in cosmetic colors, and higher selling prices ($1.8 million). Index Gross margin for the Color segment increased 20 basis points to 42.2% in 2017 from 42.0% in 2016. The increase was primarily due to higher selling prices, favorable volumes, and product mix, partially offset by the unfavorable impact of higher manufacturing and other costs. Segment operating income for the Color segment was $113.4 million in 2017, and $105.8 million in 2016, an increase of 7.2%. The higher segment operating income was due to higher segment operating income in non-food colors ($9.8 million) offset by lower segment operating income in food and beverage colors ($2.2 million). The higher operating income for non-food colors was primarily due to favorable volume and product mix ($9.1 million). The lower profit for food and beverage colors is primarily due to unfavorable volume and product mix ($4.4 million) and higher manufacturing and other costs ($1.8 million), partially offset by higher selling prices ($3.3 million). Segment operating margin was 21.5% in 2017 and 21.0% in 2016. Asia Pacific Revenue for the Asia Pacific segment was $123.2 million in 2017, and $121.2 million in 2016, an increase of 1.6%. The higher segment revenue was due to higher selling prices ($1.7 million), partially offset by lower volumes ($0.6 million). Gross margin for the Asia Pacific segment decreased 120 basis points to 36.8% in 2017 from 38.0% in 2016. The decrease was primarily due to unfavorable volumes and product mix and higher manufacturing costs, partially offset by higher selling prices and the favorable impact of exchange rates. Segment operating income for the Asia Pacific segment was $20.8 million in 2017, and $23.6 million in 2016, a decrease of 12.0%. The lower segment operating income was a result of higher manufacturing and other costs ($3.2 million) and unfavorable volume and product mix ($1.3 million), partially offset by higher selling prices ($1.7 million). Segment operating margin was 16.9% in 2017 and 19.5% in 2016. Corporate & Other The Corporate & Other expenses were $80.7 million in 2017 and $67.9 million in 2016, an increase of 18.9%, primarily due to higher restructuring and other costs ($22.0 million) partially offset by lower performance based executive compensation ($4.1 million) and professional services ($3.6 million). The Company evaluates segment performance before restructuring and other costs, and reports all of the restructuring and other costs in Corporate & Other. Restructuring and other costs were $48.1 million and $26.1 million in 2017 and 2016, respectively. RESULTS OF CONTINUING OPERATIONS 2016 vs. 2015 Revenue Sensient’s revenue was approximately $1.4 billion in both 2016 and 2015. Gross Profit The Company’s gross margin was 34.4% in 2016 and 33.0% in 2015. Included in the cost of products sold are $2.1 million and $6.1 million of restructuring costs for 2016 and 2015, respectively. The increase in the gross margin is primarily a result of higher selling prices and volumes, mainly in the Color segment, savings associated with the 2014 Restructuring Plan ($7.9 million), and reduced restructuring costs, partially offset by higher raw material and manufacturing costs. Restructuring costs reduced gross margin by 10 basis points and 50 basis points in 2016 and 2015, respectively. Selling and Administrative Expenses Selling and administrative expense as a percent of revenue was 21.0% in 2016 and 20.9% in 2015. Restructuring and other costs of $24.0 million and $37.5 million for 2016 and 2015, respectively, was included in selling and administrative expense. Selling and administrative expense as a percent of revenue in 2016 was comparable to 2015 as a result of higher performance based executive compensation ($7.6 million) and professional fees ($6.2 million), partially offset by lower restructuring and other costs ($13.5 million). Restructuring and other costs increased selling and administrative expense as a percent of revenue by 180 basis points and 270 basis points in 2016 and 2015, respectively. Operating Income Operating income was $185.6 million in 2016 and $166.3 million in 2015. Operating margins increased to 13.4% in 2016 from 12.1% in 2015. Restructuring and other costs reduced operating margins by 190 basis points and 320 basis points in 2016 and 2015, respectively. Additional information on segment results can be found in the Segment Information section. Index Interest Expense Interest expense was $18.3 million in 2016 and $16.9 million in 2015. The increase in expense was primarily due to the increase in average debt outstanding, which was partially offset by lower average interest rates. Income Taxes The effective income tax rate was 26.5% in 2016 and 28.2% in 2015. The effective tax rates in both 2016 and 2015 were impacted by audit settlements, mix of foreign earnings, and restructuring and other costs. The effective tax rate in 2015 was also impacted by changes in estimates associated with the finalization of prior year tax items. In total, the net impact of these discrete items and restructuring and other costs reduced the effective income tax rate by 1.2% for 2016 and 2.4% for 2015. Restructuring As part of the 2014 Restructuring Plan, the Company recorded $11.1 million and $42.8 million of restructuring costs in 2016 and 2015, respectively. For further information on the 2014 Restructuring Plan, see the discussion in the Management’s Discussion and Analysis of Financial Condition and Results of Operation. NON-GAAP FINANCIAL MEASURES Within the following tables, the Company reports certain non-GAAP financial measures, including: (1) adjusted operating income, adjusted net earnings, and adjusted diluted EPS from continuing operations (which exclude restructuring and other costs) and (2) percentage changes in revenue, operating income, diluted EPS, adjusted operating income, and adjusted diluted EPS on a local currency basis, which eliminates the effects that result from translating its international operations into U.S. dollars. The other costs in 2016 are for the divestiture related costs discussed under “Divestiture” above, and the other costs in 2015 are acquisition related costs. The Company has included each of these non-GAAP measures in order to provide additional information regarding our underlying operating results and comparable year-over-year performance. Such information is supplemental to information presented in accordance with GAAP and is not intended to represent a presentation in accordance with GAAP. These non-GAAP measures should not be considered in isolation. Rather, they should be considered together with GAAP measures and the rest of the information included in this report. Management internally reviews each of these non-GAAP measures to evaluate performance on a comparative period-to-period basis and to gain additional insight into underlying operating and performance trends. The Company believes the information can be beneficial to investors for the same purposes. These non-GAAP measures may not be comparable to similarly titled measures used by other companies. (1) The other costs in 2016 are for the divestiture related costs discussed under “Divestiture” above and the other costs in 2015 are acquisition related costs. Note: Earnings per share calculations may not foot due to rounding differences. Index The following table summarizes the percentage change in the 2016 results compared to the 2015 results in the respective financial measures. (1) Refer to table above for a reconciliation of these non-GAAP measures. SEGMENT INFORMATION The Company determines its operating segments based on information utilized by its chief operating decision maker to allocate resources and assess performance. Segment performance is evaluated on operating income before restructuring and other costs (which are reported in Corporate & Other), interest expense, and income taxes. The Company’s reportable segments consist of the Flavors & Fragrances, Color, and Asia Pacific segments. As stated above, beginning in the first quarter of 2017, the results of operations for certain of the Company’s cosmetic and fragrance businesses in the Asia Pacific segment are now reported in the Color segment and Flavors & Fragrances segment. In addition, the Color segment reassigned customer accounts and revised cost allocations amongst the businesses within their segment resulting in changes in the underlying components of segment revenue and segment operating income. All prior year results have been restated to reflect each of these changes. Flavors & Fragrances Revenue for the Flavors & Fragrances segment was $795.8 million in 2016 and $819.5 million in 2015, a decrease of 2.9%. The decrease in revenue was primarily due to lower revenue in North America ($13.3 million) and Europe ($9.8 million). The lower revenue in North America was primarily due to lower volumes ($29.0 million), partially offset by higher selling prices ($18.0 million). The lower revenue in Europe was primarily a result of the unfavorable impact of exchange rates ($7.2 million) and lower volumes ($4.4 million), partially offset by higher selling prices ($1.9 million). Gross margin increased 50 basis points to 27.6% in 2016 from 27.1% in 2015. The increase was primarily due to the impact of higher selling prices and savings associated with the 2014 Restructuring Plan, partially offset by higher raw material costs and lower volume and product mix. Segment operating income for the Flavors & Fragrances segment was $124.1 million in 2016 and $122.3 million in 2015, an increase of 1.5%. The higher segment operating income was primarily a result of higher segment operating income in North America ($5.8 million), partially offset by lower segment operating income in Europe ($3.2 million) and lower segment operating income in Latin America ($0.8 million). The higher operating income in North America was primarily due to higher selling prices ($18.0 million), savings associated with the Restructuring Plan ($4.4 million), lower manufacturing and other costs ($3.1 million), and profit on the sale of an import right ($2.2 million) partially offset by volume and product mix ($11.6 million) and higher raw material costs ($9.8 million). The lower operating income in Europe was primarily due to higher manufacturing and other costs ($10.2 million), partially offset by savings associated with the 2014 Restructuring Plan ($3.8 million), higher selling prices ($1.9 million), and lower raw material costs ($1.3 million). The lower operating income in Latin America was primarily due to higher raw material costs ($2.6 million), higher manufacturing and other costs ($1.9 million) and the unfavorable impact of exchange rates ($1.2 million), partially offset by higher selling prices ($2.6 million) and volume and product mix ($2.3 million). Segment operating margin increased 70 basis points in 2016 to 15.6% from 14.9% in 2015. Index Color Revenue for the Color segment was $504.1 million in 2016 and $481.9 million in 2015, an increase of 4.6%. The increase in revenue was primarily due to higher revenue in non-food colors ($21.9 million). The higher revenue in non-food colors was primarily due to higher volumes ($27.5 million), primarily in cosmetic colors and specialty inks, partially offset by the unfavorable impact of exchange rates ($3.7 million) and lower selling prices ($1.9 million). Gross margin for the Color segment increased 130 basis points to 42.0% in 2016 from 40.7% in 2015. The increase was primarily due to higher volumes and product mix, selling prices and lower manufacturing costs, partially offset by the unfavorable impact of exchange rates and higher raw material costs. Segment operating income for the Color segment was $105.8 million in 2016 and $97.7 million in 2015, an increase of 8.4%. The higher segment operating income was due to higher non-food colors ($7.4 million) and food and beverage colors ($0.7 million). The higher operating income for non-food colors was primarily due to volume and product mix ($14.4 million), partially offset by higher manufacturing and other costs ($3.9 million), lower selling prices ($1.9 million), higher raw material costs ($0.6 million), and the unfavorable impact of exchange rates ($0.6 million). The higher profit for food and beverage colors is primarily due to higher selling prices ($8.8 million), volume and product mix ($2.7 million), and savings associated with the 2014 Restructuring Plan ($0.5 million), partially offset by higher raw material costs ($4.8 million), higher manufacturing and other costs ($4.6 million) and the unfavorable impact of exchange rates ($1.8 million). Segment operating margin was 21.0% in 2016 and 20.3% in 2015. Asia Pacific Revenue for the Asia Pacific segment was $121.2 million in 2016, and $111.2 million in 2015, an increase of 9.0%. The higher segment revenue was due to higher volumes ($9.0 million) and selling prices ($2.5 million), partially offset by the unfavorable impact of exchange rates ($1.4 million). Gross margin for the Asia Pacific segment increased 10 basis points to 38.0% in 2016 from 37.9% in 2015. The increase was primarily due to higher selling prices and volumes and product mix, partially offset by higher manufacturing and other costs and raw material costs. Segment operating income for the Asia Pacific segment was $23.6 million in 2016, and $22.2 million in 2015, an increase of 6.2%. The higher segment operating income was a result of volume and product mix ($4.3 million) and higher selling prices ($2.6 million), partially offset by higher manufacturing and other costs ($4.8 million), higher raw material costs ($0.3 million) and the unfavorable impact of exchange rates ($0.5 million). Segment operating margin was 19.5% in 2016 and 20.0% in 2015. Corporate & Other The Corporate & Other expenses were $67.9 million in 2016, and $75.8 million in 2015, a decrease of 10.5%, primarily due to lower restructuring and other costs ($17.5 million), partially offset by higher performance based executive compensation ($7.6 million) and professional services ($3.5 million). The Company evaluates segment performance before restructuring and other costs, and reports all of the restructuring and other costs in Corporate & Other. Restructuring and other costs were $26.1 million and $43.6 million in 2016 and 2015, respectively. LIQUIDITY AND FINANCIAL POSITION Financial Condition The Company’s financial position remains strong. The Company is in compliance with its loan covenants calculated in accordance with applicable agreements as of December 31, 2017. In the fourth quarter of 2017, the Company amended its accounts receivable securitization program, and increased the commitment size from $40 million to $60 million. The proceeds received from this program, which equaled $40 million in 2016 and $20 million in 2017, are included in cash flows from operating activities in the Condensed Consolidated Statements of Cash Flows for the twelve months ended December 31, 2017 and 2016, See Note 7, Accounts Receivable Securitization, for additional information. The Company expects its cash flow from operations and its existing debt capacity can be used to meet anticipated future cash requirements for operations, capital expenditures, dividend payments, acquisitions, and stock repurchases. The impact of inflation on both the Company’s financial position and its results of operations has been minimal and is not expected to significantly affect 2018 results. Cash Flows from Operating Activities Net cash provided by operating activities was $180.5 million in 2017; $222.5 million in 2016; and $128.0 million in 2015. Operating cash flow provided the primary source of funds for operating needs, capital expenditures, shareholder dividends, acquisitions, and share repurchases. The decrease in net cash provided by operating activities in 2017 is primarily due to higher working capital balances, the timing of tax payments, and the impact of the accounts receivable securitization program. The increase in net cash provided by operating activities in 2016 is primarily due to increased cash earnings, favorable changes in working capital, and the impact of the accounts receivable securitization program. Index Cash Flows from Investing Activities Net cash used in investing activities was $33.8 million in 2017; $75.2 million in 2016; and $75.8 million in 2015. Capital expenditures were $56.3 million in 2017; $81.2 million in 2016; and $79.9 million in 2015. In 2017, the Company sold a facility and certain related business lines in Strasbourg, France, for approximately $12.5 million, its European Natural Ingredients business for a nominal amount, and two other production facilities for $10.1 million. Cash Flows from Financing Activities Net cash used in financing activities was $153.4 million in 2017; $128.0 million in 2016; and $50.1 million in 2015. The Company had a net decrease in debt of $8.8 million in 2017; a net decrease in debt of $24.5 million in 2016; and a net increase in debt of $174.6 million in 2015. Sensient purchased $87.2 million, $50.1 million, and $176.6 million of Company stock, which settled in 2017, 2016, and 2015, respectively. The Company has paid uninterrupted quarterly cash dividends since commencing public trading in its stock in 1962. In the fourth quarter of 2017, the Company increased its quarterly dividend from 30 cents per share to 33 cents per share. Dividends paid per share were $1.23 in 2017, $1.11 cents in 2016, and 1.04 cents in 2015. Total dividends paid were $54.0 million, $49.6 million, and $48.1 million in 2017, 2016, and 2015, respectively. ISSUER PURCHASES OF EQUITY SECURITIES Sensient purchased 1.1 million shares of Company stock in 2017 for a total cost of $87.2 million; 0.7 million shares of Company stock in 2016 for a total cost of $47.5 million; and 2.7 million shares of Company stock in 2015 for a total cost of $178.0 million. In 2014, the Board approved a share repurchase program under which the Company was authorized to repurchase five million shares of Company stock. In October 2017, the Board of Directors authorized the repurchase of up to three million additional shares. As of December 31, 2017, 3.3 million shares were available to be repurchased under existing authorizations. The Company’s share repurchase program has no expiration date. These authorizations may be modified, suspended, or discontinued by the Board of Directors at any time. CRITICAL ACCOUNTING POLICIES In preparing the financial statements in accordance with accounting principles generally accepted in the U.S., management is required to make estimates and assumptions that have an impact on the asset, liability, revenue, and expense amounts reported. These estimates can also affect supplemental information disclosures of the Company, including information about contingencies, risk, and financial condition. The Company believes, given current facts and circumstances, that its estimates and assumptions are reasonable, adhere to accounting principles generally accepted in the U.S., and are consistently applied. Inherent in the nature of an estimate or assumption is the fact that actual results may differ from estimates and estimates may vary as new facts and circumstances arise. The Company makes routine estimates and judgments in determining the net realizable value of accounts receivable, inventories, property, plant, and equipment, and prepaid expenses. Management believes the Company’s most critical accounting estimates and assumptions are in the following areas: Revenue Recognition The Company recognizes revenue (net of estimated discounts, allowances, and returns) when title passes, the customer is obligated to pay the Company, and the Company has no remaining obligations. Such recognition typically corresponds with the shipment of goods. Goodwill Valuation The Company reviews the carrying value of goodwill annually utilizing several valuation methodologies, including a discounted cash flow model. The Company completed its annual goodwill impairment test under Accounting Standards Codification (ASC) 350, Intangibles - Goodwill and Other, in the third quarter of 2017. In conducting its annual test for impairment, the Company performed a qualitative assessment of its previously calculated fair values for each of its reporting units. Fair value is estimated using both a discounted cash flow analysis and an analysis of comparable company market values. If the fair value of a reporting unit exceeds its net book value, no impairment exists. The Company’s three reporting units each had goodwill recorded and were tested for impairment. All three reporting units had fair values that were over 100% above their respective net book values. Changes in estimates of future cash flows caused by items such as unforeseen events or changes in market conditions could negatively affect the reporting units’ fair value and result in an impairment charge. Income Taxes The Company estimates its income tax expense in each of the taxing jurisdictions in which it operates. The Company is subject to a tax audit in each of these jurisdictions, which could result in changes to the estimated tax expense. The amount of these changes would vary by jurisdiction and would be recorded when probable and estimable. These changes could impact the Company’s financial statements. Management has recorded valuation allowances to reduce the Company’s deferred tax assets to the amount that is more likely than not to be realized. Examples of deferred tax assets include deductions, net operating losses, and tax credits that the Company believes will reduce its future tax payments. In assessing the future realization of these assets, management has considered future taxable income and ongoing tax planning strategies. An adjustment to the recorded valuation allowance as a result of changes in facts or circumstances could result in a significant change in the Company’s tax expense. The Company does not provide for deferred taxes on unremitted earnings of foreign subsidiaries, which are considered to be invested indefinitely. Index Inventories Inventories are stated at the lower of cost or net realizable value. Cost is determined using the first-in, first-out (“FIFO”) method with the exception of certain locations of the Flavors & Fragrances segment where cost is determined using a weighted average method. Net realizable value is determined on the basis of estimated realizable values. Cost includes direct materials, direct labor, and manufacturing overhead. The Company estimates any required write-downs for inventory obsolescence by examining inventories on a quarterly basis to determine if there are any damaged items or slow moving products in which the carrying values could exceed net realizable value. Inventory write-downs are recorded as the difference between the cost of inventory and its estimated market value. While significant judgment is involved in determining the net realizable value of inventory, the Company believes that inventory is appropriately stated at the lower of cost or net realizable value. Commitments and Contingencies The Company is subject to litigation and other legal proceedings arising in the ordinary course of its businesses or arising under applicable laws and regulations. Estimating liabilities and costs associated with these matters requires the judgment of management, who rely in part on information from Company legal counsel. When it is probable that the Company has incurred a liability associated with claims or pending or threatened litigation matters and the Company’s exposure is reasonably estimable, the Company records a charge against earnings. The Company recognizes related insurance reimbursement when receipt is deemed probable. The Company’s estimate of liabilities and related insurance recoveries may change as further facts and circumstances become known. CONTRACTUAL OBLIGATIONS The Company is subject to certain contractual obligations, including long-term debt, operating leases, manufacturing purchases, and pension benefit obligations. The Company had unrecognized tax benefits of $4.5 million as of December 31, 2017. However, the Company cannot make a reasonably reliable estimate of the period of potential cash settlement of the liabilities and, therefore, has not included unrecognized tax benefits in the following table of significant contractual obligations as of December 31, 2017. PAYMENTS DUE BY PERIOD (1) Relates to the one-time transition tax on earnings of foreign subsidiaries as enacted by the 2017 Tax Legislation. NEW PRONOUNCEMENTS In July 2015, the Financial Accounting Standards Board (FASB) affirmed its proposed one-year deferral of the effective date for Accounting Standards Update (ASU) No. 2014-09, Revenue from Contracts with Customers. Under this proposal, the requirements of the new standard are effective for interim and annual periods beginning after December 15, 2017. The proposal also permits entities to adopt the standard for interim and annual reporting periods beginning after December 15, 2016. The Company currently recognizes revenue (net of estimated discounts, allowances, and returns) when title to goods passes, the customer is obliged to pay the Company, and the Company has no remaining obligations. Such recognition typically corresponds with the shipment of goods. The Company created a project team within its Corporate Finance Department, in 2016, to review the potential impact that this ASU may have on the Company. At that time, the Company’s revenue recognition project team began gathering data, including issuing a detailed revenue recognition questionnaire designed to highlight instances of variable consideration, and reviewing existing contracts and other relevant documents across all of the Company’s segments. In the first quarter of 2017, the Company finalized a detailed project plan and distributed a second revenue recognition questionnaire designed to examine potential instances of variable consideration in greater detail. In the second and third quarters of 2017, the Company reviewed and analyzed the questionnaires and supporting documentation and completed its review and analysis during the fourth quarter. In addition, the Company has updated its current internal controls and implemented additional controls and monitoring around revenue recognition during the second and third quarters of 2017. The Company also conducted training for all financial personnel on the new standard, controls, and monitoring during the fourth quarter. The Company updated its Audit Committee throughout the year on the status of the implementation of this ASU. The Company has completed its analysis of its revenue streams and has not identified any significant changes to the timing of recognition or measurement of revenue. The Company does not anticipate that the new standard will have a material impact on the its consolidated financial statements in 2018. The Company will incorporate this new standard using the modified retrospective method. Index In July 2015, the FASB issued ASU No. 2015-11, Simplifying the Measurement of Inventory. Under this guidance, inventory that is accounted for using first-in, first-out, or average cost method, shall be measured at the lower of cost or net realizable value, as opposed to the lower of cost or market measurement under previous guidance. This guidance became effective for interim and annual periods beginning after December 15, 2016, with early adoption permitted. The Company adopted this standard in the first quarter of 2017, and it did not have a material effect on its consolidated financial statements. In February 2016, the FASB issued ASU No. 2016-02, Leases, which requires lessees to recognize the lease assets and lease liabilities that arise from leases on the balance sheet and to disclose qualitative and quantitative information about lease transactions. This guidance is effective for fiscal years beginning after December 15, 2018, including interim periods within those fiscal years. The Company created a project team within its Corporate Finance Department to review the potential impact that this ASU may have on the Company. The project team has begun gathering data and reviewing existing leases and other relevant documents across all of the Company’s segments. The Company continues to evaluate the potential impact of this standard. In August 2016, the FASB issued ASU 2016-15, Statement of Cash Flows: Classification of Certain Cash Receipts and Cash Payment. This ASU clarifies how certain cash receipts and cash payments are presented and classified in the statement of cash flows. Among these changes, is a requirement that a transferor’s receipt of a beneficial interest in securitized trade receivables be disclosed as a noncash investing transaction. The guidance is effective for fiscal years beginning after December 15, 2017, including interim periods within those years. The Company does not expect this standard to have a material impact on its financial statements. In December 2016, the FASB issued ASU 2016-16, Accounting for Income Taxes: Intra-Entity Asset Transfers of Assets Other than Inventory. Under current GAAP, the tax effects of intra-entity asset transfers are deferred until the transferred asset is sold to a third party or otherwise recovered through use. The new guidance eliminates the exception for all intra-entity sales of assets other than inventory. The guidance is effective for fiscal years beginning after December 15, 2017, including interim periods within those years. The Company continues to evaluate the expected impact of this standard. In March 2017, the FASB issued ASU No. 2017-07, Improving the Presentation of Net Periodic Pension Cost and Net Periodic Postretirement Benefit Cost. This ASU requires employers to present the service cost component of the net periodic benefit cost in the same income statement line item as the other employee compensation costs arising from services rendered during the period. The other components of net benefit cost are to be presented outside of any subtotal of operating income. This ASU is effective for fiscal years and interim periods beginning after December 15, 2017, and early adoption is permitted. The Company will adopt this standard in the first quarter of 2018, and it will not have a material impact on the its consolidated financial statements. In August 2017, the FASB issued ASU No. 2017-12, Targeted Improvements to Accounting for Hedging Activities, which expands an entity’s ability to hedge nonfinancial and financial risk components and reduce complexity in fair value hedges of interest rate risk. This guidance eliminates the requirement to separately measure and report hedge ineffectiveness and generally requires the entire change in the fair value of a hedging instrument to be presented in the same income statement line item as the hedged item. This ASU is effective for fiscal years and interim periods beginning after December 15, 2018. The Company is currently evaluating the expected impact of this standard. OFF-BALANCE SHEET ARRANGEMENTS In 2016, the Company entered into an accounts receivable securitization program with a commitment size of $40 million, whereby transactions under the program are accounted for as sales of trade receivables in accordance with ASC Topic 860, Transfers and Servicing, and removed from the Company’s consolidated balance sheet. In October 2017, the Company extended this program for one year and increased the commitment size to $60 million (refer to Note 7, Accounts Receivable Securitization, included in Part I, Item I of this report).

<s>[INST] OVERVIEW Sensient Technologies Corporation (the “Company”) is a global developer, manufacturer, and supplier of flavor and fragrance systems for the food, beverage, personal care, and householdproducts industries. The Company is also a leading developer, manufacturer, and supplier of colors for businesses worldwide. The Company provides natural and synthetic color systems for use in foods, beverages, pharmaceuticals and nutraceuticals; colors, inks and other ingredients for cosmetics, pharmaceuticals, nutraceuticals and digital printing; and technical colors for industrial applications. The Company’s three reportable segments are the Flavors & Fragrances Group and the Color Group, which are managed on a product basis, and the Asia Pacific Group, which is managed on a geographic basis. The Company’s corporate expenses and restructuring and other costs are included in the “Corporate & Other” category. The Company’s diluted earnings per share from continuing operations were $2.03 in 2017 and $2.74 in 2016. Included in the 2017 and 2016 results, were $48.1 million, or $0.96 per share, and $26.1 million, or $0.47 per share, respectively, of restructuring and other costs. Included in the 2017 results, were $18.4 million of provisional tax expense related to the enactment of the Tax Cuts and Jobs Act (“2017 Tax Legislation”) in the fourth quarter of 2017, equating to an impact of 42 cents per share. Adjusted diluted earnings per share, which exclude these restructuring and other costs as well as the impact of the 2017 Tax Legislation, were $3.42 in 2017 and $3.21 in 2016 (see discussion below regarding nonGAAP financial measures and the Company’s restructuring activities, divestiture and income taxes). Since 1962, the Company has paid without interruption a quarterly cash dividend. In 2017, the Company increased the quarterly dividend by 3 cents per share from 30 cents to 33 cents per share, or $1.32 per share on an annualized basis. In addition, the Company repurchased $87.2 million of Company stock in 2017, which is in addition to the $50.1 million repurchased in 2016. Additional information on the results is included below. RESULTS OF CONTINUING OPERATIONS 2017 vs. 2016 Revenue Sensient’s revenue was approximately $1.4 billion in both 2017 and 2016. Gross Profit The Company’s gross margin was 34.9% in 2017 and 34.4% in 2016. Included in the cost of products sold are $2.9 million and $2.1 million of restructuring costs for 2017 and 2016, respectively. The increase in the gross margin is primarily a result of higher selling prices and the favorable impact of the divestitures (See Note 12, Restructuring Charges, and Note 14, Divestitures), partially offset by higher raw material and manufacturing costs. Restructuring costs reduced gross margin by 20 basis points and 10 basis points in 2017 and 2016, respectively. Index Selling and Administrative Expenses Selling and administrative expense as a percent of revenue was 22.6% in 2017 and 21.0% in 2016, respectively. Restructuring and other costs of $45.2 million and $24.0 million for 2017 and 2016, respectively, were included in selling and administrative expense. Selling and administrative expense as a percent of revenue were higher in 2017 than 2016 primarily as a result of higher restructuring and other costs, partially offset by lower performance based executive compensation and professional fees. Restructuring and other costs increased selling and administrative expense [/INST] Negative. </s>

SENSIENT TECHNOLOGIES CORP

2019-02-22

2018-12-31

Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations. OVERVIEW Sensient Technologies Corporation (the Company or Sensient) is a global developer, manufacturer, and supplier of flavor and fragrance systems for the food, beverage, personal care, and household-products industries. The Company is also a leading developer, manufacturer, and supplier of colors for businesses worldwide. The Company provides natural and synthetic color systems for use in foods, beverages, pharmaceuticals and nutraceuticals; colors, inks, and other ingredients for cosmetics, pharmaceuticals, nutraceuticals and digital printing; and technical colors for industrial applications. The Company’s three reportable segments are the Flavors & Fragrances Group and the Color Group, which are managed on a product basis, and the Asia Pacific Group, which is managed on a geographic basis. The Company’s corporate expenses and restructuring and other costs are included in the “Corporate & Other” category. In July 2018, the Company completed the acquisition of Mazza Innovation Limited (now known as Sensient Natural Extraction Inc.). This acquisition provides the Company with an umbrella technology, which supports applications for both the Flavors & Fragrances and Color segments. The Company is in the process of integrating this business, and therefore, the Company has included its results in Corporate & Other. The Company’s diluted earnings per share from continuing operations were $3.70 in 2018 and $2.03 in 2017. Included in the 2017 results were $48.1 million, or $0.96 per share net of tax, of restructuring and other costs. There were no restructuring or other costs in 2018. Included in the 2018 and 2017 results, were $6.6 million of a benefit and $18.4 million of expense, respectively, related to the enactment of the Tax Cuts and Jobs Act (Act or 2017 Tax Legislation), equating to an impact of a 16 cents per share benefit and 42 cents per share of expense, respectively. Adjusted diluted earnings per share, which exclude these restructuring and other costs as well as the impact of the 2017 Tax Legislation, were $3.55 in 2018 and $3.42 in 2017 (see discussion below regarding non-GAAP financial measures and the Company’s restructuring activities, divestiture and income taxes). Since 1962, the Company has paid, without interruption, a quarterly cash dividend. In the fourth quarter of 2018, the Company increased the quarterly dividend by 3 cents per share from 33 cents to 36 cents per share, or $1.44 per share on an annualized basis. In addition, the Company repurchased $76.7 million of Company stock in 2018, which is in addition to the $87.2 million repurchased in 2017. Additional information on the results is included below. RESULTS OF CONTINUING OPERATIONS 2018 vs. 2017 Revenue Sensient’s revenue was approximately $1.4 billion in 2018 and 2017. Index Gross Profit The Company’s gross margin was 33.6% in 2018 and 34.9% in 2017. Included in the cost of products sold are $2.9 million of restructuring costs for 2017. The decrease in gross margin is primarily a result of higher raw material costs and the unfavorable impact of product mix, partially offset by higher selling prices. Restructuring costs reduced gross margin by 20 basis points in 2017. Selling and Administrative Expenses Selling and administrative expense as a percent of revenue was 18.9% in 2018 and 22.6% in 2017, respectively. Restructuring and other costs of $45.2 million in 2017 were included in selling and administrative expense. Selling and administrative expense as a percent of revenue was lower in 2018 than in 2017 primarily as a result of the 2017 restructuring and other costs and lower performance based executive compensation in 2018. Restructuring and other costs increased selling and administrative expense as a percent of revenue by 330 basis points in 2017. Operating Income Operating income was $203.4 million in 2018 and $167.8 million in 2017. Operating margins were 14.7% in 2018 and 12.3% in 2017. Restructuring and other costs reduced operating margins by 350 basis points in 2017. Additional information on segment results can be found in the Segment Information section. Interest Expense Interest expense was $21.9 million in 2018 and $19.4 million in 2017. The increase in expense was primarily due to the increase in average debt outstanding. Income Taxes The effective income tax rate was 13.3% in 2018 and 39.6% in 2017. The effective tax rates in both 2018 and 2017 were impacted by changes in estimates associated with the finalization of prior year foreign and domestic tax items, audit settlements, adjustments to valuation allowances and mix of foreign earnings. The effective tax rate in 2018 was also favorably impacted by U.S. tax accounting method changes that were filed with the IRS in the second quarter of 2018 and generation of foreign tax credits during 2018. The 2017 effective tax rate was impacted by the limited tax deductibility of losses, the result of the cumulative foreign currency effect related to certain repatriation transactions, and restructuring and other activities. On December 22, 2017, the U.S. enacted the 2017 Tax Legislation. The Act significantly changed U.S. corporate income tax laws by reducing the U.S. corporate income tax rate to 21% beginning in 2018 and creating a territorial tax system with a one-time mandatory tax on previously deferred foreign earnings of U.S. subsidiaries. As a result, the Company recorded a provisional net tax expense of $18.4 million during the fourth quarter of 2017. This amount consists of reevaluating the U.S. deferred tax assets and liabilities based on the lower corporate income tax rate, adjustments to the Company’s foreign tax credit carryover, and the one-time mandatory tax on previously deferred foreign earnings of U.S. subsidiaries. In 2018, the Company finalized its provisional estimates related to the Act resulting in an income tax benefit of $6.6 million. Sensient considers $11.8 million to be the final net tax expense related to the Act. The 2019 effective income tax rate is estimated to be between 22.0% and 23.0%, before any discrete items. Acquisitions On July 10, 2018, the Company completed the acquisition of Mazza Innovation Limited, a botanical extraction business with patented solvent-free extraction processes, located in Vancouver, Canada. The Company paid $19.8 million of cash for this acquisition. The assets acquired and liabilities assumed were recorded at their estimated fair values as of the acquisition date. The Company acquired net assets of $4.0 million and identified intangible assets, principally technological know-how, of $6.9 million. The remaining $8.9 million was allocated to goodwill. This acquisition provides the Company with an umbrella technology, which supports applications for both the Flavors & Fragrances and Color segments. The Company is still in the process of integrating this business, and therefore, the Company has included its results in Corporate & Other. On March 9, 2018, the Company completed the acquisition of certain net assets and the natural color business of GlobeNatural, a natural color company based in Lima, Peru. The Company paid $10.8 million of cash for this acquisition. The Company acquired net assets of $1.4 million and identified intangible assets, principally customer relationships of $2.0 million, and allocated the remaining $7.4 million to goodwill. These operations are included in the Color segment. Index Restructuring Between March 2014 and 2017, the Company executed a restructuring plan (2014 Restructuring Plan) to eliminate underperforming operations, consolidate manufacturing facilities, and improve efficiencies within the Company. In accordance with GAAP, the Company recorded total restructuring costs of $36.5 million for the year ended December 31, 2017. No restructuring costs were recorded for the year ended December 31, 2018. Divestiture In 2016, the Company’s Board of Directors authorized management to explore strategic alternatives for a facility and certain related business lines within the Flavors & Fragrances segment in Strasbourg, France. In 2016, the Company recorded a non-cash impairment charge of $10.8 million, in selling and administrative expense, and incurred $0.7 million of outside professional fees and other related costs in 2016, as a result of the then anticipated divestiture. In January 2017, the Company completed this divestiture for approximately $12.5 million. The Company recognized an additional non-cash loss of $11.6 million in 2017. NON-GAAP FINANCIAL MEASURES Within the following tables, the Company reports certain non-GAAP financial measures, including: (1) adjusted operating income, adjusted net earnings, and adjusted diluted EPS from continuing operations (which exclude restructuring and other costs as well as the impact of the 2017 Tax Legislation) and (2) percentage changes in revenue, operating income, diluted EPS, adjusted operating income, and adjusted diluted EPS on a local currency basis (which eliminate the effects that result from translating its international operations into U.S. dollars). The other costs in 2017 are divestiture related costs, discussed under “Divestiture” above. The Company has included each of these non-GAAP measures in order to provide additional information regarding our underlying operating results and comparable year-over-year performance. Such information is supplemental to information presented in accordance with GAAP and is not intended to represent a presentation in accordance with GAAP. These non-GAAP measures should not be considered in isolation. Rather, they should be considered together with GAAP measures and the rest of the information included in this report. Management internally reviews each of these non-GAAP measures to evaluate performance on a comparative period-to-period basis and to gain additional insight into underlying operating and performance trends. The Company believes that this information can be beneficial to investors for the same purposes. These non-GAAP measures may not be comparable to similarly titled measures used by other companies. (1) The other costs are for the divestiture related costs discussed under “Divestiture” above. Note: Earnings per share calculations may not foot due to rounding differences. Index The following table summarizes the percentage change in the 2018 results compared to the 2017 results in the respective financial measures. (1) Refer to table above for a reconciliation of these non-GAAP measures. SEGMENT INFORMATION The Company determines its operating segments based on information utilized by its chief operating decision maker to allocate resources and assess performance. Segment performance is evaluated on operating income before any applicable restructuring and other costs (which are reported in Corporate & Other), interest expense, and income taxes. In July 2018, the Company completed the acquisition of Mazza Innovation Limited (See Acquisitions above for further information). This acquisition provides the Company with an umbrella technology, which supports applications for both the Flavors & Fragrances and Color segments. The Company is in the process of integrating this business, and therefore, the Company has included its results in Corporate & Other. The Company’s discussion below regarding its operating segments has been updated to reflect the Company’s disaggregation of revenue, which was adopted in the first quarter of 2018, as summarized in Part IV, Item I, Note 11, Segment and Geographic Information, of this report. The Company’s reportable segments consist of the Flavors & Fragrances, Color, and Asia Pacific segments. Flavors & Fragrances Flavors & Fragrances segment revenue was $746.9 million in both 2018 and 2017. Foreign exchange rates increased segment revenue by approximately 1% in 2018. Segment revenue was consistent with the prior year due to higher revenue in Fragrances and Natural Ingredients, mostly offset by lower revenue in Flavors. The higher revenue in Fragrances is primarily a result of higher selling prices, favorable volumes, and favorable exchange rates. The higher revenue in Natural Ingredients is primarily a result of favorable volumes, partially offset by lower selling prices and the impact of the 2017 sale of the European Natural Ingredients business as part of the Company’s prior restructuring activities. The lower revenue in Flavors was primarily a result of lower volumes, partially offset by the favorable impact of exchange rates and higher selling prices. Flavors & Fragrances segment operating income was $96.4 million in 2018 and $114.3 million in 2017, a decrease of approximately 16%. Foreign exchange rates had a minimal impact on segment operating income. The lower segment operating income was primarily a result of lower operating income in Flavors and Natural Ingredients. The lower operating income in Flavors was primarily a result of lower volumes (primarily at the production site affected by last year’s plant consolidation) and product mix, partially offset by higher selling prices, lower manufacturing and other costs, and lower raw material costs. The lower operating income in Natural Ingredients was primarily due to higher raw material costs, primarily onion, and lower selling prices, partially offset by higher volumes and lower manufacturing and other costs. Segment operating income as a percent of revenue was 12.9% and 15.3% for 2018 and 2017, respectively. Index Color Segment revenue for the Color segment was $553.5 million in 2018 and $526.4 million in 2017, an increase of approximately 5%. Foreign exchange rates had a minimal impact on segment revenue. The higher segment revenue was primarily a result of higher revenue in Food & Beverage Colors and Cosmetics. The higher revenue in Food & Beverage Colors was primarily a result of higher volumes, the impact of the GlobeNatural acquisition (approximately 1%), favorable exchange rates, and higher selling prices. The higher revenue in Cosmetics was primarily a result of higher volumes. Segment operating income for the Color segment was $114.9 million in 2018 and $113.4 million in 2017, an increase of approximately 1%. The higher segment operating income was primarily a result of higher operating income in Cosmetics, partially offset by unfavorable product mix and higher raw material costs in Food & Beverage Colors. The higher operating income in Cosmetics was primarily a result of higher volumes and selling prices, favorable product mix, lower raw material costs, and the favorable impact of exchange rates, partially offset by higher manufacturing and other costs. Foreign exchange rates increased segment operating income by approximately 1%. Segment operating income as a percent of revenue was 20.8% in 2018 compared to 21.5% in 2017. Asia Pacific Segment revenue for the Asia Pacific segment was $123.2 million for both 2018 and 2017. Foreign exchange rates had a minimal impact on segment revenues. Segment revenue was consistent with the prior year as higher selling prices were mostly offset by lower volumes. Segment operating income for the Asia Pacific segment was $20.9 million in 2018 and $20.8 million in 2017, a slight increase over the prior year. The slight increase in segment operating income was a result of higher selling prices, favorable product mix, and favorable exchange rates, mostly offset by higher manufacturing and other costs. Foreign exchange rates increased segment operating income by approximately 1%. Segment operating income as a percent of revenue was 16.9% in both 2018 and 2017. Corporate & Other The Corporate & Other operating loss was $28.8 million in 2018 and $80.7 million in 2017. The lower operating loss was primarily a result of the absence in 2018 of the restructuring and other costs that were incurred in 2017 and lower performance based executive compensation incurred in 2018. Restructuring and other costs were $48.1 million in 2017. There were no restructuring and other costs incurred in 2018. RESULTS OF CONTINUING OPERATIONS 2017 vs. 2016 Revenue Sensient’s revenue was approximately $1.4 billion in both 2017 and 2016. Gross Profit The Company’s gross margin was 34.9% in 2017 and 34.4% in 2016. Included in the cost of products sold are $2.9 million and $2.1 million of restructuring costs for 2017 and 2016, respectively. The increase in the gross margin was primarily a result of higher selling prices and the favorable impact of a divestiture (See Note 13, Restructuring Charges, and Note 15, Divestiture), partially offset by higher raw material and manufacturing costs. Restructuring costs reduced gross margin by 20 basis points and 10 basis points in 2017 and 2016, respectively. Selling and Administrative Expenses Selling and administrative expense as a percent of revenue was 22.6% in 2017 and 21.0% in 2016. Restructuring and other costs of $45.2 million and $24.0 million for 2017 and 2016, respectively, were included in selling and administrative expense. Selling and administrative expense as a percent of revenue was higher in 2017 than in 2016 primarily as a result of higher restructuring and other costs, partially offset by lower performance based executive compensation and professional fees. Restructuring and other costs increased selling and administrative expense as a percent of revenue by 330 basis points and 180 basis points in 2017 and 2016, respectively. Operating Income Operating income was $167.8 million in 2017 and $185.6 million in 2016. Operating margins were 12.3% in 2017 and 13.4% in 2016. Restructuring and other costs reduced operating margins by 350 basis points and 190 basis points in 2017 and 2016, respectively. Additional information on segment results can be found in the Segment Information section. Interest Expense Interest expense was $19.4 million in 2017 and $18.3 million in 2016. The increase in expense was primarily due to the increase in average debt outstanding. Index Income Taxes The effective income tax rate was 39.6% in 2017 and 26.5% in 2016. The effective tax rates in both 2017 and 2016 were impacted by restructuring and other activities, changes in estimates associated with the finalization of prior year foreign and domestic tax items, audit settlements, adjustments to valuation allowances, and mix of foreign earnings. The effective tax rate in 2017 was also impacted by the limited tax deductibility of losses and the result of the cumulative foreign currency effect related to certain repatriation transactions. On December 22, 2017, the U.S. enacted the 2017 Tax Legislation. The Act significantly changed U.S. corporate income tax laws by reducing the U.S. corporate income tax rate to 21% beginning in 2018 and creating a territorial tax system with a one-time mandatory tax on previously deferred foreign earnings of U.S. subsidiaries. As a result, the Company recorded a net charge of $18.4 million during the fourth quarter of 2017. This amount consisted of reassessing the U.S. deferred tax assets and liabilities based on the lower corporate income tax rate, adjustments to the Company’s foreign tax credit carryover, and the one-time mandatory tax on previously deferred foreign earnings of U.S. subsidiaries. Although the Company believed that $18.4 million was a reasonable estimate of the 2017 Tax Legislation, it was considered a provisional estimate. The Company received additional guidance on the 2017 Tax Legislation in 2018, and adjusted this provisional estimate during the third and fourth quarters of 2018 (See Note 10, Income Taxes). Restructuring Between March 2014 and 2017, the Company executed a restructuring plan to eliminate underperforming operations, consolidate manufacturing facilities, and improve efficiencies within the Company. In accordance with GAAP, the Company recorded total restructuring costs of $36.5 million and $11.1 million for the years ended December 31, 2017 and 2016, respectively. Divestiture In 2016, the Company’s Board of Directors authorized management to explore strategic alternatives for a facility and certain related business lines within the Flavors & Fragrances segment in Strasbourg, France. In 2016, the Company recorded a non-cash impairment charge of $10.8 million, in selling and administrative expense, and incurred $0.7 million of outside professional fees and other related costs in 2016, as a result of the then anticipated divestiture. In January 2017, the Company completed this divestiture for approximately $12.5 million. The Company recognized an additional non-cash loss of $11.6 million in 2017. NON-GAAP FINANCIAL MEASURES Within the following tables, the Company reports certain non-GAAP financial measures, including: (1) adjusted operating income, adjusted net earnings, and adjusted diluted EPS from continuing operations (which exclude restructuring and other costs as well as the impact of the 2017 Tax Legislation) and (2) percentage changes in revenue, operating income, diluted EPS, adjusted operating income, and adjusted diluted EPS on a local currency basis (which eliminate the effects that result from translating its international operations into U.S. dollars). The other costs in 2017 and 2016 are divestiture related costs, discussed under “Divestiture” above. The Company has included each of these non-GAAP measures in order to provide additional information regarding our underlying operating results and comparable year-over-year performance. Such information is supplemental to information presented in accordance with GAAP and is not intended to represent a presentation in accordance with GAAP. These non-GAAP measures should not be considered in isolation. Rather, they should be considered together with GAAP measures and the rest of the information included in this report. Management internally reviews each of these non-GAAP measures to evaluate performance on a comparative period-to-period basis and to gain additional insight into underlying operating and performance trends. The Company believes that this information can be beneficial to investors for the same purposes. These non-GAAP measures may not be comparable to similarly titled measures used by other companies. Index (1) The other costs in 2017 and 2016 are for the divestiture related costs discussed under “Divestiture” above. Note: Earnings per share calculations may not foot due to rounding differences. The following table summarizes the percentage change in the 2017 results compared to the 2016 results in the respective financial measures. (1) Refer to table above for a reconciliation of these non-GAAP measures. SEGMENT INFORMATION The Company determines its operating segments based on information utilized by its chief operating decision maker to allocate resources and assess performance. Segment performance is evaluated on operating income before restructuring and other costs (which are reported in Corporate & Other), interest expense, and income taxes. The Company’s reportable segments consist of the Flavors & Fragrances, Color, and Asia Pacific segments. Index Beginning in the first quarter of 2017, the results of operations for certain of the Company’s cosmetic and fragrance businesses in the Asia Pacific segment are now reported in the Color segment and Flavors & Fragrances segment, respectively. In addition, the Color segment reassigned customer accounts and revised cost allocations amongst the businesses within their segment resulting in changes in the underlying components of segment revenue and segment operating income. The results for 2016 have been restated to reflect these changes. The Company’s discussion below regarding its operating segments has been updated to reflect the Company’s disaggregation of revenue, which was adopted in the first quarter of 2018, as summarized in Part IV, Item I, Note 11, Segment and Geographic Information, of this report. Flavors & Fragrances Segment revenue for the Flavors & Fragrances segment was $746.9 million in 2017 and $795.8 million in 2016, a decrease of approximately 6%. Foreign exchange did not have a material impact on revenue. The decrease in revenue was primarily due to lower revenue in Flavors and Natural Ingredients. The lower segment revenue in Flavors was primarily due to the divestiture and lower volumes, partially offset by higher selling prices. The lower segment revenue in Natural Ingredients was primarily due to lower volumes and the divestiture, partially offset by higher selling prices. Segment operating income for the Flavors & Fragrances segment was $114.3 million in 2017, and $124.1 million in 2016. The lower segment operating income was primarily a result of lower segment operating income in Flavor and Fragrances. The lower operating income in Flavor was primarily due to unfavorable volume and product mix, and higher manufacturing and other costs, partially offset by higher selling prices. The lower operating income in Fragrances was primarily due to higher manufacturing and other costs. Segment operating margin was 15.3% in 2017 and 15.6% in 2016. Color Segment revenue for the Color segment was $526.4 million in 2017, and $504.1 million in 2016, an increase of approximately 4%. The increase in revenue was primarily due to higher revenue in non-food colors. The higher revenue in non-food colors was primarily due to higher volumes, primarily in cosmetic colors, and higher selling prices. Segment operating income for the Color segment was $113.4 million in 2017, and $105.8 million in 2016, an increase of approximately 7%. The higher segment operating income was due to higher segment operating income in non-food colors, partially offset by lower segment operating income in food and beverage colors. The higher operating income for non-food colors was primarily due to favorable volume and product mix. The lower profit for food and beverage colors was primarily due to unfavorable volume and product mix and higher manufacturing and other costs, partially offset by higher selling prices. Segment operating margin was 21.5% in 2017 and 21.0% in 2016. Asia Pacific Segment revenue for the Asia Pacific segment was $123.2 million in 2017, and $121.2 million in 2016, an increase of approximately 2%. The higher segment revenue was due to higher selling prices, partially offset by lower volumes. Segment operating income for the Asia Pacific segment was $20.8 million in 2017, and $23.6 million in 2016, a decrease of 12%. The lower segment operating income was a result of higher manufacturing and other costs and unfavorable volume and product mix, partially offset by higher selling prices. Segment operating margin was 16.9% in 2017 and 19.5% in 2016. Corporate & Other The Corporate & Other expenses were $80.7 million in 2017 and $67.9 million in 2016, an increase of approximately 19%, primarily due to higher restructuring and other costs partially offset by lower performance based executive compensation and professional services. The Company evaluates segment performance before restructuring and other costs, and reports all of the restructuring and other costs in Corporate & Other. Restructuring and other costs were $48.1 million and $26.1 million in 2017 and 2016, respectively. LIQUIDITY AND FINANCIAL POSITION Financial Condition The Company’s financial position remains strong. The Company is in compliance with its loan covenants calculated in accordance with applicable agreements as of December 31, 2018. In the fourth quarter of 2018, the Company amended its accounts receivable securitization program, and increased the commitment size from $60 million to $70 million. See Note 8, Accounts Receivable Securitization, for additional information. The Company expects its cash flow from operations and its existing debt capacity can be used to meet anticipated future cash requirements for operations, capital expenditures, dividend payments, acquisitions, and stock repurchases. The impact of inflation on both the Company’s financial position and its results of operations has been minimal and is not expected to significantly affect 2019 results. Index Cash Flows from Operating Activities Net cash provided by operating activities was $83.5 million in 2018; $36.3 million in 2017; and $183.6 million in 2016. Operating cash flow provided the primary source of funds for operating needs, capital expenditures, shareholder dividends, acquisitions, and share repurchases. The increase in net cash provided by operating activities in 2018 is primarily due to the adoption of ASU 2016-15 Statement of Cash Flows: Classification of Certain Cash Receipts and Cash Payments, which required certain cash receipts related to the Company’s accounts receivable securitization (i.e. the deferred purchase price) to be classified as investing activities. As a result, the Company included $91.1 million, $141.5 million, and $35.4 million of cash received as deferred purchase price as investing activities, which were previously recorded as operating activities, in 2018, 2017, and 2016, respectively. The decrease in net cash provided by operating activities in 2017 is primarily due to the impact of the adoption of ASU 2016-15, higher working capital balances, and the timing of tax payments. Cash Flows from Investing Activities Net cash provided by (used in) investing activities was $14.8 million in 2018; $110.4 million in 2017; and $(36.4) million in 2016. Capital expenditures were $50.7 million in 2018; $56.3 million in 2017; and $81.2 million in 2016. As required under ASU 2016-15, the Company included $91.1 million, $141.5 million and $35.4 million of cash received as deferred purchase price under its accounts receivable securitization as cash provided by investing activities in 2018, 2017, and 2016, respectively. In 2018, the Company purchased Mazza Innovation Limited, for approximately $19.8 million, GlobeNatural for approximately $10.8 million, and the assets of one other business for an immaterial amount. In 2017, the Company sold a facility and certain related business lines in Strasbourg, France, for approximately $12.5 million, its European Natural Ingredients business for a nominal amount, and two other production facilities for $10.1 million. Cash Flows from Financing Activities Net cash used in financing activities was $98.7 million in 2018; $153.4 million in 2017; and $128.0 million in 2016. The Company had a net increase in debt of $38.2 million in 2018; a net decrease in debt of $8.8 million in 2017; and a net decrease in debt of $24.5 million in 2016. Sensient purchased $76.7 million, $87.2 million, and $50.1 million of Company stock, which settled in 2018, 2017, and 2016, respectively. The Company has paid uninterrupted quarterly cash dividends since commencing public trading in its stock in 1962. In the fourth quarter of 2018, the Company increased its quarterly dividend from 33 cents per share to 36 cents per share. Dividends paid per share were $1.35 in 2018, $1.23 cents in 2017, and $1.11 cents in 2016. Total dividends paid were $57.4 million, $54.0 million, and $49.6 million in 2018, 2017, and 2016, respectively. ISSUER PURCHASES OF EQUITY SECURITIES Sensient purchased 1.1 million shares of Company stock in 2018 for a total cost of $76.7 million; 1.1 million shares of Company stock in 2017 for a total cost of $87.2 million; and 0.7 million shares of Company stock in 2016 for a total cost of $47.5 million. In 2014, the Board approved a share repurchase program under which the Company was authorized to repurchase five million shares of Company stock. In October 2017, the Board of Directors authorized the repurchase of up to three million additional shares. As of December 31, 2018, 2.2 million shares were available to be repurchased under existing authorizations. The Company’s share repurchase program has no expiration date. These authorizations may be modified, suspended, or discontinued by the Board of Directors at any time. CRITICAL ACCOUNTING POLICIES In preparing the financial statements in accordance with accounting principles generally accepted in the U.S., management is required to make estimates and assumptions that have an impact on the asset, liability, revenue, and expense amounts reported. These estimates can also affect supplemental information disclosures of the Company, including information about contingencies, risk, and financial condition. The Company believes, given current facts and circumstances, that its estimates and assumptions are reasonable, adhere to accounting principles generally accepted in the U.S., and are consistently applied. Inherent in the nature of an estimate or assumption is the fact that actual results may differ from estimates and estimates may vary as new facts and circumstances arise. The Company makes routine estimates and judgments in determining the net realizable value of accounts receivable, inventories, and property, plant, and equipment. Management believes the Company’s most critical accounting estimates and assumptions are in the following areas: Revenue Recognition The Company recognizes revenue as the transfer of control of its products to the Company’s customers in an amount reflecting the consideration to which the Company expects to be entitled. Revenue is recognized when control of the product is transferred to the customer, the customer is obligated to pay the Company and the Company has no remaining obligations, which is typically at shipment. See Note 1, Summary of Significant Accounting Policies, in the Notes to Consolidated Financial Statements included in this report for additional details. Index Goodwill Valuation The Company reviews the carrying value of goodwill annually utilizing several valuation methodologies, including a discounted cash flow model. The Company completed its annual goodwill impairment test under Accounting Standards Codification (ASC) 350, Intangibles - Goodwill and Other, in the third quarter of 2018. In conducting its annual test for impairment, the Company performed a qualitative assessment of its previously calculated fair values for each of its reporting units, as the Company believes it is not more likely than not that goodwill is impaired. Fair value is estimated using both a discounted cash flow analysis and an analysis of comparable company market values. If the fair value of a reporting unit exceeds its net book value, no impairment exists. The Company’s three reporting units each had goodwill recorded and were tested for impairment. All three reporting units had fair values that were over 100% above their respective net book values. Changes in estimates of future cash flows caused by items such as unforeseen events or changes in market conditions could negatively affect the reporting units’ fair value and result in an impairment charge. Income Taxes The Company estimates its income tax expense in each of the taxing jurisdictions in which it operates. The Company is subject to a tax audit in each of these jurisdictions, which could result in changes to the estimated tax expense. The amount of these changes would vary by jurisdiction and would be recorded when probable and estimable. These changes could impact the Company’s financial statements. Management has recorded valuation allowances to reduce the Company’s deferred tax assets to the amount that is more likely than not to be realized. Examples of deferred tax assets include deductions, net operating losses, and tax credits that the Company believes will reduce its future tax payments. In assessing the future realization of these assets, management has considered future taxable income and ongoing tax planning strategies. An adjustment to the recorded valuation allowance as a result of changes in facts or circumstances could result in a significant change in the Company’s tax expense. The Company does not provide for deferred taxes on unremitted earnings of foreign subsidiaries, which are considered to be invested indefinitely. Inventories Inventories are stated at the lower of cost or net realizable value. Cost is determined using the first-in, first-out (FIFO) method with the exception of certain locations of the Flavors & Fragrances segment where cost is determined using a weighted average method. Net realizable value is determined on the basis of estimated realizable values. Cost includes direct materials, direct labor, and manufacturing overhead. The Company estimates any required write-downs for inventory obsolescence by examining inventories on a quarterly basis to determine if there are any damaged items or slow moving products in which the carrying values could exceed net realizable value. Inventory write-downs are recorded as the difference between the cost of inventory and its estimated market value. While significant judgment is involved in determining the net realizable value of inventory, the Company believes that inventory is appropriately stated at the lower of cost or net realizable value. Commitments and Contingencies The Company is subject to litigation and other legal proceedings arising in the ordinary course of its businesses or arising under applicable laws and regulations. Estimating liabilities and costs associated with these matters requires the judgment of management, who rely in part on information from Company legal counsel. When it is probable that the Company has incurred a liability associated with claims or pending or threatened litigation matters and the Company’s exposure is reasonably estimable, the Company records a charge against earnings. The Company recognizes related insurance reimbursement when receipt is deemed probable. The Company’s estimate of liabilities and related insurance recoveries may change as further facts and circumstances become known. CONTRACTUAL OBLIGATIONS The Company is subject to certain contractual obligations, including long-term debt, operating leases, manufacturing purchases, and pension benefit obligations. The Company had unrecognized tax benefits of $4.8 million as of December 31, 2018. However, the Company cannot make a reasonably reliable estimate of the period of potential cash settlement of the liabilities and, therefore, has not included unrecognized tax benefits in the following table of significant contractual obligations as of December 31, 2018. PAYMENTS DUE BY PERIOD Index NEW PRONOUNCEMENTS Recently Adopted Accounting Pronouncements In February 2018, the Financial Accounting Standards Board (FASB) issued ASU 2018-02, Reclassifications of Certain Tax Effects from Accumulated Other Comprehensive Income. This ASU allows entities the option to reclassify to retained earnings tax effects related to the change in federal tax rate for all items accounted for in Accumulated Other Comprehensive Income (AOCI). The Company adopted this standard in the fourth quarter of 2018, and as a result, has elected to reclassify $1.4 million from AOCI to Earnings Reinvested in the Business on the Consolidated Statements of Shareholders’ Equity as of January 1, 2018. In March 2017, the FASB issued ASU 2017-07, Improving the Presentation of Net Periodic Pension Cost and Net Periodic Postretirement Benefit Cost. This ASU requires employers to present the service cost component of the net periodic benefit cost in the same income statement line item as the other employee compensation costs arising from services rendered during the period. The other components of net periodic benefit cost are to be presented outside of any subtotal of operating income. This ASU is effective for fiscal years and interim periods beginning after December 15, 2017. The Company adopted this standard in the first quarter of 2018, and as a result, the Company’s non-service cost portion of its pension expense is now recorded in Interest Expense on the Company’s Consolidated Statement of Earnings. The Company’s service cost portion of pension expense is recorded in Selling and Administrative Expenses on the Company’s Consolidated Statements of Earnings. This change did not have a material impact on the Company’s consolidated financial statements. In December 2016, the FASB issued ASU 2016-16, Accounting for Income Taxes: Intra-Entity Asset Transfers of Assets Other than Inventory. Prior to the adoption of ASU 2016-16, the tax effects of intra-entity asset transfers were deferred until the transferred asset was sold to a third party or otherwise recovered through use. ASU 2016-16 eliminates the exception for all intra-entity sales of assets other than inventory. The guidance is effective for fiscal years beginning after December 15, 2017, including interim periods within those years. The Company adopted this standard in the first quarter of 2018 resulting in a cumulative effect of $0.4 million increase to Earnings reinvested in the business; an increase of $3.0 million to Deferred Tax Assets; a decrease of $3.7 million to Prepaid Expenses and Other Current Assets; and a decrease of $1.1 million to Deferred Tax Liabilities on the Company’s Consolidated Balance Sheet. In August 2016, the FASB issued ASU 2016-15, Statement of Cash Flows: Classification of Certain Cash Receipts and Cash Payments. This ASU clarifies how certain cash receipts and cash payments are presented and classified in the statement of cash flows. Among these changes is a requirement that a transferor’s receipt of a beneficial interest in securitized trade receivables be disclosed as an investing transaction. There is also a requirement to classify cash receipts received that are related to beneficial interests in previously transferred receivables (i.e., deferred purchase price) as inflows from investing activities. The guidance is effective for fiscal years beginning after December 15, 2017, including interim periods within those years. The Company adopted this standard in the first quarter of 2018 and has included $91.1 million, $141.5 million, and $35.4 million as cash flows from investing activities for the years ended December 31, 2018, 2017, and 2016, respectively, related to collections on beneficial interests in previously transferred receivables. In May 2014, the FASB issued ASU 2014-09, Revenue from Contracts with Customers. Under this new standard, revenue is recognized when a customer obtains control of promised goods or services in an amount that reflects the consideration the entity expects to receive in exchange for those goods or services. The requirements of the new standard are effective for interim and annual periods beginning after December 15, 2017. The Company adopted this standard in the first quarter of 2018 using the modified retrospective method. The adoption of this new standard did not have an impact on the revenue recognized by the Company. The Company has updated its revenue recognition accounting policy, as outlined above, and has included a disclosure on its disaggregated revenue in Note 11, Segment and Geographic Information. Recently Issued Accounting Pronouncements In February 2016, the FASB issued ASU No. 2016-02, Leases, which requires lessees to recognize the lease assets and liabilities that arise from leases on the balance sheet and to disclose qualitative and quantitative information about lease transactions. This guidance is effective for fiscal years beginning after December 15, 2018, including interim periods within those fiscal years. In 2017, the Company created a project team within its Corporate Finance Department to review the impact that this ASU will have on the Company. During 2018, the project team has gathered and reviewed existing leases and other relevant documents across all of the Company’s segments and installed a software solution to facilitate the implementation of this new standard. The Company believes it has a complete population of leasing agreements and has analyzed the agreements. The Company has also implemented additional internal controls over the evaluation of new leases and the implementation of this ASU around leases. The Company has updated its Audit Committee on the status of the implementation of this ASU. The Company’s current estimate of the impact of this ASU on the Company’s Consolidated Financial Statements is the recognition of lease assets and liabilities in the range of $19 million to $22 million based on current interest rates and population of leases. The Company will continue to evaluate this range and the impact on the Company’s Consolidated Financial Statements. The Company expects to finalize its implementation calculations in the first quarter of 2019. Index In August 2017, the FASB issued ASU 2017-12, Targeted Improvements to Accounting for Hedging Activities, which expands an entity’s ability to hedge non-financial and financial risk components and reduce complexity in fair value hedges of interest rate risk. This guidance eliminates the requirement to separately measure and report hedge ineffectiveness and generally requires the entire change in the fair value of a hedging instrument to be presented in the same income statement line item as the hedged item. This ASU is effective for fiscal years and interim periods beginning after December 15, 2018. The Company is currently evaluating the expected impact of this standard. In June 2016, the FASB issued ASU 2016-13, Financial Instruments - Credit Losses (Topic 326): Measurement of Credit Losses of Financial Instruments, which replaces the current incurred loss impairment model with a methodology that reflects expected credit losses. Under the new methodology, entities will be required to measure expected credit losses on financial instruments held at amortized cost, including trade receivables, based on historical experience, current conditions, and reasonable forecasts. Adoption of this guidance is required for interim and annual periods beginning after December 15, 2019, with early adoption permitted for interim and annual periods beginning after December 15, 2018. The Company is currently evaluating the expected impact of this standard. In January 2017, the FASB issued ASU 2017-04, Intangibles-Goodwill and Other (Topic 350): Simplifying the Test for Goodwill Impairment, which eliminates step two of the goodwill impairment test and specifies that goodwill impairment should be measured by comparing the fair value of a reporting unit with its carrying amount. This standard will be applied prospectively and is effective for annual or interim goodwill impairment tests performed in fiscal years beginning after December 15, 2019. Early adoption is permitted. The Company is currently evaluating the expected impact of this standard. In August 2018, the FASB issued Accounting Standards Update 2018-13, Fair Value Measurement (Topic 820): Disclosure Framework-Changes to the Disclosure Requirements for Fair Value Measurement, which changes the requirements on fair value measurements by removing, modifying, or adding certain disclosures. Adoption of this guidance is required for interim and annual periods beginning after December 15, 2019 with early adoption permitted. The Company is currently evaluating the expected impact of this standard. Other recently issued accounting pronouncements are not expected to have a material impact on the Company’s consolidated financial statements. OFF-BALANCE SHEET ARRANGEMENTS The Company had no off-balance sheet arrangements as of December 31, 2018.

<s>[INST] OVERVIEW Sensient Technologies Corporation (the Company or Sensient) is a global developer, manufacturer, and supplier of flavor and fragrance systems for the food, beverage, personal care, and householdproducts industries. The Company is also a leading developer, manufacturer, and supplier of colors for businesses worldwide. The Company provides natural and synthetic color systems for use in foods, beverages, pharmaceuticals and nutraceuticals; colors, inks, and other ingredients for cosmetics, pharmaceuticals, nutraceuticals and digital printing; and technical colors for industrial applications. The Company’s three reportable segments are the Flavors & Fragrances Group and the Color Group, which are managed on a product basis, and the Asia Pacific Group, which is managed on a geographic basis. The Company’s corporate expenses and restructuring and other costs are included in the “Corporate & Other” category. In July 2018, the Company completed the acquisition of Mazza Innovation Limited (now known as Sensient Natural Extraction Inc.). This acquisition provides the Company with an umbrella technology, which supports applications for both the Flavors & Fragrances and Color segments. The Company is in the process of integrating this business, and therefore, the Company has included its results in Corporate & Other. The Company’s diluted earnings per share from continuing operations were $3.70 in 2018 and $2.03 in 2017. Included in the 2017 results were $48.1 million, or $0.96 per share net of tax, of restructuring and other costs. There were no restructuring or other costs in 2018. Included in the 2018 and 2017 results, were $6.6 million of a benefit and $18.4 million of expense, respectively, related to the enactment of the Tax Cuts and Jobs Act (Act or 2017 Tax Legislation), equating to an impact of a 16 cents per share benefit and 42 cents per share of expense, respectively. Adjusted diluted earnings per share, which exclude these restructuring and other costs as well as the impact of the 2017 Tax Legislation, were $3.55 in 2018 and $3.42 in 2017 (see discussion below regarding nonGAAP financial measures and the Company’s restructuring activities, divestiture and income taxes). Since 1962, the Company has paid, without interruption, a quarterly cash dividend. In the fourth quarter of 2018, the Company increased the quarterly dividend by 3 cents per share from 33 cents to 36 cents per share, or $1.44 per share on an annualized basis. In addition, the Company repurchased $76.7 million of Company stock in 2018, which is in addition to the $87.2 million repurchased in 2017. Additional information on the results is included below. RESULTS OF CONTINUING OPERATIONS 2018 vs. 2017 Revenue Sensient’s revenue was approximately $1.4 billion in 2018 and 2017. Index Gross Profit The Company’s gross margin was 33.6% in 2018 and 34.9% in 2017. Included in the cost of products sold are $2.9 million of restructuring costs for 2017. The decrease in gross margin is primarily a result of higher raw material costs and the unfavorable impact of product mix, partially offset by higher selling prices. Restructuring costs reduced gross margin by 20 basis points in 2017. Selling and Administrative Expenses Selling and administrative expense as a percent of revenue was 18.9% in 2018 and 22.6% in 2017, respectively. Restructuring and other costs of $45.2 million in 2017 were included in selling and administrative expense. Selling and administrative expense as a percent of revenue was lower in 2018 than in 2017 primarily as [/INST] Negative. </s>

SENSIENT TECHNOLOGIES CORP

2020-02-21

2019-12-31

Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations. The following discussion and analysis of the Company’s financial condition and results of operations for the fiscal years ended December 31, 2019 and 2018 should be read in conjunction with our audited consolidated financial statements and the notes to those statements. Discussion and analysis of our financial condition for the fiscal year ended December 31, 2017 is included under the heading Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations - Liquidity and Financial Position in our Annual Report on Form 10-K/A filed for the fiscal year ended December 31, 2018 with the Securities and Exchange Commission (SEC) on February 25, 2019. OVERVIEW Sensient Technologies Corporation (the Company or Sensient) is a global developer, manufacturer, and supplier of flavor and fragrance systems for the food, beverage, personal care, and household-products industries. The Company is also a leading developer, manufacturer, and supplier of colors for businesses worldwide. The Company provides natural and synthetic color systems for use in foods, beverages, pharmaceuticals and nutraceuticals; colors, inks, and other ingredients for cosmetics, pharmaceuticals, nutraceuticals and digital printing; and technical colors for industrial applications. The Company’s three reportable segments are the Flavors & Fragrances Group and the Color Group, which are managed on a product basis, and the Asia Pacific Group, which is managed on a geographic basis. The Company’s corporate expenses, restructuring, divestiture, share-based compensation, and other costs are included in the “Corporate & Other” category. In July 2018, the Company completed the acquisition of Sensient Natural Extraction Inc. This business was included in Corporate & Other in 2018. Beginning in the first quarter of 2019, the results of operations of this business are now reported in the Color segment. The results for 2018 have been restated to reflect this change. In 2019, the Company’s business was impacted by a number of adverse market factors. Sensient experienced uncertainty and higher costs tied to raw material availability, tariffs, and trade disruptions. Sensient was also impacted by changing consumer trends for food and cosmetic products. In 2019, Sensient’s Color segment experienced strong demand for natural colors and pharmaceuticals and each of these product lines delivered positive volume growth. The ability to convert this volume growth to profit growth was limited, in part by raw material cost increases. Revenue growth in food colors and pharmaceuticals was offset by lower sales of color cosmetic ingredients and lower sales of inks. After several years of strong consumer demand for color cosmetics, consumer demand for these products has softened, which resulted in destocking throughout the supply chain and lower sales for Sensient’s color cosmetic ingredients. Sensient’s inks product line has experienced intense competition, which has resulted in lower sales and profits in this product line. Within the Flavors & Fragrances segment, Sensient’s finished flavor product lines delivered favorable volume growth in 2019, however, the segment was impacted by lower demand in other flavor ingredient product lines, particularly those that are used in yogurt and certain prepared food categories. The Company implemented a number of actions in response to these challenges, including cost reductions in each of its segments. Furthermore, in October 2019, the Company announced its intent to divest its inks, certain parts of its fragrances product line, and fruit preparation product line. These product lines represent approximately 10% of the company’s consolidated revenue and 1% of the Company’s consolidated operating income. The Company anticipates that it will complete sales and exit activities of those product lines in 2020. Index The Company’s diluted earnings per share were $1.94 in 2019 and $3.70 in 2018. Included in the 2019 results were $45.9 million ($43.2 million after tax, $1.02 per share) of divestiture & other related costs. Included in the 2018 results was $6.6 million of a benefit related to the enactment of the Tax Cuts and Jobs Act (2017 Tax Legislation), equating to an impact of a 16 cents per share benefit. Adjusted diluted earnings per share, which exclude the divestiture & other related costs as well as the impact of the 2017 Tax Legislation, were $2.96 in 2019 and $3.55 in 2018 (see discussion below regarding non-GAAP financial measures and the Company’s divestiture related costs and the impact of the 2017 Tax Legislation). Since 1962, the Company has paid, without interruption, a quarterly cash dividend. In the fourth quarter of 2019, the Company increased the quarterly dividend by 3 cents per share from 36 cents to 39 cents per share, or $1.56 per share on an annualized basis. In addition, the Company repurchased $76.7 million of Company stock in 2018. Additional information on the results is included below. RESULTS OF OPERATIONS 2019 vs. 2018 Revenue Sensient’s revenue was approximately $1.3 billion and $1.4 billion in 2019 and 2018, respectively. Gross Profit The Company’s gross margin was 31.4% in 2019 and 33.6% in 2018. The decrease in gross margin is primarily a result of unfavorable volume and the impact of a $10.6 million inventory adjustment related to the divesting of the fruit preparation product line, partially offset by higher selling prices. See Divestitures below for further information on the inventory adjustment. Selling and Administrative Expenses Selling and administrative expense as a percent of revenue was 22.2% in 2019 and 18.9% in 2018, respectively. Divestiture & other related costs of $35.3 million in 2019 were included in Selling and administrative expense and increased selling and administrative expense as a percent of revenue by approximately 270 basis points in 2019. See Divestitures below for further information. Operating Income Operating income was $121.1 million in 2019 and $203.4 million in 2018. Operating margins were 9.2% in 2019 and 14.7% in 2018. Divestiture & other related costs reduced operating margins by approximately 350 basis points in 2019. Additional information on segment results can be found in the Segment Information section. Interest Expense Interest expense was $20.1 million in 2019 and $21.9 million in 2018. The decrease in expense was primarily due to the decrease in average debt outstanding. Income Taxes The effective income tax rate was 18.8% in 2019 and 13.3% in 2018. The effective tax rates in both 2019 and 2018 were impacted by changes in estimates associated with the finalization of prior year foreign and domestic tax items, audit settlements, and mix of foreign earnings. The effective tax rate in 2019 was impacted by tax costs related to the divestiture & other related costs and the release of valuation allowances related to the foreign tax credit carryover and foreign net operating losses. The effective tax rate in 2018 was also favorably impacted by U.S. tax accounting method changes that were filed with the IRS in the second quarter of 2018 and generation of foreign tax credits during 2018. See Note 11, Income Taxes, in the Notes to Consolidated Financial Statements included in this report for additional information. On December 22, 2017, the U.S. enacted the 2017 Tax Legislation. The 2017 Tax Legislation significantly changed U.S. corporate income tax laws by reducing the U.S. corporate income tax rate to 21% beginning in 2018 and creating a territorial tax system with a one-time mandatory tax on previously deferred foreign earnings of U.S. subsidiaries. As a result, the Company recorded a provisional net tax expense of $18.4 million during the fourth quarter of 2017. This amount consists of reevaluating the U.S. deferred tax assets and liabilities based on the lower corporate income tax rate, adjustments to the Company’s foreign tax credit carryover, and the one-time mandatory tax on previously deferred foreign earnings of U.S. subsidiaries. In 2018, the Company finalized its provisional estimates related to the 2017 Tax Legislation resulting in an income tax benefit of $6.6 million. Sensient considers $11.8 million to be the final net tax expense related to the 2017 Tax Legislation. Index The 2020 effective income tax rate is estimated to be between 24% and 25%, before any discrete items, such as finalization of prior year foreign and domestic tax items, audit settlements, and valuation allowance adjustments. Acquisitions On March 9, 2018, the Company completed the acquisition of certain net assets and the natural color business of GlobeNatural, a company based in Lima, Peru. The Company paid $10.8 million of cash for this acquisition. The assets acquired and liabilities assumed were recorded at their estimated fair values as of the acquisition date. The Company acquired net assets of $1.4 million and identified intangible assets, principally customer relationships of $2.0 million, and allocated the remaining $7.4 million to goodwill. These operations are included in the Color segment. On July 10, 2018, the Company completed the acquisition of Sensient Natural Extraction Inc., a botanical extraction business with patented solvent-free extraction processes, located in Vancouver, Canada. The Company paid $19.8 million of cash for this acquisition. The assets acquired and liabilities assumed were recorded at their estimated fair values as of the acquisition date. The Company acquired net assets of $4.0 million and identified intangible assets, principally technological know-how, of $6.9 million. The remaining $8.9 million was allocated to goodwill. This business was included in Corporate & Other in 2018. Beginning in the first quarter of 2019, the results of operations of this business are now reported in the Color segment. The results for 2018 have been restated to reflect this change. Divestitures In October 2019, the Company announced its intent to divest its inks, fragrances (excluding its essential oils product line), and fruit preparation product lines. The Board of Directors approved the sale of the inks product line, which is within the Color segment, and the sale of the fragrances product line, which is within the Flavors & Fragrances segment. In the fourth quarter of 2019, the Company recorded a non-cash impairment charge of $34.0 million, primarily related to property, plant and equipment and allocated goodwill, in Selling and administrative expenses, related to the disposal group as described in Note 15, Divestitures to the Consolidated Financial Statements included in this report. The charge reduced the carrying value of certain long-lived assets to their fair value. An estimate of the fair value of these product lines less cost to sell was determined to be lower than its carrying value. This estimate will be finalized and adjusted as necessary upon the closing of the sales or as assumptions change. Also in the fourth quarter of 2019, the Company recorded a non-cash charge of $9.8 million and disposal costs of $0.8 million, in Cost of products sold, related to the fruit preparation divestiture. The charge reduced the carrying value of certain inventories, as they were determined to be excess as of December 31, 2019. The Company also incurred $1.3 million of additional costs, primarily related to severance, in the fourth quarter of 2019, in Selling and administrative expenses, related to the anticipated divestitures and other exit activities. NON-GAAP FINANCIAL MEASURES Within the following tables, the Company reports certain non-GAAP financial measures, including: (1) adjusted operating income, adjusted net earnings, and adjusted diluted EPS (which exclude divestiture & other related costs as well as the impact of the 2017 Tax Legislation) and (2) percentage changes in revenue, operating income, diluted EPS, adjusted operating income, and adjusted diluted EPS on a local currency basis (which eliminate the effects that result from translating its international operations into U.S. dollars). The Company has included each of these non-GAAP measures in order to provide additional information regarding our underlying operating results and comparable year-over-year performance. Such information is supplemental to information presented in accordance with GAAP and is not intended to represent a presentation in accordance with GAAP. These non-GAAP measures should not be considered in isolation. Rather, they should be considered together with GAAP measures and the rest of the information included in this report. Management internally reviews each of these non-GAAP measures to evaluate performance on a comparative period-to-period basis and to gain additional insight into underlying operating and performance trends. The Company believes that this information can be beneficial to investors for the same purposes. These non-GAAP measures may not be comparable to similarly titled measures used by other companies. Index Divestiture & other related costs are discussed under “Divestitures” above and Note 15, Divestitures, in the Notes to Consolidated Financial Statements included in this report. Note: Earnings per share calculations may not foot due to rounding differences. The following table summarizes the percentage change in the 2019 results compared to the 2018 results in the respective financial measures. (1) Refer to table above for a reconciliation of these non-GAAP measures. Index SEGMENT INFORMATION The Company determines its operating segments based on information utilized by its chief operating decision maker to allocate resources and assess performance. Segment performance is evaluated on operating income before any applicable divestiture & other related costs, share-based compensation, acquisition, restructuring and other costs (which are reported in Corporate & Other), interest expense, and income taxes. In July 2018, the Company completed the acquisition of Sensient Natural Extraction Inc. (See Acquisitions above for further information). This business was included in Corporate & Other in 2018. Beginning in the first quarter of 2019, the results of operations of this business are now reported in the Color segment. The results for 2018 have been restated to reflect this change. The Company’s discussion below regarding its operating segments has been updated to reflect the Company’s disaggregation of revenue, which was adopted in the first quarter of 2018, as summarized in Part IV, Item I, Note 12, Segment and Geographic Information, of this report. The Company’s reportable segments consist of the Flavors & Fragrances, Color, and Asia Pacific segments. Flavors & Fragrances Flavors & Fragrances segment revenue was $700.4 and $746.9 million in 2019 and 2018, respectively. Foreign exchange rates decreased segment revenue by approximately 1% in 2019. Segment revenue was lower than the prior year due to lower revenue in Flavors, Fragrances and Natural Ingredients. The lower revenues in Flavors and Fragrances was primarily a result of unfavorable volumes and exchange rates, partially offset by higher selling prices. The lower revenue in Natural Ingredients was primarily a result of unfavorable volumes and lower selling prices. Flavors & Fragrances segment operating income was $75.0 million in 2019 and $96.4 million in 2018, a decrease of approximately 22%. Foreign exchange rates decreased segment operating income by approximately 1%. The lower segment operating income was primarily a result of lower operating income in both Flavors and Fragrances. The lower operating income in both Flavors and Fragrances was primarily a result of lower volumes, higher manufacturing and other costs, and higher raw materials costs, partially offset by higher selling prices and a favorable product mix. Segment operating income as a percent of revenue was 10.7% and 12.9% for 2019 and 2018, respectively. Color Segment revenue for the Color segment was $535.2 million in 2019 and $554.0 million in 2018, a decrease of approximately 3%. Foreign exchange rates decreased segment revenue by approximately 3%. The lower segment revenue was primarily a result of lower revenue in Cosmetics and Other Colors, partially offset by higher revenue in Food & Beverage Colors. The lower revenue in Cosmetics was primarily a result of lower volumes and unfavorable exchange rates. The lower revenue in Other Colors was primarily a result of lower volumes and unfavorable exchange rates, partially offset by the additional revenue from the Sensient Natural Extraction Inc. acquisition. The higher revenue in Food & Beverage Colors was primarily a result of higher volumes, the additional revenue from the GlobeNatural acquisition, and higher selling prices, partially offset by unfavorable exchange rates. The additional revenue from the Sensient Natural Extraction Inc. and GlobeNatural acquisitions represent less than 1% of total segment revenue. Segment operating income for the Color segment was $101.2 million in 2019 and $113.3 million in 2018, a decrease of approximately 11%. Foreign exchange rates decreased segment operating income by approximately 3%. The lower segment operating income was primarily a result of lower operating income in Food & Beverage Colors, Cosmetics, and Other Colors. The lower segment operating income in Food & Beverage Colors was primarily due to higher raw material costs, unfavorable product mix, higher manufacturing and other costs and unfavorable exchange rates, partially offset by higher volumes and selling prices. The lower segment operating income in Cosmetics was primarily a result of lower volumes, unfavorable product mix, higher raw material costs, and the unfavorable impact of exchange rates, partially offset by lower manufacturing and other costs. The lower segment operating income in Other Colors was primarily a result of lower volumes and operating costs related to the Sensient Natural Extraction Inc. acquisition, partially offset by lower raw material costs. Segment operating income as a percent of revenue was 18.9% in 2019 compared to 20.5% in 2018. Asia Pacific Segment revenue for the Asia Pacific segment was $118.2 million and $123.2 million for 2019 and 2018, respectively. Foreign exchange rates had a minimal impact on segment revenues. Segment revenue was slightly lower than prior year as lower volumes were partially offset by higher selling prices. Segment operating income for the Asia Pacific segment was $19.4 million in 2019 and $20.9 million in 2018, a decrease of approximately 7% compared to the prior year. Foreign exchange rates increased segment operating income by approximately 3%. The decrease in segment operating income was a result of lower volumes and higher manufacturing and other costs, partially offset by higher selling prices and favorable exchange rates. Segment operating income as a percent of revenue was 16.4% in 2019 and 16.9% in 2018, respectively. Corporate & Other The Corporate & Other operating loss was $74.4 million in 2019 and $27.2 million in 2018. The higher operating loss was primarily a result of the divestiture & other related costs in 2019 of $45.9 million. See Divestitures above for further information. There were no divestiture & other related costs incurred in 2018. Index RESULTS OF OPERATIONS 2018 vs. 2017 Revenue Sensient’s revenue was approximately $1.4 billion in 2018 and 2017. Gross Profit The Company’s gross margin was 33.6% in 2018 and 34.9% in 2017. Included in the cost of products sold are $2.9 million of restructuring costs for 2017. The decrease in gross margin is primarily a result of higher raw material costs and the unfavorable impact of product mix, partially offset by higher selling prices. Restructuring costs reduced gross margin by 20 basis points in 2017. Selling and Administrative Expenses Selling and administrative expense as a percent of revenue was 18.9% in 2018 and 22.6% in 2017, respectively. Restructuring and other costs of $45.2 million in 2017 were included in selling and administrative expense. Selling and administrative expense as a percent of revenue was lower in 2018 than in 2017 primarily as a result of the 2017 restructuring and other costs and lower performance-based executive compensation in 2018. Restructuring and other costs increased selling and administrative expense as a percent of revenue by 330 basis points in 2017. Operating Income Operating income was $203.4 million in 2018 and $167.8 million in 2017. Operating margins were 14.7% in 2018 and 12.3% in 2017. Restructuring and other costs reduced operating margins by 350 basis points in 2017. Additional information on segment results can be found in the Segment Information section. Interest Expense Interest expense was $21.9 million in 2018 and $19.4 million in 2017. The increase in expense was primarily due to the increase in average debt outstanding. Income Taxes The effective income tax rate was 13.3% in 2018 and 39.6% in 2017. The effective tax rates in both 2018 and 2017 were impacted by changes in estimates associated with the finalization of prior year foreign and domestic tax items, audit settlements, adjustments to valuation allowances and mix of foreign earnings. The effective tax rate in 2018 was also favorably impacted by U.S. tax accounting method changes that were filed with the IRS in the second quarter of 2018 and generation of foreign tax credits during 2018. The 2017 effective tax rate was impacted by the limited tax deductibility of losses, the result of the cumulative foreign currency effect related to certain repatriation transactions, and restructuring and other activities. On December 22, 2017, the U.S. enacted the 2017 Tax Legislation. The 2017 Tax Legislation significantly changed U.S. corporate income tax laws by reducing the U.S. corporate income tax rate to 21% beginning in 2018 and creating a territorial tax system with a one-time mandatory tax on previously deferred foreign earnings of U.S. subsidiaries. As a result, the Company recorded a provisional net tax expense of $18.4 million during the fourth quarter of 2017. This amount consists of reevaluating the U.S. deferred tax assets and liabilities based on the lower corporate income tax rate, adjustments to the Company’s foreign tax credit carryover, and the one-time mandatory tax on previously deferred foreign earnings of U.S. subsidiaries. In 2018, the Company finalized its provisional estimates related to the 2017 Tax Legislation resulting in an income tax benefit of $6.6 million. Sensient considers $11.8 million to be the final net tax expense related to the 2017 Tax Legislation. Acquisitions On March 9, 2018, the Company completed the acquisition of certain net assets and the natural color business of GlobeNatural, a company based in Lima, Peru. The Company paid $10.8 million of cash for this acquisition. The assets acquired and liabilities assumed were recorded at their estimated fair values as of the acquisition date. The Company acquired net assets of $1.4 million and identified intangible assets, principally customer relationships of $2.0 million, and allocated the remaining $7.4 million to goodwill. These operations are included in the Color segment. Index On July 10, 2018, the Company completed the acquisition of Sensient Natural Extraction Inc., a botanical extraction business with patented solvent-free extraction processes, located in Vancouver, Canada. The Company paid $19.8 million of cash for this acquisition. The assets acquired and liabilities assumed were recorded at their estimated fair values as of the acquisition date. The Company acquired net assets of $4.0 million and identified intangible assets, principally technological know-how, of $6.9 million. The remaining $8.9 million was allocated to goodwill. This business was included in Corporate & Other in 2018. Beginning in the first quarter of 2019, the results of operations of this business are now reported in the Color segment. The results for 2018 have been restated to reflect this change. Restructuring Between March 2014 and 2017, the Company executed a restructuring plan (2014 Restructuring Plan) to eliminate underperforming operations, consolidate manufacturing facilities, and improve efficiencies within the Company. In accordance with GAAP, the Company recorded total restructuring costs of $36.5 million for the year ended December 31, 2017. No restructuring costs were recorded for the year ended December 31, 2018. Divestiture In 2016, the Company’s Board of Directors authorized management to explore strategic alternatives for a facility and certain related business lines within the Flavors & Fragrances segment in Strasbourg, France. In 2016, the Company recorded a non-cash impairment charge of $10.8 million, in Selling and administrative expenses, and incurred $0.7 million of outside professional fees and other related costs in 2016, as a result of the then anticipated divestiture. In January 2017, the Company completed this divestiture for approximately $12.5 million. The Company recognized an additional non-cash loss of $11.6 million in 2017. NON-GAAP FINANCIAL MEASURES Within the following tables, the Company reports certain non-GAAP financial measures, including: (1) adjusted operating income, adjusted net earnings, and adjusted diluted EPS (which exclude restructuring and other costs as well as the impact of the 2017 Tax Legislation) and (2) percentage changes in revenue, operating income, diluted EPS, adjusted operating income, and adjusted diluted EPS on a local currency basis (which eliminate the effects that result from translating its international operations into U.S. dollars). The other costs in 2017 are divestiture related costs, discussed under “Divestiture” above. The Company has included each of these non-GAAP measures in order to provide additional information regarding our underlying operating results and comparable year-over-year performance. Such information is supplemental to information presented in accordance with GAAP and is not intended to represent a presentation in accordance with GAAP. These non-GAAP measures should not be considered in isolation. Rather, they should be considered together with GAAP measures and the rest of the information included in this report. Management internally reviews each of these non-GAAP measures to evaluate performance on a comparative period-to-period basis and to gain additional insight into underlying operating and performance trends. The Company believes that this information can be beneficial to investors for the same purposes. These non-GAAP measures may not be comparable to similarly titled measures used by other companies. (1) The other costs are for the divestiture related costs discussed under “Divestiture” above. Note: Earnings per share calculations may not foot due to rounding differences. Index The following table summarizes the percentage change in the 2018 results compared to the 2017 results in the respective financial measures. (1) Refer to table above for a reconciliation of these non-GAAP measures. SEGMENT INFORMATION The Company determines its operating segments based on information utilized by its chief operating decision maker to allocate resources and assess performance. Segment performance is evaluated on operating income before any applicable restructuring and other costs, share-based compensation, (which are reported in Corporate & Other), interest expense, and income taxes. In July 2018, the Company completed the acquisition of Sensient Natural Extraction Inc. (See Acquisitions above for further information). This business was included in Corporate & Other in 2018. Beginning in the first quarter of 2019, the results of operations of this business are now reported in the Color segment. The results for 2018 have been restated to reflect this change. The Company’s discussion below regarding its operating segments has been updated to reflect the Company’s disaggregation of revenue, which was adopted in the first quarter of 2018, as summarized in Part IV, Item I, Note 12, Segment and Geographic Information, of this report. The Company’s reportable segments consist of the Flavors & Fragrances, Color, and Asia Pacific segments. Flavors & Fragrances Flavors & Fragrances segment revenue was $746.9 million in both 2018 and 2017. Foreign exchange rates increased segment revenue by approximately 1% in 2018. Segment revenue was consistent with the prior year due to higher revenue in Fragrances and Natural Ingredients, mostly offset by lower revenue in Flavors. The higher revenue in Fragrances is primarily a result of higher selling prices, favorable volumes, and favorable exchange rates. The higher revenue in Natural Ingredients is primarily a result of favorable volumes, partially offset by lower selling prices and the impact of the 2017 sale of the European Natural Ingredients business as part of the Company’s prior restructuring activities. The lower revenue in Flavors was primarily a result of lower volumes, partially offset by the favorable impact of exchange rates and higher selling prices. Flavors & Fragrances segment operating income was $96.4 million in 2018 and $114.3 million in 2017, a decrease of approximately 16%. Foreign exchange rates had a minimal impact on segment operating income. The lower segment operating income was primarily a result of lower operating income in Flavors and Natural Ingredients. The lower operating income in Flavors was primarily a result of lower volumes (primarily at the production site affected by last year’s plant consolidation) and product mix, partially offset by higher selling prices, lower manufacturing and other costs, and lower raw material costs. The lower operating income in Natural Ingredients was primarily due to higher raw material costs, primarily onion, and lower selling prices, partially offset by higher volumes and lower manufacturing and other costs. Segment operating income as a percent of revenue was 12.9% and 15.3% for 2018 and 2017, respectively. Index Color Segment revenue for the Color segment was $554.0 million in 2018 and $526.4 million in 2017, an increase of approximately 5%. Foreign exchange rates had a minimal impact on segment revenue. The higher segment revenue was primarily a result of higher revenue in Food & Beverage Colors and Cosmetics. The higher revenue in Food & Beverage Colors was primarily a result of higher volumes, the impact of the GlobeNatural acquisition (approximately 1%), favorable exchange rates, and higher selling prices. The higher revenue in Cosmetics was primarily a result of higher volumes. Segment operating income for the Color segment was $113.3 million in 2018 and $113.4 million in 2017. Segment operating income was consistent with the prior year as a result of higher operating income in Cosmetics, offset by the unfavorable impact of the Sensient Natural Extraction Inc. acquisition included in Other Colors. The higher operating income in Cosmetics was primarily a result of higher volumes and selling prices, favorable product mix, lower raw material costs, and the favorable impact of exchange rates, partially offset by higher manufacturing and other costs. Foreign exchange rates increased segment operating income by approximately 1%. Segment operating income as a percent of revenue was 20.5% in 2018 compared to 21.5% in 2017. Asia Pacific Segment revenue for the Asia Pacific segment was $123.2 million for both 2018 and 2017. Foreign exchange rates had a minimal impact on segment revenues. Segment revenue was consistent with the prior year as higher selling prices were mostly offset by lower volumes. Segment operating income for the Asia Pacific segment was $20.9 million in 2018 and $20.8 million in 2017, a slight increase over the prior year. The slight increase in segment operating income was a result of higher selling prices, favorable product mix, and favorable exchange rates, mostly offset by higher manufacturing and other costs. Foreign exchange rates increased segment operating income by approximately 1%. Segment operating income as a percent of revenue was 16.9% in both 2018 and 2017. Corporate & Other The Corporate & Other operating loss was $27.2 million in 2018 and $80.7 million in 2017. The lower operating loss was primarily a result of the absence in 2018 of the restructuring and other costs that were incurred in 2017 and lower performance-based executive compensation incurred in 2018. Restructuring and other costs were $48.1 million in 2017. There were no restructuring and other costs incurred in 2018. LIQUIDITY AND FINANCIAL POSITION Financial Condition The Company’s financial position remains strong. The Company is in compliance with its loan covenants calculated in accordance with applicable agreements as of December 31, 2019. In the fourth quarter of 2019, the Company amended its accounts receivable securitization program, and decreased the commitment size from $70 million to $65 million. See Note 9, Accounts Receivable Securitization, in the Notes to Consolidated Financial Statements included in this report for additional information. The Company expects its cash flow from operations and its existing debt capacity can be used to meet anticipated future cash requirements for operations, capital expenditures, dividend payments, acquisitions, and stock repurchases. The impact of inflation on both the Company’s financial position and its results of operations has been minimal and is not expected to significantly affect 2020 results. Cash Flows from Operating Activities Net cash provided by operating activities was $177.2 million and $83.5 million in 2019 and 2018, respectively. Operating cash flow provided the primary source of funds for operating needs, capital expenditures, shareholder dividends, acquisitions, and share repurchases. The increase in net cash provided by operating activities in 2019 is primarily due to the adoption of Accounting Standards Update (ASU) No. 2016-15 Statement of Cash Flows (Topic 230): Classification of Certain Cash Receipts and Cash Payments (ASU 2016-15) in the first quarter of 2018, which required certain cash receipts related to the Company’s accounts receivable securitization (i.e. the deferred purchase price) to be classified as investing activities. As a result, in 2018, the Company included $91.1 million of cash received as deferred purchase price as investing activities, which prior to ASU 2016-15, were recorded as operating activities. Cash Flows from Investing Activities Net cash used in investing activities was $37.4 million in 2019. Net cash provided by investing activities was $14.8 million in 2018. Capital expenditures were $39.1 million in 2019 and $50.7 million in 2018. As required under ASU 2016-15, the Company included $91.1 million of cash received as deferred purchase price under its accounts receivable securitization as cash provided by investing activities in 2018. In 2018, the Company purchased Sensient Natural Extraction Inc., for approximately $19.8 million, GlobeNatural for approximately $10.8 million, and the assets of one other business for an immaterial amount. Index Cash Flows from Financing Activities Net cash used in financing activities was $150.6 million in 2019 and $98.7 million in 2018. The Company had a net decrease in debt of $87.4 million in 2019 and a net increase in debt of $38.2 million in 2018. Sensient purchased $76.7 million of Company stock in 2018. There were no Company stock purchases in 2019. The Company has paid uninterrupted quarterly cash dividends since commencing public trading in its stock in 1962. In the fourth quarter of 2019, the Company increased its quarterly dividend from 36 cents per share to 39 cents per share. Dividends paid per share were $1.47 in 2019 and $1.35 in 2018. Total dividends paid were $62.2 million and $57.4 million in 2019 and 2018, respectively. ISSUER PURCHASES OF EQUITY SECURITIES Sensient purchased 1.1 million shares of Company stock in 2018 for a total cost of $76.7 million and 1.1 million shares of Company stock in 2017 for a total cost of $87.2 million. There were no shares of Company stock purchased in 2019. In October 2017, the Board of Directors authorized the repurchase of up to three million shares. As of December 31, 2019, 2.2 million shares were available to be repurchased under the existing authorization. The Company’s share repurchase program has no expiration date. These authorizations may be modified, suspended, or discontinued by the Board of Directors at any time. CRITICAL ACCOUNTING POLICIES In preparing the financial statements in accordance with accounting principles generally accepted in the U.S., management is required to make estimates and assumptions that have an impact on the asset, liability, revenue, and expense amounts reported. These estimates can also affect supplemental information disclosures of the Company, including information about contingencies, risk, and financial condition. The Company believes, given current facts and circumstances, that its estimates and assumptions are reasonable, adhere to accounting principles generally accepted in the U.S., and are consistently applied. Inherent in the nature of an estimate or assumption is the fact that actual results may differ from estimates and estimates may vary as new facts and circumstances arise. The Company makes routine estimates and judgments in determining the net realizable value of accounts receivable, inventories, and property, plant, and equipment. Management believes the Company’s most critical accounting estimates and assumptions are in the following areas: Revenue Recognition The Company recognizes revenue at the transfer of control of its products to the Company’s customers in an amount reflecting the consideration to which the Company expects to be entitled. Revenue is recognized when control of the product is transferred to the customer, the customer is obligated to pay the Company and the Company has no remaining obligations, which is typically at shipment. See Note 1, Summary of Significant Accounting Policies, in the Notes to Consolidated Financial Statements included in this report for additional details. Goodwill Valuation The Company reviews the carrying value of goodwill annually utilizing several valuation methodologies, including a discounted cash flow model. The Company completed its annual goodwill impairment test under Accounting Standards Codification (ASC) 350, Intangibles - Goodwill and Other, in the third quarter of 2019. In conducting its annual test for impairment, the Company performed a quantitative assessment of the fair values for each of its reporting units and compared each of these values to the net book value of each reporting unit. Fair value is estimated using both a discounted cash flow analysis and an analysis of comparable company market values. If the fair value of a reporting unit exceeds its net book value, no impairment exists. The Company’s three reporting units each had goodwill recorded and were tested for impairment. All three reporting units had fair values that were significantly above their respective net book values. Changes in estimates of future cash flows caused by items such as unforeseen events or changes in market conditions could negatively affect the reporting units’ fair value and result in an impairment charge. In the fourth quarter of 2019, as a result of the Company’s meeting the assets held for sale criteria for its divestitures of its inks and fragrances (excluding its essential oils product line) product lines, the Company allocated $8.4 million of goodwill to that disposal group. The $8.4 million of goodwill related to the disposal groups was determined to be fully impaired. See Note 15, Divestitures, in the Notes to Consolidated Financial Statements included in this report for additional details. Income Taxes The Company estimates its income tax expense in each of the taxing jurisdictions in which it operates. The Company is subject to a tax audit in each of these jurisdictions, which could result in changes to the estimated tax expense. The amount of these changes would vary by jurisdiction and would be recorded when probable and estimable. These changes could impact the Company’s financial statements. Management has recorded valuation allowances to reduce the Company’s deferred tax assets to the amount that is more likely than not to be realized. Examples of deferred tax assets include deductions, net operating losses, and tax credits that the Company believes will reduce its future tax payments. In assessing the future realization of these assets, management has considered future taxable income and ongoing tax planning strategies. An adjustment to the recorded valuation allowance as a result of changes in facts or circumstances could result in a significant change in the Company’s tax expense. The Company does not provide for deferred taxes on unremitted earnings of foreign subsidiaries, which are considered to be invested indefinitely. Index Inventories Inventories are stated at the lower of cost or net realizable value. Cost is determined using the first-in, first-out (FIFO) method with the exception of certain locations of the Flavors & Fragrances segment where cost is determined using a weighted average method. Net realizable value is determined on the basis of estimated realizable values. Cost includes direct materials, direct labor, and manufacturing overhead. The Company estimates any required write-downs for inventory obsolescence by examining inventories on a quarterly basis to determine if there are any damaged items or slow moving products in which the carrying values could exceed net realizable value. Inventory write-downs are recorded as the difference between the cost of inventory and its estimated market value. In the fourth quarter of 2019, the Company recorded a non-cash charge of $9.8 million and disposal costs of $0.8 million, in Cost of products sold related to the anticipated fruit preparation divestiture. The charge reduced the carrying value of certain inventories, as they were determined to be excess as of December 31, 2019. While significant judgment is involved in determining the net realizable value of inventory, the Company believes that inventory is appropriately stated at the lower of cost or net realizable value. Commitments and Contingencies The Company is subject to litigation and other legal proceedings arising in the ordinary course of its businesses or arising under applicable laws and regulations. Estimating liabilities and costs associated with these matters requires the judgment of management, who rely in part on information from Company legal counsel. When it is probable that the Company has incurred a liability associated with claims or pending or threatened litigation matters and the Company’s exposure is reasonably estimable, the Company records a charge against earnings. The Company recognizes related insurance reimbursement when receipt is deemed probable. The Company’s estimate of liabilities and related insurance recoveries may change as further facts and circumstances become known. CONTRACTUAL OBLIGATIONS The Company is subject to certain contractual obligations, including long-term debt, interest payments on long-term debt, operating leases, manufacturing purchases, and pension benefit obligations. The Company had unrecognized tax benefits of $4.9 million as of December 31, 2019. However, the Company cannot make a reasonably reliable estimate of the period of potential cash settlement of the liabilities and, therefore, has not included unrecognized tax benefits in the following table of significant contractual obligations as of December 31, 2019. PAYMENTS DUE BY PERIOD NEW PRONOUNCEMENTS Refer to the "Recently Adopted Accounting Pronouncements” and “Recently Issued Accounting Pronouncements” sections within Note 1, "Summary of Significant Accounting Policies," in the Notes to Consolidated Financial Statements included in this report for additional details. OFF-BALANCE SHEET ARRANGEMENTS The Company had no off-balance sheet arrangements as of December 31, 2019.

<s>[INST] OVERVIEW Sensient Technologies Corporation (the Company or Sensient) is a global developer, manufacturer, and supplier of flavor and fragrance systems for the food, beverage, personal care, and householdproducts industries. The Company is also a leading developer, manufacturer, and supplier of colors for businesses worldwide. The Company provides natural and synthetic color systems for use in foods, beverages, pharmaceuticals and nutraceuticals; colors, inks, and other ingredients for cosmetics, pharmaceuticals, nutraceuticals and digital printing; and technical colors for industrial applications. The Company’s three reportable segments are the Flavors & Fragrances Group and the Color Group, which are managed on a product basis, and the Asia Pacific Group, which is managed on a geographic basis. The Company’s corporate expenses, restructuring, divestiture, sharebased compensation, and other costs are included in the “Corporate & Other” category. In July 2018, the Company completed the acquisition of Sensient Natural Extraction Inc. This business was included in Corporate & Other in 2018. Beginning in the first quarter of 2019, the results of operations of this business are now reported in the Color segment. The results for 2018 have been restated to reflect this change. In 2019, the Company’s business was impacted by a number of adverse market factors. Sensient experienced uncertainty and higher costs tied to raw material availability, tariffs, and trade disruptions. Sensient was also impacted by changing consumer trends for food and cosmetic products. In 2019, Sensient’s Color segment experienced strong demand for natural colors and pharmaceuticals and each of these product lines delivered positive volume growth. The ability to convert this volume growth to profit growth was limited, in part by raw material cost increases. Revenue growth in food colors and pharmaceuticals was offset by lower sales of color cosmetic ingredients and lower sales of inks. After several years of strong consumer demand for color cosmetics, consumer demand for these products has softened, which resulted in destocking throughout the supply chain and lower sales for Sensient’s color cosmetic ingredients. Sensient’s inks product line has experienced intense competition, which has resulted in lower sales and profits in this product line. Within the Flavors & Fragrances segment, Sensient’s finished flavor product lines delivered favorable volume growth in 2019, however, the segment was impacted by lower demand in other flavor ingredient product lines, particularly those that are used in yogurt and certain prepared food categories. The Company implemented a number of actions in response to these challenges, including cost reductions in each of its segments. Furthermore, in October 2019, the Company announced its intent to divest its inks, certain parts of its fragrances product line, and fruit preparation product line. These product lines represent approximately 10% of the company’s consolidated revenue and 1% of the Company’s consolidated operating income. The Company anticipates that it will complete sales and exit activities of those product lines in 2020. Index The Company’s diluted earnings per share were $1.94 in 2019 and $3.70 in 2018. Included in the 2019 results were $45.9 million ($43.2 million after tax, $1.02 per share) of divestiture & other related costs. Included in the 2018 results was $6.6 million of a benefit related to the enactment of the Tax Cuts and Jobs Act (2017 Tax Legislation), equating to an impact of a 16 cents per share benefit. Adjusted diluted earnings per share, which exclude the divestiture & other related costs as well as the impact of the 2017 Tax Legislation, were $2.96 in 2019 and $3.55 in 2018 (see discussion below regarding nonGAAP financial measures and the Company’s divestiture related costs and the impact of the 2017 Tax Legislation). Since 1962, the Company has paid, without interruption, a quarterly cash dividend. In the fourth quarter of 20 [/INST] Positive. </s>

AVON PRODUCTS INC

2015-02-24

2014-12-31

ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS ("MD&A") (U.S. dollars in millions, except per share and share data) You should read the following discussion of the results of operations and financial condition of Avon Products, Inc. and its majority and wholly owned subsidiaries in conjunction with the information contained in the Consolidated Financial Statements and related Notes contained in our 2014 Annual Report. When used in this discussion, the terms "Avon," "Company," "we," "our" or "us" mean, unless the context otherwise indicates, Avon Products, Inc. and its majority and wholly owned subsidiaries. See "Non-GAAP Financial Measures" on pages 25 through 26 of this MD&A for a description of how Constant dollar ("Constant $") growth rates (a Non-GAAP financial measure) are determined. Overview We are a global manufacturer and marketer of beauty and related products. Our business is conducted worldwide, primarily in the direct-selling channel. As of December 31, 2014, we had sales operations in 60 countries and territories, including the United States ("U.S."), and distributed products in 41 more. Our reportable segments are based on geographic operations and include commercial business units in Latin America; Europe, Middle East & Africa; North America; and Asia Pacific. Our product categories are Beauty and Fashion & Home. Beauty consists of skincare (which includes personal care), fragrance and color (cosmetics). Fashion & Home consists of fashion jewelry, watches, apparel, footwear, accessories, gift and decorative products, housewares, entertainment and leisure products, children’s products and nutritional products. Sales are made to the ultimate consumer principally through direct selling by Representatives, who are independent contractors and not our employees. At December 31, 2014, we had approximately 6 million active Representatives. The success of our business is highly dependent on recruiting, retaining and servicing our Representatives. During 2014, approximately 89% of our consolidated revenue was derived from operations outside of the U.S. Total revenue in 2014 compared to 2013 declined 11% compared to the prior-year period, due to unfavorable foreign exchange. Constant $ revenue was relatively unchanged, as a 5% decrease in Active Representatives was partially offset by higher average order. Units sold decreased 5% while the net impact of price and mix increased 5%, as pricing benefited from inflationary impacts in Latin America, primarily in Argentina and Venezuela. Sales from the Beauty category decreased 12%, or were relatively unchanged on a Constant $ basis. Sales from the Fashion & Home category decreased 12%, or 2% on a Constant $ basis. During 2014, our Constant $ revenue was impacted by net declines in North America and to a lesser extent, Asia Pacific, which were partially offset by net growth in Latin America and Europe, Middle East & Africa. North America continued to experience year-over-year revenue declines, driven by a decrease in Active Representatives. Constant $ revenue growth in Latin America was primarily driven by Venezuela largely due to inflationary pricing, which was partially offset by declines in Mexico. Constant $ revenue growth in Europe, Middle East & Africa was driven by South Africa and the United Kingdom, which was partially offset by revenue declines in Russia and Turkey. Constant $ revenue in Russia was negatively impacted by a difficult economy, including the impact of geopolitical uncertainties, and its decline in the first half of 2014 was partially offset by Constant $ revenue growth in the second half of 2014 driven by actions to improve unit sales. In Asia Pacific, Constant $ revenue declined as compared to 2013 as growth in the Philippines was more than offset by declines in the other Asia Pacific markets. See "Segment Review" of this MD&A for additional information related to changes in revenue by segment. During 2014, foreign currency had a significant impact on our financial results. As the U.S. dollar has strengthened relative to currencies of key Avon markets, our revenue and profits have been reduced when translated into U.S. dollars and our margins have been negatively impacted by country mix, as certain of our higher margin markets experienced significant devaluation of their local currency. In addition, as our sales and costs are often denominated in different currencies, this has created a negative foreign currency transaction impact. Specifically, as compared to the prior-year period, foreign currency has impacted our consolidated financial results as a result of foreign currency transaction losses (within cost of sales, and selling, general and administrative expenses), which had an unfavorable impact to Adjusted operating profit of an estimated $155, foreign currency translation, which had an unfavorable impact to Adjusted operating profit of approximately $160, and foreign exchange losses (within other expense, net), which had an unfavorable impact of approximately $41 before tax. In 2012, we outlined initial steps toward achieving a cost-savings target of $400 before taxes by the end of 2015. In connection with this cost-savings target, in 2012, we announced a cost savings initiative (the "$400M Cost Savings Initiative"), in an effort to stabilize the business and return Avon to sustainable growth. As part of the $400M Cost Savings Initiative, we have identified areas for cost efficiency that required restructuring charges for reductions in our global workforce and related actions across many of our businesses and functions, as well as the closure of certain smaller, under-performing markets, including South Korea, Vietnam, Republic of Ireland, Bolivia and France. We also expected to achieve savings through other cost-savings strategies that would not result in restructuring charges (including reductions in legal and brochure costs). Since we announced the $400M Cost Savings Initiative, we have reduced our global headcount by approximately 15% and achieved the cost-savings target of $400 before taxes. While we have achieved the targeted cost savings, we have not yet achieved our targeted low double-digit operating margin primarily due to the unfavorable impact of foreign exchange, inflationary pressures and continued revenue decline in North America. We continue to analyze our cost structure and may incur additional restructuring charges in an effort to achieve additional cost savings. See Note 14, Restructuring Initiatives on pages through of our 2014 Annual Report for more information. In 2015, we expect to continue to make progress against our strategic objectives. Constant-dollar revenue is expected to be up modestly; however, assuming January foreign currency spot rates, reported revenue is expected to decline due to an estimated 12 point negative impact from foreign currency translation. We also expect foreign currency transaction costs and translation adjustments to have a significant negative impact on Adjusted operating profit. We expect Constant-dollar Adjusted operating margin to be up modestly as we plan to offset most of the foreign currency transaction impact with price increases and further actions to reduce costs. However, due to foreign currency translation, we expect that Adjusted operating margin could be down as much as 1 point in reported dollars. The potential impact from a pending tax law change on cosmetics in Brazil, called Industrial Production Tax ("IPI"), has not been factored into our outlook at this time. We are presently assessing this pending tax law change and looking for ways to mitigate the potential impact. In February 2014, the Venezuelan government announced a foreign exchange system ("SICAD II") which began operating on March 24, 2014. As SICAD II represents the rate which better reflects the economics of Avon Venezuela's business activity, we concluded that we should utilize the SICAD II exchange rate to remeasure our Venezuelan operations as of March 31, 2014. At March 31, 2014, the SICAD II exchange rate was approximately 50, as compared to the official exchange rate of 6.30 that we used previously, which represents a devaluation of approximately 88%. In addition, as a result of using the historical U.S. dollar cost basis of non-monetary assets, such as inventories, these assets continued to be remeasured, following the change to the SICAD II rate, at the applicable rate at the time of acquisition. As a result, we determined that an adjustment of approximately $116 to cost of sales was needed to reflect certain non-monetary assets at their net realizable value, which was recorded in the first quarter of 2014. We recognized an additional negative impact of approximately $21 to operating profit and net income relating to these non-monetary assets in the second, third and fourth quarters of 2014. In addition to the negative impact to operating margin, we recorded an after-tax loss of approximately $42 (approximately $54 in other expense, net, and a benefit of approximately $12 in income taxes) in the first quarter of 2014, primarily reflecting the write-down of monetary assets and liabilities. In February 2015, the Venezuelan government announced that the SICAD II market would no longer be available, and a new open market foreign exchange system ("SIMADI") was created. In February 2015, the SIMADI exchange rate was approximately 170. We believe that significant uncertainty exists regarding the foreign exchange mechanisms in Venezuela, as well as how any such mechanisms will operate in the future and the availability of U.S. dollars under each mechanism. We are still evaluating our future access to funds through the SIMADI or other similar markets. See "Segment Review - Latin America" in this MD&A for further discussion of Venezuela. In December 2014, the Company settled charges of violations of the books and records and internal control provisions of the Foreign Corrupt Practices Act (the "FCPA") with U.S. Department of Justice (the "DOJ") and the U.S. Securities and Exchange Commission (the "SEC"). This included the $68 fine related to Avon China paid in December 2014 in connection with the DOJ settlement, and $67 in disgorgement and prejudgment interest related to Avon Products, Inc. paid to the SEC in January 2015, both of which had been previously accrued for before December 31, 2014. In the fourth quarter of 2014, the Company also recorded a net tax benefit of approximately $19 related to the finalization of the FCPA settlements. See Risk Factors on pages 10 through 11 of our 2014 Annual Report, Note 1, Description of the Business and Summary of Significant Accounting Policies on pages through of our 2014 Annual Report, Note 7, Income Taxes on pages through of our 2014 Annual Report, and Note 15, Contingencies on pages through of our 2014 Annual Report, for more information. New Accounting Standards Information relating to new accounting standards is included in Note 2, New Accounting Standards, to our consolidated financial statements contained in this 2014 Annual Report. Performance Metrics Within this MD&A, in addition to our key financial metrics of revenue, operating profit and operating margin, we utilize the performance metrics defined below to assist in the evaluation of our business. Performance Metrics Definition Change in Active Representatives This metric is a measure of Representative activity based on the number of unique Representatives submitting at least one order in a sales campaign, totaled for all campaigns in the related period. To determine the change in Active Representatives, this calculation is compared to the same calculation in the corresponding period of the prior year. Orders in China are excluded from this metric as our business in China is predominantly retail. Liz Earle is also excluded from this calculation as they do not distribute through the direct-selling channel. Change in units sold This metric is based on the gross number of pieces of merchandise sold during a period, as compared to the same number in the same period of the prior year. Units sold include samples sold and products contingent upon the purchase of another product (for example, gift with purchase or discount purchase with purchase), but exclude free samples. Change in Average Order This metric is a measure of Representative productivity. The calculation is the difference of the year-over-year change in revenue on a Constant $ basis and the Change in Active Representatives. Change in Average Order may be impacted by a combination of factors such as inflation, units, product mix, and/or pricing. Non-GAAP Financial Measures To supplement our financial results presented in accordance with generally accepted accounting principles in the United States ("GAAP"), we disclose operating results that have been adjusted to exclude the impact of changes due to the translation of foreign currencies into U.S. dollars, including changes in: revenue, operating profit, Adjusted operating profit, operating margin and Adjusted operating margin. We also refer to these adjusted financial measures as Constant $ items, which are Non-GAAP financial measures. We believe these measures provide investors an additional perspective on trends. To exclude the impact of changes due to the translation of foreign currencies into U.S. dollars, we calculate current-year results and prior-year results at a constant exchange rate. Foreign currency impact is determined as the difference between actual growth rates and constant- currency growth rates. We also present gross margin, selling, general and administrative expenses as a percentage of revenue, total and net global expenses, operating profit, operating margin and effective tax rate on a Non-GAAP basis. The discussion of our segments presents operating profit and operating margin on a Non-GAAP basis. We refer to these Non-GAAP financial measures as "Adjusted." We have provided a quantitative reconciliation of the difference between the Non-GAAP financial measures and the financial measures calculated and reported in accordance with GAAP. The Company uses the Non-GAAP financial measures to evaluate its operating performance and believes that it is meaningful for investors to be made aware of, on a period-to-period basis, the impacts of 1) costs to implement ("CTI") restructuring initiatives, 2) costs and charges related to the devaluations of Venezuelan currency in March 2014 and February 2013, combined with being designated as a highly inflationary economy, a valuation allowance for deferred tax assets related to Venezuela, and the benefit related to the release of a provision associated with the excess cost of acquiring U.S. dollars in Venezuela ("Venezuelan special items"), 3) the $89 accrual recorded in 2013 for the settlements related to the FCPA investigations and the additional $46 accrual recorded in the first quarter of 2014 for the settlements related to the FCPA investigations, and the associated approximate $19 net tax benefit recorded in the fourth quarter of 2014 ("FCPA accrual"), 4) the settlement charges associated with the U.S. pension plan ("Pension settlement charge"), 5) the goodwill and intangible asset impairment charges and a valuation allowance for deferred tax assets related to the China business, as well as the capitalized software impairment charge related to our Service Model Transformation ("SMT") project ("Asset impairment and other charges"), 6) costs and charges related to the extinguishment of debt ("Loss on extinguishment of debt"), and 7) the non-cash income tax charge associated with our deferred tax assets recorded in 2014, and the additional provision recorded in 2012 for income taxes as we are no longer asserting that the undistributed earnings of foreign subsidiaries are indefinitely reinvested ("Special tax items"). The Company believes investors find the Non-GAAP information helpful in understanding the ongoing performance of operations separate from items that may have a disproportionate positive or negative impact on the Company's financial results in any particular period. These Non-GAAP measures should not be considered in isolation, or as a substitute for, or superior to, financial measures calculated in accordance with GAAP. The Venezuelan special items include the impact on the Consolidated Statements of Income in 2014 and 2013 caused by the devaluations of Venezuelan currency on monetary assets and liabilities, such as cash, receivables and payables; deferred tax assets and liabilities; and non-monetary assets, such as inventories. For non-monetary assets, the Venezuelan special items include the earnings impact caused by the difference between the historical U.S. dollar cost of the assets at the previous exchange rate and the revised exchange rate. In 2014, the Venezuelan special items also include an adjustment of $116 to reflect certain non-monetary assets at their net realizable value. In 2013, the devaluation was as a result of the change in the official exchange rate, which moved from 4.30 to 6.30, and in 2014, the devaluation was caused as a result of moving from the official exchange rate of 6.30 to the SICAD II exchange rate of approximately 50. The Venezuelan special items also include the impact on the Consolidated Statements of Income caused by a valuation allowance for deferred tax assets related to Venezuela recorded in the fourth quarter of 2013, as well as the release of a provision in the fourth quarter of 2012 associated with the excess cost of acquiring U.S. dollars in Venezuela at the regulated market rate as compared with the official exchange rate. The Pension settlement charge includes the impact on the Consolidated Statements of Income in the second, third and fourth quarters of 2014 associated with the payments made to former employees who are vested and participate in the U.S. pension plan. Such payments fully settle our pension plan obligation to those participants who elected to receive such payment. The Asset impairment and other charges include the impact on the Consolidated Statements of Income caused by the goodwill and intangible asset impairment charges and a valuation allowance for deferred tax assets related to the China business in the third quarter of 2013, and the goodwill impairment charge related to the China business in the third quarter of 2012. The Asset impairment and other charges also include the impact on the Consolidated Statements of Income caused by the capitalized software impairment charge related to our SMT project in the fourth quarter of 2013. The Loss on extinguishment of debt includes the impact on the Consolidated Statements of Income in the first quarter of 2013 caused by the make-whole premium and the write-off of debt issuance costs associated with the prepayment of our Private Notes (as defined below in "Liquidity and Capital Resources"), as well as the write-off of debt issuance costs associated with the early repayment of $380 of the outstanding principal amount of the term loan agreement (as defined below in "Liquidity and Capital Resources"). The Loss on extinguishment of debt also includes the impact on the Consolidated Statements of Income in the second quarter of 2013 caused by the make-whole premium and the write-off of debt issuance costs and discounts, partially offset by a deferred gain associated with the January 2013 interest-rate swap agreement termination, associated with the prepayment of the 2014 Notes (as defined below in "Liquidity and Capital Resources"). The Special tax items include the impact during 2014 on the provision for income taxes in the Consolidated Statements of Income due to a non-cash income tax charge primarily associated with a valuation allowance to reduce our U.S. deferred tax assets to an amount that is "more likely than not" to be realized. This valuation allowance was primarily due to the strengthening of the U.S. dollar against currencies of some of our key markets and, to a lesser extent, the finalization of the FCPA settlements. The Special tax items also include the impact during 2012 on the provision for income taxes in the Consolidated Statements of Income of our decision to no longer assert that the undistributed earnings of foreign subsidiaries are indefinitely reinvested. During the fourth quarter of 2012, we determined that the Company may repatriate offshore cash to meet certain domestic funding needs. See Note 14, Restructuring Initiatives on pages through of our 2014 Annual Report, "Results Of Operations - Consolidated" below, "Segment Review - Latin America" below, Note 15, Contingencies on pages through of our 2014 Annual Report, Note 11, Employee Benefit Plans on pages through of our 2014 Annual Report, Note 16, Goodwill and Intangible Assets on pages through of our 2014 Annual Report, Note 1, Description of the Business and Summary of Significant Accounting Policies on pages through of our 2014 Annual Report, Note 5, Debt and Other Financing on pages through of our 2014 Annual Report, "Liquidity and Capital Resources" below and Note 7, Income Taxes on pages through of our 2014 Annual Report for more information on these items. Critical Accounting Estimates We believe the accounting policies described below represent our critical accounting policies due to the estimation processes involved in each. See Note 1, Description of the Business and Summary of Significant Accounting Policies, on pages through of our 2014 Annual Report for a detailed discussion of the application of these and other accounting policies. Allowances for Doubtful Accounts Receivable Representatives contact their customers, selling primarily through the use of brochures for each sales campaign. Sales campaigns are generally for a two-week duration in the U.S. and a two- to four-week duration outside of the U.S. The Representative purchases products directly from us and may or may not sell them to an end user. In general, the Representative, an independent contractor, remits a payment to us during each sales campaign, which relates to the prior campaign cycle. The Representative is generally precluded from submitting an order for the current sales campaign until the accounts receivable balance for the prior campaign is paid; however, there are circumstances where the Representative fails to make the required payment. We record an estimate of an allowance for doubtful accounts on receivable balances based on an analysis of historical data and current circumstances, including seasonality and changing trends. Over the past three years, annual bad debt expense was $193 in 2014, $239 in 2013 and $251 in 2012, or approximately 2% of total revenue in each year. The allowance for doubtful accounts is reviewed for adequacy, at a minimum, on a quarterly basis. We generally have no detailed information concerning, or any communication with, any end user of our products beyond the Representative. We have no legal recourse against the end user for the collection of any accounts receivable balances due from the Representative to us. If the financial condition of our Representatives were to deteriorate, resulting in their inability to make payments, additional allowances may be required. Allowances for Sales Returns Policies and practices for product returns vary by jurisdiction, but within many jurisdictions, we generally allow an unlimited right of return. We record a provision for estimated sales returns based on historical experience with product returns. Over the past three years, annual sales returns were $298 for 2014, $340 for 2013 and $386 for 2012, or approximately 3% of total revenue in each year, which has been generally in line with our expectations. If the historical data we use to calculate these estimates does not approximate future returns, due to changes in marketing or promotional strategies, or for other reasons, additional allowances may be required. Provisions for Inventory Obsolescence We record an allowance for estimated obsolescence equal to the difference between the cost of inventory and the estimated market value. In determining the allowance for estimated obsolescence, we classify inventory into various categories based upon its stage in the product life cycle, future marketing sales plans and the disposition process. We assign a degree of obsolescence risk to products based on this classification to determine the level of obsolescence provision. If actual sales are less favorable than those projected, additional inventory allowances may need to be recorded for such additional obsolescence. Annual obsolescence expense was $101 in 2014, $117 in 2013 and $119 in 2012. Pension and Postretirement Expense We maintain defined benefit pension plans, which cover substantially all employees in the U.S. and a portion of employees in international locations. However, our U.S. defined benefit pension plan has been closed to employees hired on or after January 1, 2015. Additionally, we have unfunded supplemental pension benefit plans for some current and retired executives and provide retiree health care benefits subject to certain limitations to many retired employees in the U.S. and certain foreign countries. See Note 11, Employee Benefit Plans on pages through of our 2014 Annual Report for more information on our benefit plans. Pension plan expense and the requirements for funding our major pension plans are determined based on a number of actuarial assumptions, which are generally reviewed and determined on an annual basis. These assumptions include the expected rate of return on pension plan assets, the interest crediting rate for hybrid plans and the discount rate applied to pension plan obligations, the rate of compensation increase of plan participants and mortality rates. We use a December 31 measurement date for all of our employee benefit plans. For 2014, the weighted average assumed rate of return on all pension plan assets, including the U.S. and non-U.S. defined benefit pension plans was 6.86%, compared with 7.19% for 2013. In determining the long-term rates of return, we consider the nature of the plans’ investments, an expectation for the plans’ investment strategies, historical rates of return and current economic forecasts. We evaluate the expected long-term rate of return annually and adjust as necessary. Beginning in 2014, we have adopted an investment strategy for the U.S. defined benefit pension plan which is designed to match the movements in the pension liability through an increased allocation towards debt securities. In addition, we also have begun to utilize derivative instruments to achieve the desired market exposures or to hedge certain risks. Derivative instruments may include, but are not limited to, futures, options, swaps or swaptions. Investment types, including the use of derivatives are based on written guidelines established for each investment manager and monitored by the plan's management team. In 2015, similar investment strategies are expected to be implemented in some of our non-U.S. defined benefit pension plans. A significant portion of our pension plan assets relate to the U.S. defined benefit pension plan. The assumed rate of return for 2014 for the U.S. defined benefit pension plan was 7.50%, which was based on an asset allocation of approximately 70% in corporate and government bonds and mortgage-backed securities (which are expected to earn approximately 2% to 3% in the long term) and approximately 30% in equity securities and high yield securities (which are expected to earn approximately 6% to 9% in the long term). In addition to the physical assets, the asset portfolio has derivative instruments which increase our exposure to higher yielding securities. Historical rates of return on the assets of the U.S. defined benefit pension plan were approximately 8% for the most recent 10-year period and approximately 9% for the 20-year period. In the U.S. defined benefit pension plan, our asset allocation policy has historically favored U.S. equity securities, which have returned approximately 8% over the 10-year period and approximately 10% over the 20-year period. The rate of return on the plan assets in the U.S. was approximately 11% in 2014 and approximately 13% in 2013. Regulations under the U.S. Pension Protection Act of 2006, which are finalized but not yet effective, will require that hybrid plans limit the maximum interest crediting rate to one among several choices of crediting rates which are considered "market rates of return." The rate chosen will affect total pension obligations. The discount rate used for determining future pension obligations for each individual plan is based on a review of long-term bonds that receive a high-quality rating from a recognized rating agency. The discount rates for our more significant plans, including our U.S. defined benefit pension plan, were based on the internal rates of return for a portfolio of high quality bonds with maturities that are consistent with the projected future benefit payment obligations of each plan. The weighted-average discount rate for U.S. and non-U.S. defined benefit pension plans determined on this basis was 3.55% at December 31, 2014, and 4.56% at December 31, 2013. For the determination of the expected rate of return on assets and the discount rate, we take external actuarial advice into consideration. Our funding requirements may be impacted by standards and regulations or interpretations thereof. Our calculations of pension and postretirement costs are dependent on the use of assumptions, including discount rates, hybrid plan maximum interest crediting rates and expected return on plan assets discussed above, rate of compensation increase of plan participants, interest cost, health care cost trend rates, benefits earned, mortality rates, the number of participants and certain demographics and other factors. Actual results that differ from assumptions are accumulated and amortized to expense over future periods and, therefore, generally affect recognized expense in future periods. At December 31, 2014, we had pretax actuarial losses and prior service credits totaling $377 for the U.S. defined benefit pension and postretirement plans and $341 for the non-U.S. defined benefit pension and postretirement plans that have not yet been charged to expense. These actuarial losses have been charged to accumulated other comprehensive loss ("AOCI") within shareholders’ equity. While we believe that the assumptions used are reasonable, differences in actual experience or changes in assumptions may materially affect our pension and postretirement obligations and future expense. For 2015, our assumption for the expected rate of return on assets is 7.25% for our U.S. defined benefit pension plan and 6.55% for our non-U.S. defined benefit pension plans. Our assumptions are reviewed and determined on an annual basis. A 50 basis point change (in either direction) in the expected rate of return on plan assets, the discount rate or the rate of compensation increases, would have had approximately the following effect on 2014 pension expense and the pension benefit obligation at December 31, 2014: Restructuring Reserves We record the estimated expense for our restructuring initiatives when such costs are deemed probable and estimable, when approved by the appropriate corporate authority and by accumulating detailed estimates of costs for such plans. These expenses include the estimated costs of employee severance and related benefits, impairment or accelerated depreciation of property, plant and equipment and capitalized software, and any other qualifying exit costs. These estimated costs are grouped by specific projects within the overall plan and are then monitored on a quarterly basis by finance personnel. Such costs represent our best estimate, but require assumptions about the programs that may change over time, including attrition rates. Estimates are evaluated periodically to determine whether an adjustment is required. Taxes We record a valuation allowance to reduce our deferred tax assets to an amount that is "more likely than not" to be realized. Evaluating the need for and quantifying the valuation allowance often requires significant judgment and extensive analysis of all the weighted positive and negative evidence available to the Company in order to determine whether all or some portion of the deferred tax assets will not be realized. In performing this analysis, the Company’s forecasted domestic and foreign taxable income, and the existence of potential prudent and feasible tax planning strategies that would enable the Company to utilize some or all of its excess foreign tax credits, were taken into consideration. At December 31, 2014, we had net deferred tax assets of $858 (net of valuation allowances of $1,209). With respect to our deferred tax assets, at December 31, 2014, we had recognized deferred tax assets relating to tax loss carryforwards of $726, primarily from foreign jurisdictions, for which a valuation allowance of $718 has been provided. Prior to December 31, 2014, we had recognized deferred tax assets of $618 relating to excess U.S. foreign tax credit carryforwards of which $57, $44, $54, $124, $79, $225 and $35 expire at the end of 2018, 2019, 2020, 2021, 2022, 2023 and 2024, respectively. We have a history of domestic source losses, and our excess U.S. foreign tax credits have primarily resulted from having a greater domestic source loss in recent years which reduces foreign source income. During 2013, our domestic source loss included the tax losses generated from the sale of our Silpada business and our losses on extinguishment of debt, which led to an increase in our excess foreign tax credit carryforwards generated in 2013, which expire in 2023. Our ability to realize our U.S. deferred tax assets, such as our foreign tax credit carryforwards, is dependent on future U.S. taxable income within the carryforward period. At December 31, 2014, we would need to generate approximately $1.8 billion of excess net foreign source income in order to realize the U.S. foreign tax credits before they expire. In the assessment of our deferred tax asset position, we have relied on tax planning strategies that would, if necessary, be implemented to accelerate sufficient taxable amounts to utilize our excess foreign tax credits. During the fourth quarter of 2014, the Company’s expected net foreign source income was reduced significantly, primarily due to the strengthening of the U.S. dollar against currencies for some of our key markets and, to a lesser extent, the finalization of the FCPA settlements. This strengthening of the U.S. dollar reduced the expected dividends and royalties that could be remitted to the U.S. by our foreign subsidiaries, particularly Russia, Brazil, Mexico and Colombia. The effectiveness of our tax planning strategies, including the repatriation of foreign earnings and the acceleration of royalties from our foreign subsidiaries, was also negatively impacted by the strengthening of the U.S. dollar. In addition, the finalization of the FCPA settlements, which included a $68 fine related to Avon China in connection with the DOJ settlement and $67 in disgorgement and prejudgment interest related to Avon Products, Inc. in connection with the SEC settlement, negatively impacted expected future repatriation of foreign earnings and reduced current U.S. taxable income, respectively. As a result of these developments, we may not generate sufficient taxable income to realize all of our U.S. deferred tax assets. As such, we recorded a valuation allowance of $441 to reduce our U.S. deferred tax assets to an amount that is "more likely than not" to be realized, of which $367 was recorded to income taxes in the Consolidated Statements of Income and the remainder was recorded to various components of other comprehensive (loss) income. To the extent that U.S. taxable income is less favorable than currently projected (including the impact of foreign currency), we may be required to recognize additional valuation allowances on our U.S. deferred tax assets. Our projected U.S. taxable income includes assumptions regarding our domestic profitability, royalties received from foreign subsidiaries, and the potential impact of possible tax planning strategies, including the repatriation of foreign earnings and the acceleration of royalties. With respect to our deferred tax liability, during the fourth quarter of 2012, as a result of the uncertainty of our financing arrangements and our domestic liquidity profile at that time, we determined that we may repatriate offshore cash to meet certain domestic funding needs. Accordingly, we asserted that these undistributed earnings of foreign subsidiaries were no longer indefinitely reinvested and, therefore, recorded an additional provision for income taxes of $168 on such earnings. At December 31, 2012, we had a deferred tax liability in the amount of $225 for the U.S. tax cost on the undistributed earnings of subsidiaries outside of the U.S. of $3.1 billion. At December 31, 2014, we continue to assert that our foreign earnings are not indefinitely reinvested, as a result of our domestic liquidity profile. Accordingly, we adjusted our deferred tax liability to account for our 2014 undistributed earnings of foreign subsidiaries and for earnings that were actually repatriated to the U.S. during the year. Additionally, the deferred tax liability was reduced due to the lower cost to repatriate the undistributed earnings of our foreign subsidiaries compared to 2013. The net impact on the deferred tax liability associated with the Company’s undistributed earnings is a reduction of $129, resulting in a deferred tax liability balance of $14 related to the incremental tax cost on $1.9 billion of undistributed foreign earnings at December 31, 2014. This deferred income tax liability amount is net of the estimated foreign tax credits that would be generated upon the repatriation of such earnings. The repatriation of foreign earnings should result in the utilization of foreign tax credits in the year of repatriation; therefore, the utilization of foreign tax credits is dependent on the amount and timing of repatriations, as well as the jurisdictions involved. We have not included the undistributed earnings of our subsidiary in Venezuela in the calculation of this deferred income tax liability as local regulations restrict cash distributions denominated in U.S. dollars. With respect to our uncertain tax positions, we recognize the benefit of a tax position, if that position is more likely than not of being sustained on examination by the taxing authorities, based on the technical merits of the position. We believe that our assessment of more likely than not is reasonable, but because of the subjectivity involved and the unpredictable nature of the subject matter at issue, our assessment may prove ultimately to be incorrect, which could materially impact the Consolidated Financial Statements. We file income tax returns in the U.S. federal jurisdiction, and various state and foreign jurisdictions. In 2015, a number of open tax years are scheduled to close due to the expiration of the statute of limitations and it is possible that a number of tax examinations may be completed. If our tax positions are ultimately upheld or denied, it is possible that the 2015 provision for income taxes may be impacted. Loss Contingencies We determine whether to disclose and/or accrue for loss contingencies based on an assessment of whether the risk of loss is remote, reasonably possible or probable. We record loss contingencies when it is probable that a liability has been incurred and the amount of loss is reasonably estimable. Our assessment is developed in consultation with our outside counsel and other advisors and is based on an analysis of possible outcomes under various strategies. Loss contingency assumptions involve judgments that are inherently subjective and can involve matters that are in litigation, which, by its nature is unpredictable. We believe that our assessment of the probability of loss contingencies is reasonable, but because of the subjectivity involved and the unpredictable nature of the subject matter at issue, our assessment may prove ultimately to be incorrect, which could materially impact the Consolidated Financial Statements. Impairment of Assets Capitalized Software We review capitalized software for impairment whenever events or changes in circumstances indicate that the related carrying amounts may not be recoverable. In December 2013, we decided to halt further roll-out of our SMT project beyond the pilot market of Canada, in light of the potential risk of further business disruption. As a result, a non-cash impairment charge for the capitalized software associated with SMT of $117.2 was recorded. This impairment charge was recorded as a component of our global expenses, within selling, general and administrative expenses in the Consolidated Statements of Income. The fair value of the capitalized software associated with SMT ("SMT asset") was determined using a risk-adjusted discounted cash flow ("DCF") model under the relief-from-royalty method. The impairment analysis performed for the asset group, which includes the SMT asset, required several estimates, including revenue and cash flow projections, and royalty and discount rates. As a result of this impairment charge, the remaining carrying amount of the SMT asset is not material. See Note 1, Description of the Business and Summary of Significant Accounting Policies on pages through of our 2014 Annual Report for more information on SMT. Goodwill and Intangible Assets We test goodwill and intangible assets with indefinite lives for impairment annually, and more frequently if circumstances warrant, using various fair value methods. We review finite-lived intangible assets, which are subject to amortization, for impairment whenever events or changes in circumstances indicate that the related carrying amounts may not be recoverable. We completed our annual goodwill impairment assessment for 2014 and determined that the estimated fair values were considered substantially in excess of the carrying values of each of our reporting units. The impairment analyses performed for goodwill and intangible assets require several estimates in computing the estimated fair value of a reporting unit, an indefinite-lived intangible asset, and a finite-lived intangible asset. As part of our goodwill impairment analysis, we typically use a DCF approach to estimate the fair value of a reporting unit, which we believe is the most reliable indicator of fair value of a business, and is most consistent with the approach that we would generally expect a market participant would use. In estimating the fair value of our reporting units utilizing a DCF approach, we typically forecast revenue and the resulting cash flows for periods of five to ten years and include an estimated terminal value at the end of the forecasted period. When determining the appropriate forecast period for the DCF approach, we consider the amount of time required before the reporting unit achieves what we consider a normalized, sustainable level of cash flows. The estimation of fair value utilizing a DCF approach includes numerous uncertainties which require significant judgment when making assumptions of expected growth rates and the selection of discount rates, as well as assumptions regarding general economic and business conditions, and the structure that would yield the highest economic value, among other factors. China During the third quarter of 2012, we completed an interim impairment assessment of the fair value of goodwill related to our operations in China, based on the continued decline in revenue performance in and a corresponding lowering of our long-term growth estimates in that market. We made changes to our long-term growth estimates as the China business did not achieve our revenue, earnings and cash flows expectations primarily due to challenges in our business model. As a result of our impairment testing, we recorded a non-cash impairment charge of $44.0 in the third quarter of 2012 to reduce the carrying amount of goodwill to its estimated fair value. As compared to our projections used in our fourth quarter 2012 impairment analysis ("Q4 2012 projections"), China performed generally in line with our revenue and earnings projections during the first half of 2013. As assumed in our Q4 2012 projections, China's revenue in the first half of 2013 continued to deteriorate versus the prior-year period; however, beginning in the third quarter of 2013, this revenue decline was significantly in excess of our assumptions. As a result, in the third quarter of 2013, it became apparent that we would not achieve our 2013 and long-term forecasted revenue and earnings, and we completed an interim impairment assessment of the fair value of goodwill related to our operations in China. The revenue decline in China during the third quarter of 2013 resulted in the recognition of an operating loss while we had expected operating profit in our Q4 2012 projections. In the third quarter of 2013, we significantly lowered our long-term revenue and earnings projections for China that was included in our DCF model utilized in our interim impairment assessment. As a result of our impairment testing, we recorded a non-cash impairment charge of $42.1 in the third quarter of 2013 to reduce the carrying amounts of goodwill and finite-lived intangible assets. There are no amounts remaining associated with goodwill or intangible assets for our China reporting unit as a result of this impairment charge. Key assumptions used in measuring the fair value of China during these impairment assessments included projections of revenue and the resulting cash flows, as well as the discount rate (based on the estimated weighted-average cost of capital). To estimate the fair value of China, we forecasted revenue and the resulting cash flows over ten years using a DCF model which included a terminal value at the end of the projection period. We believed that a ten-year period was a reasonable amount of time in order to return China's cash flows to normalized, sustainable levels. See Note 16, Goodwill and Intangible Assets on pages through of our 2014 Annual Report for more information on China. Silpada During the 2012 year-end close process, our analysis of the Silpada business indicated an impairment as the carrying value of the business exceeded the estimated fair value and the finite-lived intangible assets were not recoverable. This was primarily the result of the lower than expected financial performance for 2012, which served as a baseline for the long-term projections of the business. We lowered our long-term revenue and earnings projections for Silpada to reflect a more moderate recovery of the business, which was believed to be appropriate due to the lack of sales momentum in the business and the continued inability of Silpada to achieve our financial performance expectations. Accordingly, a non-cash impairment charge of $209 was recorded to reduce the carrying amounts of goodwill, an indefinite-lived intangible asset and a finite-lived intangible asset. The decline in the fair values of the Silpada assets was driven by the reduction in the forecasted growth rates and cash flows used to estimate their respective fair values. Key assumptions used in measuring the fair value of Silpada during this impairment assessment included the discount rate (based on the estimated weighted-average cost of capital) and revenue growth, as well as silver prices and Representative growth and activity rates. To estimate the fair value of Silpada, we forecasted revenue and the resulting cash flows over ten years using a DCF model which included a terminal value at the end of the projection period. We believed that a ten-year period was a reasonable amount of time in order to return Silpada's cash flows to normalized, sustainable levels. The fair value of Silpada's indefinite-lived trademark was determined using a risk-adjusted DCF model under the relief-from-royalty method. The royalty rate used was based on a consideration of market rates. The fair value of the Silpada finite-lived customer relationships was determined using a DCF model under the multi-period excess earnings method. The impact of the impairment charge in 2012 associated with Silpada is reflected within Discontinued Operations. There is no risk of additional impairments associated with Silpada as the business was sold in July 2013. See Note 3, Discontinued Operations on pages through of our 2014 Annual Report for more information on Silpada. Results Of Operations - Consolidated Amounts in the table above may not necessarily sum due to rounding. * Calculation not meaningful (1) Advertising expenses are included within selling, general and administrative expenses. (2) Change in Constant $ Adjusted operating margin for all years presented is calculated using the current-year Constant $ rates. 2014 Compared to 2013 Revenue Total revenue in 2014 compared to 2013 declined 11% compared to the prior-year period, due to unfavorable foreign exchange. Constant $ revenue was relatively unchanged, and benefited by approximately 1 point due to the net impact of certain tax benefits in Brazil. In 2014 and 2013, we recognized tax credits in Brazil of approximately $85 and approximately $29, respectively, primarily associated with a change in estimate of expected recoveries of Value Added Tax ("VAT"). Constant $ revenue was negatively impacted by a 5% decrease in Active Representatives, partially offset by higher average order. Units sold decreased 5% while the net impact of price and mix increased 5%, as pricing benefited from inflationary impacts in Latin America, primarily in Argentina and Venezuela. See "Segment Review - Latin America" in this MD&A for a further discussion of the tax benefits in Brazil. On a category basis, our net sales and associated growth rates were as follows: During 2014, our Constant $ revenue was impacted by net declines in North America and to a lesser extent, Asia Pacific, which were partially offset by net growth in Latin America and Europe, Middle East & Africa. North America continued to experience year-over-year revenue declines, driven by a decrease in Active Representatives. Constant $ revenue growth in Latin America was primarily driven by Venezuela largely due to inflationary pricing, which was partially offset by declines in Mexico. Constant $ revenue growth in Europe, Middle East & Africa was driven by South Africa and the United Kingdom, which was partially offset by revenue declines in Russia and Turkey. Constant $ revenue in Russia was negatively impacted by a difficult economy, including the impact of geopolitical uncertainties, and its decline in the first half of 2014 was partially offset by Constant $ revenue growth in the second half of 2014 driven by actions to improve unit sales. In Asia Pacific, Constant $ revenue declined as compared to 2013 as growth in the Philippines was more than offset by declines in the other Asia Pacific markets. See "Segment Review" in this MD&A for additional information related to changes in revenue by segment. Operating Margin Operating margin and Adjusted operating margin increased 20 basis points and 40 basis points, respectively, compared to 2013. The increase in Adjusted operating margin includes the benefits associated with the $400M Cost Savings Initiative, primarily reductions in headcount, as well as other cost reductions. The increase in operating margin and increase in Adjusted operating margin are discussed further below in "Gross Margin," "Selling, General and Administrative Expenses" and "Impairment of Goodwill and Intangible Assets." Gross Margin Gross margin and Adjusted gross margin decreased by 160 basis points and 70 basis points, respectively, compared to 2013. The gross margin comparison was largely impacted by an adjustment of approximately $116 associated with our Venezuela operations to reflect certain non-monetary assets at their net realizable value, which was recorded in the first quarter of 2014. Partially offsetting the decrease in gross margin was a lower negative impact of the devaluation of the Venezuelan currency in conjunction with highly inflationary accounting, as approximately $5 was recognized in the current-year period as compared to approximately $45 in the prior-year period associated with carrying certain non-monetary assets at the historical U.S. dollar cost following a devaluation. See "Segment Review - Latin America" in this MD&A for a further discussion of Venezuela. The decrease of 70 basis points in Adjusted gross margin was primarily due to the following: • a decrease of approximately 130 basis points due to the unfavorable impact of foreign currency transaction losses and foreign currency translation, driven by Europe, Middle East & Africa and Latin America; and • an increase of 80 basis points due to the favorable net impact of mix and pricing, primarily in Latin America, which includes the realization of price increases in markets experiencing relatively high inflation (Venezuela and Argentina). Selling, General and Administrative Expenses Selling, general and administrative expenses for 2014 decreased approximately $761 compared to 2013. This decrease is primarily due to the favorable impact of foreign currency translation, as the strengthening of the U.S. dollar against many of our foreign currencies resulted in lower reported selling, general and administrative expenses. The decrease in selling, general and administrative expenses is also due to a non-cash impairment charge of approximately $117 for capitalized software related to SMT recorded in 2013 that did not recur in 2014, the $89 accrual for the settlements relating to the FCPA investigations recorded in 2013, lower expenses related to our SMT project as a result of our decision to halt the further roll-out beyond the pilot market of Canada in the fourth quarter of 2013, lower fixed expenses primarily resulting from our cost savings initiatives, lower net brochure costs, lower Representative and sales leader expense, lower bad debt expense and lower professional and related fees associated with the FCPA investigation and compliance reviews. Partially offsetting the decrease in selling, general and administrative expenses was a higher amount of CTI restructuring primarily associated with the $400M Cost Savings Initiative, the additional $46 accrual recorded in the first quarter of 2014 for the settlements related to the FCPA investigations and the approximate $36 aggregate settlement charges recorded in 2014 associated with the payments made to former employees who are vested and participate in the U.S. pension plan. Selling, general and administrative expenses and Adjusted selling, general and administrative expenses as a percentage of revenue decreased 150 basis points and 110 basis points, respectively, compared to 2013. Selling general and administrative expenses as a percentage of revenue was impacted by a higher amount of CTI restructuring as compared to the prior-year period. Additionally, in the current-year period, selling, general and administrative expenses as a percentage of revenue was impacted by the additional $46 accrual recorded in the first quarter of 2014 for the settlements related to the FCPA investigations, the approximate $36 aggregate settlement charges recorded in 2014 associated with the payments made to former employees who are vested and participate in the U.S. pension plan, and approximately $16 associated with our Venezuela operations for certain non-monetary assets carried at the historical U.S. dollar cost following a devaluation. In the prior-year period, selling, general and administrative expenses as a percentage of revenue was impacted by a non-cash impairment charge of $117 for capitalized software related to SMT, the $89 accrual for the settlements relating to the FCPA investigations and $5 associated with our Venezuela operations for certain non-monetary assets carried at the historical U.S. dollar cost following a devaluation. See Note 14, Restructuring Initiatives, on pages through of our 2014 Annual Report for more information on CTI restructuring, Note 1, Description of the Business and Summary of Significant Accounting Policies on pages through of our 2014 Annual Report for more information on SMT, Note 15, Contingencies on pages through of our 2014 Annual Report for more information on the FCPA investigations, "Segment Review - Global and Other Expenses" in this MD&A and Note 11, Employee Benefit Plans on pages through of our 2014 Annual Report for a further discussion of the pension settlement charges and "Segment Review - Latin America" in this MD&A for a further discussion of Venezuela. The decrease of 110 basis points in Adjusted selling, general and administrative expenses as a percentage of revenue was primarily due to the following: • a decrease of 50 basis points from lower expenses related to our SMT project as a result of our decision to halt the further roll-out beyond the pilot market of Canada in the fourth quarter of 2013; • a decrease of 40 points due to lower fixed expenses primarily resulting from our cost savings initiatives, mainly reductions in headcount that were associated with the $400M Cost Savings Initiative; • a decrease of 30 basis points as a result of the net impact of the incremental tax credits in Brazil recognized as revenue in 2014 and 2013; • a decrease of 30 basis points from lower net brochure costs, primarily in North America and Latin America; • a decrease of 30 basis points from lower Representative and sales leader expense, primarily in North America and Latin America; • a decrease of 30 basis points from lower bad debt expense; and • a decrease of 20 basis points from lower professional and related fees associated with the FCPA investigation and compliance reviews. These items were partially offset by the following: • an increase of approximately 90 basis points due to the unfavorable impact of foreign currency translation and foreign currency transaction losses. See "Segment Review - Latin America" in this MD&A for a further discussion of the tax benefits in Brazil. Impairment of Goodwill and Intangible Assets During the third quarter of 2013, we recorded a non-cash impairment charge of approximately $42 for goodwill and intangible assets associated with our China business. See Note 16, Goodwill and Intangible Assets on pages through of our 2014 Annual Report for more information on China. See “Segment Review” in this MD&A for additional information related to changes in operating margin by segment. Other Expense Interest expense decreased by 8% compared to the prior-year period, primarily due to lower outstanding debt balances partially offset by higher average interest rates. Loss on extinguishment of debt in 2013 is comprised of approximately $71 for the make-whole premium and the write-off of debt issuance costs associated with the prepayment of our Private Notes (as defined below in "Liquidity and Capital Resources") and approximately $2 for the write-off of debt issuance costs associated with the early repayment of the $380 of outstanding principal amount of the term loan agreement (as defined below in "Liquidity and Capital Resources"), which occurred in the first quarter of 2013. In addition, in the second quarter of 2013, we recorded a loss on extinguishment of debt of approximately $13 for the make-whole premium and the write-off of debt issuance costs, partially offset by a deferred gain associated with the January 2013 interest-rate swap agreement termination, associated with the prepayment of our 2014 Notes (as defined below in "Liquidity and Capital Resources"). See Note 5, Debt and Other Financing on pages through of our 2014 Annual Report, and "Liquidity and Capital Resources" in this MD&A for more information. Interest income decreased by approximately $11 compared to the prior-year period, primarily impacted by $12 for interest income that benefited the fourth quarter of 2013, due to an out-of-period adjustment related to judicial deposits in Brazil. Other expense, net, increased by approximately $56 compared to the prior-year period, primarily due to higher foreign exchange losses. Foreign exchange losses increased by approximately $41 compared to the prior-year period, with the most significant impact due to the weakening of the Russian ruble. In addition, the increase in other expense, net was also due to a more significant impact, approximately $54 in 2014 as compared to approximately $34 in 2013, from the devaluations of the Venezuelan currency on monetary assets and liabilities in conjunction with highly inflationary accounting. See "Segment Review - Latin America" in this MD&A for a further discussion of Venezuela. Effective Tax Rate The effective tax rate for 2014 was 334.4%, compared to 100.6% for 2013. The effective tax rate in 2014 was negatively impacted by a non-cash income tax charge of approximately $405. This was largely due to a valuation allowance, recorded in the fourth quarter of 2014, against deferred tax assets of approximately $384 which is primarily due to the strengthening of the U.S. dollar against currencies of some of our key markets. The approximate $384 includes the valuation allowance recorded against U.S. deferred tax assets of approximately $367, as well as approximately $17 associated with other foreign subsidiaries. The effective tax rates in 2014 and 2013 were impacted by the devaluation of the Venezuelan currency in conjunction with highly inflationary accounting discussed further within "Segment Review - Latin America" in this MD&A. The effective tax rate in 2013 was also negatively impacted by the $89 accrual for the settlements related to the FCPA investigations, the non-cash impairment charges for goodwill and intangible assets associated with our China business of approximately $42, and a valuation allowance for deferred tax assets related to China in the third quarter of approximately $9 and Venezuela in the fourth quarter of approximately $42. The Adjusted effective tax rate for 2014 was 39.9%, compared to 30.3% for 2013. The higher 2014 Adjusted effective tax rate is primarily due to an adjustment to the carrying value of our state deferred tax balances due to changes in the expected tax rate, valuation allowances for deferred taxes, including the impact of legislative changes, and out-of-period adjustments of approximately $6 and approximately $6 recorded in the second and fourth quarters of 2014, respectively. Impact of Foreign Currency During 2014, foreign currency had a significant impact on our financial results. Specifically, as compared to the prior-year period, foreign currency has impacted our consolidated financial results as a result of: • foreign currency transaction losses (within cost of sales, and selling, general and administrative expenses), which had an unfavorable impact to Adjusted operating profit of an estimated $155, or approximately 150 points to Adjusted operating margin; • foreign currency translation, which had an unfavorable impact to Adjusted operating profit of approximately $160, or approximately 70 points to Adjusted operating margin; and • foreign exchange losses (within other expense, net), which had an unfavorable impact of approximately $41 before tax. 2013 Compared to 2012 Revenue Total revenue in 2013 compared to 2012 declined 6% compared to the prior-year period, partially due to unfavorable foreign exchange. Constant $ revenue declined 1%, as a 2% decrease in Active Representatives was partially offset by a 1% increase in average order. Units sold decreased 5% while the net impact of price and mix increased 4%, as pricing benefited from inflationary impacts in Latin America, primarily in Argentina and Venezuela. On a category basis, our net sales and associated growth rates were as follows: Our Constant $ revenue was impacted by net declines in North America and Asia Pacific; however, these declines were partially offset by improvements in Latin America and Europe, Middle East & Africa. Growth in Latin America was driven by Brazil, particularly in Fashion & Home, and Venezuela primarily due to inflationary pricing, which was partially offset by executional challenges in Mexico in the second half of 2013. In Europe, Middle East & Africa, growth was driven by South Africa, Russia and Turkey, which was partially offset by a revenue decline in the United Kingdom. North America experienced deteriorating financial results, primarily as a result of the decline in Active Representatives. Asia Pacific's revenue decline was primarily due to continuing weak performance of our China operations and operational challenges in the Philippines. See "Segment Review" in this MD&A for additional information related to changes in revenue by segment. Operating Margin Operating margin decreased 70 basis points and Adjusted operating margin increased 130 basis points compared to 2012. The increase in Adjusted operating margin includes the benefits associated with the $400M Cost Savings Initiative. The decrease in operating margin and increase in Adjusted operating margin are discussed further below in "Gross Margin," "Selling, General and Administrative Expenses" and "Impairment of Goodwill and Intangible Assets." Gross Margin Gross margin and Adjusted gross margin increased by 90 basis points and 130 basis points, respectively, compared to 2012. The gross margin comparison was largely impacted by the devaluation of the Venezuelan currency in conjunction with highly inflationary accounting, as approximately $45 was recognized in 2013 associated with carrying certain non-monetary assets at the historical U.S. dollar cost following a devaluation. See "Segment Review - Latin America" in this MD&A for a further discussion of Venezuela. The increase of 130 basis points in Adjusted gross margin was primarily due to the following: • an increase of 70 basis points due to lower supply chain costs, largely due to 60 points from lower freight costs, primarily in Latin America due to reduced usage of air freight; • an increase of 70 basis points due to the favorable net impact of mix and pricing, primarily in Latin America including benefits in pricing due to the realization of price increases in advance of costs in markets experiencing relatively high inflation (Venezuela and Argentina), while mix negatively impacted gross margin due to higher growth in Fashion & Home; • a decrease of 60 basis points due to the unfavorable impact of foreign currency transaction losses and foreign currency translation; and • various other insignificant items that contributed to the increase in gross margin and Adjusted gross margin. Selling, General and Administrative Expenses Selling, general and administrative expenses for 2013 decreased approximately $176 compared to 2012. This decrease is primarily due to the favorable impact of foreign exchange, lower professional and related fees associated with the FCPA investigation and compliance reviews, lower CTI restructuring, and lower advertising costs, partially offset by a non-cash impairment charge of approximately $117 for capitalized software related to SMT, which was recorded during the fourth quarter of 2013, the $89 accrual for the settlements related to the FCPA investigations and higher distribution costs. As a percentage of revenue, selling, general and administrative expenses increased 160 basis points, while Adjusted selling, general and administrative expenses was relatively unchanged compared to 2012. Selling, general and administrative expenses as a percentage of revenue in 2013 was impacted by a non-cash impairment charge of approximately $117 for capitalized software related to SMT, the $89 accrual for the settlements relating to the FCPA investigations and approximately $5 associated with our Venezuela operations for certain non-monetary assets carried at the historical U.S. dollar cost following a devaluation, partially offset by lower CTI restructuring. See Note 14, Restructuring Initiatives, on pages through of our 2014 Annual Report for more information on CTI restructuring, Note 1, Description of the Business and Summary of Significant Accounting Policies on pages through of our 2014 Annual Report for more information on SMT, Note 15, Contingencies on pages through of our 2014 Annual Report for more information on the FCPA investigations and "Segment Review - Latin America" in this MD&A for a further discussion of Venezuela. The primary drivers of Adjusted selling, general and administrative expenses as a percentage of revenue as compared to the prior year were the following: • an increase of 30 basis points from higher distribution costs, driven by increased transportation costs, primarily in Latin America, and increased costs per unit as a result of lower volume in North America; • an increase of 20 basis points due to the unfavorable impact of foreign currency translation and foreign currency transaction losses; • a decrease of 20 basis points from lower administrative expenses, primarily due to lower professional and related fees associated with the FCPA investigation and compliance reviews, as well as lower compensation costs; and • a decrease of 20 basis points from lower net brochure costs, primarily in Europe and North America, partially driven by initiatives to reduce the cost of our brochures. Impairment of Goodwill and Intangible Assets During the third quarter of 2013, we recorded a non-cash impairment charge of approximately $42 for goodwill and intangible assets, as compared to a non-cash impairment charge of approximately $44 in the third quarter of 2012 for goodwill, both associated with our China business. See Note 16, Goodwill and Intangible Assets on pages through of our 2014 Annual Report for more information on China. See “Segment Review” in this MD&A for additional information related to changes in operating margin by segment. Other Expense Interest expense increased by 16% compared to the prior-year period, primarily due to higher average interest rates partially offset by lower outstanding debt balances. Loss on extinguishment of debt in 2013 is comprised of approximately $71 for the make-whole premium and the write-off of debt issuance costs associated with the prepayment of our Private Notes (as defined below in "Liquidity and Capital Resources") and approximately $2 for the write-off of debt issuance costs associated with the early repayment of $380 of the outstanding principal amount of the term loan agreement (as defined below in "Liquidity and Capital Resources"), which occurred in the first quarter of 2013. In addition, in the second quarter of 2013 we recorded a loss on extinguishment of debt of approximately $13 for the make-whole premium and the write-off of debt issuance costs, partially offset by a deferred gain associated with the January 2013 interest-rate swap agreement termination, associated with the prepayment of our 2014 Notes (as defined below in "Liquidity and Capital Resources"). See Note 5, Debt and Other Financing on pages through of our 2014 Annual Report, and "Liquidity and Capital Resources" in this MD&A for more information. Interest income increased by approximately $11 compared to the prior-year period, primarily impacted by the benefit of approximately $12 for interest income recognized in the fourth quarter of 2013, due to an out-of-period adjustment related to judicial deposits in Brazil. This out-of-period benefit to interest income was partially offset by lower average interest rates, as well as lower average cash balances in 2013 as compared to 2012. Other expense, net increased by approximately $77 compared to the prior-year period, primarily due to an approximate $34 negative impact in the first quarter of 2013 from the devaluation of the Venezuelan currency on monetary assets and liabilities in conjunction with highly inflationary accounting. In addition, other expense, net was impacted by the benefit of approximately $24 in 2012 due to the release of a provision in the fourth quarter of 2012 associated with the excess cost of acquiring U.S. dollars in Venezuela at the regulated market rate as compared with the official exchange rate. This provision was released as the Company capitalized the associated intercompany liabilities. See "Segment Review - Latin America" in this MD&A for a further discussion of Venezuela. Effective Tax Rate The effective tax rate for 2013 was 100.6%, compared to 78.2% for 2012. During the fourth quarter of 2012, as a result of the uncertainty of our financing arrangements and our domestic liquidity profile at that time, we determined that the Company may repatriate offshore cash to meet certain domestic funding needs. Accordingly, at that time, we asserted that the undistributed earnings of foreign subsidiaries were no longer indefinitely reinvested, and therefore, we recorded an additional provision for income taxes of approximately $168 related to the incremental U.S. taxes associated with the unremitted foreign earnings, which increased the 2012 tax rate. The effective tax rate in 2012 was also unfavorably impacted by the non-cash impairment charges for goodwill and intangible assets associated with our China business of $44. At December 31, 2013, we continue to assert that the Company’s foreign earnings may not be indefinitely reinvested, as a result of our domestic liquidity profile. In this regard, the 2013 effective tax rate was favorably impacted primarily due to the country mix of earnings and the lower expected tax cost to repatriate the undistributed earnings of our foreign subsidiaries. The 2013 effective tax rate was also unfavorably impacted by the non-cash impairment charges for goodwill and intangible assets associated with our China business of approximately $42. The rate was further impacted unfavorably by the devaluation of the Venezuelan currency in conjunction with highly inflationary accounting discussed further within "Segment Review - Latin America" in this MD&A, and the $89 accrual for the settlements related to the FCPA investigations. Additionally, the rate was negatively impacted by a valuation allowance for deferred tax assets related to China in the third quarter of approximately $9 and Venezuela in the fourth quarter of approximately $42. The valuation allowance in Venezuela was due to the impact of higher than expected inflation on our taxable income which negatively impacted the likelihood we would realize existing deferred tax assets. Given the short life of the net operating loss carryforward periods for these markets, we determined that it was more likely than not that we would not use these carryforward losses before they expire. The Adjusted effective tax rate for 2013 was 30.3%, compared to 35.0% for 2012, primarily due to the country mix of earnings and the lower expected tax cost to repatriate the undistributed earnings of our foreign subsidiaries. Other Comprehensive Income (Loss) Other comprehensive income (loss), net of taxes was approximately ($348) in 2014 compared with approximately $5 in 2013, primarily due to net actuarial losses of approximately $187 in 2014 as compared with net actuarial gains of approximately $81 in 2013. In 2014, net actuarial losses were negatively impacted by lower discount rates for the non-U.S. and U.S. pension plans and updated mortality rates for the U.S. pension plan, partially offset by higher asset returns in the non-U.S. and U.S. pension plans in 2014 as compared to 2013. The other comprehensive income (loss) year-over-year comparison was also unfavorably impacted by foreign currency translation adjustments, as well as higher amortization of net actuarial loss which was driven by the settlement charges associated with the U.S. pension plan. In 2014, foreign currency translation adjustments were negatively impacted by approximately $136 as compared to 2013 primarily due to unfavorable movements of the Polish zloty, the British pound, the Colombian peso and the Mexican peso. Other comprehensive income (loss), net of taxes was approximately $5 in 2013 compared with approximately ($22) in 2012, primarily due to net actuarial gains of approximately $81 in 2013 as compared with net actuarial losses of approximately $58 in 2012. In 2013, net actuarial gains in the U.S. and non-U.S. pension and postretirement plans benefited primarily due to a higher discount rate for the U.S. pension plan, as well as higher asset returns for the non-U.S. pension plans in 2013 as compared to 2012. Partially offsetting these benefits was the unfavorable impact of foreign currency translation adjustments. In 2013, foreign currency translation adjustments were negatively impacted by approximately $113 as compared to 2012 primarily due to unfavorable movements of the Colombian peso, the Polish zloty and the Mexican peso. See Note 11, Employee Benefit Plans on pages through of our 2014 Annual Report for more information. Segment Review Below is an analysis of the key factors affecting revenue and operating profit (loss) by reportable segment for each of the years in the three-year period ended December 31, 2014. Latin America - 2014 Compared to 2013 Amounts in the table above may not necessarily sum due to rounding. Total revenue decreased 12% compared to the prior-year period due to the unfavorable impact from foreign exchange. On a Constant $ basis, revenue grew 5%. The region's revenue growth benefited by approximately 1 point due to the net impact of certain tax benefits in Brazil. In addition, higher average order was partially offset by a decrease in Active Representatives. Average order benefited from pricing, including inflationary impacts, primarily in Venezuela. Revenue in Venezuela and Mexico declined 55% and 9%, respectively, which were unfavorably impacted by foreign exchange, and Constant $ revenue in Venezuela and Mexico increased 45% and declined 6%, respectively. Revenue in Brazil declined 5%, which was unfavorably impacted by foreign exchange, and Constant $ revenue in Brazil increased 3%. Brazil's revenue benefited by approximately 3 points as a result of the net impact of certain tax benefits. In 2014, our Constant $ revenue growth and Constant $ operating profit growth were not impacted by the use of the SICAD II exchange rate as we applied the exchange rate of 6.30 to current and prior periods for our Venezuela operations in order to determine Constant $ growth. If we had used an exchange rate of 50 (which is a rate more reflective of the SICAD II rate) for our Venezuela operations for the year ended December 31, 2014, the region's Constant $ revenue would have been an increase of 1% from the prior-year period, the region's Constant $ Adjusted operating margin would have been a decrease of .8 points from the prior-year period, and Avon's consolidated Constant $ revenue decline would have been a decrease of 2% from the prior-year period. As we update our Constant $ rates on an annual basis, we will utilize a rate of approximately 50 in our Constant $ financial performance beginning with our 2015 results. See below for further discussion regarding the impact of the Venezuelan currency devaluation. Brazil's Constant $ revenue benefited by approximately 3 points due to the net benefit of larger tax credits recognized in 2014 as compared to the benefit and tax credits recognized in 2013. In 2014 and 2013, we recognized tax credits in Brazil of approximately $85 and approximately $29, respectively, primarily associated with a change in estimate of expected recoveries of VAT. Of the VAT credits recognized in 2014, approximately $13 were out-of-period adjustments. As the tax credits are associated with VAT, which is recorded as a reduction to revenue, the benefit from these VAT credits is recognized as revenue. Brazil's Active Representatives and average order were relatively unchanged from the prior-year period. On a Constant $ basis, Brazil’s sales from both Beauty and Fashion & Home products were relatively unchanged. Mexico's Constant $ revenue decline was primarily due to a decrease in Active Representatives, partially offset by higher average order. Constant $ revenue growth in Venezuela was primarily due to higher average order, partially offset by a decrease in Active Representatives. Venezuela's average order benefited from the inflationary impact on pricing that was partially offset by a decrease in units sold. Venezuela's Active Representatives and units sold were negatively impacted by the reduced size of our product offering, primarily the result of our increased difficulty to import products and raw materials. Additional information on our Venezuela operations is discussed in more detail below. Operating margin was negatively impacted by 2.2 points as compared to the prior-year period due to a larger impact in 2014 of the Venezuelan special items in conjunction with highly inflationary accounting as discussed further below. Operating margin was also negatively impacted by .4 points as compared to the prior-year period from higher CTI restructuring. Adjusted operating margin decreased .6 points, or increased .1 points on a Constant $ basis, primarily as a result of: • a benefit of 1.1 points from lower Representative, sales leader and field expense, which was primarily attributable to a shift towards more cost-effective incentives; • a benefit of 1.0 point associated with the net impact of the incremental tax credits in Brazil recognized as revenue in 2014 and 2013, discussed above; • a benefit of .3 points from lower net brochure costs, driven by Venezuela as a result of cost savings initiatives; • a decline of .8 points due to lower gross margin caused primarily by 1.4 points from the unfavorable impact of foreign currency transaction losses, primarily in Venezuela, and .9 points from higher supply chain costs, which was driven by higher obsolescence primarily in Venezuela and Brazil. These items were partially offset by 1.8 points from the favorable net impact of mix and pricing. Benefits from pricing include the realization of price increases in markets experiencing relatively high inflation (Venezuela and Argentina) on inventory acquired in advance of such inflation; • a decline of .8 points from higher distribution expenses, driven by inflation in Venezuela and Argentina and other cost pressures in the region; and • a decline of .7 points from higher administrative expenses, partially driven by inflationary costs, and increased legal expenses associated with labor and civil related matters in Brazil. We expect the environment in Latin America to continue to be challenging in the near term with a weak economy and high levels of competition. Venezuela Discussion Currency restrictions enacted by the Venezuelan government since 2003 have impacted the ability of Avon Venezuela to obtain foreign currency at the official rate to pay for imported products. Since 2010, we have been accounting for our operations in Venezuela under accounting guidance associated with highly inflationary economies. Under U.S. GAAP, the financial statements of a foreign entity operating in a highly inflationary economy are required to be remeasured as if the functional currency is the company’s reporting currency, the U.S. dollar. This generally results in translation adjustments, caused by changes in the exchange rate, being reported in earnings currently for monetary assets (e.g., cash, accounts receivable) and liabilities (e.g., accounts payable, accrued expenses) and requires that different procedures be used to translate non-monetary assets (e.g., inventories, fixed assets). Non-monetary assets and liabilities are remeasured at the historical U.S. dollar cost basis. This diverges significantly from the application of accounting rules prior to designation as highly inflationary accounting, where such gains and losses would have been recognized only in other comprehensive income (shareholders' equity). With respect to our 2013 results, effective February 13, 2013, the official exchange rate moved from 4.30 to 6.30, a devaluation of approximately 32%. As a result of the change in the official rate to 6.30, we recorded an after-tax loss of approximately $51 (approximately $34 in other expense, net, and approximately $17 in income taxes) in the first quarter of 2013, primarily reflecting the write-down of monetary assets and liabilities and deferred tax benefits. Additionally, certain non-monetary assets are carried at the historical U.S. dollar cost subsequent to the devaluation. Therefore, these costs impacted the income statement during 2013 at a disproportionate rate as they were not devalued based on the new exchange rates, but were expensed at their historical U.S. dollar value. As a result of using the historical U.S. dollar cost basis of non-monetary assets, such as inventories, acquired prior to the devaluation, 2013 operating profit and net income were negatively impacted by approximately $45, due to the difference between the historical U.S. dollar cost at the previous official exchange rate of 4.30 and the new official exchange rate of 6.30. Results for periods prior to 2013 were not impacted by the change in the official rate in February 2013. In March 2013, the Venezuelan government announced a foreign exchange system ("SICAD I") that increased government control over the allocation of U.S. dollars in the country. The availability of U.S. dollars under the SICAD I market for Avon has been limited to-date. At December 31, 2014, the SICAD I rate was approximately 12. In February 2014, the Venezuelan government announced a foreign exchange system ("SICAD II") which began operating on March 24, 2014. The Venezuelan government had indicated that all companies incorporated or domiciled in Venezuela in all sectors will be allowed to obtain U.S. dollars through the SICAD II market. The exchange rates established through the SICAD II market fluctuated daily and were significantly higher than both the official rate and SICAD I rate. In April 2014, we began to access the SICAD II market and were able to obtain only limited U.S. dollars. While liquidity was limited through the SICAD II market, in comparison to the other available exchange rates (the official rate and SICAD I rate), it represented the rate which better reflected the economics of Avon Venezuela's business activity. Accordingly, we concluded that we should utilize the SICAD II exchange rate to remeasure our Venezuelan operations effective March 31, 2014. In February 2015, the Venezuelan government announced that the SICAD II market would no longer be available, and a new open market foreign exchange system ("SIMADI") was created. In February 2015, the SIMADI exchange rate was approximately 170. We believe that significant uncertainty exists regarding the foreign exchange mechanisms in Venezuela, as well as how any such mechanisms will operate in the future and the availability of U.S. dollars under each mechanism. We are still evaluating our future access to funds through the SIMADI or other similar markets. At March 31, 2014, the SICAD II exchange rate was approximately 50, as compared to the official exchange rate of 6.30 that we used previously, which caused the recognition of a devaluation of approximately 88%. As a result of our change to the SICAD II rate, we recorded an after-tax loss of approximately $42 (approximately $54 in other expense, net, and a benefit of approximately $12 in income taxes) in the first quarter of 2014, primarily reflecting the write-down of monetary assets and liabilities. At December 31, 2014, the SICAD II exchange rate was approximately 50. Additionally, certain non-monetary assets are carried at their historical U.S. dollar cost subsequent to the devaluation. As a result of using the historical U.S. dollar cost basis of non-monetary assets, such as inventories, these assets continued to be remeasured, following the change to the SICAD II rate, at the applicable rate at the time of acquisition. As a result, we determined that an adjustment of approximately $116 to cost of sales was needed to reflect certain non-monetary assets at their net realizable value, which was recorded in the first quarter of 2014. We recognized an additional negative impact of approximately $21 to operating profit and net income relating to these non-monetary assets in the second, third and fourth quarters of 2014. In addition, at March 31, 2014, we reviewed Avon Venezuela's long-lived assets to determine whether the carrying amount of the assets were recoverable, and determined that they were. As such, no impairment of Avon Venezuela's long-lived assets was required; however, further devaluations or regulatory actions may impair the carrying value of Avon Venezuela's long-lived assets, which was approximately $107 at December 31, 2014. At December 31, 2014, we had a net asset position of $100 associated with our operations in Venezuela, which included cash balances of approximately $4, of which approximately $3 was denominated in Bolívares. Of the $100 net asset position, a net liability of approximately $5 was associated with Bolívar-denominated monetary net assets. During 2014, Avon Venezuela (using the 6.30 exchange rate for the first quarter and the SICAD II rate beginning in the second quarter) represented approximately 2% of Avon’s consolidated revenue and 3% of Avon’s consolidated Adjusted operating profit. If we had remeasured Avon Venezuela's income statement at the SICAD II rate of approximately 50 for the entire year ended December 31, 2014, Avon Venezuela would have represented approximately 1% of Avon's consolidated revenue and approximately 1% of Avon's consolidated Adjusted operating profit. There also could be ongoing impacts primarily related to the remeasurement of Avon Venezuela's financial statements. To illustrate our sensitivity to potential future changes in the foreign exchange rates in Venezuela, if we were to utilize an exchange rate of approximately 170 Bolívares to the U.S. dollar to remeasure our Venezuelan operations as of December 31, 2014 (a devaluation of approximately 70% from the exchange rate of approximately 50), and using 2014 results, Avon's annualized consolidated results would be negatively impacted as follows: • As a result of the use of a further devalued exchange rate for the remeasurement of Avon Venezuela's revenues and profits, Avon's annualized consolidated revenues would likely be negatively impacted by approximately 1% and annualized consolidated Adjusted operating profit would likely be negatively impacted by approximately 1% prospectively, assuming no operational improvements occurred to offset the negative impact of a further devaluation. • Avon's consolidated Adjusted operating profit during the first twelve months following the devaluation would likely be negatively impacted by approximately 5%, assuming no offsetting operational improvements or any impairment of Avon Venezuela's long-lived assets. The larger negative impact on Adjusted operating profit during the first twelve months as compared to the prospective impact is caused by costs of non-monetary assets, primarily inventories, being carried at their historical U.S. dollar cost in accordance with the requirement to account for Venezuela as a highly inflationary economy while revenue would be remeasured at the further devalued rate. • We would likely incur an immediate benefit of approximately $3 (primarily in other expense, net) associated with the net liability of Bolívar-denominated monetary net assets. In 2014, the Venezuelan government also issued a Law on Fair Pricing, establishing a maximum profit margin. During 2014, this law did not have a significant effect on Avon Venezuela's results; however, it is uncertain how this law may be interpreted and enforced in the future. Argentina Discussion In late 2011, the Argentine government introduced restrictive foreign currency exchange controls. Unless foreign exchange is made more readily available at the official exchange rate, Avon Argentina's operations may be negatively impacted. At December 31, 2014, we had a net asset position of approximately $91 associated with our operations in Argentina. During 2014, Avon Argentina represented approximately 4% of Avon’s consolidated revenue and approximately 6% of Avon’s consolidated Adjusted operating profit. To illustrate our sensitivity to potential future changes in the exchange rate in Argentina, if the exchange rate was devalued by approximately 50% from the average exchange rate of Argentina's 2014 results, and using 2014 results, Avon's annualized consolidated revenues would likely be negatively impacted by approximately 2% and annualized consolidated Adjusted operating profit would likely be negatively impacted by approximately 4% prospectively. This sensitivity analysis was performed assuming no operational improvements occurred to offset the negative impact of a devaluation. As of December 31, 2014, we did not account for Argentina as a highly inflationary economy. As a result, any potential devaluation would not negatively impact earnings with respect to Argentina's monetary and non-monetary assets. Latin America - 2013 Compared to 2012 Amounts in the table above may not necessarily sum due to rounding. Total revenue decreased 3% compared to the prior-year period due to the unfavorable impact from foreign exchange, including the impact of the Venezuelan currency devaluation. On a Constant $ basis, revenue grew 6%. The region's revenue was favorably impacted by approximately 1 point as a result of the aggregate of the tax credits of approximately $22 recognized in the third quarter of 2013 associated with a change in estimate of expected recoveries of VAT, as well as the initial realization of a government incentive that was recognized in the first quarter of 2013 associated with activity in prior years. As the tax credits are associated with VAT, and the government incentive is associated with excise taxes, which are both recorded as a reduction to revenue, the benefit from these VAT credits and government incentive is recognized as revenue. The region's Constant $ revenue growth was primarily due to higher average order, which benefited from pricing, including inflationary impacts, primarily in Argentina and Venezuela, and new Beauty product launches. Active Representatives were relatively unchanged. Revenue in Venezuela, Brazil and Mexico declined 17%, 1% and 1%, respectively. Revenue growth in Brazil and Venezuela was unfavorably impacted by foreign exchange. Constant $ revenue increased 9% in Brazil, and 16% in Venezuela, and declined 4% in Mexico. Constant $ revenue in Brazil was favorably impacted by approximately 2 points due to the benefit of the aggregate of the VAT credits recognized in the third quarter of 2013 and the government incentive recognized in the first quarter of 2013. Brazil's Constant $ revenue growth was primarily driven by higher average order, as well as an increase in Active Representatives. Higher average order was primarily due to benefits from pricing, new Beauty product launches and continued strength in Fashion & Home. On a Constant $ basis, Brazil’s sales from Beauty products increased 3% and sales from Fashion & Home products increased 20% primarily due to more effective pricing and merchandising. Constant $ revenue in Mexico was negatively impacted by lower average order, while Active Representatives were relatively unchanged. In the second half of 2013, Constant $ revenue in Mexico was negatively impacted by executional challenges coupled with the weaker economy. Constant $ revenue growth in Venezuela was due to higher average order, benefiting from the inflationary impact on pricing that was partially offset by a decrease in units sold. Higher average order in Venezuela was partially offset by a decrease in Active Representatives, which was impacted by continued economic and political instability as well as service issues. Revenue and operating profit in Venezuela was negatively impacted in 2013 by the Venezuelan currency devaluation. Additional information on our Venezuela operations is discussed in more detail above. Operating margin was negatively impacted by 1.0 point due to the Venezuelan currency devaluation in conjunction with highly inflationary accounting as discussed further above. Operating margin benefited by .2 points as compared to the prior-year period from lower CTI restructuring. Adjusted operating margin increased 1.8 points, or 2.0 points on a Constant $ basis, primarily as a result of: • a benefit of .5 points associated with the aggregate of the VAT credits in Brazil recognized in the third quarter of 2013 and the government incentive in Brazil recognized in the first quarter of 2013, discussed above; • a benefit of 1.9 points due to higher gross margin caused primarily by 1.5 points from the favorable net impact of mix and pricing. Benefits from pricing include the realization of price increases in advance of costs in markets experiencing relatively high inflation (Venezuela and Argentina), while mix negatively impacted gross margin due to higher growth in Fashion & Home. In addition, there were various other insignificant items that favorably impacted gross margin. These items were partially offset by .6 points from the unfavorable impact of foreign currency transaction losses; and • a decline of .5 points from higher transportation costs, primarily in Venezuela. Europe, Middle East & Africa - 2014 Compared to 2013 Amounts in the table above may not necessarily sum due to rounding. Total revenue decreased 7% compared to the prior-year period, due to the unfavorable impact from foreign exchange. On a Constant $ basis, revenue grew 1%. The region's Constant $ revenue was negatively impacted by approximately 1 point as a result of the closure of the France business. In Russia, revenue declined 18%, which was unfavorably impacted by foreign exchange. On a Constant $ basis, Russia's revenue declined 1%, primarily due to a decrease in Active Representatives, partially offset by higher average order. Russia was negatively impacted by a difficult economy, including the impact of geopolitical uncertainties. Russia's Constant $ revenue decline in the first half of 2014 was partially offset by Constant $ revenue growth in the second half of 2014, driven by actions to improve unit sales. In the United Kingdom, revenue increased 6%, which was favorably impacted by foreign exchange. On a Constant $ basis, the United Kingdom's revenue increased 1%, primarily due to higher average order, partially offset by a decrease in Active Representatives. In Turkey, revenue declined 14%, which was unfavorably impacted by foreign exchange. On a Constant $ basis, Turkey's revenue declined 2%, primarily due to lower average order. In South Africa, revenue declined 3%, which was unfavorably impacted by foreign exchange. On a Constant $ basis, South Africa’s revenue increased 8%, primarily due to an increase in Active Representatives. Operating margin was negatively impacted by .3 points as compared to the prior-year period from higher CTI restructuring. Adjusted operating margin decreased 2.6 points, or 2.4 points on a Constant $ basis, primarily as a result of a decline of 2.2 points due to lower gross margin caused primarily by an estimated 3 points from the unfavorable impact of foreign currency transaction losses, partially offset by 1.0 point from lower supply chain costs. Europe, Middle East & Africa - 2013 Compared to 2012 Amounts in the table above may not necessarily sum due to rounding. Total revenue decreased 1% compared to the prior-year period due to the unfavorable impact from foreign exchange. On a Constant $ basis, revenue grew 2% primarily due to an increase in Active Representatives and higher average order. The region’s Constant $ revenue benefited from growth in South Africa, Russia and Turkey. This growth was partially offset by a decline in the United Kingdom. In Russia, revenue declined 1%, or grew 2% on a Constant $ basis, primarily due to an increase in Active Representatives, which was partially offset by lower average order. During the second half of 2013, average order in Russia was negatively impacted by product portfolio mix and merchandising execution coupled with the weaker economy. In the United Kingdom, revenue declined 6%, or 5% on a Constant $ basis, negatively impacted by a decrease in Active Representatives, which was partially offset by higher average order. In Turkey, revenue declined 5%, unfavorably impacted by foreign exchange. On a Constant $ basis, Turkey's revenue grew 2%, as higher average order was partially offset by a decrease in Active Representatives. In South Africa, revenue declined 8%, unfavorably impacted by foreign exchange. On a Constant $ basis, South Africa’s revenue grew 9%, primarily due to higher average order from successful marketing strategies and Representative mix. Operating margin was negatively impacted by .2 points as compared to the prior-year period from higher CTI restructuring. Adjusted operating margin increased 3.5 points, or 3.6 points on a Constant $ basis, primarily as a result of: • a benefit of 1.9 points due to higher gross margin caused primarily by lower supply chain costs, largely due to lower material and overhead costs together with the benefits from productivity initiatives, including facility rationalization. These items were partially offset by the unfavorable net impact of mix and pricing of .5 points as a result of discounts and the unfavorable impact of foreign currency transaction losses; • a benefit of .9 points from lower bad debt expense partially due to a higher provision in the first quarter of 2012 to increase reserves for bad debts in South Africa as a result of growth in new territories, of which .5 points was an adjustment associated with prior periods. Bad debt expense was also favorably impacted by the change in estimate of the collection of our receivables which increased bad debt in the prior-year period that did not recur in 2013; and • a benefit of .5 points from lower net brochure costs, partially impacted by initiatives to reduce the cost of our brochures in various European markets. North America - 2014 Compared to 2013 Amounts in the table above may not necessarily sum due to rounding. Total revenue decreased 17% on both a reported and Constant $ basis compared to the prior-year period, primarily due to a decrease in Active Representatives. Sales from Beauty products and Fashion & Home products each declined 17% on both a reported and Constant $ basis. In addition, we believe units were negatively impacted by the decreased depth and frequency of discounting, primarily during the first half of 2014. We continue to adjust the balance of both the depth and frequency of discounting in an effort to drive revenue and maximize profitability. Operating margin was negatively impacted by 2.2 points from settlement charges associated with the U.S. pension plan as discussed in more detail below. Operating margin was also negatively impacted by 1.4 points as compared to the prior-year period from higher CTI restructuring. Adjusted operating margin increased 1.9 points, or 1.8 points on a Constant $ basis, primarily as a result of: • a benefit of 1.1 points due to lower net brochure costs, which was primarily as a result of cost savings initiatives; • a benefit of 1.0 point due to reduced advertising spend, which was primarily attributable to a shift towards more cost-effective recruitment strategies; • a benefit of .5 points due to lower Representative and sales leader expense primarily due to lower commissions and reduced appointments of new Representatives; • a benefit of .4 points due to lower distribution expenses, primarily resulting from our cost savings initiatives, including the closure of the Atlanta distribution facility that was associated with the $400M Cost Savings Initiative; and • a net decline of 1.6 points due to the unfavorable impact of declining revenue with respect to our fixed expenses, partially offset by lower fixed expenses primarily resulting from our cost savings initiatives, mainly reductions in headcount that were associated with the $400M Cost Savings Initiative, and reduced field spending. In an effort to reduce our pension benefit obligations, in March 2014, we offered former employees who are vested and participate in the U.S. pension plan a payment that would fully settle our pension plan obligation to those participants who elected to receive such payment. The election period ended during the second quarter of 2014 and the payments were made in June 2014 from our plan assets. As a result of the lump-sum payments made, in the second quarter of 2014, we recorded a settlement charge of approximately $24. Because the settlement threshold was exceeded in the second quarter of 2014, settlement charges of approximately $5 and approximately $7 were also recorded in the third and fourth quarters of 2014, respectively, as a result of additional payments from our U.S. pension plan. These settlement charges were allocated between Global Expenses and the operating results of North America. We continue to expect year-over-year revenue declines within North America. We are focused on restoring field health, improving our brochure and creating a sustainable cost base which may include additional restructuring actions. North America - 2013 Compared to 2012 *Calculation not meaningful Amounts in the table above may not necessarily sum due to rounding. Total revenue decreased 17% compared to the prior-year period, or 16% on a Constant $ basis, primarily due to a decrease in Active Representatives. Active Representatives were negatively impacted by recruitment challenges. Sales from Beauty products declined 19%, on both a reported and Constant $ basis, driven primarily by skincare. Sales from Fashion & Home products declined 14%, or 13% on a Constant $ basis. In the second half of 2013, revenue in Canada was adversely impacted due to significant field disruptions as a result of the piloting of the SMT technology platform and associated business process changes initiated in the second quarter of 2013. See "Global and other expenses" in this MD&A for more information on SMT. Operating margin benefited by .8 points as compared to the prior-year period from lower CTI restructuring. Adjusted operating margin declined 4.8 points, or 4.7 points on a Constant $ basis, primarily as a result of: • a decline of 4.3 points due to the net impact of declining revenue with respect to our fixed expenses, partially offset by lower expenses primarily resulting from our cost savings initiatives, mainly reductions in headcount that were primarily associated with the $400M Cost Savings Initiative, and reduced field spending; • a decline of .9 points with respect to transportation expenses, due to the net impact of declining revenue and increased costs per unit as a result of lower volume; • a decline of .6 points due to lower gross margin caused primarily by .7 points from unfavorable supply chain costs, partially as a result of .3 points that benefited the prior-year period for out-of-period adjustments associated with vendor liabilities, and the impact of lower unit volume that was partially offset by productivity initiatives; and • a benefit of .6 points from lower net brochure costs impacted by initiatives to reduce the cost of our brochures and the number of brochures printed as a result of lower Representative count. Asia Pacific - 2014 Compared to 2013 (1) Excludes China. *Calculation not meaningful Amounts in the table above may not necessarily sum due to rounding. Total revenue decreased 7% compared to the prior-year period, partially due to the unfavorable impact from foreign exchange. On a Constant $ basis, revenue decreased 4%, as an increase in the Philippines was more than offset by declines in the other Asia Pacific markets. Constant $ revenue was also impacted by a decrease in Active Representatives, partially offset by higher average order. Revenue in the Philippines declined 2%, which was unfavorably impacted by foreign exchange. On a Constant $ basis, revenue in the Philippines increased 3%, as higher average order was partially offset by a decrease in Active Representatives. Revenue in China declined 10% on both a reported and Constant $ basis, primarily due to a decline in the number of beauty boutiques. The decline in the number of beauty boutiques negatively impacted unit sales, but was partially offset by actions taken during the second half of 2013 which were intended to reduce inventory levels held by the beauty boutiques that did not recur in 2014. Operating margin benefited by 5.6 points as compared to the prior-year period due to the impact of non-cash goodwill and intangible asset impairment charges associated with our China business as discussed in more detail below. Operating margin was negatively impacted by .6 points as compared to the prior-year period from higher CTI restructuring. Adjusted operating margin decreased .3 points, or increased .1 point on a Constant $ basis, primarily as a result of: • a benefit of 1.3 points from lower bad debt expense, primarily as our 2013 results included an adjustment associated with prior periods in the Philippines; • a net benefit of .9 points due to lower fixed expenses, which was partially offset by the unfavorable impact of declining revenue with respect to our fixed expenses. Lower fixed expenses primarily resulted from our cost savings initiatives, mainly reductions in headcount that were associated with the $400M Cost Savings Initiative; • a decline of 1.2 points due to lower gross margin caused primarily by .7 points from the unfavorable net impact of pricing and mix primarily driven by the Philippines largely due to unit driving offers, and .6 points from the unfavorable impact of foreign currency transaction losses; and • a decline of .9 points due to higher advertising spend, primarily in China to support product re-launches. Asia Pacific - 2013 Compared to 2012 (1) Excludes China. *Calculation not meaningful Amounts in the table above may not necessarily sum due to rounding. Total revenue declined 16% compared to the prior-year period, or 15% on a Constant $ basis, driven by the unfavorable results of our China operations and a decrease in Active Representatives in the other Asia Pacific markets. The region's revenue was also negatively impacted by approximately 1 point as a result of our decision to exit the South Korea and Vietnam markets. Revenue in the Philippines declined 5%, or 4% on a Constant $ basis, as operational challenges in that market contributed to the decrease in Active Representatives and a decline in unit sales. Revenue in China declined 42%, or 44% on a Constant $ basis, primarily due to declines in unit sales. We have experienced operational challenges in China and the number of beauty boutiques has declined. Additionally, we began our transition to a retail incentive model during the third quarter of 2012, which negatively impacted the region's Constant $ revenue during the first half of 2013. During the second half of 2013, we also took actions intended to reduce inventory levels held by the beauty boutiques, which negatively impacted our sales to the beauty boutiques in China. Operating margin was negatively impacted by .7 points as compared to the prior-year period due to a larger impact from non-cash goodwill and intangible asset impairment charges associated with our China business during 2013. The non-cash goodwill and intangible asset impairment charge in the third quarter of 2013 was recorded based on an interim impairment analysis, which was completed as a result of the significant lowering of our long-term revenue and earnings projections for China and the decline in revenue performance in China in the third quarter of 2013, which was significantly in excess of our expectations. See Note 16, Goodwill and Intangible Assets on pages through of our 2014 Annual Report for more information on China. Operating margin benefited by 1.3 points as compared to the prior-year period from lower CTI restructuring. Adjusted operating margin decreased 2.9 points, or 2.7 points on a Constant $ basis, primarily as a result of: • a decline of 1.5 points due to lower gross margin caused primarily by 1.0 point of unfavorable supply chain costs, primarily driven by higher material costs and the impact of lower unit volume that was partially offset by productivity initiatives. Gross margin was also negatively impacted by the net impact of mix and pricing by approximately .9 points partially driven by the underperformance of skincare; • a decline of .6 points due to an adjustment associated with prior periods related to bad debt expense in the Philippines; and • the unfavorable impact of lower revenue on fixed costs was significantly offset by benefits from our cost savings initiatives, mainly reductions in headcount associated with the $400M Cost Savings Initiative, resulting in a net negative impact on Adjusted operating margin of approximately 1.0 point. Global and Other Expenses Global and other expenses include, among other things, costs related to our executive and administrative offices, information technology, research and development, marketing, professional and related fees associated with the FCPA investigations and compliance reviews, the accrual for the settlements related to the FCPA investigations, a non-cash impairment charge for the capitalized software associated with SMT and pension settlement charges. We allocate certain planned global expenses to our business segments primarily based on planned revenue. The unallocated costs remain as Global and other expenses. We do not allocate to our segments costs of implementing restructuring initiatives related to our global functions, professional and related fees associated with the FCPA investigations and compliance reviews, the accrual for the settlements related to the FCPA investigations, a non-cash impairment charge for the capitalized software associated with SMT and settlement charges associated with the U.S. pension plan. Costs of implementing restructuring initiatives related to a specific segment are recorded within that segment. (1) Net global expenses represents total global expenses less amounts allocated to segments. Amounts in the table above may not necessarily sum due to rounding. 2014 Compared to 2013 As compared to the prior-year period, total global expenses benefited from a non-cash impairment charge of approximately $117 for capitalized software related to SMT (discussed below) and the $89 accrual for the settlements related to the FCPA investigations which were recorded in 2013, partially offset by the additional $46 accrual for the settlements related to the FCPA investigations and settlement charges associated with the U.S. pension plan (discussed below) which were recorded in 2014. As a result of the payments made to former employees who are vested and participate in the U.S. pension plan, in the second quarter of 2014, we recorded a settlement charge of approximately $24. Because the settlement threshold was exceeded in the second quarter of 2014, settlement charges of approximately $5 and approximately $7 were also recorded in the third and fourth quarters of 2014, respectively, as a result of additional payments from our U.S. pension plan. These settlement charges were allocated between Global Expenses and the operating results of North America. See "Segment Review - North America" in this MD&A for a further discussion of the settlement charges. In the fourth quarter of 2013, we decided to halt further roll-out of our SMT project beyond the pilot market of Canada, in light of the potential risk of further business disruption. As a result, a non-cash impairment charge for the capitalized software associated with SMT was recorded. See Note 1, Description of the Business and Summary of Significant Accounting Policies on pages through of our 2014 Annual Report for more information. Adjusted total global expenses decreased compared to the prior-year period primarily as a result of cost savings initiatives, including lower expenses related to our SMT project, and to a lesser extent, lower marketing expenses. In addition, professional and related fees associated with the FCPA investigations and compliance reviews decreased compared to the prior-year period. Professional and related fees associated with the FCPA investigations and compliance reviews described in Note 15, Contingencies on pages through of our 2014 Annual Report, amounted to approximately $7 in 2014, as compared to approximately $28 in 2013. These fees were not allocated to the segments. Although the FCPA investigations and compliance reviews are now complete and we have reached settlements with the government, we will incur ongoing costs related to the monitor and self-reporting obligations undertaken pursuant to the settlements. With respect to the global expenses discussion above and below, for all years presented, please see Risk Factors on pages 10 through 11 of our 2014 Annual Report, and Note 15, Contingencies on pages through of our 2014 Annual Report for more information regarding the FCPA settlements, and other related matters, including our expectations with respect to future professional and related fees related to the monitor and self-reporting obligations undertaken pursuant to the settlements. 2013 Compared to 2012 As compared to the prior-year period, total global expenses was negatively impacted by a non-cash impairment charge of approximately $117 for capitalized software related to SMT and the $89 accrual for the settlements related to the FCPA investigations, which were recorded in 2013, and partially offset by lower CTI restructuring. Adjusted total global expenses decreased compared to the prior-year period primarily due to lower professional and related fees associated with the FCPA investigations and compliance reviews as well as lower consulting fees, partially offset by higher expenses related to our SMT project. Amounts allocated to segments decreased compared to the prior-year period primarily due to the decrease in budgeted marketing and research and development costs, which are costs that are allocated to segments. Professional and related fees associated with the FCPA investigations and compliance reviews described in Note 15, Contingencies on pages through of our 2014 Annual Report, amounted to approximately $28 in 2013, as compared to approximately $92 in 2012. These fees were not allocated to the segments. While these fees are difficult to predict, we expect ongoing fees may vary during the course of these investigations and reviews. Liquidity and Capital Resources Our principal sources of funding historically have been cash flows from operations, public offerings of notes, bank financings, issuance of commercial paper, borrowings under lines of credit and a private placement of notes. At December 31, 2014, we had cash and cash equivalents totaling approximately $961, which includes cash balances associated with our Venezuela operations denominated in Bolívares amounting to approximately $3. We believe that our sources of funding will be sufficient to satisfy our currently anticipated cash requirements through at least the next twelve months. For more information with respect to these foreign currency restrictions and the foreign currency devaluation, see "Segment Review - Latin America" in this MD&A above, and for more information regarding risks with respect to these foreign currency restrictions, see "Risk Factors - We are subject to financial risks related to our international operations, including exposure to foreign currency fluctuations and the impact of foreign currency restrictions" included in Item 1A on pages 8 through 18 of our 2014 Annual Report. We may seek to repurchase our equity or to retire our outstanding debt in open market purchases, privately negotiated transactions, through derivative instruments or otherwise. Repurchases of equity and debt may be funded by the incurrence of additional debt or the issuance of equity or convertible securities and will depend on prevailing market conditions, our liquidity requirements, contractual restrictions and other factors, and the amounts involved may be material. We may also elect to incur additional debt or issue equity or convertible securities to finance ongoing operations or to meet our other liquidity needs. Any issuances of equity securities or convertible securities could have a dilutive effect on the ownership interest of our current shareholders and may adversely impact earnings per share in future periods. Our credit ratings were downgraded in 2014, which may impact our access to these transactions on favorable terms, if at all. For more information see "Risk Factors - Our credit ratings were downgraded in 2014, which could limit our access to financing, affect the market price of our financing and increase financing costs. A further downgrade in our credit ratings may adversely affect our access to liquidity, and our working capital," "Risk Factors - Our indebtedness could adversely affect us by reducing our flexibility to respond to changing business and economic conditions," and "Risk Factors - A general economic downturn, a recession globally or in one or more of our geographic regions or markets, such as Russia, or sudden disruption in business conditions or other challenges may adversely affect our business, our access to liquidity and capital, and our credit ratings" included in Item 1A on pages 8 through 18 of our 2014 Annual Report. Our liquidity could also be negatively impacted by restructuring initiatives, dividends, capital expenditures, acquisitions, and certain contingencies, including any legal or regulatory settlements, described more fully in Note 15, Contingencies on pages through of our 2014 Annual Report. See our Cautionary Statement for purposes of the "Safe Harbor" Statement under the Private Securities Litigation Reform Act of 1995 on pages 1 through 2 of our 2014 Annual Report. Balance Sheet Data Cash Flows Net Cash from Continuing Operating Activities Net cash provided by continuing operating activities during 2014 was approximately $180 lower than during 2013. Operating cash flow during 2014 was unfavorably impacted by lower cash-related earnings (including the unfavorable impact of foreign currency), the $68 fine paid in connection with the FCPA settlement with the DOJ and higher payments for employee incentive compensation. These unfavorable impacts to the year-over-year comparison of cash from operating activities were partially offset by the benefit due to the timing of accounts payable, primarily for inventory purchases. In addition, operating cash flow during 2013 was unfavorably impacted by payments for the make-whole premiums of approximately $90 in connection with the prepayment of debt and an approximate $25 contribution to the United Kingdom pension plan as a result of our decision to freeze the plan, both of which did not recur in 2014. Net cash provided by continuing operating activities during 2013 was approximately $4 lower than during 2012. Operating cash flow during 2013 was unfavorably impacted by the payments for the make-whole premiums and the contribution to the United Kingdom pension plan, as discussed above, as well as higher payments for employee incentive compensation. Substantially offsetting these unfavorable impacts was improved Adjusted operating profit. We maintain defined benefit pension plans and unfunded supplemental pension benefit plans (see Note 11, Employee Benefit Plans on pages through of our 2014 Annual Report). Our funding policy for these plans is based on legal requirements and available cash flows. The amounts necessary to fund future obligations under these plans could vary depending on estimated assumptions (as detailed in "Critical Accounting Estimates - Pension and Postretirement Expense" in this MD&A). The future funding for these plans will depend on economic conditions, employee demographics, mortality rates, the number of associates electing to take lump-sum distributions, investment performance and funding decisions. Based on current assumptions, we expect to make contributions in the range of $50 to $55 to our U.S. defined benefit pension and postretirement plans and in the range of $25 to $30 to our non-U.S. defined benefit pension and postretirement plans during 2015. Net Cash from Continuing Investing Activities Net cash used by continuing investing activities during 2014 was approximately $68 lower than during 2013, primarily due to lower capital expenditures, partially offset by higher proceeds received for the disposal of assets, primarily in the U.S., due to the sale of facilities associated with our restructuring initiatives. Net cash used by continuing investing activities during 2013 was $40 lower than during 2012, primarily due to lower capital expenditures, as well as higher proceeds received for the disposal of assets, primarily in the U.S., due to the sale of facilities associated with our restructuring initiatives. Capital expenditures during 2014 were approximately $131 compared with approximately $197 during 2013, driven by the decision to halt the further roll-out of SMT beyond Canada in the fourth quarter of 2013. Capital expenditures during 2013 were approximately $197 compared with approximately $229 during 2012, driven by lower spend associated with SMT primarily due to the launch of the pilot in Canada, and to a lesser extent, the decision to halt the further roll-out of SMT beyond Canada in the fourth quarter of 2013. Capital expenditures in 2015 are currently expected to be in the range of $125 to $150 and are expected to be funded by cash from operations. Net Cash from Continuing Financing Activities Net cash used by continuing financing activities was approximately $219 during 2014 compared to approximately $468 during 2013. This was primarily due to the significant financing transactions in 2013, partially offset by the repayment of the remaining approximate $53 outstanding principal amount of the term loan agreement (as defined below) in the second quarter of 2014. The 2013 transactions included the prepayment of $535 principal amount of the Private Notes (as defined below), the prepayment of $500 principal amount of the 2014 Notes (as defined below), the repayment of $498 of the outstanding principal amount of the term loan agreement (as defined below), the scheduled repayment of $250 principal amount of the 4.80% Notes, due March 1, 2013, and the scheduled repayment of $125 principal amount of the 4.625% Notes, due May 15, 2013, which were partially offset by the proceeds of $1.5 billion related to issuance of the Notes (as defined below) and proceeds of $88 related to the termination of interest-rate swap agreements designated as fair value hedges. See Note 5, Debt and Other Financing on pages through of our 2014 Annual Report, and Note 8, Financial Instruments and Risk Management on pages through of our 2014 Annual Report for more information. Net cash used by continuing financing activities was approximately $468 during 2013 compared to approximately $401 during 2012 primarily due to the significant repayments and prepayments in 2013 (as discussed above) and lower debt issuances in various markets. This was partially offset by proceeds of $1.5 billion related to issuance of the Notes (as defined below) in the first quarter of 2013 as compared to proceeds of $550 related to borrowings under our term loan agreement (as defined below) in 2012, as well as lower repayments of commercial paper and lower dividend payments in 2013. See Note 5, Debt and Other Financing on pages through of our 2014 Annual Report for more information. In addition, during 2013 we had proceeds of approximately $88 related to the termination of interest-rate swap agreements designated as fair value hedges, compared to proceeds of approximately $44 during 2012. See Note 8, Financial Instruments and Risk Management on pages through of our 2014 Annual Report for more information. We purchased approximately .7 million shares of our common stock for $9.8 during 2014, as compared to .5 million shares of our common stock for $9.4 during 2013 and .5 million shares for $8.8 during 2012, through repurchases by the Company in connection with employee elections to use shares to pay withholding taxes upon the vesting of their restricted stock units and private transactions with a broker in connection with stock based obligations under our Deferred Compensation Plan. We have maintained a quarterly dividend of $.06 per share for 2014, which was equivalent to our quarterly dividends in 2013. During the first nine months of 2012 our quarterly dividend payments were $.23 per share, whereas in the fourth quarter of 2012 our quarterly dividend payment was $.06 per share. We have maintained the dividend of $.06 per share for the first quarter of 2015. Debt and Contractual Financial Obligations and Commitments At December 31, 2014, our debt and contractual financial obligations and commitments by due dates were as follows: (1) Capital lease and financing obligations is primarily comprised of $40.4 related to the sale and leaseback of equipment in one of our distribution facilities in North America entered into in 2009 and $11.6 of capital leases which were primarily related to automobiles and equipment. (2) Amounts are based on our current long-term credit ratings. See Note 5, Debt and Other Financing on pages through of our 2014 Annual Report for more information. (3) Amounts represent expected future benefit payments for our unfunded defined benefit pension and postretirement benefit plans, as well as expected contributions for 2015 to our funded defined benefit pension benefit plans. We are not able to estimate our contributions to our funded defined benefit pension and postretirement plans beyond 2015. (4) The amount of debt and contractual financial obligations and commitments excludes amounts due under derivative transactions. The table also excludes information on non-binding purchase orders of inventory. The table does not include any reserves for uncertain income tax positions because we are unable to reasonably predict the ultimate amount or timing of settlement of these uncertain income tax positions. At December 31, 2014, our reserves for uncertain income tax positions, including interest and penalties, totaled $44.6. See Note 5, Debt and Other Financing, and Note 13, Leases and Commitments, on pages through, and on page, respectively, of our 2014 Annual Report for more information on our debt and contractual financial obligations and commitments. Additionally, as disclosed in Note 14, Restructuring Initiatives on pages through of our 2014 Annual Report, we have a remaining liability of $50.6 associated with our $400M Cost Savings Initiative, at December 31, 2014. We also have a remaining liability of $8.9 associated with other restructuring initiatives approved during 2012 at December 31, 2014. The majority of future cash payments associated with these restructuring liabilities are expected to be made during 2015. Off Balance Sheet Arrangements At December 31, 2014, we had no material off-balance-sheet arrangements. Capital Resources Revolving Credit Facility In March 2013, we entered into a four-year $1 billion revolving credit facility (the “revolving credit facility”), which expires in March 2017. The revolving credit facility replaced the previous $1 billion revolving credit facility (the "2010 revolving credit facility"), which was terminated in March 2013 prior to its scheduled expiration in November 2013. There were no amounts drawn under the 2010 revolving credit facility on the date of termination and no early termination penalties were incurred. In the first quarter of 2013, $1.2 was recorded for the write-off of issuance costs related to the 2010 revolving credit facility. Borrowings under the revolving credit facility bear interest, at our option, at a rate per annum equal to LIBOR plus an applicable margin or a floating base rate plus an applicable margin, in each case subject to adjustment based on our credit ratings. The revolving credit facility has an annual fee of approximately $3.0, payable quarterly, based on our current credit ratings. The revolving credit facility may be used for general corporate purposes. As of December 31, 2014, there were no amounts outstanding under the revolving credit facility. The revolving credit facility contains covenants limiting our ability to incur liens and enter into mergers and consolidations or sales of substantially all our assets. The revolving credit facility also contains a covenant that limits our subsidiary debt to existing subsidiary debt at February 28, 2013 plus $500.0, with certain other exceptions. In addition, the revolving credit facility contains financial covenants which require our interest coverage ratio at the end of each fiscal quarter to equal or exceed 4:1 and our leverage ratio to not be greater than 3.5:1 at the end of the fiscal quarter ended December 31, 2014 and each fiscal quarter thereafter. In addition, the revolving credit facility contains customary events of default and cross-default provisions. The interest coverage ratio is determined by dividing our consolidated EBIT (as defined in the revolving credit facility) by our consolidated interest expense, in each case for the period of four fiscal quarters ending on the date of determination. The leverage ratio is determined by dividing the amount of our consolidated funded debt on the date of determination by our consolidated EBITDA (as defined in the revolving credit facility) for the period of four fiscal quarters ending on the date of determination. When calculating the interest coverage and leverage ratios, the revolving credit facility allows us, subject to certain conditions and limitations, to add back to our consolidated net income, among other items: (i) extraordinary and other non-cash losses and expenses, (ii) one-time fees, cash charges and other cash expenses, premiums or penalties incurred in connection with any asset sale, equity issuance or incurrence or repayment of debt or refinancing or modification or amendment of any debt instrument and (iii) cash charges and other cash expenses, premiums or penalties incurred in connection with any restructuring or relating to any legal or regulatory action, settlement, judgment or ruling, in an aggregate amount not to exceed $400.0 for the period from October 1, 2012 until the termination of commitments under the revolving credit facility (which expires in March 2017); provided, that cash restructuring charges incurred after December 31, 2014 shall not be added back to our consolidated net income. Beginning January 1, 2015, charges taken for cash restructuring cannot be added back to our consolidated net income. As of December 31, 2014, we have less than $10 remaining for the other items (cash charges and other cash expenses, premiums or penalties incurred relating to any legal or regulatory action, settlement, judgment or ruling). We were in compliance with our interest coverage and leverage ratios under the revolving credit facility for the four fiscal quarters ended December 31, 2014. As of December 31, 2014, and based on then applicable interest rates, approximately $825 of the $1 billion revolving credit facility could have been drawn down without violating any covenant. A continued decline in our business results (including the impact of any adverse foreign exchange movements, significant restructuring charges and significant legal or regulatory settlements) may further reduce our borrowing capacity under the revolving credit facility or cause us to be non-compliant with our interest coverage and leverage ratios. If we were to be non-compliant with our interest coverage or leverage ratio, we would no longer have access to our revolving credit facility. As of December 31, 2014, there were no amounts outstanding under the revolving credit facility. Public Notes On April 15, 2013, we prepaid our 5.625% Notes, due March 1, 2014 (the "2014 Notes") at a prepayment price equal to 100% of the principal amount of $500.0, plus accrued interest of $3.4 and a make-whole premium of $21.7. In connection with the prepayment of our 2014 Notes, we incurred a loss on extinguishment of debt of $13.0 in the second quarter of 2013 consisting of the $21.7 make-whole premium for the 2014 Notes and the write-off of $1.1 of debt issuance costs and discounts related to the initial issuance of the 2014 Notes, partially offset by a deferred gain of $9.8 associated with the January 2013 interest-rate swap agreement termination. See Note 8, Financial Instruments and Risk Management on pages through of our 2014 Annual Report for more information. In addition, the $250.0 principal amount of our 4.80% Notes due March 1, 2013 and the $125.0 principal amount of our 4.625% Notes due May 15, 2013 were repaid in full at maturity. In March 2013, we issued, in a public offering, $250.0 principal amount of 2.375% Notes, due March 15, 2016 (the "2016 Notes"), $500.0 principal amount of 4.60% Notes, due March 15, 2020 (the "2020 Notes"), $500.0 principal amount of 5.00% Notes, due March 15, 2023 (the "2023 Notes") and $250.0 principal amount of 6.95% Notes, due March 15, 2043 (the "2043 Notes") (collectively, the "Notes"). The net proceeds from these Notes were used to repay $380.0 of the outstanding principal amount of the term loan agreement (as defined below), to prepay the Private Notes (as defined below) and 2014 Notes (plus make-whole premium and accrued interest for both prepayments), and to repay the 4.625% Notes, due May 15, 2013 at maturity. Interest on the Notes is payable semi-annually on March 15 and September 15 of each year. As a result of the long-term credit rating downgrades by S&P to BB+ (Stable outlook) and by Moody's to Ba1 (Stable outlook) (as discussed below), the interest rates on the Notes will increase by .50%, effective as of March 15, 2015. At December 31, 2014, we also had outstanding $250.0 principal amount of our 5.75% Notes due March 1, 2018 (the "2018 Notes"), $250.0 principal amount of our 4.20% Notes due July 15, 2018 (the "4.20% Notes") and $350.0 principal amount of our 6.50% Notes due March 1, 2019 (the "2019 Notes"). Interest on the 2018 Notes, the 4.20% Notes and the 2019 Notes is payable semi-annually. The indentures governing our outstanding notes described above contain certain covenants, including limitations on the incurrence of liens and restrictions on the incurrence of sale/leaseback transactions and transactions involving a merger, consolidation or sale of substantially all of our assets. In addition, these indentures contain customary events of default and cross-default provisions. Further, we would be required to make an offer to repurchase the 2018 Notes, the 2019 Notes and each series of the Notes at a price equal to 101% of their aggregate principal amount plus accrued and unpaid interest in the event of a change in control involving Avon and a corresponding credit ratings downgrade to below investment grade. In addition, the indenture governing the Notes contains interest rate adjustment provisions depending on our credit ratings with S&P and Moody's. As described in the indenture, the interest rates on the Notes increase by .25% for each one-notch downgrade below investment grade on each of our long-term credit ratings by S&P or Moody's. These adjustments are limited to a total increase of 2% above the respective interest rates in effect on the date of issuance of the Notes. As a result of the long-term credit rating downgrades by S&P to BB+ (Stable outlook) and by Moody's to Ba1 (Stable outlook) (as discussed below), the interest rates on the Notes will increase by .50%, effective as of March 15, 2015. Term Loan Agreement On June 29, 2012, we entered into a $500.0 term loan agreement (the "term loan agreement"). Subsequently on August 2, 2012, we borrowed an incremental $50.0 of principal from subscriptions by new lenders under the term loan agreement. Borrowings under the term loan agreement bore interest, at our option, at a rate per annum equal to LIBOR plus an applicable margin or a floating base rate plus an applicable margin, in each case subject to adjustment based on our credit ratings. In March 2013, we repaid $380.0 of the outstanding principal amount of the term loan agreement with a portion of the proceeds from the issuance of the Notes, which repayment resulted in a loss in the first quarter of 2013 of $1.6 on extinguishment of debt associated with the write-off of debt issuance costs related to the term loan agreement. On July 25, 2013, we prepaid $117.5 of the outstanding principal balance under the term loan agreement, without prepayment penalties. On June 30, 2014, we paid the $52.5 remaining outstanding principal balance under the term loan agreement, of which $39.4 was not yet due, without prepayment penalties, effectively terminating the term loan agreement since amounts thereunder may not be reborrowed. Private Notes On March 29, 2013, we prepaid the $535.0 senior notes issued in 2010 in a private placement exempt from registration under the Securities Act of 1933, as amended (the "Private Notes"). In connection with the prepayment of our Private Notes, we incurred a loss on extinguishment of debt of $71.4 in the first quarter of 2013, which included a make-whole premium of $68.0 and the write-off of $3.4 of debt issuance costs related to the Private Notes. Commercial Paper Program In November 2014, we terminated our $1 billion commercial paper program, which was supported by the revolving credit facility, as our current credit ratings essentially eliminated the demand for our commercial paper. We had not sought to issue commercial paper since our March 2013 public offering. Additional Information Our long-term credit ratings are Ba1 (Stable Outlook) with Moody's, BB+ (Stable Outlook) with S&P, and BB (Negative Outlook) with Fitch, which are below investment grade. In November 2014, S&P lowered their long-term credit rating from BBB- (Negative Outlook) to BB+ (Stable Outlook). In October 2014, Moody's lowered their long-term credit rating from Baa3 (Negative Outlook) to Ba1 (Stable Outlook). We do not believe these long-term credit rating downgrades will have a material impact on our near-term liquidity. However, additional rating agency reviews could result in a change in outlook or downgrade, which could further limit our access to new financing, particularly short-term financing, reduce our flexibility with respect to working capital needs, affect the market price of some or all of our outstanding debt securities, as well as most likely result in an increase in financing costs, including interest expense under certain of our debt instruments, and less favorable covenants and financial terms of our financing arrangements. For more information, see "Risk Factors - A general economic downturn, a recession globally or in one or more of our geographic regions or markets, such as Russia, or sudden disruption in business conditions or other challenges may adversely affect our business, our access to liquidity and capital, and our credit ratings," "Risk Factors - Our credit ratings were downgraded in 2014, which could limit our access to financing, affect the market price of our financing and increase financing costs. A further downgrade in our credit ratings may adversely affect our access to liquidity, and our working capital," and "Risk Factors - Our indebtedness could adversely affect us by reducing our flexibility to respond to changing business and economic conditions" included in Item 1A on pages 8 through 18 of our 2014 Annual Report. Please also see Note 5, Debt and Other Financing on pages through of our 2014 Annual Report for more information relating to our debt and the maturities thereof.

<s>[INST] You should read the following discussion of the results of operations and financial condition of Avon Products, Inc. and its majority and wholly owned subsidiaries in conjunction with the information contained in the Consolidated Financial Statements and related Notes contained in our 2014 Annual Report. When used in this discussion, the terms "Avon," "Company," "we," "our" or "us" mean, unless the context otherwise indicates, Avon Products, Inc. and its majority and wholly owned subsidiaries. See "NonGAAP Financial Measures" on pages 25 through 26 of this MD&A for a description of how Constant dollar ("Constant $") growth rates (a NonGAAP financial measure) are determined. Overview We are a global manufacturer and marketer of beauty and related products. Our business is conducted worldwide, primarily in the directselling channel. As of December 31, 2014, we had sales operations in 60 countries and territories, including the United States ("U.S."), and distributed products in 41 more. Our reportable segments are based on geographic operations and include commercial business units in Latin America; Europe, Middle East & Africa; North America; and Asia Pacific. Our product categories are Beauty and Fashion & Home. Beauty consists of skincare (which includes personal care), fragrance and color (cosmetics). Fashion & Home consists of fashion jewelry, watches, apparel, footwear, accessories, gift and decorative products, housewares, entertainment and leisure products, children’s products and nutritional products. Sales are made to the ultimate consumer principally through direct selling by Representatives, who are independent contractors and not our employees. At December 31, 2014, we had approximately 6 million active Representatives. The success of our business is highly dependent on recruiting, retaining and servicing our Representatives. During 2014, approximately 89% of our consolidated revenue was derived from operations outside of the U.S. Total revenue in 2014 compared to 2013 declined 11% compared to the prioryear period, due to unfavorable foreign exchange. Constant $ revenue was relatively unchanged, as a 5% decrease in Active Representatives was partially offset by higher average order. Units sold decreased 5% while the net impact of price and mix increased 5%, as pricing benefited from inflationary impacts in Latin America, primarily in Argentina and Venezuela. Sales from the Beauty category decreased 12%, or were relatively unchanged on a Constant $ basis. Sales from the Fashion & Home category decreased 12%, or 2% on a Constant $ basis. During 2014, our Constant $ revenue was impacted by net declines in North America and to a lesser extent, Asia Pacific, which were partially offset by net growth in Latin America and Europe, Middle East & Africa. North America continued to experience yearoveryear revenue declines, driven by a decrease in Active Representatives. Constant $ revenue growth in Latin America was primarily driven by Venezuela largely due to inflationary pricing, which was partially offset by declines in Mexico. Constant $ revenue growth in Europe, Middle East & Africa was driven by South Africa and the United Kingdom, which was partially offset by revenue declines in Russia and Turkey. Constant $ revenue in Russia was negatively impacted by a difficult economy, including the impact of geopolitical uncertainties, and its decline in the first half of 2014 was partially offset by Constant $ revenue growth in the second half of 2014 driven by actions to improve unit sales. In Asia Pacific, Constant $ revenue declined as compared to 2013 as growth in the Philippines was more than offset by declines in the other Asia Pacific markets. See "Segment Review" of this MD&A for additional information related to changes in revenue by segment. During 2014, foreign currency had a significant impact on our financial results. As the U.S. dollar has strengthened relative to currencies of key Avon markets, our revenue and profits have been reduced when translated into U.S. dollars and our margins have been negatively impacted by country mix, as certain of our higher margin markets experienced significant devaluation of their local currency. In addition, as our sales and costs are often denominated in different currencies, this has created a negative foreign currency transaction impact. Specifically [/INST] Negative. </s>

AVON PRODUCTS INC

2016-02-23

2015-12-31

ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS ("MD&A") (U.S. dollars in millions, except per share and share data) You should read the following discussion of the results of operations and financial condition of Avon Products, Inc. and its majority and wholly owned subsidiaries in conjunction with the information contained in the Consolidated Financial Statements and related Notes contained in our 2015 Annual Report. When used in this discussion, the terms "Avon," "Company," "we," "our" or "us" mean, unless the context otherwise indicates, Avon Products, Inc. and its majority and wholly owned subsidiaries. See "Non-GAAP Financial Measures" on pages 29 through 31 of this MD&A for a description of how Constant dollar ("Constant $") growth rates (a Non-GAAP financial measure) are determined. Overview We are a global manufacturer and marketer of beauty and related products. Our business is conducted primarily in the direct-selling channel. During 2015, we had sales operations in 57 countries and territories, and distributed products in 15 more. In addition, in our North America business (which has been presented as discontinued operations) we had sales operations in 3 countries and territories, and distributed our products in 27 other countries and territories. Our reportable segments are based on geographic operations and include commercial business units in Latin America; Europe, Middle East & Africa; and Asia Pacific. In addition, we operate our business in North America, which has been presented as discontinued operations for all periods presented and is discussed further below. Our product categories are Beauty and Fashion & Home. Beauty consists of skincare (which includes personal care), fragrance and color (cosmetics). Fashion & Home consists of fashion jewelry, watches, apparel, footwear, accessories, gift and decorative products, housewares, entertainment and leisure products, children’s products and nutritional products. Sales are made to the ultimate consumer principally through direct selling by Representatives, who are independent contractors and not our employees. As of December 31, 2015, we had nearly 6 million active Representatives which represents the number of Representatives submitting an order in a sales campaign, totaled for all campaigns during the year and then divided by the number of campaigns. The success of our business is highly dependent on recruiting, retaining and servicing our Representatives. During 2015, all of our consolidated revenue was derived from operations outside of the U.S. In December 2015, we entered into definitive agreements with affiliates of Cerberus Capital Management ("Cerberus"), which include a $435 investment in Avon by an affiliate of Cerberus through the purchase of our convertible preferred stock and the separation of the North America business from Avon into a privately-held company, which will include a $100 contribution by Avon, that will be majority-owned and managed by an affiliate of Cerberus. Avon will retain approximately 20% ownership in this new privately-held company. These transactions are expected to close concurrently in the first half of 2016. The North America business, which represents the Company's operations in the United States, Canada and Puerto Rico, was previously its own reportable segment and has been presented as discontinued operations for all periods presented. Refer to Note 3, Discontinued Operations and Divestitures, on pages through of our 2015 Annual Report, for additional information regarding the investment by an affiliate of Cerberus and the separation of the North America business. Total revenue in 2015 compared to 2014 declined 19% compared to the prior-year period, due to unfavorable foreign exchange. Constant $ revenue increased 2%. Constant $ revenue was negatively impacted by approximately 2 points due to taxes in Brazil from the combined impact of the recognition of Value Added Tax ("VAT") credits in 2014 which did not recur in 2015 along with a new Industrial Productions Tax ("IPI") on cosmetics which went into effect in May 2015. Constant $ revenue was also negatively impacted by approximately 1 point as a result of the sale of Liz Earle which was completed in July 2015. Sales from the Beauty category decreased 20%, or increased 3% on a Constant $ basis. Sales from the Fashion & Home category decreased 15%, or increased 5% on a Constant $ basis. Our Constant $ revenue benefited from growth in markets experiencing relatively high inflation (Venezuela and Argentina), which contributed approximately 2 points to our Constant $ revenue growth. Our Constant $ revenue also benefited from growth in Europe, Middle East & Africa, most significantly Eastern Europe (Russia and Ukraine), and to a lesser extent, South Africa and underlying growth in Brazil. Constant $ revenue benefited from higher average order and a 1% increase in Active Representatives. The increase in Active Representatives was primarily due to growth in Europe, Middle East & Africa, most significantly Russia, which was primarily due to sustained momentum in recruitment and retention, partially offset by markets experiencing relatively high inflation (Venezuela and Argentina). The net impact of price and mix increased 4%, driven by increases in all regions. The net impact of price and mix was primarily positively impacted by markets experiencing relatively high inflation (Venezuela and Argentina), as these markets benefited from the inflationary impact on pricing. Units sold decreased 2%, primarily due to declines in units sold in Brazil and Venezuela, partially offset by an increase in units sold in Russia. See "Segment Review" of this MD&A for additional information related to changes in revenue by segment. Over the last two years, our profitability has suffered significantly given our geographic footprint and the strength of the U.S. dollar relative to currencies of key Avon markets. As a result, our revenue and profits have been reduced when translated into U.S. dollars and our margins have been negatively impacted by country mix, as certain of our markets which have historically had higher operating margins experienced significant devaluation of their local currency. In addition, as our sales and costs are often denominated in different currencies, this has created a negative foreign currency transaction impact. Specifically, as compared to the prior-year period, foreign currency has impacted our consolidated financial results as a result of foreign currency transaction losses (classified within cost of sales, and selling, general and administrative expenses), which had an unfavorable impact to Adjusted operating profit of an estimated $210, foreign currency translation, which had an unfavorable impact to Adjusted operating profit of approximately $265 (of which approximately $90 related to Venezuela, as discussed further below), and lower foreign exchange losses on our working capital (classified within other expense, net), which had a favorable impact of approximately $10 before tax. In November 2015, we announced an internal reorganization of our management structure, including the combined management of Latin America and Europe, Middle East & Africa, effective January 1, 2016. As a result of the internal reorganization, we will report results for the following four reportable segments beginning in the first quarter of 2016: Europe, Middle East & Africa; Northern Latin America; South America; and Asia Pacific. In January 2016, we announced a transformation plan (the "Transformation Plan"), which includes investing in growth, reducing costs in an effort to continue to improve our cost structure and improving our financial resilience. As a result of this plan, we expect to invest $350 into the business over the next three years with an estimated $150 in media and social selling and $200 related to the service model evolution and information technology, which will be aimed at improving the overall Representative experience. With respect to cost reductions, we have targeted pre-tax annualized cost savings of approximately $350 after three years, with an estimated $200 from supply chain reductions and an estimated $150 from other cost reductions. These cost savings are expected to be achieved through restructuring actions as well as other cost-savings strategies that will not result in restructuring charges. We are targeting the realization of $70 of these pre-tax cost savings in 2016. We have initiated this Transformation Plan in order to enable us to achieve our long-term goals of double-digit operating margin and mid single-digit constant-dollar revenue growth. While we expect to evaluate options to improve our financial resilience, we have already implemented actions in this area, including refinancing our revolving credit facility, divesting Liz Earle Beauty Co. Limited ("Liz Earle"), prepaying our 2.375% Notes (as defined below in "Capital Resources" on pages 58 through 59) and suspending our dividend. See Note 14, Restructuring Initiatives on pages through of our 2015 Annual Report, Note 3, Discontinued Operations and Divestitures on pages through of our 2015 Annual Report and Note 5, Debt and Other Financing on pages through of our Annual Report for more information on these items. In July 2015, we sold Liz Earle, and as a result, we expect Avon's Constant $ and reported revenue in 2016 to be negatively impacted by approximately 1 point. See Note 3, Discontinued Operations and Divestitures on pages through of our 2015 Annual Report for more information. In February 2015, the Venezuelan government announced that the SICAD II market would no longer be available, and a new foreign exchange system was created, referred to as the SIMADI exchange ("SIMADI"). SIMADI began operating on February 12, 2015. Use of the SIMADI exchange rate caused the recognition of a devaluation of approximately 70%. In addition, we recognized impairment charges of approximately $11 to cost of sales and approximately $90 to selling, general and administrative expenses in order to reflect the write-down of inventory and long-lived assets, respectively, which was recorded in the first quarter of 2015. We recognized an additional negative impact of approximately $19 to operating profit and net income relating to these non-monetary assets in the first, second, third and fourth quarters of 2015 due to the recognition of the cost basis at a higher exchange rate than the rate at which revenue was reported in U.S. dollars. In addition to the negative impact to operating margin, we recorded an after-tax benefit of approximately $3 (a benefit of approximately $4 in other expense, net, and a loss of approximately $1 in income taxes) in the first quarter of 2015, primarily reflecting the write-down of monetary assets and liabilities. See "Segment Review - Latin America" of this MD&A for further discussion of our Venezuela operations. New Accounting Standards Information relating to new accounting standards is included in Note 2, New Accounting Standards, to our consolidated financial statements contained in this 2015 Annual Report. Performance Metrics Within this MD&A, in addition to our key financial metrics of revenue, operating profit and operating margin, we utilize the performance metrics defined below to assist in the evaluation of our business. Performance Metrics Definition Change in Active Representatives This metric is a measure of Representative activity based on the number of unique Representatives submitting at least one order in a sales campaign, totaled for all campaigns in the related period. To determine the change in Active Representatives, this calculation is compared to the same calculation in the corresponding period of the prior year. Orders in China are excluded from this metric as our business in China is predominantly retail. Liz Earle was also excluded from this calculation as it did not distribute through the direct-selling channel. Change in units sold This metric is based on the gross number of pieces of merchandise sold during a period, as compared to the same number in the same period of the prior year. Units sold include samples sold and products contingent upon the purchase of another product (for example, gift with purchase or discount purchase with purchase), but exclude free samples. Change in Average Order This metric is a measure of Representative productivity. The calculation is the difference of the year-over-year change in revenue on a Constant $ basis and the Change in Active Representatives. Change in Average Order may be impacted by a combination of factors such as inflation, units, product mix, and/or pricing. Non-GAAP Financial Measures To supplement our financial results presented in accordance with generally accepted accounting principles in the United States ("GAAP"), we disclose operating results that have been adjusted to exclude the impact of changes due to the translation of foreign currencies into U.S. dollars, including changes in: revenue, operating profit, Adjusted operating profit, operating margin and Adjusted operating margin. We also refer to these adjusted financial measures as Constant $ items, which are Non-GAAP financial measures. We believe these measures provide investors an additional perspective on trends and underlying business results. To exclude the impact of changes due to the translation of foreign currencies into U.S. dollars, we calculate current-year results and prior-year results at a constant exchange rate. Foreign currency impact is determined as the difference between actual growth rates and constant-currency growth rates. We also present gross margin, selling, general and administrative expenses as a percentage of revenue, total and net global expenses, operating profit, operating margin and effective tax rate on a Non-GAAP basis. The discussion of our segments presents operating profit and operating margin on a Non-GAAP basis. We refer to these Non-GAAP financial measures as "Adjusted." We have provided a quantitative reconciliation of the difference between the Non-GAAP financial measures and the most directly comparable financial measures calculated and reported in accordance with GAAP. The Company uses the Non-GAAP financial measures to evaluate its operating performance and believes that it is meaningful for investors to be made aware of, on a period-to-period basis, the impacts of 1) costs to implement ("CTI") restructuring initiatives, 2) costs and charges related to the devaluations of Venezuelan currency in February 2015, March 2014 and February 2013, combined with being designated as a highly inflationary economy, and a valuation allowance for deferred tax assets related to Venezuela ("Venezuelan special items"), 3) the $89 accrual recorded in 2013 for the settlements related to the Foreign Corrupt Practices Act ("FCPA") investigations, the additional $46 accrual in 2014 for the settlements related to the FCPA investigations and, in the fourth quarter of 2014, the associated approximate $19 net tax benefit ("FCPA accrual"), 4) the settlement charges associated with the U.S. pension plan ("Pension settlement charge"), 5) the goodwill impairment charge related to the Egypt business, and the goodwill and intangible asset impairment charges and a valuation allowance for deferred tax assets related to the China business ("Asset impairment and other charges"), 6) various other items associated with the sale of Liz Earle, the separation of the North America business and debt-related charges ("Other items") and, as it relates to our effective tax rate discussion, 7) the non-cash income tax adjustments associated with our deferred tax assets recorded in 2015 and 2014, and an income tax benefit realized as a result of tax planning strategies ("Special tax items"). The Company believes investors find the Non-GAAP information helpful in understanding the ongoing performance of operations separate from items that may have a disproportionate positive or negative impact on the Company's financial results in any particular period. These Non-GAAP measures should not be considered in isolation, or as a substitute for, or superior to, financial measures calculated in accordance with GAAP. The Venezuelan special items include the impact on the Consolidated Statements of Operations in 2015, 2014 and 2013 caused by the devaluations of Venezuelan currency on monetary assets and liabilities, such as cash, receivables and payables; deferred tax assets and liabilities; and non-monetary assets, such as inventories. For non-monetary assets, the Venezuelan special items include the earnings impact caused by the difference between the historical U.S. dollar cost of the assets at the previous exchange rate and the revised exchange rate. In 2015 and 2014, the Venezuelan special items also include adjustments of approximately $11 and approximately $116, respectively, to reflect certain non-monetary assets at their net realizable value. In 2015, the Venezuelan special items also include an impairment charge of approximately $90 to reflect the write-down of the long-lived assets to their estimated fair value. In 2013, the devaluation was as a result of the change in the official exchange rate, which moved from 4.30 to 6.30. In 2014, the devaluation was caused as a result of moving from the official exchange rate of 6.30 to the SICAD II exchange rate of approximately 50. In 2015, the devaluation was caused as a result of moving from the SICAD II exchange rate of approximately 50 to the SIMADI exchange rate of approximately 170. The Venezuelan special items also include the impact on the Consolidated Statements of Operations caused by a valuation allowance for deferred tax assets related to Venezuela recorded in the fourth quarter of 2013. The Pension settlement charge includes the impact on the Consolidated Statements of Operations in the third and fourth quarters of 2015 and the second, third and fourth quarters of 2014 associated with the payments made to former employees who were vested and participated in the U.S. defined benefit pension plan. Such payments fully settle our pension plan obligation to those participants who elected to receive such payment. The Asset impairment and other charges include the impact on the Consolidated Statements of Operations caused by the goodwill impairment charge related to the Egypt business in the fourth quarter of 2015. The Asset impairment and other charges also include the impact on the Consolidated Statements of Operations caused by the goodwill and intangible asset impairment charges and a valuation allowance for deferred tax assets related to the China business in 2013. The Other items include the impact during 2015 on the Consolidated Statements of Operations due to the gain on the sale of Liz Earle. The Other items also includes the impact on the Consolidated Statements of Operations in the fourth quarter of 2015 caused by transaction-related costs of $3.1 associated with the planned separation of the North America business that were included in continuing operations. In addition, Other items includes the impact on the Consolidated Statements of Operations of the loss on extinguishment of debt caused by the make-whole premium and the write-off of debt issuance costs and discounts associated with the prepayment of our 2.375% Notes (as defined below in "Liquidity and Capital Resources"). The Other items also include the impact on other expense, net in the Consolidated Statements of Operations of $2.5 associated with the write-off of issuance costs related to our previous $1 billion revolving credit facility. The Other items, in 2013, also include the impact on the Consolidated Statements of Operations caused by the make-whole premium and the write-off of debt issuance costs associated with the prepayment of our private notes issued in 2010, as well as the write-off of debt issuance costs associated with the early repayment of $380 of the outstanding principal amount of a term loan agreement. The Other items also include the impact on the Consolidated Statements of Operations in 2013 caused by the make-whole premium and the write-off of debt issuance costs and discounts, partially offset by a deferred gain associated with the January 2013 interest-rate swap agreement termination, associated with the prepayment of the notes due in 2014. In addition, the effective tax rate discussion includes Special tax items which include the impact during 2015 on income taxes in the Consolidated Statements of Operations due to a non-cash income tax charge in the first quarter of 2015 and a non-cash income tax benefit in the second quarter of 2015, each associated with valuation allowances, to adjust our U.S. deferred tax assets to an amount that was "more likely than not" to be realized. These adjustments were primarily caused by fluctuations of the U.S. dollar against currencies of some of our key markets. The Special tax items also include the impact during the third quarter of 2015 on income taxes in the Consolidated Statements of Operations due to a non-cash income tax charge as a result of establishing a valuation allowance for the full amount of our U.S. deferred tax assets due to the impact of the continued strengthening of the U.S. dollar against currencies of some of our key markets and its associated effect on our tax planning strategies. Additionally, the Special tax items includes the impact on income taxes in the Consolidated Statements of Operations due to a non-cash income tax charge associated with valuation allowances, to adjust certain non-U.S. deferred tax assets to an amount that is "more likely than not" to be realized. The non-U.S. valuation allowance included an adjustment associated with Russia, which was primarily the result of lower earnings, which were significantly impacted by foreign exchange losses on working capital balances. The Special tax items also include the impact during the fourth quarter of 2014 on the income taxes in the Consolidated Statements of Operations due to a non-cash income tax charge primarily associated with a valuation allowance to reduce our U.S. deferred tax assets to an amount that is "more likely than not" to be realized, and was primarily due to the strengthening of the U.S. dollar against currencies of some of our key markets and, to a lesser extent, the finalization of the FCPA settlements. The Special tax items also include the impact during the fourth quarter of 2015 on the income taxes in the Consolidated Statements of Operations due to an income tax benefit recognized as a result of the implementation of foreign tax planning strategies. See Note 14, Restructuring Initiatives on pages through of our 2015 Annual Report, "Results Of Operations - Consolidated" below, "Segment Review - Latin America" below, Note 1, Description of the Business and Summary of Significant Accounting Policies on pages through of our 2015 Annual Report, Note 15, Contingencies on pages through of our 2015 Annual Report, "Segment Review - Global and Other Expense" below, Note 11, Employee Benefit Plans on pages through of our 2015 Annual Report, Note 16, Goodwill and Intangible Assets on pages through of our 2015 Annual Report, Note 3, Discontinued Operations and Divestitures on pages through of our 2015 Annual Report, "Liquidity and Capital Resources" below, Note 5, Debt and Other Financing on pages through of our 2015 Annual Report, and Note 7, Income Taxes on pages through of our 2015 Annual Report for more information on these items. Critical Accounting Estimates We believe the accounting policies described below represent our critical accounting policies due to the estimation processes involved in each. See Note 1, Description of the Business and Summary of Significant Accounting Policies, on pages through of our 2015 Annual Report for a detailed discussion of the application of these and other accounting policies. Allowances for Doubtful Accounts Receivable Representatives contact their customers, selling primarily through the use of brochures for each sales campaign. Sales campaigns are generally for a three- to four-week duration. The Representative purchases products directly from us and may or may not sell them to an end user. In general, the Representative, an independent contractor, remits a payment to us during each sales campaign, which relates to the prior campaign cycle. The Representative is generally precluded from submitting an order for the current sales campaign until the accounts receivable balance for the prior campaign is paid; however, there are circumstances where the Representative fails to make the required payment. We record an estimate of an allowance for doubtful accounts on receivable balances based on an analysis of historical data and current circumstances, including seasonality and changing trends. Over the past three years, annual bad debt expense was $144 in 2015, $171 in 2014 and $209 in 2013, or approximately 2% of total revenue in each year. The allowance for doubtful accounts is reviewed for adequacy, at a minimum, on a quarterly basis. We generally have no detailed information concerning, or any communication with, any end user of our products beyond the Representative. We have no legal recourse against the end user for the collection of any accounts receivable balances due from the Representative to us. If the financial condition of our Representatives were to deteriorate, resulting in their inability to make payments, additional allowances may be required. Allowances for Sales Returns Policies and practices for product returns vary by jurisdiction, but within many jurisdictions, we generally allow an unlimited right of return. We record a provision for estimated sales returns based on historical experience with product returns. Over the past three years, annual sales returns were $191 for 2015, $241 for 2014 and $274 for 2013, or approximately 3% of total revenue in each year, which has been generally in line with our expectations. If the historical data we use to calculate these estimates does not approximate future returns, due to changes in marketing or promotional strategies, or for other reasons, additional allowances may be required. Provisions for Inventory Obsolescence We record an allowance for estimated obsolescence equal to the difference between the cost of inventory and the estimated market value. In determining the allowance for estimated obsolescence, we classify inventory into various categories based upon its stage in the product life cycle, future marketing sales plans and the disposition process. We assign a degree of obsolescence risk to products based on this classification to determine the level of obsolescence provision. If actual sales are less favorable than those projected, additional inventory allowances may need to be recorded for such additional obsolescence. Annual obsolescence expense was $45 in 2015, $78 in 2014 and $82 in 2013. Pension and Postretirement Expense We maintain defined benefit pension plans, which cover substantially all employees in the U.S. and a portion of employees in international locations. However, our U.S. defined benefit pension plan is closed to employees hired on or after January 1, 2015. Additionally, we have unfunded supplemental pension benefit plans for some current and retired executives and provide retiree health care benefits subject to certain limitations to many retired employees in the U.S. and certain foreign countries. See Note 11, Employee Benefit Plans on pages through of our 2015 Annual Report for more information on our benefit plans. Pension plan expense and the requirements for funding our major pension plans are determined based on a number of actuarial assumptions, which are generally reviewed and determined on an annual basis. These assumptions include the expected rate of return on pension plan assets, the interest crediting rate for hybrid plans and the discount rate applied to pension plan obligations, the rate of compensation increase of plan participants and mortality rates. We use a December 31 measurement date for all of our employee benefit plans. For 2015, the weighted average assumed rate of return on all pension plan assets, including the U.S. and non-U.S. defined benefit pension plans was 6.87%, as compared with 6.86% for 2014. In determining the long-term rates of return, we consider the nature of the plans’ investments, an expectation for the plans’ investment strategies, historical rates of return and current economic forecasts. We evaluate the expected long-term rate of return annually and adjust as necessary. As part of the separation of the North America business, we will transfer certain pension liabilities under the U.S. defined benefit pension plan associated with current and former employees of the North America business and certain other former Avon employees, along with a portion of the assets held by the U.S. defined benefit pension plan, to a defined benefit pension plan sponsored by the new privately-held company. We will also transfer certain other postretirement liabilities (namely, retiree medical and supplemental pension liabilities) in respect of such employees and former employees. We will continue to retain certain U.S. pension and other postretirement liabilities primarily associated with employees who are actively employed by Avon outside of the North America business. Prior to this separation, our net periodic benefit costs for the U.S. pension and postretirement benefit plans were allocated between Discontinued Operations and Global and Other Expenses as the plan includes both North America and U.S. Corporate Avon associates. In line with this allocation, our ongoing net periodic benefit costs within Global and Other Expenses are not expected to be materially impacted by the separation of the North America business. Beginning in 2014, we adopted an investment strategy for the U.S. defined benefit pension plan which is designed to match the movements in the pension liability through an increased allocation towards debt securities. In addition, we also have begun to utilize derivative instruments to achieve the desired market exposures or to hedge certain risks. Derivative instruments may include, but are not limited to, futures, options, swaps or swaptions. Investment types, including the use of derivatives are based on written guidelines established for each investment manager and monitored by the plan's investment committee. In 2015, similar investment strategies were implemented in some of our non-U.S. defined benefit pension plans. A significant portion of our pension plan assets relate to the U.S. defined benefit pension plan. The assumed rate of return for 2015 for the U.S. defined benefit pension plan was 7.25%, which was based on an asset allocation of approximately 70% in corporate and government bonds and mortgage-backed securities (which are expected to earn approximately 3% to 5% in the long-term) and approximately 30% in equity securities and high yield securities (which are expected to earn approximately 5% to 7% in the long term). In addition to the physical assets, the asset portfolio has derivative instruments which increase our exposure to higher yielding securities. Historical rates of return on the assets of the U.S. defined benefit pension plan were approximately 8% for the most recent 10-year period and approximately 8% for the 20-year period. In the U.S. defined benefit pension plan, our asset allocation policy has historically favored U.S. equity securities, which have returned approximately 7% over the 10-year period and approximately 8% over the 20-year period. The rate of return on the plan assets in the U.S. was approximately negative 3% in 2015 and approximately 11% in 2014. The discount rate used for determining the present value of future pension obligations for each individual plan is based on a review of bonds that receive a high-quality rating from a recognized rating agency. The discount rates for our more significant plans, including our U.S. defined benefit pension plan, were based on the internal rates of return for a portfolio of high-quality bonds with maturities that are consistent with the projected future benefit payment obligations of each plan. The weighted-average discount rate for U.S. and non-U.S. defined benefit pension plans determined on this basis was 3.92% at December 31, 2015, and 3.54% at December 31, 2014. For the determination of the expected rate of return on assets and the discount rate, we take external actuarial advice into consideration. Our funding requirements may be impacted by standards and regulations or interpretations thereof. Our calculations of pension and postretirement costs are dependent on the use of assumptions, including discount rates, hybrid plan maximum interest crediting rates and expected return on plan assets discussed above, rate of compensation increase of plan participants, interest cost, health care cost trend rates, benefits earned, mortality rates, the number of participants and certain demographics and other factors. Actual results that differ from assumptions are accumulated and amortized to expense over future periods and, therefore, generally affect recognized expense in future periods. At December 31, 2015, we had pretax actuarial losses and prior service credits totaling approximately $296 for the U.S. defined benefit pension and postretirement plans and approximately $238 for the non-U.S. defined benefit pension and postretirement plans that have not yet been charged to expense, of which approximately $247 of the U.S. defined benefit pension and postretirement plans are associated with discontinued operations. These actuarial losses have been charged to accumulated other comprehensive loss ("AOCI") within shareholders’ equity. While we believe that the assumptions used are reasonable, differences in actual experience or changes in assumptions may materially affect our pension and postretirement obligations and future expense. For 2016, our assumption for the expected rate of return on assets is 7.00% for our U.S. defined benefit pension plan and 6.40% for our non-U.S. defined benefit pension plans. Our assumptions are reviewed and determined on an annual basis. A 50 basis point change (in either direction) in the expected rate of return on plan assets, the discount rate or the rate of compensation increases, would have had approximately the following effect on 2015 pension expense and the pension benefit obligation at December 31, 2015: The above table reflects the entire U.S. pension and postretirement plans, a portion of which are associated with discontinued operations. Restructuring Reserves We record the estimated expense for our restructuring initiatives when such costs are deemed probable and estimable, when approved by the appropriate corporate authority and by accumulating detailed estimates of costs for such plans. These expenses include the estimated costs of employee severance and related benefits, impairment or accelerated depreciation of property, plant and equipment and capitalized software, and any other qualifying exit costs. These estimated costs are grouped by specific projects within the overall plan and are then monitored on a quarterly basis by finance personnel. Such costs represent our best estimate, but require assumptions about the programs that may change over time, including attrition rates. Estimates are evaluated periodically to determine whether an adjustment is required. Taxes We record a valuation allowance to reduce our deferred tax assets to an amount that is "more likely than not" to be realized. Evaluating the need for and quantifying the valuation allowance often requires significant judgment and extensive analysis of all the weighted positive and negative evidence available to the Company in order to determine whether all or some portion of the deferred tax assets will not be realized. In performing this analysis, the Company’s forecasted domestic and foreign taxable income, and the existence of potential prudent and feasible tax planning strategies that would enable the Company to utilize some or all of its excess foreign tax credits, were taken into consideration. At December 31, 2015, we had net deferred tax assets of $151 (net of valuation allowances of $1,972). With respect to our deferred tax assets, at December 31, 2015, we had recognized deferred tax assets relating to tax loss carryforwards of $657, primarily from foreign and U.S. state jurisdictions, for which a valuation allowance of $652 has been provided. Prior to December 31, 2015, we had recognized deferred tax assets of $746 relating to excess U.S. foreign tax and other U.S. general business credit carryforwards for which a valuation allowance of $746 has been provided. We have a history of domestic source losses, and our excess U.S. foreign tax and general business credits have primarily resulted from having a greater domestic source loss in recent years which reduces our ability to credit foreign taxes or utilize the general business credits which we generate. Our ability to realize our U.S. deferred tax assets, such as our foreign tax and general business credit carryforwards, is dependent on future U.S. taxable income within the carryforward period. At December 31, 2015, we would need to generate approximately $2.1 billion of excess net foreign source income in order to realize the U.S. foreign tax and general business credits before they expire. During the fourth quarter of 2014, the Company’s expected net foreign source income was reduced significantly, primarily due to the strengthening of the U.S. dollar against currencies for some of our key markets and, to a lesser extent, the finalization of the FCPA settlements. This strengthening of the U.S. dollar reduced the expected dividends and royalties that could be remitted to the U.S. by our foreign subsidiaries, particularly Russia, Brazil, Mexico and Colombia. The effectiveness of our tax planning strategies, including the repatriation of foreign earnings and the acceleration of royalties from our foreign subsidiaries, was also negatively impacted by the strengthening of the U.S. dollar. In addition, the finalization of the FCPA settlements, which included a $68 fine related to Avon China in connection with the DOJ settlement and $67 in disgorgement and prejudgment interest related to Avon Products, Inc. in connection with the SEC settlement, negatively impacted expected future repatriation of foreign earnings and reduced current U.S. taxable income, respectively. As a result of these developments, we determined that we may not generate sufficient taxable income to realize all of our U.S. deferred tax assets. As such, we recorded a valuation allowance of $441 to reduce our U.S. deferred tax assets to an amount that is "more likely than not" to be realized, of which $367 was recorded to income taxes in the Consolidated Statements of Operations and the remainder was recorded to various components of other comprehensive (loss) income. During the first and second quarters of 2015, the Company recorded a $31 charge and a $3 benefit, respectively, associated with valuation allowances, to adjust our U.S. deferred tax assets to an amount that was “more likely than not” to be realized. These adjustments were primarily caused by fluctuations of the U.S. dollar against currencies of some of our key markets. During the third quarter of 2015, we recorded an additional valuation allowance for the remaining U.S. deferred tax assets of $642. The increase in the valuation allowance resulted from reduced tax benefits expected to be obtained from tax planning strategies associated with an anticipated accelerated receipt in the U.S. of foreign source income. As the U.S. dollar had further strengthened against currencies of some of our key markets during the third quarter of 2015, the benefits associated with the Company’s tax planning strategies were no longer sufficient for the Company to continue to conclude that its tax planning strategies were prudent. In the absence of any alternative prudent tax planning strategies and other sources of future taxable income, it was determined that a full valuation allowance should be recorded. Although the Company continues to expect that it will generate taxable income and tax liability in the U.S., the Company is expected to offset its current and future tax liability with foreign tax credits, and as a result, the expected level of future taxable income and tax liability is not adequate to realize the benefit of previously recorded deferred tax assets. Although the Company may not be able to recognize a financial statement benefit associated with its deferred tax assets, the Company will continue to manage and plan for the utilization of its deferred tax assets to avoid the expiration of deferred tax assets that may have limited lives. At December 31, 2015, we continue to assert that our foreign earnings are not indefinitely reinvested, as a result of our domestic liquidity profile. Accordingly, we adjusted our deferred tax liability to account for our 2015 undistributed earnings of foreign subsidiaries and for the tax effect of earnings that were actually repatriated to the U.S. during the year. The net impact on the deferred tax liability associated with the Company’s undistributed earnings is an increase of $75, resulting in a deferred tax liability balance of $89 related to the incremental tax cost on $1.4 billion of undistributed foreign earnings at December 31, 2015. This deferred income tax liability amount is net of the estimated foreign tax credits that would be generated upon the repatriation of such earnings. The repatriation of foreign earnings may result in the utilization of a portion of our foreign tax credits in the year of repatriation; therefore, the utilization of foreign tax credits is dependent on the amount and timing of repatriations, as well as the jurisdictions involved. We have not included the undistributed earnings of our subsidiary in Venezuela in the calculation of this deferred income tax liability as local regulations restrict cash distributions denominated in U.S. dollars. In addition, in the fourth quarter of 2015, we recognized a benefit of approximately $19 associated with the implementation of foreign tax planning strategies. We completed the implementation of these tax planning strategies and expect to recognize an additional benefit of approximately $30 in the first quarter of 2016. With respect to our uncertain tax positions, we recognize the benefit of a tax position, if that position is more likely than not of being sustained on examination by the taxing authorities, based on the technical merits of the position. We believe that our assessment of more likely than not is reasonable, but because of the subjectivity involved and the unpredictable nature of the subject matter at issue, our assessment may prove ultimately to be incorrect, which could materially impact the Consolidated Financial Statements. We file income tax returns in the U.S. federal jurisdiction, and various state and foreign jurisdictions. In 2016, a number of open tax years are scheduled to close due to the expiration of the statute of limitations and it is possible that a number of tax examinations may be completed. If our tax positions are ultimately upheld or denied, it is possible that the 2016 provision for income taxes, as well as tax related cash receipts or payments, may be impacted. Loss Contingencies We determine whether to disclose and/or accrue for loss contingencies based on an assessment of whether the risk of loss is remote, reasonably possible or probable. We record loss contingencies when it is probable that a liability has been incurred and the amount of loss is reasonably estimable. Our assessment is developed in consultation with our outside counsel and other advisors and is based on an analysis of possible outcomes under various strategies. Loss contingency assumptions involve judgments that are inherently subjective and can involve matters that are in litigation, which, by its nature is unpredictable. We believe that our assessment of the probability of loss contingencies is reasonable, but because of the subjectivity involved and the unpredictable nature of the subject matter at issue, our assessment may prove ultimately to be incorrect, which could materially impact the Consolidated Financial Statements. Impairment of Assets Plant, Property and Equipment and Capitalized Software We evaluate our plant, property and equipment and capitalized software for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset group may not be recoverable. Recoverability of assets to be held and used is measured by a comparison of the carrying amount of an asset to estimated undiscounted future cash flows expected to be generated by the asset. If the carrying amount of an asset exceeds its estimated future cash flows, an impairment charge is recognized for the amount by which the carrying amount of the asset exceeds the fair value of the asset. In February 2015, we reviewed Avon Venezuela's long-lived assets to determine whether the carrying amount of the assets was recoverable. Based on our expected cash flows associated with the asset group, we determined that the carrying amount of the assets, carried at their historical U.S. dollar cost basis, was not recoverable. As such, an impairment charge of $90.3 to selling, general and administrative expenses was recorded to reflect the write-down of the long-lived assets to their estimated fair value of $15.7, which was recorded in the first quarter of 2015. The fair value of Avon Venezuela's long-lived assets was determined using both market and cost valuation approaches. The valuation analysis performed required several estimates, including market conditions and inflation rates. See Note 1, Description of the Business and Summary of Significant Accounting Policies on pages through of our 2015 Annual Report for more information on Avon Venezuela. Goodwill and Intangible Assets We test goodwill and intangible assets with indefinite lives for impairment annually, and more frequently if circumstances warrant, using various fair value methods. We review finite-lived intangible assets, which are subject to amortization, for impairment whenever events or changes in circumstances indicate that the related carrying amounts may not be recoverable. We completed our annual goodwill impairment assessment for 2015 and determined that the estimated fair values were considered substantially in excess of the carrying values of each of our reporting units, with the exception of our Egypt reporting unit (discussed below). The impairment analyses performed for goodwill and intangible assets require several estimates in computing the estimated fair value of a reporting unit, an indefinite-lived intangible asset, and a finite-lived intangible asset. As part of our goodwill impairment analysis, we typically use a discounted cash flow ("DCF") approach to estimate the fair value of a reporting unit, which we believe is the most reliable indicator of fair value of a business, and is most consistent with the approach that we would generally expect a market participant would use. In estimating the fair value of our reporting units utilizing a DCF approach, we typically forecast revenue and the resulting cash flows for periods of five to ten years and include an estimated terminal value at the end of the forecasted period. When determining the appropriate forecast period for the DCF approach, we consider the amount of time required before the reporting unit achieves what we consider a normalized, sustainable level of cash flows. The estimation of fair value utilizing a DCF approach includes numerous uncertainties which require significant judgment when making assumptions of expected growth rates and the selection of discount rates, as well as assumptions regarding general economic and business conditions, and the structure that would yield the highest economic value, among other factors. Egypt During the 2015 year-end close process, our analysis of the Egypt business indicated an impairment as the carrying value of the business exceeded the estimated fair value. This was primarily the result of reducing our long-term projections of the business. During 2015, Egypt performed generally in line with our revenue and earnings projections, which assumed growth as compared to 2014. However, as a result of currency restrictions for the payment of goods in Egypt, we lowered our long-term revenue and earnings projections for the business. Accordingly, a non-cash impairment charge of $6.9 was recorded to reduce the carrying amount of goodwill. There is no amount remaining associated with goodwill for our Egypt reporting unit as a result of this impairment charge. China During the first half of 2013, China performed generally in line with our revenue and earnings projections. As assumed in our projections, China's revenue in the first half of 2013 continued to deteriorate versus the prior-year period; however, beginning in the third quarter of 2013, this revenue decline was significantly in excess of our assumptions. As a result, in the third quarter of 2013, it became apparent that we would not achieve our 2013 and long-term forecasted revenue and earnings, and we completed an interim impairment assessment of the fair value of goodwill related to our operations in China. The revenue decline in China during the third quarter of 2013 resulted in the recognition of an operating loss while we had expected operating profit in our projections. In the third quarter of 2013, we significantly lowered our long-term revenue and earnings projections for China that was included in our DCF model utilized in our interim impairment assessment. As a result of our impairment testing, we recorded a non-cash impairment charge of $42.1 in the third quarter of 2013 to reduce the carrying amounts of goodwill and finite-lived intangible assets. There are no amounts remaining associated with goodwill or intangible assets for our China reporting unit as a result of this impairment charge. Key Assumptions - Egypt and China Key assumptions used in measuring the fair value of Egypt and China during these impairment assessments included projections of revenue and the resulting cash flows, as well as the discount rate (based on the estimated weighted-average cost of capital). To estimate the fair value of Egypt and China, we forecasted revenue and the resulting cash flows over five years and ten years, respectively, using a DCF model which included a terminal value at the end of the projection period. We believed that a five-year period and a ten-year period was a reasonable amount of time in order to return cash flows of Egypt and China, respectively, to normalized, sustainable levels. See Note 16, Goodwill and Intangible Assets on pages through of our 2015 Annual Report for more information on Egypt and China. Results Of Operations - Consolidated Amounts in the table above may not necessarily sum due to rounding. * Calculation not meaningful (1) Advertising expenses are included within selling, general and administrative expenses. (2) Selling, general and administrative expenses and Adjusted selling, general, and administrative expenses as a percentage of revenue, as well as operating margin and Adjusted operating margin, have been impacted as compared to amounts previously reported due to classifying North America within discontinued operations for all periods presented. Global expenses previously allocated to North America will remain in continuing operations, as these represent costs associated with functions of the Company's continuing operations. (3) Change in Constant $ Adjusted operating margin for all years presented is calculated using the current-year Constant $ rates. 2015 Compared to 2014 Revenue Total revenue in 2015 compared to 2014 declined 19% compared to the prior-year period, due to unfavorable foreign exchange. Constant $ revenue increased 2%. Constant $ revenue was negatively impacted by approximately 2 points due to taxes in Brazil from the combined impact of the recognition of VAT credits in 2014 which did not recur in 2015 along with a new IPI tax on cosmetics which went into effect in May 2015. Constant $ revenue was also negatively impacted by approximately 1 point as a result of the sale of Liz Earle which was completed in July 2015. Our Constant $ revenue benefited from growth in markets experiencing relatively high inflation (Venezuela and Argentina), which contributed approximately 2 points to our Constant $ revenue growth. Our Constant $ revenue also benefited from growth in Europe, Middle East & Africa, most significantly Eastern Europe (Russia and Ukraine), and to a lesser extent, South Africa and underlying growth in Brazil. Constant $ revenue benefited from higher average order and a 1% increase in Active Representatives. The increase in Active Representatives was primarily due to growth in Europe, Middle East & Africa, most significantly Russia, which was primarily due to sustained momentum in recruitment and retention, partially offset by markets experiencing relatively high inflation (Venezuela and Argentina). The net impact of price and mix increased 4%, driven by increases in all regions. The net impact of price and mix was primarily positively impacted by markets experiencing relatively high inflation (Venezuela and Argentina), as these markets benefited from the inflationary impact on pricing. Units sold decreased 2%, primarily due to declines in units sold in Brazil and Venezuela, partially offset by an increase in units sold in Russia. See "Segment Review" in this MD&A for additional information related to changes in revenue by segment and "Segment Review - Latin America" in this MD&A for a further discussion of the tax benefits in Brazil. On a category basis, our net sales and associated growth rates were as follows: Operating Margin Operating margin and Adjusted operating margin decreased 300 basis points and 360 basis points, respectively, compared to 2014. The decrease in Adjusted operating margin includes the benefits associated with the restructuring actions taken during 2015 and the $400M Cost Savings Initiative, primarily reductions in headcount, as well as other cost reductions. The decrease in operating margin and Adjusted operating margin are discussed further below in "Gross Margin," "Selling, General and Administrative Expenses" and "Impairment of Goodwill and Intangible Assets." Gross Margin Gross margin and Adjusted gross margin decreased 40 basis points and 150 basis points, respectively, compared to 2014. The gross margin comparison was impacted by a lower negative impact of the devaluation of the Venezuelan currency in conjunction with highly inflationary accounting, as approximately $29 was recognized in the current-year period as compared to approximately $121 in the prior-year period, primarily associated with adjustments to reflect certain non-monetary assets at their net realizable value. See "Segment Review - Latin America" in this MD&A for a further discussion of our Venezuela operations. The decrease of 150 basis points in Adjusted gross margin was primarily due to the following: • a decrease of approximately 270 basis points due to the unfavorable impact of foreign currency transaction losses and foreign currency translation; • a decrease of 40 basis points associated with the net impact of VAT credits in Brazil recognized in revenue in 2014 that did not recur in 2015; and • a decrease of 20 basis points as a result of the IPI tax law on cosmetics in Brazil that went into effect in May 2015. These items were partially offset by the following: • an increase of 130 basis points due to the favorable net impact of mix and pricing, primarily in Latin America, which includes the realization of price increases in markets experiencing relatively high inflation (Venezuela and Argentina); and • an increase of approximately 60 basis points due to lower supply chain costs, primarily in Europe, Middle East & Africa which was largely due to lower overhead costs. The negative impact of foreign currency transaction losses was partially mitigated by the benefits of pricing as we realized the impact of inflation in certain of our markets. See "Segment Review - Latin America" in this MD&A for a further discussion of the VAT credits and IPI tax law in Brazil. Selling, General and Administrative Expenses Selling, general and administrative expenses for 2015 decreased approximately $664 compared to 2014. This decrease is primarily due to the favorable impact of foreign currency translation, as the strengthening of the U.S. dollar against many of our foreign currencies resulted in lower reported selling, general and administrative expenses. The decrease in selling, general and administrative expenses is also due to the additional $46 accrual recorded in the first quarter of 2014 for the settlements related to the FCPA investigations and a lower amount of CTI restructuring. Partially offsetting the decrease in selling, general and administrative expenses was an approximate $90 impairment charge recorded in 2015 to reflect the write-down of the long-lived assets to their estimated fair value associated with the devaluation of the Venezuelan currency in conjunction with highly inflationary accounting, higher Representative, sales leader and field expense, higher foreign currency transaction costs and higher expenses associated with long-term employee incentive compensation plans as the prior-year period includes the benefit from the reversal of such accruals that did not recur in the current-year period. Selling, general and administrative expenses and Adjusted selling, general, and administrative expenses as a percentage of revenue increased 250 basis points and 220 basis points, respectively, compared to 2014. In the current-year period, selling, general and administrative expenses as a percentage of revenue was impacted by an approximate $90 impairment charge recorded in 2015 to reflect the write-down of the long-lived assets to their estimated fair value associated with the devaluation of the Venezuelan currency in conjunction with highly inflationary accounting, the approximate $7 aggregate settlement charges associated with the payments made to former employees who were vested and participated in the U.S. defined benefit pension plan, approximately $3 of transaction-related costs associated with the separation of North America that were included in continuing operations, and approximately $1 associated with our Venezuela operations for certain non-monetary assets carried at the historical U.S. dollar cost following the devaluation of the Venezuelan currency in conjunction with highly inflationary accounting. In the prior-year period, selling, general and administrative expenses as a percentage of revenue was impacted by the additional $46 accrual recorded in 2014 for the settlements related to the FCPA investigations that did not recur in 2015, approximately $16 associated with our Venezuela operations for certain non-monetary assets carried at the historical U.S. dollar cost following the devaluation of the Venezuelan currency in conjunction with highly inflationary accounting, and the approximate $10 aggregate settlement charges associated with the payments made to former employees who were vested and participated in the U.S. defined benefit pension plan. Additionally, the selling, general and administrative expenses as a percentage of revenue comparison was impacted by lower CTI restructuring as compared to the prior-year period. See "Segment Review - Latin America" in this MD&A and Note 1, Description of the Business and Summary of Significant Accounting Policies on pages through of our 2015 Annual Report for a further discussion of our Venezuela operations, Note 15, Contingencies on pages through of our 2015 Annual Report for more information on the FCPA investigations, "Segment Review - Global and Other Expenses" in this MD&A and Note 11, Employee Benefit Plans on pages through of our 2015 Annual Report for a further discussion of the pension settlement charges, and Note 14, Restructuring Initiatives on pages through of our 2015 Annual Report for more information on CTI restructuring. The increase of 220 basis points in Adjusted selling, general and administrative expenses as a percentage of revenue was primarily due to the following: • an increase of approximately 210 basis points due to the unfavorable impact of foreign currency translation and foreign currency transaction losses; • an increase of 60 basis points associated with the net impact of VAT credits in Brazil recognized in revenue in 2014 that did not recur in 2015; • an increase of 60 basis points as a result of the IPI tax law on cosmetics in Brazil, which reduced revenue as we did not raise the prices paid by Representatives to the same extent as the IPI tax; and • an increase of 40 basis points due to higher expenses associated with long-term employee incentive compensation plans as the prior-year period includes the benefit from the reversal of such accruals that did not recur in the current-year period. These items were partially offset by the following: • a decrease of 160 basis points primarily due to the impact of Constant $ revenue growth with respect to our fixed expenses. In addition, lower fixed expenses, primarily resulting from our cost savings initiatives, mainly reductions in headcount, were largely offset by the inflationary impact on our expenses. See "Segment Review - Latin America" in this MD&A for a further discussion of the VAT credits and IPI tax law in Brazil. Impairment of Goodwill and Intangible Assets During the fourth quarter of 2015, we recorded a non-cash impairment charge of approximately $7 for goodwill associated with our Egypt business. See Note 16, Goodwill and Intangible Assets on pages through of our 2015 Annual Report for more information on Egypt. See “Segment Review” in this MD&A for additional information related to changes in operating margin by segment. Other Expense Interest expense increased by approximately $12 compared to the prior-year period, primarily due to the increase in the interest rates on the 2013 Notes (defined below) as a result of the long-term credit rating downgrades. Interest income decreased by approximately $2 compared to the prior-year period. Loss on extinguishment of debt in 2015 was comprised of approximately $5 for the make-whole premium and approximately $1 for the write-off of debt issuance costs and discounts associated with the prepayment of our 2.375% Notes (as defined below in "Liquidity and Capital Resources"). Refer to Note 5, Debt and Other Financing on pages through of our 2015 Annual Report and "Liquidity and Capital Resources" in this MD&A for additional information. Other expense, net, decreased by approximately $66 compared to the prior-year period, primarily due to a less significant impact from the devaluation of the Venezuelan currency on monetary assets and liabilities in conjunction with highly inflationary accounting, as we recorded a benefit of approximately $4 in the first quarter of 2015 as compared to a loss of approximately $54 in the first quarter of 2014. In addition, the decrease in other expense, net was partially due to lower foreign exchange losses, which decreased by approximately $10 compared to the prior-year period. See "Segment Review - Latin America" in this MD&A for a further discussion of our Venezuela operations. Gain on sale of business in 2015 was the result of the sale of Liz Earle in July 2015. Refer to Note 3, Discontinued Operations and Divestitures on pages through of our 2015 Annual Report, for additional information regarding the sale of Liz Earle. Effective Tax Rate The effective tax rate in 2015 was negatively impacted by additional valuation allowances for U.S. deferred tax assets of approximately $670. The additional valuation allowances in 2015 were due to the continued strengthening of the U.S. dollar against currencies of some of our key markets and the impact on the benefits from our tax planning strategies associated with the realization of our deferred tax assets. In addition, the effective tax rate in 2015 was negatively impacted by additional valuation allowances for deferred tax assets outside of the U.S. of approximately $15, primarily in Russia, which was largely due to lower earnings, which were significantly impacted by foreign exchange losses on working capital balances. In addition, in the fourth quarter of 2015, we recognized a benefit of approximately $19 as a result of the implementation of foreign tax planning strategies. The additional valuation allowances for deferred tax assets in 2015 caused income taxes to be significantly in excess of income before taxes. The effective tax rate in 2014 was negatively impacted by a non-cash income tax charge of approximately $396. This was largely due to a valuation allowance, recorded in the fourth quarter of 2014, against deferred tax assets of approximately $375 which is primarily due to the strengthening of the U.S. dollar against currencies of some of our key markets. The approximate $375 includes the valuation allowance recorded for U.S. deferred tax assets of approximately $367, as well as approximately $8 associated with other foreign subsidiaries. In addition, the effective tax rates in 2015 and 2014 were negatively impacted by the devaluations of the Venezuelan currency in conjunction with highly inflationary accounting discussed further within "Segment Review - Latin America" in this MD&A. See Note 7, Income Taxes on pages through of our 2015 Annual Report, for more information. The Adjusted effective tax rate in 2015 was negatively impacted by the country mix of earnings and the inability to recognize additional deferred tax assets in various jurisdictions related to our current-year operating results. The Adjusted effective tax rate in 2014 was negatively impacted by an adjustment to the carrying value of our state deferred tax balances due to changes in the expected tax rate, valuation allowances for deferred taxes, including the impact of legislative changes, and out-of-period adjustments of approximately $6 recorded in the fourth quarter of 2014. Discontinued Operations Loss from discontinued operations, net of tax was $349 compared to a loss of $40 for 2014. During 2015, we recorded a charge of approximately $340 before tax ($340 after tax) associated with the estimated loss on the sale of the North America business that is expected to be completed in 2016. In addition, the North America operations achieved higher operating income in 2015 as compared with 2014 despite lower revenues as a result of significant cost savings, as well as lower costs to implement restructuring initiatives. The estimated loss on sale was comprised of the following: See Note 3, Discontinued Operations and Divestitures on pages through of our 2015 Annual Report for a further discussion of the pension settlement charges. Impact of Foreign Currency During 2015, foreign currency had a significant impact on our financial results. Specifically, as compared to the prior-year period, foreign currency has impacted our consolidated financial results as a result of: • foreign currency transaction losses (classified within cost of sales, and selling, general and administrative expenses), which had an unfavorable impact to Adjusted operating profit of an estimated $210, or approximately 280 points to Adjusted operating margin; • foreign currency translation, which had an unfavorable impact to Adjusted operating profit of approximately $265 (of which approximately $90 related to Venezuela), or approximately 200 points to Adjusted operating margin; and • lower foreign exchange losses (classified within other expense, net), which had a favorable impact of approximately $10 before tax. 2014 Compared to 2013 Revenue Total revenue in 2014 declined 10% compared to the prior-year period, due to unfavorable foreign exchange. Constant $ revenue increased 3%, and benefited by approximately 1 point due to the net impact of certain tax benefits in Brazil. In 2014 and 2013, we recognized tax credits in Brazil of approximately $85 and approximately $29, respectively, primarily associated with a change in estimate of expected recoveries of VAT. See "Segment Review - Latin America" in this MD&A for a further discussion of the tax benefits in Brazil. Constant $ revenue benefited from higher average order, which was partially offset by a 4% decrease in Active Representatives. The net impact of price and mix increased 5%, as pricing benefited from inflationary impacts in Latin America, primarily in Argentina and Venezuela, while units sold decreased 2%. During 2014, our Constant $ revenue benefited from net growth in Latin America and Europe, Middle East & Africa, which was partially offset by a net decline in Asia Pacific. Constant $ revenue growth in Latin America was primarily driven by Venezuela largely due to inflationary pricing, which was partially offset by declines in Mexico. Constant $ revenue growth in Europe, Middle East & Africa was driven by South Africa and the United Kingdom, which was partially offset by revenue declines in Russia and Turkey. Constant $ revenue in Russia was negatively impacted by a difficult economy, including the impact of geopolitical uncertainties, and its decline in the first half of 2014 was partially offset by Constant $ revenue growth in the second half of 2014 driven by actions to improve unit sales. In Asia Pacific, Constant $ revenue declined as compared to 2013 as growth in the Philippines was more than offset by declines in the other Asia Pacific markets. See "Segment Review" in this MD&A for additional information related to changes in revenue by segment. On a category basis, our net sales and associated growth rates were as follows: Operating Margin Operating margin and Adjusted operating margin decreased 70 basis points and increased 20 basis points, respectively, compared to 2013. The increase in Adjusted operating margin includes the benefits associated with the $400M Cost Savings Initiative, primarily reductions in headcount, as well as other cost reductions. The decrease in operating margin and increase in Adjusted operating margin are discussed further below in "Gross Margin," "Selling, General and Administrative Expenses" and "Impairment of Goodwill and Intangible Assets." Gross Margin Gross margin and Adjusted gross margin decreased 200 basis points and 90 basis points, respectively, compared to 2013. The gross margin comparison was largely impacted by an adjustment of approximately $116 associated with our Venezuela operations to reflect certain non-monetary assets at their net realizable value, which was recorded in the first quarter of 2014. Partially offsetting the decrease in gross margin was a lower negative impact of the devaluation of the Venezuelan currency in conjunction with highly inflationary accounting, as approximately $5 was recognized in the current-year period as compared to approximately $45 in the prior-year period associated with carrying certain non-monetary assets at the historical U.S. dollar cost following a devaluation. See "Segment Review - Latin America" in this MD&A for a further discussion of our Venezuela operations. The decrease of 90 basis points in Adjusted gross margin was primarily due to the following: • a decrease of approximately 140 basis points due to the unfavorable impact of foreign currency transaction losses and foreign currency translation, driven by Europe, Middle East & Africa and Latin America; and • an increase of 80 basis points due to the favorable net impact of mix and pricing, primarily in Latin America, which includes the realization of price increases in markets experiencing relatively high inflation (Venezuela and Argentina). Selling, General and Administrative Expenses Selling, general and administrative expenses for 2014 decreased approximately $535 compared to 2013. This decrease is primarily due to the favorable impact of foreign currency translation, as the strengthening of the U.S. dollar against many of our foreign currencies resulted in lower reported selling, general and administrative expenses. The decrease in selling, general and administrative expenses is also due to the $89 accrual for the settlements relating to the FCPA investigations recorded in 2013, lower expenses related to our Service Model Transformation ("SMT") project as a result of our decision to halt the further roll-out beyond the pilot market of Canada in the fourth quarter of 2013, lower professional and related fees associated with the FCPA investigation and compliance reviews and lower bad debt expense. Partially offsetting the decrease in selling, general and administrative expenses was the additional $46 accrual recorded in the first quarter of 2014 for the settlements related to the FCPA investigations and a higher amount of CTI restructuring primarily associated with the $400M Cost Savings Initiative. Selling, general and administrative expenses and Adjusted selling, general and administrative expenses as a percentage of revenue decreased 80 basis points and 120 basis points, respectively, compared to 2013. The selling, general and administrative expenses as a percentage of revenue comparison was impacted by a higher amount of CTI restructuring as compared to the prior-year period. Additionally, in the current-year period, selling, general and administrative expenses as a percentage of revenue was impacted by the additional $46 accrual recorded in the first quarter of 2014 for the settlements related to the FCPA investigations, approximately $16 associated with our Venezuela operations for certain non-monetary assets carried at the historical U.S. dollar cost following a devaluation, and the approximate $10 aggregate settlement charges recorded in 2014 associated with the payments made to former employees who were vested and participated in the U.S. defined benefit pension plan. In the prior-year period, selling, general and administrative expenses as a percentage of revenue was impacted by the $89 accrual for the settlements relating to the FCPA investigations and $5 associated with our Venezuela operations for certain non-monetary assets carried at the historical U.S. dollar cost following a devaluation. See Note 14, Restructuring Initiatives on pages through of our 2015 Annual Report for more information on CTI restructuring, Note 1, Description of the Business and Summary of Significant Accounting Policies on pages through of our 2015 Annual Report for more information on SMT, Note 15, Contingencies on pages through of our 2015 Annual Report for more information on the FCPA investigations, "Segment Review - Global and Other Expenses" in this MD&A and Note 11, Employee Benefit Plans on pages through of our 2015 Annual Report for a further discussion of the pension settlement charges and "Segment Review - Latin America" in this MD&A for a further discussion of our Venezuela operations. The decrease of 120 basis points in Adjusted selling, general and administrative expenses as a percentage of revenue was primarily due to the following: • a decrease of 80 basis points from lower expenses related to our SMT project as a result of our decision to halt the further roll-out beyond the pilot market of Canada in the fourth quarter of 2013; • a decrease of 50 basis points primarily due to the impact of Constant $ revenue growth with respect to our fixed expenses. In addition, lower fixed expenses, primarily resulting from our cost savings initiatives, mainly reductions in headcount, were largely offset by the inflationary impact on our expenses; • a decrease of 30 basis points as a result of the net impact of the incremental tax credits in Brazil recognized as revenue in 2014 and 2013; • a decrease of 30 basis points from lower Representative and sales leader expense, primarily in Latin America; • a decrease of 30 basis points from lower bad debt expense; and • a decrease of 30 basis points from lower professional and related fees associated with the FCPA investigation and compliance reviews. These items were partially offset by the following: • an increase of approximately 100 basis points due to the unfavorable impact of foreign currency translation and foreign currency transaction losses. See "Segment Review - Latin America" in this MD&A for a further discussion of the tax credits in Brazil. Impairment of Goodwill and Intangible Assets During the third quarter of 2013, we recorded a non-cash impairment charge of approximately $42 for goodwill and intangible assets associated with our China business. See Note 16, Goodwill and Intangible Assets on pages through of our 2015 Annual Report for more information on China. See “Segment Review” in this MD&A for additional information related to changes in operating margin by segment. Other Expense Interest expense decreased by approximately $9 compared to the prior-year period, primarily due to lower outstanding debt balances partially offset by higher average interest rates. Loss on extinguishment of debt in 2013 is comprised of approximately $71 for the make-whole premium and the write-off of debt issuance costs associated with the prepayment of our private notes issued in 2010 and approximately $2 for the write-off of debt issuance costs associated with the early repayment of the $380 of outstanding principal amount of a term loan agreement, which occurred in the first quarter of 2013. In addition, in the second quarter of 2013, we recorded a loss on extinguishment of debt of approximately $13 for the make-whole premium and the write-off of debt issuance costs, partially offset by a deferred gain associated with the January 2013 interest-rate swap agreement termination, associated with the prepayment of notes due in 2014. See Note 5, Debt and Other Financing on pages through of our 2015 Annual Report, and "Liquidity and Capital Resources" in this MD&A for more information. Interest income decreased by approximately $11 compared to the prior-year period, primarily impacted by $12 for interest income that benefited the fourth quarter of 2013, due to an out-of-period adjustment related to judicial deposits in Brazil. Other expense, net, increased by approximately $56 compared to the prior-year period, primarily due to higher foreign exchange losses. Foreign exchange losses increased by approximately $41 compared to the prior-year period, with the most significant impact due to the weakening of the Russian ruble. In addition, the increase in other expense, net was also due to a more significant impact, approximately $54 in 2014 as compared to approximately $34 in 2013, from the devaluations of the Venezuelan currency on monetary assets and liabilities in conjunction with highly inflationary accounting. See "Segment Review - Latin America" in this MD&A for a further discussion of our Venezuela operations. Effective Tax Rate The effective tax rate in 2014 was negatively impacted by a non-cash income tax charge of approximately $396. This was largely due to a valuation allowance, recorded in the fourth quarter of 2014, for deferred tax assets of approximately $375 which is primarily due to the strengthening of the U.S. dollar against currencies of some of our key markets. The approximate $375 includes the valuation allowance recorded for U.S. deferred tax assets of approximately $367, as well as approximately $8 associated with other foreign subsidiaries. The effective tax rates in 2014 and 2013 were impacted by the devaluation of the Venezuelan currency in conjunction with highly inflationary accounting discussed further within "Segment Review - Latin America" in this MD&A. The effective tax rate in 2013 was also negatively impacted by the $89 accrual for the settlements related to the FCPA investigations, the non-cash impairment charges for goodwill and intangible assets associated with our China business of approximately $42, a valuation allowance for deferred tax assets related to China of approximately $9, and a valuation allowance for deferred tax assets related to Venezuela in the fourth quarter of approximately $42. See Note 7, Income Taxes on pages through of our 2015 Annual Report, for more information. The Adjusted effective tax rate for 2014 negatively impacted by an adjustment to the carrying value of our state deferred tax balances due to changes in the expected tax rate, valuation allowances for deferred taxes, including the impact of legislative changes, and an out-of-period adjustment of approximately $6 recorded in the fourth quarter of 2014. Discontinued Operations Loss from discontinued operations, net of tax was $40 compared to a loss of $119 for 2013. During 2013, we recorded a non-cash impairment charge of approximately $117 ($74 after tax) for capitalized software related to SMT and a charge of approximately $79 ($50 after tax) associated with our Silpada jewelry business which was sold in July 2013. The North America Avon operations achieved lower operating income in 2014 as compared with 2013 due to lower revenues, higher costs to implement restructuring initiatives and settlement charges associated with the U.S. pension plan. These were partially offset by significant cost savings from our North America Avon business as compared to 2013. See Note 3, Discontinued Operations and Divestitures on pages through and "Segment Review - Global and Other Expenses" in this MD&A and Note 11, Employee Benefit Plans on pages through of our 2015 Annual Report for a further discussion of the pension settlement charges. Other Comprehensive Income (Loss) Other comprehensive income (loss), net of taxes was approximately ($151) in 2015 compared with approximately ($348) in 2014, primarily due to net actuarial gains of approximately $41 in 2015 as compared with net actuarial losses of approximately $187 in 2014. In 2015, net actuarial gains benefited from higher discount rates for the non-U.S. and U.S. pension plans, partially offset by lower asset returns in the non-U.S. and U.S. pension plans in 2015 as compared to 2014. The other comprehensive income (loss) year-over-year comparison was also unfavorably impacted by foreign currency translation adjustments, which increased by approximately $27 as compared to 2014 primarily due to unfavorable movements of the Brazilian real, partially offset by the year-over-year comparison of movements of the Polish zloty and Russian ruble. Other comprehensive income (loss), net of taxes was approximately ($348) in 2014 compared with approximately $5 in 2013, primarily due to net actuarial losses of approximately $187 in 2014 as compared with net actuarial gains of approximately $81 in 2013. In 2014, net actuarial losses were negatively impacted by lower discount rates for the non-U.S. and U.S. pension plans and updated mortality rates for the U.S. pension plan, partially offset by higher asset returns in the non-U.S. and U.S. pension plans in 2014 as compared to 2013. The other comprehensive income (loss) year-over-year comparison was also unfavorably impacted by foreign currency translation adjustments, as well as higher amortization of net actuarial loss which was driven by the settlement charges associated with the U.S. pension plan. In 2014, foreign currency translation adjustments were negatively impacted by approximately $136 as compared to 2013 primarily due to unfavorable movements of the Polish zloty, the British pound, the Colombian peso and the Mexican peso. See Note 11, Employee Benefit Plans on pages through of our 2015 Annual Report for more information. Segment Review Below is an analysis of the key factors affecting revenue and operating profit (loss) by reportable segment for each of the years in the three-year period ended December 31, 2015: Latin America - 2015 Compared to 2014 Amounts in the table above may not necessarily sum due to rounding. Total revenue decreased 23% compared to the prior-year period, due to the unfavorable impact from foreign exchange which was primarily driven by the strengthening of the U.S. dollar relative to the Brazilian real and the Venezuelan currency devaluation. See below for further discussion regarding the impact of the Venezuelan currency devaluation. On a Constant $ basis, revenue increased 1%, despite the growth rate being negatively impacted by approximately 5 points due to taxes in Brazil from the combined impact of the recognition of VAT credits in 2014 along with a new IPI tax on cosmetics in 2015. Specifically, during 2014, we recognized $85 in Brazil for expected VAT recoveries which did not recur in 2015, and as such, there was an approximate 2 point negative impact on the region’s Constant $ growth rate. In addition, an IPI tax law on cosmetics in Brazil went into effect in May 2015 and has caused an estimated 3 point negative impact on the region's Constant $ revenue growth. Further, the markets experiencing relatively high inflation (Venezuela and Argentina) contributed approximately 5 points to the region's Constant $ revenue growth. The region's Constant $ revenue growth benefited from higher average order, which was partially offset by a decrease in Active Representatives. The region's higher average order was positively impacted by markets experiencing relatively high inflation (Venezuela and Argentina), as these markets benefited from the inflationary impact on pricing, while Active Representatives was negatively impacted by these markets. Average order was negatively impacted by the taxes in Brazil. Revenue in Brazil decreased 34%, unfavorably impacted by foreign exchange, or decreased 8% on a Constant $ basis. Revenue in Mexico declined 15%, unfavorably impacted by foreign exchange, or increased 2% on a Constant $ basis, primarily due to higher average order. Brazil’s Constant $ revenue decline of 8% was negatively impacted by approximately 10 points due to the combined impact of the VAT credits in 2014 and the IPI tax in 2015 discussed above. The negative impact of these tax items were partially offset by an increase in Active Representatives. On a Constant $ basis, Brazil’s sales from Beauty products decreased 5%, negatively impacted by the IPI tax. This negative impact on Beauty sales was partially offset by increased sales of fragrance, which benefited from our alliance with Coty, as well as from new product launches during the first quarter of 2015. The IPI tax also negatively impacted Brazil's Beauty units, as we increased prices to partially offset the new tax. On a Constant $ basis, Brazil's sales from Fashion & Home products increased 1%. Brazil continues to be impacted by a difficult economic environment as well as high levels of competition. Operating margin was negatively impacted by .5 points as compared to the prior-year period due to the Venezuelan special items in conjunction with highly inflationary accounting as discussed further below. Operating margin also benefited by .6 points as compared to the prior-year period from lower CTI restructuring. Adjusted operating margin decreased 3.6 points, or 1.8 points on a Constant $ basis, primarily as a result of: • a decline of 1.9 points associated with the net impact of VAT credits in Brazil recognized in revenue in 2014, discussed above; • a decline of 1.4 points as a result of the IPI tax law on cosmetics in Brazil, which reduced revenue as we did not raise the prices paid by Representatives to the same extent as the IPI tax; • a net benefit of 1.2 points primarily due to the impact of Constant $ revenue growth with respect to our fixed expenses. This includes a reduction of corporate expenses, which are allocated from Global, partially offset by the inflationary impact on our expenses; and • gross margin benefited only slightly compared to the prior year period, as 2.1 points from the favorable net impact of mix and pricing, which includes the realization of price increases in markets experiencing relatively high inflation (Venezuela and Argentina) was largely offset by 2.0 points from the unfavorable impact of foreign currency transaction losses. Venezuela Discussion Currency restrictions enacted by the Venezuelan government since 2003 have impacted the ability of Avon Venezuela to obtain foreign currency to pay for imported products. Since 2010, we have been accounting for our operations in Venezuela under accounting guidance associated with highly inflationary economies. Under U.S. GAAP, the financial statements of a foreign entity operating in a highly inflationary economy are required to be remeasured as if the functional currency is the company’s reporting currency, the U.S. dollar. This generally results in translation adjustments, caused by changes in the exchange rate, being reported in earnings currently for monetary assets (e.g., cash, accounts receivable) and liabilities (e.g., accounts payable, accrued expenses) and requires that different procedures be used to translate non-monetary assets (e.g., inventories, fixed assets). Non-monetary assets and liabilities are remeasured at the historical U.S. dollar cost basis. This diverges significantly from the application of accounting rules prior to designation as highly inflationary accounting, where such gains and losses would have been recognized only in accumulated other comprehensive income (loss) (shareholders' equity). With respect to our 2013 results, effective February 13, 2013, the official exchange rate moved from 4.30 to 6.30, a devaluation of approximately 32%. As a result of the change in the official rate to 6.30, we recorded an after-tax loss of approximately $51 (approximately $34 in other expense, net, and approximately $17 in income taxes) in the first quarter of 2013, primarily reflecting the write-down of monetary assets and liabilities and deferred tax benefits. Additionally, certain non-monetary assets are carried at their historical U.S. dollar cost subsequent to the devaluation. Therefore, these costs will impact the income statement during 2015 at a disproportionate rate as they were not devalued based on the new exchange rates, but were expensed at their historical U.S. dollar value. As a result of using the historical U.S. dollar cost basis of non-monetary assets, such as inventories, these assets continued to be remeasured, following the devaluation, at the applicable rate at the time of their acquisition. As a result, we recognized an additional negative impact of approximately $45 to operating profit and net income relating to these non-monetary assets in the first, second, third and fourth quarters of 2013. In March 2013, the Venezuelan government announced a foreign exchange system that increased government control over the allocation of U.S. dollars in the country, referred to as the SICAD I exchange ("SICAD I"). In February 2014, the Venezuelan government announced a foreign exchange system which began operating on March 24, 2014, referred to as the SICAD II exchange ("SICAD II"). While liquidity was limited through the SICAD II market, in comparison to the other available exchange rates (the official rate and SICAD I rate), it represented the rate which better reflected the economics of Avon Venezuela's business activity. Accordingly, we concluded that we should utilize the SICAD II exchange rate to remeasure our Venezuelan operations effective March 31, 2014. With respect to our 2014 results, at March 31, 2014, the SICAD II exchange rate was approximately 50, as compared to the official exchange rate of 6.30 that we used previously, which caused the recognition of a devaluation of approximately 88%. As a result of our change to the SICAD II rate, we recorded an after-tax loss of approximately $42 (approximately $54 in other expense, net, and a benefit of approximately $12 in income taxes) in the first quarter of 2014, primarily reflecting the write-down of monetary assets and liabilities. As a result of using the historical U.S. dollar cost basis of non-monetary assets, such as inventories, these assets continued to be remeasured, following the change to the SICAD II rate, at the applicable rate at the time of acquisition. As a result, we determined that an adjustment of approximately $116 to cost of sales was needed to reflect certain non-monetary assets at their net realizable value, which was recorded in the first quarter of 2014. We recognized an additional negative impact of approximately $21 to operating profit and net income relating to these non-monetary assets in the second, third and fourth quarters of 2014. In February 2015, the Venezuelan government announced that the SICAD II market would no longer be available, and a new foreign exchange system was created, referred to as the SIMADI exchange ("SIMADI"). SIMADI began operating on February 12, 2015. The SICAD I and SICAD II markets merged to create a single foreign exchange system, referred to as the SICAD exchange ("SICAD"). At December 31, 2015, the SICAD exchange rate was approximately 13. The exchange rates established through the SIMADI market fluctuate and have been significantly higher than both the official rate and SICAD rate. In March 2015, we began to access the SIMADI market and have been able to obtain only limited U.S. dollars. While liquidity is limited through the SIMADI market, in comparison to the other available exchange rates (the official rate and SICAD rate), it represents the rate which better reflects the economics of Avon Venezuela's business activity. Accordingly, we concluded that we should utilize the SIMADI exchange rate to remeasure our Venezuelan operations effective February 12, 2015. At February 12, 2015, the SIMADI exchange rate was approximately 170, as compared to the SICAD II exchange rate of approximately 50 that we used previously, which caused the recognition of a devaluation of approximately 70%. As a result of our change to the SIMADI rate, we recorded an after-tax benefit of approximately $3 (a benefit of approximately $4 in other expense, net, and a loss of approximately $1 in income taxes) in the first quarter of 2015, primarily reflecting the write-down of monetary assets and liabilities. Additionally, certain non-monetary assets are carried at their historical U.S. dollar cost subsequent to the devaluation. Therefore, these costs will impact the income statement during 2015 at a disproportionate rate as they were not devalued based on the new exchange rates, but were expensed at their historical U.S. dollar value. As a result of using the historical U.S. dollar cost basis of non-monetary assets, such as inventories, these assets continued to be remeasured, following the change to the SIMADI rate, at the applicable rate at the time of their acquisition. As a result, we determined that an adjustment of approximately $11 to cost of sales was needed to reflect certain non-monetary assets at their net realizable value, which was recorded in the first quarter of 2015. We recognized an additional negative impact of approximately $19 to operating profit and net income relating to these non-monetary assets in the first, second, third and fourth quarters of 2015. In addition, in February 2015, we reviewed Avon Venezuela's long-lived assets to determine whether the carrying amount of the assets was recoverable. Based on our expected cash flows associated with the asset group, we determined that the carrying amount of the assets, carried at their historical U.S. dollar cost basis, was not recoverable. As such, an impairment charge of approximately $90 to selling, general and administrative expenses was recorded to reflect the write-down of the long-lived assets to estimated fair value of approximately $16, which was recorded in the first quarter of 2015. Further devaluations or regulatory actions may further impair the carrying value of Avon Venezuela's long-lived assets. At December 31, 2015, the SIMADI exchange rate was approximately 200. During 2015, Avon Venezuela (using an average exchange rate which included SICAD II exchange rates in the first part of the first quarter and SIMADI exchange rates in the latter part of the first quarter and the entire second, third and fourth quarters) represented less than 1% of Avon’s consolidated revenue and less than 3% of Avon’s consolidated Adjusted operating profit. While the rate in the SIMADI market will vary, the ongoing impacts primarily related to the remeasurement of Avon Venezuela's financial statements are not expected to have a material impact on Avon's consolidated results. The Company continuously monitors factors such as our ability to access and transact in the various exchange mechanisms currently in place, the political and economic environment in Venezuela and our ability to effectively make key operational decisions in regard to its Venezuela operations. If the Company is unable to make key operational decisions regarding its business in Venezuela, on an ongoing basis, the Company may conclude that it should deconsolidate its operations in Venezuela. At December 31, 2015, we had a net asset position in Avon Venezuela of approximately $33 and accumulated foreign currency translation adjustments within accumulated other comprehensive income (loss) (shareholders' equity) associated with foreign currency movements before Venezuela was accounted for as a highly inflationary economy of approximately $81. Argentina Discussion In 2011, the Argentine government introduced restrictive foreign currency exchange controls. In December 2015, the Argentine government began the process of removing foreign currency exchange controls; however, some uncertainty exists regarding the foreign currency exchange controls in the future. Unless foreign exchange is made more readily available, Avon Argentina's operations may be negatively impacted. At December 31, 2015, we had a net asset position of approximately $92 associated with our operations in Argentina, including cash of approximately $48. During 2015, Avon Argentina represented approximately 7% of Avon’s consolidated revenue and approximately 18% of Avon’s consolidated Adjusted operating profit. Also in late December 2015, the exchange rate in Argentina was devalued by approximately 25%, from approximately 10 to approximately 13 at December 31, 2015. Avon Argentina's 2015 results were not materially impacted by this devaluation as it occurred late in the year. As of December 31, 2015, we did not account for Argentina as a highly inflationary economy, and as a result, this devaluation did not negatively impact earnings with respect to Argentina's monetary and non-monetary assets. Latin America - 2014 Compared to 2013 Amounts in the table above may not necessarily sum due to rounding. Total revenue decreased 12% compared to the prior-year period due to the unfavorable impact from foreign exchange. On a Constant $ basis, revenue grew 5%. The region's revenue growth benefited by approximately 1 point due to the net impact of certain tax benefits in Brazil. In addition, higher average order was partially offset by a decrease in Active Representatives. Average order benefited from pricing, including inflationary impacts, primarily in Venezuela. Revenue in Venezuela and Mexico declined 55% and 9%, respectively, which were unfavorably impacted by foreign exchange, and Constant $ revenue in Venezuela and Mexico increased 45% and declined 6%, respectively. Revenue in Brazil declined 5%, which was unfavorably impacted by foreign exchange, and Constant $ revenue in Brazil increased 3%. Brazil's revenue benefited by approximately 3 points as a result of the net impact of certain tax benefits. In 2014, our Constant $ revenue growth and Constant $ operating profit growth were not impacted by the use of the SICAD II exchange rate as we applied the exchange rate of 6.30 to current and prior periods for our Venezuela operations in order to determine Constant $ growth. If we had used an exchange rate of 50 (which is a rate more reflective of the SICAD II rate) for our Venezuela operations for the year ended December 31, 2014, the region's Constant $ revenue would have been an increase of 1% from the prior-year period, the region's Constant $ Adjusted operating margin would have been a decrease of .8 points from the prior-year period, and Avon's consolidated Constant $ revenue decline would have been a decrease of 2% from the prior-year period. As we update our Constant $ rates on an annual basis, we utilized a rate of approximately 50 in our Constant $ financial performance beginning with our 2015 results. See below for further discussion regarding the impact of the Venezuelan currency devaluation. Brazil's Constant $ revenue benefited by approximately 3 points due to the net benefit of larger tax credits recognized in 2014 as compared to the benefit and tax credits recognized in 2013. In 2014 and 2013, we recognized tax credits in Brazil of approximately $85 and approximately $29, respectively, primarily associated with a change in estimate of expected recoveries of VAT. Of the VAT credits recognized in 2014, approximately $13 were out-of-period adjustments. As the tax credits are associated with VAT, which is recorded as a reduction to revenue, the benefit from these VAT credits is recognized as revenue. Brazil's Active Representatives and average order were relatively unchanged from the prior-year period. On a Constant $ basis, Brazil’s sales from both Beauty and Fashion & Home products were relatively unchanged. Mexico's Constant $ revenue decline was primarily due to a decrease in Active Representatives, partially offset by higher average order. Constant $ revenue growth in Venezuela was primarily due to higher average order, partially offset by a decrease in Active Representatives. Venezuela's average order benefited from the inflationary impact on pricing that was partially offset by a decrease in units sold. Venezuela's Active Representatives and units sold were negatively impacted by the reduced size of our product offering, primarily the result of our increased difficulty to import products and raw materials. Additional information on our Venezuela operations is discussed in more detail above. Operating margin was negatively impacted by 2.2 points as compared to the prior-year period due to the Venezuelan special items in conjunction with highly inflationary accounting as discussed further above. Operating margin was also negatively impacted by .4 points as compared to the prior-year period from higher CTI restructuring. Adjusted operating margin decreased .6 points, or increased .1 points on a Constant $ basis, primarily as a result of: • a benefit of 1.1 points from lower Representative, sales leader and field expense, which was primarily attributable to a shift towards more cost-effective incentives; • a benefit of 1.0 point associated with the net impact of the incremental tax credits in Brazil recognized as revenue in 2014 and 2013, discussed above; • a benefit of .3 points from lower net brochure costs, driven by Venezuela as a result of cost savings initiatives; • a decline of .8 points due to lower gross margin caused primarily by 1.4 points from the unfavorable impact of foreign currency transaction losses, primarily in Venezuela, and .9 points from higher supply chain costs, which was driven by higher obsolescence primarily in Venezuela and Brazil. These items were partially offset by 1.8 points from the favorable net impact of mix and pricing. Benefits from pricing include the realization of price increases in markets experiencing relatively high inflation (Venezuela and Argentina) on inventory acquired in advance of such inflation; • a decline of .8 points from higher distribution expenses, driven by inflation in Venezuela and Argentina and other cost pressures in the region; and • a decline of .7 points from higher administrative expenses, partially driven by inflationary costs, and increased legal expenses associated with labor and civil related matters in Brazil. Europe, Middle East & Africa - 2015 Compared to 2014 Amounts in the table above may not necessarily sum due to rounding. Total revenue decreased 16% compared to the prior-year period, due to the unfavorable impact from foreign exchange including the strengthening of the U.S. dollar relative to the Russian ruble, and to a lesser extent, due to the sale of Liz Earle. On a Constant $ basis, revenue grew 6%, primarily driven by Eastern Europe. The region's Constant $ revenue was negatively impacted by approximately 2 points as a result of the sale of Liz Earle. An increase in Active Representatives drove the region's Constant $ revenue growth. In Russia, revenue declined 23%, which was unfavorably impacted by foreign exchange. On a Constant $ basis, Russia's revenue grew 23%, primarily due to an increase in Active Representatives which benefited from sustained momentum in recruiting and retention, and higher average order. In the United Kingdom, revenue declined 12%, which was unfavorably impacted by foreign exchange. On a Constant $ basis, the United Kingdom's revenue declined 5%, primarily due to a decrease in Active Representatives. In Turkey, revenue declined 15%, which was unfavorably impacted by foreign exchange. On a Constant $ basis, Turkey's revenue grew 5%. In South Africa, revenue grew 1%, which was unfavorably impacted by foreign exchange. On a Constant $ basis, South Africa’s revenue grew 19%, primarily due to an increase in Active Representatives and higher average order. Operating margin was negatively impacted by .3 points as compared to the prior-year period due to the impact of a non-cash goodwill impairment charge associated with our Egypt business during 2015. The non-cash goodwill impairment charge in the fourth quarter of 2015 was recorded based on our annual impairment analysis. See Note 16, Goodwill and Intangible Assets on pages through of our 2015 Annual Report for more information on Egypt. Operating margin benefited by .7 points as compared to the prior-year period from lower CTI restructuring. Adjusted operating margin decreased 2.0 points, or .7 points on a Constant $ basis, primarily as a result of: • a decline of 2.4 points due to lower gross margin caused primarily by an estimated 4 points from the unfavorable impact of foreign currency transaction losses, partially offset by approximately 1.2 points from lower supply chain costs and .8 points from the favorable net impact of mix and pricing. Supply chain costs benefited primarily as a result of lower overhead costs which were attributable to increased productivity. The favorable net impact of mix and pricing was primarily driven by Eastern Europe; • a decline of .6 points from higher Representative, sales leader and field expense; and • a net benefit of 2.0 points primarily due to the Constant $ revenue growth with respect to our fixed expenses and a reduction of corporate expenses, which are allocated from Global. Europe, Middle East & Africa - 2014 Compared to 2013 Amounts in the table above may not necessarily sum due to rounding. Total revenue decreased 7% compared to the prior-year period, due to the unfavorable impact from foreign exchange. On a Constant $ basis, revenue grew 1%. The region's Constant $ revenue was negatively impacted by approximately 1 point as a result of the closure of the France business. In Russia, revenue declined 18%, which was unfavorably impacted by foreign exchange. On a Constant $ basis, Russia's revenue declined 1%, primarily due to a decrease in Active Representatives, partially offset by higher average order. Russia was negatively impacted by a difficult economy, including the impact of geopolitical uncertainties. Russia's Constant $ revenue decline in the first half of 2014 was partially offset by Constant $ revenue growth in the second half of 2014, driven by actions to improve unit sales. In the United Kingdom, revenue increased 6%, which was favorably impacted by foreign exchange. On a Constant $ basis, the United Kingdom's revenue increased 1%, primarily due to higher average order, partially offset by a decrease in Active Representatives. In Turkey, revenue declined 14%, which was unfavorably impacted by foreign exchange. On a Constant $ basis, Turkey's revenue declined 2%, primarily due to lower average order. In South Africa, revenue declined 3%, which was unfavorably impacted by foreign exchange. On a Constant $ basis, South Africa’s revenue increased 8%, primarily due to an increase in Active Representatives. Operating margin was negatively impacted by .3 points as compared to the prior-year period from higher CTI restructuring. Adjusted operating margin decreased 2.6 points, or 2.4 points on a Constant $ basis, primarily as a result of a decline of 2.2 points due to lower gross margin caused primarily by an estimated 3 points from the unfavorable impact of foreign currency transaction losses, partially offset by 1.0 point from lower supply chain costs. Asia Pacific - 2015 Compared to 2014 * Calculation not meaningful Amounts in the table above may not necessarily sum due to rounding. Total revenue decreased 11% compared to the prior-year period, primarily due to the unfavorable impact from foreign exchange. On a Constant $ basis, revenue decreased 5%, as growth in the Philippines was more than offset by declines in other Asia Pacific markets, led by China which declined 29%, or 28% on a Constant $ basis. The region's Constant $ revenue decline was due to lower average order, primarily driven by declines in China, and a decrease in Active Representatives. Revenue in the Philippines increased 3%, or 5% on a Constant $ basis, primarily due to higher average order, as a result of strength in Fashion & Home, and an increase in Active Representatives. Operating margin was negatively impacted by .4 points as compared to the prior-year period from higher CTI restructuring. Adjusted operating margin increased 3.0 points, or 3.3 points on a Constant $ basis, primarily as a result of: • a net benefit of 2.5 points primarily due to lower fixed expenses, which primarily resulted from our cost savings initiatives, mainly reductions in headcount, and to a lesser extent, a reduction of corporate expenses, which are allocated from Global. Partially offsetting the lower fixed expenses was the unfavorable impact of declining revenue with respect to our fixed expenses; and • a benefit of .9 points due to lower advertising spend. Asia Pacific - 2014 Compared to 2013 *Calculation not meaningful Amounts in the table above may not necessarily sum due to rounding. Total revenue decreased 7% compared to the prior-year period, partially due to the unfavorable impact from foreign exchange. On a Constant $ basis, revenue decreased 4%, as an increase in the Philippines was more than offset by declines in the other Asia Pacific markets. Constant $ revenue was also impacted by a decrease in Active Representatives, partially offset by higher average order. Revenue in the Philippines declined 2%, which was unfavorably impacted by foreign exchange. On a Constant $ basis, revenue in the Philippines increased 3%, as higher average order was partially offset by a decrease in Active Representatives. Revenue in China declined 10% on both a reported and Constant $ basis, primarily due to a decline in the number of beauty boutiques. The decline in the number of beauty boutiques negatively impacted unit sales, but was partially offset by actions taken during the second half of 2013 which were intended to reduce inventory levels held by the beauty boutiques that did not recur in 2014. Operating margin benefited by 5.6 points as compared to the prior-year period due to the impact of non-cash goodwill and intangible asset impairment charges associated with our China business during 2013. The non-cash goodwill and intangible asset impairment charge in the third quarter of 2013 was recorded based on an interim impairment analysis, which was completed as a result of the significant lowering of our long-term revenue and earnings projections for China and the decline in revenue performance in China in the third quarter of 2013, which was significantly in excess of our expectations. See Note 16, Goodwill and Intangible Assets on pages through of our 2015 Annual Report for more information on China. Operating margin was negatively impacted by .6 points as compared to the prior-year period from higher CTI restructuring. Adjusted operating margin decreased .3 points, or increased .1 point on a Constant $ basis, primarily as a result of: • a benefit of 1.3 points from lower bad debt expense, primarily as our 2013 results included an adjustment associated with prior periods in the Philippines; • a net benefit of .9 points due to lower fixed expenses, which was partially offset by the unfavorable impact of declining revenue with respect to our fixed expenses. Lower fixed expenses primarily resulted from our cost savings initiatives, mainly reductions in headcount that were associated with the $400M Cost Savings Initiative; • a decline of 1.2 points due to lower gross margin caused primarily by .7 points from the unfavorable net impact of pricing and mix primarily driven by the Philippines largely due to unit driving offers, and .6 points from the unfavorable impact of foreign currency transaction losses; and • a decline of .9 points due to higher advertising spend, primarily in China to support product re-launches. Global and Other Expenses Global and other expenses include, among other things, costs related to our executive and administrative offices, information technology, research and development, and marketing, costs in connection with the ongoing compliance with the deferred prosecution agreement (the "DPA") and the consent to settlement (the "Consent"), prior professional and related fees associated with the FCPA investigations and compliance reviews, the prior accrual for the settlements related to the FCPA investigations, and settlement charges associated with the U.S. defined benefit pension plan. We allocate certain planned global expenses to our business segments primarily based on planned revenue. The unallocated costs remain as Global and other expenses. We do not allocate to our segments costs of implementing restructuring initiatives related to our global functions, costs in connection with the ongoing compliance with the DPA and the Consent, prior professional and related fees associated with the FCPA investigations and compliance reviews, the prior accrual for the settlements related to the FCPA investigations, and settlement charges associated with the U.S. defined benefit pension plan. Costs of implementing restructuring initiatives related to a specific segment are recorded within that segment. (1) Net global expenses represents total global expenses less amounts allocated to segments. Amounts in the table above may not necessarily sum due to rounding. As a result of its classification within discontinued operations, amounts allocated to segments have been reduced by amounts that were previously allocated to North America for all periods presented, as these represent costs associated with functions of the Company's continuing operations. 2015 Compared to 2014 The comparability of total global expenses was impacted by the $46 accrual for the settlements related to the FCPA investigations which was recorded in 2014 and lower settlement charges associated with the U.S. defined benefit pension plan in 2015, partially offset by higher CTI restructuring and transaction-related costs associated with the separation of North America that were included in continuing operations. See below for a further discussion of the settlement charges. Adjusted total global expenses decreased compared to the prior-year period primarily as a result of cost savings initiatives, partially offset by higher expenses associated with long-term employee incentive compensation plans as the prior-year period includes the benefit from the reversal of such accruals that did not recur in the current-year period. Amounts allocated to segments decreased compared to the prior-year period primarily due to lower planned corporate expenses, primarily as a result of our cost savings initiatives. As a result of the lump-sum payments made to former employees who were vested and participated in the U.S. defined benefit pension plan, in the third quarter of 2015, we recorded a settlement charge of approximately $24. These lump sum payments were made from our plan assets and were not the result of a specific offer to participants of our U.S. defined benefit pension plan as described below. As the settlement threshold was exceeded in the third quarter of 2015, a settlement charge of approximately $4 was also recorded in the fourth quarter of 2015, as a result of additional payments from our U.S. defined benefit pension plan. These settlement charges were allocated between Global Expenses and Discontinued Operations. In an effort to reduce our pension benefit obligations, in March 2014, we offered former employees who were vested and participated in the U.S. defined benefit pension plan a payment that would fully settle our pension plan obligation to those participants who elected to receive such payment. The election period ended during the second quarter of 2014 and the payments were made in June 2014 from our plan assets. As a result of the lump-sum payments made, in the second quarter of 2014, we recorded a settlement charge of approximately $24. As the settlement threshold was exceeded in the second quarter of 2014, settlement charges of approximately $5 and approximately $7 were also recorded in the third and fourth quarters of 2014, respectively, as a result of additional payments from our U.S. defined benefit pension plan. These settlement charges were allocated between Global Expenses and Discontinued Operations. 2014 Compared to 2013 The comparability of total global expenses was impacted by the $89 accrual for the settlements related to the FCPA investigations which was recorded in 2013, partially offset by the additional $46 accrual for the settlements related to the FCPA investigations and settlement charges associated with the U.S. defined benefit pension plan (discussed above) which were recorded in 2014 and higher CTI restructuring. Adjusted total global expenses decreased compared to the prior-year period primarily as a result of cost savings initiatives, including lower expenses related to our SMT project, and to a lesser extent, lower marketing expenses. In addition, professional and related fees associated with the FCPA investigations and compliance reviews decreased compared to the prior-year period. Professional and related fees associated with the FCPA investigations and compliance reviews amounted to approximately $7 in 2014, as compared to approximately $28 in 2013. These fees were not allocated to the segments. Although the FCPA investigations and compliance reviews are now complete and we have reached settlements with the government, we incur costs related to the ongoing compliance with the DPA and Consent. With respect to the global expenses discussion above, for all years presented, please see Risk Factors on pages 10 through 11 of our 2015 Annual Report, and Note 15, Contingencies on pages through of our 2015 Annual Report for more information regarding the FCPA settlements, and other related matters, including our expectations with respect to future costs related to the ongoing compliance with the DPA and Consent, including the monitor and self-reporting obligations undertaken pursuant to the settlements. Liquidity and Capital Resources Our principal sources of funding historically have been cash flows from operations, public offerings of notes, bank financings, borrowings under lines of credit, issuance of commercial paper and a private placement of notes. At December 31, 2015, we had cash and cash equivalents totaling approximately $687. We believe that our sources of funding will be sufficient to satisfy our currently anticipated cash requirements through at least the next twelve months. For more information with respect to foreign currency restrictions, see "Segment Review - Latin America" in this MD&A above, and for more information regarding risks with respect to these foreign currency restrictions, see "Risk Factors - We are subject to financial risks related to our international operations, including exposure to foreign currency fluctuations and the impact of foreign currency restrictions" included in Item 1A on pages 8 through 20 of our 2015 Annual Report. We may seek to repurchase our equity or to retire our outstanding debt in open market purchases, privately negotiated transactions, through derivative instruments or otherwise. Repurchases of equity and debt may be funded by the incurrence of additional debt or the issuance of equity (including shares of preferred stock) or convertible securities and will depend on prevailing market conditions, our liquidity requirements, contractual restrictions and other factors, and the amounts involved may be material. We may also elect to incur additional debt or issue equity (including shares of preferred stock) or convertible securities to finance ongoing operations or to meet our other liquidity needs. Any issuances of equity (including shares of preferred stock) or convertible securities could have a dilutive effect on the ownership interest of our current shareholders and may adversely impact earnings per share in future periods. Our credit ratings were downgraded in 2014 and 2015, which may impact our access to these transactions on favorable terms, if at all. For more information see "Risk Factors - Our credit ratings were downgraded in 2015, which could limit our access to financing, affect the market price of our financing and increase financing costs. A further downgrade in our credit ratings may adversely affect our access to liquidity." "Risk Factors - Our indebtedness could adversely affect us by reducing our flexibility to respond to changing business and economic conditions," and "Risk Factors - A general economic downturn, a recession globally or in one or more of our geographic regions or markets or sudden disruption in business conditions or other challenges may adversely affect our business, our access to liquidity and capital, and our credit ratings" included in Item 1A on pages 8 through 20 of our 2015 Annual Report. Our liquidity could also be negatively impacted by restructuring initiatives, dividends, capital expenditures, acquisitions, and certain contingencies, including any legal or regulatory settlements, described more fully in Note 15, Contingencies on pages through of our 2015 Annual Report. See our Cautionary Statement for purposes of the "Safe Harbor" Statement under the Private Securities Litigation Reform Act of 1995 on pages 1 through 2 of our 2015 Annual Report. Balance Sheet Data Cash Flows Net Cash from Continuing Operating Activities Net cash provided by continuing operating activities during 2015 was approximately $198 lower than during 2014. The approximate $198 decrease to net cash provided by continuing operating activities was primarily due to lower cash-related earnings, which were impacted by the unfavorable impact of foreign currency translation. Lower operating tax payments (such as VAT), primarily in Brazil, and lower payments for employee incentive compensation in 2015 as compared to 2014, partially offset these items. Net cash provided by continuing operating activities during 2014 was approximately $182 lower than during 2013. The approximate $182 decrease to net cash provided by continuing operating activities was primarily due to lower cash-related earnings, which was impacted by the unfavorable impact of foreign currency translation, the $68 fine paid in connection with the FCPA settlement with the DOJ and higher payments for employee incentive compensation. These unfavorable impacts to the year-over-year comparison of cash from operating activities were partially offset by the benefit due to the timing of accounts payable, primarily for inventory purchases. In addition, operating cash flow during 2013 was unfavorably impacted by payments for the make-whole premiums of approximately $90 in connection with the prepayment of debt and an approximate $25 contribution to the United Kingdom pension plan as a result of our decision to freeze the plan, both of which did not recur in 2014. We maintain defined benefit pension plans and unfunded supplemental pension benefit plans (see Note 11, Employee Benefit Plans on pages through of our 2015 Annual Report). Our funding policy for these plans is based on legal requirements and available cash flows. The amounts necessary to fund future obligations under these plans could vary depending on estimated assumptions (as detailed in "Critical Accounting Estimates - Pension and Postretirement Expense" in this MD&A). The future funding for these plans will depend on economic conditions, employee demographics, mortality rates, the number of associates electing to take lump-sum distributions, investment performance and funding decisions. Based on current assumptions, we expect to make contributions in the range of $25 to $30 to our U.S. defined benefit pension and postretirement plans and in the range of $20 to $25 to our non-U.S. defined benefit pension and postretirement plans during 2016. Net Cash from Continuing Investing Activities Net cash provided by continuing investing activities during 2015 was approximately $143, as compared to net cash used of $101 during 2014. The approximate $243 increase to net cash provided (used) by continuing investing activities was primarily due to the net proceeds on the sale of Liz Earle of approximately $208, which was partially offset by lower capital expenditures. Net cash used by continuing investing activities during 2014 was approximately $101, as compared to $191 during 2013. The approximate $90 decrease to net cash used by continuing investing activities was primarily due to lower capital expenditures. Capital expenditures during 2015 were approximately $92 compared with approximately $126 during 2014. Capital expenditures during 2014 were approximately $126 compared with approximately $190 during 2013, driven by the decision to halt the further roll-out of SMT beyond Canada in the fourth quarter of 2013. Capital expenditures in 2016 are currently expected to be in the range of $115 to $135 and are expected to be funded by cash from operations. Net Cash from Continuing Financing Activities Net cash used by continuing financing activities was approximately $431 during 2015 compared to approximately $209 during 2014 primarily due to the prepayment of $250 principal amount of our 2.375% Notes (as defined below) in the third quarter of 2015, partially offset by the repayment of the remaining $53 outstanding principal amount of a term loan agreement in the second quarter of 2014. See Note 5, Debt and Other Financing on pages through of our 2015 Annual Report for more information. Net cash used by continuing financing activities was approximately $209 during 2014 compared to approximately $469 during 2013. This was primarily due to the significant financing transactions in 2013, partially offset by the repayment of the remaining approximate $53 outstanding principal amount of a term loan agreement in the second quarter of 2014. The 2013 transactions included the prepayment of $535 principal amount of private notes, the prepayment of $500 principal amount of notes due in 2014, the repayment of $498 of the outstanding principal amount of the term loan agreement (as defined below), the scheduled repayment of $250 principal amount of the 4.80% Notes, due March 1, 2013, and the scheduled repayment of $125 principal amount of the 4.625% Notes, due May 15, 2013, which were partially offset by the proceeds of $1.5 billion related to issuance of the 2013 Notes (as defined below) and proceeds of $88 related to the termination of interest-rate swap agreements designated as fair value hedges. See Note 5, Debt and Other Financing on pages through of our 2015 Annual Report, and Note 8, Financial Instruments and Risk Management on pages through of our 2015 Annual Report for more information. We purchased approximately .3 million shares of our common stock for $3.1 during 2015, as compared to .7 million shares of our common stock for $9.8 during 2014 and .5 million shares for $9.4 during 2013, through repurchases by the Company in connection with employee elections to use shares to pay withholding taxes upon the vesting of their restricted stock units, and in 2014 and 2013, also through private transactions with a broker in connection with stock based obligations under our Deferred Compensation Plan. We maintained a quarterly dividend of $.06 per share for 2015, which was equivalent to our quarterly dividends in both 2014 and 2013. We suspended the dividend effective in the first quarter of 2016. Debt and Contractual Financial Obligations and Commitments At December 31, 2015, our debt and contractual financial obligations and commitments by due dates were as follows: (1) Amounts are based on our current long-term credit ratings. See Note 5, Debt and Other Financing on pages through of our 2015 Annual Report for more information. (2) Amounts are net of expected sublease rental income. See Note 13, Leases and Commitments on page of our 2015 Annual Report for more information. (3) Amounts represent expected future benefit payments for our unfunded defined benefit pension and postretirement benefit plans, as well as expected contributions for 2016 to our funded defined benefit pension benefit plans. We are not able to estimate our contributions to our funded defined benefit pension and postretirement plans beyond 2016. (4) The amount of debt and contractual financial obligations and commitments excludes amounts due under derivative transactions. The table also excludes information on non-binding purchase orders of inventory. The table does not include any reserves for uncertain income tax positions because we are unable to reasonably predict the ultimate amount or timing of settlement of these uncertain income tax positions. At December 31, 2015, our reserves for uncertain income tax positions, including interest and penalties, totaled $39.0. See Note 5, Debt and Other Financing, and Note 13, Leases and Commitments, on pages through, and on page, respectively, of our 2015 Annual Report for more information on our debt and contractual financial obligations and commitments. Additionally, as disclosed in Note 14, Restructuring Initiatives on pages through of our 2015 Annual Report, at December 31, 2015, we have liabilities of $21.4 associated with our Transformation Plan, $4.0 associated with various restructuring initiatives during 2015 and $6.2 associated with our $400M Cost Savings Initiative. The majority of future cash payments associated with these restructuring liabilities are expected to be made during 2016. Off Balance Sheet Arrangements At December 31, 2015, we had no material off-balance-sheet arrangements. Capital Resources Revolving Credit Facility In June 2015, the Company and Avon International Operations, Inc., a wholly-owned domestic subsidiary of the Company (“AIO”), entered into a new five-year $400.0 senior secured revolving credit facility (the “2015 revolving credit facility”). The Company terminated its previous $1 billion unsecured revolving credit facility (the “2013 revolving credit facility”) in June 2015 prior to its scheduled expiration in March 2017. There were no amounts drawn under the 2013 revolving credit facility on the date of termination and no early termination penalties were incurred. In the second quarter of 2015, $2.5 was recorded for the write-off of issuance costs related to the 2013 revolving credit facility. Borrowings under the 2015 revolving credit facility bear interest, at our option, at a rate per annum equal to LIBOR plus 250 basis points or a floating base rate plus 150 basis points, in each case subject to adjustment based upon a leverage-based pricing grid. The 2015 revolving credit facility may be used for general corporate purposes. As of December 31, 2015, there were no amounts outstanding under the 2015 revolving credit facility. All obligations of AIO under the 2015 revolving credit facility are (i) unconditionally guaranteed by each material domestic restricted subsidiary of the Company (other than AIO, the borrower), in each case, subject to certain exceptions and (ii) guaranteed on a limited recourse basis by the Company. The obligations of AIO and the guarantors are secured by first priority liens on and security interest in substantially all of the assets of AIO and the subsidiary guarantors and by certain assets of the Company, in each case, subject to certain exceptions. The 2015 revolving credit facility will terminate in June 2020; provided, however, that it shall terminate on the 91st day prior to the maturity of the 2018 Notes (as defined below), the 4.20% Notes (as defined below), the 2019 Notes (as defined below) and the 4.60% Notes (as defined below), if on such 91st day, the applicable notes are not redeemed, repaid, discharged, defeased or otherwise refinanced in full. The 2015 revolving credit facility contains affirmative and negative covenants, which are customary for financings of this type, including, among other things, limits on the ability of the Company, AIO or any restricted subsidiary to, subject to certain exceptions, incur liens, incur debt, make restricted payments, make investments or merge, consolidate or dispose of all or substantially all its assets. In addition, the 2015 revolving credit facility contains customary events of default and cross-default provisions, as well as financial covenants (interest coverage and total leverage ratios). As of December 31, 2015, we were in compliance with our interest coverage and total leverage ratios under the 2015 revolving credit facility, and based on then applicable interest rates, the entire $400.0 2015 revolving credit facility could have been drawn down without violating any covenant. Public Notes In March 2013, we issued, in a public offering, $250.0 principal amount of 2.375% Notes due March 15, 2016 (the "2.375% Notes"), $500.0 principal amount of 4.60% Notes due March 15, 2020 (the "4.60% Notes"), $500.0 principal amount of 5.00% Notes due March 15, 2023 (the "5.00% Notes") and $250.0 principal amount of 6.95% Notes due March 15, 2043 (the "6.95% Notes") (collectively, the "2013 Notes"). The net proceeds from these 2013 Notes were used to repay outstanding debt. Interest on the 2013 Notes is payable semi-annually on March 15 and September 15 of each year. On August 10, 2015, we prepaid our 2.375% Notes at a prepayment price equal to 100% of the principal amount of $250.0, plus accrued interest of $3.1 and a make-whole premium of $5.0. In connection with the prepayment of our 2.375% Notes, we incurred a loss on extinguishment of debt of $5.5 in the third quarter of 2015 consisting of the $5.0 make-whole premium for the 2.375% Notes and the write-off of $.5 of debt issuance costs and discounts related to the initial issuance of the 2.375% Notes. The indenture governing the 2013 Notes contains interest rate adjustment provisions depending on the long-term credit ratings assigned to the 2013 Notes with S&P and Moody's. As described in the indenture, the interest rates on the 2013 Notes increase by .25% for each one-notch downgrade below investment grade on each of our long-term credit ratings assigned to the 2013 Notes by S&P or Moody's. These adjustments are limited to a total increase of 2% above the respective interest rates in effect on the date of issuance of the 2013 Notes. As a result of the long-term credit rating downgrades by S&P in November 2014 to BB+, in February 2015 to BB and in June 2015 to B+, and by Moody's in October 2014 to Ba1 and in May 2015 to Ba3 for senior unsecured debt, the interest rates on the 2013 Notes have increased by 1.75%, of which .75% was effective as of March 15, 2015 and 1.0% was effective as of September 15, 2015. At December 31, 2015, we also had outstanding $250.0 principal amount of our 5.75% Notes due March 1, 2018 (the "2018 Notes"), $250.0 principal amount of our 4.20% Notes due July 15, 2018 (the "4.20% Notes") and $350.0 principal amount of our 6.50% Notes due March 1, 2019 (the "2019 Notes"), with interest on each series of these Notes payable semi-annually. The indentures governing our outstanding notes described above contain certain covenants, including limitations on the incurrence of liens and restrictions on the incurrence of sale/leaseback transactions and transactions involving a merger, consolidation or sale of substantially all of our assets. In addition, these indentures contain customary events of default and cross-default provisions. Further, we would be required to make an offer to repurchase all of our outstanding notes described above, with the exception of our 4.20% Notes, at a price equal to 101% of their aggregate principal amount plus accrued and unpaid interest in the event of a change in control involving Avon and a corresponding credit ratings downgrade to below investment grade. Long-Term Credit Ratings Our long-term credit ratings are Ba2 (Negative Outlook) for corporate family debt, and Ba3 (Negative Outlook) for senior unsecured debt, with Moody's; B+ (Stable Outlook) with S&P; and B+ (Negative Outlook) with Fitch, which are below investment grade. We do not believe these long-term credit ratings will have a material impact on our near-term liquidity. However, any rating agency reviews could result in a change in outlook or downgrade, which could further limit our access to new financing, particularly short-term financing, reduce our flexibility with respect to working capital needs, affect the market price of some or all of our outstanding debt securities, and likely result in an increase in financing costs, including interest expense under certain of our debt instruments, and less favorable covenants and financial terms under our financing arrangements. For more information, see "Risk Factors - A general economic downturn, a recession globally or in one or more of our geographic regions or markets or sudden disruption in business conditions or other challenges may adversely affect our business, our access to liquidity and capital, and our credit ratings," "Risk Factors - Our credit ratings were downgraded in 2015, which could limit our access to financing, affect the market price of our financing and increase financing costs. A further downgrade in our credit ratings may adversely affect our access to liquidity," and "Risk Factors - Our indebtedness could adversely affect us by reducing our flexibility to respond to changing business and economic conditions" included in Item 1A on pages 8 through 20 of our 2015 Annual Report. Please also see Note 5, Debt and Other Financing on pages through of our 2015 Annual Report for more information relating to our debt and the maturities thereof.

<s>[INST] You should read the following discussion of the results of operations and financial condition of Avon Products, Inc. and its majority and wholly owned subsidiaries in conjunction with the information contained in the Consolidated Financial Statements and related Notes contained in our 2015 Annual Report. When used in this discussion, the terms "Avon," "Company," "we," "our" or "us" mean, unless the context otherwise indicates, Avon Products, Inc. and its majority and wholly owned subsidiaries. See "NonGAAP Financial Measures" on pages 29 through 31 of this MD&A for a description of how Constant dollar ("Constant $") growth rates (a NonGAAP financial measure) are determined. Overview We are a global manufacturer and marketer of beauty and related products. Our business is conducted primarily in the directselling channel. During 2015, we had sales operations in 57 countries and territories, and distributed products in 15 more. In addition, in our North America business (which has been presented as discontinued operations) we had sales operations in 3 countries and territories, and distributed our products in 27 other countries and territories. Our reportable segments are based on geographic operations and include commercial business units in Latin America; Europe, Middle East & Africa; and Asia Pacific. In addition, we operate our business in North America, which has been presented as discontinued operations for all periods presented and is discussed further below. Our product categories are Beauty and Fashion & Home. Beauty consists of skincare (which includes personal care), fragrance and color (cosmetics). Fashion & Home consists of fashion jewelry, watches, apparel, footwear, accessories, gift and decorative products, housewares, entertainment and leisure products, children’s products and nutritional products. Sales are made to the ultimate consumer principally through direct selling by Representatives, who are independent contractors and not our employees. As of December 31, 2015, we had nearly 6 million active Representatives which represents the number of Representatives submitting an order in a sales campaign, totaled for all campaigns during the year and then divided by the number of campaigns. The success of our business is highly dependent on recruiting, retaining and servicing our Representatives. During 2015, all of our consolidated revenue was derived from operations outside of the U.S. In December 2015, we entered into definitive agreements with affiliates of Cerberus Capital Management ("Cerberus"), which include a $435 investment in Avon by an affiliate of Cerberus through the purchase of our convertible preferred stock and the separation of the North America business from Avon into a privatelyheld company, which will include a $100 contribution by Avon, that will be majorityowned and managed by an affiliate of Cerberus. Avon will retain approximately 20% ownership in this new privatelyheld company. These transactions are expected to close concurrently in the first half of 2016. The North America business, which represents the Company's operations in the United States, Canada and Puerto Rico, was previously its own reportable segment and has been presented as discontinued operations for all periods presented. Refer to Note 3, Discontinued Operations and Divestitures, on pages through of our 2015 Annual Report, for additional information regarding the investment by an affiliate of Cerberus and the separation of the North America business. Total revenue in 2015 compared to 2014 declined 19% compared to the prioryear period, due to unfavorable foreign exchange. Constant $ revenue increased 2%. Constant $ revenue was negatively impacted by approximately 2 points due to taxes in Brazil from the combined impact of the recognition of Value Added Tax ("VAT") credits in 2014 which did not recur in 2015 along with a new Industrial Productions Tax ("IPI") on cosmetics which went into effect in May 2015. Constant $ revenue was also negatively impacted by approximately 1 point as a result of the sale of Liz Earle which was completed in July 2015. Sales from the Beauty category decreased 20%, or increased 3% on a Constant $ basis. Sales from the Fashion & Home category decreased 15%, or increased 5% on a Constant [/INST] Positive. </s>

AVON PRODUCTS INC

2017-02-22

2016-12-31

ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS ("MD&A") (U.S. dollars in millions, except per share and share data) You should read the following discussion of the results of operations and financial condition of Avon Products, Inc. and its majority and wholly owned subsidiaries in conjunction with the information contained in the Consolidated Financial Statements and related Notes contained in our 2016 Annual Report. When used in this discussion, the terms "Avon," "Company," "we," "our" or "us" mean, unless the context otherwise indicates, Avon Products, Inc. and its majority and wholly owned subsidiaries. See "Non-GAAP Financial Measures" on pages 28 through 30 of this MD&A for a description of how constant dollar ("Constant $") growth rates (a Non-GAAP financial measure) are determined and see "Performance Metrics" on page 28 of this MD&A for definitions of our performance metrics (Change in Active Representatives, Change in units sold, Change in Ending Representatives and Change in Average Order). Overview We are a global manufacturer and marketer of beauty and related products. Our business is conducted primarily in the direct-selling channel. During 2016, we had sales operations in 57 countries and territories, and distributed products in 18 more. In March 2016, we separated from our North America business, which had consisted of the Company's operations in the U.S., Canada and Puerto Rico; this business has been presented as discontinued operations for all periods presented. As a result, all of our consolidated revenue is derived from operations of subsidiaries outside of the U.S. Our reportable segments are based on geographic operations in four regions: Europe, Middle East & Africa; South Latin America; North Latin America; and Asia Pacific. Our product categories are Beauty and Fashion & Home. Beauty consists of skincare (which includes personal care), fragrance and color (cosmetics). Fashion & Home consists of fashion jewelry, watches, apparel, footwear, accessories, gift and decorative products, housewares, entertainment and leisure products, children’s products and nutritional products. Sales are made to the ultimate consumer principally through direct selling by Representatives, who are independent contractors and not our employees. As of December 31, 2016, we had approximately 6 million active Representatives which represents the number of Representatives submitting an order in a sales campaign, totaled for all campaigns during the year and then divided by the number of campaigns. The success of our business is highly dependent on recruiting, retaining and servicing our Representatives. Total revenue in 2016 declined 7% compared to the prior-year period, primarily due to unfavorable foreign exchange, while Constant $ revenue increased 2%. A number of items affected the year-over-year comparison of Constant $ revenue, the most significant being the sale of Liz Earle, which was completed in July 2015, that negatively impacted Constant $ revenue growth by approximately 1 point. The other items affecting the year-over-year comparison netted to an immaterial impact. In addition, our Constant $ revenue benefited from growth in Argentina, South Africa, Russia, Mexico and Brazil. Argentina contributed approximately 1 point to Avon's consolidated Constant $ revenue growth, as this market's results were impacted by the inflationary impact on pricing. The growth in Constant $ revenue was driven by higher average order, partially offset by a 2% decrease in Active Representatives. Average order benefited from the net impact of price and mix which increased 6%, while units sold decreased 4%, primarily due to declines in units sold in Brazil and Mexico, and the impact of the deconsolidation of Venezuela. We have been improving our discipline of pricing with inflation, strategically pricing in certain markets and categories, and launching products at more advantageous price points, while considering the potential impact on unit sales. The decrease in Active Representatives was primarily due to the impact of the deconsolidation of Venezuela and a decline in Asia Pacific, which included the impact caused by a reduction in the number of sales campaigns in the Philippines. These declines in Active Representatives were partially offset by growth in Europe, Middle East & Africa, most significantly Russia, which was primarily due to sustained momentum in recruitment and retention. See "Segment Review" in this MD&A for additional information related to changes in revenue by segment. Ending Representatives decreased by 2%. The decrease in Ending Representatives at December 31, 2016 as compared to the prior-year period was primarily due to the impact of the deconsolidation of Venezuela, which had a negative impact of 2 points, and declines in Asia Pacific. These decreases were partially offset by growth in Europe, Middle East & Africa, most significantly South Africa and Russia, as well as growth in South Latin America, most significantly Brazil. During 2016, foreign currency continued to have a significant impact on our financial results. As the U.S. dollar has strengthened relative to currencies of key Avon markets, our revenue and profits have been reduced when translated into U.S. dollars and our margins have been negatively impacted by country mix, as certain of our markets which have historically had higher operating margins experienced significant devaluation of their local currency. In addition, as our sales and costs are often denominated in different currencies, this has created a negative foreign currency transaction impact. Specifically, as compared to the prior-year period, foreign currency has impacted our consolidated financial results in the form of foreign currency transaction losses (classified within cost of sales, and selling, general and administrative expenses), which had an unfavorable impact to operating profit and Adjusted operating profit of an estimated $165, foreign currency translation, which had an unfavorable impact to operating profit of approximately $60 and Adjusted operating profit of approximately $65, and foreign exchange losses on our working capital (classified within other expense, net), which were lower by approximately $35 before tax and $40 before tax on an Adjusted basis. Effective March 31, 2016, we deconsolidated our Venezuelan operations. Our operating results for the first quarter of 2016 include the results of our Venezuelan operations; however, we recorded a charge at March 31, 2016 to write-off the balance sheet accounts associated with our Venezuelan operations, and since March 31, 2016, the Venezuelan operating results are no longer included in the Company's consolidated financial statements. As a result of this change in accounting, we recorded a loss of approximately $120 in the first quarter of 2016. The loss was comprised of approximately $39 in net assets of the Venezuelan business and approximately $81 in accumulated foreign currency translation adjustments within accumulated other comprehensive loss ("AOCI") associated with foreign currency movements before Venezuela was accounted for as a highly inflationary economy. See "Venezuela Discussion" in this MD&A and Note 1, Description of the Business and Summary of Significant Accounting Policies on pages through of our 2016 Annual Report for further discussion of our Venezuelan operations. Transformation Plan In December 2015, we entered into definitive agreements with affiliates of Cerberus Capital Management, L.P. ("Cerberus"), which included a $435 investment in Avon by an affiliate of Cerberus through the purchase of our convertible preferred stock and the separation of the North America business (including approximately $100 of cash, subject to certain adjustments) from Avon into New Avon, a privately-held company that is majority-owned and managed by an affiliate of Cerberus. These transactions closed on March 1, 2016 and Avon retained approximately 20% ownership in New Avon. See Note 3, Discontinued Operations and Divestitures on page through of our 2016 Annual Report and Note 16, Series C Convertible Preferred Stock on page of our 2016 Annual Report for more information. In January 2016, we announced the transformation plan (the “Transformation Plan”), which includes three pillars: investing in growth, reducing costs in an effort to continue to improve our cost structure and improving our financial resilience. We made good progress in 2016, the first year of our three-year Transformation Plan, exceeding cost targets and significantly strengthening the balance sheet. The Transformation Plan continues through 2018. Invest in Growth Over the three years that began in 2016, we expect to invest $350 into the business with an estimated $150 in media and social selling and $200 related to the service model evolution and information technology, primarily capital expenditures, which will be aimed at improving the overall Representative experience. These investments will be funded initially from cash on hand, and the continued investment over the three years from the cost savings improvements, as well as benefits from pricing actions. The launch of an improved service model will depend on the existing stage of the technological development of the systems in the respective market supporting the Representatives. We expect to incrementally invest, over time, in media, shifting our media spend more to digital, with the focus of the spending in our top ten markets. With regards to social selling, we formed a team focused on social selling, and during 2017, we will be piloting in Argentina before a phased implementation to additional markets. Improve our Cost Structure With respect to cost reductions within our Transformation Plan, we have targeted pre-tax annualized cost savings of approximately $350 after three years. We are targeting an estimated $200 from supply chain reductions by: rationalizing our manufacturing capacity; optimizing the distribution network as the global manufacturing footprint evolves; reducing costs related to transportation, physical warehousing and distribution; and through sourcing opportunities, such as the harmonization of direct material purchases to generate greater scale and purchasing power. We are targeting an estimated $150 from other cost reductions which are expected to be achieved primarily through reductions in headcount. We have initiated this Transformation Plan in order to enable us to achieve our long-term goals of a targeted low double-digit operating margin and mid single-digit Constant $ revenue growth. We believe that we are on track to deliver the targeted $350 in savings related to the Transformation Plan over the three-year plan period. For 2016, we accelerated certain cost savings initiatives and came in ahead of the targeted savings of $70 before taxes, as well as savings to cover the stranded costs of approximately $20 before taxes that resulted from the separation of the Company's North America business. During 2016, we realized an estimated savings of $120 before taxes associated with the Transformation Plan, including savings from restructuring actions as well as savings from other cost-savings strategies that did not result in restructuring charges. We expect to realize annualized savings of an estimated $180 before taxes associated with these cost savings initiatives taken during 2016. In connection with the actions and associated savings discussed above, we have incurred costs to implement ("CTI") restructuring initiatives of approximately $106 before taxes associated with the Transformation Plan to-date. In connection with the restructuring actions approved to-date associated with the Transformation Plan, we expect to realize annualized savings of an estimated $95 to $105 before taxes. We have realized an estimated $25 before taxes of savings associated with the restructuring actions in 2016 and are expected to achieve the significant majority of the annualized savings beginning in 2017. For the market closures, the expected annualized savings represented the operating profit (loss) no longer included within Avon's operating results as a result of no longer operating in the respective market. For actions that did not result in the closure of a market, the annualized savings represent the net reduction of expenses that will no longer be incurred by Avon. In addition, as part of the Transformation Plan, we will transition, over time, the location of our headquarters to the United Kingdom. For additional details, see Note 15, Restructuring Initiatives on pages through of our 2016 Annual Report for more information. Improve our Financial Resilience With respect to improving our financial resilience within our Transformation Plan, we targeted to reduce debt by approximately $250 during 2016. We exceeded this target, reducing debt by approximately $260 during 2016 and extending our maturity profile with no long-term debt due until March 2019, thereby strengthening the balance sheet. The steps taken through December 31, 2016 include the issuance of the new $500 Senior Secured Notes due August 2022, the repayment of approximately $720 of our public notes, and a reduction in the debt of foreign subsidiaries of approximately $40. For additional details, see Note 6, Debt and Other Financing on pages through of our 2016 Annual Report and "Liquidity and Capital Resources" on pages 52 through 57 in this MD&A for additional information. New Accounting Standards Information relating to new accounting standards is included in Note 2, New Accounting Standards on pages through of our 2016 Annual Report. Performance Metrics Within this MD&A, in addition to our key financial metrics of revenue, operating profit and operating margin, we utilize the performance metrics defined below to assist in the evaluation of our business. Performance Metrics Definition Change in Active Representatives This metric is a measure of Representative activity based on the number of unique Representatives submitting at least one order in a sales campaign, totaled for all campaigns in the related period. To determine the change in Active Representatives, this calculation is compared to the same calculation in the corresponding period of the prior year. Orders in China are excluded from this metric as our business in China is predominantly retail. Liz Earle was also excluded from this calculation as it did not distribute through the direct-selling channel. Change in units sold This metric is based on the gross number of pieces of merchandise sold during a period, as compared to the same number in the same period of the prior year. Units sold include samples sold and products contingent upon the purchase of another product (for example, gift with purchase or discount purchase with purchase), but exclude free samples. Change in Ending Representatives This metric is based on the total number of Representatives who were eligible to place an order in the last sales campaign in the related period as a result of being on an active roster. To determine the Change in Ending Representatives, this calculation is compared to the same calculation in the corresponding period of the prior year. Change in Ending Representatives may be impacted by a combination of factors such as our requirements to become and/or remain a Representative, our practices regarding minimum order requirements and our practices regarding reinstatement of Representatives. We believe this may be an indicator of future revenue performance. Change in Average Order This metric is a measure of Representative productivity. The calculation is the difference of the year-over-year change in revenue on a Constant $ basis and the Change in Active Representatives. Change in Average Order may be impacted by a combination of factors such as inflation, units, product mix, and/or pricing. Non-GAAP Financial Measures To supplement our financial results presented in accordance with generally accepted accounting principles in the United States ("GAAP"), we disclose operating results that have been adjusted to exclude the impact of changes due to the translation of foreign currencies into U.S. dollars, including changes in: revenue, operating profit, Adjusted operating profit, operating margin and Adjusted operating margin. We also refer to these adjusted financial measures as Constant $ items, which are Non-GAAP financial measures. We believe these measures provide investors an additional perspective on trends and underlying business results. To exclude the impact of changes due to the translation of foreign currencies into U.S. dollars, we calculate current-year results and prior-year results at constant exchange rates, which are updated on an annual basis as part of our budgeting process. When comparing 2015 results to 2014 results, we used constant exchange rates that were in effect from our 2015 budgeting process. Foreign currency impact is determined as the difference between actual growth rates and Constant $ growth rates. We also present gross margin, selling, general and administrative expenses as a percentage of revenue, operating profit, operating margin and effective tax rate on a Non-GAAP basis. We refer to these Non-GAAP financial measures as "Adjusted." We have provided a quantitative reconciliation of the difference between the Non-GAAP financial measures and the financial measures calculated and reported in accordance with GAAP. See "Reconciliation of Non-GAAP Financial Measures" within "Results of Operations - Consolidated" on page 36 of this MD&A for this quantitative reconciliation. The Company uses the Non-GAAP financial measures to evaluate its operating performance. These Non-GAAP measures should not be considered in isolation, or as a substitute for, or superior to, financial measures calculated in accordance with GAAP. The Company believes investors find the Non-GAAP information helpful in understanding the ongoing performance of operations separate from items that may have a disproportionate positive or negative impact on the Company's financial results in any particular period. The Company believes that it is meaningful for investors to be made aware of the impacts of: 1) CTI restructuring initiatives; 2) the net proceeds recognized as a result of settling claims relating to professional services ("Legal settlement"); 3) charges related to the deconsolidation of our Venezuelan operations as of March 31, 2016 and the devaluations of Venezuelan currency in February 2015 and March 2014, combined with being designated as a highly inflationary economy ("Venezuelan special items"); 4) the additional $46 accrual in 2014 for the settlements related to the Foreign Corrupt Practices Act ("FCPA") investigations and, in the fourth quarter of 2014, the associated approximate $19 net tax benefit ("FCPA accrual"); 5) the settlement charges associated with the U.S. pension plan ("Pension settlement charge"); 6) the goodwill impairment charge related to the Egypt business ("Asset impairment and other charges"); 7) various other items associated with the sale of Liz Earle, the separation of the North America business and debt-related charges ("Other items"); and, as it relates to our effective tax rate discussion, 8) income tax benefits realized in 2016 and 2015 as a result of tax planning strategies, an income tax benefit in the second quarter of 2016 primarily due to the release of a valuation allowance associated with Russia and the non-cash income tax adjustments associated with our deferred tax assets recorded in 2016, 2015 and 2014 ("Special tax items"). The Legal settlement includes the impact on the Consolidated Statements of Operations in the third quarter of 2016 associated with the net proceeds of $27.2 recognized as a result of settling claims relating to professional services that had been provided to the Company prior to 2013 in connection with a previously disclosed legal matter. The Venezuelan special items include the impact on the Consolidated Statements of Operations in 2016 caused by the deconsolidation of our Venezuelan operations for which we recorded a loss of approximately $120 in other expense, net. The loss was comprised of approximately $39 in net assets of the Venezuelan business and approximately $81 in accumulated foreign currency translation adjustments within AOCI associated with foreign currency changes before Venezuela was accounted for as a highly inflationary economy. The Venezuelan special items include the impact on the Consolidated Statements of Operations in 2015 and 2014 caused by the devaluations of Venezuelan currency on monetary assets and liabilities, such as cash, receivables and payables; deferred tax assets and liabilities; and non-monetary assets, such as inventories. For non-monetary assets, the Venezuelan special items include the earnings impact caused by the difference between the historical U.S. dollar cost of the assets at the previous exchange rate and the revised exchange rate. In 2015 and 2014, the Venezuelan special items also include adjustments of approximately $11 and approximately $116, respectively, to reflect certain non-monetary assets at their net realizable value. In 2015, the Venezuelan special items also include an impairment charge of approximately $90 to reflect the write-down of the long-lived assets to their estimated fair value. The Pension settlement charge includes the impact on the Consolidated Statements of Operations in the third and fourth quarters of 2015 and the second, third and fourth quarters of 2014 associated with the payments made to former employees who were vested and participated in the U.S. defined benefit pension plan. Such payments fully settled our pension plan obligation to those participants who elected to receive such payment. The Asset impairment and other charges include the impact on the Consolidated Statements of Operations caused by the goodwill impairment charge related to the Egypt business in the fourth quarter of 2015. The Other items include the impact during 2016 on the Consolidated Statements of Operations due to a net gain on extinguishment of debt associated with the cash tender offers in August 2016, the debt repurchases in October and December 2016, and the prepayment of the remaining principal amount of our 4.20% Notes (as defined in "Capital Resources") and our 5.75% Notes (as defined in "Capital Resources") in November 2016. The Other items also include the impact during 2015 on the Consolidated Statements of Operations due to the gain on the sale of Liz Earle. In addition, the Other items include the impact on the Consolidated Statements of Operations in the fourth quarter of 2015 caused by transaction-related costs of $3.1 associated with the planned separation of the North America business that were included in continuing operations. In addition, Other items in 2015 include the impact on the Consolidated Statements of Operations of the loss on extinguishment of debt caused by the make-whole premium and the write-off of debt issuance costs and discounts associated with the prepayment of our 2.375% Notes (as defined in "Capital Resources"). Other items, in 2015, also include the impact on other expense, net in the Consolidated Statements of Operations of $2.5 associated with the write-off of issuance costs related to our previous $1 billion revolving credit facility. In addition, the effective tax rate discussion includes Special tax items, including the impact during the fourth quarter of 2016 on the provision for income taxes in the Consolidated Statements of Operations due to the non-cash income tax charge of approximately $9 associated with valuation allowances to adjust certain non-U.S. deferred tax assets to an amount that is "more likely than not" to be realized. The Special tax items also include the impact during the second quarter of 2016 on the provision for income taxes in the Consolidated Statements of Operations primarily due to the release of a valuation allowance associated with Russia of approximately $7. The Special tax items also include the impact during the first quarter of 2016 and the fourth quarter of 2015 on the provision for income taxes in the Consolidated Statements of Operations due to income tax benefits of approximately $29 and approximately $19, respectively, recognized as the result of the implementation of foreign tax planning strategies. The Special tax items also include the impact during the first and second quarters of 2015 on the provision for income taxes in the Consolidated Statements of Operations due to a non-cash income tax charge of approximately $31 and a benefit of approximately $3, respectively, associated with valuation allowances to adjust our U.S. deferred tax assets to an amount that was "more likely than not" to be realized. The additional valuation allowance was due to the strengthening of the U.S. dollar against currencies of some of our key markets and its associated effect on our tax planning strategies, and the partial release of the valuation allowance was due to the weakening of the U.S. dollar against currencies of some of our key markets. The Special tax items also include the impact during the third quarter of 2015 on the provision for income taxes in the Consolidated Statements of Operations due to a non-cash income tax charge of approximately $642 as a result of establishing a valuation allowance for the full amount of our U.S. deferred tax assets due to the impact of the continued strengthening of the U.S. dollar against currencies of some of our key markets and its associated effect on our tax planning strategies. Additionally, the Special tax items include the impact during the third quarter of 2015 on the provision for income taxes in the Consolidated Statements of Operations due to a non-cash income tax charge of approximately $15 associated with valuation allowances to adjust certain non-U.S. deferred tax assets to an amount that is "more likely than not" to be realized. The non-U.S. valuation allowance included an adjustment associated with Russia, which was primarily the result of lower earnings, which were significantly impacted by foreign exchange losses on working capital balances. The Special tax items also include the impact during the fourth quarter of 2014 on the income taxes in the Consolidated Statements of Operations due to a non-cash income tax charge primarily associated with a valuation allowance to reduce our U.S. deferred tax assets to an amount that is "more likely than not" to be realized, and was primarily due to the strengthening of the U.S. dollar against currencies of some of our key markets and, to a lesser extent, the finalization of the FCPA settlements. See Note 15, Restructuring Initiatives on pages through of our 2016 Annual Report, Note 13, Segment Information on pages through of our 2016 Annual Report, "Results Of Operations - Consolidated" below, "Venezuela Discussion" below, Note 1, Description of the Business and Summary of Significant Accounting Policies on pages through of our 2016 Annual Report, Note 17, Contingencies on pages through of our 2016 Annual Report, Note 12, Employee Benefit Plans on pages through of our 2016 Annual Report, Note 18, Goodwill on pages through of our 2016 Annual Report, Note 3, Discontinued Operations and Divestitures on pages through of our 2016 Annual Report, "Liquidity and Capital Resources" below, Note 6, Debt and Other Financing on pages through of our 2016 Annual Report, and Note 8, Income Taxes on pages through of our 2016 Annual Report for more information on these items. Critical Accounting Estimates We believe the accounting policies described below represent our critical accounting policies due to the estimation processes involved in each. See Note 1, Description of the Business and Summary of Significant Accounting Policies on pages through of our 2016 Annual Report for a detailed discussion of the application of these and other accounting policies. Allowances for Doubtful Accounts Receivable Representatives contact their customers, selling primarily through the use of brochures for each sales campaign, generally on credit if they meet certain criteria. Sales campaigns are generally for a three- to four-week duration. The Representative purchases products directly from us and may or may not sell them to an end user. In general, the Representative, an independent contractor, remits a payment to us during each sales campaign, which relates to the prior campaign cycle. The Representative is generally precluded from submitting an order for the current sales campaign until the accounts receivable balance past due for prior campaigns is paid; however, there are circumstances where the Representative fails to make the required payment. We record an estimate of an allowance for doubtful accounts on receivable balances based on an analysis of historical data and current circumstances, including seasonality and changing trends. Over the past three years, annual bad debt expense was $191 in 2016, $144 in 2015 and $171 in 2014, or approximately 3% of total revenue in 2016, and approximately 2% of total revenue 2015 and 2014. The allowance for doubtful accounts is reviewed for adequacy, at a minimum, on a quarterly basis. We generally have no detailed information concerning, or any communication with, any end user of our products beyond the Representative. We have no legal recourse against the end user for the collection of any accounts receivable balances due from the Representative to us. If the financial condition of our Representatives were to deteriorate, resulting in their inability to make payments, additional allowances may be required. Allowances for Sales Returns Policies and practices for product returns vary by jurisdiction, but we generally allow an unlimited right of return. We record a provision for estimated sales returns based on historical experience with product returns. Over the past three years, annual sales returns were $187 for 2016, $191 for 2015 and $241 for 2014, or approximately 3% of total revenue in each year, which has been generally in line with our expectations. If the historical data we use to calculate these estimates does not approximate future returns, due to changes in marketing or promotional strategies, or for other reasons, additional allowances may be required. Provisions for Inventory Obsolescence We record an allowance for estimated obsolescence, when applicable, equal to the difference between the cost of inventory and the estimated market value. In determining the allowance for estimated obsolescence, we classify inventory into various categories based upon its stage in the product life cycle, future marketing sales plans and the disposition process. We assign a degree of obsolescence risk to products based on this classification to estimate the level of obsolescence provision. If actual sales are less favorable than those projected, additional inventory allowances may need to be recorded for such additional obsolescence. Annual obsolescence expense was $37 in 2016, $45 in 2015 and $78 in 2014. Pension and Postretirement Expense We maintain defined benefit pension plans, which cover substantially all employees in the U.S. and a portion of employees in international locations. However, our U.S. defined benefit pension plan is closed to employees hired on or after January 1, 2015. Additionally, we have unfunded supplemental pension benefit plans for some current and retired executives and provide retiree health care benefits subject to certain limitations to many retired employees in the U.S. and certain foreign countries. See Note 12, Employee Benefit Plans on pages through of our 2016 Annual Report for more information on our benefit plans. Pension and postretirement expense and the requirements for funding our major pension plans are determined based on a number of actuarial assumptions, which are generally reviewed and determined on an annual basis. These assumptions include the discount rate applied to plan obligations, the expected rate of return on plan assets, the rate of compensation increase of plan participants, price inflation, cost-of-living adjustments, mortality rates and certain other demographic assumptions, and other factors. We use a December 31 measurement date for all of our employee benefit plans. For 2016, the weighted average assumed rate of return on all pension plan assets, including the U.S. and non-U.S. defined benefit pension plans was 6.65%, as compared with 6.87% for 2015. In determining the long-term rates of return, we consider the nature of the plans’ investments, an expectation for the plans’ investment strategies, historical rates of return and current economic forecasts. We generally evaluate the expected long-term rate of return annually and adjust as necessary. In some of our defined benefit pension plans, we have adopted investment strategies which are designed to match the movements in the pension liability through an increased allocation towards debt securities. In addition, we also utilize derivative instruments in some of our non-U.S. defined benefit pension plans to achieve the desired market exposures or to hedge certain risks. Derivative instruments may include, but are not limited to, futures, options, swaps or swaptions. Investment types, including the use of derivatives are based on written guidelines established for each investment manager and monitored by the plan's investment committee. A significant portion of our pension plan assets relate to the United Kingdom ("UK") defined benefit pension plan. The assumed rate of return for determining 2016 net costs for the UK defined benefit pension plan was 6.65%. In addition, the current rate of return assumption for the UK defined benefit pension plan was based on an asset allocation of approximately 80% in corporate and government bonds and mortgage-backed securities (which are expected to earn approximately 2% to 4% in the long-term) and approximately 20% in equity securities, emerging market debt and high yield securities (which are expected to earn approximately 6% to 9% in the long-term). In addition to the physical assets, the asset portfolio for the UK defined benefit pension plan has derivative instruments which increase our exposure to fixed income (in order to better match liabilities) and, to a lesser extent, impact our equity exposure. The rate of return on the plan assets in the UK was approximately 36% in 2016 and approximately 12% in 2015. Historically, the pension plan with the most significant pension plan assets was the U.S. defined benefit pension plan. As part of the separation of the North America business, we transferred $499.6 of pension liabilities under the U.S. defined benefit pension plan associated with current and former employees of the North America business and certain other former Avon employees, along with $355.9 of assets held by the U.S. defined benefit pension plan, to a defined benefit pension plan sponsored by New Avon. We also transferred $60.4 of other postretirement liabilities (namely, retiree medical and supplemental pension liabilities) in respect of such employees and former employees. See Note 3, Discontinued Operations and Divestitures on pages through of our 2016 Annual Report. We continue to retain certain U.S. pension and other postretirement liabilities primarily associated with employees who are actively employed by Avon outside of the North America business. Prior to this separation, our net periodic benefit costs for the U.S. pension and postretirement benefit plans were allocated between Discontinued Operations and Global as the plan included both North America and U.S. Corporate Avon associates, and as such, our ongoing net periodic benefit costs within Global were not materially impacted by the separation of the North America business. The assumed rate of return for 2016 for the U.S. defined benefit pension plan was 7.00%, which was based on an asset allocation of approximately 70% in corporate and government bonds and mortgage-backed securities (which are expected to earn approximately 3% to 4% in the long-term) and approximately 30% in equity securities and high yield securities (which are expected to earn approximately 6% to 8% in the long-term). Historical rates of return on the assets of the U.S. defined benefit pension plan were approximately 8% for the most recent 10-year period and approximately 8% for the 20-year period. In the U.S. defined benefit pension plan, our asset allocation policy has historically favored U.S. equity securities, which have returned approximately 7% over the 10-year period and approximately 8% over the 20-year period. The rate of return on the plan assets in the U.S. was approximately 6% in 2016 and approximately 3% in 2015. The discount rate used for determining the present value of future pension obligations for each individual plan is based on a review of bonds that receive a high-quality rating from a recognized rating agency. The discount rates for calculating the balance sheet obligations of our more significant plans, including our UK defined benefit pension plan and our U.S. defined benefit pension plan, were based on the internal rates of return for a portfolio of high-quality bonds with maturities that are consistent with the projected future benefit payment obligations of each plan. The weighted-average discount rate for U.S. and non-U.S. defined benefit pension plans determined on this basis was 2.81% at December 31, 2016, and 3.92% at December 31, 2015. For the determination of the expected rate of return on assets and the discount rate, we take external actuarial and investment advice into consideration. Our funding requirements may be impacted by standards and regulations or interpretations thereof. Our calculations of pension and postretirement costs are dependent on the use of assumptions, including discount rates, hybrid plan maximum interest crediting rates and expected return on plan assets discussed above, rate of compensation increase of plan participants, interest cost, benefits earned, mortality rates, the number of participants and certain demographics and other factors. Actual results that differ from assumptions are accumulated and amortized to expense over future periods and, therefore, generally affect recognized expense in future periods. At December 31, 2016, we had pretax actuarial losses and prior service credits totaling approximately $49 for the U.S. defined benefit pension and postretirement plans and approximately $176 for the non-U.S. defined benefit pension and postretirement plans that have not yet been charged to expense. These actuarial losses have been charged to accumulated other comprehensive loss ("AOCI") within shareholders’ equity. While we believe that the assumptions used are reasonable, differences in actual experience or changes in assumptions may materially affect our pension and postretirement obligations and future expense. For 2017, our assumption for the expected rate of return on assets is 5.50% for our U.S. defined benefit pension plan and 5.09% for our non-U.S. defined benefit pension plans (which includes 5.15% for our UK defined benefit pension plan). The decrease in the expected rate of return on assets for our U.S. defined benefit pension plan was largely due to the elimination of the derivative instruments from our portfolio, as a result of the transfer of a portion of the assets held by the U.S. defined benefit pension plan to a defined benefit pension plan sponsored by New Avon. The decrease in the expected rate of return on assets for the UK defined benefit pension plan was driven by a reduction in the exposure to equity markets obtained through derivative instruments, simultaneously increasing the extent to which the plan assets match the pension obligation, as the plan’s funding level improved. Our assumptions are generally reviewed and determined on an annual basis. A 50 basis point change (in either direction) in the expected rate of return on plan assets, the discount rate or the rate of compensation increases, would have had approximately the following effect on 2016 pension expense and the pension benefit obligation at December 31, 2016: Restructuring Reserves We record the estimated expense for our restructuring initiatives when such costs are deemed probable and estimable, when approved by the appropriate corporate authority and by accumulating detailed estimates of costs for such plans. These expenses include the estimated costs of employee severance and related benefits, impairment or accelerated depreciation of property, plant and equipment and capitalized software, and any other qualifying exit costs. These estimated costs are grouped by specific projects within the overall plan and are then monitored on a quarterly basis by finance personnel. Such costs represent our best estimate, but require assumptions about the programs that may change over time, including attrition rates. Estimates are evaluated periodically to determine whether an adjustment is required. Taxes We record a valuation allowance to reduce our deferred tax assets to an amount that is "more likely than not" to be realized. Evaluating the need for and quantifying the valuation allowance often requires significant judgment and extensive analysis of all the weighted positive and negative evidence available to the Company in order to determine whether all or some portion of the deferred tax assets will not be realized. In performing this analysis, the Company’s forecasted U.S. and foreign taxable income, and the existence of potential prudent and feasible tax planning strategies that would enable the Company to utilize some or all of its excess foreign tax credits, are taken into consideration. At December 31, 2016, we had net deferred tax assets of approximately $140 (net of valuation allowances of approximately $3,277). With respect to our deferred tax assets, at December 31, 2016, we had recognized deferred tax assets relating to tax loss carryforwards of approximately $2,033, primarily from foreign jurisdictions, for which a valuation allowance of approximately $1,994 has been provided. Prior to December 31, 2016, we had recognized deferred tax assets of approximately $874 relating to excess U.S. foreign tax and other U.S. general business credit carryforwards for which a full valuation allowance has been provided. We have a history of U.S. source losses, and our excess U.S. foreign tax and general business credits have primarily resulted from having a greater U.S. source loss in recent years which reduces our ability to credit foreign taxes or utilize the general business credits which we generate. Our ability to realize our U.S. deferred tax assets, such as our foreign tax and general business credit carryforwards, is dependent on future U.S. taxable income within the carryforward period. At December 31, 2016, we would need to generate approximately $2.5 billion of excess net foreign source income in order to realize the U.S. foreign tax and general business credits before they expire. During the fourth quarter of 2014, the Company’s expected net foreign source income was reduced significantly, primarily due to the strengthening of the U.S. dollar against currencies for some of our key markets and, to a lesser extent, the finalization of the FCPA settlements. This strengthening of the U.S. dollar reduced the expected dividends and royalties that could be remitted to the U.S. by our foreign subsidiaries, particularly Russia, Brazil, Mexico and Colombia. The effectiveness of our tax planning strategies, including the repatriation of foreign earnings and the acceleration of royalties from our foreign subsidiaries, was also negatively impacted by the strengthening of the U.S. dollar. In addition, the finalization of the FCPA settlements, which included a $68 fine related to Avon China in connection with the DOJ settlement and $67 in disgorgement and prejudgment interest related to Avon Products, Inc. in connection with the SEC settlement, negatively impacted expected future repatriation of foreign earnings and reduced current U.S. taxable income, respectively. As a result of these developments, we determined that we may not generate sufficient taxable income to realize all of our U.S. deferred tax assets. As such, we recorded a valuation allowance of $441 to reduce our U.S. deferred tax assets to an amount that is "more likely than not" to be realized, of which $367 was recorded to income taxes in the Consolidated Statements of Operations and the remainder was recorded to various components of other comprehensive (loss) income. During 2015, the Company recorded an additional valuation allowance for the remaining U.S. deferred tax assets of approximately $670. The increase in the valuation allowance resulted from reduced tax benefits expected to be obtained from tax planning strategies associated with an anticipated accelerated receipt in the U.S. of foreign source income. As the U.S. dollar had further strengthened against currencies of some of our key markets during 2015, the benefits associated with the Company’s tax planning strategies were no longer sufficient for the Company to continue to conclude that its tax planning strategies were prudent. In the absence of any alternative prudent tax planning strategies and other sources of future taxable income, it was determined that a full valuation allowance should be recorded. Although the Company continues to expect that it will generate taxable income and tax liability in the U.S., the Company is expected to offset its current and future tax liability with foreign tax credits, and as a result, the expected level of future taxable income and tax liability is not adequate to realize the benefit of previously recorded deferred tax assets. Although the Company may not be able to recognize a financial statement benefit associated with its deferred tax assets, the Company will continue to manage and plan for the utilization of its deferred tax assets to avoid the expiration of deferred tax assets that may have limited lives. In addition, in the fourth quarter of 2015, we recognized a benefit of approximately $19 associated with the implementation of the initial stages of foreign tax planning strategies. We completed the implementation of these tax planning strategies and recognized an additional benefit of approximately $29 in the first quarter of 2016. At December 31, 2016, as a result of our U.S. liquidity profile, we continue to assert that our foreign earnings are not indefinitely reinvested. Accordingly, we adjusted our deferred tax liability to account for our 2016 undistributed earnings of foreign subsidiaries and for the tax effect of earnings that were actually repatriated to the U.S. during the year. The net impact on the deferred tax liability associated with the Company’s undistributed earnings is a decrease of approximately $2, resulting in a deferred tax liability balance of approximately $87 related to the incremental tax cost on approximately $1.4 billion of undistributed foreign earnings at December 31, 2016. This deferred income tax liability amount is net of the estimated foreign tax credits that would be generated upon the repatriation of such earnings. The repatriation of foreign earnings may result in the utilization of a portion of our foreign tax credits in the year of repatriation; therefore, the utilization of foreign tax credits is dependent on the amount and timing of repatriations, as well as the jurisdictions involved. With respect to our uncertain tax positions, we recognize the benefit of a tax position, if that position is more likely than not of being sustained on examination by the taxing authorities, based on the technical merits of the position. We believe that our assessment of more likely than not is reasonable, but because of the subjectivity involved and the unpredictable nature of the subject matter at issue, our assessment may prove ultimately to be incorrect, which could materially impact the Consolidated Financial Statements. We file income tax returns in the U.S. federal jurisdiction, and various state and foreign jurisdictions. In 2017, a number of open tax years are scheduled to close due to the expiration of the statute of limitations and it is possible that a number of tax examinations may be completed. If our tax positions are ultimately upheld or denied, it is possible that the 2017 provision for income taxes, as well as tax related cash receipts or payments, may be impacted. Loss Contingencies We determine whether to disclose and/or accrue for loss contingencies based on an assessment of whether the risk of loss is remote, reasonably possible or probable. We record loss contingencies when it is probable that a liability has been incurred and the amount of loss is reasonably estimable. Our assessment is developed in consultation with our outside counsel and other advisors and is based on an analysis of possible outcomes under various strategies. Loss contingency assumptions involve judgments that are inherently subjective and can involve matters that are in litigation, which, by its nature is unpredictable. We believe that our assessment of the probability of loss contingencies is reasonable, but because of the subjectivity involved and the unpredictable nature of the subject matter at issue, our assessment may prove ultimately to be incorrect, which could materially impact the Consolidated Financial Statements. Impairment of Assets Plant, Property and Equipment and Capitalized Software We evaluate our plant, property and equipment and capitalized software for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset group may not be recoverable. Recoverability of assets to be held and used is measured by a comparison of the carrying amount of an asset to estimated pre-tax undiscounted future cash flows expected to be generated by the asset. If the carrying amount of an asset exceeds its estimated future cash flows, an impairment charge is recognized for the amount by which the carrying amount of the asset exceeds the fair value of the asset. The fair value of the asset is determined using revenue and cash flow projections, and royalty and discount rates, as appropriate. In February 2015, we reviewed Avon Venezuela's long-lived assets to determine whether the carrying amount of the assets was recoverable. Based on our expected cash flows associated with the asset group, we determined that the carrying amount of the assets, carried at their historical U.S. dollar cost basis, was not recoverable. As such, an impairment charge of approximately $90 to selling, general and administrative expenses was recorded to reflect the write-down of the long-lived assets to their estimated fair value of approximately $16, which was recorded in the first quarter of 2015. The fair value of Avon Venezuela's long-lived assets was determined using both market and cost valuation approaches. The valuation analysis performed required several estimates, including market conditions and inflation rates. As discussed in Note 1, Description of the Business and Summary of Significant Accounting Policies, we concluded that, effective March 31, 2016, we deconsolidated our Venezuelan operations. Our Consolidated Balance Sheets no longer includes the assets and liabilities of our Venezuelan operations, and we no longer include the results of our Venezuelan operations in the Consolidated Financial Statements. See Note 1, Description of the Business and Summary of Significant Accounting Policies on pages through of our 2016 Annual Report for more information on Avon Venezuela. Goodwill We test goodwill for impairment annually, and more frequently if circumstances warrant, using various fair value methods. We completed our annual goodwill impairment assessment for 2016 and determined that the estimated fair values were considered substantially in excess of the carrying values of each of our reporting units. The impairment analyses performed for goodwill require several estimates in computing the estimated fair value of a reporting unit. As part of our goodwill impairment analysis, we typically use a discounted cash flow ("DCF") approach to estimate the fair value of a reporting unit, which we believe is the most reliable indicator of fair value of a business, and is most consistent with the approach that we would generally expect a market participant would use. In estimating the fair value of our reporting units utilizing a DCF approach, we typically forecast revenue and the resulting cash flows for periods of five to ten years and include an estimated terminal value at the end of the forecasted period. When determining the appropriate forecast period for the DCF approach, we consider the amount of time required before the reporting unit achieves what we consider a normalized, sustainable level of cash flows. The estimation of fair value utilizing a DCF approach includes numerous uncertainties which require significant judgment when making assumptions of expected growth rates and the selection of discount rates, as well as assumptions regarding general economic and business conditions, and the structure that would yield the highest economic value, among other factors. During the 2015 year-end close process, our analysis of the Egypt business indicated an impairment as the carrying value of the business exceeded the estimated fair value. This was primarily the result of reducing our long-term projections of the business. During 2015, Egypt performed generally in line with our revenue and earnings projections, which assumed growth as compared to 2014. However, as a result of currency restrictions for the payment of goods in Egypt, we lowered our long-term revenue and earnings projections for the business. Accordingly, a non-cash impairment charge of approximately $7 was recorded to reduce the carrying amount of goodwill. There is no amount remaining associated with goodwill for our Egypt reporting unit as a result of this impairment charge. Key assumptions used in measuring the fair value of Egypt during this impairment assessment included projections of revenue and the resulting cash flows, as well as the discount rate (based on the estimated weighted-average cost of capital). To estimate the fair value of Egypt, we forecasted revenue and the resulting cash flows over five years using a DCF model which included a terminal value at the end of the projection period. We believed that a five-year period was a reasonable amount of time in order to return cash flows of Egypt to normalized, sustainable levels. See Note 18, Goodwill on pages through of our 2016 Annual Report for more information regarding Egypt. Results Of Operations - Consolidated Amounts in the table above may not necessarily sum due to rounding. * Calculation not meaningful (1) Advertising expenses are included within selling, general and administrative expenses. (2) Change in Constant $ Adjusted operating margin for all years presented is calculated using the current-year Constant $ rates. 2016 Compared to 2015 Revenue Total revenue in 2016 declined 7% compared to the prior-year period, primarily due to unfavorable foreign exchange, while Constant $ revenue increased 2%. A number of items affected the year-over-year comparison of Constant $ revenue, the most significant being the sale of Liz Earle, which was completed in July 2015, that negatively impacted Constant $ revenue growth by approximately 1 point. The other items affecting the year-over-year comparison netted to an immaterial impact. In addition, our Constant $ revenue benefited from growth in Argentina, South Africa, Russia, Mexico and Brazil. Argentina contributed approximately 1 point to Avon's consolidated Constant $ revenue growth, as this market's results were impacted by the inflationary impact on pricing. The growth in Constant $ revenue was driven by higher average order, partially offset by a 2% decrease in Active Representatives. Average order benefited from the net impact of price and mix which increased 6%, while units sold decreased 4%, primarily due to declines in units sold in Brazil and Mexico, and the impact of the deconsolidation of Venezuela. We have been improving our discipline of pricing with inflation, strategically pricing in certain markets and categories, and launching products at more advantageous price points, while managing the potential impact on unit sales. The decrease in Active Representatives was primarily due to the impact of the deconsolidation of Venezuela and a decline in Asia Pacific, which included the impact caused by a reduction in the number of sales campaigns in the Philippines. These declines in Active Representatives were partially offset by growth in Europe, Middle East & Africa, most significantly Russia, which was primarily due to sustained momentum in recruitment and retention. See "Segment Review" in this MD&A for additional information related to changes in revenue by segment. Ending Representatives decreased by 2%. The decrease in Ending Representatives at December 31, 2016 as compared to the prior-year period was primarily due to the impact of the deconsolidation of Venezuela, which had a negative impact of 2 points, and declines in Asia Pacific. These decreases were partially offset by growth in Europe, Middle East & Africa, most significantly South Africa and Russia, as well as growth in South Latin America, most significantly Brazil. See "Venezuela Discussion" in this MD&A and Note 1, Description of the Business and Summary of Significant Accounting Policies on pages through of our 2016 Annual Report to the consolidated financial statements included herein for further discussion of our Venezuelan operations. See Note 3, Discontinued Operations and Divestitures on pages through of our 2016 Annual Report, and Note 4, Related Party Transactions on pages through of our 2016 Annual Report for more information on New Avon. On a category basis, our net sales from reportable segments and associated growth rates were as follows: See "Segment Review" in this MD&A for additional information related to changes in revenue by segment. Operating Margin Operating margin and Adjusted operating margin increased 290 basis points and 80 basis points, respectively, compared to 2015. The increases in operating margin and Adjusted operating margin includes the benefits associated with costs savings initiatives, including the Transformation Plan, primarily reductions in headcount, as well as other cost reductions. The increases in operating margin and Adjusted operating margin are discussed further below in "Gross Margin," "Selling, General and Administrative Expenses" and "Impairment of Goodwill." Gross Margin Gross margin and Adjusted gross margin increased 20 basis points and decreased 30 basis points, respectively, compared to 2015. The gross margin comparison was impacted by approximately 50 basis points in the prior year by the devaluation of the Venezuelan currency in conjunction with highly inflationary accounting, as approximately $29 was recognized in the prior-year period associated with carrying certain non-monetary assets at the historical U.S. dollar cost following a devaluation. See "Venezuela Discussion" in this MD&A for a further discussion of our Venezuelan operations. The remaining decrease in gross margin and the decrease of 30 basis points in Adjusted gross margin was primarily due to the following: • a decrease of approximately 260 basis points due to the unfavorable impact of foreign currency transaction losses and foreign currency translation; • a decrease of 30 basis points due to sales of products to New Avon since the separation of the Company's North America business into New Avon on March 1, 2016; and • various other insignificant items that decreased gross margin. These items were partially offset by the following: • an increase of 190 basis points due to the favorable net impact of mix and pricing, primarily due to inflationary and strategic pricing in South Latin America, Europe, Middle East & Africa and North Latin America; and • an increase of 90 basis points due to lower supply chain costs, primarily from lower material costs and cost savings initiatives in Europe, Middle East & Africa and South Latin America. See Note 4, Related Party Transactions on pages through of our 2016 Annual Report for more information on New Avon. Selling, General and Administrative Expenses Selling, general and administrative expenses for 2016 decreased approximately $404 compared to 2015. This decrease is primarily due to the favorable impact of foreign currency translation, as the strengthening of the U.S. dollar against many of our foreign currencies resulted in lower reported selling, general and administrative expenses. The decrease in selling, general and administrative expenses is also due to approximate $90 impairment charge recorded in the prior-year period to reflect the write-down of the long-lived assets to their estimated fair value associated with the devaluation of the Venezuelan currency in conjunction with highly inflationary accounting, lower fixed expenses resulting primarily from our cost savings initiatives, lower expenses associated with employee incentive compensation plans, the approximate $27 of net proceeds recognized as a result of a legal settlement in the third quarter of 2016 and lower advertising expense. Partially offsetting the decrease in selling, general and administrative expenses was higher bad debt expense, higher amount of CTI restructuring, higher foreign currency transaction costs and higher Representative, sales leader and field expense. Selling, general and administrative expenses as a percentage of revenue and Adjusted selling, general, and administrative expenses as a percentage of revenue decreased 260 basis points and 110 basis points, respectively, compared to 2015. The selling, general and administrative expenses as a percentage of revenue comparison benefited from: • approximately 150 basis points by the devaluation of the Venezuelan currency in conjunction with highly inflationary accounting in the prior-year period, primarily as an approximate $90 impairment charge was recognized in the prior-year period to reflect the write-down of the long-lived assets to their estimated fair value following a devaluation; • approximately 50 basis points by the approximate $27 of net proceeds recognized as a result of a legal settlement in the third quarter of 2016; • approximately 10 basis points by the approximate $7 aggregate settlement charges associated with the payments made to former employees who were vested and participated in the U.S. defined benefit pension plan recorded in the prior-year period, which did not occur in 2016; and • approximately 10 basis points by the approximately $3 of transaction-related costs associated with the separation of North America that were included in continuing operations recorded in the prior-year period. These items were partially offset by: • approximately 50 basis points for higher CTI restructuring. See "Venezuela Discussion" in this MD&A and Note 1, Description of the Business and Summary of Significant Accounting Policies on pages through of our 2016 Annual Report for a further discussion of our Venezuelan operations, Note 13, Segment Information on pages through of our 2016 Annual Report for more information on the legal settlement, Note 12, Employee Benefit Plans on pages through of our 2016 Annual Report for a further discussion of the pension settlement charges, and Note 15, Restructuring Initiatives on pages through of our 2016 Annual Report for more information on CTI restructuring. The remaining decrease in selling, general and administrative expenses as a percentage of revenue and the decrease of 110 basis points in Adjusted selling, general and administrative expenses as a percentage of revenue was primarily due to the following: • a decrease of 210 basis points primarily due to lower fixed expenses, as well as the impact of the Constant $ revenue growth with respect to our fixed expenses. Lower fixed expenses resulted primarily from our costs savings initiatives, mainly reductions in headcount, but were partially offset by the inflationary impact on our expenses; • a decrease of 40 basis points due to lower expenses associated with employee incentive compensation plans; and • a decrease of 30 basis points from lower advertising expense, primarily in Europe, Middle East & Africa. These items were partially offset by the following: • an increase of 80 basis points from higher bad debt expense, driven by Brazil primarily due to the macroeconomic environment, coupled with actions taken to recruit new Representatives; • an increase of approximately 50 basis points due to the unfavorable impact of foreign currency translation and foreign currency transaction losses; and • an increase of 20 basis points as a result of the Industrial Production Tax ("IPI") tax law on cosmetics in Brazil that went into effect in May 2015, which reduced revenue as we did not raise the prices paid by Representatives to the same extent as the IPI tax. See "Segment Review - South Latin America" in this MD&A for a further discussion of the IPI tax law in Brazil. Impairment of Goodwill During the fourth quarter of 2015, we recorded a non-cash impairment charge of approximately $7 for goodwill associated with our Egypt business. See Note 18, Goodwill on pages through of our 2016 Annual Report for more information on Egypt. See “Segment Review” in this MD&A for additional information related to changes in segment margin. Other Expense Interest expense increased by approximately $16 compared to the prior-year period, primarily due to the interest associated with the $500 of Senior Secured Notes (as defined in "Capital Resources") issued in August 2016 and the increase in the interest rates on the 2013 Notes (as defined in "Capital Resources") as a result of the downgrades of our long-term credit ratings. These items were partially offset by the interest savings associated with the prepayment of the remaining principal amount of the 4.20% Notes (as defined in "Capital Resources") and 5.75% Notes (as defined in "Capital Resources") in November 2016, the prepayment of the $250 principal amount of our 2.375% Notes (as defined in "Capital Resources") in the third quarter of 2015 and the August 2016 cash tender offers. Refer to Note 6, Debt on pages through of our 2016 Annual Report and "Liquidity and Capital Resources" in this MD&A for additional information. Gain on extinguishment of debt in 2016 of approximately $1 was comprised of a gain of approximately $4 associated with the cash tender offers in August 2016 and a gain of approximately $1 associated with the debt repurchases in December 2016, partially offset by a loss of approximately $3 associated with the prepayment of the remaining principal amount of the 4.20% Notes (as defined in "Capital Resources") and 5.75% Notes (as defined in "Capital Resources") in November 2016 and a loss of approximately $1 associated with the debt repurchases in October 2016. Loss on extinguishment of debt in 2015 of approximately $6 was associated with the prepayment of our 2.375% Notes (as defined in "Capital Resources"). Refer to Note 6, Debt and Other Financing on pages through of our 2016 Annual Report and "Liquidity and Capital Resources" in this MD&A for additional information. Interest income increased by approximately $3 compared to the prior-year period. Other expense, net, increased by approximately $97 compared to the prior-year period, primarily due to the year-on-year impact of the Venezuelan special items as we recorded a loss of approximately $120 in the first quarter of 2016 as compared to a benefit of approximately $4 in the first quarter of 2015. In addition, other expense, net was positively impacted by lower losses on foreign exchange, partially offset by our proportionate share of New Avon's loss of approximately $12. Foreign exchange losses decreased by approximately $40 compared to the prior-year period, despite the unfavorable impact of approximately $17 as a result of the devaluation of the Egyptian pound in the fourth quarter of 2016. See "Venezuela Discussion" in this MD&A for a further discussion of our Venezuelan operations. See Note 3, Discontinued Operations and Divestitures on pages through of our 2016 Annual Report for more information on New Avon. Gain on sale of business in 2015 was the result of the sale of Liz Earle in July 2015. Refer to Note 3, Discontinued Operations and Divestitures on pages through of our 2016 Annual Report, for additional information regarding the sale of Liz Earle. Effective Tax Rate The effective tax rates in 2016 and 2015 continue to be impacted by our inability to recognize additional deferred tax assets in various jurisdictions related to our current-year operating results. In addition, the effective tax rates in 2016 and 2015 continue to be impacted by withholding taxes associated with certain intercompany payments, including royalties, service charges and dividends, which in the aggregate are relatively consistent each year due to the need to repatriate funds to cover U.S.-based costs, such as interest on debt and corporate overhead. Our inability to recognize additional deferred tax assets in various jurisdictions related to our current-year operating results, along with these withholding taxes, resulted in unusually high effective tax rates in 2016 and 2015. The effective tax rate in 2016 was impacted by the deconsolidation of our Venezuelan operations, valuation allowances for deferred tax assets outside of the U.S. of approximately $9 and CTI restructuring, partially offset by a benefit of approximately $29 as a result of the implementation of foreign tax planning strategies, a net benefit of approximately $7 primarily due to the release of a valuation allowance associated with Russia and a benefit from the net proceeds recognized as a result of a legal settlement. The effective tax rate in 2015 was negatively impacted by additional valuation allowances for U.S. deferred tax assets of approximately $670. The additional valuation allowances in 2015 were due to the continued strengthening of the U.S. dollar against currencies of some of our key markets and the impact on the benefits from our tax planning strategies associated with the realization of our deferred tax assets. In addition, the effective tax rate in 2015 was negatively impacted by valuation allowances for deferred tax assets outside of the U.S. of approximately $15, primarily in Russia, which was largely due to lower earnings, which were significantly impacted by foreign exchange losses on working capital balances. During 2015, we also recognized a benefit of approximately $19 as a result of the implementation of the initial stages of foreign tax planning strategies. The valuation allowances for deferred tax assets in 2015 caused income taxes to be significantly in excess of income before taxes. In addition, the effective tax rate in 2015 was negatively impacted by the devaluation of the Venezuelan currency in conjunction with highly inflationary accounting. The Adjusted effective tax rates in 2016 and 2015 were negatively impacted by the country mix of earnings and the inability to recognize additional deferred tax assets in various jurisdictions related to our current-year operating results, including the impact caused by the withholding taxes associated with certain intercompany payments, including royalties, service charges and dividends. See Note 8, Income Taxes on pages through of our 2016 Annual Report, for more information. In addition, see "Venezuela Discussion" in this MD&A and Note 1, Description of the Business and Summary of Significant Accounting Policies on pages through of our 2016 Annual Report for further discussion of our Venezuelan operations, Note 15, Restructuring Initiatives on pages through of our 2016 Annual Report for more information on CTI restructuring, and Note 13, Segment Information on pages through of our 2016 Annual Report for more information on the legal settlement. Impact of Foreign Currency During 2016, foreign currency continued to have a significant impact on our financial results. Specifically, as compared to the prior-year period, foreign currency has impacted our consolidated financial results in the form of: • foreign currency transaction losses (classified within cost of sales, and selling, general and administrative expenses), which had an unfavorable impact to operating profit and Adjusted operating profit of an estimated $165, or approximately 270 points to operating margin and Adjusted operating margin; • foreign currency translation, which had an unfavorable impact to operating profit of approximately $60 and Adjusted operating profit of approximately $65, or approximately 40 points to operating margin and Adjusted operating margin; and • foreign exchange losses on our working capital (classified within other expense, net), which were lower by approximately $35 before tax and $40 before tax on an Adjusted basis, despite the unfavorable impact of approximately $17 as a result of the devaluation of the Egyptian pound in the fourth quarter of 2016. Discontinued Operations Loss from discontinued operations, net of tax was approximately $14 compared to approximately $349 for 2015. During 2016, we recorded charges of approximately $16 before tax (approximately $5 after tax) in the aggregate associated with the separation of the North America business which closed on March 1, 2016. During 2015, we recorded a charge of approximately $340 before tax (approximately $340 after tax) associated with the estimated loss on the separation of the North America business. See Note 3, Discontinued Operations and Divestitures on pages through of our 2016 Annual Report for further discussion. Venezuela Discussion Avon Venezuela operates in the direct-selling channel offering Beauty and Fashion & Home products. Avon Venezuela has a manufacturing facility that produces the Beauty products that it sells. Avon Venezuela imports many of its Fashion & Home products and raw materials and components needed to manufacture its Beauty products. Currency restrictions enacted by the Venezuelan government since 2003 impacted the ability of Avon Venezuela to obtain foreign currency to pay for imported products. In 2010, we began accounting for our operations in Venezuela under accounting guidance associated with highly inflationary economies. Under U.S. GAAP, the financial statements of a foreign entity operating in a highly inflationary economy are required to be remeasured as if the functional currency is the company’s reporting currency, the U.S. dollar. This generally results in translation adjustments, caused by changes in the exchange rate, being reported in earnings currently for monetary assets (e.g., cash, accounts receivable) and liabilities (e.g., accounts payable, accrued expenses) and requires that different procedures be used to translate non-monetary assets (e.g., inventories, fixed assets). Non-monetary assets and liabilities are remeasured at the historical U.S. dollar cost basis. This diverges significantly from the application of accounting rules prior to designation as highly inflationary accounting, where such gains and losses would have been recognized only in other comprehensive income (loss) (shareholders' deficit). Venezuela's restrictive foreign exchange control regulations and our Venezuelan operations' increasingly limited access to U.S. dollars resulted in lack of exchangeability between the Venezuelan bolivar and the U.S. dollar, and restricted our Venezuelan operations' ability to pay dividends and settle intercompany obligations. The severe currency controls imposed by the Venezuelan government significantly limited our ability to realize the benefits from earnings of our Venezuelan operations and access the resulting liquidity provided by those earnings. We expected that this lack of exchangeability would continue for the foreseeable future, and as a result, we concluded that, effective March 31, 2016, this condition was other-than-temporary and we no longer met the accounting criteria of control in order to continue consolidating our Venezuelan operations. As a result, since March 31, 2016, we account for our Venezuelan operations using the cost method of accounting. As a result of the change to the cost method of accounting, in the first quarter of 2016 we recorded a loss of approximately $120 in other expense, net. The loss was comprised of approximately $39 in net assets of the Venezuelan business and approximately $81 in accumulated foreign currency translation adjustments within AOCI associated with foreign currency movements before Venezuela was accounted for as a highly inflationary economy. The net assets of the Venezuelan business were comprised of inventories of approximately $24, property, plant and equipment, net of approximately $15, other assets of approximately $11, accounts receivable of approximately $5, cash of approximately $4, and accounts payable and accrued liabilities of approximately $20. Our Consolidated Balance Sheets no longer include the assets and liabilities of our Venezuelan operations, and we no longer include the results of our Venezuelan operations in the Consolidated Financial Statements, and will include income relating to our Venezuelan operations only to the extent that we receive cash for dividends or royalties remitted by Avon Venezuela. In February 2015, the Venezuelan government announced the creation of a new foreign exchange system referred to as the SIMADI exchange ("SIMADI"), which represented the rate which better reflected the economics of Avon Venezuela's business activity, in comparison to the other then available exchange rates; as such, we concluded that we should utilize the SIMADI exchange rate to remeasure our Venezuelan operations. As a result of the change to the SIMADI rate, which caused the recognition of a devaluation of approximately 70% as compared to the exchange rate we had used previously, we recorded an after-tax benefit of approximately $3 (a benefit of approximately $4 in other expense, net, and a loss of approximately $1 in income taxes) in the first quarter of 2015, primarily reflecting the write-down of net monetary assets. In addition, as a result of using the historical U.S. dollar cost basis of non-monetary assets, such as inventories, these assets continued to be remeasured, following the change to the SIMADI rate, at the applicable rate at the time of their acquisition. The remeasurement of non-monetary assets at the historical U.S. dollar cost basis caused a disproportionate expense as these assets were consumed in operations, negatively impacting operating profit and net income by approximately $19 during 2015. Also as a result of the change to the SIMADI rate, we determined that an adjustment of approximately $11 to cost of sales was needed to reflect certain non-monetary assets, primarily inventories, at their net realizable value, which was recorded in the first quarter of 2015. In addition, in February 2015, we reviewed Avon Venezuela's long-lived assets to determine whether the carrying amount of the assets was recoverable. Based on our expected cash flows associated with the asset group, we determined that the carrying amount of the assets, carried at their historical U.S. dollar cost basis, was not recoverable. As such, an impairment charge of approximately $90 to selling, general and administrative expenses was needed to reflect the write-down of the long-lived assets to their estimated fair value of approximately $16, which was recorded in the first quarter of 2015. In February 2014, the Venezuelan government announced a foreign exchange system which began operating in March 2014, referred to as the SICAD II exchange ("SICAD II"). As SICAD II represented the rate which better reflected the economics of Avon Venezuela's business activity, in comparison to the other then available exchange rates, we concluded that we should utilize the SICAD II exchange rate to remeasure our Venezuelan operations effective March 31, 2014. As a result of the change to the SICAD II rate, which caused the recognition of a devaluation of approximately 88% as compared to the official exchange rate we used previously, we recorded an after-tax loss of approximately $42 (approximately $54 in other expense, net, and a benefit of approximately $12 in income taxes) in the first quarter of 2014, primarily reflecting the write-down of net monetary assets. In addition, as a result of using the historical U.S. dollar cost basis of non-monetary assets, such as inventories, these assets continued to be remeasured, following the change to the SICAD II rate, at the applicable rate at the time of their acquisition. The remeasurement of non-monetary assets at the historical U.S. dollar cost basis caused a disproportionate expense as these assets are consumed in operations, negatively impacting operating profit and net income by approximately $21 during 2014. Also as a result, we determined that an adjustment of approximately $116 to cost of sales was needed to reflect certain non-monetary assets, primarily inventories, at their net realizable value, which was recorded in the first quarter of 2014. 2015 Compared to 2014 Revenue Total revenue in 2015 declined 19% compared to the prior-year period, primarily due to unfavorable foreign exchange. Constant $ revenue increased 2%. Constant $ revenue was negatively impacted by approximately 2 points due to taxes in Brazil from the combined impact of the recognition of Value Added Tax ("VAT") credits in 2014 which did not recur in 2015 along with a new IPI tax law on cosmetics which went into effect in May 2015. Constant $ revenue was also negatively impacted by approximately 1 point as a result of the sale of Liz Earle which was completed in July 2015. Our Constant $ revenue benefited from growth in markets experiencing relatively high inflation (Venezuela and Argentina), which contributed approximately 2 points to our Constant $ revenue growth. Our Constant $ revenue also benefited from growth in Europe, Middle East & Africa, most significantly Eastern Europe (Russia and Ukraine), and to a lesser extent, South Africa and underlying growth in Brazil. Constant $ revenue benefited from higher average order and a 1% increase in Active Representatives. The increase in Active Representatives was primarily due to growth in Europe, Middle East & Africa, most significantly Russia, which was primarily due to sustained momentum in recruitment and retention, partially offset by markets experiencing relatively high inflation (Venezuela and Argentina). The net impact of price and mix increased 4%, driven by increases in all segments. The net impact of price and mix was primarily positively impacted by markets experiencing relatively high inflation (Venezuela and Argentina), as these markets benefited from the inflationary impact on pricing. Units sold decreased 2%, primarily due to declines in units sold in Brazil and Venezuela, partially offset by an increase in units sold in Russia. See "Segment Review - South Latin America" in this MD&A for a further discussion of the tax benefits in Brazil. Ending Representatives increased by 3%. The increase in Ending Representatives at December 31, 2015 as compared to the prior-year period was primarily due growth in Europe, Middle East & Africa, most significantly Russia and South Africa, as well as growth in South Latin America. On a category basis, our net sales from reportable segments and associated growth rates were as follows: See "Segment Review" in this MD&A for additional information related to changes in revenue by segment. Operating Margin Operating margin and Adjusted operating margin decreased 300 basis points and 360 basis points, respectively, compared to 2014. The decrease in Adjusted operating margin includes the benefits associated with the restructuring actions taken during 2015 and the $400M Cost Savings Initiative, primarily reductions in headcount, as well as other cost reductions. The decrease in operating margin and Adjusted operating margin are discussed further below in "Gross Margin," "Selling, General and Administrative Expenses" and "Impairment of Goodwill." Gross Margin Gross margin and Adjusted gross margin decreased 40 basis points and 150 basis points, respectively, compared to 2014. The gross margin comparison was impacted by approximately 110 basis points by a lower negative impact of the devaluation of the Venezuelan currency in conjunction with highly inflationary accounting, as approximately $29 was recognized in the current-year period as compared to approximately $121 in the prior-year period, primarily associated with adjustments to reflect certain non-monetary assets at their net realizable value. See "Venezuela Discussion" in this MD&A for a further discussion of our Venezuelan operations. The remaining decrease in gross margin and the decrease of 150 basis points in Adjusted gross margin was primarily due to the following: • a decrease of approximately 270 basis points due to the unfavorable impact of foreign currency transaction losses and foreign currency translation; • a decrease of 40 basis points associated with the net impact of VAT credits in Brazil recognized in revenue in 2014 that did not recur in 2015; and • a decrease of 20 basis points as a result of the IPI tax law on cosmetics in Brazil that went into effect in May 2015. These items were partially offset by the following: • an increase of 130 basis points due to the favorable net impact of mix and pricing, which includes the realization of price increases in markets experiencing relatively high inflation (Venezuela and Argentina), on inventory acquired in advance of such inflation; and • an increase of approximately 60 basis points due to lower supply chain costs, primarily in Europe, Middle East & Africa which was largely due to lower overhead costs. The negative impact of foreign currency transaction losses was partially mitigated by the benefits of pricing as we realized the impact of inflation in certain of our markets. See "Segment Review - South Latin America" in this MD&A for a further discussion of the VAT credits and IPI tax law in Brazil. Selling, General and Administrative Expenses Selling, general and administrative expenses for 2015 decreased approximately $664 compared to 2014. This decrease is primarily due to the favorable impact of foreign currency translation, as the strengthening of the U.S. dollar against many of our foreign currencies resulted in lower reported selling, general and administrative expenses. The decrease in selling, general and administrative expenses is also due to the additional $46 accrual recorded in the first quarter of 2014 for the settlements related to the FCPA investigations and a lower amount of CTI restructuring. Partially offsetting the decrease in selling, general and administrative expenses was an approximate $90 impairment charge recorded in 2015 to reflect the write-down of the long-lived assets to their estimated fair value associated with the devaluation of the Venezuelan currency in conjunction with highly inflationary accounting, higher Representative, sales leader and field expense, higher foreign currency transaction costs and higher expenses associated with long-term employee incentive compensation plans as the prior-year period includes the benefit from the reversal of such accruals that did not recur in the current-year period. Selling, general and administrative expenses and Adjusted selling, general, and administrative expenses as a percentage of revenue increased 250 basis points and 220 basis points, respectively, compared to 2014. The selling, general and administrative expenses as a percentage of revenue comparison was negatively impacted by: • approximately 130 basis points by the devaluation of the Venezuelan currency in conjunction with highly inflationary accounting. During 2015, an approximate $90 impairment charge was recorded to reflect the write-down of the long-lived assets to their estimated fair value following a devaluation. In addition, approximately $1 was recorded in 2015 as compared to $16 recorded in 2014 associated with our Venezuelan operations for certain non-monetary assets carried at the historical U.S. dollar cost following the devaluation of the Venezuelan currency in conjunction with highly inflationary accounting; and • approximately 10 basis points by the approximate $3 of transaction-related costs recorded in 2015 associated with the separation of North America that were included in continuing operations. These items were partially offset by: • approximately 60 basis points by the additional $46 accrual recorded in 2014 for the settlements related to the FCPA investigations that did not recur in 2015; and • approximately 30 basis points for lower CTI restructuring. In addition, during 2015 and 2014 we recorded approximately $7 and $10, respectively, of aggregate settlement charges associated with the payments made to former employees who were vested and participated in the U.S. defined benefit pension plan. See "Venezuela Discussion" in this MD&A and Note 1, Description of the Business and Summary of Significant Accounting Policies on pages through of our 2016 Annual Report for a further discussion of our Venezuelan operations, Note 17, Contingencies on pages through of our 2016 Annual Report for more information on the FCPA investigations, Note 12, Employee Benefit Plans on pages through of our 2016 Annual Report for a further discussion of the pension settlement charges, and Note 15, Restructuring Initiatives on pages through of our 2016 Annual Report for more information on CTI restructuring. The remaining increase in selling, general and administrative expenses as a percentage of revenue and the increase of 220 basis points in Adjusted selling, general and administrative expenses as a percentage of revenue was primarily due to the following: • an increase of approximately 210 basis points due to the unfavorable impact of foreign currency translation and foreign currency transaction losses; • an increase of 60 basis points associated with the net impact of VAT credits in Brazil recognized in revenue in 2014 that did not recur in 2015; • an increase of 60 basis points as a result of the IPI tax law on cosmetics in Brazil, which reduced revenue as we did not raise the prices paid by Representatives to the same extent as the IPI tax; and • an increase of 40 basis points due to higher expenses associated with long-term employee incentive compensation plans as the prior-year period includes the benefit from the reversal of such accruals that did not recur in the current-year period. These items were partially offset by the following: • a decrease of 160 basis points primarily due to the impact of Constant $ revenue growth with respect to our fixed expenses. In addition, lower fixed expenses, primarily resulting from our cost savings initiatives, mainly reductions in headcount, were largely offset by the inflationary impact on our expenses. See "Segment Review - South Latin America" in this MD&A for a further discussion of the VAT credits and IPI tax law in Brazil. Impairment of Goodwill During the fourth quarter of 2015, we recorded a non-cash impairment charge of approximately $7 for goodwill associated with our Egypt business. See Note 18, Goodwill on pages through of our 2016 Annual Report for more information on Egypt. See “Segment Review” in this MD&A for additional information related to changes in segment margin. Other Expense Interest expense increased by approximately $12 compared to the prior-year period, primarily due to the increase in the interest rates on the 2013 Notes (as defined in "Capital Resources") as a result of the downgrades of our long-term credit ratings. Loss on extinguishment of debt in 2015 of approximately $6 was associated with the prepayment of our 2.375% Notes (as defined in "Capital Resources"). Refer to Note 6, Debt and Other Financing on pages through of our 2016 Annual Report and "Liquidity and Capital Resources" in this MD&A for additional information. Interest income decreased by approximately $2 compared to the prior-year period. Other expense, net, decreased by approximately $66 compared to the prior-year period, primarily due to the year-on-year impact of the Venezuelan special items as we recorded a benefit of approximately $4 in the first quarter of 2015 as compared to a loss of approximately $54 in the first quarter of 2014. In addition, the decrease in other expense, net was partially due to lower losses on foreign exchange of approximately $10 compared to the prior-year period. See "Venezuela Discussion" in this MD&A for a further discussion of our Venezuelan operations. Gain on sale of business in 2015 was the result of the sale of Liz Earle in July 2015. Refer to Note 3, Discontinued Operations and Divestitures on pages through of our 2016 Annual Report, for additional information regarding the sale of Liz Earle. Effective Tax Rate The effective tax rate in 2015 was negatively impacted by additional valuation allowances for U.S. deferred tax assets of approximately $670. The additional valuation allowances in 2015 were due to the continued strengthening of the U.S. dollar against currencies of some of our key markets and the impact on the benefits from our tax planning strategies associated with the realization of our deferred tax assets. In addition, the effective tax rate in 2015 was negatively impacted by valuation allowances for deferred tax assets outside of the U.S. of approximately $15, primarily in Russia, which was largely due to lower earnings, which were significantly impacted by foreign exchange losses on working capital balances. During 2015, we also recognized a benefit of approximately $19 as a result of the implementation of the initial stages of foreign tax planning strategies. The valuation allowances for deferred tax assets in 2015 caused income taxes to be significantly in excess of income before taxes. The effective tax rate in 2014 was negatively impacted by a non-cash income tax charge of approximately $396. This was largely due to a valuation allowance, recorded in the fourth quarter of 2014, against deferred tax assets of approximately $375 which is primarily due to the strengthening of the U.S. dollar against currencies of some of our key markets. The approximate $375 includes the valuation allowance recorded for U.S. deferred tax assets of approximately $367, as well as approximately $8 associated with other foreign subsidiaries. In addition, the effective tax rates in 2015 and 2014 were negatively impacted by the devaluations of the Venezuelan currency in conjunction with highly inflationary accounting discussed further within "Venezuela Discussion" in this MD&A. The Adjusted effective tax rate in 2015 was negatively impacted by the country mix of earnings and the inability to recognize additional deferred tax assets in various jurisdictions related to our current-year operating results. The Adjusted effective tax rate in 2014 was negatively impacted by an adjustment to the carrying value of our state deferred tax balances due to changes in the expected tax rate, valuation allowances for deferred taxes, including the impact of legislative changes, and out-of-period adjustments of approximately $6 recorded in the fourth quarter of 2014. See Note 8, Income Taxes on pages through of our 2016 Annual Report, for more information. Impact of Foreign Currency During 2015, foreign currency had a significant impact on our financial results. Specifically, as compared to the prior-year period, foreign currency has impacted our consolidated financial results in the form of: • foreign currency transaction losses (classified within cost of sales, and selling, general and administrative expenses), which had an unfavorable impact to operating profit and Adjusted operating profit of an estimated $210, or approximately 280 points to operating margin and Adjusted operating margin; • foreign currency translation, which had an unfavorable impact of approximately $385 (of which approximately $210 related to Venezuela, primarily from the impact from the devaluation of the Venezuelan currency in conjunction with highly inflationary accounting) to operating profit and approximately $265 (of which approximately $90 related to Venezuela) to Adjusted operating profit, or approximately 420 points to operating margin and 200 points to Adjusted operating margin; and • foreign exchange losses on our working capital (classified within other expense, net), which were lower by approximately $68 before tax (of which approximately $60 related to Venezuela, primarily from the impact from the devaluation of the Venezuelan currency in conjunction with highly inflationary accounting) and $10 before tax on an Adjusted basis. See "Venezuela Discussion" in this MD&A for a further discussion of our Venezuelan operations. Discontinued Operations Loss from discontinued operations, net of tax was approximately $349 compared approximately $40 for 2014. During 2015, we recorded a charge of approximately $340 before tax (approximately $340 after tax) associated with the estimated loss on the sale of the North America business. In addition, the North America operations achieved higher operating income in 2015 as compared with 2014 despite lower revenues as a result of significant cost savings, as well as lower costs to implement restructuring initiatives. The estimated loss on sale was comprised of the following: See Note 3, Discontinued Operations and Divestitures on pages through of our 2016 Annual Report for further discussion. Other Comprehensive Income (Loss) Other comprehensive income (loss), net of taxes was approximately $333 in 2016 compared with approximately ($151) in 2015, driven by the recognition of losses of $259 from other comprehensive income (loss) into the Consolidated Statements of Operations as a result of the separation of the North America business, primarily related to unamortized losses associated with the employee benefit plans. Other comprehensive income (loss), net of taxes was also favorably impacted by foreign currency translation adjustments, which decreased by approximately $240 as compared to 2015 primarily due to the favorable year-over-year comparison of movements of the Brazilian real, Colombian peso and Argentine peso, partially offset by the unfavorable year-over-year comparison of movements of the British pound. In addition, other comprehensive income (loss) in 2016 as compared with 2015 was favorably impacted by the approximate $82 impact of the deconsolidation of Venezuela. These favorable impacts to other comprehensive income (loss) were partially offset by the unfavorable impacts of lower amortization of net actuarial losses of approximately $64, largely as a result of the separation of the North America business, and lower net actuarial gains, which were approximately $3 in 2016 as compared with net actuarial gains of approximately $41 in 2015. In 2016, net actuarial gains decreased as a result of lower discount rates for the non-U.S. and U.S. pension plans, partially offset by higher asset returns in the U.S. and non-U.S. pension plans in 2016 as compared to 2015. Other comprehensive income (loss), net of taxes was approximately ($151) in 2015 compared with approximately ($348) in 2014, primarily due to net actuarial gains of approximately $41 in 2015 as compared with net actuarial losses of approximately $187 in 2014. In 2015, net actuarial gains benefited from higher discount rates for the non-U.S. and U.S. pension plans, partially offset by lower asset returns in the non-U.S. and U.S. pension plans in 2015 as compared to 2014. The other comprehensive income (loss) year-over-year comparison was also unfavorably impacted by foreign currency translation adjustments, which increased by approximately $27 as compared to 2014 primarily due to unfavorable movements of the Brazilian real, partially offset by the year-over-year comparison of movements of the Polish zloty and Russian ruble. See Note 3, Discontinued Operations and Divestitures on pages through of our 2016 Annual Report for more information on the separation of the North America business, see "Venezuela Discussion" in this MD&A and Note 1, Description of the Business and Summary of Significant Accounting Policies on pages through of our 2016 Annual Report for a further discussion of our Venezuelan operations, and see Note 12, Employee Benefit Plans on pages through of our 2016 Annual Report for more information on our benefit plans. Segment Review We determine segment profit by deducting the related costs and expenses from segment revenue. In order to ensure comparability between periods, segment profit includes an allocation of global marketing expenses based on actual revenues. Segment profit excludes global expenses other than the allocation of marketing, CTI restructuring initiatives, certain significant asset impairment charges, and other items, which are not allocated to a particular segment, if applicable. This is consistent with the manner in which we assess our performance and allocate resources. Refer to Note 13, Segment Information on pages through of our 2016 Annual Report for a reconciliation of segment profit to operating profit. Summarized financial information concerning our reportable segments was as follows: Below is an analysis of the key factors affecting revenue and segment profit by reportable segment for each of the years in the three-year period ended December 31, 2016. Foreign currency impact is determined as the difference between actual growth rates and Constant $ growth rates. Refer to "Non-GAAP Financial Measures" in this MD&A for more information. Europe, Middle East & Africa - 2016 Compared to 2015 Amounts in the table above may not necessarily sum due to rounding. Total revenue decreased 4% compared to the prior-year period, due to the unfavorable impact from foreign exchange, most significantly the strengthening of the U.S. dollar relative to the British pound, Russian ruble and South African rand. On a Constant $ basis, revenue grew 4%, primarily driven by South Africa and Russia. The segment's Constant $ revenue growth was driven primarily by an increase in Active Representatives as well as higher average order. The increase in Ending Representatives was driven primarily by growth in Russia and South Africa. In Russia, revenue was relatively unchanged, which was unfavorably impacted by foreign exchange. On a Constant $ basis, Russia's revenue grew 9%, primarily due to an increase in Active Representatives, which benefited from sustained momentum in recruiting and retention, and to a lesser extent, higher average order, which was driven by pricing benefits. Russia's Constant $ revenue growth was driven by the strength of the performance in the first half of 2016 which tempered in the second half of 2016. During the fourth quarter of 2016, Russia's Constant $ revenue declined primarily as a result of increased pricing that negatively impacted Representative engagement and activity. In the United Kingdom, revenue declined 12%, which was unfavorably impacted by foreign exchange. On a Constant $ basis, the United Kingdom's revenue was relatively unchanged, as higher average order was offset by a decrease in Active Representatives. In South Africa, revenue grew 6%, which was unfavorably impacted by foreign exchange. On a Constant $ basis, South Africa’s revenue grew 21%, primarily due to an increase in Active Representatives. Segment margin increased 1.4 points, or 1.3 points on a Constant $ basis, primarily as a result of: • a net benefit of 1.0 point primarily due to the impact of the Constant $ revenue growth with respect to our fixed expenses; • a benefit of .7 points due to lower advertising expense, most significantly in Russia; and • a decline of .3 points due to lower gross margin, caused primarily by an estimated 3 points from the unfavorable impact of foreign currency transaction losses, which was partially offset by benefits of 1.5 points from the favorable net impact of mix and pricing and 1.1 points due to lower supply chain costs. Mix and pricing was primarily driven by inflationary and strategic pricing in Russia and lower supply chain costs included benefits from lower material costs and cost savings initiatives. Europe, Middle East & Africa - 2015 Compared to 2014 Amounts in the table above may not necessarily sum due to rounding. Total revenue decreased 15% compared to the prior-year period, due to the unfavorable impact from foreign exchange including the strengthening of the U.S. dollar relative to the Russian ruble. On a Constant $ basis, revenue grew 8%, primarily driven by Eastern Europe. An increase in Active Representatives drove the segment's Constant $ revenue growth. The increase in Ending Representatives was driven primarily by growth in Eastern Europe, largely due to Russia. In Russia, revenue declined 23%, which was unfavorably impacted by foreign exchange. On a Constant $ basis, Russia's revenue grew 23%, primarily due to an increase in Active Representatives which benefited from sustained momentum in recruiting and retention, and higher average order. In the United Kingdom, revenue declined 12%, which was unfavorably impacted by foreign exchange. On a Constant $ basis, the United Kingdom's revenue declined 5%, primarily due to a decrease in Active Representatives. In Turkey, revenue declined 15%, which was unfavorably impacted by foreign exchange. On a Constant $ basis, Turkey's revenue grew 5%. In South Africa, revenue grew 1%, which was unfavorably impacted by foreign exchange. On a Constant $ basis, South Africa’s revenue grew 19%, primarily due to an increase in Active Representatives and higher average order. Segment margin decreased 2.5 points, or 2.3 points on a Constant $ basis, primarily as a result of: • a decline of 2.4 points due to lower gross margin caused primarily by an estimated 4 points from the unfavorable impact of foreign currency transaction losses, partially offset by approximately 1.0 point from lower supply chain costs and 1.0 point from the favorable net impact of mix and pricing. Supply chain costs benefited primarily as a result of lower overhead costs which were attributable to increased productivity. The favorable net impact of mix and pricing was primarily driven by Eastern Europe; • a decline of .5 points from higher Representative, sales leader and field expense; and • various other insignificant items that partially offset the decrease in segment margin. South Latin America - 2016 Compared to 2015 Amounts in the table above may not necessarily sum due to rounding. Total revenue decreased 7% compared to the prior-year period, due to the unfavorable impact from foreign exchange which was primarily driven by the strengthening of the U.S. dollar relative to the Argentine peso and the Brazilian real. On a Constant $ basis, revenue increased 5%. The segment's Constant $ revenue growth was negatively impacted by an estimated 1 point from additional VAT state taxes in Brazil that were implemented in late 2015. In addition, an IPI tax law on cosmetics in Brazil that went into effect in May 2015 caused an estimated 1 point negative impact on the segment's Constant $ revenue growth. The segment's Constant $ revenue benefited from higher average order, which was driven by pricing, and was partially offset by a decrease in Active Representatives. The segment's Constant $ revenue and higher average order benefited from relatively high inflation in Argentina, as this market's results were impacted by the inflationary impact on pricing. Argentina contributed approximately 4 points to the segment's Constant $ revenue growth. Revenue in Argentina decreased 20%, unfavorably impacted by foreign exchange. On a Constant $ basis, Argentina's revenue grew 28% which was primarily due to higher average order, partially offset by a decrease in Active Representatives. The increase in Ending Representatives was primarily driven by growth in Brazil. Revenue in Brazil decreased 3%, unfavorably impacted by foreign exchange. Brazil’s Constant $ revenue increased 2%, despite the negative impact of an estimated 3 points due to the additional VAT state taxes discussed above. Constant $ revenue in Brazil was also negatively impacted by an estimated 3 points from the impact of the IPI tax discussed above. The negative impact of the additional VAT state taxes and the IPI tax was partially offset by higher average order, which was driven by pricing. In addition, Brazil continued to be impacted by a difficult economic environment. On a Constant $ basis, Brazil’s sales from Beauty products increased 1%, despite the negative impact of the IPI tax and the additional VAT state taxes. On a Constant $ basis, Brazil's sales from Fashion & Home products increased 1%. Segment margin decreased 1.0 point, or .8 points on a Constant $ basis, primarily as a result of: • a decline of 2.0 points from higher bad debt expense, driven by Brazil primarily due to the macroeconomic environment, coupled with actions taken to recruit new Representatives, including the adjustment of credit terms; • a decline of .6 points as a result of the IPI tax law on cosmetics in Brazil, which are a reduction of revenue and we have not raised the prices paid by Representatives to the same extent as the IPI tax; • a decline of .4 points from higher advertising expense, primarily in Brazil in the second half of 2016; • a benefit of .7 points primarily due to the impact of the Constant $ revenue growth with respect to our fixed expenses; • a benefit of .5 points due to higher gross margin caused by 2.6 points from the favorable net impact of mix and pricing, primarily due to inflationary and strategic pricing, and 1.2 points from lower supply chain costs, partially offset by an estimated 3.2 points from the unfavorable impact of foreign currency transaction losses. Supply chain costs benefited primarily as a result of lower material costs and cost savings initiatives; • a benefit of .3 points primarily due to the net impact of the Constant $ revenue growth with respect to our Representative, sales leader and field expense; and • various other insignificant items that partially offset the decline in segment margin. As a result of enhancements to our collection processes and tightening recruiting terms, we anticipate moderated growth of Ending Representatives in Brazil. South Latin America - 2015 Compared to 2014 Amounts in the table above may not necessarily sum due to rounding. Total revenue decreased 24% compared to the prior-year period, due to the unfavorable impact from foreign exchange which was primarily driven by the strengthening of the U.S. dollar relative to the Brazilian real. On a Constant $ basis, revenue decreased 2%, negatively impacted by approximately 6 points due to taxes in Brazil from the combined impact of the recognition of VAT credits in 2014 along with the IPI tax discussed above in 2015. Specifically, during 2014, we recognized $85 in Brazil for expected VAT recoveries which did not recur in 2015, and as such, there was an approximate 3 point negative impact on the segment’s Constant $ growth rate. In addition, the IPI tax law on cosmetics in Brazil in 2015 caused an estimated 3 point negative impact on the segment's Constant $ revenue growth. Further, Argentina, which is a market experiencing relatively high inflation, contributed approximately 4 points to the segment's Constant $ revenue growth. Average order in the segment benefited from the inflationary impact on pricing in Argentina, while Active Representatives was negatively impacted by this market. Average order was negatively impacted by the taxes in Brazil. The increase in Ending Representatives was primarily driven by growth in Brazil. Revenue in Brazil decreased 34%, unfavorably impacted by foreign exchange. Brazil’s Constant $ revenue decreased 8%, negatively impacted by approximately 10 points due to the combined impact of the VAT credits in 2014 and the IPI tax in 2015 discussed above. The negative impact of these tax items were partially offset by an increase in Active Representatives. On a Constant $ basis, Brazil’s sales from Beauty products decreased 5%, negatively impacted by the IPI tax. This negative impact on Beauty sales was partially offset by increased sales of fragrance, which benefited from our alliance with Coty, as well as from new product launches during the first quarter of 2015. The IPI tax also negatively impacted Brazil's Beauty units, as we increased prices to partially offset the new tax. On a Constant $ basis, Brazil's sales from Fashion & Home products increased 1%. Brazil continues to be impacted by a difficult economic environment as well as high levels of competition. Segment margin decreased 5.1 points, or 5.0 points on a Constant $ basis, primarily as a result of: • a decline of 2.5 points associated with the net impact of VAT credits in Brazil recognized in revenue in 2014, discussed above; • a decline of 1.8 points as a result of the IPI tax law on cosmetics in Brazil, which are a reduction of revenue and we have not raised the prices paid by Representatives to the same extent as the IPI tax; and • a decline of 1.0 point due to lower gross margin caused primarily by 2.3 points from the unfavorable impact of foreign currency transaction losses, partially offset by 1.3 points from the favorable net impact of mix and pricing, which includes the realization of price increases in Argentina on inventory acquired in advance of inflation. North Latin America - 2016 Compared to 2015 Amounts in the table above may not necessarily sum due to rounding. North Latin America consists largely of the Mexico business. Total revenue decreased 8% compared to the prior-year period, due to the unfavorable impact from foreign exchange which was primarily driven by the strengthening of the U.S. dollar relative to the Mexican peso. On a Constant $ basis, revenue increased 3%, which benefited from higher average order. Revenue in Mexico decreased 11%, unfavorably impacted by foreign exchange. On a Constant $ basis, Mexico's revenue grew 5%, primarily due to higher average order driven primarily from pricing, partially offset by a decline in units sold. Segment margin increased 1.9 points, or 2.2 points on a Constant $ basis, primarily as a result of: • a benefit of 1.1 points due to higher gross margin caused primarily by a benefit of 2.7 points from the favorable impact of mix and pricing, primarily due to inflationary and strategic pricing, partially offset by 1.5 points from the unfavorable impact of foreign currency transaction losses; and • a benefit of .8 points primarily from lower fixed expenses, which includes .6 points as a result of an out-of-period adjustment which negatively impacted the prior-year period, as well as due to the impact of the Constant $ revenue growth with respect to our fixed expenses. North Latin America - 2015 Compared to 2014 Amounts in the table above may not necessarily sum due to rounding. Total revenue decreased 10% compared to the prior-year period, due to the unfavorable impact from foreign exchange which was primarily driven by the strengthening of the U.S. dollar relative to the Mexican peso. On a Constant $ basis, revenue increased 2%, The segment's Constant $ revenue growth benefited from an increase in Active Representatives and higher average order. Revenue in Mexico declined 15%, unfavorably impacted by foreign exchange, or increased 2% on a Constant $ basis, primarily due to higher average order. Segment margin decreased .9 points, or .6 points on a Constant $ basis, primarily as a result of: • a decline of 1.0 points from higher Representative, sales leader and field expense, primarily in Mexico; • a decline of .3 points from higher fixed expenses, which includes .6 points as a result of an out-of-period adjustment, partially offset by the impact of the Constant $ revenue growth with respect to our fixed expenses; • a benefit of .4 points due to higher gross margin caused primarily by .4 points from lower supply chain costs and .4 points from the favorable net impact of mix and pricing, partially offset by immaterial items that unfavorably impacted gross margin. Lower supply chain costs were driven by lower material costs and productivity initiatives, partially offset by higher obsolescence; and • various other insignificant items that partially offset the decline in segment margin. Asia Pacific - 2016 Compared to 2015 Amounts in the table above may not necessarily sum due to rounding. Total revenue decreased 11% compared to the prior-year period, partially due to the unfavorable impact from foreign exchange. On a Constant $ basis, revenue decreased 7%, due to declines in most markets. The segment's Constant $ revenue decline was primarily due to a decrease in Active Representatives, partially offset by higher average order. Revenue in the Philippines decreased 3%, but grew 2% on a Constant $ basis, primarily due to higher average order, partially offset by a decrease in Active Representatives. The segment's and the Philippines' Active Representatives decline was impacted by a reduction in the number of sales campaigns in the Philippines. The decrease in Ending Representatives was driven by declines in all markets and included a negative impact of 1 point due to the closure of Thailand. Segment margin declined .2 points, or increased .1 point on a Constant $ basis, primarily as a result of: • a net benefit of .3 points primarily from lower fixed expenses, largely offset by the unfavorable impact of the declining revenue with respect to our fixed expenses; • a decline of .8 points due to lower gross margin, caused primarily by 1.1 points from the unfavorable impact of mix and pricing and .3 points from the unfavorable impact of foreign currency transaction losses, partially offset by .7 points from lower supply chain costs; and • various other insignificant items that benefited segment margin. We continue to evaluate strategic alternatives for China. Asia Pacific - 2015 Compared to 2014 Amounts in the table above may not necessarily sum due to rounding. Total revenue decreased 11% compared to the prior-year period, primarily due to the unfavorable impact from foreign exchange. On a Constant $ basis, revenue decreased 5%, as growth in the Philippines was more than offset by declines in other Asia Pacific markets, led by China which declined 29%, or 28% on a Constant $ basis. The segment's Constant $ revenue decline was due to lower average order, primarily driven by declines in China, and a decrease in Active Representatives. Revenue in the Philippines increased 3%, or 5% on a Constant $ basis, primarily due to higher average order, as a result of strength in Fashion & Home, and an increase in Active Representatives. The increase in Ending Representatives was primarily driven by growth in the Philippines. Segment margin increased 2.5 points, or 2.6 points on a Constant $ basis, primarily as a result of: • a net benefit of 1.8 points primarily from lower fixed expenses, which primarily resulted from our cost savings initiatives, mainly reductions in headcount. Partially offsetting the lower fixed expenses was the unfavorable impact of the declining revenue with respect to our fixed expenses; and • a benefit of .9 points due to lower advertising spend. Liquidity and Capital Resources Our principal sources of funding historically have been cash flows from operations, public offerings of notes, bank financings, borrowings under lines of credit, issuance of commercial paper, a private placement of notes and an issuance of shares of preferred stock. At December 31, 2016, we had cash and cash equivalents totaling approximately $654. We believe that our sources of funding will be sufficient to satisfy our currently anticipated cash requirements through at least the next twelve months. We may seek to repurchase our equity or to retire our outstanding debt in open market purchases, privately negotiated transactions, through derivative instruments, cash tender offers or otherwise. Repurchases of equity and debt may be funded by the incurrence of additional debt or the issuance of equity (including shares of preferred stock) or convertible securities and will depend on prevailing market conditions, our liquidity requirements, contractual restrictions and other factors, and the amounts involved may be material. We may also elect to incur additional debt or issue equity (including shares of preferred stock) or convertible securities to finance ongoing operations or to meet our other liquidity needs. Any issuances of equity (including shares of preferred stock) or convertible securities could have a dilutive effect on the ownership interest of our current shareholders and may adversely impact earnings per share in future periods. Our credit ratings were downgraded in 2016, 2015 and 2014, which may impact our access to these transactions on favorable terms, if at all. For more information see "Risk Factors - Our credit ratings were downgraded in each of the last three years, which could limit our access to financing, affect the market price of our financing and increase financing costs. A further downgrade in our credit ratings may adversely affect our access to liquidity," "Risk Factors - Our indebtedness and any future inability to meet any of our obligations under our indebtedness, could adversely affect us by reducing our flexibility to respond to changing business and economic conditions," and "Risk Factors - A general economic downturn, a recession globally or in one or more of our geographic regions or markets or sudden disruption in business conditions or other challenges may adversely affect our business, our access to liquidity and capital, and our credit ratings" included in Item 1A on pages 7 through 20 of our 2016 Annual Report. Our liquidity could also be negatively impacted by restructuring initiatives, dividends, capital expenditures, acquisitions, and certain contingencies, including any legal or regulatory settlements, described more fully in Note 17, Contingencies on pages through of our 2016 Annual Report. See our Cautionary Statement for purposes of the "Safe Harbor" Statement under the Private Securities Litigation Reform Act of 1995 on pages 1 through 2 of our 2016 Annual Report. Balance Sheet Data Cash Flows Net Cash from Continuing Operating Activities Net cash provided by continuing operating activities during 2016 was approximately $37 higher than during 2015. The approximate $37 increase to net cash provided by continuing operating activities was primarily due to the approximate $67 payment to the U.S. Securities and Exchange Commission in connection with the FCPA settlement in 2015, which did not recur in 2016, lower operating tax payments, primarily in Brazil, and higher cash-related earnings. The net cash provided by continuing operating activities in 2016 also benefited from approximately $27 of proceeds, net of legal fees, related to settling claims relating to professional services in connection with a previously disclosed legal matter. These items were partially offset by the timing of payments, primarily for inventory, increased levels of accounts receivable which was primarily attributable to macroeconomic conditions in Brazil, and the contribution to the U.S. pension plan in 2016 of $20, which did not occur in 2015. Net cash provided by continuing operating activities during 2015 was approximately $198 lower than during 2014. The approximate $198 decrease to net cash provided by continuing operating activities was primarily due to lower cash-related earnings, which were impacted by the unfavorable impact of foreign currency translation. Lower operating tax payments, primarily in Brazil, and lower payments for employee incentive compensation in 2015 as compared to 2014, partially offset these items. We maintain defined benefit pension plans and unfunded supplemental pension benefit plans (see Note 12, Employee Benefit Plans on pages through of our 2016 Annual Report). Our funding policy for these plans is based on legal requirements and available cash flows. The amounts necessary to fund future obligations under these plans could vary depending on estimated assumptions (as detailed in "Critical Accounting Estimates - Pension and Postretirement Expense" in this MD&A). The future funding for these plans will depend on economic conditions, employee demographics, mortality rates, the number of associates electing to take lump-sum distributions, investment performance and funding decisions. Based on current assumptions, we expect to make contributions in the range of $10 to $15 to our U.S. defined benefit pension and postretirement plans and in the range of $20 to $25 to our non-U.S. defined benefit pension and postretirement plans during 2017. Net Cash from Continuing Investing Activities Net cash used by continuing investing activities during 2016 was approximately $83, as compared to net cash provided by continuing investing activities of approximately $143 during 2015. The approximate $226 decrease to net cash (used) provided by continuing investing activities was primarily due to the net proceeds on the sale of Liz Earle in 2015 of approximately $208. Net cash provided by continuing investing activities during 2015 was approximately $143, as compared to net cash used of $101 during 2014. The approximate $243 increase to net cash provided (used) by continuing investing activities was primarily due to the net proceeds on the sale of Liz Earle of approximately $208, which was partially offset by lower capital expenditures. Capital expenditures during 2016 were approximately $93 compared with approximately $92 during 2015 and approximately $126 during 2014. Capital expenditures in 2017 are currently expected to be in the range of $150 to $170 and are expected to be funded by cash from operations. Net Cash from Continuing Financing Activities Net cash provided by continuing financing activities during 2016 was approximately $137, as compared to net cash used by continuing financing activities of approximately $431 during 2015. The approximately $568 increase to net cash provided (used) by continuing financing activities was primarily due to the net proceeds related to the $500 principal amount of our Senior Secured Notes (as defined below in "Liquidity and Capital Resources") issued in the third quarter of 2016, the net proceeds of approximately $426 from the sale of Series C Preferred Stock, the suspension of our dividend, and the prepayment of the $250 principal amount of our 2.375% Notes (as defined below in "Liquidity and Capital Resources") in the third quarter of 2015, which were partially offset by the payments for the August 2016 cash tender offers of approximately $301, the prepayment of the remaining principal amount of our 4.20% Notes (as defined below in "Liquidity and Capital Resources") and 5.75% Notes (as defined below in "Liquidity and Capital Resources") of approximately $238 in the aggregate, and the payments for the October and December debt repurchases of approximately $181 in the aggregate. See Note 16, Series C Convertible Preferred Shares on page of our 2016 Annual Report and Note 6, Debt and Other Financing on pages through of our 2016 Annual Report for more information. Net cash used by continuing financing activities was approximately $431 during 2015, as compared to approximately $209 during 2014 primarily due to the prepayment of $250 principal amount of our 2.375% Notes (as defined below in "Liquidity and Capital Resources") in the third quarter of 2015, partially offset by the repayment of the remaining $53 outstanding principal amount of a term loan agreement in the second quarter of 2014. See Note 6, Debt and Other Financing on pages through of our 2016 Annual Report for more information. We purchased approximately 1.4 million shares of our common stock for $5.6 during 2016, as compared to .3 million shares of our common stock for $3.1 during 2015 and .7 million shares for $9.8 during 2014, through acquisition of stock from employees in connection with tax payments upon vesting of restricted stock units and upon vesting of performance restricted stock units in 2016, as well as through private transactions with a broker in connection with stock based obligations under our Deferred Compensation Plan in 2014. We did not declare a dividend for 2016 as we suspended the dividend effective in the first quarter of 2016. We maintained a quarterly dividend of $.06 per share for 2015 and 2014. Debt and Contractual Financial Obligations and Commitments At December 31, 2016, our debt and contractual financial obligations and commitments by due dates were as follows: (1) Amounts are based on our current long-term credit ratings. See Note 6, Debt and Other Financing on pages through of our 2016 Annual Report for more information. (2) Amounts are net of expected sublease rental income. See Note 14, Leases and Commitments on page of our 2016 Annual Report for more information. (3) Amounts represent expected future benefit payments for our unfunded defined benefit pension and postretirement benefit plans, as well as expected contributions for 2017 to our funded defined benefit pension benefit plans. We are not able to estimate our contributions to our funded defined benefit pension and postretirement plans beyond 2017. (4) The amount of debt and contractual financial obligations and commitments excludes amounts due under derivative transactions. The table also excludes information on non-binding purchase orders of inventory. The table does not include any reserves for uncertain income tax positions because we are unable to reasonably predict the ultimate amount or timing of settlement of these uncertain income tax positions. At December 31, 2016, our reserves for uncertain income tax positions, including interest and penalties, totaled approximately $51. See Note 6, Debt and Other Financing, and Note 14, Leases and Commitments, on pages through, and on page, respectively, of our 2016 Annual Report for more information on our debt and contractual financial obligations and commitments. Additionally, as disclosed in Note 15, Restructuring Initiatives on pages through of our 2016 Annual Report, at December 31, 2016, we have liabilities of approximately $51 associated with our Transformation Plan, approximately $1 associated with various restructuring initiatives during 2016 and approximately $3 associated with our $400M Cost Savings Initiative. The majority of future cash payments associated with these restructuring liabilities are expected to be made during 2017. Off Balance Sheet Arrangements At December 31, 2016, we had no material off-balance-sheet arrangements. Capital Resources Revolving Credit Facility In June 2015, the Company and Avon International Operations, Inc., a wholly-owned domestic subsidiary of the Company (“AIO”), entered into a five-year $400.0 senior secured revolving credit facility (the “2015 facility”). Borrowings under the 2015 facility bear interest, at our option, at a rate per annum equal to LIBOR plus 250 basis points or a floating base rate plus 150 basis points, in each case subject to adjustment based upon a leverage-based pricing grid. The 2015 facility may be used for general corporate purposes. As of December 31, 2016, there were no amounts outstanding under the 2015 facility. The 2015 facility replaced the Company's previous $1 billion unsecured revolving credit facility (the "2013 facility"). In the second quarter of 2015, $2.5 before tax was recorded for the write-off of issuance costs related to the 2013 facility. All obligations of AIO under the 2015 facility are (i) unconditionally guaranteed by each material domestic restricted subsidiary of the Company (other than AIO, the borrower), in each case, subject to certain exceptions and (ii) fully guaranteed on an unsecured basis by the Company. The obligations of AIO and the subsidiary guarantors are secured by first priority liens on and security interest in substantially all of the assets of AIO and the subsidiary guarantors, in each case, subject to certain exceptions. The 2015 facility will terminate in June 2020; provided, however, that it shall terminate on the 91st day prior to the maturity of the 6.50% Notes (as defined below) and the 4.60% Notes (as defined below), if on such 91st day, the applicable notes are not redeemed, repaid, discharged, defeased or otherwise refinanced in full. The 2015 facility contains affirmative and negative covenants, which are customary for secured financings of this type, as well as financial covenants (interest coverage and total leverage ratios). As of December 31, 2016, we were in compliance with our interest coverage and total leverage ratios under the 2015 facility. The amount of the facility available to be drawn down on is reduced by any standby letters of credit granted by AIO, which, as of December 31, 2016, was approximately $46. As of December 31, 2016, based on then applicable interest rates, the entire amount of the remaining 2015 facility, which is approximately $354, could have been drawn down without violating any covenant. A decline in our business results (including the impact of any adverse foreign exchange movements and significant restructuring charges) may further reduce our borrowing capacity under the 2015 facility or cause us to be non-compliant with our interest coverage and total leverage ratios. If we were to be non-compliant with our interest coverage or total leverage ratio, we would no longer have access to our 2015 facility and our credit ratings may be downgraded. As of December 31 2016, there were no amounts outstanding under the 2015 facility. Public Notes In March 2013, we issued, in a public offering, $250.0 principal amount of 2.375% Notes due March 15, 2016 (the "2.375% Notes"), $500.0 principal amount of 4.60% Notes due March 15, 2020 (the "4.60% Notes"), $500.0 principal amount of 5.00% Notes due March 15, 2023 (the "5.00% Notes") and $250.0 principal amount of 6.95% Notes due March 15, 2043 (the "6.95% Notes") (collectively, the "2013 Notes"). The net proceeds from these 2013 Notes were used to repay outstanding debt. Interest on the 2013 Notes is payable semi-annually on March 15 and September 15 of each year. On August 10, 2015, we prepaid our 2.375% Notes at a prepayment price equal to 100% of the principal amount of $250.0, plus accrued interest of $3.1 and a make-whole premium of $5.0. In connection with the prepayment of our 2.375% Notes, we incurred a loss on extinguishment of debt of $5.5 before tax in the third quarter of 2015 consisting of the $5.0 make-whole premium for the 2.375% Notes and the write-off of $.5 of debt issuance costs and discounts related to the initial issuance of the 2.375% Notes. The indenture governing the 2013 Notes contains interest rate adjustment provisions depending on the long-term credit ratings assigned to the 2013 Notes with S&P and Moody's. As described in the indenture, the interest rates on the 2013 Notes increase by .25% for each one-notch downgrade below investment grade on each of our long-term credit ratings assigned to the 2013 Notes by S&P or Moody's. These adjustments are limited to a total increase of 2% above the respective interest rates in effect on the date of issuance of the 2013 Notes. As a result of the long-term credit rating downgrades by S&P and Moody's since issuance of the 2013 Notes, the interest rates on these notes have increased by the maximum allowable increase. In August 2016, we completed cash tender offers which resulted in a reduction of principal of $108.6 of our 5.75% Notes due March 1, 2018 (the "5.75% Notes"), $73.8 of our 4.20% Notes due July 15, 2018 (the "4.20% Notes"), $68.1 of our 6.50% Notes due March 1, 2019 (the "6.50% Notes") and $50.1 of our 4.60% Notes. In connection with the cash tender offers, we incurred a gain on extinguishment of debt of $3.9 before tax in the third quarter of 2016, consisting of a deferred gain of $12.8 associated with the March 2012 and January 2013 interest-rate swap agreement terminations (see Note 9, Financial Instruments and Risk Management on pages through of our 2016 Annual Report), partially offset by the $5.8 of early tender premium paid for the cash tender offers, $1.2 of a deferred loss associated with treasury lock agreements designated as cash flow hedges of the anticipated interest payments on the 5.75% Notes (see Note 9, Financial Instruments and Risk Management on pages through of our 2016 Annual Report), $1.0 of deal costs and the write-off of $.9 of debt issuance costs and discounts related to the initial issuances of the notes that were the subject of the cash tender offers. In October 2016, we repurchased $44.0 of our 6.50% Notes, $44.0 of our 4.20% Notes, $40.0 of our 4.60% Notes and $35.2 of our 5.75% Notes. The aggregate repurchase price was equal to the principal amount of the notes, plus a premium of $6.2 and accrued interest of $1.1. In connection with these repurchases of debt, we incurred a loss on extinguishment of debt of $1.0 before tax in the fourth quarter of 2016 consisting of the $6.2 premium paid for the repurchases, $.5 for the write-off of debt issuance costs and discounts related to the initial issuance of the notes that were repurchased and $.4 for a deferred loss associated with treasury lock agreements designated as cash flow hedges of the anticipated interest payments on the 5.75% Notes (see Note 9, Financial Instruments and Risk Management on pages through of our 2016 Annual Report), partially offset by a deferred gain of approximately $6.1 associated with the March 2012 and January 2013 interest-rate swap agreement terminations (see Note 9, Financial Instruments and Risk Management on pages through of our 2016 Annual Report). On November 30, 2016, we prepaid the remaining principal amount of our 4.20% Notes and 5.75% Notes. The prepayment price was equal to the remaining principal amount of $132.2 for our 4.20% Notes and $106.2 for our 5.75% Notes, plus a make-whole premium of $12.1 for both series of notes and accrued interest of $3.6 for both series of notes. In connection with the prepayment of our 4.20% Notes and 5.75% Notes, we incurred a loss on extinguishment of debt of $2.9 before tax in the fourth quarter of 2016 consisting of the $12.1 make-whole premium, $1.0 of a deferred loss associated with treasury lock agreements designated as cash flow hedges of the anticipated interest payments on the 5.75% Notes (see Note 9, Financial Instruments and Risk Management on pages through of our 2016 Annual Report) and the write-off of $.3 of debt issuance costs and discounts related to the initial issuances of the notes that were prepaid, partially offset by a deferred gain of $10.5 associated with the January 2013 interest-rate swap agreement termination (see Note 9, Financial Instruments and Risk Management on pages through of our 2016 Annual Report). In December 2016, we repurchased $11.1 of our 5.00% Notes and $6.2 of our 6.95% Notes, and the aggregate repurchase price was equal to the principal amount of the notes, less a discount received of $1.3 and plus accrued interest of $.3. In connection with this repurchase of debt, we incurred a gain on extinguishment of debt of $1.1 before tax in the fourth quarter of 2016 consisting of the $1.3 discount received for the repurchases, partially offset by $.2 for the write-off of debt issuance costs and discounts related to the initial issuance of the notes that were repurchased. The indentures governing our outstanding notes described above contain certain customary covenants and customary events of default and cross-default provisions. Further, we would be required to make an offer to repurchase all of our outstanding notes described above, with the exception of our 4.20% Notes, at a price equal to 101% of their aggregate principal amount plus accrued and unpaid interest in the event of a change in control involving Avon and, at such time, the outstanding notes are rated below investment grade. Senior Secured Notes In August 2016, AIO issued, in a private placement exempt from registration under the Securities Act of 1933, as amended, $500.0 in aggregate principal amount of 7.875% Senior Secured Notes, which will mature on August 15, 2022 (the "Senior Secured Notes"). Interest on the Senior Secured Notes is payable semi-annually on February 15 and August 15 of each year. All obligations of AIO under the Senior Secured Notes are unconditionally guaranteed by each current and future wholly-owned domestic restricted subsidiary of the Company that is a guarantor under the 2015 facility and fully guaranteed on an unsecured basis by the Company. The obligations of AIO and the subsidiary guarantors are secured by first priority liens on and security interest in substantially all of the assets of AIO and the subsidiary guarantors, in each case, subject to certain exceptions. The indenture governing our Senior Secured Notes contains certain customary covenants and restrictions as well as customary events of default and cross-default provisions. The indenture also contains a covenant requiring AIO and its restricted subsidiaries to, at the end of each year, own at least a certain percentage of the total assets of API and its restricted subsidiaries, subject to certain qualifications. Further, we would be required to make an offer to repurchase all of our Senior Secured Notes, at a price equal to 101% of their aggregate principal amount plus accrued and unpaid interest, in the event of a change in control involving Avon. Long-Term Credit Ratings Our long-term credit ratings are: Moody’s ratings of Negative Outlook with Ba3 for corporate family debt, B1 for senior unsecured debt, and Ba1 for the Senior Secured Notes; S&P ratings of Positive Outlook with B for corporate family debt and senior unsecured debt and BB- for the Senior Secured Notes; and Fitch rating of Negative Outlook with B+, each of which are below investment grade. We do not believe these long-term credit ratings will have a material impact on our near-term liquidity. However, any rating agency reviews could result in a change in outlook or downgrade, which could further limit our access to new financing, particularly short-term financing, reduce our flexibility with respect to working capital needs, affect the market price of some or all of our outstanding debt securities, and likely result in an increase in financing costs, and less favorable covenants and financial terms under our financing arrangements. For more information, see "Risk Factors - A general economic downturn, a recession globally or in one or more of our geographic regions or markets or sudden disruption in business conditions or other challenges may adversely affect our business, our access to liquidity and capital, and our credit ratings," "Risk Factors - Our credit ratings were downgraded in each of the last three years, which could limit our access to financing, affect the market price of our financing and increase financing costs. A further downgrade in our credit ratings may adversely affect our access to liquidity," and "Risk Factors - Our indebtedness could adversely affect us by reducing our flexibility to respond to changing business and economic conditions" included in Item 1A on pages 7 through 20 of our 2016 Annual Report. Please also see Note 6, Debt and Other Financing on pages through of our 2016 Annual Report for more information relating to our debt and the maturities thereof.

<s>[INST] You should read the following discussion of the results of operations and financial condition of Avon Products, Inc. and its majority and wholly owned subsidiaries in conjunction with the information contained in the Consolidated Financial Statements and related Notes contained in our 2016 Annual Report. When used in this discussion, the terms "Avon," "Company," "we," "our" or "us" mean, unless the context otherwise indicates, Avon Products, Inc. and its majority and wholly owned subsidiaries. See "NonGAAP Financial Measures" on pages 28 through 30 of this MD&A for a description of how constant dollar ("Constant $") growth rates (a NonGAAP financial measure) are determined and see "Performance Metrics" on page 28 of this MD&A for definitions of our performance metrics (Change in Active Representatives, Change in units sold, Change in Ending Representatives and Change in Average Order). Overview We are a global manufacturer and marketer of beauty and related products. Our business is conducted primarily in the directselling channel. During 2016, we had sales operations in 57 countries and territories, and distributed products in 18 more. In March 2016, we separated from our North America business, which had consisted of the Company's operations in the U.S., Canada and Puerto Rico; this business has been presented as discontinued operations for all periods presented. As a result, all of our consolidated revenue is derived from operations of subsidiaries outside of the U.S. Our reportable segments are based on geographic operations in four regions: Europe, Middle East & Africa; South Latin America; North Latin America; and Asia Pacific. Our product categories are Beauty and Fashion & Home. Beauty consists of skincare (which includes personal care), fragrance and color (cosmetics). Fashion & Home consists of fashion jewelry, watches, apparel, footwear, accessories, gift and decorative products, housewares, entertainment and leisure products, children’s products and nutritional products. Sales are made to the ultimate consumer principally through direct selling by Representatives, who are independent contractors and not our employees. As of December 31, 2016, we had approximately 6 million active Representatives which represents the number of Representatives submitting an order in a sales campaign, totaled for all campaigns during the year and then divided by the number of campaigns. The success of our business is highly dependent on recruiting, retaining and servicing our Representatives. Total revenue in 2016 declined 7% compared to the prioryear period, primarily due to unfavorable foreign exchange, while Constant $ revenue increased 2%. A number of items affected the yearoveryear comparison of Constant $ revenue, the most significant being the sale of Liz Earle, which was completed in July 2015, that negatively impacted Constant $ revenue growth by approximately 1 point. The other items affecting the yearoveryear comparison netted to an immaterial impact. In addition, our Constant $ revenue benefited from growth in Argentina, South Africa, Russia, Mexico and Brazil. Argentina contributed approximately 1 point to Avon's consolidated Constant $ revenue growth, as this market's results were impacted by the inflationary impact on pricing. The growth in Constant $ revenue was driven by higher average order, partially offset by a 2% decrease in Active Representatives. Average order benefited from the net impact of price and mix which increased 6%, while units sold decreased 4%, primarily due to declines in units sold in Brazil and Mexico, and the impact of the deconsolidation of Venezuela. We have been improving our discipline of pricing with inflation, strategically pricing in certain markets and categories, and launching products at more advantageous price points, while considering the potential impact on unit sales. The decrease in Active Representatives was primarily due to the impact of the deconsolidation of Venezuela and a decline in Asia Pacific, which included the impact caused by a reduction in the number of sales campaigns in the Philippines. These declines in Active Representatives were partially offset by growth in Europe, Middle East & Africa, most significantly Russia, which was primarily due to sustained momentum in recruitment and retention. See "Segment Review" in this MD&A for additional information related to changes in revenue by segment. Ending Representatives decreased by 2%. The decrease in Ending Representatives at December 31, [/INST] Negative. </s>

AVON PRODUCTS INC

2018-02-22

2017-12-31

ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS ("MD&A") (U.S. dollars in millions, except per share and share data) You should read the following discussion of the results of operations and financial condition of Avon Products, Inc. and its majority and wholly owned subsidiaries in conjunction with the information contained in the Consolidated Financial Statements and related Notes contained in our 2017 Annual Report. When used in this discussion, the terms "Avon," "Company," "we," "our" or "us" mean, unless the context otherwise indicates, Avon Products, Inc. and its majority and wholly owned subsidiaries. See "Non-GAAP Financial Measures" on pages 29 through 31 of this management's discussion and analysis of financial condition and results of operations ("MD&A") for a description of how constant dollar ("Constant $") growth rates (a Non-GAAP financial measure) are determined and see "Performance Metrics" on page 29 of this MD&A for definitions of our performance metrics (Change in Active Representatives, Change in units sold, Change in Ending Representatives and Change in Average Order). Overview We are a global manufacturer and marketer of beauty and related products. Our business is conducted primarily in the direct-selling channel. During 2017, we had sales operations in 56 countries and territories, and distributed products in 18 more. All of our consolidated revenue is derived from operations of subsidiaries outside of the United States ("U.S."). Our reportable segments are based on geographic operations in four regions: Europe, Middle East & Africa; South Latin America; North Latin America; and Asia Pacific. Our product categories are Beauty and Fashion & Home. Beauty consists of skincare, fragrance and color (cosmetics). Fashion & Home consists of fashion jewelry, watches, apparel, footwear, accessories, gift and decorative products, housewares, entertainment and leisure products, children’s products and nutritional products. Sales are made to the ultimate consumer principally through direct selling by Representatives, who are independent contractors and not our employees. As of December 31, 2017, we had approximately 6 million active Representatives which represents the number of Representatives submitting an order in a sales campaign, totaled for all campaigns during the year and then divided by the number of campaigns. The success of our business is highly dependent on recruiting, retaining and servicing the Representatives. During 2017, revenue was relatively unchanged compared to the prior-year period, partially benefiting from foreign exchange, while Constant $ revenue decreased 2%. Our Constant $ revenue decline was primarily driven by declines in Brazil, Russia and the United Kingdom, partially offset by growth in Argentina and South Africa. The decline in revenue and Constant $ revenue was primarily due to a 3% decrease in Active Representatives, which was partially offset by higher average order. The decrease in Active Representatives was impacted by declines in all reportable segments, most significantly in South Latin America (driven by Brazil) and Europe, Middle East & Africa. The net impact of price and mix increased 2%, primarily due to the inflationary impact on pricing in Argentina, Russia and Mexico. Units sold decreased 4%, primarily due to declines in Russia, Brazil, Mexico and the United Kingdom. The revenue performance was negatively impacted most significantly by a decline in Color sales, as we experienced issues in some markets while we segmented our Color category into three distinct brands. The timing of innovation also impacted the decline in Color sales. Ending Representatives were relatively unchanged. Ending Representatives at December 31, 2017 as compared to the prior-year period benefited from growth in Russia, which was offset by a decline in Brazil. See "Segment Review" in this MD&A for additional information related to changes in revenue by segment. Transformation Plan In January 2016, we initiated a transformation plan (the “Transformation Plan”) in order to enable us to achieve our long-term goals of mid-single-digit Constant $ revenue growth and low double-digit operating margin. The Transformation Plan included three pillars: invest in growth, reduce costs in an effort to continue to improve our cost structure and improve our financial resilience. The Transformation Plan was designed to focus on cost savings and financial resilience in the first year, in order to support future investment in growth. In 2016 we estimate that we achieved cost savings of $120 before taxes, and we significantly strengthened the balance sheet. In 2017 we estimate that we achieved cost savings of $255 before taxes when comparing to our costs in 2015. These savings include both run-rate savings from 2016, along with in-year savings from current year initiatives. These savings have mostly been offset by the impact of inflation. In connection with the actions and associated savings discussed above, we have incurred costs to implement ("CTI") restructuring initiatives of approximately $167 before taxes associated with the Transformation Plan to-date. In connection with the restructuring actions approved to-date associated with the Transformation Plan, we expect to realize annualized cost savings of an estimated $110 to $120 before taxes. During 2017, we realized an estimated $55 before taxes of cost savings associated with the restructuring actions and achieved the majority of the annualized savings. In addition, we have realized savings from other cost-savings strategies that did not result in restructuring charges. For the market closures, the expected annualized savings represented the operating loss no longer included within Avon's operating results as a result of no longer operating in the respective market. For actions that did not result in the closure of a market, the annualized savings represent the net reduction of expenses that will no longer be incurred by Avon. For additional details on restructuring initiatives, see Note 16, Restructuring Initiatives on pages through of our 2017 Annual Report. For additional details on strengthening the balance sheet, see Note 7, Debt and Other Financing on pages through of our 2017 Annual Report. Foundational Initiatives The Company continues to make progress in a number of key areas. Transformation will require the Company to continue to execute in a coordinated way against each of these foundational initiatives: • Deliver a Seamless, Competitive Representative Experience - prioritize investments to upgrade systems; • Insightful Data & Analytics - improve the Company's ability to support the Representative and help her run her business more effectively through deeper insight and analytics into Representative behavior and needs; • Rigorous Performance Management - the new executive team is a key enabler to driving a performance-based culture for ownership of results and is working well together, taking action to enforce accountability and beginning to identify ways to drive the right behavior; and • Relentless Focus on Execution Capabilities - focus on developing a service mindset and using pilot programs that cover service from end to end to enable the implementation of changes, with minimal disruption. The Company believes it has the capacity to achieve its long-term goals of mid single-digit constant-dollar revenue growth and low double-digit operating margin. However, the Company recognizes it will take time to achieve its long-term goals. New Accounting Standards Information relating to new accounting standards is included in Note 2, New Accounting Standards on pages through of our 2017 Annual Report. Performance Metrics Within this MD&A, in addition to our key financial metrics of revenue, operating profit and operating margin, we utilize the performance metrics defined below to assist in the evaluation of our business. Performance Metrics Definition Change in Active Representatives This metric is a measure of Representative activity based on the number of unique Representatives submitting at least one order in a sales campaign, totaled for all campaigns in the related period. To determine the change in Active Representatives, this calculation is compared to the same calculation in the corresponding period of the prior year. Orders in China are excluded from this metric as our business in China is predominantly retail. Liz Earle was also excluded from this calculation as it did not distribute through the direct-selling channel. Change in units sold This metric is based on the gross number of pieces of merchandise sold during a period, as compared to the same number in the same period of the prior year. Units sold include samples sold and products contingent upon the purchase of another product (for example, gift with purchase or discount purchase with purchase), but exclude free samples. Change in Ending Representatives This metric is based on the total number of Representatives who were eligible to place an order in the last sales campaign in the related period as a result of being on an active roster. To determine the Change in Ending Representatives, this calculation is compared to the same calculation in the corresponding period of the prior year. Change in Ending Representatives may be impacted by a combination of factors such as our requirements to become and/or remain a Representative, our practices regarding minimum order requirements and our practices regarding reinstatement of Representatives. We believe this may be an indicator of future revenue performance. Change in Average Order This metric is a measure of Representative productivity. The calculation is the difference of the year-over-year change in revenue on a Constant $ basis and the Change in Active Representatives. Change in Average Order may be impacted by a combination of factors such as inflation, units, product mix, and/or pricing. Non-GAAP Financial Measures To supplement our financial results presented in accordance with generally accepted accounting principles in the U.S. ("GAAP"), we disclose operating results that have been adjusted to exclude the impact of changes due to the translation of foreign currencies into U.S. dollars, including changes in: revenue, operating profit, Adjusted operating profit, operating margin and Adjusted operating margin. We also refer to these adjusted financial measures as Constant $ items, which are Non-GAAP financial measures. We believe these measures provide investors an additional perspective on trends and underlying business results. To exclude the impact of changes due to the translation of foreign currencies into U.S. dollars, we calculate current-year results and prior-year results at constant exchange rates, which are updated on an annual basis as part of our budgeting process. Foreign currency impact is determined as the difference between actual growth rates and Constant $ growth rates. We also present gross margin, selling, general and administrative expenses as a percentage of revenue, operating profit, operating margin and effective tax rate on a Non-GAAP basis. We refer to these Non-GAAP financial measures as "Adjusted." We have provided a quantitative reconciliation of the Non-GAAP financial measures to the most directly comparable financial measures calculated and reported in accordance with GAAP. See "Reconciliation of Non-GAAP Financial Measures" within "Results of Operations - Consolidated" on pages 36 through 37 in this MD&A for this quantitative reconciliation. The Company uses Non-GAAP financial measures to evaluate its operating performance. These Non-GAAP measures should not be considered in isolation, or as a substitute for, or superior to, financial measures calculated in accordance with GAAP. The Company believes investors find the Non-GAAP information helpful in understanding the ongoing performance of operations separate from items that may have a disproportionate positive or negative impact on the Company's financial results in any particular period. The Company believes that it is meaningful for investors to be made aware of the impacts of 1) CTI restructuring initiatives; 2) a charge for a loss contingency related to a non-U.S. pension plan ("Loss contingency"); 3) the net proceeds recognized as a result of settling claims relating to professional services ("Legal settlement"); 4) charges related to the deconsolidation of our Venezuelan operations as of March 31, 2016 and the devaluation of Venezuelan currency in February 2015, combined with Venezuela being designated as a highly inflationary economy ("Venezuelan special items"); 5) the settlement charges associated with the U.S. pension plan ("Pension settlement charge"); 6) a goodwill impairment charge related to the Egypt business ("Asset impairment charge"); 7) various other items associated with the sale of Liz Earle, the separation of the North America business and debt-related charges ("Other items"); and, as it relates to our effective tax rate discussion, 8) the net income tax benefit as a result of the enactment of the Tax Cuts and Jobs Act in the U.S., a release of valuation allowances associated with a number of markets in Europe, Middle East & Africa, and a benefit as a result of a favorable court decision in Brazil, partially offset by a charge associated with valuation allowances to adjust deferred tax assets in Mexico, which were recognized in 2017, income tax benefits realized in 2016 and 2015 as a result of tax planning strategies, an income tax benefit in the second quarter of 2016 primarily due to the release of a valuation allowance associated with Russia and the adjustments associated with our deferred tax assets recorded in 2016 and 2015 ("Special tax items"). The Loss contingency includes the impact on our Consolidated Statements of Operations during the second quarter of 2017 caused by a charge of approximately $18 for a loss contingency related to a non-U.S. pension plan, for which an amendment to the plan that occurred in a prior year may not have been appropriately implemented. The Legal settlement includes the impact on our Consolidated Statements of Operations during the third quarter of 2016 associated with the net proceeds of approximately $27 recognized as a result of settling claims relating to professional services that had been provided to the Company prior to 2013 in connection with a previously disclosed legal matter. The Venezuelan special items include the impact on our Consolidated Statements of Operations during the first quarter of 2016 caused by the deconsolidation of our Venezuelan operations for which we recorded a loss of approximately $120 in other expense, net. The loss was comprised of approximately $39 in net assets of the Venezuelan business and approximately $81 in accumulated foreign currency translation adjustments within accumulated other comprehensive loss ("AOCI") associated with foreign currency changes before Venezuela was accounted for as a highly inflationary economy. The Venezuelan special items also include the impact on our Consolidated Statements of Operations in 2015 caused by the devaluations of Venezuelan currency on monetary assets and liabilities, such as cash, receivables and payables; deferred tax assets and liabilities; and non-monetary assets, such as inventories. For non-monetary assets, the Venezuelan special items include the earnings impact caused by the difference between the historical U.S. dollar cost of the assets at the previous exchange rate and the revised exchange rate. In 2015, the Venezuelan special items also include an adjustment of approximately $11 to reflect certain non-monetary assets at their net realizable value and an impairment charge of approximately $90 to reflect the write-down of the long-lived assets to their estimated fair value. The Pension settlement charge includes the impact on our Consolidated Statements of Operations during the third and fourth quarters of 2015 associated with the payments made to former employees who were vested and participated in the U.S. defined benefit pension plan. Such payments fully settled our pension plan obligation to those participants who elected to receive such payment. The Asset impairment charge includes the impact on our Consolidated Statements of Operations during the fourth quarter of 2015 caused by the goodwill impairment charge related to the Egypt business. The Other items include the impact on our Consolidated Statements of Operations during the third quarter of 2016 due to a net gain on extinguishment of debt associated with the cash tender offers in August 2016, the debt repurchases in October and December 2016, and the prepayment of the remaining principal amount of our 4.20% Notes due July 15, 2018 and our 5.75% Notes due March 1, 2018 in November 2016. The Other items also include the impact during 2015 on our Consolidated Statements of Operations due to the gain on the sale of Liz Earle. In addition, the Other items include the impact on our Consolidated Statements of Operations in the fourth quarter of 2015 caused by transaction-related costs of $3.1 associated with the planned separation of the North America business that were included in continuing operations. In addition, Other items in 2015 include the impact on our Consolidated Statements of Operations of the loss on extinguishment of debt caused by the make-whole premium and the write-off of debt issuance costs and discounts associated with the prepayment of our 2.375% Notes due March 15, 2016. Other items, in 2015, also include the impact on other expense, net in our Consolidated Statements of Operations of $2.5 associated with the write-off of issuance costs related to our previous $1 billion revolving credit facility. In addition, the effective tax rate discussion includes Special tax items, including the impact on the provision for income taxes in our Consolidated Statements of Operations during 2017 due to an approximate $30 net benefit recognized as a result of the enactment of the Tax Cuts and Jobs Act in the U.S., a release of valuation allowances of approximately $26 associated with a number of markets in Europe, Middle East & Africa, and an approximate $10 benefit as a result of a favorable court decision in Brazil, partially offset by a charge of approximately $16 associated with valuation allowances to adjust deferred tax assets in Mexico. Special tax items also include the impact on the provision for income taxes in our Consolidated Statements of Operations during the fourth quarter of 2016 due to the charge of approximately $9 associated with valuation allowances to adjust certain non-U.S. deferred tax assets to an amount that is "more likely than not" to be realized. Special tax items also include the impact on the provision for income taxes in our Consolidated Statements of Operations during the second quarter of 2016 primarily due to the release of a valuation allowance associated with Russia of approximately $7. Special tax items also include the impact on the provision for income taxes in our Consolidated Statements of Operations during the first quarter of 2016 and the fourth quarter of 2015 due to income tax benefits of approximately $29 and approximately $19, respectively, recognized as the result of the implementation of foreign tax planning strategies. Special tax items also include the impact on the provision for income taxes in our Consolidated Statements of Operations during the first and second quarters of 2015 due to a charge of approximately $31 and a benefit of approximately $3, respectively, associated with valuation allowances to adjust our U.S. deferred tax assets to an amount that was "more likely than not" to be realized. The additional valuation allowance was due to the strengthening of the U.S. dollar against currencies of some of our key markets and its associated effect on our tax planning strategies, and the partial release of the valuation allowance was due to the weakening of the U.S. dollar against currencies of some of our key markets. Special tax items also include the impact on the provision for income taxes in our Consolidated Statements of Operations during the third quarter of 2015 due to a charge of approximately $642 as a result of establishing a valuation allowance for the full amount of our U.S. deferred tax assets due to the impact of the continued strengthening of the U.S. dollar against currencies of some of our key markets and its associated effect on our tax planning strategies. Additionally, Special tax items include the impact on the provision for income taxes in our Consolidated Statements of Operations during the third quarter of 2015 due to a charge of approximately $15 associated with valuation allowances to adjust certain non-U.S. deferred tax assets to an amount that is "more likely than not" to be realized. The non-U.S. valuation allowance included an adjustment associated with Russia, which was primarily the result of lower earnings, which were significantly impacted by foreign exchange losses on working capital balances. See Note 16, Restructuring Initiatives on pages through of our 2017 Annual Report, Note 13, Employee Benefit Plans on pages through of our 2017 Annual Report, Note 14, Segment Information on pages through of our 2017 Annual Report, "Results Of Operations - Consolidated" below, Note 1, Description of the Business and Summary of Significant Accounting Policies on pages through of our 2017 Annual Report, "Venezuela Discussion" below, Note 19, Goodwill on page of our 2017 Annual Report, Note 7, Debt and Other Financing on pages through of our 2017 Annual Report, and Note 9, Income Taxes on pages through of our 2017 Annual Report for more information on these items. Critical Accounting Estimates We believe the accounting policies described below represent our critical accounting policies due to the estimation processes involved in each. See Note 1, Description of the Business and Summary of Significant Accounting Policies on pages through of our 2017 Annual Report for a detailed discussion of the application of these and other accounting policies. Allowances for Doubtful Accounts Receivable Representatives contact their customers, selling primarily through the use of brochures for each sales campaign, generally on credit if the Representatives meet certain criteria. Sales campaigns are generally for a three- to four-week duration. The Representative purchases products directly from us and may or may not sell them to an end user. In general, the Representative, an independent contractor, remits a payment to us during each sales campaign, which relates to the prior campaign cycle. The Representative is generally precluded from submitting an order for the current sales campaign until the accounts receivable balance past due for prior campaigns is paid; however, there are circumstances where the Representative fails to make the required payment. We record an estimate of an allowance for doubtful accounts on receivable balances based on an analysis of historical data and current circumstances, including seasonality and changing trends. Over the past three years, annual bad debt expense was $222 in 2017, $191 in 2016 and $144 in 2015, or approximately 4% of total revenue in 2017, approximately 3% of total revenue in 2016, and approximately 2% of total revenue 2015. The allowance for doubtful accounts is reviewed for adequacy, at a minimum, on a quarterly basis. We generally have no detailed information concerning, or any communication with, any end user of our products beyond the Representative. We have no legal recourse against the end user for the collection of any accounts receivable balances due from the Representative to us. If the financial condition of the Representatives were to deteriorate, resulting in their inability to make payments, additional allowances may be required. Allowances for Sales Returns Policies and practices for product returns vary by jurisdiction. We record a provision for estimated sales returns based on historical experience with product returns. Over the past three years, annual sales returns were $198 for 2017, $187 for 2016 and $191 for 2015, or approximately 3% of total revenue in each year, which has been generally in line with our expectations. If the historical data we use to calculate these estimates does not approximate future returns, due to changes in marketing or promotional strategies, or for other reasons, additional allowances may be required. Provisions for Inventory Obsolescence We record an allowance for estimated obsolescence, when applicable, equal to the difference between the cost of inventory and the net realizable value. In determining the allowance for estimated obsolescence, we classify inventory into various categories based upon its stage in the product life cycle, future marketing sales plans and the disposition process. We assign a degree of obsolescence risk to products based on this classification to estimate the level of obsolescence provision. If actual sales are less favorable than those projected, additional inventory allowances may need to be recorded for such additional obsolescence. Annual obsolescence expense was $37 in 2017, $37 in 2016 and $45 in 2015, or less than 1% of total revenue in each year. Pension and Postretirement Expense We maintain defined benefit pension plans, the most significant of which are in the United Kingdom ("UK"), Germany and the U.S. However, our U.S. defined benefit pension plan is closed to employees hired on or after January 1, 2015 and the UK defined benefit pension plan is closed to employees hired on or after April 1, 2013. Additionally, we have unfunded supplemental pension benefit plans for some current and retired executives and provide retiree health care benefits subject to certain limitations to certain retired employees in the U.S. and certain foreign countries. See Note 13, Employee Benefit Plans on pages through of our 2017 Annual Report for more information on our benefit plans. Pension and postretirement expense and the requirements for funding our major pension plans are determined based on a number of actuarial assumptions, which are generally reviewed and determined on an annual basis. These assumptions include the discount rate applied to plan obligations, the expected rate of return on plan assets, the rate of compensation increase of plan participants, price inflation, cost-of-living adjustments, mortality rates and certain other demographic assumptions, and other factors. We use a December 31 measurement date for all of our employee benefit plans. For 2017, the weighted average assumed rate of return on all pension plan assets was 5.12%, as compared with 6.65% for 2016. In determining the long-term rates of return, we consider the nature of the plans’ investments, an expectation for the plans’ investment strategies, historical rates of return and current economic forecasts. We generally evaluate the expected long-term rates of return annually and adjust as necessary. In some of our defined benefit pension plans, we have adopted investment strategies which are designed to match the movements in the pension liability through an increased allocation towards debt securities. In addition, we also utilize derivative instruments in our UK defined benefit pension plans to achieve the desired market exposures or to hedge certain risks. Derivative instruments may include, but are not limited to, futures, options, swaps or swaptions. Investment types, including the use of derivatives are based on written guidelines established for each investment manager and monitored by the plan's investment committee. A significant portion of our pension plan assets relate to the UK defined benefit pension plan. The assumed rate of return for determining 2017 net periodic benefit cost for the UK defined benefit pension plan was 5.15%. In addition, the 2018 rate of return assumption for the UK defined benefit pension plan was based on an asset allocation of approximately 80% in corporate and government bonds and mortgage-backed securities (which are expected to earn approximately 2% to 4% in the long-term) and approximately 20% in equity securities, emerging market debt and high yield securities (which are expected to earn approximately 5% to 9% in the long-term). In addition to the physical assets, the asset portfolio for the UK defined benefit pension plan has derivative instruments which increase our exposure to fixed income (in order to better match liabilities) and, to a lesser extent, impact our equity exposure. The rate of return on the plan assets in the UK was approximately 9% in 2017 and approximately 36% in 2016. Historically, the pension plan with the most significant pension plan assets was the U.S. defined benefit pension plan. As part of the separation of the North America business, in 2016 we transferred $499.6 of pension liabilities under the U.S. defined benefit pension plan associated with current and former employees of the North America business and certain other former Avon employees, along with $355.9 of assets held by the U.S. defined benefit pension plan, to a defined benefit pension plan sponsored by New Avon. We also transferred $60.4 of other postretirement liabilities (namely, retiree medical and supplemental pension liabilities) in respect of such employees and former employees. See Note 3, Discontinued Operations and Divestitures on pages through of our 2017 Annual Report. We continue to retain certain U.S. pension and other postretirement liabilities primarily associated with employees who are actively employed by Avon in the U.S. providing services other than with respect to the North America business. Prior to this separation, our net periodic benefit costs for the U.S. pension and postretirement benefit plans were allocated between Discontinued Operations and Global as the plan included both North America and U.S. Corporate Avon associates, and as such, our ongoing net periodic benefit costs within Global were not materially impacted by the separation of the North America business. The assumed rate of return for determining 2017 net periodic benefit cost for the U.S. defined benefit pension plan was 5.50%, which was based on an asset allocation of approximately 70% in corporate and government bonds (which are expected to earn approximately 3% to 5% in the long-term) and approximately 30% in equity securities (which are expected to earn approximately 6% to 8% in the long-term). The rate of return on the plan assets in the U.S. was approximately 15% in 2017 and approximately 6% in 2016. The discount rate used for determining the present value of future pension obligations for each individual plan is based on a review of bonds that receive a high-quality rating from a recognized rating agency. The discount rates for calculating the balance sheet obligations of our more significant plans, including our UK defined benefit pension plan and our U.S. defined benefit pension plan, were based on the internal rates of return for a portfolio of high-quality bonds with maturities that are consistent with the projected future benefit payment obligations of each plan. The weighted-average discount rate for U.S. and non-U.S. defined benefit pension plans determined on this basis was 2.66% at December 31, 2017, and 2.81% at December 31, 2016. For the determination of the expected rates of return on assets and the discount rates, we take external actuarial and investment advice into consideration. Effective as of January 1, 2018, we are changing the method we use to estimate the service and interest cost components of net periodic benefit cost for the U.S. defined benefit pension plan and the majority of our significant non-U.S. pension plans, including the UK defined benefit pension plan. Historically, including in 2017, we estimated the service and interest cost components using a single weighted-average discount rate derived from the yield curve used to measure the benefit obligation at the beginning of the period. Beginning in 2018, we have now elected to use a full yield curve approach in the estimation of these components of net periodic benefit cost by applying the specific spot rates along the yield curve used in the determination of the benefit obligation to the relevant projected cash flows. We have made this change to improve the correlation between projected benefit cash flows and the corresponding yield curve spot rates, which we believe will result in a more precise measurement of service and interest costs. This change does not affect the measurement of our benefit obligation and does not impact our 2017 net periodic benefit cost. We will account for this change in estimate on a prospective basis beginning in 2018. We do not expect this change to result in a material reduction of our future net periodic benefit costs. Our funding requirements may be impacted by standards and regulations or interpretations thereof. Our calculations of pension and postretirement costs are dependent on the use of assumptions, including discount rates, hybrid plan maximum interest crediting rates and expected return on plan assets discussed above, rate of compensation increase of plan participants, interest cost, benefits earned, mortality rates, the number of participants and certain demographics and other factors. Actual results that differ from assumptions are accumulated and amortized to expense over future periods and, therefore, generally affect recognized expense in future periods. At December 31, 2017, we had pretax actuarial losses and prior service credits totaling approximately $41 for the U.S. defined benefit pension and postretirement plans and approximately $176 for the non-U.S. defined benefit pension and postretirement plans that have not yet been charged to expense. These actuarial losses have been charged to AOCI within shareholders’ equity. While we believe that the assumptions used are reasonable, differences in actual experience or changes in assumptions may materially affect our pension and postretirement obligations and future expense. For 2018, our assumption for the expected rate of return on assets is 5.50% for our U.S. defined benefit pension plan and 5.20% for our non-U.S. defined benefit pension plans (which includes 5.20% for our UK defined benefit pension plan). Our assumptions are generally reviewed and determined on an annual basis. A 50 basis point change (in either direction) in the expected rate of return on plan assets, the discount rate or the rate of compensation increases, would have had approximately the following effect on 2017 pension expense and the pension benefit obligation at December 31, 2017: Restructuring Reserves We record the estimated expense for our restructuring initiatives when such costs are deemed probable and estimable, when approved by the appropriate corporate authority and by accumulating detailed estimates of costs for such plans. These expenses include the estimated costs of employee severance and related benefits, impairment or accelerated depreciation of property, plant and equipment and capitalized software, and any other qualifying exit costs. These estimated costs are grouped by specific projects within the overall plan and are then monitored on a quarterly basis by finance personnel. Such costs represent our best estimate, but require assumptions about the programs that may change over time, including attrition rates. Estimates are evaluated periodically to determine whether an adjustment is required. Taxes We record a valuation allowance to reduce our deferred tax assets to an amount that is "more likely than not" to be realized. Evaluating the need for and quantifying the valuation allowance often requires significant judgment and extensive analysis of all the weighted positive and negative evidence available to the Company in order to determine whether all or some portion of the deferred tax assets will not be realized. In performing this analysis, the Company’s forecasted U.S. and foreign taxable income, and the existence of potential prudent and feasible tax planning strategies that would enable the Company to utilize some or all of its excess foreign tax credits, are taken into consideration. At December 31, 2017, we had net deferred tax assets of approximately $182 (net of valuation allowances of approximately $3,218 and deferred tax liabilities of $75). With respect to our deferred tax assets, at December 31, 2017, we had recognized deferred tax assets of approximately $2,022 relating to foreign and state tax loss carryforwards, for which a valuation allowance of approximately $1,962 has been provided. At December 31, 2017, we had recognized deferred tax assets of approximately $981 primarily relating to excess U.S. foreign tax and other U.S. general business credit carryforwards for which a valuation allowance of approximately $947 had been provided. We have a history of U.S. source losses, and our excess U.S. foreign tax and general business credits have primarily resulted from having a greater U.S. source loss in recent years which reduces our ability to credit foreign taxes or utilize the general business credits which we generate. Our ability to realize our U.S. deferred tax assets, such as our foreign tax and general business credit carryforwards, is dependent on future U.S. taxable income within the carryforward period. At December 31, 2017, we would need to generate approximately $4.7 billion of excess net foreign source income in order to realize the U.S. foreign tax and general business credits before they expire. Following a valuation allowance recorded in 2014 to reduce our U.S. deferred tax assets to an amount that is "more likely than not" to be realized, during 2015, the Company recorded an additional valuation allowance for the remaining U.S. deferred tax assets of approximately $670. The increase in the valuation allowance resulted from reduced tax benefits expected to be obtained from tax planning strategies associated with an anticipated accelerated receipt in the U.S. of foreign source income. As the U.S. dollar had further strengthened against currencies of some of our key markets during 2015, the benefits associated with the Company’s tax planning strategies were no longer sufficient for the Company to continue to conclude that its tax planning strategies were prudent. In the absence of any alternative prudent tax planning strategies and other sources of future taxable income, it was determined that a full valuation allowance should be recorded. Although the Company continues to expect that it will generate taxable income from intercompany transactions and consequently, tax liability in the U.S., the Company is expected to offset its current and future tax liability with foreign tax credits, and as a result, the expected level of future taxable income and tax liability is not adequate to realize the benefit of previously recorded deferred tax assets. Although the Company may not be able to recognize a financial statement benefit associated with its deferred tax assets, the Company will continue to manage and plan for the utilization of its deferred tax assets to avoid the expiration of deferred tax assets that may have limited lives. In addition, in the fourth quarter of 2015, we recognized a benefit of approximately $19 associated with the implementation of the initial stages of foreign tax planning strategies. We completed the implementation of these tax planning strategies and recognized an additional benefit of approximately $29 in the first quarter of 2016. At December 31, 2017, as a result of our U.S. liquidity profile, we continue to assert that our foreign earnings are not indefinitely reinvested. Accordingly, we adjusted our deferred tax liability each period to account for our undistributed earnings of foreign subsidiaries and for the tax effect of earnings that were actually repatriated to the U.S. during the year. The net impact on the deferred tax liability associated with the Company’s undistributed earnings is a decrease of approximately $64, resulting in a deferred tax liability balance of approximately $23 related to the incremental tax cost on approximately $1.5 billion of undistributed foreign earnings at December 31, 2017. The approximate $64 decrease was primarily a result of the enactment of the Tax Cuts and Jobs Act in the U.S. With respect to our uncertain tax positions, we recognize the benefit of a tax position, if that position is more likely than not of being sustained on examination by the taxing authorities, based on the technical merits of the position. We believe that our assessment of more likely than not is reasonable, but because of the subjectivity involved and the unpredictable nature of the subject matter at issue, our assessment may prove ultimately to be incorrect, which could materially impact our Consolidated Financial Statements. We file income tax returns in the U.S. federal jurisdiction, and various state and foreign jurisdictions. In 2018, a number of open tax years are scheduled to close due to the expiration of the statute of limitations and it is possible that a number of tax examinations may be completed. If our tax positions are ultimately upheld or denied, it is possible that the 2018 provision for income taxes, as well as tax related cash receipts or payments, may be impacted. Loss Contingencies We determine whether to disclose and/or accrue for loss contingencies based on an assessment of whether the risk of loss is remote, reasonably possible or probable. We record loss contingencies when it is probable that a liability has been incurred and the amount of loss is reasonably estimable. Our assessment is developed in consultation with our outside counsel and other advisors and is based on an analysis of possible outcomes under various strategies. Loss contingency assumptions involve judgments that are inherently subjective and can involve matters that are in litigation, which, by its nature is unpredictable. We believe that our assessment of the probability of loss contingencies is reasonable, but because of the subjectivity involved and the unpredictable nature of the subject matter at issue, our assessment may prove ultimately to be incorrect, which could materially impact our Consolidated Financial Statements. Impairment of Assets Plant, Property and Equipment and Capitalized Software We evaluate our plant, property and equipment and capitalized software for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset group may not be recoverable. Recoverability of assets to be held and used is measured by a comparison of the carrying amount of an asset to estimated pre-tax undiscounted future cash flows expected to be generated by the asset. If the carrying amount of an asset exceeds its estimated future cash flows, an impairment charge is recognized for the amount by which the carrying amount of the asset exceeds the fair value of the asset. The fair value of the asset is determined using revenue and cash flow projections, and royalty and discount rates, as appropriate. In February 2015, we reviewed Avon Venezuela's long-lived assets to determine whether the carrying amount of the assets was recoverable. Based on our expected cash flows associated with the asset group, we determined that the carrying amount of the assets, carried at their historical U.S. dollar cost basis, was not recoverable. As such, an impairment charge of approximately $90 to selling, general and administrative expenses was recorded to reflect the write-down of the long-lived assets to their estimated fair value of approximately $16, which was recorded in the first quarter of 2015. The fair value of Avon Venezuela's long-lived assets was determined using both market and cost valuation approaches. The valuation analysis performed required several estimates, including market conditions and inflation rates. As discussed in Note 1, Description of the Business and Summary of Significant Accounting Policies, we concluded that, effective March 31, 2016, we deconsolidated our Venezuelan operations. Our Consolidated Balance Sheets no longer includes the assets and liabilities of our Venezuelan operations, and we no longer include the results of our Venezuelan operations in our Consolidated Financial Statements. See Note 1, Description of the Business and Summary of Significant Accounting Policies on pages through of our 2017 Annual Report for more information on Avon Venezuela. Goodwill We test goodwill for impairment annually, and more frequently if circumstances warrant, using various fair value methods. We completed our annual goodwill impairment assessment for 2017 and determined that the estimated fair values were considered substantially in excess of the carrying values of each of our reporting units. The impairment analyses performed for goodwill require several estimates in computing the estimated fair value of a reporting unit. As part of our goodwill impairment analysis, we typically use a discounted cash flow ("DCF") approach to estimate the fair value of a reporting unit, which we believe is the most reliable indicator of fair value of a business, and is most consistent with the approach that we would generally expect a market participant would use. In estimating the fair value of our reporting units utilizing a DCF approach, we typically forecast revenue and the resulting cash flows for periods of five to ten years and include an estimated terminal value at the end of the forecasted period. When determining the appropriate forecast period for the DCF approach, we consider the amount of time required before the reporting unit achieves what we consider a normalized, sustainable level of cash flows. The estimation of fair value utilizing a DCF approach includes numerous uncertainties which require significant judgment when making assumptions of expected growth rates and the selection of discount rates, as well as assumptions regarding general economic and business conditions, and the structure that would yield the highest economic value, among other factors. During the 2015 year-end close process, our analysis of the Egypt business indicated an impairment as the carrying value of the business exceeded the estimated fair value. This was primarily the result of reducing our long-term projections of the business. During 2015, Egypt performed generally in line with our revenue and earnings projections, which assumed growth as compared to 2014. However, as a result of currency restrictions for the payment of goods in Egypt, we lowered our long-term revenue and earnings projections for the business. Accordingly, a non-cash impairment charge of approximately $7 was recorded to reduce the carrying amount of goodwill. There is no amount remaining associated with goodwill for our Egypt reporting unit as a result of this impairment charge. Key assumptions used in measuring the fair value of Egypt during this impairment assessment included projections of revenue and the resulting cash flows, as well as the discount rate (based on the estimated weighted-average cost of capital). To estimate the fair value of Egypt, we forecasted revenue and the resulting cash flows over five years using a DCF model which included a terminal value at the end of the projection period. We believed that a five-year period was a reasonable amount of time in order to return cash flows of Egypt to normalized, sustainable levels. See Note 19, Goodwill on page of our 2017 Annual Report for more information regarding Egypt. Results Of Operations - Consolidated Amounts in the table above may not necessarily sum due to rounding. * Calculation not meaningful (1) Advertising expenses are recorded in selling, general and administrative expenses. (2) Change in Constant $ Adjusted operating margin for all years presented is calculated using the current-year Constant $ rates. 2017 Compared to 2016 Revenue During 2017, revenue was relatively unchanged compared to the prior-year period, partially benefiting from foreign exchange, while Constant $ revenue decreased 2%. Our Constant $ revenue decline was primarily driven by declines in Brazil, Russia and the United Kingdom, partially offset by growth in Argentina and South Africa. The decline in revenue and Constant $ revenue was primarily due to a 3% decrease in Active Representatives, which was partially offset by higher average order. The decrease in Active Representatives was impacted by declines in all reportable segments, most significantly in South Latin America (driven by Brazil) and Europe, Middle East & Africa. The net impact of price and mix increased 2%, primarily due to the inflationary impact on pricing in Argentina, Russia and Mexico. Units sold decreased 4%, primarily due to declines in Russia, Brazil, Mexico and the United Kingdom. The revenue performance was negatively impacted most significantly by a decline in Color sales, as we experienced issues in some markets while we segmented our Color category into three distinct brands. The timing of innovation also impacted the decline in Color sales. Ending Representatives were relatively unchanged. Ending Representatives at December 31, 2017 as compared to the prior-year period benefited from growth in Russia, which was offset by a decline in Brazil. On a category basis, our net sales from reportable segments and associated growth rates were as follows: See "Segment Review" in this MD&A for additional information related to changes in revenue by segment. Operating Margin Operating margin and Adjusted operating margin decreased 80 basis points and 30 basis points, respectively, compared to 2016. The decreases in operating margin and Adjusted operating margin include the benefits associated with the Transformation Plan, primarily reductions in headcount, as well as other cost reductions. These savings were largely offset by the inflationary impact on costs outpacing revenue growth. The decreases in operating margin and Adjusted operating margin are discussed further below in "Gross Margin" and "Selling, General and Administrative Expenses." Gross Margin Gross margin and Adjusted gross margin both increased 100 basis points compared to 2016, in each case primarily due to an increase of 120 basis points from the favorable net impact of mix and pricing, driven by inflationary pricing in South Latin America. Selling, General and Administrative Expenses Selling, general and administrative expenses for 2017 increased approximately $100 compared to 2016. This increase is primarily due to the unfavorable impact of foreign currency translation, as the weakening of the U.S. dollar against many of our foreign currencies resulted in higher reported selling, general and administrative expenses. The increase in selling, general and administrative expenses is also due to the approximate $27 of net proceeds recognized as a result of a legal settlement in 2016, higher bad debt expense, higher transportation costs, the loss contingency related to a non-U.S. pension plan and higher Representative, sales leader and field expense. Partially offsetting the increase in selling, general and administrative expenses was lower expenses associated with employee incentive compensation plans and lower CTI restructuring. Selling, general and administrative expenses as a percentage of revenue and Adjusted selling, general, and administrative expenses as a percentage of revenue increased 180 basis points and 130 basis points, respectively, compared to 2016. The selling, general and administrative expenses as a percentage of revenue comparison was negatively impacted by: • approximately 50 basis points for the approximate $27 of net proceeds recognized as a result of a legal settlement in the 2016; and • approximately 30 basis points for a loss contingency related to a non-U.S. pension plan. These items were partially offset by: • approximately 30 basis points for lower CTI restructuring. The remaining increase in selling, general and administrative expenses as a percentage of revenue and the increase of 130 basis points in Adjusted selling, general and administrative expenses as a percentage of revenue were, in each case, primarily due to the following: • an increase of 50 basis points from higher bad debt expense, driven by Brazil due to the lower than anticipated collection of receivables, primarily impacted by the macroeconomic environment, as well as resulting from an adjustment to credit terms available to new Representatives during 2016; • an increase of 50 basis points primarily due to higher Representative, sales leader and field expense, most significantly in Brazil to support efforts to activate the field and improve Representative recruitment, as well as in the Philippines; • an increase of 40 basis points from higher transportation costs, most significantly in Russia which was driven by new delivery rates; and • an increase of 20 basis points primarily due to the impact of the Constant $ revenue decline causing deleverage of our fixed expenses, partially offset by lower fixed expenses. Fixed expenses include the benefits associated with the Transformation Plan, primarily reductions in headcount, as well as other cost reductions. These savings were largely offset by the inflationary impact on costs outpacing revenue growth. These items were partially offset by the following: • a decrease of 30 basis points due to lower expenses associated with employee incentive compensation plans; and • a decrease of approximately 20 basis points due to the favorable impact of foreign currency translation and foreign currency transaction losses. See Note 14, Segment Information on pages through of our 2017 Annual Report for more information on the legal settlement, Note 13, Employee Benefit Plans on pages through of our 2017 Annual Report for more information on the loss contingency related to a non-U.S. pension plan and Note 16, Restructuring Initiatives on pages through of our 2017 Annual Report for more information on CTI restructuring. Other Expenses Interest expense increased by approximately $4 compared to the prior-year period, primarily due to the interest associated with $500 principal amount of 7.875% Senior Secured Notes issued in August 2016 and lower amortization of gains associated with the termination of interest rate swaps. These items were partially offset by the interest savings associated with the repayment of certain of our debt in 2016 and lower interest due to a reduction of the international debt balances. Refer to Note 7, Debt and Other Financing on pages through of our 2017 Annual Report and Note 10, Financial Instruments and Risk Management on pages through of our 2017 Annual Report for additional information. Gain on extinguishment of debt in 2016 of approximately $1 was comprised of a gain of approximately $4 associated with the cash tender offers in August 2016 and a gain of approximately $1 associated with the debt repurchases in December 2016, partially offset by a loss of approximately $3 associated with the prepayment of the remaining principal amount of our 4.20% Notes and 5.75% Notes in November 2016 and a loss of approximately $1 associated with the debt repurchases in October 2016. Refer to Note 7, Debt and Other Financing on pages through of our 2017 Annual Report for additional information. Interest income decreased by approximately $1 compared to the prior-year period. Other expense, net, decreased by approximately $144 compared to the prior-year period, primarily due to the deconsolidation of our Venezuelan operations, as we recorded a loss of approximately $120 in the first quarter of 2016. In addition, other expense, net was positively impacted by foreign exchange net gains in the current year as compared to net losses in the prior year, resulting in a year-over-year benefit of approximately $28. The amounts recorded for our proportionate share of New Avon's losses was approximately $12 in both 2017 and 2016. As the recorded investment balance in New Avon was zero at the end of the third quarter of 2017, we have not recorded any additional losses associated with New Avon since the third quarter of 2017. See "Venezuela Discussion" in this MD&A and Note 1, Description of the Business and Summary of Significant Accounting Policies on pages through of our 2017 Annual Report for further discussion of our Venezuelan operations. See Note 4, Investment in New Avon on page of our 2017 Annual Report for more information on New Avon. Effective Tax Rate The effective tax rates in 2017 and 2016 continue to be impacted by our inability to recognize additional deferred tax assets in various jurisdictions related to our current-year operating results. In addition, the effective tax rates in 2017 and 2016 continue to be impacted by withholding taxes associated with certain intercompany payments, including royalties, service charges and dividends, which in the aggregate are relatively consistent each year due to the need to repatriate funds to cover U.S.-based costs, such as interest on debt and corporate overhead. These factors resulted in unusually high effective tax rates in 2017 and 2016. The effective tax rate in 2017 was impacted by an approximate net $30 benefit recognized as a result of the enactment of the Tax Cuts and Jobs Act in U.S., a release of valuation allowances of approximately $26 associated with a number of markets in Europe, Middle East & Africa as a result of a business model change related to the headquarters move, and an approximate $10 benefit as a result of a favorable court decision in Brazil, partially offset by a charge of approximately $16 associated with valuation allowances to adjust deferred tax assets in Mexico. The effective tax rate in 2017 was also impacted by a loss contingency related to a non-U.S. pension plan and CTI restructuring, both for which tax benefits cannot currently be claimed. The effective tax rate in 2016 was impacted by the deconsolidation of our Venezuelan operations, valuation allowances for deferred tax assets outside of the U.S. of approximately $9 and CTI restructuring, partially offset by a benefit of approximately $29 as a result of the implementation of foreign tax planning strategies, a net benefit of approximately $7 primarily due to the release of a valuation allowance associated with Russia and a benefit from the net proceeds recognized as a result of a legal settlement. In addition, the effective tax rates and the Adjusted effective tax rates in 2017 and 2016 were negatively impacted by the country mix of earnings. See Note 9, Income Taxes on pages through of our 2017 Annual Report for more information on tax items, Note 13, Employee Benefit Plans on pages through of our 2017 Annual Report for more information on the loss contingency related to a non-U.S. pension plan, Note 16, Restructuring Initiatives on pages through of our 2017 Annual Report for more information on CTI restructuring and "Venezuela Discussion" in this MD&A and Note 1, Description of the Business and Summary of Significant Accounting Policies on pages through of our 2017 Annual Report for more information for further discussion of our Venezuelan operations. Impact of Foreign Currency As compared to the prior-year period, foreign currency in 2017 impacted our consolidated financial results in the form of: • foreign currency transaction net gains (classified within cost of sales, and selling, general and administrative expenses), which had an immaterial impact to operating profit and Adjusted operating profit, and operating margin and Adjusted operating margin; • foreign currency translation, which had a favorable impact to operating profit and Adjusted operating profit of approximately $20, or approximately 30 basis points to operating margin and approximately 20 basis points to Adjusted operating margin; and • foreign exchange net gains on our working capital (classified within other expense, net) as compared to net losses in the prior year, resulting in a year-over-year benefit of approximately $28 before tax on both a reported and Adjusted basis. Discontinued Operations There were no amounts recorded in discontinued operations for the year ended December 31, 2017. Loss from discontinued operations, net of tax was approximately $14 for the year ended December 31, 2016. See Note 3, Discontinued Operations and Divestitures on pages through of our 2017 Annual Report for further discussion. Venezuela Discussion Avon Venezuela operates in the direct-selling channel offering Beauty and Fashion & Home products. Avon Venezuela has a manufacturing facility that produces the Beauty products that it sells. Avon Venezuela imports many of its Fashion & Home products and raw materials and components needed to manufacture its Beauty products. Currency restrictions enacted by the Venezuelan government since 2003 impacted the ability of Avon Venezuela to obtain foreign currency to pay for imported products. In 2010, we began accounting for our operations in Venezuela under accounting guidance associated with highly inflationary economies. Under U.S. GAAP, the financial statements of a foreign entity operating in a highly inflationary economy are required to be remeasured as if the functional currency is the company’s reporting currency, the U.S. dollar. This generally results in translation adjustments, caused by changes in the exchange rate, being reported in earnings currently for monetary assets (e.g., cash, accounts receivable) and liabilities (e.g., accounts payable, accrued expenses) and requires that different procedures be used to translate non-monetary assets (e.g., inventories, fixed assets). Non-monetary assets and liabilities are remeasured at the historical U.S. dollar cost basis. This diverges significantly from the application of accounting rules prior to designation as highly inflationary accounting, where such gains and losses would have been recognized only in other comprehensive income (loss) (shareholders' deficit). Venezuela's restrictive foreign exchange control regulations and our Venezuelan operations' increasingly limited access to U.S. dollars resulted in lack of exchangeability between the Venezuelan bolivar and the U.S. dollar, and restricted our Venezuelan operations' ability to pay dividends and settle intercompany obligations. The severe currency controls imposed by the Venezuelan government significantly limited our ability to realize the benefits from earnings of our Venezuelan operations and access the resulting liquidity provided by those earnings. We expected that this lack of exchangeability would continue for the foreseeable future, and as a result, we concluded that, effective March 31, 2016, this condition was other-than-temporary and we no longer met the accounting criteria of control in order to continue consolidating our Venezuelan operations. As a result, since March 31, 2016, we account for our Venezuelan operations using the cost method of accounting. As a result of the change to the cost method of accounting, in the first quarter of 2016 we recorded a loss of approximately $120 in other expense, net. The loss was comprised of approximately $39 in net assets of the Venezuelan business and approximately $81 in accumulated foreign currency translation adjustments within AOCI associated with foreign currency movements before Venezuela was accounted for as a highly inflationary economy. The net assets of the Venezuelan business were comprised of inventories of approximately $24, property, plant and equipment, net of approximately $15, other assets of approximately $11, accounts receivable of approximately $5, cash of approximately $4, and accounts payable and accrued liabilities of approximately $20. Our Consolidated Balance Sheets no longer include the assets and liabilities of our Venezuelan operations. We no longer include the results of our Venezuelan operations in our Consolidated Financial Statements, and will include income relating to our Venezuelan operations only to the extent that we receive cash for dividends or royalties remitted by Avon Venezuela. In February 2015, the Venezuelan government announced the creation of a new foreign exchange system referred to as the SIMADI exchange ("SIMADI"), which represented the rate which better reflected the economics of Avon Venezuela's business activity, in comparison to the other then available exchange rates; as such, we concluded that we should utilize the SIMADI exchange rate to remeasure our Venezuelan operations. As a result of the change to the SIMADI rate, which caused the recognition of a devaluation of approximately 70% as compared to the exchange rate we had used previously, we recorded an after-tax benefit of approximately $3 (a benefit of approximately $4 in other expense, net, and a loss of approximately $1 in income taxes) in the first quarter of 2015, primarily reflecting the write-down of net monetary assets. In addition, as a result of using the historical U.S. dollar cost basis of non-monetary assets, such as inventories, these assets continued to be remeasured, following the change to the SIMADI rate, at the applicable rate at the time of their acquisition. The remeasurement of non-monetary assets at the historical U.S. dollar cost basis caused a disproportionate expense as these assets were consumed in operations, negatively impacting operating profit and net income by approximately $19 during 2015. Also as a result of the change to the SIMADI rate, we determined that an adjustment of approximately $11 to cost of sales was needed to reflect certain non-monetary assets, primarily inventories, at their net realizable value, which was recorded in the first quarter of 2015. In addition, in February 2015, we reviewed Avon Venezuela's long-lived assets to determine whether the carrying amount of the assets was recoverable. Based on our expected cash flows associated with the asset group, we determined that the carrying amount of the assets, carried at their historical U.S. dollar cost basis, was not recoverable. As such, an impairment charge of approximately $90 to selling, general and administrative expenses was needed to reflect the write-down of the long-lived assets to their estimated fair value of approximately $16, which was recorded in the first quarter of 2015. 2016 Compared to 2015 Revenue Total revenue in 2016 declined 7% compared to the prior-year period, primarily due to unfavorable foreign exchange, while Constant $ revenue increased 2%. A number of items affected the year-over-year comparison of Constant $ revenue, the most significant being the sale of Liz Earle, which was completed in July 2015, that negatively impacted Constant $ revenue growth by approximately 1 point. The other items affecting the year-over-year comparison netted to an immaterial impact. In addition, our Constant $ revenue benefited from growth in Argentina, South Africa, Russia, Mexico and Brazil. Argentina contributed approximately 1 point to Avon's consolidated Constant $ revenue growth, as this market's results were impacted by the inflationary impact on pricing. The growth in Constant $ revenue was driven by higher average order, partially offset by a 2% decrease in Active Representatives. Average order benefited from the net impact of price and mix which increased 6%, while units sold decreased 4%, primarily due to declines in units sold in Brazil and Mexico, and the impact of the deconsolidation of Venezuela. TThe decrease in Active Representatives was primarily due to the impact of the deconsolidation of Venezuela and a decline in Asia Pacific, which included the impact caused by a reduction in the number of sales campaigns in the Philippines. These declines in Active Representatives were partially offset by growth in Europe, Middle East & Africa, most significantly Russia, which was primarily due to sustained momentum in recruitment and retention. Ending Representatives decreased by 2%. The decrease in Ending Representatives at December 31, 2016 as compared to the prior-year period was primarily due to the impact of the deconsolidation of Venezuela, which had a negative impact of 2 points, and declines in Asia Pacific. These decreases were partially offset by growth in Europe, Middle East & Africa, most significantly South Africa and Russia, as well as growth in South Latin America, most significantly Brazil. See "Venezuela Discussion" in this MD&A and Note 1, Description of the Business and Summary of Significant Accounting Policies on pages through of our 2017 Annual Report to the consolidated financial statements included herein for further discussion of our Venezuelan operations. On a category basis, our net sales from reportable segments and associated growth rates were as follows: See "Segment Review" in this MD&A for additional information related to changes in revenue by segment. Operating Margin Operating margin and Adjusted operating margin increased 290 basis points and 80 basis points, respectively, compared to 2015. The increases in operating margin and Adjusted operating margin include the benefits associated with costs savings initiatives, including the Transformation Plan, primarily reductions in headcount, as well as other cost reductions. The increases in operating margin and Adjusted operating margin are discussed further below in "Gross Margin," "Selling, General and Administrative Expenses" and "Impairment of Goodwill." Gross Margin Gross margin and Adjusted gross margin increased 20 basis points and decreased 30 basis points, respectively, compared to 2015. The gross margin comparison was impacted by approximately 50 basis points in the prior year by the devaluation of the Venezuelan currency in conjunction with highly inflationary accounting, as approximately $29 was recognized in the prior-year period associated with carrying certain non-monetary assets at the historical U.S. dollar cost following a devaluation. See "Venezuela Discussion" in this MD&A for a further discussion of our Venezuelan operations. The remaining decrease in gross margin and the decrease of 30 basis points in Adjusted gross margin were, in each case, primarily due to the following: • a decrease of approximately 260 basis points due to the unfavorable impact of foreign currency transaction losses and foreign currency translation; • a decrease of 30 basis points due to sales of products to New Avon since the separation of the Company's North America business into New Avon on March 1, 2016; and • various other insignificant items that decreased gross margin. These items were partially offset by the following: • an increase of 190 basis points due to the favorable net impact of mix and pricing, primarily due to inflationary and strategic pricing in South Latin America, Europe, Middle East & Africa and North Latin America; and • an increase of 90 basis points due to lower supply chain costs, primarily from lower material costs and cost savings initiatives in Europe, Middle East & Africa and South Latin America. See Note 5, Related Party Transactions on pages through of our 2017 Annual Report for more information on New Avon. Selling, General and Administrative Expenses Selling, general and administrative expenses for 2016 decreased approximately $404 compared to 2015. This decrease is primarily due to the favorable impact of foreign currency translation, as the strengthening of the U.S. dollar against many of our foreign currencies resulted in lower reported selling, general and administrative expenses. The decrease in selling, general and administrative expenses is also due to approximate $90 impairment charge recorded in the prior-year period to reflect the write-down of the long-lived assets to their estimated fair value associated with the devaluation of the Venezuelan currency in conjunction with highly inflationary accounting, lower fixed expenses resulting primarily from our cost savings initiatives, lower expenses associated with employee incentive compensation plans, the approximate $27 of net proceeds recognized as a result of a legal settlement in 2016 and lower advertising expense. Partially offsetting the decrease in selling, general and administrative expenses was higher bad debt expense, higher amount of CTI restructuring, higher foreign currency transaction costs and higher Representative, sales leader and field expense. Selling, general and administrative expenses as a percentage of revenue and Adjusted selling, general, and administrative expenses as a percentage of revenue decreased 260 basis points and 110 basis points, respectively, compared to 2015. The selling, general and administrative expenses as a percentage of revenue comparison benefited from: • approximately 150 basis points by the devaluation of the Venezuelan currency in conjunction with highly inflationary accounting in the prior-year period, primarily as an approximate $90 impairment charge was recognized in the prior-year period to reflect the write-down of the long-lived assets to their estimated fair value following a devaluation; • approximately 50 basis points by the approximate $27 of net proceeds recognized as a result of a legal settlement in 2016; • approximately 10 basis points by the approximate $7 aggregate settlement charges associated with the payments made to former employees who were vested and participated in the U.S. defined benefit pension plan recorded in the prior-year period, which did not occur in 2016; and • approximately 10 basis points by the approximately $3 of transaction-related costs associated with the separation of North America that were included in continuing operations recorded in the prior-year period. These items were partially offset by: • approximately 50 basis points for higher CTI restructuring. See "Venezuela Discussion" in this MD&A and Note 1, Description of the Business and Summary of Significant Accounting Policies on pages through of our 2017 Annual Report for a further discussion of our Venezuelan operations, Note 14, Segment Information on pages through of our 2017 Annual Report for more information on the legal settlement, Note 13, Employee Benefit Plans on pages through of our 2017 Annual Report for a further discussion of the pension settlement charges, and Note 16, Restructuring Initiatives on pages through of our 2017 Annual Report for more information on CTI restructuring. The remaining decrease in selling, general and administrative expenses as a percentage of revenue and the decrease of 110 basis points in Adjusted selling, general and administrative expenses as a percentage of revenue were, in each case, primarily due to the following: • a decrease of 210 basis points primarily due to lower fixed expenses, as well as the impact of the Constant $ revenue growth with respect to our fixed expenses. Lower fixed expenses resulted primarily from our costs savings initiatives, mainly reductions in headcount, but were partially offset by the inflationary impact on our expenses; • a decrease of 40 basis points due to lower expenses associated with employee incentive compensation plans; and • a decrease of 30 basis points from lower advertising expense, primarily in Europe, Middle East & Africa. These items were partially offset by the following: • an increase of 80 basis points from higher bad debt expense, driven by Brazil primarily due to the macroeconomic environment, coupled with actions taken to recruit new Representatives; • an increase of approximately 50 basis points due to the unfavorable impact of foreign currency translation and foreign currency transaction losses; and • an increase of 20 basis points as a result of the Industrial Production Tax ("IPI") tax law on cosmetics in Brazil that went into effect in May 2015, which reduced revenue as we did not raise the prices paid by Representatives to the same extent as the IPI tax. See "Segment Review - South Latin America" in this MD&A for a further discussion of the IPI tax law in Brazil. Impairment of Goodwill During the fourth quarter of 2015, we recorded a non-cash impairment charge of approximately $7 for goodwill associated with our Egypt business. See Note 19, Goodwill on page of our 2017 Annual Report for more information on Egypt. See “Segment Review” in this MD&A for additional information related to changes in segment margin. Other Expense Interest expense increased by approximately $16 compared to the prior-year period, primarily due to the interest associated with the $500 principal amount of 7.875% Senior Secured Notes issued in August 2016 and the increase in the interest rates on the Notes issued in March 2013 as a result of the downgrades of our long-term credit ratings. These items were partially offset by the interest savings associated with the repayment of certain of our debt in 2016 and the prepayment of the $250 principal amount of our 2.375% Notes due March 15, 2016 (the "2.375% Notes") in the third quarter of 2015. Refer to Note 7, Debt and Other Financing on pages through of our 2017 Annual Report for additional information. Gain on extinguishment of debt in 2016 of approximately $1 was comprised of a gain of approximately $4 associated with the cash tender offers in August 2016 and a gain of approximately $1 associated with the debt repurchases in December 2016, partially offset by a loss of approximately $3 associated with the prepayment of the remaining principal amount of our 4.20% Notes and our 5.75% Notes in November 2016 and a loss of approximately $1 associated with the debt repurchases in October 2016. Loss on extinguishment of debt in 2015 of approximately $6 was associated with the prepayment of our 2.375% Notes. Refer to Note 7, Debt and Other Financing on pages through of our 2017 Annual Report for additional information. Interest income increased by approximately $3 compared to the prior-year period. Other expense, net, increased by approximately $97 compared to the prior-year period, primarily due to the year-on-year impact of the Venezuelan special items as we recorded a loss of approximately $120 in the first quarter of 2016 as compared to a benefit of approximately $4 in the first quarter of 2015. In addition, other expense, net was positively impacted by lower net losses on foreign exchange, partially offset by our proportionate share of New Avon's loss of approximately $12. Foreign exchange net losses decreased by approximately $40 compared to the prior-year period, despite the unfavorable impact of approximately $17 as a result of the devaluation of the Egyptian pound in the fourth quarter of 2016. See "Venezuela Discussion" in this MD&A for a further discussion of our Venezuelan operations. See Note 4, Investment in New Avon on page of our 2017 Annual Report for more information on New Avon. Gain on sale of business in 2015 was the result of the sale of Liz Earle in July 2015. Refer to Note 3, Discontinued Operations and Divestitures on pages through of our 2017 Annual Report, for additional information regarding the sale of Liz Earle. Effective Tax Rate The effective tax rates in 2016 and 2015 continue to be impacted by our inability to recognize additional deferred tax assets in various jurisdictions related to our current-year operating results. In addition, the effective tax rates in 2016 and 2015 continue to be impacted by withholding taxes associated with certain intercompany payments, including royalties, service charges and dividends, which in the aggregate are relatively consistent each year due to the need to repatriate funds to cover U.S.-based costs, such as interest on debt and corporate overhead. These factors resulted in unusually high effective tax rates in 2016 and 2015. Our inability to recognize additional deferred tax assets in various jurisdictions related to our current-year operating results, along with these withholding taxes, resulted in unusually high effective tax rates in 2016 and 2015. The effective tax rate in 2016 was impacted by the deconsolidation of our Venezuelan operations, valuation allowances for deferred tax assets outside of the U.S. of approximately $9 and CTI restructuring, partially offset by a benefit of approximately $29 as a result of the implementation of foreign tax planning strategies, a net benefit of approximately $7 primarily due to the release of a valuation allowance associated with Russia and a benefit from the net proceeds recognized as a result of a legal settlement. The effective tax rate in 2015 was negatively impacted by additional valuation allowances for U.S. deferred tax assets of approximately $670. The additional valuation allowances in 2015 were due to the continued strengthening of the U.S. dollar against currencies of some of our key markets and the impact on the benefits from our tax planning strategies associated with the realization of our deferred tax assets. In addition, the effective tax rate in 2015 was negatively impacted by valuation allowances for deferred tax assets outside of the U.S. of approximately $15, primarily in Russia, which was largely due to lower earnings, which were significantly impacted by foreign exchange losses on working capital balances. During 2015, we also recognized a benefit of approximately $19 as a result of the implementation of the initial stages of foreign tax planning strategies. The valuation allowances for deferred tax assets in 2015 caused income taxes to be significantly in excess of income before taxes. In addition, the effective tax rate in 2015 was negatively impacted by the devaluation of the Venezuelan currency in conjunction with highly inflationary accounting. In addition, the effective tax rates and the Adjusted effective tax rates in 2016 and 2015 were negatively impacted by the country mix of earnings. See Note 9, Income Taxes on pages through of our 2017 Annual Report, for more information. In addition, see "Venezuela Discussion" in this MD&A and Note 1, Description of the Business and Summary of Significant Accounting Policies on pages through of our 2017 Annual Report for further discussion of our Venezuelan operations, Note 16, Restructuring Initiatives on pages through of our 2017 Annual Report for more information on CTI restructuring, and Note 14, Segment Information on pages through of our 2017 Annual Report for more information on the legal settlement. Impact of Foreign Currency During 2016, foreign currency continued to have a significant impact on our financial results. Specifically, as compared to the prior-year period, foreign currency in 2016 impacted our consolidated financial results in the form of: • foreign currency transaction net losses (classified within cost of sales, and selling, general and administrative expenses), which had an unfavorable impact to operating profit and Adjusted operating profit of an estimated $165, or approximately 270 points to operating margin and Adjusted operating margin; • foreign currency translation, which had an unfavorable impact to operating profit of approximately $60 and Adjusted operating profit of approximately $65, or approximately 40 points to operating margin and Adjusted operating margin; and • foreign exchange net losses on our working capital (classified within other expense, net), which were lower by approximately $35 before tax and $40 before tax on an Adjusted basis, despite the unfavorable impact of approximately $17 as a result of the devaluation of the Egyptian pound in the fourth quarter of 2016. Discontinued Operations Loss from discontinued operations, net of tax was approximately $14 in 2016 compared to approximately $349 for 2015. During 2016, we recorded charges of approximately $16 before tax (approximately $5 after tax) in the aggregate associated with the separation of the North America business which closed on March 1, 2016. During 2015, we recorded a charge of approximately $340 before tax (approximately $340 after tax) associated with the estimated loss on the separation of the North America business. See Note 3, Discontinued Operations and Divestitures on pages through of our 2017 Annual Report for further discussion. Other Comprehensive Income (Loss) Other comprehensive income, net of taxes was approximately $108 in 2017 compared with approximately $333 in 2016. The year-over-year comparison was unfavorably impacted by the recognition of losses of $259 from other comprehensive income into our Consolidated Statements of Operations in 2016 as a result of the separation of the North America business, primarily related to unamortized losses associated with the employee benefit plans, and the approximate $82 impact of the deconsolidation of Venezuela. The remaining approximate $116 benefit to the year-over-year comparison was primarily due to foreign currency translation adjustments, which benefited by approximately $117 as compared to 2016 primarily due to the favorable year-over-year comparison of movements of the Polish zloty and Mexican peso, partially offset by the unfavorable year-over-year comparison of movements of the Brazilian real. Other comprehensive income (loss), net of taxes was approximately $333 in 2016 compared with approximately ($151) in 2015, driven by the recognition of losses of $259 from other comprehensive income (loss) into our Consolidated Statements of Operations in 2016 as a result of the separation of the North America business, as noted above. Other comprehensive income (loss), net of taxes was also favorably impacted in 2016 by foreign currency translation adjustments, which benefited by approximately $240 as compared to 2015 primarily due to the favorable year-over-year comparison of movements of the Brazilian real, Colombian peso and Argentine peso, partially offset by the unfavorable year-over-year comparison of movements of the British pound. In addition, other comprehensive income (loss) in 2016 as compared with 2015 was favorably impacted by the approximate $82 impact of the deconsolidation of Venezuela. These favorable impacts to other comprehensive income (loss) were partially offset by the unfavorable impacts of lower amortization of net actuarial losses of approximately $64, largely as a result of the separation of the North America business, and lower net actuarial gains, which were approximately $3 in 2016 as compared with approximately $41 in 2015. In 2016, net actuarial gains decreased as a result of lower discount rates for the non-U.S. and U.S. pension plans, partially offset by higher asset returns in the U.S. and non-U.S. pension plans in 2016 as compared to 2015. See Note 3, Discontinued Operations and Divestitures on pages through of our 2017 Annual Report for more information on the separation of the North America business, see "Venezuela Discussion" in this MD&A and Note 1, Description of the Business and Summary of Significant Accounting Policies on pages through of our 2017 Annual Report for a further discussion of our Venezuelan operations, and Note 13, Employee Benefit Plans on pages through of our 2017 Annual Report for more information on our benefit plans. Segment Review We determine segment profit by deducting the related costs and expenses from segment revenue. In order to ensure comparability between periods, segment profit includes an allocation of global marketing expenses based on actual revenues. Segment profit excludes global expenses other than the allocation of marketing, CTI restructuring initiatives, certain significant asset impairment charges, and other items, which are not allocated to a particular segment, if applicable. This is consistent with the manner in which we assess our performance and allocate resources. See Note 14, Segment Information on pages through of our 2017 Annual Report for a reconciliation of segment profit to operating profit. Summarized financial information concerning our reportable segments was as follows: Below is an analysis of the key factors affecting revenue and segment profit by reportable segment for each of the years in the three-year period ended December 31, 2017. Foreign currency impact is determined as the difference between actual growth rates and Constant $ growth rates. Refer to "Non-GAAP Financial Measures" in this MD&A for more information. Europe, Middle East & Africa - 2017 Compared to 2016 Amounts in the table above may not necessarily sum due to rounding. Total revenue decreased 1% compared to the prior-year period, despite the favorable impact of foreign exchange which was primarily driven by the weakening of the U.S. dollar relative to the Russian ruble and to a lesser extent, the South African rand, partially offset by the strengthening of the U.S. dollar relative to the Turkish lira and the British pound. On a Constant $ basis, revenue decreased 4%, most significantly impacted by declines in Russia and the United Kingdom, partially offset by growth in South Africa. The segment's Constant $ revenue decline was primarily driven by a decrease in Active Representatives and lower average order. The increase in Ending Representatives was primarily driven by increases in Russia, Turkey and South Africa, partially offset by a decline in the United Kingdom. In Russia, revenue increased 5%, benefiting significantly from the favorable impact of foreign exchange. On a Constant $ basis, Russia's revenue declined 8%, primarily due to lower average order along with a decrease in Active Representatives. During the first half of 2017, the Constant $ revenue decline in Russia was impacted by the comparison to strong volume growth in the prior-year period, which benefited primarily from a pricing lag during an inflationary period. The Constant $ revenue decline in Russia was also impacted by competitive pressures, innovation issues and a continued difficult macroeconomic environment, primarily in the second half of 2017. These issues also negatively impacted Active Representatives, despite the increase in Ending Representatives. In the United Kingdom, revenue declined 14%, which was unfavorably impacted by foreign exchange. On a Constant $ basis, the United Kingdom's revenue declined 11%, primarily due to a decrease in Active Representatives, and to a lesser extent, lower average order. In South Africa, revenue grew 20%, which was favorably impacted by foreign exchange. On a Constant $ basis, South Africa’s revenue grew 9%, primarily due to an increase in Active Representatives, partially offset by lower average order. Segment margin increased .1 point, or decreased .2 points on a Constant $ basis, in each case primarily as a result of: • a decline of .7 points from higher transportation costs, driven primarily by new delivery rates in Russia; • a decline of .7 points primarily due to the impact of the Constant $ revenue decline causing deleverage of our fixed expenses, partially offset by lower fixed expenses. Fixed expenses benefited from lower expenses associated with employee incentive compensation plans, which were partially offset by higher other administrative costs; • a decline of .4 points from higher bad debt expense, primarily in South Africa and Russia. Higher bad debt expense in South Africa was driven primarily by lower collection of receivables as a result of deteriorating economic conditions, and in Russia was driven primarily by a payment facilitation agency that has not remitted to us the funds it received from certain Representatives; • a decline of .3 points primarily related to the net impact of declining revenue with respect to Representative, sales leader and field expense; and • a benefit of 1.8 points due to higher gross margin caused primarily by 1.0 point from the favorable net impact of mix and pricing primarily driven by Russia, and .7 points due to lower supply chain costs. Supply chain costs benefited primarily from lower material and distribution costs, partially due to productivity initiatives. Europe, Middle East & Africa - 2016 Compared to 2015 Amounts in the table above may not necessarily sum due to rounding. Total revenue decreased 4% compared to the prior-year period, due to the unfavorable impact from foreign exchange, most significantly the strengthening of the U.S. dollar relative to the British pound, Russian ruble and South African rand. On a Constant $ basis, revenue grew 4%, primarily driven by South Africa and Russia. The segment's Constant $ revenue growth was driven primarily by an increase in Active Representatives as well as higher average order. The increase in Ending Representatives was driven primarily by growth in Russia and South Africa. In Russia, revenue was relatively unchanged, which was unfavorably impacted by foreign exchange. On a Constant $ basis, Russia's revenue grew 9%, primarily due to an increase in Active Representatives, which benefited from sustained momentum in recruiting and retention, and to a lesser extent, higher average order, which was driven by pricing benefits. Russia's Constant $ revenue growth was driven by the strength of the performance in the first half of 2016 which tempered in the second half of 2016. During the fourth quarter of 2016, Russia's Constant $ revenue declined primarily as a result of increased pricing that negatively impacted Representative engagement and activity. In the United Kingdom, revenue declined 12%, which was unfavorably impacted by foreign exchange. On a Constant $ basis, the United Kingdom's revenue was relatively unchanged, as higher average order was offset by a decrease in Active Representatives. In South Africa, revenue grew 6%, which was unfavorably impacted by foreign exchange. On a Constant $ basis, South Africa’s revenue grew 21%, primarily due to an increase in Active Representatives. Segment margin increased 1.4 points, or 1.3 points on a Constant $ basis, in each case primarily as a result of: • a benefit of 1.0 point primarily due to the impact of the Constant $ revenue growth with respect to our fixed expenses; • a benefit of .7 points due to lower advertising expense, most significantly in Russia; and • a decline of .3 points due to lower gross margin, caused primarily by an estimated 3 points from the unfavorable impact of foreign currency transaction losses, which was partially offset by benefits of 1.5 points from the favorable net impact of mix and pricing and 1.1 points due to lower supply chain costs. Mix and pricing were primarily driven by inflationary and strategic pricing in Russia and lower supply chain costs included benefits from lower material costs and cost savings initiatives. South Latin America - 2017 Compared to 2016 Amounts in the table above may not necessarily sum due to rounding. Total revenue increased 4% compared to the prior-year period, primarily due to the favorable impact of foreign exchange which was primarily driven by the weakening of the U.S. dollar relative to the Brazilian real. On a Constant $ basis, revenue was relatively unchanged compared to the prior year, as higher average order was offset by a decrease in Active Representatives. The decline in Ending Representatives was primarily driven by a decline in Brazil as described below. Revenue in Brazil increased 4%, favorably impacted by foreign exchange. Brazil’s Constant $ revenue declined 4%, primarily due to a decrease in Active Representatives, partially offset by higher average order. On a Constant $ basis, Brazil’s sales from Beauty products and Fashion & Home products decreased 4% and 5%, respectively. The decline in Constant $ Beauty sales in Brazil was driven by weaker performance in Color. Revenue in Brazil, as well as Active Representatives and Ending Representatives, was impacted by a difficult macroeconomic environment particularly in the first half of 2017, combined with the application of stricter credit requirements for the acceptance of new Representatives as compared to the requirements in the prior year. In addition, Brazil's results were negatively impacted by competition primarily in the second half of 2017. Revenue in Argentina grew 10%, or 23% on a Constant $ basis primarily due to higher average order, which was impacted by the inflationary pricing. Segment margin decreased .6 points, or .4 points on a Constant $ basis, in each case primarily as a result of: • a decline of .6 points from higher bad debt expense, driven by Brazil due to the lower than anticipated collection of receivables, primarily impacted by the macroeconomic environment, as well as resulting from an adjustment to credit terms available to new Representatives during 2016; • a decline of .6 points primarily due to higher fixed expenses, driven by the inflationary impact on costs outpacing revenue growth, particularly in Argentina, partially offset by lower expenses associated with employee incentive compensation plans; • a decline of .5 points due to higher Representative, sales leader and field expense, most significantly in Brazil to support efforts to activate the field and improve Representative recruitment; • a decline of .3 points from higher transportation expense, driven by Argentina due to inflationary cost increases; and • a benefit of 1.8 points due to higher gross margin caused by 2.0 points from the favorable net impact of mix and pricing, primarily due to inflationary pricing, partially offset by .3 points from higher supply chain costs, which were primarily negatively impacted by higher material costs which included inflationary pressures in Argentina. South Latin America - 2016 Compared to 2015 Amounts in the table above may not necessarily sum due to rounding. Total revenue decreased 7% compared to the prior-year period, due to the unfavorable impact from foreign exchange which was primarily driven by the strengthening of the U.S. dollar relative to the Argentine peso and the Brazilian real. On a Constant $ basis, revenue increased 5%. The segment's Constant $ revenue growth was negatively impacted by an estimated 1 point from additional Value Added Tax ("VAT") state taxes in Brazil that were implemented in late 2015. In addition, an IPI tax law on cosmetics in Brazil that went into effect in May 2015 caused an estimated 1 point negative impact on the segment's Constant $ revenue growth. The segment's Constant $ revenue benefited from higher average order, which was driven by pricing, and was partially offset by a decrease in Active Representatives. The segment's Constant $ revenue and higher average order benefited from relatively high inflation in Argentina, as this market's results were impacted by the inflationary impact on pricing. Argentina contributed approximately 4 points to the segment's Constant $ revenue growth. Revenue in Argentina decreased 20%, unfavorably impacted by foreign exchange. On a Constant $ basis, Argentina's revenue grew 28% which was primarily due to higher average order, partially offset by a decrease in Active Representatives. The increase in Ending Representatives was primarily driven by growth in Brazil. Revenue in Brazil decreased 3%, unfavorably impacted by foreign exchange. Brazil’s Constant $ revenue increased 2%, despite the negative impact of an estimated 3 points due to the additional VAT state taxes discussed above. Constant $ revenue in Brazil was also negatively impacted by an estimated 3 points from the impact of the IPI tax discussed above. The negative impact of the additional VAT state taxes and the IPI tax was partially offset by higher average order, which was driven by pricing. Actions taken to recruit new Representatives, including the adjustment of credit terms, also benefited Brazil's Constant $ revenue. In addition, Brazil continued to be impacted by a difficult economic environment. On a Constant $ basis, Brazil’s sales from Beauty products increased 1%, despite the negative impact of the IPI tax and the additional VAT state taxes. On a Constant $ basis, Brazil's sales from Fashion & Home products increased 1%. Segment margin decreased 1.0 point, or .8 points on a Constant $ basis, in each case primarily as a result of: • a decline of 2.0 points from higher bad debt expense, driven by Brazil primarily due to the macroeconomic environment, coupled with actions taken to recruit new Representatives, including the adjustment of credit terms; • a decline of .6 points as a result of the IPI tax law on cosmetics in Brazil, which are a reduction of revenue and we have not raised the prices paid by Representatives to the same extent as the IPI tax; • a decline of .4 points from higher advertising expense, primarily in Brazil in the second half of 2016; • a benefit of .7 points primarily due to the impact of the Constant $ revenue growth with respect to our fixed expenses; • a benefit of .5 points due to higher gross margin caused by 2.6 points from the favorable net impact of mix and pricing, primarily due to inflationary and strategic pricing, and 1.2 points from lower supply chain costs, partially offset by an estimated 3.2 points from the unfavorable impact of foreign currency transaction losses. Supply chain costs benefited primarily as a result of lower material costs and cost savings initiatives; • a benefit of .3 points primarily due to the net impact of the Constant $ revenue growth with respect to our Representative, sales leader and field expense; and • various other insignificant items that partially offset the decline in segment margin. North Latin America - 2017 Compared to 2016 Amounts in the table above may not necessarily sum due to rounding. North Latin America consists largely of the Mexico business. Total revenue for the segment decreased 2% compared to the prior-year period, partly due to the unfavorable impact from foreign exchange, which was primarily driven by the strengthening of the U.S. dollar relative to the Mexican peso. On a Constant $ basis, revenue decreased 1% due to a decrease in Active Representatives, both of which were negatively impacted by product fulfillment shortfalls in the region in the second quarter of 2017. Constant $ revenue for the region and Mexico were both negatively impacted by approximately 1 point and 1 point, respectively, due to the earthquake in Mexico. This earthquake occurred in late September 2017 and adversely impacted Mexico's fourth quarter 2017 results. The segment's Constant $ revenue benefited from growth in Central America, offset by a Constant $ revenue decline in Mexico. The decline in Ending Representatives was primarily driven by a decline in Central America. Revenue in Mexico declined 4%, and was unfavorably impacted by foreign exchange. On a Constant $ basis, Mexico's revenue declined 2%, primarily due to a decrease in Active Representatives and the impact of the earthquake. Segment margin decreased 3.7 points, or 3.5 points on a Constant $ basis, in each case primarily as a result of: • a decline of .9 points due to lower gross margin caused primarily by .9 points from higher supply chain costs and .5 points from the unfavorable impact of foreign currency transaction net losses, partially offset by .5 points from the favorable net impact of mix and pricing. The impact of supply chain costs on gross margin was primarily due to lower volume and fixed overhead costs, as well as higher material costs; • a decline of .8 points from higher bad debt expense, primarily in Mexico partially due to the implementation of a new collection process as a result of changes in regulations; • a decline of .7 points due to higher Representative, sales leader and field expense, primarily as a result of increasing incentives to mitigate the impact of the product fulfillment shortfalls in the region and the earthquake in Mexico; • a decline of .6 points from higher transportation costs driven by Mexico primarily due to increased fuel prices; and • a decline of .3 points from higher net brochure costs, partly due to an increase in the number of pages in support of the segmentation of our Color category. North Latin America - 2016 Compared to 2015 Amounts in the table above may not necessarily sum due to rounding. Total revenue decreased 8% compared to the prior-year period, due to the unfavorable impact from foreign exchange which was primarily driven by the strengthening of the U.S. dollar relative to the Mexican peso. On a Constant $ basis, revenue increased 3%, which benefited from higher average order. Revenue in Mexico decreased 11%, unfavorably impacted by foreign exchange. On a Constant $ basis, Mexico's revenue grew 5%, primarily due to higher average order driven primarily from pricing, partially offset by a decline in units sold. Segment margin increased 1.9 points, or 2.2 points on a Constant $ basis, in each case primarily as a result of: • a benefit of 1.1 points due to higher gross margin caused primarily by a benefit of 2.7 points from the favorable impact of mix and pricing, primarily due to inflationary and strategic pricing, partially offset by 1.5 points from the unfavorable impact of foreign currency transaction losses; and • a benefit of .8 points primarily from lower fixed expenses, which includes .6 points as a result of an out-of-period adjustment which negatively impacted the prior-year period, as well as due to the impact of the Constant $ revenue growth with respect to our fixed expenses. Asia Pacific - 2017 Compared to 2016 Amounts in the table above may not necessarily sum due to rounding. Effective in the first quarter of 2017, given that we exited Thailand during 2016, the results of Thailand are now reported in Other operating segments and business activities for all periods presented, while previously the results had been reported in Asia Pacific. The impact was not material to Asia Pacific or Other operating segments and business activities and is consistent with how we present other market exits. Total revenue decreased 6% compared to the prior-year period, partially due to the unfavorable impact from foreign exchange. On a Constant $ basis, revenue decreased 3%, primarily due to a decrease in Active Representatives, most significantly in Malaysia, partially offset by higher average order. The decrease in Ending Representatives was impacted most significantly by a decline in Malaysia, which was partially offset by growth in the Philippines. Revenue in the Philippines decreased 2%, or increased 3% on a Constant $ basis, primarily due to higher average order and an increase in Active Representatives. Revenue growth in the Philippines was driven by the latter half of 2017, as strong commercial offers, including pricing, which, along with television advertising associated with our Color category, helped drive momentum in the field. In addition, actions implemented to improve inventory availability provided benefits to revenue growth. Segment margin decreased 1.8 points, or 1.3 points on a Constant $ basis, in each case primarily as a result of: • a decline of 1.4 points primarily related to the net impact of declining revenue with respect to Representative, sales leader and field expense, primarily in the Philippines; • a decline of 1.0 point due to lower gross margin caused primarily by .7 points from supply chain costs and .4 points from the unfavorable net impact of mix and pricing. The impact of supply chain costs on gross margin was primarily due to lower volume on fixed overhead costs; • a decline of .4 points due to higher advertising expense, primarily in the Philippines, related to television advertising associated with our Color category during the the latter half of 2017; • a benefit of 1.0 point due to the lower fixed expenses, including the benefits associated with the Transformation Plan, primarily reductions in headcount; and • a benefit of .4 points from lower bad debt expense, primarily in the Philippines, driven mainly by improved collection. Earlier in 2017, we completed the review of our China operations and have determined that we will retain China in our portfolio of businesses. Asia Pacific - 2016 Compared to 2015 Amounts in the table above may not necessarily sum due to rounding. Total revenue decreased 11% compared to the prior-year period, partially due to the unfavorable impact from foreign exchange. On a Constant $ basis, revenue decreased 7%, due to declines in most markets. The segment's Constant $ revenue decline was primarily due to a decrease in Active Representatives, partially offset by higher average order. Revenue in the Philippines decreased 3%, but grew 2% on a Constant $ basis, primarily due to higher average order, partially offset by a decrease in Active Representatives. The segment's and the Philippines' Active Representatives decline was impacted by a reduction in the number of sales campaigns in the Philippines. The decrease in Ending Representatives was driven by declines in all markets. Segment margin declined .3 points, or increased .1 point on a Constant $ basis, in each case primarily as a result of: • a net benefit of .3 points primarily from lower fixed expenses, largely offset by the unfavorable impact of the declining revenue causing deleverage of our fixed expenses; • a decline of .8 points due to lower gross margin, caused primarily by 1.1 points from the unfavorable impact of mix and pricing and .3 points from the unfavorable impact of foreign currency transaction losses, partially offset by .7 points from lower supply chain costs; and • various other insignificant items that benefited segment margin. Liquidity and Capital Resources Our principal sources of funding historically have been cash flows from operations, public offerings of notes, bank financings, issuance of commercial paper, borrowings under lines of credit and a private placement of notes. At December 31, 2017, we had cash and cash equivalents totaling approximately $882. We believe that our sources of funding will be sufficient to satisfy our currently anticipated cash requirements through at least the next twelve months. We may seek to repurchase our equity or to retire our outstanding debt in open market purchases, privately negotiated transactions, through derivative instruments, cash tender offers or otherwise. Repurchases of equity and debt may be funded by the incurrence of additional debt or the issuance of equity (including shares of preferred stock) or convertible securities and will depend on prevailing market conditions, our liquidity requirements, contractual restrictions and other factors, and the amounts involved may be material. We may also elect to incur additional debt or issue equity (including shares of preferred stock) or convertible securities to finance ongoing operations or to meet our other liquidity needs. Any issuances of equity (including shares of preferred stock) or convertible securities could have a dilutive effect on the ownership interest of our current shareholders and may adversely impact earnings per share in future periods. Our credit ratings were downgraded during the past several years, which may impact our ability to access such transactions on favorable terms, if at all. For more information, see "Risk Factors - Our credit ratings were downgraded in each of the last three years, which could limit our access to financing, affect the market price of our financing and increase financing costs. A further downgrade in our credit ratings may adversely affect our access to liquidity," "Risk Factors - Our indebtedness could adversely affect us by reducing our flexibility to respond to changing business and economic conditions," and "Risk Factors - A general economic downturn, a recession globally or in one or more of our geographic regions or markets or sudden disruption in business conditions or other challenges may adversely affect our business, our access to liquidity and capital, and our credit ratings" included in Item 1A on pages 7 through 20 of our 2017 Annual Report. Our liquidity could also be negatively impacted by restructuring initiatives, dividends, capital expenditures, acquisitions, and certain contingencies, including any legal or regulatory settlements, described more fully in Note 18, Contingencies on pages through of our 2017 Annual Report. See our Cautionary Statement for purposes of the "Safe Harbor" Statement under the Private Securities Litigation Reform Act of 1995 on pages 1 through 2 of our 2017 Annual Report. Balance Sheet Data Cash Flows Net Cash from Continuing Operating Activities Net cash provided by continuing operating activities during 2017 was approximately $271 as compared to approximately $128 during 2016, an increase of approximately $143 million. The year-over-year comparison was unfavorably impacted by approximately $27 of proceeds, net of legal fees, related to settling claims relating to professional services in connection with a previously disclosed legal matter, which was received in 2016. This unfavorable impact was partially offset by an injunction we received in May 2016 for cash deposits associated with IPI in Brazil. As a result, we were not required to make cash deposits in 2017, while we paid approximately $19 for these cash deposits in 2016, prior to May. See Note 18, Contingencies on pages through of our 2017 Annual Report for additional information on the IPI taxes. The remaining approximate $135 benefit to the year-over-year comparison of net cash provided by continuing operating activities was primarily due to improvements in working capital, most significantly from lower purchases of inventory and the timing of payments, as well as lower net receivables. Net cash provided by continuing operating activities during 2016 was approximately $37 higher than during 2015. The approximate $37 increase to net cash provided by continuing operating activities was primarily due to the approximate $67 payment to the U.S. Securities and Exchange Commission in connection with the FCPA settlement in 2015, which did not recur in 2016, lower operating tax payments, primarily in Brazil, and higher cash-related earnings. The net cash provided by continuing operating activities in 2016 also benefited from approximately $27 of proceeds, net of legal fees, related to settling claims relating to professional services in connection with a previously disclosed legal matter. These items were partially offset by the timing of payments, primarily for inventory, increased levels of accounts receivable which was primarily attributable to macroeconomic conditions in Brazil, and the contribution to the U.S. pension plan in 2016 of $20, which did not occur in 2015. We maintain defined benefit pension plans and unfunded supplemental pension benefit plans (see Note 13, Employee Benefit Plans on pages through of our 2017 Annual Report). Our funding policy for these plans is based on legal requirements and available cash flows. The amounts necessary to fund future obligations under these plans could vary depending on estimated assumptions (as detailed in "Critical Accounting Estimates - Pension and Postretirement Expense" in this MD&A). The future funding for these plans will depend on economic conditions, employee demographics, mortality rates, the number of associates electing to take lump-sum distributions, investment performance and funding decisions. Based on current assumptions, we expect to make contributions in the range of $10 to $15 to our U.S. defined benefit pension and postretirement plans and in the range of $20 to $25 to our non-U.S. defined benefit pension and postretirement plans during 2018. Net Cash from Continuing Investing Activities Net cash used by continuing investing activities during 2017 was approximately $70, as compared to approximately $83 during 2016. The approximate $13 decrease to net cash used by continuing investing activities was primarily due to an approximate $22 cash distribution received from New Avon in the third quarter of 2017, partially offset by lower asset disposals as compared to the prior-year period. See Note 4, Investment in New Avon on page of our 2017 Annual Report for more information on the cash distribution received from New Avon. Net cash used by continuing investing activities during 2016 was approximately $83, as compared to net cash provided by continuing investing activities of approximately $143 during 2015. The approximate $226 decrease to net cash (used) provided by continuing investing activities was primarily due to the net proceeds on the sale of Liz Earle in 2015 of approximately $208. See Note 3, Discontinued Operations and Divestitures on pages through of our 2017 Annual Report for more information on the sale of Liz Earle. Capital expenditures during 2017 were approximately $97 compared with approximately $93 during 2016 and approximately $92 during 2015. Capital expenditures in 2018 are currently expected to be in the range of $120 to $140 and are expected to be funded by cash from operations. Net Cash from Continuing Financing Activities Net cash provided by continuing financing activities during 2017 was zero, as compared to approximately $137 during 2016. The approximate $137 decrease to net cash provided by continuing financing activities was primarily due to the net proceeds related to the $500 principal amount of 7.875% Senior Secured Notes issued in the August 2016 and the net proceeds from the sale of series C preferred stock. These drivers were partially offset by the repayment of certain of our debt in 2016 of approximately $720 in the aggregate and higher repayments of short-term debt in the prior-year period. See Note 7, Debt and Other Financing on pages through of our 2017 Annual Report and Note 17, Series C Convertible Preferred Shares on pages through of our 2017 Annual Report for more information. Net cash provided by continuing financing activities during 2016 was approximately $137, as compared to net cash used by continuing financing activities of approximately $431 during 2015. The approximately $568 increase to net cash provided (used) by continuing financing activities was primarily due to the net proceeds related to the $500 principal amount of 7.875% Senior Secured Notes issued in the third quarter of 2016, the net proceeds of approximately $426 from the sale of series C preferred stock, the suspension of our dividend, and the prepayment of the $250 principal amount of our 2.375% Notes in the third quarter of 2015, which were partially offset by the repayment of certain of our debt in 2016 of approximately $720 in the aggregate. See Note 17, Series C Convertible Preferred Shares on pages through of our 2017 Annual Report and Note 7, Debt and Other Financing on pages through of our 2017 Annual Report for more information. We purchased approximately 1.6 million shares of our common stock for $7.2 during 2017, as compared to 1.4 million shares of our common stock for $5.6 during 2016 and .3 million shares of our common stock for $3.1 during 2015, through acquisition of stock from employees in connection with tax payments upon vesting of restricted stock units and upon vesting of performance restricted stock units in 2017 and 2016. We did not declare a dividend for 2017 or 2016 as we suspended the dividend effective in the first quarter of 2016. We maintained a quarterly dividend of $.06 per share for 2015. Debt and Contractual Financial Obligations and Commitments At December 31, 2017, our debt and contractual financial obligations and commitments by due dates were as follows: (1) Amounts are based on our current long-term credit ratings. See Note 7, Debt and Other Financing on pages through of our 2017 Annual Report for more information. (2) Amounts are net of expected sublease rental income. See Note 15, Leases and Commitments on page of our 2017 Annual Report for more information. (3) Amounts represent expected future benefit payments for our unfunded defined benefit pension and postretirement benefit plans, as well as expected contributions for 2018 to our funded defined benefit pension benefit plans. We are not able to estimate our contributions to our funded defined benefit pension and postretirement plans beyond 2018. (4) The amount of debt and contractual financial obligations and commitments excludes amounts due under derivative transactions. The table also excludes information on non-binding purchase orders of inventory. The table does not include any reserves for uncertain income tax positions because we are unable to reasonably predict the ultimate amount or timing of settlement of these uncertain income tax positions. At December 31, 2017, our reserves for uncertain income tax positions, including interest and penalties, totaled approximately $54. See Note 7, Debt and Other Financing, and Note 15, Leases and Commitments on pages through, and on page, respectively, of our 2017 Annual Report for more information on our debt and contractual financial obligations and commitments. Additionally, as disclosed in Note 16, Restructuring Initiatives on pages through of our 2017 Annual Report, at December 31, 2017, we have liabilities of approximately $49 associated with our Transformation Plan. The majority of future cash payments associated with these restructuring liabilities are expected to be made during 2018. Off Balance Sheet Arrangements At December 31, 2017, we had no material off-balance-sheet arrangements. Capital Resources Revolving Credit Facility In June 2015, Avon International Operations, Inc. ("AIO"), a wholly-owned domestic subsidiary of the Company, entered into a five-year $400.0 senior secured revolving credit facility (the “2015 facility”). Borrowings under the 2015 facility bear interest, at our option, at a rate per annum equal to LIBOR plus 250 basis points or a floating base rate plus 150 basis points, in each case subject to adjustment based upon a leverage-based pricing grid. In December 2017, AIO entered into an amendment to the 2015 facility, which, among other things, modified the financial covenants (interest coverage and total leverage ratios) to provide the Company additional flexibility. The 2015 facility may be used for general corporate purposes. As of December 31, 2017, there were no amounts outstanding under the 2015 facility. The 2015 facility replaced the Company's previous $1 billion unsecured revolving credit facility (the "2013 facility"). In the second quarter of 2015, $2.5 before tax was recorded for the write-off of issuance costs related to the 2013 facility. All obligations of AIO under the 2015 facility are (i) unconditionally guaranteed by each material domestic restricted subsidiary of the Company (other than AIO, the borrower), in each case, subject to certain exceptions and (ii) fully guaranteed on an unsecured basis by the Company. The obligations of AIO and the subsidiary guarantors are secured by first priority liens on and security interest in substantially all of the assets of AIO and the subsidiary guarantors, in each case, subject to certain exceptions. The 2015 facility will terminate in June 2020; provided, however, that it shall terminate on the 91st day prior to the maturity of the 6.50% Notes (as defined above) and the 4.60% Notes (as defined above), if on such 91st day, the applicable notes are not redeemed, repaid, discharged, defeased or otherwise refinanced in full. The 2015 facility contains affirmative and negative covenants, which are customary for secured financings of this type, as well as financial covenants (interest coverage and total leverage ratios). As of December 31, 2017, we were in compliance with our interest coverage and total leverage ratios under the 2015 facility, as amended. The amount of the facility available to be drawn down on is reduced by any standby letters of credit granted by AIO, which, as of December 31, 2017, was approximately $38. As of December 31, 2017, based on then applicable interest rates, the entire amount of the remaining 2015 facility, which is approximately $362, could have been drawn down without violating any covenant. Depending on our business results (including the impact of any adverse foreign exchange movements and significant restructuring charges), it is possible that we may be non-compliant with our interest coverage or total leverage ratio absent the Company undertaking other alternatives to avoid noncompliance, such as obtaining additional amendments to the 2015 facility or repurchasing certain debt. If we were to be non-compliant with our interest coverage or total leverage ratio, we would no longer have access to our 2015 facility and our credit ratings may be downgraded. As of December 31, 2017, there were no amounts outstanding under the 2015 facility.

<s>[INST] You should read the following discussion of the results of operations and financial condition of Avon Products, Inc. and its majority and wholly owned subsidiaries in conjunction with the information contained in the Consolidated Financial Statements and related Notes contained in our 2017 Annual Report. When used in this discussion, the terms "Avon," "Company," "we," "our" or "us" mean, unless the context otherwise indicates, Avon Products, Inc. and its majority and wholly owned subsidiaries. See "NonGAAP Financial Measures" on pages 29 through 31 of this management's discussion and analysis of financial condition and results of operations ("MD&A") for a description of how constant dollar ("Constant $") growth rates (a NonGAAP financial measure) are determined and see "Performance Metrics" on page 29 of this MD&A for definitions of our performance metrics (Change in Active Representatives, Change in units sold, Change in Ending Representatives and Change in Average Order). Overview We are a global manufacturer and marketer of beauty and related products. Our business is conducted primarily in the directselling channel. During 2017, we had sales operations in 56 countries and territories, and distributed products in 18 more. All of our consolidated revenue is derived from operations of subsidiaries outside of the United States ("U.S."). Our reportable segments are based on geographic operations in four regions: Europe, Middle East & Africa; South Latin America; North Latin America; and Asia Pacific. Our product categories are Beauty and Fashion & Home. Beauty consists of skincare, fragrance and color (cosmetics). Fashion & Home consists of fashion jewelry, watches, apparel, footwear, accessories, gift and decorative products, housewares, entertainment and leisure products, children’s products and nutritional products. Sales are made to the ultimate consumer principally through direct selling by Representatives, who are independent contractors and not our employees. As of December 31, 2017, we had approximately 6 million active Representatives which represents the number of Representatives submitting an order in a sales campaign, totaled for all campaigns during the year and then divided by the number of campaigns. The success of our business is highly dependent on recruiting, retaining and servicing the Representatives. During 2017, revenue was relatively unchanged compared to the prioryear period, partially benefiting from foreign exchange, while Constant $ revenue decreased 2%. Our Constant $ revenue decline was primarily driven by declines in Brazil, Russia and the United Kingdom, partially offset by growth in Argentina and South Africa. The decline in revenue and Constant $ revenue was primarily due to a 3% decrease in Active Representatives, which was partially offset by higher average order. The decrease in Active Representatives was impacted by declines in all reportable segments, most significantly in South Latin America (driven by Brazil) and Europe, Middle East & Africa. The net impact of price and mix increased 2%, primarily due to the inflationary impact on pricing in Argentina, Russia and Mexico. Units sold decreased 4%, primarily due to declines in Russia, Brazil, Mexico and the United Kingdom. The revenue performance was negatively impacted most significantly by a decline in Color sales, as we experienced issues in some markets while we segmented our Color category into three distinct brands. The timing of innovation also impacted the decline in Color sales. Ending Representatives were relatively unchanged. Ending Representatives at December 31, 2017 as compared to the prioryear period benefited from growth in Russia, which was offset by a decline in Brazil. See "Segment Review" in this MD&A for additional information related to changes in revenue by segment. Transformation Plan In January 2016, we initiated a transformation plan (the “Transformation Plan”) in order to enable us to achieve our longterm goals of midsingledigit Constant $ revenue growth and low doubledigit operating margin. The Transformation Plan included three pillars: invest in growth, reduce costs in an effort to continue to improve our cost structure and improve our financial resilience. The Transformation Plan was designed to focus on cost savings and financial resilience in the first year, in order to support future investment in growth. In 2016 we estimate that we achieved cost savings of $120 before taxes, and we significantly strengthened the balance sheet [/INST] Positive. </s>

AVON PRODUCTS INC

2019-02-21

2018-12-31

ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS ("MD&A") (U.S. dollars in millions, except per share and share data) You should read the following discussion of the results of operations and financial condition of Avon Products, Inc. and its majority and wholly owned subsidiaries in conjunction with the information contained in the Consolidated Financial Statements and related Notes contained in our 2018 Annual Report. When used in this discussion, the terms "Avon," "Company," "we," "our" or "us" mean, unless the context otherwise indicates, Avon Products, Inc. and its majority and wholly owned subsidiaries. See "Non-GAAP Financial Measures" on pages 29 through 30 of this MD&A for a description of how constant dollar ("Constant $") growth rates (a Non-GAAP financial measure) are determined and see "Performance Metrics" on page 29 of this MD&A for definitions of our performance metrics (Change in Active Representatives, Change in units sold, Change in Ending Representatives and Change in Average Order). Overview We are a global manufacturer and marketer of beauty and related products. Our business is conducted primarily in the direct-selling channel. During 2018, we had sales operations in 56 countries and territories, and distributed products in 21 more. All of our consolidated revenue is derived from operations of subsidiaries outside of the United States ("U.S."). Our reportable segments are based on geographic operations in four regions: Europe, Middle East & Africa; South Latin America; North Latin America; and Asia Pacific. Our product categories are Beauty and Fashion & Home. Beauty consists of skincare, fragrance and color (cosmetics). Fashion & Home consists of fashion jewelry, watches, apparel, footwear, accessories, gift and decorative products, housewares, entertainment and leisure products, children’s products and nutritional products. Sales are made to the ultimate consumer principally through direct selling by Representatives, who are independent contractors and not our employees. As of December 31, 2018, we had approximately 5 million active Representatives which represents the number of Representatives submitting an order in a sales campaign, totaled for all campaigns during the year and then divided by the number of campaigns. The success of our business is highly dependent on recruiting, retaining and servicing our Representatives. During 2018, revenue declined 3% compared to the prior-year period. Excluding the Brazil IPI release, Adjusted revenue was down 5%, primarily due to the unfavorable impact of foreign exchange. Constant $ Adjusted revenue increased 1%. Revenue and Constant $ Adjusted revenue included a benefit of approximately 4% due to the impact of adopting the new revenue recognition standard. The 4% benefit was driven primarily by the reclassification of fees paid by Representatives for brochures, late payments and payment processing, and income from appointment kits, from SG&A. The impact of timing of revenue recognition for sales incentives was negligible. Constant $ Adjusted revenue was impacted by declines primarily in Brazil, which continued to be negatively impacted by competitive pressures against a backdrop of a challenging macroeconomic environment and lower consumption in the market, as well as lower appointments, partly due to the application of strict credit requirements for the acceptance of new Representatives. To a lesser extent, Constant $ Adjusted revenue was also impacted by declines in the United Kingdom, South Africa and Russia, as well as lower revenue from the closure of Australia and New Zealand during 2018. These declines were partially offset by improved revenue growth management, including inflationary, pricing in Argentina. Revenue and Constant $ Adjusted revenue were impacted by a decrease in Active Representatives of 5%, which was primarily driven by Brazil, and to a lesser extent, Russia. Average order in Constant $ increased 2%, including a benefit of approximately 4% due to the impact of adopting the new revenue recognition standard. Units sold decreased 6%, driven by a decline in Brazil. Ending Representatives declined 8%, primarily driven by declines in Russia and Brazil. The impact of the new revenue recognition standard was primarily driven by the following accounting changes effective as of January 1, 2018: • Certain of our sales incentives and prospective discounts are now considered to be a separate deliverable, thus initially revenue is deferred generally until delivery of the incentive prize to the Representative or future discounts are realized, and at that time the associated cost is recognized in cost of sales. Historically, the cost of sales incentives was recognized in SG&A over the period that the sales incentive was earned; and • Fees paid by Representatives to the Company for brochures, late payments and payment processing are now reflected as revenue, rather than reflected as a reduction of SG&A. The associated cost for brochures that are sold is now recognized in cost of sales rather than in SG&A. Further, the fees and costs associated with brochures are now recognized upon delivery to the Representatives, rather than recognized over the campaign length. See Note 1, Description of the Business and Summary of Significant Accounting Policies, and Note 2, New Accounting Standards, to the Consolidated Financial Statements included herein for additional information on the new revenue recognition standard. See "Segment Review" in this MD&A for additional information related to changes in revenue by segment. Transformation Plan and Open Up Avon In January 2016, we initiated a transformation plan (the "Transformation Plan"), in order to enable us to achieve our long-term goals of mid-single-digit Constant $ revenue growth and low double-digit operating margin. The Transformation Plan included three pillars: invest in growth, reduce costs in an effort to continue to improve our cost structure and improve our financial resilience. Under this plan, we had targeted pre-tax annualized cost savings of approximately $350 after three years, which were expected to be achieved through restructuring actions, as well as other cost-savings strategies that would not result in restructuring charges. There are no further restructuring actions to be taken associated with our Transformation Plan, as beginning in the third quarter of 2018, all new restructuring actions that are approved will operate under our new Open Up Avon plan described below. In September 2018, we initiated a new strategy in order to return Avon to growth (“Open Up Avon”). The Open Up Avon strategy is integral to our ability to return Avon to growth, built around the necessity of incorporating new approaches to various elements of our business, including increased utilization of third-party providers in manufacturing and technology, a more fit for purpose asset base, and a focus on enabling our Representatives to more easily interact with the company and achieve relevant earnings. The commercial elements of the strategy were developed to help increase Representative earnings and thereby retention. Elements of the Representative facing strategy include improvements in service functions, increased training on utilization of digital tools to expand her consumer reach, product bundling and regimens designed to help improve her earnings opportunity and sharper more targeted product innovation to drive brand relevancy. Cost savings under this plan are targeted as pre-tax annualized cost savings of approximately $400 by 2021, and expected to be generated from efficiencies in manufacturing and sourcing, distribution, general and administrative activities, and back office functions, as well as through revenue management, interest and tax. These savings are expected to be achieved through restructuring actions (that may result in charges related to severance, contract terminations and inventory and other asset write-offs), as well as other cost-savings strategies that would not result in restructuring charges. In January 2019, we announced significant advancements in this strategy, including a structural reset of inventory processes and an aggregate 18% reduction in global workforce. The structural reset of inventory processes includes a 15% reduction in inventory levels and 25% reduction in Stock Keeping Units (SKUs). The structural reset of inventory will result in lower operational and ongoing obsolescence costs. Over the longer term, it will result in a more concentrated focus on high-turn, higher margin products, driving greater earnings for Representatives due to lessened discount pressure and enhanced service levels. The structural reset resulted in an incremental one-off inventory obsolescence expense of $88 recognized at December 31, 2018. In addition, the global workforce will be reduced in 2019 by approximately 10% to align with ongoing operating model changes and to create a leaner organization that is better aligned with Avon’s current and future business focus. This reduction is incremental to an 8% reduction of the global workforce that was completed in 2018. We expect to incur a restructuring charge of approximately $100 in 2019 relating to the global workforce reduction, which wasn't approved by the Board of Directors until January 2019. We initiated the Open Up Avon strategy to enable us to achieve our goals of low-single-digit Constant $ revenue growth and low double-digit operating margin by 2021. We plan to reinvest a portion of these cost savings in commercial initiatives, including training for Representatives, and digital and information technology infrastructure initiatives. During 2018, we estimate that we achieved total cost savings of approximately $110 before taxes, of which approximately $40 is attributable to Open Up Avon and approximately $70 is attributable to the Transformation Plan. The estimated $40 of savings attributable to Open Up Avon primarily relates to tax and interest, when compared to our costs in 2017. As it relates to the Transformation Plan, we exceeded our cost savings target of $65 before taxes for full-year 2018. These savings include both run-rate savings from the Transformation Plan from 2017, along with in-year savings from current year initiatives already identified, and are associated with restructuring actions and from other cost-savings strategies that did not result in restructuring charges. As a result of restructuring actions and other cost-savings strategies taken to-date, as it relates to the Transformation Plan, we exited 2018 with run-rate savings in excess of our total cumulative cost savings target of $350. In connection with the actions and associated savings discussed above, we have incurred costs to implement ("CTI") restructuring initiatives of approximately $205 before taxes to-date associated with the Transformation Plan and approximately $143 before taxes to-date associated with Open Up Avon, which includes $88 relating to the structural reset of inventory. Of these costs, approximately $38 and approximately $143 was recorded during 2018 associated with the Transformation Plan and Open Up Avon, respectively. The additional charges not yet incurred associated with the restructuring actions approved as at December 31, 2018 relate to Open Up Avon and are negligible. At December 31, 2018, we have liabilities of approximately $59 associated with our restructuring actions, primarily associated with our Transformation Plan. The majority of future cash payments associated with these restructuring liabilities are expected to be made during 2019. For additional details on restructuring initiatives, see Note 17, Restructuring Initiatives, to the Consolidated Financial Statements included herein. New Accounting Standards Information relating to new accounting standards is included in Note 2, New Accounting Standards on pages through of our 2018 Annual Report. Performance Metrics Within this MD&A, in addition to our key financial metrics of revenue, operating profit and operating margin, we utilize the performance metrics defined below to assist in the evaluation of our business. Performance Metrics Definition Change in Active Representatives This metric is a measure of Representative activity based on the number of unique Representatives submitting at least one order in a sales campaign, totaled for all campaigns in the related period. To determine the change in Active Representatives, this calculation is compared to the same calculation in the corresponding period of the prior year. Orders in China are excluded from this metric as our business in China is predominantly retail. Change in units sold This metric is based on the gross number of pieces of merchandise sold during a period, as compared to the same number in the same period of the prior year. Units sold include samples sold and products contingent upon the purchase of another product (for example, gift with purchase or discount purchase with purchase), but exclude free samples. Change in Ending Representatives This metric is based on the total number of Representatives who were eligible to place an order in the last sales campaign in the related period as a result of being on an active roster. To determine the Change in Ending Representatives, this calculation is compared to the same calculation in the corresponding period of the prior year. Change in Ending Representatives may be impacted by a combination of factors such as our requirements to become and/or remain a Representative, our practices regarding minimum order requirements and our practices regarding reinstatement of Representatives. We believe this may be an indicator of future revenue performance. Change in Average Order This metric is a measure of Representative productivity. The calculation is the difference of the year-over-year change in revenue on a Constant $ basis and the Change in Active Representatives. Change in Average Order may be impacted by a combination of factors such as inflation, units, product mix, and/or pricing. Non-GAAP Financial Measures To supplement our financial results presented in accordance with generally accepted accounting principles in the U.S. ("GAAP"), we disclose operating results that have been adjusted to exclude the impact of changes due to the translation of foreign currencies into U.S. dollars, including changes in: revenue, Adjusted revenue, operating profit, Adjusted operating profit, operating margin and Adjusted operating margin. We refer to these adjusted financial measures as Constant $ items, which are Non-GAAP financial measures. We believe these measures provide investors an additional perspective on trends and underlying business results. To exclude the impact of changes due to the translation of foreign currencies into U.S. dollars, we calculate current-year results and prior-year results at constant exchange rates, which are updated on an annual basis, usually in October, as part of our budgeting process. Foreign currency impact is determined as the difference between actual growth rates and Constant $ growth rates. We also present revenue, gross margin, SG&A expenses as a percentage of revenue, operating profit, operating margin, income (loss) before taxes, income taxes and effective tax rate on a Non-GAAP basis. We refer to these Non-GAAP financial measures as "Adjusted." We have provided a quantitative reconciliation of the Non-GAAP financial measures to the most directly comparable financial measures calculated and reported in accordance with GAAP. See "Reconciliation of Non-GAAP Financial Measures" within "Results of Operations - Consolidated" on pages 35 through 43 in this MD&A for this quantitative reconciliation. The Company uses Non-GAAP financial measures to evaluate its operating performance. These Non-GAAP measures should not be considered in isolation, or as a substitute for, or superior to, financial measures calculated in accordance with GAAP. The Company believes investors find the Non-GAAP information helpful in understanding the ongoing performance of operations separate from items that may have a disproportionate positive or negative impact on the Company's financial results in any particular period. The Company believes that it is meaningful for investors to be made aware of the impacts of 1) CTI restructuring initiatives; 2) the Brazil IPI tax release; 3) a charge for a loss contingency related to a non-U.S. pension plan ("Loss contingency"); 4) the net proceeds recognized as a result of settling claims relating to professional services ("Legal settlement"); 5) charges related to the deconsolidation of our Venezuelan operations as of March 31, 2016, combined with Venezuela being designated as a highly inflationary economy ("Venezuelan special items"); 6) various other items associated with debt-related charges ("Other items"); and, as it relates to our effective tax rate discussion, 7) special tax items associated with uncertain tax positions and the ownership transfer of certain operational assets within the consolidated group, which were recognized in 2018, the net income tax benefit as a result of the enactment of the Tax Cuts and Jobs Act in the U.S., a release of valuation allowances associated with a number of markets in Europe, Middle East & Africa, and a benefit as a result of a favorable court decision in Brazil, partially offset by a charge associated with valuation allowances to adjust deferred tax assets in Mexico, which were recognized in 2017, income tax benefits realized in 2016 as a result of tax planning strategies, an income tax benefit in the second quarter of 2016 primarily due to the release of a valuation allowance associated with Russia and the adjustments associated with our deferred tax assets recorded in 2016 ("Special tax items"). (1) CTI restructuring initiatives includes the impact on the Consolidated Statement of Operations for all periods presented of net charges incurred on approved restructuring initiatives. (2) The Brazil IPI tax release includes the impact on the Consolidated Statement of Operations during the third quarter of 2018 of the release of the liability related to IPI tax on cosmetics in Brazil. The release was recorded in net sales and other (income) expense, net in the amounts of approximately $168 and approximately $27, respectively. The Brazil IPI tax release also includes approximately $66 recorded in income taxes. (3) The Loss contingency includes the impact on our Consolidated Statements of Operations during the second quarter of 2017 caused by a charge of approximately $18 for a loss contingency related to a non-U.S. pension plan, for which an amendment to the plan that occurred in a prior year may not have been appropriately implemented. (4) The Legal settlement includes the impact on our Consolidated Statements of Operations during the third quarter of 2016 associated with the net proceeds of approximately $27 recognized as a result of settling claims relating to professional services that had been provided to the Company prior to 2013 in connection with a previously disclosed legal matter. (5) The Venezuelan special items include the impact on our Consolidated Statements of Operations during the first quarter of 2016 caused by the deconsolidation of our Venezuelan operations for which we recorded a loss of approximately $120 in other expense, net. The loss was comprised of approximately $39 in net assets of the Venezuelan business and approximately $81 in accumulated foreign currency translation adjustments within accumulated other comprehensive loss ("AOCI") associated with foreign currency changes before Venezuela was accounted for as a highly inflationary economy. (6) The Other items include the impact on our Consolidated Statements of Operations during the third quarter of 2016 due to a net gain on extinguishment of debt associated with the cash tender offers in August 2016, the debt repurchases in October and December 2016, and the prepayment of the remaining principal amount of our 4.20% Notes due July 15, 2018 and our 5.75% Notes due March 1, 2018 in November 2016. (7) In addition, the effective tax rate discussion includes Special tax items, including the impact on the provision for income taxes in our Consolidated Statements of Operations during 2018 due to one-time tax reserves of approximately $18 associated with our uncertain tax positions, and an expense of approximately $3 associated with the ownership transfer of certain operational assets within the consolidated group. Special tax items also include the impact on the provision for income taxes in our Consolidated Statements of Operations during 2017 due to an approximate $30 net benefit recognized as a result of the enactment of the Tax Cuts and Jobs Act in the U.S., a release of valuation allowances of approximately $26 associated with a number of markets in Europe, Middle East & Africa, and an approximate $10 benefit as a result of a favorable court decision in Brazil, partially offset by a charge of approximately $16 associated with valuation allowances to adjust deferred tax assets in Mexico. Special tax items also include the impact on the provision for income taxes in our Consolidated Statements of Operations during the fourth quarter of 2016 due to the charge of approximately $9 associated with valuation allowances to adjust certain non-U.S. deferred tax assets to an amount that is "more likely than not" to be realized. Special tax items also include the impact on the provision for income taxes in our Consolidated Statements of Operations during the second quarter of 2016 primarily due to the release of a valuation allowance associated with Russia of approximately $7. Special tax items also include the impact on the provision for income taxes in our Consolidated Statements of Operations during the first quarter of 2016 due to income tax benefits of approximately $29 recognized as the result of the implementation of foreign tax planning strategies. See Note 19, Contingencies on pages through of our 2018 Annual Report, Note 17, Restructuring Initiatives on pages through of our 2018 Annual Report, Note 14, Employee Benefit Plans on pages through of our 2018 Annual Report, Note 15, Segment Information on pages through of our 2018 Annual Report, "Results Of Operations - Consolidated" below, Note 1, Description of the Business and Summary of Significant Accounting Policies on pages through of our 2018 Annual Report, "Venezuela Discussion" below, Note 8, Debt and Other Financing on pages through of our 2018 Annual Report, Note 10, Income Taxes on pages through of our 2018 Annual Report and "Effective Tax Rate" on pages 39 in this MD&A for more information on these items. Critical Accounting Estimates We believe the accounting policies described below represent our critical accounting policies due to the estimation processes involved in each. See Note 1, Description of the Business and Summary of Significant Accounting Policies on pages through of our 2018 Annual Report for a detailed discussion of the application of these and other accounting policies. Revenue Recognition Revenue is recognized when control of a product or service is transferred to a customer, which is generally the Representative. Revenue is measured based on the consideration specified in a contract with a customer and excludes amounts collected on behalf of third parties, such as Value Added Taxes (“VAT”) collected for taxing authorities. Our contracts with Representatives often include multiple promises to transfer products and/or services to the Representative and determining which of these products and/or services are considered distinct performance obligations that should be accounted for separately. When assessing the recognition of revenue for the identified performance obligations, management has exercised significant judgment in the following areas: estimation of variable consideration and the stand-alone selling prices ("SSP") of promised goods or services delivered under sales incentives to determine and allocate the transaction price. Typically included within a contract with customers is variable consideration, such as sales returns and late payment fees. Revenue is only recorded to the extent it is probable that it will not be reversed, and therefore revenue is adjusted for variable consideration. Judgment is required to estimate the variable consideration. The Company uses the expected value method, which considers possible outcomes weighted by their probability. Specifically, for sales returns, a refund liability will be recorded for the estimated cash to be refunded for the products expected to be returned, and a returns asset will be recorded for the products which we expect to be returned and re-sold, each of these based on historical experience. The estimate of sales returns as well as the measurement of the returns asset and the refund liability is updated at the end of each month for changes in expectations regarding the amount of salvageable returns, reconditioning costs and any additional decreases in the value of the returned products. Late payment fees are recorded when the uncertainty associated with collecting such fees are resolved (i.e., when collected). Additionally, management has exercised significant judgment in the estimation of the SSP of promised goods or services delivered under sales incentives such as status programs, loyalty points, prospective discounts, and gift with purchase, among others, to determine and allocate the transaction price. SSP represents the estimated market value, or the estimated amount that could be charged for that material right when the entity sells it separately in similar circumstances to similar customers. Judgment is required to determine the SSP for each distinct performance obligation. In instances where SSP is not directly observable, such as when we do not sell the product or service separately, including for certain sales incentives, we determine the SSP using information that may include market prices and other observable inputs. The new standard related to revenue recognition had a material impact in our consolidated financial statements. See Note 1, Description of the Business and Summary of Significant Accounting Policies pages through of our 2018 Annual Report for more information on our revenue recognition accounting policy. Allowances for Doubtful Accounts Receivable Representatives contact their customers, selling primarily through the use of brochures for each sales campaign, generally on credit if the Representatives meet certain criteria. Sales campaigns are generally for a three- to four-week duration. The Representative purchases products directly from us and may or may not sell them to an end user. In general, the Representative, an independent contractor, remits a payment to us during each sales campaign, which relates to the prior campaign cycle. The Representative is generally precluded from submitting an order for the current sales campaign until the accounts receivable balance past due for prior campaigns is paid; however, there are circumstances where the Representative fails to make the required payment. We record an estimate of an allowance for doubtful accounts on receivable balances based on an analysis of historical data and current circumstances, including seasonality and changing trends. Over the past three years, annual bad debt expense was $162 in 2018, $222 in 2017 and $191 in 2016, or approximately 3% of total revenue in 2018, approximately 4% of total revenue in 2017, and approximately 3% of total revenue in 2016. The allowance for doubtful accounts is reviewed for adequacy, at a minimum, on a quarterly basis. We generally have no detailed information concerning, or any communication with, any end user of our products beyond the Representative. We have no legal recourse against the end user for the collection of any accounts receivable balances due from the Representative to us. If the financial condition of the Representatives were to deteriorate, resulting in their inability to make payments, additional allowances may be required. Allowances for Sales Returns Policies and practices for product returns vary by jurisdiction. We record a provision for estimated sales returns based on historical experience with product returns. Over the past three years, annual sales returns were $172 for 2018, $198 for 2017 and $187 for 2016, or approximately 3% of total revenue in each year, which has been generally in line with our expectations. If the historical data we use to calculate these estimates does not approximate future returns, due to changes in marketing or promotional strategies, or for other reasons, additional allowances may be required. Provisions for Inventory Obsolescence We record an allowance for estimated obsolescence, when applicable, equal to the difference between the cost of inventory and the net realizable value. In determining the allowance for estimated obsolescence, we classify inventory into various categories based upon its stage in the product life cycle, future marketing sales plans and the disposition process. We assign a degree of obsolescence risk to products based on this classification to estimate the level of obsolescence provision. If actual sales are less favorable than those projected, additional inventory allowances may need to be recorded for such additional obsolescence. Annual obsolescence expense was $114 in 2018, $37 in 2017 and $37 in 2016, or 2% of total revenue in 2018, and less than 1% of total revenue in 2017 and 2016. As discussed in the Overview section, 2018 includes inventory obsolescence charges of $88 related to our inventory reset program. Pension and Postretirement Expense We maintain defined benefit pension plans, the most significant of which are in the UK, Germany and the U.S. However, our U.S. defined benefit pension plan is closed to employees hired on or after January 1, 2015 and the UK defined benefit pension plan was frozen for future accruals as of April 1, 2013. Additionally, we have unfunded supplemental pension benefit plans for some current and retired executives and provide retiree health care benefits subject to certain limitations to certain retired employees in the U.S. and certain foreign countries. See Note 14, Employee Benefit Plans on pages through of our 2018 Annual Report for more information on our benefit plans. Pension and postretirement expense and the requirements for funding our major pension plans are determined based on a number of actuarial assumptions, which are generally reviewed and determined on an annual basis. These assumptions include the discount rate applied to plan obligations, the expected rate of return on plan assets, the rate of compensation increase of plan participants, price inflation, cost-of-living adjustments, mortality rates and certain other demographic assumptions, and other factors. We use a December 31 measurement date for all of our employee benefit plans. For 2018, the weighted average assumed rate of return on all pension plan assets was 5.23%, as compared with 5.12% for 2017. In determining the long-term rates of return, we consider the nature of the plans’ investments, an expectation for the plans’ investment strategies, historical rates of return and current economic forecasts. We generally evaluate the expected long-term rates of return annually and adjust as necessary. In some of our defined benefit pension plans, we have adopted investment strategies which are designed to match the movements in the pension liability through an increased allocation towards debt securities. In addition, we also utilize derivative instruments in our UK defined benefit pension plans to achieve the desired market exposures or to hedge certain risks. Derivative instruments may include, but are not limited to, futures, options, swaps or swaptions. Investment types, including the use of derivatives are based on written guidelines established for each investment manager and monitored by the plan's investment committee. A significant portion of our pension plan assets relate to the UK defined benefit pension plan. The assumed rate of return for determining 2018 net periodic benefit cost for the UK defined benefit pension plan was 5.20%. In addition, the 2018 rate of return assumption for the UK defined benefit pension plan was based on an asset allocation of approximately 80% in corporate and government bonds and mortgage-backed securities (which are expected to earn approximately 2% to 4% in the long-term) and approximately 20% in equity securities, emerging market debt and high yield securities (which are expected to earn approximately 5% to 9% in the long-term). In addition to the physical assets, the asset portfolio for the UK defined benefit pension plan has derivative instruments which increase our exposure to fixed income (in order to better match liabilities) and, to a lesser extent, impact our equity exposure. The rate of return on the plan assets in the UK was approximately -4% in 2018 and approximately 9% in 2017. Historically, the pension plan with the most significant pension plan assets was the U.S. defined benefit pension plan. As part of the separation of the North America business, in 2016 we transferred $499.6 of pension liabilities under the U.S. defined benefit pension plan associated with current and former employees of the North America business and certain other former Avon employees, along with $355.9 of assets held by the U.S. defined benefit pension plan, to a defined benefit pension plan sponsored by New Avon. We also transferred $60.4 of other postretirement liabilities (namely, retiree medical and supplemental pension liabilities) in respect of such employees and former employees. See Note 3, Discontinued Operations and Assets and Liabilities Held for Sale on pages through of our 2018 Annual Report. We continue to retain certain U.S. pension and other postretirement liabilities primarily associated with employees who are actively employed by Avon in the U.S. providing services other than with respect to the North America business. Prior to this separation, our net periodic benefit costs for the U.S. pension and postretirement benefit plans were allocated between Discontinued Operations and Global as the plan included both North America and U.S. Corporate Avon associates, and as such, our ongoing net periodic benefit costs within Global were not materially impacted by the separation of the North America business. The assumed rate of return for determining 2018 net periodic benefit cost for the U.S. defined benefit pension plan was 5.50%, which was based on an asset allocation of approximately 70% in corporate and government bonds (which are expected to earn approximately 3% to 5% in the long-term) and approximately 30% in equity securities (which are expected to earn approximately 6% to 8% in the long-term). The rate of return on the plan assets in the U.S. was approximately -6% in 2018 and approximately 15% in 2017. The discount rate used for determining the present value of future pension obligations for each individual plan is based on a review of bonds that receive a high-quality rating from a recognized rating agency. The discount rates for calculating the balance sheet obligations of our more significant plans, including our UK defined benefit pension plan and our U.S. defined benefit pension plan, were based on the internal rates of return for a portfolio of high-quality bonds with maturities that are consistent with the projected future benefit payment obligations of each plan. The weighted-average discount rate for U.S. and non-U.S. defined benefit pension plans determined on this basis was 3.06% at December 31, 2018, and 2.66% at December 31, 2017. For the determination of the expected rates of return on assets and the discount rates, we take external actuarial and investment advice into consideration. Effective as of January 1, 2018, we changed the method we use to estimate the service and interest cost components of net periodic benefit cost for the U.S. defined benefit pension plan and the majority of our significant non-U.S. pension plans, including the UK defined benefit pension plan. Historically, including in 2017, we estimated the service and interest cost components using a single weighted-average discount rate derived from the yield curve used to measure the benefit obligation at the beginning of the period. Beginning in 2018, we elected to use a full yield curve approach in the estimation of these components of net periodic benefit cost by applying the specific spot rates along the yield curve used in the determination of the benefit obligation to the relevant projected cash flows. We made this change to improve the correlation between projected benefit cash flows and the corresponding yield curve spot rates, which we believe will result in a more precise measurement of service and interest costs. We accounted for this change in estimate on a prospective basis beginning in 2018. Our funding requirements may be impacted by standards and regulations or interpretations thereof. Our calculations of pension and postretirement costs are dependent on the use of assumptions, including discount rates, hybrid plan maximum interest crediting rates and expected return on plan assets discussed above, rate of compensation increase of plan participants, interest cost, benefits earned, mortality rates, the number of participants and certain demographics and other factors. Actual results that differ from assumptions are accumulated and amortized to expense over future periods and, therefore, generally affect recognized expense in future periods. At December 31, 2018, we had pretax actuarial losses and prior service credits totaling approximately $33 for the U.S. defined benefit pension and postretirement plans and approximately $175 for the non-U.S. defined benefit pension and postretirement plans that have not yet been charged to expense. These actuarial losses have been charged to AOCI within shareholders’ equity. While we believe that the assumptions used are reasonable, differences in actual experience or changes in assumptions may materially affect our pension and postretirement obligations and future expense. For 2019, our assumption for the expected rate of return on assets is 5.5% for our U.S. defined benefit pension plan and 5.3% for our non-U.S. defined benefit pension plans (which includes 5.20% for our UK defined benefit pension plan). Our assumptions are generally reviewed and determined on an annual basis. A 50 basis point change (in either direction) in the expected rate of return on plan assets, the discount rate or the rate of compensation increases, would have had approximately the following effect on 2018 pension expense and the pension benefit obligation at December 31, 2018: Restructuring Reserves We record the estimated expense for our restructuring initiatives when such costs are deemed probable and estimable, when approved by the appropriate corporate authority and by accumulating detailed estimates of costs for such plans. These expenses include the estimated costs of employee severance and related benefits, inventory write-offs, impairment or accelerated depreciation of property, plant and equipment and capitalized software, and any other qualifying exit costs. These estimated costs are grouped by specific projects within the overall plan and are then monitored on a quarterly basis by finance personnel. Such costs represent our best estimate, but require assumptions about the programs that may change over time, including attrition rates. Estimates are evaluated periodically to determine whether an adjustment is required. Taxes We record a valuation allowance to reduce our deferred tax assets to an amount that is "more likely than not" to be realized. Evaluating the need for and quantifying the valuation allowance often requires significant judgment and extensive analysis of all the weighted positive and negative evidence available to the Company in order to determine whether all or some portion of the deferred tax assets will not be realized. In performing this analysis, the Company’s forecasted U.S. and foreign taxable income, and the existence of potential prudent and feasible tax planning strategies that would enable the Company to utilize some or all of its excess foreign tax credits, are taken into consideration. At December 31, 2018, we had net deferred tax assets of approximately $193 (net of valuation allowances of approximately $3,258 and deferred tax liabilities of $85). With respect to our deferred tax assets, at December 31, 2018, we had recognized deferred tax assets of approximately $2,144 relating to foreign and state tax loss carryforwards, for which a valuation allowance of approximately $2,073 has been provided. At December 31, 2018, we had recognized deferred tax assets of approximately $831 primarily relating to excess U.S. foreign tax and other U.S. general business credit carryforwards for which a valuation allowance of approximately $813 had been provided. We have a history of U.S. source losses, and our excess U.S. foreign tax and general business credits have primarily resulted from having a greater U.S. source loss in recent years which reduces our ability to credit foreign taxes or utilize the general business credits which we generate. Our ability to realize our U.S. deferred tax assets, such as our foreign tax and general business credit carryforwards, is dependent on future U.S. taxable income within the carryforward period. At December 31, 2018, we would need to generate approximately $4.0 billion of excess net foreign source income in order to realize the U.S. foreign tax and general business credits before they expire. At December 31, 2018, we continue to assert that our foreign earnings are not indefinitely reinvested. Accordingly, we adjusted our deferred tax liability each period to account for our undistributed earnings of foreign subsidiaries and for the tax effect of earnings that were actually repatriated during the year. The net impact on the deferred tax liability associated with the Company’s undistributed earnings is a decrease of approximately $5, resulting in a deferred tax liability balance of approximately $17 related to the incremental tax cost on approximately $1.1 billion of undistributed foreign earnings at December 31, 2018. With respect to our uncertain tax positions, we recognize the benefit of a tax position, if that position is more likely than not of being sustained on examination by the taxing authorities, based on the technical merits of the position. We believe that our assessment of more likely than not is reasonable, but because of the subjectivity involved and the unpredictable nature of the subject matter at issue, our assessment may prove ultimately to be incorrect, which could materially impact our Consolidated Financial Statements. We file income tax returns in the U.S. federal jurisdiction, and various state and foreign jurisdictions. In 2019, a number of open tax years are scheduled to close due to the expiration of the statute of limitations and it is possible that a number of tax examinations may be completed. If our tax positions are ultimately upheld or denied, it is possible that the 2019 provision for income taxes, as well as tax related cash receipts or payments, may be impacted. Loss Contingencies We determine whether to disclose and/or accrue for loss contingencies based on an assessment of whether the risk of loss is remote, reasonably possible or probable. We record loss contingencies when it is probable that a liability has been incurred and the amount of loss is reasonably estimable. Our assessment is developed in consultation with our outside counsel and other advisors and is based on an analysis of possible outcomes under various strategies. Loss contingency assumptions involve judgments that are inherently subjective and can involve matters that are in litigation, which, by its nature is unpredictable. We believe that our assessment of the probability of loss contingencies is reasonable, but because of the subjectivity involved and the unpredictable nature of the subject matter at issue, our assessment may prove ultimately to be incorrect, which could materially impact our Consolidated Financial Statements. Impairment of Assets Plant, Property and Equipment and Capitalized Software We evaluate our plant, property and equipment and capitalized software for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset group may not be recoverable. Recoverability of assets to be held and used is measured by a comparison of the carrying amount of an asset to estimated pre-tax undiscounted future cash flows expected to be generated by the asset. If the carrying amount of an asset exceeds its estimated future cash flows, an impairment charge is recognized for the amount by which the carrying amount of the asset exceeds the fair value of the asset. The fair value of the asset is determined using revenue and cash flow projections, and royalty and discount rates, as appropriate. Goodwill We test goodwill for impairment annually, and more frequently if circumstances warrant, using various fair value methods. We completed our annual goodwill impairment assessment for 2018 and determined that the estimated fair values were considered substantially in excess of the carrying values of each of our reporting units. The impairment analyses performed for goodwill require several estimates in computing the estimated fair value of a reporting unit. As part of our goodwill impairment analysis, we typically use a discounted cash flow ("DCF") approach to estimate the fair value of a reporting unit, which we believe is the most reliable indicator of fair value of a business, and is most consistent with the approach that we would generally expect a market participant would use. In estimating the fair value of our reporting units utilizing a DCF approach, we typically forecast revenue and the resulting cash flows for periods of five to ten years and include an estimated terminal value at the end of the forecasted period. When determining the appropriate forecast period for the DCF approach, we consider the amount of time required before the reporting unit achieves what we consider a normalized, sustainable level of cash flows. The estimation of fair value utilizing a DCF approach includes numerous uncertainties which require significant judgment when making assumptions of expected growth rates and the selection of discount rates, as well as assumptions regarding general economic and business conditions, and the structure that would yield the highest economic value, among other factors. Results Of Operations - Consolidated Amounts in the table above may not necessarily sum due to rounding. * Calculation not meaningful (1) Advertising expenses are recorded in SG&A expenses. (2) Change in Constant $ Adjusted operating margin for all years presented is calculated using the current-year Constant $ rates. 2018 Compared to 2017 Revenue During 2018, revenue declined 3% compared to the prior-year period. Excluding the Brazil IPI release, Adjusted revenue was down 5%, primarily due to the unfavorable impact of foreign exchange. Constant $ Adjusted revenue increased 1%. Revenue and Constant $ Adjusted revenue included a benefit of approximately 4% due to the impact of adopting the new revenue recognition standard. The 4% benefit was driven primarily by the reclassification of fees paid by Representatives for brochures, late payments and payment processing, and income from appointment kits, from SG&A. The impact of timing of revenue recognition for sales incentives was negligible. Revenue and constant $ Adjusted revenue was impacted by declines primarily in Brazil, which continued to be negatively impacted by competitive pressures against a backdrop of a challenging macroeconomic environment and lower consumption in the market, as well as lower appointments due to the application of strict credit requirements for the acceptance of new Representatives. To a lesser extent, Constant $ Adjusted revenue was also impacted by declines in the UK, South Africa and Russia, as well as lower revenue from the closure of Australia and New Zealand during 2018. These declines were partially offset by improved revenue growth management including inflationary pricing in Argentina. Revenue and Constant $ Adjusted revenue were impacted by a decrease in Active Representatives of 5%, which was primarily driven by Brazil, and to a lesser extent, Russia. Average order in Constant $ increased 2%, including a benefit of approximately 4% due to the impact of adopting the new revenue recognition standard. Units sold decreased 6%, driven by a decline in Brazil. Ending Representatives declined 8%, primarily driven by declines in Russia and Brazil. On a category basis, our net sales from reportable segments and associated growth rates were as follows: See "Segment Review" in this MD&A for additional information related to changes in revenue by segment. Operating Margin Operating margin decreased 70 basis points and Adjusted operating margin decreased 170 basis points, compared to 2017, including a benefit of 10 basis points due to the impact of adopting the new revenue recognition standard. The benefit of 10 basis points was driven by the net positive contribution to operating margin of fourth quarter 2017 sales incentives satisfied during 2018 and sales incentives deferred during the period, impacted by the mix of products. The changes in operating margin and Adjusted operating margin include the benefits associated with the Transformation Plan, primarily reductions in headcount, as well as other cost reductions. These savings were partially offset by the inflationary impact on costs. Operating margin and Adjusted operating margin drivers are discussed further below in "Gross Margin" and "SG&A Expenses." Gross Margin Gross margin decreased 390 basis points and Adjusted gross margin decreased 360 basis points, compared to the same period of 2017, including a decline of 350 basis points due to the impact of adopting the new revenue recognition standard. The 350 basis point decline was driven by the reclassification of sales incentive costs from SG&A to cost of sales, partially offset by the reclassification of fees paid by Representatives for late payments, payment processing and brochures from SG&A to other revenue and the reclassification of income from appointment kits from SG&A to net sales. Gross margin and Adjusted gross margin were primarily impacted by the following: • a decrease of 80 basis points due to higher supply chain costs, driven by higher material costs primarily in South Latin America; • a decrease of 20 basis points due to the net unfavorable impact of foreign currency transaction losses and foreign currency translation; and • a decrease of 20 basis points due to the unfavorable impact as a result of hyperinflationary accounting in Argentina effective July 1, 2018, primarily due to inventory being accounted for at its historical dollar cost. This item was partially offset by the following: • an increase of 110 basis points due to the favorable net impact of mix and pricing, driven by inflationary pricing in Argentina. SG&A Expenses SG&A as a percentage of total revenue, which decreased 320 basis points, benefited 170 basis points from the Brazil IPI release in the third quarter of 2018 and 30 basis points from a loss contingency recorded in the prior-year period related to a non-U.S. pension plan, partially offset by 60 basis point from higher CTI restructuring. Adjusted SG&A as a percentage of Adjusted revenue decreased 180 basis points, compared to the same period of 2017. SG&A as a percentage of total revenue and Adjusted SG&A as a percentage of Adjusted revenue include a benefit of 350 basis points due to the impact of adopting the new revenue recognition standard. The 350 basis point benefit was driven by the reclassification of sales incentive costs from SG&A to cost of sales, partially offset by the reclassification of fees paid by Representatives for late payments, payment processing and brochures from SG&A to other revenue and the reclassification of income from appointment kits from SG&A to net sales. SG&A as a percentage of total revenue and Adjusted SG&A as a percentage of Adjusted revenue were primarily impacted by the following: • an increase of 50 basis points due to higher Representative, sales leader and field expense, primarily in Brazil due to investments aimed at recovering activity levels that were disrupted by the national transportation strike in the second quarter of 2018, as well as increased focus on Representatives training in the second half of 2018; • an increase of 40 basis points from higher advertising expense primarily due to increased investments in Europe, Middle East & Africa; • an increase of 40 basis points from higher transportation costs, mainly in Brazil primarily driven by inefficiencies caused by the national transportation strike and an increase in fuel prices, in Europe, Middle East & Africa driven by further increases in delivery rates in Russia and increased flexibility in order processing in the UK and in Mexico due to an increase in fuel prices; • an increase of approximately 40 basis points due to the net unfavorable impact of foreign currency transaction losses and foreign currency translation; • an increase of 40 basis points due to higher net brochure expense primarily due to an increase in brochure volumes in Brazil; and • a decrease of 50 basis points from lower bad debt expense, primarily in Brazil due to improved credit control and collections processes. See Note 15, Segment Information on pages through of our 2018 Annual Report for more information on the legal settlement, Note 14, Employee Benefit Plans on pages through of our 2018 Annual Report for more information on the loss contingency related to a non-U.S. pension plan and Note 17, Restructuring Initiatives on pages through of our 2018 Annual Report for more information on CTI restructuring. Other Expenses Interest expense decreased by approximately $6, primarily due to interest savings associated with prepayment of the $237.8 principal amount of our 6.50% Notes due March 2019. Refer to Note 8, Debt and Other Financing on pages through of our 2018 Annual Report for additional information. A loss on extinguishment of debt of approximately $1 was comprised of a loss of approximately $3 associated with the prepayment of our 6.50% Notes, partially offset by a gain of approximately $2 associated with the debt repurchases in the fourth quarter of 2018. Refer to Note 8, Debt and Other Financing on pages through of our 2018 Annual Report for additional information. Interest income increased by $1 compared to the prior-year period. Other expense, net, decreased by approximately $28 compared to the prior-year period, including the impact of the Brazil IPI tax release of $27. Other expense, net, was positively impacted by lower expenses associated with employee benefit plans of $12, primarily related to the UK and including the impact of a $3 settlement charge recorded in the third quarter of 2017, and approximately $12 recorded for our proportionate share of New Avon's losses during the nine months ended September 30, 2017. As the recorded investment balance in New Avon was zero at the end of the third quarter of 2017, we have not recorded any additional losses associated with New Avon since the third quarter of 2017. These benefits were partially offset by foreign exchange net losses, which increased by approximately $19 compared to the prior-year period, and other miscellaneous unfavorable impacts totaling $4 See Note 4, Investment in New Avon on page of our 2018 Annual Report for more information on New Avon. Effective Tax Rate The effective tax rates in 2018 and 2017 continue to be impacted by our inability to recognize additional deferred tax assets in various jurisdictions related to our current-year operating results. In addition, the effective tax rates in 2018 and 2017 continue to be impacted by withholding taxes associated with certain intercompany payments, including royalties, service charges and dividends, which in the aggregate are relatively consistent each year due to the need to repatriate funds to cover U.S.-based costs, such as interest on debt and corporate overhead. These factors resulted in unusually high effective tax rates in 2018 and 2017. The effective tax rate in 2018 was impacted by an approximate net $25 benefit recognized primarily due to Avon's interpretation of case law and/or guidance provided during 2018 in the U.S. and Latin America and the release of valuation allowances of approximately $5 associated with improved profitability of certain Markets partially offset by a net charge of approximately $11 primarily associated with an increase in reserves for uncertain tax positions. The effective tax rate in 2018 was also impacted by the accrual of taxes associated with the reversal of the Brazil IPI loss contingency and CTI restructuring for which tax benefits cannot currently be claimed in all affected jurisdictions. The effective tax rate in 2017 was impacted by an approximate net $30 benefit recognized as a result of the enactment of the Tax Cuts and Jobs Act in U.S., a release of valuation allowances of approximately $26 associated with a number of markets in Europe, Middle East & Africa as a result of a business model change related to the headquarters move, and an approximate $10 benefit as a result of a favorable court decision in Brazil, partially offset by a charge of approximately $16 associated with valuation allowances to adjust deferred tax assets in Mexico. The effective tax rate in 2017 was also impacted by a loss contingency related to a non-U.S. pension plan and CTI restructuring, both for which tax benefits cannot currently be claimed. In addition, the effective tax rates and the Adjusted effective tax rates in 2018 and 2017 were negatively impacted by the country mix of earnings. See Note 10, Income Taxes on pages through of our 2018 Annual Report for more information on tax items, Note 14, Employee Benefit Plans on pages through of our 2018 Annual Report for more information on the loss contingency related to a non-U.S. pension plan, Note 17, Restructuring Initiatives on pages through of our 2018 Annual Report for more information on CTI restructuring and "Venezuela Discussion" in this MD&A and Note 1, Description of the Business and Summary of Significant Accounting Policies on pages through of our 2018 Annual Report for more information for further discussion of our Venezuelan operations. Impact of Foreign Currency As compared to the prior-year period, foreign currency in 2018 impacted our consolidated financial results in the form of: • foreign currency transaction net losses as compared to net gains in the prior year (classified within cost of SG&A expenses), which had an unfavorable impact to operating profit and Adjusted operating profit of an estimated $30, or approximately 50 basis points to operating margin and Adjusted operating margin; • foreign currency translation, which had an unfavorable impact, as compared to a favorable impact in the prior year, to operating profit and Adjusted operating profit of approximately $75 and approximately $35, respectively, or approximately 80 basis points and approximately 30 basis points, respectively, to operating margin and Adjusted operating margin; and • higher foreign exchange net losses on our working capital (classified within other expense, net) as compared to net gains in the prior year, resulting in a year-over-year unfavorable impact of approximately $20 before tax on both a reported and Adjusted basis. 2017 Compared to 2016 Revenue During 2017, revenue was relatively unchanged compared to the prior-year period, partially benefiting from foreign exchange, while Constant $ revenue decreased 2%. Our Constant $ revenue decline was primarily driven by declines in Brazil, Russia and the UK, partially offset by growth in Argentina and South Africa. The decline in revenue and Constant $ revenue was primarily due to a 3% decrease in Active Representatives, which was partially offset by higher average order. The decrease in Active Representatives was impacted by declines in all reportable segments, most significantly in South Latin America (driven by Brazil) and Europe, Middle East & Africa. The net impact of price and mix increased 2%, primarily due to the inflationary impact on pricing in Argentina, Russia and Mexico. Units sold decreased 4%, primarily due to declines in Russia, Brazil, Mexico and the UK. The revenue performance was negatively impacted most significantly by a decline in Color sales, as we experienced issues in some markets while we segmented our Color category into three distinct brands. The timing of innovation also impacted the decline in Color sales. Ending Representatives were relatively unchanged. Ending Representatives at December 31, 2017 as compared to the prior-year period benefited from growth in Russia, which was offset by a decline in Brazil. On a category basis, our net sales from reportable segments and associated growth rates were as follows: See "Segment Review" in this MD&A for additional information related to changes in revenue by segment. Operating Margin Operating margin and Adjusted operating margin decreased 80 basis points and 20 basis points, respectively, compared to 2016. The decreases in operating margin and Adjusted operating margin include the benefits associated with the Transformation Plan, primarily reductions in headcount, as well as other cost reductions. These savings were largely offset by the inflationary impact on costs outpacing revenue growth. The decreases in operating margin and Adjusted operating margin are discussed further below in "Gross Margin" and "SG&A Expenses." Gross Margin Gross margin and Adjusted gross margin both increased 100 basis points compared to 2016, in each case primarily due to an increase of 120 basis points from the favorable net impact of mix and pricing, driven by inflationary pricing in South Latin America. SG&A Expenses SG&A expenses for 2017 increased approximately $94 compared to 2016. This increase is primarily due to the unfavorable impact of foreign currency translation, as the weakening of the U.S. dollar against many of our foreign currencies resulted in higher reported SG&A expenses. The increase in SG&A expenses is also due to the approximate $27 of net proceeds recognized as a result of a legal settlement in 2016, higher bad debt expense, higher transportation costs, the loss contingency related to a non-U.S. pension plan and higher Representative, sales leader and field expense. Partially offsetting the increase in SG&A expenses was lower expenses associated with employee incentive compensation plans and lower CTI restructuring. SG&A expenses as a percentage of revenue and Adjusted SG&A expenses as a percentage of revenue increased 160 basis points and 120 basis points, respectively, compared to 2016. The SG&A expenses as a percentage of revenue comparison was negatively impacted by: • approximately 50 basis points for the approximate $27 of net proceeds recognized as a result of a legal settlement in the 2016; and • approximately 30 basis points for a loss contingency related to a non-U.S. pension plan. These items were partially offset by: • approximately 30 basis points for lower CTI restructuring. The remaining increase in SG&A expenses as a percentage of revenue and the increase of 120 basis points in Adjusted SG&A expenses as a percentage of revenue were, in each case, primarily due to the following: • an increase of 50 basis points from higher bad debt expense, driven by Brazil due to the lower than anticipated collection of receivables, primarily impacted by the macroeconomic environment, as well as resulting from an adjustment to credit terms available to new Representatives during 2016; • an increase of 50 basis points primarily due to higher Representative, sales leader and field expense, most significantly in Brazil to support efforts to activate the field and improve Representative recruitment, as well as in the Philippines; • an increase of 40 basis points from higher transportation costs, most significantly in Russia which was driven by new delivery rates; and • an increase of 20 basis points primarily due to the impact of the Constant $ revenue decline causing deleverage of our fixed expenses, partially offset by lower fixed expenses. Fixed expenses include the benefits associated with the Transformation Plan, primarily reductions in headcount, as well as other cost reductions. These savings were largely offset by the inflationary impact on costs outpacing revenue growth. These items were partially offset by the following: • a decrease of 30 basis points due to lower expenses associated with employee incentive compensation plans; and • a decrease of approximately 20 basis points due to the favorable impact of foreign currency translation and foreign currency transaction losses. See Note 15, Segment Information on pages through of our 2018 Annual Report for more information on the legal settlement, Note 14, Employee Benefit Plans on pages through of our 2018 Annual Report for more information on the loss contingency related to a non-U.S. pension plan and Note 17, Restructuring Initiatives on pages through of our 2018 Annual Report for more information on CTI restructuring. Other Expenses Interest expense increased by approximately $4 compared to the prior-year period, primarily due to the interest associated with $500 principal amount of 7.875% Senior Secured Notes issued in August 2016 and lower amortization of gains associated with the termination of interest rate swaps. These items were partially offset by the interest savings associated with the repayment of certain of our debt in 2016 and lower interest due to a reduction of the international debt balances. Refer to Note 8, Debt and Other Financing on pages through of our 2018 Annual Report and Note 11, Financial Instruments and Risk Management on pages through of our 2018 Annual Report for additional information. Gain on extinguishment of debt in 2016 of approximately $1 was comprised of a gain of approximately $4 associated with the cash tender offers in August 2016 and a gain of approximately $1 associated with the debt repurchases in December 2016, partially offset by a loss of approximately $3 associated with the prepayment of the remaining principal amount of our 4.20% Notes and 5.75% Notes in November 2016 and a loss of approximately $1 associated with the debt repurchases in October 2016. Refer to Note 8, Debt and Other Financing on pages through of our 2018 Annual Report for additional information. Interest income decreased by approximately $1 compared to the prior-year period. Other expense, net, decreased by approximately $138 compared to the prior-year period, primarily due to the deconsolidation of our Venezuelan operations, as we recorded a loss of approximately $120 in the first quarter of 2016. In addition, other expense, net was positively impacted by foreign exchange net gains in the current year as compared to net losses in the prior year, resulting in a year-over-year benefit of approximately $28. The amounts recorded for our proportionate share of New Avon's losses was approximately $12 in both 2017 and 2016. As the recorded investment balance in New Avon was zero at the end of the third quarter of 2017, we have not recorded any additional losses associated with New Avon since the third quarter of 2017. See "Venezuela Discussion" in this MD&A and Note 1, Description of the Business and Summary of Significant Accounting Policies on pages through of our 2018 Annual Report for further discussion of our Venezuelan operations. See Note 4, Investment in New Avon on page of our 2018 Annual Report for more information on New Avon. Effective Tax Rate The effective tax rates in 2017 and 2016 continue to be impacted by our inability to recognize additional deferred tax assets in various jurisdictions related to our current-year operating results. In addition, the effective tax rates in 2017 and 2016 continue to be impacted by withholding taxes associated with certain intercompany payments, including royalties, service charges and dividends, which in the aggregate are relatively consistent each year due to the need to repatriate funds to cover U.S.-based costs, such as interest on debt and corporate overhead. These factors resulted in unusually high effective tax rates in 2017 and 2016. The effective tax rate in 2017 was impacted by an approximate net $30 benefit recognized as a result of the enactment of the Tax Cuts and Jobs Act in U.S., a release of valuation allowances of approximately $26 associated with a number of markets in Europe, Middle East & Africa as a result of a business model change related to the headquarters move, and an approximate $10 benefit as a result of a favorable court decision in Brazil, partially offset by a charge of approximately $16 associated with valuation allowances to adjust deferred tax assets in Mexico. The effective tax rate in 2017 was also impacted by a loss contingency related to a non-U.S. pension plan and CTI restructuring, both for which tax benefits cannot currently be claimed. The effective tax rate in 2016 was impacted by the deconsolidation of our Venezuelan operations, valuation allowances for deferred tax assets outside of the U.S. of approximately $9 and CTI restructuring, partially offset by a benefit of approximately $29 as a result of the implementation of foreign tax planning strategies, a net benefit of approximately $7 primarily due to the release of a valuation allowance associated with Russia and a benefit from the net proceeds recognized as a result of a legal settlement. In addition, the effective tax rates and the Adjusted effective tax rates in 2017 and 2016 were negatively impacted by the country mix of earnings. See Note 10, Income Taxes on pages through of our 2018 Annual Report for more information on tax items, Note 14, Employee Benefit Plans on pages through of our 2018 Annual Report for more information on the loss contingency related to a non-U.S. pension plan, Note 17, Restructuring Initiatives on pages through of our 2018 Annual Report for more information on CTI restructuring and "Venezuela Discussion" in this MD&A and Note 1, Description of the Business and Summary of Significant Accounting Policies on pages through of our 2018 Annual Report for more information for further discussion of our Venezuelan operations. Impact of Foreign Currency As compared to the prior-year period, foreign currency in 2017 impacted our consolidated financial results in the form of: • foreign currency transaction net gains (classified within cost of sales, and SG&A expenses), which had an immaterial impact to operating profit and Adjusted operating profit, and operating margin and Adjusted operating margin; • foreign currency translation, which had a favorable impact to operating profit and Adjusted operating profit of approximately $20, or approximately 30 basis points to operating margin and approximately 20 basis points to Adjusted operating margin; and • foreign exchange net gains on our working capital (classified within other expense, net) as compared to net losses in the prior year, resulting in a year-over-year benefit of approximately $28 before tax on both a reported and Adjusted basis. Discontinued Operations There were no amounts recorded in discontinued operations for the year ended December 31, 2017. Loss from discontinued operations, net of tax was approximately $14 for the year ended December 31, 2016. See Note 3, Discontinued Operations and Assets and Liabilities Held for Sale on pages through of our 2018 Annual Report for further discussion. Venezuela Discussion Avon Venezuela operates in the direct-selling channel offering Beauty and Fashion & Home products. Avon Venezuela has a manufacturing facility that produces the Beauty products that it sells. Avon Venezuela imports many of its Fashion & Home products and raw materials and components needed to manufacture its Beauty products. Currency restrictions enacted by the Venezuelan government since 2003 impacted the ability of Avon Venezuela to obtain foreign currency to pay for imported products. In 2010, we began accounting for our operations in Venezuela under accounting guidance associated with highly inflationary economies. Under U.S. GAAP, the financial statements of a foreign entity operating in a highly inflationary economy are required to be remeasured as if the functional currency is the company’s reporting currency, the U.S. dollar. This generally results in translation adjustments, caused by changes in the exchange rate, being reported in earnings currently for monetary assets (e.g., cash, accounts receivable) and liabilities (e.g., accounts payable, accrued expenses) and requires that different procedures be used to translate non-monetary assets (e.g., inventories, fixed assets). Non-monetary assets and liabilities are remeasured at the historical U.S. dollar cost basis. This diverges significantly from the application of accounting rules prior to designation as highly inflationary accounting, where such gains and losses would have been recognized only in other comprehensive income (loss) (shareholders' deficit). Venezuela's restrictive foreign exchange control regulations and our Venezuelan operations' increasingly limited access to U.S. dollars resulted in lack of exchangeability between the Venezuelan bolivar and the U.S. dollar, and restricted our Venezuelan operations' ability to pay dividends and settle intercompany obligations. The severe currency controls imposed by the Venezuelan government significantly limited our ability to realize the benefits from earnings of our Venezuelan operations and access the resulting liquidity provided by those earnings. We expected that this lack of exchangeability would continue for the foreseeable future, and as a result, we concluded that, effective March 31, 2016, this condition was other-than-temporary and we no longer met the accounting criteria of control in order to continue consolidating our Venezuelan operations. As a result, since March 31, 2016, we account for our Venezuelan operations using the cost method of accounting. As a result of the change to the cost method of accounting, in the first quarter of 2016 we recorded a loss of approximately $120 in other expense, net. The loss was comprised of approximately $39 in net assets of the Venezuelan business and approximately $81 in accumulated foreign currency translation adjustments within AOCI associated with foreign currency movements before Venezuela was accounted for as a highly inflationary economy. The net assets of the Venezuelan business were comprised of inventories of approximately $24, property, plant and equipment, net of approximately $15, other assets of approximately $11, accounts receivable of approximately $5, cash of approximately $4, and accounts payable and accrued liabilities of approximately $20. Our Consolidated Balance Sheets no longer include the assets and liabilities of our Venezuelan operations. We no longer include the results of our Venezuelan operations in our Consolidated Financial Statements, and will include income relating to our Venezuelan operations only to the extent that we receive cash for dividends or royalties remitted by Avon Venezuela. Other Comprehensive (Loss) Income Other comprehensive loss, net of taxes was approximately $104 in 2018 compared with other comprehensive income of approximately $108 in 2017. The year-over-year comparison was unfavorably impacted by unrealized losses on the revaluation of long-term intercompany balances of $58 compared to unrealized gains of $62 in the prior-year period. These long-term intercompany balances are denominated in Brazilian real and the British Pound. Foreign currency translation adjustments unfavorably impacted other comprehensive loss by approximately $69 as compared to 2017, primarily due to the unfavorable year-over-year comparison of movements of the Polish zloty and Argentinian peso for the first half of 2018, before highly inflationary accounting was applied for our Argentinian subsidiary from July 1, 2018. Other comprehensive income, net of taxes was approximately $108 in 2017 compared with approximately $333 in 2016. The year-over-year comparison was unfavorably impacted by the recognition of losses of $259 from other comprehensive income into our Consolidated Statements of Operations in 2016 as a result of the separation of the North America business, primarily related to unamortized losses associated with the employee benefit plans, and the approximate $82 impact of the deconsolidation of Venezuela. The remaining approximate $116 benefit to the year-over-year comparison was primarily due to foreign currency translation adjustments, which benefited by approximately $117 as compared to 2016 primarily due to the favorable year-over-year comparison of movements of the Polish zloty and Mexican peso, partially offset by the unfavorable year-over-year comparison of movements of the Brazilian real. See Note 3, Discontinued Operations and Assets and Liabilities Held for Sale on pages through of our 2018 Annual Report for more information on the separation of the North America business, see "Venezuela Discussion" in this MD&A and Note 1, Description of the Business and Summary of Significant Accounting Policies on pages through of our 2018 Annual Report for a further discussion of our Venezuelan operations, and Note 14, Employee Benefit Plans on pages through of our 2018 Annual Report for more information on our benefit plans. Segment Review We determine segment profit by deducting the related costs and expenses from segment revenue. In order to ensure comparability between periods, segment profit includes an allocation of global marketing expenses based on actual revenues. Segment profit excludes global expenses other than the allocation of marketing, CTI restructuring initiatives, certain significant asset impairment charges, and other items, which are not allocated to a particular segment, if applicable. This is consistent with the manner in which we assess our performance and allocate resources. See Note 15, Segment Information on pages through of our 2018 Annual Report for a reconciliation of segment profit to operating profit. Summarized financial information concerning our reportable segments was as follows: Below is an analysis of the key factors affecting revenue and segment profit by reportable segment for each of the years in the three-year period ended December 31, 2018. Foreign currency impact is determined as the difference between actual growth rates and Constant $ growth rates. Refer to "Non-GAAP Financial Measures" in this MD&A for more information. Europe, Middle East & Africa - 2018 Compared to 2017 Amounts in the table above may not necessarily sum due to rounding. Total revenue decreased 2% compared to the prior-year period, unfavorably impacted by foreign exchange. On a Constant $ basis, revenue decreased 1%. Revenue and Constant $ revenue included a benefit of approximately 3% due to the impact of adopting the new revenue recognition standard. Revenue and Constant $ revenue were negatively impacted primarily by a decrease in Active Representatives, partially offset by higher average order. The decrease in Ending Representatives was driven primarily by declines in Russia. In Russia, revenue decreased 6%, unfavorably impacted by foreign exchange. On a Constant $ basis, Russia's revenue increased 1%. Russia's revenue and Constant $ revenue included a benefit of approximately 4% due to the impact of adopting the new revenue recognition standard. Revenue and Constant $ revenue in Russia were negatively impacted by a decrease in Active Representatives, partially offset by higher average order. Revenue and Constant $ revenue in Russia was also negatively impacted by lower consumption in the market. In the UK, revenue decreased 6%, despite the favorable impact of foreign exchange. On a Constant $ basis, the UK's revenue decreased 9%. The UK's revenue and Constant $ revenue included a benefit of approximately 4% due to the impact of adopting the new revenue recognition standard. Revenue and Constant $ revenue in the UK were negatively impacted by a decrease in Active Representatives, driven by underlying field issues and temporary service issues in the fourth quarter of 2018, partially offset by higher average order. In South Africa, revenue decreased 4%, despite the favorable impact of foreign exchange. On a Constant $ basis, South Africa's revenue decreased 5%. South Africa's revenue and Constant $ revenue included a benefit of approximately 2% due to the impact of adopting the new revenue recognition standard. Revenue and Constant $ revenue in South Africa were negatively impacted by a decrease in Active Representatives, resulting from the challenging macroeconomic environment and the application of strict credit requirements for the acceptance of new Representatives as compared to the requirements in the prior year. Segment margin decreased 270 basis points, or 280 basis points on a Constant $ basis, including a decline of approximately 30 basis points due to the impact of the new revenue recognition standard. The decrease in reported and Constant $ segment margin was primarily as a result of: • a decline of 70 basis points from higher advertising expense, primarily due to increased investments in the UK, South Africa and Russia; • a decline of 50 basis points from higher rep and sales leader investments primarily in Russia and Poland and Turkey; • a decline of 50 basis points due to higher fixed expenses, primarily due to the impact of the Constant $ Adjusted revenue decline causing deleverage of our fixed expenses; • a decline of 40 basis points from higher transportation costs, driven by further increases in delivery rates in Russia and increased flexibility in order processing in the UK; • a decline of 40 basis points from higher variable distribution cost primarily relating to increased flexibility in order processing in the UK; and • a benefit of 40 basis points due to lower net bad debt expense, driven by Russia, South Africa and the UK. Bad debt expense in Russia in the prior-period was negatively impacted by a payment facilitation agency that had not remitted to us the funds it received from certain Representatives. The year-over-year bad debt expense comparison in South Africa and the UK benefited from improved credit control and enhancement of collections processes. Europe, Middle East & Africa - 2017 Compared to 2016 Amounts in the table above may not necessarily sum due to rounding. Total revenue decreased 1% compared to the prior-year period, despite the favorable impact of foreign exchange which was primarily driven by the weakening of the U.S. dollar relative to the Russian ruble and to a lesser extent, the South African rand, partially offset by the strengthening of the U.S. dollar relative to the Turkish lira and the British pound. On a Constant $ basis, revenue decreased 4%, most significantly impacted by declines in Russia and the UK, partially offset by growth in South Africa. The segment's Constant $ revenue decline was primarily driven by a decrease in Active Representatives and lower average order. The increase in Ending Representatives was primarily driven by increases in Russia, Turkey and South Africa, partially offset by a decline in the UK. In Russia, revenue increased 5%, benefiting significantly from the favorable impact of foreign exchange. On a Constant $ basis, Russia's revenue declined 8%, primarily due to lower average order along with a decrease in Active Representatives. During the first half of 2017, the Constant $ revenue decline in Russia was impacted by the comparison to strong volume growth in the prior-year period, which benefited primarily from a pricing lag during an inflationary period. The Constant $ revenue decline in Russia was also impacted by competitive pressures, innovation issues and a continued difficult macroeconomic environment, primarily in the second half of 2017. These issues also negatively impacted Active Representatives, despite the increase in Ending Representatives. In the UK, revenue declined 14%, which was unfavorably impacted by foreign exchange. On a Constant $ basis, the UK's revenue declined 11%, primarily due to a decrease in Active Representatives, and to a lesser extent, lower average order. In South Africa, revenue grew 20%, which was favorably impacted by foreign exchange. On a Constant $ basis, South Africa’s revenue grew 9%, primarily due to an increase in Active Representatives, partially offset by lower average order. Segment margin increased 40 basis points, or was relatively unchanged on a Constant $ basis, in each case primarily as a result of: • a decline of 70 basis points from higher transportation costs, driven primarily by new delivery rates in Russia; • a decline of 70 basis points primarily due to the impact of the Constant $ revenue decline causing deleverage of our fixed expenses, partially offset by lower fixed expenses. Fixed expenses benefited from lower expenses associated with employee incentive compensation plans, which were partially offset by higher other administrative costs; • a decline of 40 basis points from higher bad debt expense, primarily in South Africa and Russia. Higher bad debt expense in South Africa was driven primarily by lower collection of receivables as a result of deteriorating economic conditions, and in Russia was driven primarily by a payment facilitation agency that has not remitted to us the funds it received from certain Representatives; • a decline of 30 basis points primarily related to the net impact of declining revenue with respect to Representative, sales leader and field expense; and • a benefit of 180 basis points due to higher gross margin caused primarily by 100 basis points from the favorable net impact of mix and pricing primarily driven by Russia, and 70 basis points due to lower supply chain costs. Supply chain costs benefited primarily from lower material and distribution costs, partially due to productivity initiatives. South Latin America - 2018 Compared to 2017 Amounts in the table above may not necessarily sum due to rounding. Total revenue decreased 3% compared to the prior-year period. Excluding the Brazil IPI release, Adjusted revenue for the region was down 11%, unfavorably impacted by foreign exchange, which was primarily driven by the strengthening of the U.S. dollar relative to the Argentinian peso and the Brazilian real. On a Constant $ basis, Adjusted revenue increased 3%. Revenue and Constant $ Adjusted revenue included a benefit of approximately 6% due to the impact of adopting the new revenue recognition standard. Revenue and Constant $ Adjusted revenue were negatively impacted by a decrease in Active Representatives primarily driven by a decline in Brazil, partially offset by higher average order driven by Argentina. The decrease in Ending Representatives was driven primarily by declines in Brazil. Revenue in Brazil remained relatively unchanged. Excluding the Brazil IPI release, Adjusted revenue in Brazil decreased 13%, unfavorably impacted by foreign exchange. Brazil's Constant $ Adjusted revenue decreased 1%. Brazil's revenue and Constant $ Adjusted revenue included a benefit of approximately 9% due to the impact of adopting the new revenue recognition standard. Revenue and Constant $ Adjusted revenue in Brazil were negatively impacted primarily by a decrease in Active Representatives, and to a lesser extent, lower average order. Revenue and Constant $ Adjusted revenue in Brazil, as well as Active Representatives and Ending Representatives were negatively impacted by competitive pressures against a backdrop of a challenging macroeconomic environment and lower consumption in the market, as well as lower appointments, partly due to the application of strict credit requirements for the acceptance of new Representatives. In addition, revenue and Constant $ Adjusted revenue in Brazil, as well as Active Representatives and Ending Representatives, were also impacted by a national transportation strike which affected sales and distribution in the second quarter of 2018. On an Adjusted Constant $ basis, Brazil’s sales from Beauty products and Fashion & Home products declined 8% and 4%, respectively, including a 2% benefit in both categories due to the impact of the new revenue recognition standard. The decline in Constant $ Beauty sales in Brazil was mainly in Color. Revenue in Argentina declined 25%, unfavorably impacted by foreign exchange. On a Constant $ basis, Argentina's revenue grew 22%. Argentina's revenue and Constant $ revenue included a benefit of approximately 1% due to the impact of adopting the new revenue recognition standard. Revenue and Constant $ revenue in Argentina benefited from higher average order, which was impacted by improved revenue growth management including inflationary pricing. Segment margin increased 590 basis points, including 730 basis points from the Brazil IPI tax release. On a Constant $ basis, segment margin increased 690 basis points, including 800 basis points from the Brazil IPI tax release. The reported segment margin increase and the Constant $ Adjusted segment margin decrease of 110 basis points both included a decline of approximately 20 basis points due to the impact of adopting the new revenue recognition standard. The remaining decrease in reported and in Constant $ Adjusted segment margin was primarily as a result of: • a decline of 110 basis points due to higher Representative, sales leader and field expense, primarily in Brazil due to investments aimed at recovering activity levels that were disrupted by the national transportation strike in the second quarter of 2018, as well as increased focus on Representatives training in the second half of 2018; • a decline of 90 basis points due to higher net brochure cost, primarily due to an increase in brochure volumes in Brazil; • a decline of 60 basis points due to higher transportation costs in Brazil, primarily driven by inefficiencies caused by the national transportation strike and an increase in fuel prices; • a decline of 50 basis points due to higher fixed expenses, primarily due to the impact of the Constant $ Adjusted revenue decline causing deleverage of our fixed expenses; • a benefit of 110 basis points from lower net bad debt expense, primarily in Brazil due to improved credit control and collections processes; and • a benefit of 80 basis points due to higher gross margin of 200 basis points from the favorable net impact of mix and pricing, driven by inflationary pricing in Argentina and revenue management initiatives in Brazil. These items were partially offset by 150 basis points due to higher supply chain costs driven by higher material costs. Brazil IPI tax discussion In May 2015, an Executive Decree on certain cosmetics went into effect in Brazil which increased the amount of IPI taxes that are to be remitted by Avon Brazil to the taxing authority on the sales of cosmetic products subject to IPI. As of September 30, 2018, due in part, to judicial decisions across the industry and other developments, we concluded, supported by the opinion of legal counsel, that the Executive Decree is unconstitutional. We therefore assessed the IPI tax under ASC 450, Contingencies and determined that the risk of loss during ongoing judicial reviews is reasonably possible but not probable, and accordingly, we released our liability accrued as of September 30, 2018 of $195. We considered the release of the liability as a non-GAAP adjustment, and therefore, we adjusted for the IPI tax of $168 (which was recorded in net sales in our Consolidated Income Statements) and the associated interest of $27 (which was recorded in other (income) expense, net in our Consolidated Income Statements) in our Adjusted non-GAAP results during the period ended December 31, 2018. The accrual for the Brazil IPI tax negatively impacted total revenue for the nine month period ended September 30, 2018 for Brazil, South Latin America, and total Avon by approximately 4-5%, approximately 2-3% and approximately 1%, respectively. For additional details on the IPI tax on cosmetics increase in Brazil, see Note 19, Contingencies, to the Consolidated Financial Statements included herein. Argentina discussion During the quarter ended June 30, 2018, based on published official exchange rates which indicate that Argentina's three-year cumulative inflation rate has exceeded 100%, we concluded that Argentina had become a highly inflationary economy. From July 1, 2018, we have applied highly inflationary accounting for our Argentinian subsidiary. As such, the functional currency for Argentina has changed to the U.S. dollar, which is the consolidated group's reporting currency. When an entity operates in a highly inflationary economy, exchange gains and losses associated with monetary assets and liabilities resulting from changes in the exchange rate are recorded in income. Nonmonetary assets and liabilities, which include inventories, property, plant and equipment and contract liabilities, are carried forward at their historical dollar cost, which was calculated using the exchange rate at June 30, 2018. As a result of the devaluation of the Argentinian peso of approximately 25% from June 30, 2018 to December 31, 2018, operating profit was negatively impacted by approximately $8, largely in cost of sales in our Consolidated Income Statements, primarily due to inventory being accounted for at its historical dollar cost. During the six months ended December 31, 2018, we also recorded a benefit of approximately $6 in other expense, net primarily associated with the net monetary liability position of Argentina, and an approximate $2 positive impact on income taxes, both in our Consolidated Income Statements. Our Argentinian operations contributed approximately $272, or approximately 5% of revenues, or approximately 7% of Constant $ Adjusted revenue during the year ended December 31, 2018. As of December 31, 2018, the net Argentine peso-denominated monetary liability position of Argentina was $33 and the net Argentine peso-denominated non-monetary asset position was $50, primarily consisting of inventory balances of $32. South Latin America - 2017 Compared to 2016 Amounts in the table above may not necessarily sum due to rounding. Total revenue increased 4% compared to the prior-year period, primarily due to the favorable impact of foreign exchange which was primarily driven by the weakening of the U.S. dollar relative to the Brazilian real. On a Constant $ basis, revenue was relatively unchanged compared to the prior year, as higher average order was offset by a decrease in Active Representatives. The decline in Ending Representatives was primarily driven by a decline in Brazil as described below. Revenue in Brazil increased 4%, favorably impacted by foreign exchange. Brazil’s Constant $ revenue declined 4%, primarily due to a decrease in Active Representatives, partially offset by higher average order. On a Constant $ basis, Brazil’s sales from Beauty products and Fashion & Home products decreased 4% and 5%, respectively. The decline in Constant $ Beauty sales in Brazil was driven by weaker performance in Color. Revenue in Brazil, as well as Active Representatives and Ending Representatives, was impacted by a difficult macroeconomic environment particularly in the first half of 2017, combined with the application of strict credit requirements for the acceptance of new Representatives as compared to the requirements in the prior year. In addition, Brazil's results were negatively impacted by competition primarily in the second half of 2017. Revenue in Argentina grew 10%, or 23% on a Constant $ basis primarily due to higher average order, which was impacted by the inflationary pricing. Segment margin decreased 60 basis points, or 30 basis points on a Constant $ basis, in each case primarily as a result of: • a decline of 60 basis points from higher bad debt expense, driven by Brazil due to the lower than anticipated collection of receivables, primarily impacted by the macroeconomic environment, as well as resulting from an adjustment to credit terms available to new Representatives during 2016; • a decline of 60 basis points primarily due to higher fixed expenses, driven by the inflationary impact on costs outpacing revenue growth, particularly in Argentina, partially offset by lower expenses associated with employee incentive compensation plans; • a decline of 50 basis points due to higher Representative, sales leader and field expense, most significantly in Brazil to support efforts to activate the field and improve Representative recruitment; • a decline of 30 basis points from higher transportation expense, driven by Argentina due to inflationary cost increases; and • a benefit of 180 basis points due to higher gross margin caused by 200 basis points from the favorable net impact of mix and pricing, primarily due to inflationary pricing, partially offset by 30 basis points from higher supply chain costs, which were primarily negatively impacted by higher material costs which included inflationary pressures in Argentina. North Latin America - 2018 Compared to 2017 Amounts in the table above may not necessarily sum due to rounding. North Latin America consists largely of our Mexico business. Total revenue for the segment remained relatively unchanged compared to the prior-year period. On a Constant $ basis, revenue increased 2%. Revenue and Constant $ revenue included a benefit of approximately 4% due to the impact of adopting the new revenue recognition standard. Revenue and Constant $ revenue were negatively impacted by a decrease in Active Representatives, partially offset by higher average order. The decline in Ending Representatives was primarily driven by a decline in Mexico. Revenue in Mexico increased 2%, despite the unfavorable impact of foreign exchange. On a Constant $ basis, Mexico's revenue increased 5%. Mexico's revenue and Constant $ revenue included a benefit of approximately 4% due to the impact of the new revenue recognition standard. Revenue and Constant $ revenue in Mexico benefited from higher average order driven by incremental media investment in the Color and Fragrance categories in the second half of 2018, partially offset by a decrease in Active Representatives primarily due to quality issues in the Fashion & Home category in the first quarter of 2018. Segment margin decreased 160 basis points, or 170 basis points on a Constant $ basis, including an immaterial impact of adopting the new revenue recognition standard. The decrease in reported and Constant $ segment margin was primarily as a result of: • a net decline of 170 basis points primarily from higher fixed expenses, primarily related to personnel cost; • a decline of 50 basis points due to higher transportation costs, primarily related to an increase in fuel prices in Mexico; • a decline of 40 basis points from higher advertising expense, primarily in Mexico due to incremental media investment in the Color and Fragrance categories to support new product launches in the second half of 2018; • a benefit of 50 basis points due to lower net brochure costs; and • a benefit of 30 basis points due to higher gross margin primarily due to 70 basis points from the favorable net impact of mix and pricing and 30 basis points from the favorable impact of foreign currency net gains, partially offset by 70 basis points from higher supply chain costs driven by higher material costs. North Latin America - 2017 Compared to 2016 Amounts in the table above may not necessarily sum due to rounding. North Latin America consists largely of the Mexico business. Total revenue for the segment decreased 2% compared to the prior-year period, partly due to the unfavorable impact from foreign exchange, which was primarily driven by the strengthening of the U.S. dollar relative to the Mexican peso. On a Constant $ basis, revenue decreased 1% due to a decrease in Active Representatives, both of which were negatively impacted by product fulfillment shortfalls in the region in the second quarter of 2017. Constant $ revenue for the region and Mexico were both negatively impacted by approximately 1 point and 1 point, respectively, due to the earthquake in Mexico. This earthquake occurred in late September 2017 and adversely impacted Mexico's fourth quarter 2017 results. The segment's Constant $ revenue benefited from growth in Central America, offset by a Constant $ revenue decline in Mexico. The decline in Ending Representatives was primarily driven by a decline in Central America. Revenue in Mexico declined 4%, and was unfavorably impacted by foreign exchange. On a Constant $ basis, Mexico's revenue declined 2%, primarily due to a decrease in Active Representatives and the impact of the earthquake. Segment margin decreased 370 basis points, or 350 basis points on a Constant $ basis, in each case primarily as a result of: • a decline of 90 basis points due to lower gross margin caused primarily by 90 basis points from higher supply chain costs and 50 basis points from the unfavorable impact of foreign currency transaction net losses, partially offset by 50 basis points from the favorable net impact of mix and pricing. The impact of supply chain costs on gross margin was primarily due to lower volume and fixed overhead costs, as well as higher material costs; • a decline of 80 basis points from higher bad debt expense, primarily in Mexico partially due to the implementation of a new collection process as a result of changes in regulations; • a decline of 70 basis points due to higher Representative, sales leader and field expense, primarily as a result of increasing incentives to mitigate the impact of the product fulfillment shortfalls in the region and the earthquake in Mexico; • a decline of 60 basis points from higher transportation costs driven by Mexico primarily due to increased fuel prices; and • a decline of 30 basis points from higher net brochure costs, partly due to an increase in the number of pages in support of the segmentation of our Color category. Asia Pacific - 2018 Compared to 2017 Amounts in the table above may not necessarily sum due to rounding. Effective from the first quarter of 2018, given that we have exited Australia and New Zealand during 2018, the results of Australia and New Zealand are now reported in Other operating segments and business activities for all periods presented, while previously the results had been reported in the Asia Pacific segment. Total revenue has remained relatively unchanged compared to the prior-year period, unfavorably impacted by foreign exchange. On a Constant $ basis, revenue increased 2%. Revenue and Constant $ revenue included a benefit of approximately 1% due to the impact of adopting the new revenue recognition standard. Revenue and Constant $ revenue benefited from higher average order, partially offset by a decrease in Active Representatives, most significantly in Malaysia. The decline in Ending Representatives was driven by a declines in the Philippines and Malaysia. Revenue in the Philippines decreased 1%, negatively impacted by the unfavorable impact of foreign exchange. On a Constant $ basis, revenue in the Philippines increased 4%. Revenue and Constant $ revenue in the Philippines included a benefit of approximately 2% due to the impact of adopting the new revenue recognition standard. Revenue and Constant $ revenue in the Philippines benefited from an increase in Active Representatives and higher average order, driven by the market's initiative to grow the Skincare category, mainly in the second half of 2018. Segment margin decreased 190 basis points, or 140 basis points on a Constant $ basis, including a decline of approximately 30 basis points due to the impact of adopting the new revenue recognition standard. The decrease in reported and Constant $ segment margin was primarily as a result of: • a decline of 120 basis points due to higher gross margin primarily caused by 80 basis points from higher supply chain costs due to higher logistics cost in the Philippines, and 20 basis points from the unfavorable impact of foreign current transaction losses; • a decline of 30 basis points due to higher advertising expense, primarily in China, related to celebrity and digital advertising to support growth; and • a benefit of 40 basis points due to lower fixed expenses primarily due to the impact of the Constant $ revenue growth with respect to out fixed expenses. Asia Pacific - 2017 Compared to 2016 Amounts in the table above may not necessarily sum due to rounding. Effective in the first quarter of 2017, given that we exited Thailand during 2016, the results of Thailand are now reported in Other operating segments and business activities for all periods presented, while previously the results had been reported in Asia Pacific. The impact was not material to Asia Pacific or Other operating segments and business activities and is consistent with how we present other market exits. Total revenue decreased 4% compared to the prior-year period, partially due to the unfavorable impact from foreign exchange. On a Constant $ basis, revenue decreased 1%, primarily due to a decrease in Active Representatives, most significantly in Malaysia, partially offset by higher average order. The decrease in Ending Representatives was impacted most significantly by a decline in Malaysia, which was partially offset by growth in the Philippines. Revenue in the Philippines decreased 2%, or increased 3% on a Constant $ basis, primarily due to higher average order and an increase in Active Representatives. Revenue growth in the Philippines was driven by the latter half of 2017, as strong commercial offers, including pricing, which, along with television advertising associated with our Color category, helped drive momentum in the field. In addition, actions implemented to improve inventory availability provided benefits to revenue growth. Segment margin decreased 190 basis points, or 140 basis points on a Constant $ basis, in each case primarily as a result of: • a decline of 140 basis points primarily related to the net impact of declining revenue with respect to Representative, sales leader and field expense, primarily in the Philippines; • a decline of 100 basis points due to lower gross margin caused primarily by 70 basis points from supply chain costs and 40 basis points from the unfavorable net impact of mix and pricing. The impact of supply chain costs on gross margin was primarily due to lower volume on fixed overhead costs; • a decline of 40 basis points due to higher advertising expense, primarily in the Philippines, related to television advertising associated with our Color category during the latter half of 2017; • a benefit of 100 basis points due to the lower fixed expenses, including the benefits associated with the Transformation Plan, primarily reductions in headcount; and • a benefit of 40 basis points from lower bad debt expense, primarily in the Philippines, driven mainly by improved collection. Earlier in 2017, we completed the review of our China operations and have determined that we will retain China in our portfolio of businesses. Liquidity and Capital Resources Our principal sources of funding historically have been cash flows from operations, public offerings of notes, bank financings, issuance of commercial paper, borrowings under lines of credit and a private placement of notes. At December 31, 2018, we had cash and cash equivalents totaling approximately $532.7 We believe that our sources of funding will be sufficient to satisfy our currently anticipated cash requirements through at least the next twelve months. We may seek to repurchase our equity or to retire our outstanding debt in open market purchases, privately negotiated transactions, through derivative instruments, cash tender offers or otherwise. Repurchases of equity and debt may be funded by cash, the incurrence of additional debt or the issuance of equity (including shares of preferred stock) or convertible securities and will depend on prevailing market conditions, our liquidity requirements, contractual restrictions and other factors, and the amounts involved may be material. We may also elect to incur additional debt or issue equity (including shares of preferred stock) or convertible securities to finance ongoing operations or to meet our other liquidity needs. Any issuances of equity (including shares of preferred stock) or convertible securities could have a dilutive effect on the ownership interest of our current shareholders and may adversely impact earnings per share in future periods. Our credit ratings were downgraded during the past several years, which may impact our ability to access such transactions on favorable terms, if at all. For more information, see "Risk Factors -Our credit ratings were downgraded during the past several years, which could limit our access to financing, affect the market price of our financing and increase financing costs. A further downgrade in our credit ratings may adversely affect our access to liquidity," "Risk Factors - Our indebtedness and any future inability to meet any of our obligations under our indebtedness, could adversely affect us by reducing our flexibility to respond to changing business and economic conditions" and "Risk Factors - A general economic downturn, a recession globally or in one or more of our geographic regions or markets or sudden disruption in business conditions or other challenges may adversely affect our business, our access to liquidity and capital, and our credit ratings" included in Item 1A on pages 7 through 20 of our 2018 Annual Report. Our liquidity could also be negatively impacted by restructuring initiatives, dividends, capital expenditures, acquisitions, and certain contingencies, including any legal or regulatory settlements, described more fully in Note 19, Contingencies on pages through of our 2018 Annual Report. See our Cautionary Statement for purposes of the "Safe Harbor" Statement under the Private Securities Litigation Reform Act of 1995 on pages 1 through 2 of our 2018 Annual Report. Balance Sheet Data Cash Flows Net Cash from Continuing Operating Activities Net cash provided by continuing operating activities during 2018 was approximately $93 as compared to net cash provided by continuing operating activities of approximately $271 during 2017, a decrease of approximately $178. The year-over-year comparison of net cash used by continuing operating activities was unfavorably impacted by lower cash-related earnings and higher inventory purchases. These unfavorable impacts to the year-over-year comparison of cash from operating activities were partially offset by the judicial deposit receipt of approximately $68 relating to Brazil IPI taxes (described more fully in Note 19, Contingencies on pages through of our 2018 Annual Report) and lower net receivables. Net cash provided by continuing operating activities during 2017 was approximately $271 as compared to approximately $128 during 2016, an increase of approximately $143. The year-over-year comparison was unfavorably impacted by approximately $27 of proceeds, net of legal fees, related to settling claims relating to professional services in connection with a previously disclosed legal matter, which was received in 2016. This unfavorable impact was partially offset by an injunction we received in May 2016 for cash deposits associated with IPI in Brazil. As a result, we were not required to make cash deposits in 2017, while we paid approximately $19 for these cash deposits in 2016, prior to May. See Note 19, Contingencies on pages through of our 2018 Annual Report for additional information on the IPI taxes. The remaining approximate $135 benefit to the year-over-year comparison of net cash provided by continuing operating activities was primarily due to improvements in working capital, most significantly from lower purchases of inventory and the timing of payments, as well as lower net receivables. We maintain defined benefit pension plans and unfunded supplemental pension benefit plans (see Note 14, Employee Benefit Plans on pages through of our 2018 Annual Report). Our funding policy for these plans is based on legal requirements and available cash flows. The amounts necessary to fund future obligations under these plans could vary depending on estimated assumptions (as detailed in "Critical Accounting Estimates - Pension and Postretirement Expense" in this MD&A). The future funding for these plans will depend on economic conditions, employee demographics, mortality rates, the number of associates electing to take lump-sum distributions, investment performance and funding decisions. Based on current assumptions, we expect to make contributions in the range of $5 to $10 to our U.S. defined benefit pension and postretirement plans and in the range of $10 to $15 to our non-U.S. defined benefit pension and postretirement plans during 2019. Net Cash from Continuing Investing Activities Net cash used by continuing investing activities during 2018 was approximately $93, as compared to approximately $70 during 2017. The approximate $23 increase to net cash used by continuing investing activities was primarily due to an approximate $22 cash distribution received from New Avon LLC in the third quarter of 2017. Net cash used by continuing investing activities during 2017 was approximately $70, as compared to approximately $83 during 2016. The approximate $13 decrease to net cash used by continuing investing activities was primarily due to an approximate $22 cash distribution received from New Avon in the third quarter of 2017, partially offset by lower asset disposals as compared to the prior-year period. See Note 4, Investment in New Avon on page of our 2018 Annual Report for more information on the cash distribution received from New Avon. Capital expenditures during 2018 were approximately $95 compared with approximately $97 during 2017 and approximately $93 during 2016. Capital expenditures in 2019 are currently expected to be in the range of $120 to $140 and are expected to be funded by cash from operations. Net Cash from Continuing Financing Activities Net cash used by continuing financing activities during 2018 was approximately $307, as compared to zero in 2017. The approximate $307 unfavorable impact to net cash used by continuing financing activities was primarily due to a $238 repayment of debt in the second quarter of 2018 plus a make-whole premium of $6, as well as open market repurchases of $48 in the fourth quarter of 2018. Net cash provided by continuing financing activities during 2017 was zero, as compared to approximately $137 during 2016. The approximate $137 decrease to net cash provided by continuing financing activities was primarily due to the net proceeds related to the $500 principal amount of 7.875% Senior Secured Notes issued in the August 2016 and the net proceeds from the sale of series C preferred stock. These drivers were partially offset by the repayment of certain of our debt in 2016 of approximately $720 in the aggregate and higher repayments of short-term debt in the prior-year period. See Note 8, Debt and Other Financing on pages through of our 2018 Annual Report and Note 18, Series C Convertible Preferred Shares on page of our 2018 Annual Report for more information. We purchased approximately 1.1 million shares of our common stock for $3.2 during 2018, as compared to 1.6 million shares of our common stock for $7.2 during 2017 and 1.4 million shares for $5.6 during 2016, through acquisition of stock from employees in connection with tax payments upon vesting of restricted stock units and upon vesting of performance restricted stock units in 2018, 2017 and 2016. We did not declare a dividend for 2018 or 2017 as we suspended the dividend effective in the first quarter of 2016. Debt and Contractual Financial Obligations and Commitments At December 31, 2018, our debt and contractual financial obligations and commitments by due dates were as follows: (1) Amounts are based on our current long-term credit ratings. See Note 8, Debt and Other Financing on pages through of our 2018 Annual Report for more information. (2) Amounts are net of expected sublease rental income. See Note 16, Leases and Commitments on page of our 2018 Annual Report for more information. (3) Amounts represent expected future benefit payments for our unfunded defined benefit pension and postretirement benefit plans, as well as expected contributions for 2019 to our funded defined benefit pension benefit plans. We are not able to estimate our contributions to our funded defined benefit pension and postretirement plans beyond 2019. (4) The amount of debt and contractual financial obligations and commitments excludes amounts due under derivative transactions. The table also excludes information on non-binding purchase orders of inventory. The table does not include any reserves for uncertain income tax positions because we are unable to reasonably predict the ultimate amount or timing of settlement of these uncertain income tax positions. At December 31, 2018, our reserves for uncertain income tax positions, including interest and penalties, totaled approximately $107. See Note 8, Debt and Other Financing, and Note 16, Leases and Commitments on pages to, and on page, respectively, of our 2018 Annual Report for more information on our debt and contractual financial obligations and commitments. Additionally, as disclosed in Note 17, Restructuring Initiatives on pages through of our 2018 Annual Report, at December 31, 2017, we have liabilities of approximately $59 associated with our restructuring actions, primarily associated with our Transformation Plan. The majority of future cash payments associated with these restructuring liabilities are expected to be made during 2019. Off Balance Sheet Arrangements At December 31, 2018, we had no material off-balance-sheet arrangements. Capital Resources Revolving Credit Facility In June 2015, Avon International Operations, Inc. ("AIO"), a wholly-owned domestic subsidiary of the Company, entered into a five-year $400.0 senior secured revolving credit facility (the “2015 facility”). In December 2017, AIO entered into an amendment to the 2015 facility, which, among other things, modified the financial covenants (interest coverage and total leverage ratios) to provide the Company additional flexibility. As of December 31, 2018, there were no amounts outstanding under the 2015 facility. In February 2019, Avon International Capital, p.l.c. ("AIC"), a wholly-owned foreign subsidiary of the Company, entered into a three-year €200.0 senior secured revolving credit facility (the “2019 facility”). The 2019 facility replaced the 2015 facility and the 2015 facility was terminated at such time. Borrowings under the 2019 facility bear interest at our option, at a rate per annum, equal to either LIBOR or EURIBOR (for any loan in euros) plus 225 basis points, in each case subject to adjustment based upon a leveraged-based pricing grid. The 2019 facility may be used for general corporate and working capital purposes. There are no amounts outstanding under the 2019 facility. The amount available to be drawn on under the 2019 facility is reduced by any standby letters of credit granted by AIC or any Obligor under the 2019 facility, including the standby letters of credit granted by AIO under the 2015 facility that were rolled over into the 2019 facility, which, as of December 31, 2018, were approximately $29. All obligations of AIC under the 2019 facility are unconditionally guaranteed by the Company, AIO and each other material United States or English restricted subsidiary of the Company (collectively, the “Obligors”), in each case, subject to certain exceptions. The obligations of the Obligors are secured by first priority liens on and security interests in substantially all of the assets of the Obligors, in each case, subject to certain exceptions. The 2019 facility will terminate in February 2022; provided, however, that it shall terminate on the 91st day prior to the maturity of the 4.60% Notes, if on such 91st day, the applicable notes are not redeemed, repaid, discharged, defeased or otherwise refinanced in full. The 2019 facility contains affirmative and negative covenants, which are customary for secured financings of this type, as well as financial covenants (interest coverage and total leverage ratios). Depending on our business results (including the impact of any adverse foreign exchange movements and significant restructuring charges), it is possible that we may become non-compliant with our interest coverage or total leverage ratio absent the Company undertaking other alternatives to avoid noncompliance, such as obtaining additional amendments to the 2019 facility or repurchasing certain debt. If we were to be non-compliant with our interest coverage or total leverage ratio, we would no longer have access to our 2019 facility and our credit ratings may be downgraded.

<s>[INST] You should read the following discussion of the results of operations and financial condition of Avon Products, Inc. and its majority and wholly owned subsidiaries in conjunction with the information contained in the Consolidated Financial Statements and related Notes contained in our 2018 Annual Report. When used in this discussion, the terms "Avon," "Company," "we," "our" or "us" mean, unless the context otherwise indicates, Avon Products, Inc. and its majority and wholly owned subsidiaries. See "NonGAAP Financial Measures" on pages 29 through 30 of this MD&A for a description of how constant dollar ("Constant $") growth rates (a NonGAAP financial measure) are determined and see "Performance Metrics" on page 29 of this MD&A for definitions of our performance metrics (Change in Active Representatives, Change in units sold, Change in Ending Representatives and Change in Average Order). Overview We are a global manufacturer and marketer of beauty and related products. Our business is conducted primarily in the directselling channel. During 2018, we had sales operations in 56 countries and territories, and distributed products in 21 more. All of our consolidated revenue is derived from operations of subsidiaries outside of the United States ("U.S."). Our reportable segments are based on geographic operations in four regions: Europe, Middle East & Africa; South Latin America; North Latin America; and Asia Pacific. Our product categories are Beauty and Fashion & Home. Beauty consists of skincare, fragrance and color (cosmetics). Fashion & Home consists of fashion jewelry, watches, apparel, footwear, accessories, gift and decorative products, housewares, entertainment and leisure products, children’s products and nutritional products. Sales are made to the ultimate consumer principally through direct selling by Representatives, who are independent contractors and not our employees. As of December 31, 2018, we had approximately 5 million active Representatives which represents the number of Representatives submitting an order in a sales campaign, totaled for all campaigns during the year and then divided by the number of campaigns. The success of our business is highly dependent on recruiting, retaining and servicing our Representatives. During 2018, revenue declined 3% compared to the prioryear period. Excluding the Brazil IPI release, Adjusted revenue was down 5%, primarily due to the unfavorable impact of foreign exchange. Constant $ Adjusted revenue increased 1%. Revenue and Constant $ Adjusted revenue included a benefit of approximately 4% due to the impact of adopting the new revenue recognition standard. The 4% benefit was driven primarily by the reclassification of fees paid by Representatives for brochures, late payments and payment processing, and income from appointment kits, from SG&A. The impact of timing of revenue recognition for sales incentives was negligible. Constant $ Adjusted revenue was impacted by declines primarily in Brazil, which continued to be negatively impacted by competitive pressures against a backdrop of a challenging macroeconomic environment and lower consumption in the market, as well as lower appointments, partly due to the application of strict credit requirements for the acceptance of new Representatives. To a lesser extent, Constant $ Adjusted revenue was also impacted by declines in the United Kingdom, South Africa and Russia, as well as lower revenue from the closure of Australia and New Zealand during 2018. These declines were partially offset by improved revenue growth management, including inflationary, pricing in Argentina. Revenue and Constant $ Adjusted revenue were impacted by a decrease in Active Representatives of 5%, which was primarily driven by Brazil, and to a lesser extent, Russia. Average order in Constant $ increased 2%, including a benefit of approximately 4% due to the impact of adopting the new revenue recognition standard. Units sold decreased 6%, driven by a decline in Brazil. Ending Representatives declined 8%, primarily driven by declines in Russia and Brazil. The impact of the new revenue recognition standard was primarily driven by the following accounting changes effective as of January 1, 2018: Certain of our sales incentives and prospective discounts are now considered to be a separate deliverable, thus initially revenue is deferred generally until delivery of the incentive prize to the [/INST] Positive. </s>

HAVERTY FURNITURE COMPANIES INC

2015-03-16

2014-12-31

ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Overview Industry The retail residential furniture industry's results are influenced by new and existing housing sales, consumer confidence, spending on large ticket items, interest rates and availability of credit and the overall strength of the economy. The industry experienced a rebound in 2012 as its drivers have improved. These factors remain tempered by continued high levels of unemployment, lower home values, and reduced access to credit, all of which provide impediments to industry growth. Our Business We sell home furnishings in our retail stores and via our website and record revenue when the products are delivered to our customer. Our products are selected to appeal to a middle to upper-middle income consumer across a variety of styles. Our commissioned sales associates receive a high level of product training and are provided a number of tools with which to serve our customers. We also have in-home designers serving 109 stores. These individuals work with our sales associates to provide customers additional confidence and inspiration. We do not outsource the delivery function, something common in the industry, but instead ensure that the "last contact" is handled by a customer-oriented Havertys delivery team. We are recognized as a provider of high quality fashionable products and service in the markets we serve. 2014 Highlights Sales for 2014 grew 3.0% or $22.3 million over 2013. Gross profit as a percent of net sales decreased 10 basis points, and SG&A increased 80 basis points. We terminated and settled the obligations related to our defined benefit pension plan and recorded a pretax charge of $21.6 million. Our pre-tax income was $25.3 million, and excluding the pension charge and an out-of-period adjustment in 2013 decreased 9.2% or $4.8 million. We experienced import vendor and supply chain disruptions to our business from which we began to recover late in the year. Our fourth quarter results were a pre-tax loss of $5.0 million. Excluding the pension charge, our fourth quarter pre-tax income was $16.6 million, up 5.5% over the prior year period. We continued our focus on cash flow and made important investments in our business and returned cash to our stockholders. We did not use our credit facility during the year and our total debt to total capital was 14.4% at December 31, 2014. Management Objectives Management is focused on capturing more market share and increasing sales per square foot of showroom space. This organic growth will be driven by concentrating our efforts on our customers with improved interactions highlighted by new products, enhanced stores and better technology. The Company's strategies for profitability include targeted marketing initiatives, productivity and process improvements, and efficiency and cost-saving measures. Our focus is to serve our customers better and distinguish ourselves in the marketplace. Key Performance Indicators We evaluate our performance based on several key metrics which include net sales, comparable store sales, sales per square foot, gross profit, operating costs as a percentage of sales, cash flow, total debt to total capital, and earnings per share. The goal of utilizing these measurements is to provide tools in economic decision-making such as store growth, capital allocation and product pricing. We also employ metrics that are customer focused (customer satisfaction score, on-time-delivery and quality), and internal effectiveness and efficiency metrics (sales per employee, average sale per ticket, closing ratios per customer store visit, exceptions per deliveries, and lost time incident rate). These measurements aid us in determining areas of our operations that are in need of additional attention and in determining compensation. Operating Results The following table provides selected data for the periods indicated and reconciles the non-GAAP financial measures to their comparable GAAP measures. See the additional discussion contained in this Item 7 (in thousands, except per share data): Net Sales Comparable-store or "comp-store" sales is a measure which indicates the performance of our existing stores by comparing the growth in sales for these stores for a particular period over the corresponding period in the prior year. Stores are considered non-comparable if open for less than 12 full calendar months or if the selling square footage has been changed significantly during the past 12 full calendar months. Large clearance sales events from warehouses or temporary locations are also excluded from comparable store sales, as are periods when stores are closed or being remodeled. As a retailer, comp-store sales is an indicator of relative customer spending and store performance. Total sales increased $22.3 million or 3.0% in 2014 and $76.0 million or 11.3% in 2013. Comparable store sales increased 3.6% or $26.2 million in 2014 and 11.0% or $72.0 million in 2013. The remaining $3.9 million in 2014 and $4.0 million in 2013 of the changes were from closed, new and otherwise non-comparable stores. The following outlines our sales and comp-store sales increases and decreases for the periods indicated. (Amounts and percentages may not always add to totals due to rounding.) Sales in 2014 were challenged by weather in the first quarter and case goods vendor supply and import flow issues through much of the remainder of the year. The store displays in this important category were not as robust as our merchandise team had planned and began to recover in the fourth quarter. Our improved custom order configurator web based tool helped our specialty upholstery sales to continue to grow with a 10.8% increase over 2013 including a 19.3% growth rate in the fourth quarter. We also expanded our in-home-design service in 2014 which has yielded higher average tickets. Sales in 2013 increased as the fundamental drivers of home furnishings purchases continued to recover. We capitalized on this trend with improved merchandising and expansion of our complimentary in-home design service. These generated an increase in our average ticket of 7.8% and a 19.8% increase in our custom order upholstery business. Sales in 2012 increased at a strong pace as our industry began its recovery. Our average ticket was up 7.8% as our customers responded to the value offered in our fashionable better quality merchandise. Sales in the upholstery product category showed strength increasing 12.6% over 2011 including a 17.9% increase in custom and special orders. 2015 Outlook We believe as the general economy improves and consumer spending and the housing market strengthens, our business will benefit. We have upgraded stores, offer appealing merchandise and expanded special order and service offerings which will be important drivers for our 2015 sales results. We are growing our weighted average square footage approximately 3.4%. We do anticipate headwinds in 2015 for certain of our markets due to changes in the competitive landscape. Gross Profit Our cost of sales consist primarily of the purchase price of the merchandise together with inbound freight, handling within our distribution centers and transportation costs to the local markets we serve. Our gross profit is primarily dependent upon vendor pricing, the mix of products sold and promotional pricing activity. Substantially all of our occupancy and home delivery costs are included in selling, general and administrative expenses as is a portion of our warehousing expenses. Accordingly, our gross profit may not be comparable to those entities that include some of these expenses in cost of goods sold. Year-to-Year Comparisons Gross profit as a percentage of net sales was 53.7% in 2014 compared to 53.8% in 2013. Our LIFO impact was $0.5 million greater in 2014 than in 2013 and during 2014 we had slightly lower delivery fee revenue and higher than normal clearance sale activity resulting from store and local warehouse closings. We recorded an $0.8 million positive out-of-period adjustment in the first quarter 2013 for vendor pricing allowances. Excluding the impact of the out-of-period adjustment, gross profit was 53.7% in 2013. Gross profit as a percentage of net sales increased to 53.8% in 2013 compared to 52.5% in 2012. Our focus on higher price point products and pricing discipline were key to the gross profit improvement combined with a $1.1 million smaller LIFO impact and the $0.8 million out-of-period adjustment. 2015 Outlook Our merchandising strategy will be similar to 2014 using promotional pricing selectively and focusing on product fashion and customer service. We expect that annual gross profit margins for 2015 will be approximately 53.3%, down slightly reflecting some higher import costs and the impact of increased competition in certain of our markets. Selling, General and Administrative Expenses SG&A expenses are comprised of five categories: selling; occupancy; delivery and certain warehousing costs; advertising and administrative. Selling expenses primarily are comprised of compensation of sales associates and sales support staff, and fees paid to credit card and third-party finance companies. Occupancy costs include rents, depreciation charges, insurance and property taxes, repairs and maintenance expense and utility costs. Delivery costs include personnel, fuel costs, and depreciation and rental charges for rolling stock. Warehouse costs include supplies, depreciation and rental charges for equipment. Advertising expenses are primarily media production and space, direct mail costs, market research expenses, employee compensation and agency fees. Administrative expenses are comprised of compensation costs for store personnel exclusive of sales associates, information systems, executive, accounting, merchandising, advertising, supply chain, real estate and human resource departments. We classify our SG&A expenses as either variable or fixed and discretionary. Our variable expenses include the costs in the selling and delivery categories and certain warehouse expenses as these amounts will generally move in tandem with our level of sales. The remaining categories and expenses are classified as fixed and discretionary because these costs do not fluctuate with sales. The following table outlines our SG&A expenses by classification: Year-to-Year Comparisons Our SG&A costs as a percent of sales increased 80 basis points to 47.5% for 2014 from 46.7% in 2013. The fixed and discretionary expenses of $230.5 million in 2014 were $6.7 million or 3% above the 2013 level primarily due to increases in spending on advertising of $2.6 million, depreciation and other occupancy costs of $1.8 million and greater communication and data expense of $2.2 million. Variable expense as a percent of sales for 2014 increased to 17.5% from 16.7% in 2013. Our selling costs as a percent of sales increased 47 basis points in 2014 over 2013 due in part to the expansion of our in-home design program. Labor and insurance costs increased in our delivery and certain warehouse operations. The fixed and discretionary expenses increased $11.9 million in 2013 to $223.8 million from $211.9 million in 2012. This increase was driven by $7.8 million in additional administrative costs primarily from greater incentive and compensation expense and higher health insurance costs. Our new stores and improvements generated a $2.0 million increase in depreciation in 2013 compared to 2012. We also spent $1.2 million more on advertising in 2013 over 2012. Our variable expenses were lower as a percent of net sales in 2013 compared to 2012 primarily due to efficiencies in our warehouse and delivery functions and changes in credit costs. 2015 Outlook The fixed and discretionary type expenses within SG&A for the full year of 2015 are expected to be approximately $239.0 million to $241.0 million, up approximately 3.5% to 5% over those same costs in 2014. These expenses should average approximately $60.0 million per quarter and are expected to be slightly higher for the second half of the year in connection with our expansion activity. The main increases in this category are expected to be for personnel costs, new store occupancy expense and advertising expenses. Variable costs within SG&A are expected to be 17.3% to 17.5% as a percent of sales for 2015. Pension Settlement We terminated our qualified defined benefit pension plan (the "Plan") effective July 20, 2014 as reported on our Form 8-K filed May 16, 2014. The Plan had been previously amended to freeze benefit accruals for eligible employees under the Plan effective December 31, 2006 when we transitioned to a stronger emphasis on our employee savings/ retirement (401(k)) plan. We informed Plan participants of the termination in May 2014 and they received vested benefits in December via either a lump sum cash distribution, roll-over contribution to other retirement accounts, or the purchase of an annuity contract with a third-party insurance company. The Plan was fully funded and we made no contributions in 2014. The final settlement of lump sum payments and rollovers of $29.9 million and annuity purchases of $53.6 million were made in December 2014. There were surplus assets of $0.8 million remaining after the Plan's obligations were settled. The remaining Plan assets, less expenses, will be distributed to participants according to provisions of the Plan following final regulatory approvals which is expected to occur in 2015. The settlement of the Plan's obligations required the recognition of pension settlement expenses in the fourth quarter. We recognized termination and settlement expense of $21.6 million and a related tax benefit of $0.9 million for a total impact on consolidated net income of $20.7 million or $0.90 per diluted earnings per share. We had approximately $6.8 million of unamortized costs net of $4.2 million of tax related to the Plan included on our balance sheet in accumulated other comprehensive income (loss) ("AOCI") prior to settlement. Also included in AOCI was a debit of $6.9 million resulting from the 'backward-tracing" prohibition related to changes in a valuation allowance from previous periods. See additional discussion in "Provision for Income Taxes" which follows. The settlement of the Plan caused these amounts totaling $13.6 million to be reclassified from AOCI to other comprehensive income. The impact of the termination and settlement of the Plan did not impact cash flow and resulted in a net reduction of approximately $7.1 million in our total stockholders equity. Interest Expense Our interest expense for the years 2012 to 2014 is primarily driven by amounts related to our lease obligations. For leases accounted for as capital and financing lease obligations, we only record straight-line rent expense for the land portion in occupancy costs in SG&A along with depreciation on the additional asset recorded. Rental payments are recognized as a reduction of the obligations and as interest expense. The number of stores, including those under construction, which are accounted for in this manner has increased from eight in 2012, to sixteen in 2014. We expect interest expense for lease obligations will be $2.7 million in 2015. Provision for Income Taxes Our effective tax rate was 66.0%, 38.5% and 36.6% for 2014, 2013 and 2012, respectively. Refer to Note 7 of the Notes to the Consolidated Financial Statements for a reconciliation of our income tax expense to the federal income tax rate. Our 2014 rate includes the reversal of $6.9 million from AOCI to income tax expense. We established a valuation allowance in 2008 against virtually all of our deferred tax assets due to our operating loss in that year and projected loss in 2009. A portion of the allowance was charged to AOCI and was increased in 2009. Our profitability in 2011 was sufficient for us to release the valuation allowance. The "backward-tracing" prohibition in ASC 740, Income Taxes required us to record the total amount of the release as a tax benefit in net income including the portion originally charged to AOCI. This resulted in a debit valuation allowance of $6.9 million remaining in AOCI which would remain until the settlement of the Plan's pension obligations when it was reversed and included in total tax expense. The 2014 rate, excluding this reversal, varies from the 35% U.S federal statutory rate primarily due to state income taxes. Our 2013 rate varies from the 35% U.S. federal statutory rate primarily due to state income taxes. Our 2012 rate included a benefit from income taxes of $0.7 million related to the change in our uncertain tax positions. This benefit was partially offset by changes in our receivables and state net operating loss carryforwards of $0.3 million. Liquidity and Capital Resources Overview of Liquidity Our primary cash requirements include working capital needs, contractual obligations, benefit plan contributions, income tax obligations and capital expenditures. We have funded these requirements exclusively through cash generated from operations and have not used our credit facility since 2008. We believe funds generated from our expected results of operations and available cash and cash equivalents will be sufficient to fund our primary obligations and complete projects that we have underway or currently contemplate for the next fiscal and foreseeable future years. At December 31, 2014, our cash and cash equivalents balance was $65.5 million, a decrease of $17.7 million compared to December 31, 2013. This decrease in cash primarily resulted from strong operating results offset by purchases of property and equipment, the payment of special cash dividends to stockholders and the purchases of certificates of deposit. Additional discussion of our cash flow results, including the comparison of 2014 activity to 2013, is set forth in the Analysis of Cash Flows section. At December 31, 2014, our outstanding indebtedness was $49.1 million in lease obligations required to be recorded on our balance sheet. We had no amounts outstanding and $43.8 million available under our revolving credit facility. Capital Expenditures Our primary capital requirements have been focused on our stores and the development of both proprietary and purchased information systems. Our capital expenditures were $30.9 million in 2014, $10.7 million more than in 2013. Our future capital requirements will depend in large part on the number of and timing for new stores we open within a given year, the investments we make to the improvement and maintenance of our existing stores, and our investment in distribution improvements and new information systems to support our key strategies. In 2015, we anticipate that our capital expenditures will be approximately $31 million, refer to our Store Expansion and Capital Expenditures discussion below. Analysis of Cash Flows The following table illustrates the main components of our cash flows (in thousands): Cash flows from operating activities. During 2014, net cash provided by operating activities was $55.5 million. Cash from net income, net of depreciation and amortization, pension settlement expense and stock-based compensation expense was partially reduced by cash used for working capital. The primary components of the changes in working capital are listed below: · Increase in inventories of $15.7 million, mainly due to the desire for a better stocking position and replenishment efforts in advance of Chinese New Year. · Increase in other current assets of $3.7 million, primarily from $3.3 million increase in receivables for tenant incentives. · Decrease in other assets of $5.8 million mainly due to the settlement of pension partly offset by the purchase of certain certificates of deposit. · Increase in accounts payable of $2.3 million. · Increase in customer deposits of $4.7 million. During 2013, net cash provided by operating activities was $55.9 million. Our cash provided by operating activities was mainly the result of pre-tax income generated during 2013. Cash from net income, net of depreciation and amortization and stock-based compensation expense, along with cash provided by working capital, was partially reduced by pension plan contributions. Pension plan contributions in 2013 included a $4.2 million discretionary contribution made to improve the funded status of the plan and as part of our broader pension de-risking strategy. · Decrease in inventories of $5.4 million, mainly due to timing of sales and replenishment. · Decrease in other liabilities of $9.0 million, and increase in other assets of $9.9 million mainly due to the shift from a $6.8 million pension plan liability to a $9.4 million pension asset. · Decrease in accounts payable of $6.4 million. During 2012, net cash provided by operating activities was $52.2 million. We generated net income of $14.9 million during the year, and depreciation and amortization totaled $19.4 million. Working capital increased and the major components of the change are listed below. · Increase in customer deposits of $6.4 million as the level of our special order business increased and deliveries at the end of 2012 were hampered by product availability. · Increase in accounts payable of $7.0 million, offset by increased inventory levels of $3.5 million. These increases were primarily due to our higher level of purchases in advance of the Chinese New Year and in response to our increased sales activity. · Decrease in other liabilities of $3.5 million as the pension plan liability decreased $4.3 million. Cash flows used in investing activities. Net cash used in investing activities was $41.4 million, $20.1 million and $24.8 million for 2014, 2013 and 2012, respectively. In each of these years, the amounts of cash used in investing activities consisted principally of capital expenditures related to store construction and improvements and information technology projects, refer to our Store Expansion and Capital Expenditures discussion below. During 2014, in addition to the expenditures for new stores and one store's major expansion, we purchased $10.0 million in certificates of deposit. During 2013, we invested in our distribution system for future expansion and added capacity to our internal cloud architecture to support our sales systems and video communications. During 2012, we completed information technology projects replacing our core network that controls the communication between our stores and data centers and invested in cloud infrastructure. Cash flows used in financing activities. Net cash used in financing activities was $31.8 million for 2014, $6.1 million for 2013 and $23.4 million for 2012. During 2014 we paid a special dividend of approximately $22.6 million. During 2013 the number of restricted shares vesting increased as the acceleration goals of certain grants were met. This increased the withholding taxes for vested shares and contributed to the tax benefit from stock-based plans. During 2012 we paid a special dividend of approximately $22.0 million and we had expiring in-the-money options which generated additional option exercise activity in 2012. During 2014, 2013, and 2012, we did not make any draws on our revolving credit facility. Long-Term Debt In September 2011 Havertys entered into an Amended and Restated Credit Agreement (the "Credit Agreement") with a bank. Refer to Note 5 of the Notes to Consolidated Financial Statements for information about our Credit Agreement. Off-Balance Sheet Arrangements We do not generally enter into off-balance sheet arrangements. We did not have any relationships with unconsolidated entities or financial partnerships which would have been established for the purposes of facilitating off-balance sheet financial arrangements for any period during the three years ended December 31, 2014. Accordingly, we are not materially exposed to any financing, liquidity, market or credit risk that could arise if we had engaged in such relationships. Contractual Obligations The following summarizes our contractual obligations and commercial commitments as of December 31, 2014 (in thousands): (1) These amounts are for our lease obligations recorded in our consolidated balance sheets, including interest amounts. For additional information about our leases, refer to Note 8 of the Notes to the Consolidated Financial Statements. (2) The contractual obligations do not include any amounts related to retirement benefits. For additional information about our plans, refer to Note 10 of the Notes to the Consolidated Financial Statements. Store Expansion and Capital Expenditures We have entered new markets and made continued improvements and relocations of our store base. The following outlines the change in our selling square footage for each of the three years ended December 31 (square footage in thousands): During 2014 we also had a major remodeling project in our Knoxville, Tennessee store which increased its selling square footage. The following table summarizes our store activity in 2014 and plans for 2015. These plans and other changes should increase net selling space in 2015 by approximately 3.8% assuming the new stores open and existing stores close as planned. Our investing activities in stores and operations in 2014, 2013 and 2012 and planned outlays for 2015 are categorized in the table below. Capital expenditures for stores in the years noted do not necessarily coincide with the years in which the stores open. Non-GAAP Financial Measures and Reconciliations - Adjusted Net Income and Adjusted Earnings We have included financial measures that are not prepared in accordance with GAAP. Any analysis of non-GAAP financial measures should be used only in conjunction with results presented in accordance with GAAP. The non-GAAP measures are not intended to be substitutes for GAAP financial measures and should not be used as such. We use the non-GAAP measures "EBIT," "adjusted EBIT," "adjusted net income" and "adjusted earnings per diluted share." Management believes these non-GAAP financial measures provide our board of directors, investors, potential investors, analysts and others with useful information to evaluate the performance of the Company because it excludes the impact of the pension settlement expense and another specific item that management believes are not indicative of the ongoing operating results of the business. The Company and our board of directors use this information to evaluate the Company's performance relative to other periods. We believe that the most directly comparable GAAP measures to EBIT, adjusted net income and adjusted diluted earnings per share are "Income before interest and income taxes," "Net income" and "Diluted earnings per share." Set forth above in our discussion of Operating Results are reconciliations of adjusted net income to net income and adjusted diluted earnings per share to diluted earnings per share. EBIT is equal to income before interest and income taxes and adjusted EBIT is reconciled to EBIT. Critical Accounting Estimates and Assumptions Our discussion and analysis is based upon our consolidated financial statements, which have been prepared in accordance with U.S. generally accepted accounting principles. The preparation of these financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses, and related disclosures. On an on-going basis, we evaluate our estimates, including those related to accounts receivable and allowance for doubtful accounts, pension and retirement benefits, self-insurance and realizability of deferred tax assets. We base our estimates on historical experience and on various other assumptions that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions. An accounting policy is deemed to be critical if it requires an accounting estimate to be made based on assumptions about matters that are highly uncertain at the time the estimate is made, and if different estimates that reasonably could have been used or changes in the accounting estimate that are reasonably likely to occur could materially change the financial statements. We believe the following critical accounting policies reflect our more significant estimates and assumptions used in the preparation of our consolidated financial statements: Retirement benefits. Our supplemental executive retirement plan ("SERP") costs require the use of assumptions for discount rates, projected salary increases and mortality rates. Management is required to make certain critical estimates related to actuarial assumptions used to determine our expense and related obligation. We believe the most critical assumptions are related to (1) the discount rate used to determine the present value of the liabilities and (2) mortality rates. All of our actuarial assumptions are reviewed annually. Changes in these assumptions could have a material impact on the measurement of our SERP expense and related obligation. The SERP is not funded so we pay benefits directly to participants. The unfunded obligation increased by $1.3 million between December 31, 2013 and December 31, 2014. At each measurement date, we determine the discount rate by reference to rates of high quality, long-term corporate bonds that mature in a pattern similar to the future payments we anticipate making under the plans. As of December 31, 2014 and 2013, the weighted-average discount rates used to compute our benefit obligation were 4.09% and 4.96% respectively. This increased the SERP's benefit obligation by 12%. The SERP's mortality tables were updated in 2014 which increased the benefit obligation by 6%. Refer to Note 10 to the Notes to Consolidated Financial Statements for additional information about our defined benefit pension plan which was terminated and settled in 2014 and other actuarial assumptions. Self-Insurance. We are self-insured for certain losses related to worker's compensation, general liability and vehicle claims for amounts up to a deductible per occurrence. Our reserve is developed based on historical claims data and contains an actuarially developed incurred but not reported component. The resulting estimate is discounted and recorded as a liability. Our actuarial assumptions and discount rates are reviewed periodically and compared with actual claims experience and external benchmarks to ensure appropriateness. A one-percentage-point change in the actuarial assumption for the discount rate would impact 2014 expense for insurance by approximately $82,000, a 1.3% change. We became primarily self-insured for employee group health care claims in 2012. We have purchased insurance coverage in order to establish certain limits to our exposure on both a per claim and aggregate basis. We record an accrual for the estimated amount of self-insured health care claims incurred by all participants but not yet reported (IBNR) using an actuarial method of applying a development factor to the reported monthly claims amounts. The Company's risk management and accounting management utilize a consistent methodology which involves various assumptions, judgment and other factors. The most significant factors which impact the determination of a required accrual are the historical pattern of the timeliness of claims processing, any changes in the nature or types of benefit plans, changes in the plan benefit designs, and medical trends and inflation. Historical experience is continually monitored, and accruals are adjusted when warranted by changes in facts and circumstances. The Company believes that the total health care cost accruals are reasonable and adequate to cover future payments on incurred claims. Stock-based compensation. We have stock-based compensation plans and since 2004 have made grants of restricted stock, restricted stock units, and stock-settled appreciation rights. See Note 12, Stock Based Compensation Plans, to the Notes to the Consolidated Financial Statements for a complete discussion of our stock-based compensation programs. We recognize stock-based compensation expense based on the fair value of the respective awards. We estimated the fair value of our stock-settled appreciation rights awards as of the grant date based upon a Black-Scholes-Merton option pricing model. We estimate the fair value of our restricted stock awards and units as of the grant date utilizing the closing market price of our stock on that date. The compensation expense associated with these awards is recorded in the consolidated statements of income with a corresponding credit to common stock.

<s>[INST] Industry The retail residential furniture industry's results are influenced by new and existing housing sales, consumer confidence, spending on large ticket items, interest rates and availability of credit and the overall strength of the economy. The industry experienced a rebound in 2012 as its drivers have improved. These factors remain tempered by continued high levels of unemployment, lower home values, and reduced access to credit, all of which provide impediments to industry growth. Our Business We sell home furnishings in our retail stores and via our website and record revenue when the products are delivered to our customer. Our products are selected to appeal to a middle to uppermiddle income consumer across a variety of styles. Our commissioned sales associates receive a high level of product training and are provided a number of tools with which to serve our customers. We also have inhome designers serving 109 stores. These individuals work with our sales associates to provide customers additional confidence and inspiration. We do not outsource the delivery function, something common in the industry, but instead ensure that the "last contact" is handled by a customeroriented Havertys delivery team. We are recognized as a provider of high quality fashionable products and service in the markets we serve. 2014 Highlights Sales for 2014 grew 3.0% or $22.3 million over 2013. Gross profit as a percent of net sales decreased 10 basis points, and SG&A increased 80 basis points. We terminated and settled the obligations related to our defined benefit pension plan and recorded a pretax charge of $21.6 million. Our pretax income was $25.3 million, and excluding the pension charge and an outofperiod adjustment in 2013 decreased 9.2% or $4.8 million. We experienced import vendor and supply chain disruptions to our business from which we began to recover late in the year. Our fourth quarter results were a pretax loss of $5.0 million. Excluding the pension charge, our fourth quarter pretax income was $16.6 million, up 5.5% over the prior year period. We continued our focus on cash flow and made important investments in our business and returned cash to our stockholders. We did not use our credit facility during the year and our total debt to total capital was 14.4% at December 31, 2014. Management Objectives Management is focused on capturing more market share and increasing sales per square foot of showroom space. This organic growth will be driven by concentrating our efforts on our customers with improved interactions highlighted by new products, enhanced stores and better technology. The Company's strategies for profitability include targeted marketing initiatives, productivity and process improvements, and efficiency and costsaving measures. Our focus is to serve our customers better and distinguish ourselves in the marketplace. Key Performance Indicators We evaluate our performance based on several key metrics which include net sales, comparable store sales, sales per square foot, gross profit, operating costs as a percentage of sales, cash flow, total debt to total capital, and earnings per share. The goal of utilizing these measurements is to provide tools in economic decisionmaking such as store growth, capital allocation and product pricing. We also employ metrics that are customer focused (customer satisfaction score, ontimedelivery and quality), and internal effectiveness and efficiency metrics (sales per employee, average sale per ticket, closing ratios per customer store visit, exceptions per deliveries, and lost time incident rate). These measurements aid us in determining areas of our operations that are in need of additional attention and in determining compensation. Operating Results The following table provides selected data for the periods indicated and reconciles the nonGAAP financial measures to their comparable GAAP measures. See the additional discussion contained in this Item 7 (in thousands, except per share data): Net Sales Comparablestore or "compstore" sales is a measure which indicates the performance of our existing stores by comparing the growth in sales for these stores for a particular period over the corresponding period in the prior year. Stores are considered noncomparable if open for less than 12 full calendar months or if the selling square footage has been changed significantly during the past 12 full calendar months. Large clearance sales events from warehouses or temporary locations are also excluded from comparable store sales, as are periods when stores are closed or being remodeled. As a retailer, compstore sales is an indicator of [/INST] Negative. </s>

HAVERTY FURNITURE COMPANIES INC

2016-03-04

2015-12-31

ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Overview Industry The retail residential furniture industry's results are influenced by new and existing housing sales, consumer confidence, spending on large ticket items, interest rates and availability of credit and the overall strength of the economy. The industry experienced a rebound in 2012 as its drivers have improved. These factors remain tempered by continued high levels of unemployment, lower home values, and reduced access to credit, all of which provide impediments to industry growth. Our Business We sell home furnishings in our retail stores and via our website and record revenue when the products are delivered to our customer. Our products are selected to appeal to a middle to upper-middle income consumer across a variety of styles. Our commissioned sales associates receive a high level of product training and are provided a number of tools with which to serve our customers. We also have over 100 in-home designers serving most of our stores. These individuals work with our sales associates to provide customers additional confidence and inspiration. We do not outsource the delivery function, something common in the industry, but instead ensure that the "last contact" is handled by a customer-oriented Havertys delivery team. We are recognized as a provider of high quality fashionable products and service in the markets we serve. 2015 Highlights Sales for 2015 grew 4.7% or $36.5 million over 2014. Gross profit as a percent of net sales decreased 20 basis points, and SG&A increased 30 basis points. Our pre-tax income was $45.3 million, and excluding the $21.6 million pre-tax pension termination charge in 2014, decreased 3.4% or $1.6 million. Our fourth quarter results were pre-tax income of $15.1 million down 9.3% from $16.6 million over the prior year period excluding the pension charge. We made $27.1 million in important capital expenditure investments in our business and $14.0 million in purchases of treasury stock. Our debt is comprised completely of lease obligations. We did not use our credit facility during the year and our total debt to total capital was 15.0% at December 31, 2015. Management Objectives Management is focused on capturing more market share and increasing sales per square foot of showroom space. This organic growth will be driven by concentrating our efforts on our customers with improved interactions highlighted by new products, enhanced stores and better technology. The Company's strategies for profitability include targeted marketing initiatives, productivity and process improvements, and efficiency and cost-saving measures. Our focus is to serve our customers better and distinguish ourselves in the marketplace. Key Performance Indicators We evaluate our performance based on several key metrics which include net sales, comparable store sales, sales per square foot, gross profit, operating costs as a percentage of sales, cash flow, total debt to total capital, and earnings per share. The goal of utilizing these measurements is to provide tools in economic decision-making such as store growth, capital allocation and product pricing. We also employ metrics that are customer focused (customer satisfaction score, on-time-delivery and quality), and internal effectiveness and efficiency metrics (sales per employee, average sale per ticket, closing ratios per customer store visit, exceptions per deliveries, and lost time incident rate). These measurements aid us in determining areas of our operations that are in need of additional attention and in determining compensation. Operating Results The following table provides selected data for the periods indicated and reconciles the non-GAAP financial measures to their comparable GAAP measures. See the additional discussion contained in this Item 7 (in thousands, except per share data): Net Sales Comparable-store or "comp-store" sales is a measure which indicates the performance of our existing stores by comparing the growth in sales for these stores for a particular period over the corresponding period in the prior year. Stores are considered non-comparable if open for less than 12 full calendar months or if the selling square footage has been changed significantly during the past 12 full calendar months. Large clearance sales events from warehouses or temporary locations are also excluded from comparable store sales, as are periods when stores are closed or being remodeled. As a retailer, comp-store sales is an indicator of relative customer spending and store performance. Total sales increased $36.5 million or 4.7% in 2015 and $22.3 million or 3.0% in 2014. Comparable store sales increased 2.5% or $18.9 in 2015 and 3.6% or $26.2 million in 2014. The remaining $17.6 in 2015 and $3.9 million in 2014 of the changes were from closed, new and otherwise non-comparable stores. The following outlines our sales and comp-store sales increases and decreases for the periods indicated. (Amounts and percentages may not always add to totals due to rounding.) Sales in 2015 increased at a modest pace during the first nine months of the year. We did have some product availability issues during the first quarter resulting from the impact of the West Coast port slowdown. We experienced a softening in our business in the fourth quarter, more prevalent in Texas but also across many of our markets. Our average ticket increased 4.7% as our custom upholstery sales increased 11.8% over 2014 as more business involved a member of our in-home design team. Sales in 2014 were challenged by weather in the first quarter and case goods vendor supply and import flow issues through much of the remainder of the year. The store displays in this important category were not as robust as our merchandise team had planned and began to recover in the fourth quarter. Our improved custom order configurator web based tool helped our specialty upholstery sales to continue to grow with a 10.8% increase over 2013 including a 19.3% growth rate in the fourth quarter. We also expanded our in-home-design service in 2014 which has yielded higher average tickets. Sales in 2013 increased as the fundamental drivers of home furnishings purchases continued to recover. We capitalized on this trend with improved merchandising and expansion of our complimentary in-home design service. These generated an increase in our average ticket of 7.8% and a 19.8% increase in our custom order upholstery business. 2016 Outlook We believe as the general economy improves and consumer spending and the housing market strengthens, our business will benefit. Our comparable store sales will begin to anniversary the impact of new competition in the Dallas, Texas market in the second quarter. We have upgraded stores, offer appealing merchandise and expanded special order and service offerings which will be important drivers for our 2016 sales results. We expect to grow our retail square footage by 1.4% in 2016 with weighted average square footage increasing by 0.6%. Gross Profit Our cost of sales consist primarily of the purchase price of the merchandise together with inbound freight, handling within our distribution centers and transportation costs to the local markets we serve. Our gross profit is primarily dependent upon vendor pricing, the mix of products sold and promotional pricing activity. Substantially all of our occupancy and home delivery costs are included in selling, general and administrative expenses as is a portion of our warehousing expenses. Accordingly, our gross profit may not be comparable to those entities that include some of these expenses in cost of goods sold. Year-to-Year Comparisons Gross profit as a percentage of net sales was 53.5% in 2015 compared to 53.7% in 2014. We had a larger than normal number of new merchandise group introductions over the last quarter of 2014 and the first quarter of 2015. The closeout sales of the replaced products, quality issues from certain new products and the related increased reserves contributed to slightly lower margins in 2015. Gross profit as a percentage of net sales was 53.7% in 2014 compared to 53.8% in 2013. Our LIFO impact was $0.5 million greater in 2014 than in 2013 and during 2014 we had slightly lower delivery fee revenue and higher than normal clearance sale activity resulting from store and local warehouse closings. We recorded a $0.8 million positive out-of-period adjustment in the first quarter of 2013 for vendor pricing allowances. Excluding the impact of the out-of-period adjustment, gross profit was 53.7% in 2013. 2016 Outlook Our merchandising strategy will be similar to 2015 using promotional pricing selectively and focusing on product fashion and customer service. We expect that annual gross profit margins for 2016 will be approximately 53.5%, reflecting the impact of new products with slightly higher gross margins, increased competition and increased sales of markdown merchandise. Selling, General and Administrative Expenses SG&A expenses are comprised of five categories: selling; occupancy; delivery and certain warehousing costs; advertising and administrative. Selling expenses primarily are comprised of compensation of sales associates and sales support staff, and fees paid to credit card and third-party finance companies. Occupancy costs include rents, depreciation charges, insurance and property taxes, repairs and maintenance expense and utility costs. Delivery costs include personnel, fuel costs, and depreciation and rental charges for rolling stock. Warehouse costs include supplies, depreciation and rental charges for equipment. Advertising expenses are primarily media production and space, direct mail costs, market research expenses, employee compensation and agency fees. Administrative expenses are comprised of compensation costs for store personnel exclusive of sales associates, information systems, executive, accounting, merchandising, advertising, supply chain, real estate and human resource departments. We classify our SG&A expenses as either variable or fixed and discretionary. Our variable expenses include the costs in the selling and delivery categories and certain warehouse expenses as these amounts will generally move in tandem with our level of sales. The remaining categories and expenses are classified as fixed and discretionary because these costs do not fluctuate with sales. The following table outlines our SG&A expenses by classification: Year-to-Year Comparisons Our SG&A costs as a percent of sales increased 30 basis points to 47.8% for 2015 from 47.5% in 2014. The fixed and discretionary expenses increased $10.5 million or 4.5% in 2015 to $240.9 million from $230.5 million in 2014. This increase was driven by $4.7 million in additional administrative costs primarily from compensation expense, of which $1.4 million related to new stores. Our new locations and improvements generated a $4.2 million increase in depreciation and other occupancy costs in 2015 compared to 2014. Our variable expenses were higher as a percent of net sales in 2015 compared to 2014 primarily due to sales associates added in new locations and the expansion of our in-home design program. Our SG&A costs as a percent of sales increased 80 basis points to 47.5% for 2014 from 46.7% in 2013. The fixed and discretionary expenses of $230.5 million in 2014 were $6.7 million or 3% above the 2013 level primarily due to increases in spending on advertising of $2.6 million, depreciation and other occupancy costs of $1.8 million and greater communication and data expense of $2.2 million. Variable expense as a percent of sales for 2014 increased to 17.5% from 16.7% in 2013. Our selling costs as a percent of sales increased 47 basis points in 2014 over 2013 due in part to the expansion of our in-home design program. 2016 Outlook Fixed and discretionary type expenses within SG&A are expected to be approximately $251.0 million for 2016, up $10.1 million or 4.2% over those same costs in 2015. The increase is largely due to depreciation on capital expenditures, occupancy costs from new and relocated stores, staffing increases and inflation. First quarter 2016 advertising costs are expected to be higher than last year's quarter but comparatively flat for the remainder of 2016. Fixed and discretionary type expenses in total should average approximately $62.0 million per quarter in the first half of 2016 and $63.5 million per quarter in the second half. For 2015 these expenses averaged $58.2 million per quarter in the first half and $62.3 million in the second half. Variable costs within SG&A for 2016 are expected to remain at the 2015 rate of 17.9% as a percent of sales. Pension Settlement We terminated our qualified defined benefit pension plan (the "Plan") in 2014 as reported more fully in Note 10 to the Notes to Consolidated Financial Statements. The settlement of the Plan's obligations required the recognition of pension settlement expenses in the fourth quarter of 2014. We recognized termination and settlement expense of $21.6 million and a related tax benefit of $0.9 million for a total impact on consolidated net income of $20.7 million or $0.90 per diluted earnings per share. We had approximately $6.8 million of unamortized costs net of $4.2 million of tax related to the Plan included on our balance sheet in accumulated other comprehensive income (loss) ("AOCI") prior to settlement. Also included in AOCI was a debit of $6.9 million resulting from the 'backward-tracing" prohibition related to changes in a valuation allowance from previous periods. See additional discussion in "Provision for Income Taxes" which follows. The settlement of the Plan caused these amounts totaling $13.6 million to be reclassified from AOCI to income. The termination and settlement of the Plan did not impact cash flow and resulted in a net reduction of approximately $7.1 million in our total stockholders equity. Interest Expense Our interest expense for the years 2013 to 2015 is primarily driven by amounts related to our lease obligations. For leases accounted for as capital and financing lease obligations, we record straight-line rent expense for the land portion in occupancy costs in SG&A along with amortization on the additional asset recorded. Rental payments are recognized as a reduction of the obligations and as interest expense. The number of stores, including those under construction, which are accounted for in this manner has increased from eight in 2013, to 17 in 2015. We expect interest expense for lease obligations will be $2.4 million in 2016. Provision for Income Taxes Our effective tax rate was 38.6%, 66.0% and 38.5% for 2015, 2014 and 2013, respectively. Refer to Note 7 of the Notes to the Consolidated Financial Statements for a reconciliation of our income tax expense to the federal income tax rate. Our 2015 rate varies from the 35% U.S. federal statutory rate primarily due to state income taxes. Our 2014 rate includes the reversal of $6.9 million from AOCI to income tax expense. We established a valuation allowance in 2008 against virtually all of our deferred tax assets due to our operating loss in that year and projected loss in 2009. A portion of the allowance was charged to AOCI and was increased in 2009. Our profitability in 2011 was sufficient for us to release the valuation allowance. The "backward-tracing" prohibition in ASC 740, Income Taxes required us to record the total amount of the release as a tax benefit in net income including the portion originally charged to AOCI. This resulted in a debit of $6.9 million remaining in AOCI which would remain until the settlement of the Plan's pension obligations when it was reversed and included in total tax expense. The 2014 rate, excluding this reversal, varies from the 35% U.S federal statutory rate primarily due to state income taxes. Our 2013 rate varies from the 35% U.S. federal statutory rate primarily due to state income taxes. Liquidity and Capital Resources Overview of Liquidity Our primary cash requirements include working capital needs, contractual obligations, benefit plan contributions, income tax obligations and capital expenditures. We have funded these requirements exclusively through cash generated from operations and have not used our credit facility since 2008. We believe funds generated from our expected results of operations and available cash and cash equivalents will be sufficient to fund our primary obligations and complete projects that we have underway or currently contemplate for the next fiscal and foreseeable future years. At December 31, 2015, our cash and cash equivalents balance was $70.7 million, an increase of $5.2 million compared to December 31, 2014. This increase in cash primarily resulted from strong operating results offset by purchases of property and equipment, the acquisition of treasury stock and dividends paid to stockholders. Additional discussion of our cash flow results, including the comparison of 2015 activity to 2014, is set forth in the Analysis of Cash Flows section. At December 31, 2015, our outstanding indebtedness was $53.1 million in lease obligations required to be recorded on our balance sheet. We had no amounts outstanding and $43.8 million available under our revolving credit facility. Capital Expenditures Our primary capital requirements have been focused on our stores and the development of both proprietary and purchased information systems. Our capital expenditures were $27.1 million in 2015, $3.7 million less than in 2014. Our future capital requirements will depend in large part on the number of and timing for new stores we open within a given year, the investments we make to the improvement and maintenance of our existing stores, and our investment in distribution improvements and new information systems to support our key strategies. In 2016, we anticipate that our capital expenditures will be approximately $33.0 million, refer to our Store Expansion and Capital Expenditures discussion below. Analysis of Cash Flows The following table illustrates the main components of our cash flows (in thousands): Cash flows from operating activities. During 2015, net cash provided by operating activities was $52.2 million. Cash from net income, adjusted for depreciation and amortization and stock-based compensation expense was partially reduced by cash used for working capital. The primary components of the changes in working capital are listed below: · Increase in inventories of $2.3 million, mainly due to the increase in showrooms, reduced $0.5 million for the inventory in our Lubbock store that was destroyed. · Decrease in other current assets of $1.7 million, resulting from a $3.3 million decrease in receivables for tenant incentives, partially offset by a casualty claim of $1.3 million. · Decrease in other assets of $2.7 million mainly due to the maturities of certain certificates of deposit. · Increase in accounts payable of $3.7 million. · Decrease in customer deposits of $2.7 million as our business was down in the fourth quarter of 2015 versus the comparable period of 2014. During 2014, net cash provided by operating activities was $55.5 million. Cash from net income, adjusted for depreciation and amortization, pension settlement expense and stock-based compensation expense was partially reduced by cash used for working capital. The primary components of the changes in working capital are listed below: · Increase in inventories of $15.7 million, mainly due to the desire for a better stocking position and replenishment efforts in advance of Chinese New Year. · Increase in other current assets of $3.7 million, primarily from $3.3 million increase in receivables for tenant incentives. · Decrease in other assets of $5.8 million mainly due to the settlement of pension partly offset by the purchase of certain certificates of deposit. · Increase in accounts payable of $2.3 million. · Increase in customer deposits of $4.7 million. During 2013, net cash provided by operating activities was $55.9 million. Our cash provided by operating activities was mainly the result of pre-tax income generated during 2013. Cash from net income, adjusted for depreciation and amortization and stock-based compensation expense, along with cash provided by working capital, was partially reduced by pension plan contributions. Pension plan contributions in 2013 included a $4.2 million discretionary contribution made to improve the funded status of the plan and as part of our broader pension de-risking strategy. · Decrease in inventories of $5.4 million, mainly due to timing of sales and replenishment. · Decrease in other liabilities of $9.0 million, and increase in other assets of $9.9 million mainly due to the shift from a $6.8 million pension plan liability to a $9.4 million pension asset. · Decrease in accounts payable of $6.4 million. Cash flows used in investing activities. Net cash used in investing activities was $28.4 million, $41.4 million and $20.1 million for 2015, 2014 and 2013, respectively. In each of these years, the amounts of cash used in investing activities consisted principally of capital expenditures related to store construction and improvements and information technology projects, refer to our Store Expansion and Capital Expenditures discussion below. During 2015, in addition to the expenditures for new stores and major expansions and remodels of showrooms we purchased $10.0 million of commercial paper and $7.5 million of certificates of deposit matured. During 2014, in addition to the expenditures for new stores and one store's major expansion, we purchased $10.0 million in certificates of deposit. During 2013, we invested in our distribution system for future expansion and added capacity to our internal cloud architecture to support our sales systems and video communications. Cash flows used in financing activities. Net cash used in financing activities was $18.7 million for 2015, $31.8 million for 2014 and $6.1 million for 2013. During 2015 we purchased $14.0 million in treasury stock and paid $8.1 million in dividends. We also received $6.7 million in construction allowances. During 2014 we paid a special dividend of approximately $22.6 million. During 2013 the number of restricted shares vesting increased as the acceleration goals of certain grants were met. This increased the withholding taxes for vested shares and contributed to the tax benefit from stock-based plans. During 2015, 2014 and 2013, we did not make any draws on our revolving credit facility. Long-Term Debt In September 2011 Havertys entered into an Amended and Restated Credit Agreement (the "Credit Agreement") with a bank. Refer to Note 5 of the Notes to Consolidated Financial Statements for information about our Credit Agreement. Off-Balance Sheet Arrangements We do not generally enter into off-balance sheet arrangements. We did not have any relationships with unconsolidated entities or financial partnerships which would have been established for the purposes of facilitating off-balance sheet financial arrangements for any period during the three years ended December 31, 2015. Accordingly, we are not materially exposed to any financing, liquidity, market or credit risk that could arise if we had engaged in such relationships. Contractual Obligations The following summarizes our contractual obligations and commercial commitments as of December 31, 2015 (in thousands): (1) These amounts are for our lease obligations recorded in our consolidated balance sheets, including interest amounts. For additional information about our leases, refer to Note 8 of the Notes to the Consolidated Financial Statements. (2) The contractual obligations do not include any amounts related to retirement benefits. For additional information about our plans, refer to Note 10 of the Notes to the Consolidated Financial Statements. Store Expansion and Capital Expenditures We have entered new markets and made continued improvements and relocations of our store base. The following outlines the change in our selling square footage for each of the three years ended December 31 (square footage in thousands): We also had major remodeling projects in a Tampa, Florida store in 2015 and in our Knoxville, Tennessee store in 2014 which increased selling square footage. The following table summarizes our store activity in 2015 and plans for 2016. Our store in Lubbock, Texas sustained significant damage from a blizzard at the end of December 2015. We plan to operate in a temporary location during the rebuilding process. These plans and other changes should increase net selling space in 2016 by approximately 1.4% assuming the new stores open and existing store close as planned. Our investing activities in stores and operations in 2015, 2014 and 2013 and planned outlays for 2016 are categorized in the table below. Capital expenditures for stores in the years noted do not necessarily coincide with the years in which the stores open. Non-GAAP Financial Measures and Reconciliations - Adjusted Net Income and Adjusted Earnings We have included financial measures that are not prepared in accordance with GAAP. Any analysis of non-GAAP financial measures should be used only in conjunction with results presented in accordance with GAAP. The non-GAAP measures are not intended to be substitutes for GAAP financial measures and should not be used as such. We use the non-GAAP measures "EBIT," "adjusted EBIT," "adjusted net income" and "adjusted earnings per diluted share." Management believes these non-GAAP financial measures provide our board of directors, investors, potential investors, analysts and others with useful information to evaluate the performance of the Company because it excludes the impact of the pension settlement expense and another specific item that management believes are not indicative of the ongoing operating results of the business. The Company and our board of directors use this information to evaluate the Company's performance relative to other periods. We believe that the most directly comparable GAAP measures to EBIT, adjusted net income and adjusted diluted earnings per share are "Income before interest and income taxes," "Net income" and "Diluted earnings per share." Set forth above in our discussion of Operating Results are reconciliations of adjusted net income to net income and adjusted diluted earnings per share to diluted earnings per share. EBIT is equal to income before interest and income taxes and adjusted EBIT is reconciled to EBIT. Critical Accounting Estimates and Assumptions Our discussion and analysis is based upon our consolidated financial statements, which have been prepared in accordance with U.S. generally accepted accounting principles. The preparation of these financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses, and related disclosures. On an on-going basis, we evaluate our estimates, including those related to pension and retirement benefits and self-insurance. We base our estimates on historical experience and on various other assumptions that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions. An accounting policy is deemed to be critical if it requires an accounting estimate to be made based on assumptions about matters that are highly uncertain at the time the estimate is made, and if different estimates that reasonably could have been used or changes in the accounting estimate that are reasonably likely to occur could materially change the financial statements. We believe the following critical accounting policies reflect our more significant estimates and assumptions used in the preparation of our consolidated financial statements: Retirement benefits. Our supplemental executive retirement plan ("SERP") costs require the use of assumptions for discount rates, projected salary increases and mortality rates. Management is required to make certain critical estimates related to actuarial assumptions used to determine our expense and related obligation. We believe the most critical assumptions are related to (1) the discount rate used to determine the present value of the liabilities and (2) mortality rates. All of our actuarial assumptions are reviewed annually. Changes in these assumptions could have a material impact on the measurement of our SERP expense and related obligation. The SERP is not funded so we pay benefits directly to participants. The unfunded obligation increased by $0.4 million between December 31, 2014 and December 31, 2015. At each measurement date, we determine the discount rate by reference to rates of high quality, long-term corporate bonds that mature in a pattern similar to the future payments we anticipate making under the plan. The weighted-average discount rate used to compute our benefit obligation increased 49 basis points from 4.09% to 4.58% at December 31, 2014 and December 31, 2015, respectively. This reduced the SERP's benefit obligation by 6%. The SERP's mortality tables were updated to the white collar separate annuitant in 2015 which increased the benefit obligation by 4%. Census data changes, particularly those related to compensation, increased the benefit obligation by 6%. Refer to Note 10 to the Notes to Consolidated Financial Statements for additional information about our defined benefit pension plan which was terminated and settled in 2014 and other actuarial assumptions. Self-Insurance. We are self-insured for certain losses related to worker's compensation, general liability and vehicle claims for amounts up to a deductible per occurrence. Our reserve is developed based on historical claims data and contains an actuarially developed incurred but not reported component. The resulting estimate is discounted and recorded as a liability. Our actuarial assumptions and discount rates are reviewed periodically and compared with actual claims experience and external benchmarks to ensure appropriateness. A one-percentage-point change in the actuarial assumption for the discount rate would impact 2015 expense for insurance by approximately $90,000, a 1.39% change. We are primarily self-insured for employee group health care claims. We have purchased insurance coverage in order to establish certain limits to our exposure on both a per claim and aggregate basis. We record an accrual for the estimated amount of self-insured health care claims incurred by all participants but not yet reported (IBNR) using an actuarial method of applying a development factor to the reported monthly claims amounts. The Company's risk management and accounting management utilize a consistent methodology which involves various assumptions, judgment and other factors. The most significant factors which impact the determination of a required accrual are the historical pattern of the timeliness of claims processing, any changes in the nature or types of benefit plans, changes in the plan benefit designs, and medical trends and inflation. Historical experience is continually monitored, and accruals are adjusted when warranted by changes in facts and circumstances. The Company believes that the total health care cost accruals are reasonable and adequate to cover future payments on incurred claims.

<s>[INST] Industry The retail residential furniture industry's results are influenced by new and existing housing sales, consumer confidence, spending on large ticket items, interest rates and availability of credit and the overall strength of the economy. The industry experienced a rebound in 2012 as its drivers have improved. These factors remain tempered by continued high levels of unemployment, lower home values, and reduced access to credit, all of which provide impediments to industry growth. Our Business We sell home furnishings in our retail stores and via our website and record revenue when the products are delivered to our customer. Our products are selected to appeal to a middle to uppermiddle income consumer across a variety of styles. Our commissioned sales associates receive a high level of product training and are provided a number of tools with which to serve our customers. We also have over 100 inhome designers serving most of our stores. These individuals work with our sales associates to provide customers additional confidence and inspiration. We do not outsource the delivery function, something common in the industry, but instead ensure that the "last contact" is handled by a customeroriented Havertys delivery team. We are recognized as a provider of high quality fashionable products and service in the markets we serve. 2015 Highlights Sales for 2015 grew 4.7% or $36.5 million over 2014. Gross profit as a percent of net sales decreased 20 basis points, and SG&A increased 30 basis points. Our pretax income was $45.3 million, and excluding the $21.6 million pretax pension termination charge in 2014, decreased 3.4% or $1.6 million. Our fourth quarter results were pretax income of $15.1 million down 9.3% from $16.6 million over the prior year period excluding the pension charge. We made $27.1 million in important capital expenditure investments in our business and $14.0 million in purchases of treasury stock. Our debt is comprised completely of lease obligations. We did not use our credit facility during the year and our total debt to total capital was 15.0% at December 31, 2015. Management Objectives Management is focused on capturing more market share and increasing sales per square foot of showroom space. This organic growth will be driven by concentrating our efforts on our customers with improved interactions highlighted by new products, enhanced stores and better technology. The Company's strategies for profitability include targeted marketing initiatives, productivity and process improvements, and efficiency and costsaving measures. Our focus is to serve our customers better and distinguish ourselves in the marketplace. Key Performance Indicators We evaluate our performance based on several key metrics which include net sales, comparable store sales, sales per square foot, gross profit, operating costs as a percentage of sales, cash flow, total debt to total capital, and earnings per share. The goal of utilizing these measurements is to provide tools in economic decisionmaking such as store growth, capital allocation and product pricing. We also employ metrics that are customer focused (customer satisfaction score, ontimedelivery and quality), and internal effectiveness and efficiency metrics (sales per employee, average sale per ticket, closing ratios per customer store visit, exceptions per deliveries, and lost time incident rate). These measurements aid us in determining areas of our operations that are in need of additional attention and in determining compensation. Operating Results The following table provides selected data for the periods indicated and reconciles the nonGAAP financial measures to their comparable GAAP measures. See the additional discussion contained in this Item 7 (in thousands, except per share data): Net Sales Comparablestore or "compstore" sales is a measure which indicates the performance of our existing stores by comparing the growth in sales for these stores for a particular period over the corresponding period in the prior year. Stores are considered noncomparable if open for less than 12 full calendar months or if the selling square footage has been changed significantly during the past 12 full calendar months. Large clearance sales events from warehouses or temporary locations are also excluded from comparable store sales, as are periods when stores are closed or being remodeled. As a retailer, compstore sales is an indicator of relative customer spending and store performance. Total sales increased $36.5 million or 4.7% in 2015 and $ [/INST] Negative. </s>

HAVERTY FURNITURE COMPANIES INC

2017-03-03

2016-12-31

ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Overview Industry The retail residential furniture industry's results are influenced by the overall strength of the economy, new and existing housing sales, consumer confidence, spending on large ticket items, interest rates, and availability of credit. These factors remain tempered by rising consumer debt, home inventory constraints, and tight access to home mortgage credit, all of which provide impediments to industry growth. Our Business We sell home furnishings in our retail stores and via our website and record revenue when the products are delivered to our customer. Our products are selected to appeal to a middle to upper-middle income consumer across a variety of styles. Our commissioned sales associates receive a high level of product training and are provided a number of tools with which to serve our customers. We also have over 100 in-home designers serving most of our stores. These individuals work with our sales associates to provide customers additional confidence and inspiration. We do not outsource the delivery function, something common in the industry, but instead ensure that the "last contact" is handled by a customer-oriented Havertys delivery team. We are recognized as a provider of high quality fashionable products and service in the markets we serve. 2016 Highlights Sales for 2016 grew 2.1% or $16.7 million over 2015. Gross profit as a percent of net sales increased 50 basis points, and SG&A increased 80 basis points. Our pre-tax income was $45.8 million, an increase of 1.2% or $0.5 million. Our fourth quarter results were pre-tax income of $17.3 million up 14.9% from $15.1 million in the prior year period. We made $29.8 million in important capital expenditure investments in our business, $21.3 million in purchases of treasury stock, and paid $30.4 million in dividends. Management Objectives Management is focused on capturing more market share and increasing sales per square foot of showroom space. This organic growth will be driven by concentrating our efforts on our customers with improved interactions highlighted by new products, services, enhanced stores and better technology. The Company's strategies for profitability include targeted marketing initiatives, productivity and process improvements, and efficiency and cost-saving measures. Our focus is to serve our customers better and distinguish ourselves in the marketplace. Key Performance Indicators We evaluate our performance based on several key metrics which include net sales, comparable store sales, sales per square foot, gross profit, operating costs as a percentage of sales, cash flow, total debt to total capital, and earnings per share. The goal of utilizing these measurements is to provide tools in economic decision-making such as store growth, capital allocation and product pricing. We also employ metrics that are customer focused (customer satisfaction score, on-time-delivery and quality), and internal effectiveness and efficiency metrics (sales per employee, average sale per ticket, closing ratios per customer store visit, inventory out-of-stock, exceptions per deliveries, and lost time incident rate). These measurements aid us in determining areas of our operations that are in need of additional attention but are not evaluated in isolation from others, so as not to conflict with our company goals. Operating Results The following table provides selected data for the periods indicated and reconciles the non-GAAP financial measures to their comparable GAAP measures. See the additional discussion contained in this Item 7 (in thousands, except per share data): Net Sales Comparable-store or "comp-store" sales is a measure which indicates the performance of our existing stores by comparing the growth in sales for these stores for a particular period over the corresponding period in the prior year. Stores are considered non-comparable if open for less than 12 full calendar months or if the selling square footage has been changed significantly during the past 12 full calendar months. Large clearance sales events from warehouses or temporary locations are also excluded from comparable store sales, as are periods when stores are closed or being remodeled. As a retailer, comp-store sales is an indicator of relative customer spending and store performance. Total sales increased $16.7 million or 2.1% in 2016 and $36.5 million or 4.7% in 2015. Comparable store sales increased 2.1% or $16.2 million in 2016 and 2.5% or $18.9 million in 2015. The remaining $0.5 million in 2016 and $17.6 million in 2015 of the changes were from closed, new and otherwise non-comparable stores. The following outlines our sales and comp-store sales increases and decreases for the periods indicated. (Amounts and percentages may not always add to totals due to rounding.) Sales in 2016 began slowly as first quarter consumer spending remained at its sluggish end of 2015 pace. Throughout 2016 our business became more concentrated around holidays and we adjusted our advertising cadence accordingly. Our average ticket increased 2.3% and our in-home designers were part of 19.7% of our sales. Sales in 2015 increased at a modest pace during the first nine months of the year. We did have some product availability issues during the first quarter resulting from the impact of the West Coast port slowdown. We experienced a softening in our business in the fourth quarter, more prevalent in Texas but also across many of our markets. Our average ticket increased 4.7% as our custom upholstery sales increased 11.8% over 2014 as more business involved a member of our in-home design team. Sales in 2014 were challenged by weather in the first quarter and case goods vendor supply and import flow issues through much of the remainder of the year. The store displays in this important category were not as robust as our merchandise team had planned and began to recover in the fourth quarter. Our improved custom order configurator web based tool helped our specialty upholstery sales to continue to grow with a 10.8% increase over 2013 including a 19.3% growth rate in the fourth quarter. We also expanded our in-home-design service in 2014 which has yielded higher average tickets. 2017 Outlook We believe as the general economy improves and consumer spending and the housing market strengthens, our business will benefit. We have upgraded stores, offer appealing merchandise and expanded special order and service offerings which will be important drivers for our 2017 sales results. We expect our retail square footage will remain relatively flat in 2017. Gross Profit Our cost of goods sold consists primarily of the purchase price of the merchandise together with inbound freight, handling within our distribution centers and transportation costs to the local markets we serve. Our gross profit is primarily dependent upon vendor pricing, the mix of products sold and promotional pricing activity. Substantially all of our occupancy and home delivery costs are included in selling, general and administrative expenses as is a portion of our warehousing expenses. Accordingly, our gross profit may not be comparable to those entities that include some of these expenses in cost of goods sold. Year-to-Year Comparisons Gross profit as a percentage of net sales was 54.0% in 2016 compared to 53.5% in 2015. We use the LIFO inventory valuation method and the impact of changes in the LIFO reserve generated a $1.9 million or 23 basis points positive impact in 2016 over 2015. Our execution on product mix and pricing yielded the rest of the total improvement. Our Havertys branded merchandise provides a strong value and fashion statement to consumers. The increasing sales generated by our in-home designers have boosted higher margin mix opportunities through custom upholstery and accessories sales. Gross profit as a percentage of net sales was 53.5% in 2015 compared to 53.7% in 2014. We had a larger than normal number of new merchandise group introductions over the last quarter of 2014 and the first quarter of 2015. The closeout sales of the replaced products, quality issues from certain new products and the related increased reserves contributed to slightly lower margins in 2015. 2017 Outlook Our expectations for 2017 are for annual gross profit margins of approximately 53.6%. This reduction is based on anticipated changes to product and transportation costs, a negative impact from LIFO, and increased sales of markdown merchandise. We do not plan to increase the level of our promotional pricing. Selling, General and Administrative Expenses SG&A expenses are comprised of five categories: selling, occupancy, delivery and certain warehousing costs, advertising, and administrative. Selling expenses primarily are comprised of compensation of sales associates and sales support staff, and fees paid to credit card and third-party finance companies. Occupancy costs include rents, depreciation charges, insurance and property taxes, repairs and maintenance expense and utility costs. Delivery costs include personnel, fuel costs, and depreciation and rental charges for rolling stock. Warehouse costs include supplies, depreciation, and rental charges for equipment. Advertising expenses are primarily media production and space, direct mail costs, market research expenses and agency fees. Administrative expenses are comprised of compensation costs for store personnel exclusive of sales associates, information systems, executive, accounting, merchandising, advertising, supply chain, real estate and human resource departments. We classify our SG&A expenses as either variable or fixed and discretionary. Our variable expenses include the costs in the selling and delivery categories and certain warehouse expenses as these amounts will generally move in tandem with our level of sales. The remaining categories and expenses are classified as fixed and discretionary because these costs do not fluctuate with sales. The following table outlines our SG&A expenses by classification: Year-to-Year Comparisons Our SG&A costs as a percent of sales increased 80 basis points to 48.6% from 47.8% in 2015. The fixed and discretionary expenses increased $9.0 million or 3.7% in 2016 over 2015. This change was primarily due to a $6.5 million rise in administrative costs driven by increases in medical insurance and compensation expense. Our depreciation expense increased $3.3 million offset partly by a reduction of $1.3 million in all other occupancy costs. Our variable expenses increased 30 basis points as our in-home design business grew and due to slightly higher delivery costs. Our SG&A costs as a percent of sales increased 30 basis points to 47.8% for 2015 from 47.5% in 2014. The fixed and discretionary expenses increased $10.5 million or 4.5% in 2015 to $240.9 million from $230.5 million in 2014. This increase was driven by $4.7 million in additional administrative costs primarily from compensation expense, of which $1.4 million related to new stores. Our new locations and improvements generated a $4.2 million increase in depreciation and other occupancy costs in 2015 compared to 2014. Our variable expenses were higher as a percent of net sales in 2015 compared to 2014 primarily due to sales associates added in new locations and the expansion of our in-home design program. 2017 Outlook Fixed and discretionary type expenses within SG&A are expected to be in the $260.0 to $261.0 million range for 2017, up approximately 4.0% over those same costs in 2016. The increase is largely due to an expanded advertising budget, higher occupancy costs from new and relocated stores, staffing increases and inflation. Fixed and discretionary type expenses in total should average approximately $64.0 million per quarter in the first half of 2017 and $66.0 million per quarter in the second half. For 2016 these expenses averaged $61.2 million per quarter in the first half and $63.7 million in the second half. Variable costs within SG&A for 2017 are expected to be 18.1% as a percent of sales, somewhat higher in the first half and lower in the second half due to efficiencies from the typical higher volume in the third and fourth quarters. Pension Settlement We terminated our qualified defined benefit pension plan (the "Plan") in 2014 as reported more fully in Note 10 to the Notes to Consolidated Financial Statements. The settlement of the Plan's obligations required the recognition of pension settlement expenses in the fourth quarter of 2014. We recognized termination and settlement expense of $21.6 million and a related tax benefit of $0.9 million for a total impact on consolidated net income of $20.7 million or $0.90 per diluted earnings per share. We had approximately $6.8 million of unamortized costs net of $4.2 million of tax related to the Plan included on our balance sheet in accumulated other comprehensive income (loss) ("AOCI") prior to settlement. Also included in AOCI was a debit of $6.9 million resulting from the 'backward-tracing" prohibition related to changes in a valuation allowance from previous periods. See additional discussion in "Provision for Income Taxes" which follows. The settlement of the Plan caused these amounts totaling $13.6 million to be reclassified from AOCI to income. The termination and settlement of the Plan did not impact cash flow and resulted in a net reduction of approximately $7.1 million in our total stockholders' equity. Interest Expense Our interest expense for the years 2014 to 2016 is primarily driven by amounts related to our lease obligations. For leases accounted for as capital and financing lease obligations, we record straight-line rent expense for the land portion in occupancy costs in SG&A along with amortization on the additional asset recorded. Rental payments are recognized as a reduction of the obligations and as interest expense. The number of stores, including those under construction, which are accounted for in this manner has increased from 16 in 2014 to 18 in 2016. We expect interest expense for lease obligations will be $2.3 million in 2017. Provision for Income Taxes Our effective tax rate was 38.1%, 38.6% and 66.0% for 2016, 2015 and 2014, respectively. Refer to Note 7 of the Notes to the Consolidated Financial Statements for a reconciliation of our income tax expense to the federal income tax rate. Our 2016 and 2015 rate varies from the 35% U.S. federal statutory rate primarily due to state income taxes. Our 2014 rate includes the reversal of $6.9 million from AOCI to income tax expense. We established a valuation allowance in 2008 against virtually all of our deferred tax assets due to our operating loss in that year and projected loss in 2009. A portion of the allowance was charged to AOCI and was increased in 2009. Our profitability in 2011 was sufficient for us to release the valuation allowance. The "backward-tracing" prohibition in ASC 740, Income Taxes required us to record the total amount of the release as a tax benefit in net income including the portion originally charged to AOCI. This resulted in a debit of $6.9 million remaining in AOCI which would remain until the settlement of the Plan's pension obligations when it was reversed and included in total tax expense. The 2014 rate, excluding this reversal, varies from the 35% U.S federal statutory rate primarily due to state income taxes. Liquidity and Capital Resources Overview of Liquidity Our primary cash requirements include working capital needs, contractual obligations, benefit plan contributions, income tax obligations and capital expenditures. We have funded these requirements exclusively through cash generated from operations and have not used our credit facility since 2008. We believe funds generated from our expected results of operations and available cash and cash equivalents will be sufficient to fund our primary obligations and complete projects that we have underway or currently contemplate for the next fiscal and foreseeable future years. At December 31, 2016, our cash and cash equivalents balance was $63.5 million, a decrease of $7.2 million compared to December 31, 2015. This change in cash primarily resulted from strong operating results offset by purchases of property and equipment, the acquisition of treasury stock and dividends paid to stockholders. Additional discussion of our cash flow results, including the comparison of 2016 activity to 2015, is set forth in the Analysis of Cash Flows section. At December 31, 2016, our outstanding indebtedness was $55.5 million in lease obligations required to be recorded on our balance sheet. We had no amounts outstanding and $53.4 million available under our revolving credit facility. Capital Expenditures Our primary capital requirements have been focused on our stores and the development of both proprietary and purchased information systems. Our capital expenditures were $29.8 million in 2016, $2.7 million more than in 2015. Our future capital requirements will depend in large part on the number of and timing for new stores we open within a given year, the investments we make to the improvement and maintenance of our existing stores, and our investment in distribution improvements and new information systems to support our key strategies. In 2017, we anticipate that our capital expenditures will be approximately $26.9 million, refer to our Store Expansion and Capital Expenditures discussion below. Analysis of Cash Flows The following table illustrates the main components of our cash flows (in thousands): Cash flows from operating activities. During 2016, net cash provided by operating activities was $60.1 million. The primary components of the changes in operating assets and liabilities are listed below: · Decrease in inventories of $6.9 million as we operated with leaner quantities in our distribution centers. · Increase in other assets of $2.5 million, resulting from increased prepaid maintenance contracts and assets held under a non-qualified deferred compensation plan. · Increase in prepaid expenses of $2.7 million primarily from the timing of the payment of payroll taxes and computer maintenance agreements. · Decrease in accounts payable of $2.2 million. · Increase in customer deposits of $3.9 million. During 2015, net cash provided by operating activities was $52.2 million. The primary components of the changes in operating assets and liabilities are listed below: · Increase in inventories of $2.3 million, mainly due to the increase in showrooms, reduced $0.5 million for the inventory in our Lubbock store that was destroyed. · Decrease in other current assets of $1.7 million, resulting from a $3.3 million decrease in receivables for tenant incentives, partially offset by a casualty claim of $1.3 million. · Decrease in other assets of $2.7 million mainly due to the maturities of certain certificates of deposit. · Increase in accounts payable of $3.7 million. · Decrease in customer deposits of $2.7 million as our business was down in the fourth quarter of 2015 versus the comparable period of 2014. During 2014, net cash provided by operating activities was $55.5 million. The primary components of the changes in operating assets and liabilities are listed below: · Increase in inventories of $15.7 million, mainly due to the desire for a better stocking position and replenishment efforts in advance of Chinese New Year. · Increase in other current assets of $3.7 million, primarily from $3.3 million increase in receivables for tenant incentives. · Decrease in other assets of $5.8 million mainly due to the settlement of pension partly offset by the purchase of certain certificates of deposit. · Increase in accounts payable of $2.3 million. · Increase in customer deposits of $4.7 million. Cash flows used in investing activities. Net cash used in investing activities was $13.2 million, $28.4 million, and $41.4 million for 2016, 2015 and 2014, respectively. In each of these years, the amounts of cash used in investing activities consisted principally of capital expenditures related to store construction and improvements and information technology projects, refer to our Store Expansion and Capital Expenditures discussion below. During 2016, partly offsetting the expenditures for new stores and the expansion of the Florida distribution center we had $12.7 million of investments which matured and received $3.0 million in insurance proceeds for the destroyed Lubbock store. During 2015, in addition to the expenditures for new stores and major expansions and remodels of showrooms we purchased $10.0 million of commercial paper and $7.5 million of certificates of deposit matured. During 2014, in addition to the expenditures for new stores and one store's major expansion, we purchased $10.0 million in certificates of deposit. Cash flows used in financing activities. Net cash used in financing activities was $54.0 million for 2016, $18.7 million for 2015 and $31.8 million for 2014. During 2016 we purchased $21.3 million in treasury stock, paid $9.4 million in dividends, and paid $21.0 million as a special dividend. During 2015 we purchased $14.0 million in treasury stock and paid $8.1 million in dividends. We also received $6.7 million in construction allowances. During 2014 we paid a special dividend of approximately $22.6 million. During 2016, 2015 and 2014, we did not make any draws on our revolving credit facility. Long-Term Debt In September 2015 Havertys entered into an Amended and Restated Credit Agreement (the "Credit Agreement") with a bank. Refer to Note 5 of the Notes to Consolidated Financial Statements for information about our Credit Agreement. Off-Balance Sheet Arrangements We have not entered into agreements which meet the SEC's definition of an off-balance sheet arrangement other than operating leases and have made no financial commitments to or guarantees with respect to any unconsolidated entities or financial partnerships or special purpose entities. Contractual Obligations The following summarizes our contractual obligations and commercial commitments as of December 31, 2016 (in thousands): (1) These amounts are for our lease obligations recorded in our consolidated balance sheets, including interest amounts. For additional information about our leases, refer to Note 8 of the Notes to the Consolidated Financial Statements. (2) The contractual obligations do not include any amounts related to retirement benefits. For additional information about our plans, refer to Note 10 of the Notes to the Consolidated Financial Statements. Store Expansion and Capital Expenditures We have entered new markets and made continued improvements and relocations of our store base. The following outlines the change in our selling square footage for each of the three years ended December 31 (square footage in thousands): We also had major remodeling projects in a Tampa, Florida store in 2015 and in our Knoxville, Tennessee store in 2014 which increased selling square footage. The following table summarizes our store activity in 2016 and plans for 2017. Our store in Lubbock, Texas sustained significant damage from a blizzard at the end of December 2015. We are operating in a temporary location during the rebuilding process. For additional information about the gain associated with this event, refer to Note 1, Other Income, of the Notes to the Consolidated Financial Statements. These plans and other changes should increase net selling space in 2017 by approximately 0.3% assuming the new stores open and existing stores close as planned. Our investing activities in stores and operations in 2016, 2015 and 2014 and planned outlays for 2017 are categorized in the table below. Capital expenditures for stores in the years noted do not necessarily coincide with the years in which the stores open. Non-GAAP Financial Measures and Reconciliations - Adjusted Net Income and Adjusted Earnings We have included financial measures that are not prepared in accordance with GAAP. Any analysis of non-GAAP financial measures should be used only in conjunction with results presented in accordance with GAAP. The non-GAAP measures are not intended to be substitutes for GAAP financial measures and should not be used as such. We use the non-GAAP measures "EBIT," "adjusted EBIT," "adjusted net income" and "adjusted earnings per diluted share." Management believes these non-GAAP financial measures provide our board of directors, investors, potential investors, analysts and others with useful information to evaluate the performance of the Company because it excludes the impact of the pension settlement expense that management believes is not indicative of the ongoing operating results of the business. The Company and our board of directors use this information to evaluate the Company's performance relative to other periods. We believe that the most directly comparable GAAP measures to EBIT, adjusted net income and adjusted diluted earnings per share are "Income before interest and income taxes," "Net income" and "Diluted earnings per share." Set forth above in our discussion of Operating Results are reconciliations of adjusted net income to net income and adjusted diluted earnings per share to diluted earnings per share. EBIT is equal to income before interest and income taxes and adjusted EBIT is reconciled to EBIT. Critical Accounting Estimates and Assumptions Our discussion and analysis is based upon our consolidated financial statements, which have been prepared in accordance with U.S. generally accepted accounting principles. The preparation of these financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses, and related disclosures. On an on-going basis, we evaluate our estimates, including those related to retirement benefits and self-insurance. We base our estimates on historical experience and on various other assumptions that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions. An accounting policy is deemed to be critical if it requires an accounting estimate to be made based on assumptions about matters that are highly uncertain at the time the estimate is made, and if different estimates that reasonably could have been used or changes in the accounting estimate that are reasonably likely to occur could materially change the financial statements. We believe the following critical accounting policies reflect our more significant estimates and assumptions used in the preparation of our consolidated financial statements: Retirement benefits. Our supplemental executive retirement plan ("SERP") costs require the use of assumptions for discount rates, mortality rates, and prior to its freezing, projected salary increases. Management is required to make certain critical estimates related to actuarial assumptions used to determine our expense and related obligation. We believe the most critical assumptions are related to (1) the discount rate used to determine the present value of the liabilities and (2) mortality rates. All of our actuarial assumptions are reviewed annually. Changes in these assumptions could have a material impact on the measurement of our SERP expense and related obligation. The SERP is not funded so we pay benefits directly to participants. The unfunded obligation decreased by $45,000 between December 31, 2015 and December 31, 2016. At each measurement date, we determine the discount rate by reference to rates of high quality, long-term corporate bonds that mature in a pattern similar to the future payments we anticipate making under the plan. The weighted-average discount rate used to compute our benefit obligation decreased 28 basis points to 4.30% from 4.58% at December 31, 2016 and December 31, 2015, respectively. This increased the SERP's benefit obligation by 4%. The SERP's mortality tables were updated which decreased the benefit obligation by 2%. Census data changes reduced the benefit obligation by 2%. Refer to Note 10 to the Notes to Consolidated Financial Statements for additional information about our defined benefit pension plan which was terminated and settled in 2014 and other actuarial assumptions. Self-Insurance. We are self-insured for certain losses related to worker's compensation, general liability and vehicle claims for amounts up to a deductible per occurrence. Our reserve is developed based on historical claims data and contains an actuarially developed incurred but not reported component. The resulting estimate is discounted and recorded as a liability. Our actuarial assumptions and discount rates are reviewed periodically and compared with actual claims experience and external benchmarks to ensure appropriateness. A one-percentage-point change in the actuarial assumption for the discount rate would impact 2016 expense for insurance by approximately $91,000, a 1.4% change. We are primarily self-insured for employee group health care claims. We have purchased insurance coverage in order to establish certain limits to our exposure on a per claim basis. We record an accrual for the estimated amount of self-insured health care claims incurred by all participants but not yet reported (IBNR) using an actuarial method of applying a development factor to the reported monthly claims amounts. The Company's risk management and accounting management utilize a consistent methodology which involves various assumptions, judgment and other factors. The most significant factors which impact the determination of a required accrual are the historical pattern of the timeliness of claims processing, any changes in the nature or types of benefit plans, changes in the plan benefit designs, and medical trends and inflation. Historical experience is continually monitored, and accruals are adjusted when warranted by changes in facts and circumstances. The Company believes that the total health care cost accruals are reasonable and adequate to cover future payments on incurred claims.

<s>[INST] Industry The retail residential furniture industry's results are influenced by the overall strength of the economy, new and existing housing sales, consumer confidence, spending on large ticket items, interest rates, and availability of credit. These factors remain tempered by rising consumer debt, home inventory constraints, and tight access to home mortgage credit, all of which provide impediments to industry growth. Our Business We sell home furnishings in our retail stores and via our website and record revenue when the products are delivered to our customer. Our products are selected to appeal to a middle to uppermiddle income consumer across a variety of styles. Our commissioned sales associates receive a high level of product training and are provided a number of tools with which to serve our customers. We also have over 100 inhome designers serving most of our stores. These individuals work with our sales associates to provide customers additional confidence and inspiration. We do not outsource the delivery function, something common in the industry, but instead ensure that the "last contact" is handled by a customeroriented Havertys delivery team. We are recognized as a provider of high quality fashionable products and service in the markets we serve. 2016 Highlights Sales for 2016 grew 2.1% or $16.7 million over 2015. Gross profit as a percent of net sales increased 50 basis points, and SG&A increased 80 basis points. Our pretax income was $45.8 million, an increase of 1.2% or $0.5 million. Our fourth quarter results were pretax income of $17.3 million up 14.9% from $15.1 million in the prior year period. We made $29.8 million in important capital expenditure investments in our business, $21.3 million in purchases of treasury stock, and paid $30.4 million in dividends. Management Objectives Management is focused on capturing more market share and increasing sales per square foot of showroom space. This organic growth will be driven by concentrating our efforts on our customers with improved interactions highlighted by new products, services, enhanced stores and better technology. The Company's strategies for profitability include targeted marketing initiatives, productivity and process improvements, and efficiency and costsaving measures. Our focus is to serve our customers better and distinguish ourselves in the marketplace. Key Performance Indicators We evaluate our performance based on several key metrics which include net sales, comparable store sales, sales per square foot, gross profit, operating costs as a percentage of sales, cash flow, total debt to total capital, and earnings per share. The goal of utilizing these measurements is to provide tools in economic decisionmaking such as store growth, capital allocation and product pricing. We also employ metrics that are customer focused (customer satisfaction score, ontimedelivery and quality), and internal effectiveness and efficiency metrics (sales per employee, average sale per ticket, closing ratios per customer store visit, inventory outofstock, exceptions per deliveries, and lost time incident rate). These measurements aid us in determining areas of our operations that are in need of additional attention but are not evaluated in isolation from others, so as not to conflict with our company goals. Operating Results The following table provides selected data for the periods indicated and reconciles the nonGAAP financial measures to their comparable GAAP measures. See the additional discussion contained in this Item 7 (in thousands, except per share data): Net Sales Comparablestore or "compstore" sales is a measure which indicates the performance of our existing stores by comparing the growth in sales for these stores for a particular period over the corresponding period in the prior year. Stores are considered noncomparable if open for less than 12 full calendar months or if the selling square footage has been changed significantly during the past 12 full calendar months. Large clearance sales events from warehouses or temporary locations are also excluded from comparable store sales, as are periods when stores are closed or being remodeled. As a retailer, compstore sales is an indicator of relative customer spending and store performance. Total sales increased $16.7 million or 2.1% in 2016 and $36.5 million or 4.7% in 2015. Comparable store sales increased 2.1% or $16.2 million in 2016 and 2.5% or $18.9 million in 2015. [/INST] Negative. </s>

HAVERTY FURNITURE COMPANIES INC

2018-03-02

2017-12-31

ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Overview Industry The retail residential furniture industry's results are influenced by the overall strength of the economy, new and existing housing sales, consumer confidence, spending on large ticket items, interest rates, and availability of credit. These factors remain tempered by rising consumer debt, home inventory constraints, and tight access to home mortgage credit, all of which provide impediments to industry growth. Our Business We sell home furnishings in our retail stores and via our website and record revenue when the products are delivered to our customer. Our products are selected to appeal to a middle to upper-middle income consumer across a variety of styles. Our commissioned sales associates receive a high level of product training and are provided a number of tools with which to serve our customers. We also have over 100 in-home designers serving most of our stores. These individuals work with our sales associates to provide customers additional confidence and inspiration in their furniture purchase journey. We do not outsource the delivery function, something common in the industry, but instead ensure that the "last contact" is handled by a customer-oriented Havertys delivery team. We are recognized as a provider of high quality fashionable products and exceptional service in the markets we serve. 2017 Highlights Sales were slightly lower in 2017 than in 2016, falling 0.2% or $1.7 million. Our average ticket increased 2% but store traffic was down mid-single digits. Gross profit as a percent of net sales increased 30 basis points in spite of a negative 33 basis points impact from LIFO. SG&A costs increased less than 1% but with less leverage increased 50 basis points as a percent of sales. Our pre-tax income was $43.2 million, a decrease of 5.7% or $2.6 million. Our fourth quarter results were pre-tax income of $14.1 million down from $17.3 million in the prior year period. We made $24.5 million in important capital expenditure investments in our business and paid $11.4 million in dividends in 2017. Management Objectives Management is focused on capturing more market share and increasing sales per square foot of showroom space. This organic growth will be driven by concentrating our efforts on our customers with improved interactions highlighted by new products, services, enhanced stores and better technology. The Company's strategies for profitability include targeted marketing initiatives, productivity and process improvements, and efficiency and cost-saving measures. Our focus is to serve our customers better and distinguish ourselves in the marketplace. Key Performance Indicators We evaluate our performance based on several key metrics which include net sales, comparable store sales, sales per square foot, gross profit, operating costs as a percentage of sales, EBITDA, cash flow, total debt to total capital, and earnings per share. The goal of utilizing these measurements is to provide tools in economic decision-making such as store growth, capital allocation and product pricing. We also employ metrics that are customer focused (customer satisfaction score, on-time-delivery and quality), and internal effectiveness and efficiency metrics (sales per employee, average sale per ticket, closing ratios per customer store visit, inventory out-of-stock, exceptions per deliveries, and lost time incident rate). These measurements aid us in determining areas of our operations that are in need of additional attention but are not evaluated in isolation from others, so as not to conflict with our company goals. Net Sales Comparable-store or "comp-store" sales is a measure which indicates the performance of our existing stores by comparing the growth in sales for these stores for a particular period over the corresponding period in the prior year. Stores are considered non-comparable if open for less than 12 full calendar months or if the selling square footage has been changed significantly during the past 12 full calendar months. Large clearance sales events from warehouses or temporary locations are also excluded from comparable store sales, as are periods when stores are closed or being remodeled. As a retailer, comp-store sales is an indicator of relative customer spending and store performance. Total sales decreased $1.7 million or 0.2% in 2017 and increased $16.7 million or 2.1% in 2016. Comparable store sales decreased 1.3% or $10.9 million in 2017 and increased 2.1% or $16.2 million in 2016. The remaining $9.2 million in 2017 and $0.5 million in 2016 of the changes were from closed, new and otherwise non-comparable stores. The following outlines our sales and comp-store sales increases and decreases for the periods indicated. (Amounts and percentages may not always add to totals due to rounding.) Sales in 2017 declined slightly as the level of our store traffic weakened throughout the year. Our average ticket increased 2.1% allowing our sales results to not moderate at the same pace as traffic. Our in-home designers were part of 20.6% of our sales, with their average ticket twice the overall average. Sales in 2016 began slowly as first quarter consumer spending remained at its sluggish end of 2015 pace. Throughout 2016 our business became more concentrated around holidays and we adjusted our advertising cadence accordingly. Our average ticket increased 2.3% and our in-home designers were part of 19.7% of our sales. Sales in 2015 increased at a modest pace during the first nine months of the year. We did have some product availability issues during the first quarter resulting from the impact of the West Coast port slowdown. We experienced a softening in our business in the fourth quarter, more prevalent in Texas but also across many of our markets. Our average ticket increased 4.7% as our custom upholstery sales increased 11.8% over 2014 as more business involved a member of our in-home design team. 2018 Outlook We believe as the general economy improves and consumer spending and the housing market strengthens, our business will benefit. We have upgraded stores, offer appealing merchandise and expanded special order and service offerings which will be important drivers for our 2018 sales results. We expect our retail square footage will remain relatively flat in 2018. Gross Profit Our cost of goods sold consists primarily of the purchase price of the merchandise together with inbound freight, handling within our distribution centers and transportation costs to the local markets we serve. Our gross profit is primarily dependent upon vendor pricing, the mix of products sold and promotional pricing activity. Substantially all of our occupancy and home delivery costs are included in selling, general and administrative expenses as is a portion of our warehousing expenses. Accordingly, our gross profit may not be comparable to those entities that include some of these expenses in cost of goods sold. Year-to-Year Comparisons Gross profit as a percentage of net sales was 54.3% in 2017 compared to 54.0% in 2016. We use the LIFO inventory valuation method and the impact of changes in the LIFO reserve generated a $2.7 million or 33 basis points negative impact in 2017 over 2016. Our execution on product mix and pricing was able to offset this impact and deliver an overall improvement of 63 basis points. Our Havertys branded merchandise provides a strong value and fashion statement to consumers. The increasing sales generated by our in-home designers have boosted higher margin mix opportunities through custom upholstery and accessories sales. Gross profit as a percentage of net sales was 54.0% in 2016 compared to 53.5% in 2015. The use of the LIFO method generated a $1.9 million or 23 basis points positive impact in 2016 over 2015. 2018 Outlook Our expectations for 2018 are for annual gross profit margins of approximately 54.7%. This increase is based on anticipated changes to our product mix and lower markdowns. We do not plan to increase the level of our promotional pricing. Selling, General and Administrative Expenses SG&A expenses are comprised of five categories: selling, occupancy, delivery and certain warehousing costs, advertising, and administrative. Selling expenses primarily are comprised of compensation of sales associates and sales support staff, and fees paid to credit card and third-party finance companies. Occupancy costs include rents, depreciation charges, insurance and property taxes, repairs and maintenance expense and utility costs. Delivery costs include personnel, fuel costs, and depreciation and rental charges for rolling stock. Warehouse costs include supplies, depreciation, and rental charges for equipment. Advertising expenses are primarily media production and space, direct mail costs, market research expenses and agency fees. Administrative expenses are comprised of compensation costs for store personnel exclusive of sales associates, information systems, executive, accounting, merchandising, advertising, supply chain, real estate and human resource departments. We classify our SG&A expenses as either variable or fixed and discretionary. Our variable expenses include the costs in the selling and delivery categories and certain warehouse expenses as these amounts will generally move in tandem with our level of sales. The remaining categories and expenses are classified as fixed and discretionary because these costs do not fluctuate with sales. The following table outlines our SG&A expenses by classification: Year-to-Year Comparisons Our SG&A as a percent of sales increased 50 basis points to 49.1% from 48.6% in 2016. The fixed and discretionary expenses increased $3.3 million or 1.3% in 2017 over 2016. This change was primarily due to increases in advertising and marketing expenses of $2.9 million and higher depreciation, rent, and other occupancy costs totaling $3.7 million. These increases were partly offset by $3.0 million in lower administrative costs driven by lower medical costs. Our variable expenses increased slightly due to continued growth generated by our in-home designers and increases in delivery costs. Our SG&A costs as a percent of sales increased 80 basis points to 48.6% from 47.8% in 2015. The fixed and discretionary expenses increased $9.0 million or 3.7% in 2016 over 2015. This change was primarily due to a $6.5 million rise in administrative costs driven by increases in medical insurance and compensation expense. Our depreciation expense increased $3.3 million offset partly by a reduction of $1.3 million in all other occupancy costs. Our variable expenses increased 30 basis points as our in-home design business grew and due to slightly higher delivery costs. 2018 Outlook Fixed and discretionary type expenses within SG&A are expected to be in the $258 to $260 million range for 2018, up approximately 2.3% over those same costs in 2017. The increase is largely due to increased marketing expenses, higher occupancy costs from new and relocated stores, increases in employee group medical costs, higher employee compensation and benefits expense, and inflation. Fixed and discretionary type expenses in total should average approximately $65.3 million per quarter excluding the second quarter which is expected to be $2.0 million lower. For 2017 these expenses averaged $64.0 million per quarter in all but the second quarter which was $60.9 million. Variable costs within SG&A for 2018 are expected to be 18.5% as a percent of sales, somewhat higher than in 2017 due to increases in personnel costs. Interest Expense Our interest expense for the years 2015 to 2017 is primarily driven by amounts related to our lease obligations. For leases accounted for as capital and financing lease obligations, we record straight-line rent expense for the land portion in occupancy costs in SG&A along with amortization on the additional asset recorded. Rental payments are recognized as a reduction of the obligations and as interest expense. The number of stores, including those under construction, which are accounted for in this manner has increased from 17 in 2015 to 19 in 2017. We expect interest expense for lease obligations will be $2.3 million in 2018. Provision for Income Taxes The Tax Cuts and Jobs Act (the "Tax Act") was signed into law on December 22, 2017. The Tax Act significantly revises the U.S. corporate income tax by lowering the statutory corporate tax rate from 35% to 21%. It also eliminates certain deductions and enhances and extends through 2026 the option to claim accelerated depreciation deductions on qualified property. We have not completed our determination of the accounting implications of the Tax Act. However, we have reasonably estimated the effects of the Tax Act and recorded provisional amounts in our financial statements as of December 31, 2017 of approximately $10.6 million. This amount is primarily comprised of the determination and remeasurement of net deferred tax assets related to depreciation. As we complete our analysis of the Tax Act, collect and prepare necessary data, and interpret any additional guidance issued by the IRS, U.S. Treasury Department, and other standard-setting bodies, we may make adjustments to the provisional amounts. We also recognized a tax benefit of $4.7 million for the re-measurement of deferred tax assets and liabilities for which our accounting is complete. The total of these adjustments was additional deferred tax expense of $5.9 million and is what we believe is the impact of the Tax Act. Our effective tax rate was 51.2% in 2017, 38.1% in 2016, and 38.6% in 2015. The 2016 and 2015 rate varies from the 35% U.S. federal statutory rate primarily due to state income taxes. The 2017 rate is impacted by the negative effect of $5.9 million for the Tax Act. Liquidity and Capital Resources Overview of Liquidity Our primary cash requirements include working capital needs, contractual obligations, benefit plan contributions, income tax obligations and capital expenditures. We have funded these requirements exclusively through cash generated from operations and have not used our credit facility since 2008. We believe funds generated from our expected results of operations and available cash and cash equivalents will be sufficient to fund our primary obligations and complete projects that we have underway or currently contemplate for the next fiscal and foreseeable future years. At December 31, 2017, our cash and cash equivalents balance was $79.5 million, an increase of $16.0 million compared to December 31, 2016. This change in cash primarily resulted from strong operating results offset by purchases of property and equipment and dividends paid to stockholders. Additional discussion of our cash flow results, including the comparison of 2017 activity to 2016, is set forth in the Analysis of Cash Flows section. At December 31, 2017, our outstanding indebtedness was $54.6 million in lease obligations required to be recorded on our balance sheet. We had no amounts outstanding and $47.4 million available under our revolving credit facility. Capital Expenditures Our primary capital requirements have been focused on our stores, distribution centers, and the development of both proprietary and purchased information systems. We have successfully concluded our store remodeling program and in 2017 we completed the expansion of our Florida Distribution Center and began a similar project in our Western Distribution Center. Our capital expenditures were $24.5 million in 2017, $5.4 million less than in 2016. Our future capital requirements will depend in large part on the number of and timing for new stores we open within a given year, the investments we make for the maintenance of our existing stores, and our investment in new information systems to support our key strategies. In 2018, we anticipate that our capital expenditures will be approximately $20.0 million, refer to our Store Expansion and Capital Expenditures discussion below. Analysis of Cash Flows The following table illustrates the main components of our cash flows (in thousands): Cash flows from operating activities. During 2017, net cash provided by operating activities was $52.5 million. The primary components of the changes in operating assets and liabilities are listed below: · Increase in inventories of $2.1 million as we increased stocking levels in the distribution centers in advance of Chinese New Year when suppliers are closed and added a new store. · Increase in prepaid expenses of $2.5 million primarily from the timing of the payment of taxes and computer maintenance agreements. · Increase in customer deposits of $2.9 million. · Decrease in accounts payable of $5.2 million. · Decrease in accrued liabilities of $4.3 million primarily from the timing of payments for compensation and real estate and property taxes. During 2016, net cash provided by operating activities was $60.1 million. The primary components of the changes in operating assets and liabilities are listed below: · Decrease in inventories of $6.9 million as we operated with leaner quantities in our distribution centers. · Increase in other assets of $2.5 million, resulting from increased prepaid maintenance contracts and assets held under a non-qualified deferred compensation plan. · Increase in prepaid expenses of $2.7 million primarily from the timing of the payment of payroll taxes and computer maintenance agreements. · Decrease in accounts payable of $2.2 million. · Increase in customer deposits of $3.9 million. During 2015, net cash provided by operating activities was $52.2 million. The primary components of the changes in operating assets and liabilities are listed below: · Increase in inventories of $2.3 million, mainly due to the increase in showrooms, reduced $0.5 million for the inventory in our Lubbock store that was destroyed. · Decrease in other current assets of $1.7 million, resulting from a $3.3 million decrease in receivables for tenant incentives, partially offset by a casualty claim of $1.3 million. · Decrease in other assets of $2.7 million mainly due to the maturities of certain certificates of deposit. · Increase in accounts payable of $3.7 million. · Decrease in customer deposits of $2.7 million as our business was down in the fourth quarter of 2015 versus the comparable period of 2014. Cash flows used in investing activities. Net cash used in investing activities was $21.6 million, $13.2 million and $28.4 million for 2017, 2016 and 2015, respectively. In each of these years, the amounts of cash used in investing activities consisted principally of capital expenditures related to store construction and improvements, distribution, and information technology projects, refer to our Store Expansion and Capital Expenditures discussion below. During 2017, we received approximately $2.0 million in insurance proceeds to offset costs of rebuilding and repairing two stores. During 2016, partly offsetting the expenditures for new stores and the expansion of the Florida distribution center we had $12.7 million of investments which matured and received $3.0 million in insurance proceeds for the destroyed Lubbock store. Cash flows used in financing activities. Net cash used in financing activities was $14.8 million for 2017, $54.0 million for 2016 and $18.7 million for 2015. During 2017 we paid $11.4 million in dividends. During 2016 we purchased $21.3 million in treasury stock, paid $9.4 million in dividends, and paid $21.0 million as a special dividend. During 2015 we purchased $14.0 million in treasury stock and paid $8.1 million in dividends. We also received $6.7 million in construction allowances. Long-Term Debt In March 2016 Havertys entered into an Amended and Restated Credit Agreement (the "Credit Agreement") with a bank. Refer to Note 5 of the Notes to Consolidated Financial Statements for information about our Credit Agreement. Off-Balance Sheet Arrangements We have not entered into agreements which meet the SEC's definition of an off-balance sheet arrangement other than operating leases and have made no financial commitments to or guarantees with respect to any unconsolidated entities or financial partnerships or special purpose entities. Contractual Obligations The following summarizes our contractual obligations and commercial commitments as of December 31, 2017 (in thousands): (1) These amounts are for our lease obligations recorded in our consolidated balance sheets, including interest amounts. For additional information about our leases, refer to Note 8 of the Notes to the Consolidated Financial Statements. (2) The contractual obligations do not include any amounts related to retirement benefits. For additional information about our plans, refer to Note 10 of the Notes to the Consolidated Financial Statements. Store Expansion and Capital Expenditures We have entered new markets and made continued improvements and relocations of our store base. The following outlines the change in our selling square footage for each of the three years ended December 31 (square footage in thousands): We also had major remodeling projects in a Tampa, Florida store in 2015. The following table summarizes our store activity in 2017 and plans for 2018. Our store in Lubbock, Texas sustained significant damage from a blizzard at the end of December 2015. We operated in a temporary location during the rebuilding process. For additional information about the gain associated with this event, refer to Note 1, Other Income, of the Notes to the Consolidated Financial Statements. These plans and other changes should decrease net selling space in 2018 by approximately 1.4% assuming the new stores open and existing stores close as planned. Our investing activities in stores and operations in 2017, 2016 and 2015 and planned outlays for 2018 are categorized in the table below. Capital expenditures for stores in the years noted do not necessarily coincide with the years in which the stores open. Critical Accounting Estimates and Assumptions Our discussion and analysis is based upon our consolidated financial statements, which have been prepared in accordance with U.S. generally accepted accounting principles. The preparation of these financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses, and related disclosures. On an on-going basis, we evaluate our estimates, including those related to self-insurance and income taxes. We base our estimates on historical experience and on various other assumptions that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions. An accounting policy is deemed to be critical if it requires an accounting estimate to be made based on assumptions about matters that are highly uncertain at the time the estimate is made, and if different estimates that reasonably could have been used or changes in the accounting estimate that are reasonably likely to occur could materially change the financial statements. We believe the following critical accounting policies reflect our more significant estimates and assumptions used in the preparation of our consolidated financial statements: Self-Insurance. We are self-insured for certain losses related to worker's compensation, general liability and vehicle claims for amounts up to a deductible per occurrence. Our reserve is developed based on historical claims data and contains an actuarially developed incurred but not reported component. The resulting estimate is discounted and recorded as a liability. Our actuarial assumptions and discount rates are reviewed periodically and compared with actual claims experience and external benchmarks to ensure appropriateness. A one-percentage-point change in the actuarial assumption for the discount rate would impact 2017 expense for insurance by approximately $85,000, a 1.1% change. We are primarily self-insured for employee group health care claims. We have purchased insurance coverage in order to establish certain limits to our exposure on a per claim basis. We record an accrual for the estimated amount of self-insured health care claims incurred by all participants but not yet reported (IBNR) using an actuarial method of applying a development factor to the reported monthly claims amounts. The Company's risk management and accounting management utilize a consistent methodology which involves various assumptions, judgment and other factors. The most significant factors which impact the determination of a required accrual are the historical pattern of the timeliness of claims processing, any changes in the nature or types of benefit plans, changes in the plan benefit designs, and medical trends and inflation. Historical experience is continually monitored, and accruals are adjusted when warranted by changes in facts and circumstances. The Company believes that the total health care cost accruals are reasonable and adequate to cover future payments on incurred claims. Income Taxes. The Tax Act was signed into law on December 22, 2017 and we are required to recognize the effect of the tax law changes in the period of enactment, such as remeasuring our deferred tax assets and liabilities. In December 2017, the Securities and Exchange Commission (SEC) staff issued Staff Accounting Bulletin No. 118, Income Tax Accounting Implications of the Tax Cuts and Jobs Act (SAB 118), which allows us to record provisional amounts during a measurement period not to extend beyond one year of the enactment date. Since the Tax Act was passed late in the fourth quarter of 2017, and ongoing guidance and accounting interpretation are expected over the next 12 months, we consider the accounting for certain deferred taxes and the related deferred tax re-measurements to be provisional due to the forthcoming guidance and our ongoing analysis of final year-end data and tax positions. We expect to complete our analysis within the measurement period in accordance with SAB 118. At December 31, 2017, we have made a reasonable estimate of the effects of the Tax Act on our existing deferred tax balances and recorded additional provisional tax expense of $10.6 million. This provisional amount is primarily related to depreciation deductions. We also recognized a tax benefit of $4.7 million for the remeasurement of deferred tax assets and liabilities for which our accounting is complete.

<s>[INST] Industry The retail residential furniture industry's results are influenced by the overall strength of the economy, new and existing housing sales, consumer confidence, spending on large ticket items, interest rates, and availability of credit. These factors remain tempered by rising consumer debt, home inventory constraints, and tight access to home mortgage credit, all of which provide impediments to industry growth. Our Business We sell home furnishings in our retail stores and via our website and record revenue when the products are delivered to our customer. Our products are selected to appeal to a middle to uppermiddle income consumer across a variety of styles. Our commissioned sales associates receive a high level of product training and are provided a number of tools with which to serve our customers. We also have over 100 inhome designers serving most of our stores. These individuals work with our sales associates to provide customers additional confidence and inspiration in their furniture purchase journey. We do not outsource the delivery function, something common in the industry, but instead ensure that the "last contact" is handled by a customeroriented Havertys delivery team. We are recognized as a provider of high quality fashionable products and exceptional service in the markets we serve. 2017 Highlights Sales were slightly lower in 2017 than in 2016, falling 0.2% or $1.7 million. Our average ticket increased 2% but store traffic was down midsingle digits. Gross profit as a percent of net sales increased 30 basis points in spite of a negative 33 basis points impact from LIFO. SG&A costs increased less than 1% but with less leverage increased 50 basis points as a percent of sales. Our pretax income was $43.2 million, a decrease of 5.7% or $2.6 million. Our fourth quarter results were pretax income of $14.1 million down from $17.3 million in the prior year period. We made $24.5 million in important capital expenditure investments in our business and paid $11.4 million in dividends in 2017. Management Objectives Management is focused on capturing more market share and increasing sales per square foot of showroom space. This organic growth will be driven by concentrating our efforts on our customers with improved interactions highlighted by new products, services, enhanced stores and better technology. The Company's strategies for profitability include targeted marketing initiatives, productivity and process improvements, and efficiency and costsaving measures. Our focus is to serve our customers better and distinguish ourselves in the marketplace. Key Performance Indicators We evaluate our performance based on several key metrics which include net sales, comparable store sales, sales per square foot, gross profit, operating costs as a percentage of sales, EBITDA, cash flow, total debt to total capital, and earnings per share. The goal of utilizing these measurements is to provide tools in economic decisionmaking such as store growth, capital allocation and product pricing. We also employ metrics that are customer focused (customer satisfaction score, ontimedelivery and quality), and internal effectiveness and efficiency metrics (sales per employee, average sale per ticket, closing ratios per customer store visit, inventory outofstock, exceptions per deliveries, and lost time incident rate). These measurements aid us in determining areas of our operations that are in need of additional attention but are not evaluated in isolation from others, so as not to conflict with our company goals. Net Sales Comparablestore or "compstore" sales is a measure which indicates the performance of our existing stores by comparing the growth in sales for these stores for a particular period over the corresponding period in the prior year. Stores are considered noncomparable if open for less than 12 full calendar months or if the selling square footage has been changed significantly during the past 12 full calendar months. Large clearance sales events from warehouses or temporary locations are also excluded from comparable store sales, as are periods when stores are closed or being remodeled. As a retailer, compstore sales is an indicator of relative customer spending and store performance. Total sales decreased $1.7 million or 0.2% in 2017 and increased $16.7 million or 2.1% in 2016. Comparable store sales decreased 1.3% or $10.9 million in 2017 and increased 2.1% or $16.2 million in 2016. The remaining $9 [/INST] Negative. </s>

HAVERTY FURNITURE COMPANIES INC

2019-03-04

2018-12-31

ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Overview Industry The retail residential furniture industry's results are influenced by the overall strength of the economy, new and existing housing sales, consumer confidence, spending on large ticket items, interest rates, and availability of credit. These factors remain tempered by rising consumer debt, home inventory constraints, and tight access to home mortgage credit, all of which provide impediments to industry growth. Our Business We sell home furnishings in our retail stores and via our website and record revenue when the products are delivered to our customer. Our products are selected to appeal to a middle to upper-middle income consumer across a variety of styles. Our commissioned sales associates receive a high level of product training and are provided a number of tools with which to serve our customers. We also have over 120 in-home designers serving most of our stores. These individuals work with our sales associates to provide customers additional confidence and inspiration in their furniture purchase journey. We do not outsource the delivery function, something common in the industry, but instead ensure that the “last contact” is handled by a customer-oriented Havertys delivery team. We are recognized as a provider of high-quality fashionable products and exceptional service in the markets we serve. Sales were slightly lower in 2018 than in 2017, falling 0.3% or $2.2 million. Our average ticket increased 4.4% but store traffic was down mid-single digits. Gross profit as a percent of net sales increased 30 basis points. SG&A costs increased less than 1% but with less leverage increased 40 basis points as a percent of sales. Our pre-tax income was $40.4 million, a decrease of 6.5% or $2.8 million. Our fourth quarter results were pre-tax income of $12.3 million, down from $14.1 million in the prior year period. We made $21.5 million in important capital expenditure investments in our business and returned $54.2 million to shareholders with $15.0 million in dividends, $20.5 million in special cash dividends, and $18.7 million in purchases of common stock. Management Objectives Management is focused on capturing more market share and increasing sales per square foot of showroom space. This organic growth will be driven by concentrating our efforts on our customers with improved interactions highlighted by new products, services, enhanced stores and better technology. The Company’s strategies for profitability include targeted marketing initiatives, productivity and process improvements, and efficiency and cost-saving measures. Our focus is to serve our customers better and distinguish ourselves in the marketplace. Key Performance Indicators We evaluate our performance based on several key metrics which include net sales, comparable store sales, sales per square foot, gross profit, operating costs as a percentage of sales, EBITDA, cash flow, total debt to total capital, and earnings per share. The goal of utilizing these measurements is to provide tools in economic decision-making such as store growth, capital allocation and product pricing. We also employ metrics that are customer focused (customer satisfaction score, on-time-delivery and quality), and internal effectiveness and efficiency metrics (sales per employee, average sale per ticket, closing ratios per customer store visit, inventory out-of-stock, exceptions per deliveries, and lost time incident rate). These measurements aid us in determining areas of our operations that are in need of additional attention but are not evaluated in isolation from others, so as not to conflict with our company goals. Net Sales Comparable-store or “comp-store” sales is a measure which indicates the performance of our existing stores and website by comparing the growth in sales in store and online for a particular period over the corresponding period in the prior year. Stores are considered non-comparable if open for less than 12 full calendar months or if the selling square footage has been changed significantly during the past 12 full calendar months. Large clearance sales events from warehouses or temporary locations are also excluded from comparable store sales, as are periods when stores are closed or being remodeled. As a retailer, comp-store sales is an indicator of relative customer spending and store performance. Total sales decreased $2.2 million or 0.3% in 2018 and $1.7 million or 0.2% in 2017. Comparable store sales, which includes online sales, increased 0.3% or $2.2 million in 2018 and decreased 1.3% or $10.9 million in 2017. The remaining $4.4 million in 2018 and $9.2 million in 2017 of the changes were from closed, new and otherwise non-comparable stores. The following outlines our sales and comp-store sales increases and decreases for the periods indicated. (Amounts and percentages may not always add to totals due to rounding.) Sales in 2018 declined for the year as business slowed markedly in the last half of the fourth quarter. Our revenues by category remained relatively consistent with prior years with increases in our accessories sales and delivery revenue. Our average ticket increased 4.4% to $2,184 which helped offset the decline in the number of transactions. Our in-home designers were part of 21.5% of our sales and their average ticket was $4,466. Sales in 2017 declined slightly as the level of our store traffic weakened throughout the year. Our average ticket increased 2.1% allowing our sales results to not moderate at the same pace as traffic. Our in-home designers were part of 20.6% of our sales, with their average ticket twice the overall average. Sales in 2016 began slowly as first quarter consumer spending remained at its sluggish end of 2015 pace. Throughout 2016 our business became more concentrated around holidays and we adjusted our advertising cadence accordingly. Our average ticket increased 2.3% and our in-home designers were part of 19.7% of our sales. 2019 Outlook We believe as the general economic outlook stabilizes, and consumer spending and the housing market strengthens, our business will benefit. We have an appealing online presence and upgraded stores, and we offer on-trend merchandise, knowledgeable salespeople, and expanded special order capabilities which will be important drivers for our 2019 sales results. We expect our retail square footage to increase 2.0% in the second half of 2019. Gross Profit Our cost of goods sold consists primarily of the purchase price of the merchandise together with inbound freight, handling within our distribution centers and transportation costs to the local markets we serve. Our gross profit is primarily dependent upon vendor pricing, the mix of products sold and promotional pricing activity. Substantially all of our occupancy and home delivery costs are included in selling, general and administrative expenses as is a portion of our warehousing expenses. Accordingly, our gross profit may not be comparable to those entities that include some of these expenses in cost of goods sold. Year-to-Year Comparisons Gross profit as a percentage of net sales was 54.6% in 2018 compared to 54.3% in 2017. This improvement was predominately driven by our execution on product mix and pricing. Our Havertys branded merchandise provides a strong value and fashion statement to consumers. The increasing sales generated by our in-home designers have boosted higher margin mix opportunities through custom upholstery and accessories sales. The imposition of tariffs of 10% on products imported in China began in late September. We raised the selling prices on some impacted products and worked with our suppliers to minimize cost increases. Gross profit as a percentage of net sales was 54.3% in 2017 compared to 54.0% in 2016. The use of the LIFO method generated a $2.7 million or 33 basis points positive impact in 2017 over 2016. 2019 Outlook Our expectations for 2019 are for annual gross profit margins of approximately 54.6%. This assumes no additional increases in tariffs for goods imported from China. We are shifting some product to other countries and have factored this into our 2019 gross profit margin expectations. The impact of a further increase in tariffs is difficult to quantify given the variables of product cost, replacement merchandise, and changing retail prices. We do not plan to increase the level of our promotional pricing. Selling, General and Administrative Expenses SG&A expenses are comprised of five categories: selling, occupancy, delivery and certain warehousing costs, advertising, and administrative. Selling expenses primarily are comprised of compensation of sales associates and sales support staff, and fees paid to credit card and third-party finance companies. Occupancy costs include rents, depreciation charges, insurance and property taxes, repairs and maintenance expense and utility costs. Delivery costs include personnel, fuel costs, and depreciation and rental charges for rolling stock. Warehouse costs include supplies, depreciation, and rental charges for equipment. Advertising expenses are primarily media production and space, direct mail costs, market research expenses and agency fees. Administrative expenses are comprised of compensation costs for store personnel exclusive of sales associates, information systems, executive, accounting, merchandising, advertising, supply chain, real estate and human resource departments. We classify our SG&A expenses as either variable or fixed and discretionary. Our variable expenses include the costs in the selling and delivery categories and certain warehouse expenses as these amounts will generally move in tandem with our level of sales. The remaining categories and expenses are classified as fixed and discretionary because these costs do not fluctuate with sales. The following table outlines our SG&A expenses by classification: Year-to-Year Comparisons Our SG&A as a percent of sales increased 40 basis points to 49.5% in 2018 from 49.1% in 2017. Our fixed and discretionary expenses increased $1.7 million or 0.7% in 2018 over 2017. This change was primarily due to increases in administrative costs of $1.5 million which included a $2.0 million increase in group medical expenses. We also had increases in our advertising and marketing expenses, warehouse costs and other occupancy costs totaling $1.4 million. These increases were partly offset by $0.7 million in lower depreciation expense and rent expense. Our variable expenses increased slightly due to higher transportation and delivery costs. Our SG&A costs as a percent of sales increased 50 basis points to 49.1% in 2017 from 48.6% in 2016. Our fixed and discretionary expenses increased $3.3 million or 1.3% in 2017 over 2016. This change was primarily due to increases in advertising and marketing expenses of $2.9 million and higher depreciation, rent, and other occupancy costs totaling $3.7 million. These increases were partly offset by $3.0 million in lower administrative costs driven by lower medical costs. Our variable expenses increased slightly due to continued growth generated by our in-home designers and increases in delivery costs. 2019 Outlook Fixed and discretionary type expenses within SG&A are expected to be in the $260.0 to $262.0 million range for 2019. Approximately $2.0 million of the increase is due to amounts previously charged to interest expense that will be classified as lease expense. This change is the result of the implementation on January 1, 2019 of the lease accounting standard update ASU 2016-02 (“ASU”). We also anticipate in 2019 higher occupancy costs from new and relocated stores, increases in employee group medical costs and increases from inflation. Fixed and discretionary type expenses in total should average approximately $66.0 million per quarter excluding the second quarter which is expected to be $3.0 million lower. For 2018 these expenses averaged $64.5 million per quarter in all but the second quarter which was $61.5 million. Variable costs within SG&A for 2019 are expected to be 18.2% as a percent of sales. Interest Expense Our interest expense for the years 2016 to 2018 is primarily driven by amounts related to our lease obligations. For leases accounted for as capital and financing lease obligations, we record straight-line rent expense for the land portion in occupancy costs in SG&A along with amortization on the additional asset recorded. Rental payments are recognized as a reduction of the obligations and as interest expense. Provision for Income Taxes The Tax Cuts and Jobs Act (the “Tax Act”) was signed into law on December 22, 2017. The Tax Act significantly revised the U.S. corporate income tax by lowering the statutory corporate tax rate from 35% to 21%. It also eliminated certain deductions and enhanced and extended through 2026 the option to claim accelerated depreciation deductions on qualified property. We estimated the effects of the Tax Act and recorded in our financial statements as of December 31, 2017 approximately $5.9 million in additional tax expense for the remeasurement of net deferred tax assets and liabilities. We completed our analysis in 2018 and no additional adjustments were made for the impact of the Tax Act. Our effective tax rate was 25.0% in 2018, 51.2% in 2017 and 38.1% in 2016. The 2018 and 2016 rate varies from the U.S. federal statutory rate primarily due to state income taxes. The 2017 rate is impacted by the negative effect of $5.9 million for the Tax Act. Liquidity and Capital Resources Overview of Liquidity Our primary cash requirements include working capital needs, contractual obligations, benefit plan contributions, income tax obligations and capital expenditures. We have funded these requirements exclusively through cash generated from operations and have not used our credit facility since 2008. We believe funds generated from our expected results of operations and available cash and cash equivalents will be sufficient to fund our primary obligations and complete projects that we have underway or currently contemplate for the next fiscal and foreseeable future years. At December 31, 2018, our cash, cash equivalents and restricted cash equivalents balance was $79.8 million, a decrease of $7.8 million compared to December 31, 2017. This change primarily resulted from strong operating results offset by purchases of property and equipment and dividends paid to stockholders, including a special dividend, and repurchases of common stock. Additional discussion of our cash flow results, including the comparison of 2018 activity to 2017, is set forth in the Analysis of Cash Flows section. At December 31, 2018, our outstanding indebtedness was $50.8 million in lease obligations required to be recorded on our balance sheet. We had no amounts outstanding and $51.5 million available under our revolving credit facility. Capital Expenditures Our primary capital requirements have been focused on our stores, distribution centers, and the development of both proprietary and purchased information systems. We have successfully concluded our store remodeling program and in 2018 we completed the expansion of our Western Distribution Center. Our capital expenditures were $21.5 million in 2018, $3.0 million less than 2017. Our future capital requirements will depend in large part on the number of and timing for new stores we open within a given year, the investments we make for the maintenance of our existing stores, and our investment in new information systems to support our key strategies. In 2019, we anticipate that our capital expenditures will be approximately $18.5 million, refer to our Store Expansion and Capital Expenditures discussion below. Analysis of Cash Flows The following table illustrates the main components of our cash flows (in thousands): Cash flows from operating activities. During 2018, net cash provided by operating activities was $70.4 million. The primary components of the changes in operating assets and liabilities are listed below: · Increase in inventories of $2.4 million as we increased stock in advance of Chinese New Year when suppliers are closed and before the imposition of tariffs on goods imported from China. · Decrease in prepaid expenses of $3.2 million primarily associated with income taxes. · Decrease in customer deposits of $3.3 million. · Increase in other liabilities of $3.8 million primarily due to receipt of incentives that will amortize over six years. During 2017, net cash provided by operating activities was $52.5 million. The primary components of the changes in operating assets and liabilities are listed below: · Increase in inventories of $2.1 million as we increased stocking levels in the distribution centers in advance of Chinese New Year and added a new store. · Increase in prepaid expenses of $2.5 million primarily from the timing of the payment of taxes and computer maintenance agreements. · Increase in customer deposits of $2.9 million. · Decrease in accounts payable of $5.2 million. · Decrease in accrued liabilities of $4.3 million primarily from the timing of payments for compensation and real estate and property taxes. During 2016, net cash provided by operating activities was $60.1 million. The primary components of the changes in operating assets and liabilities are listed below: · Decrease in inventories of $6.9 million as we operated with leaner quantities in our distribution centers. · Increase in other assets of $2.5 million, resulting from increased prepaid maintenance contracts and assets held under a non-qualified deferred compensation plan. · Increase in prepaid expenses of $2.7 million primarily from the timing of the payment of payroll taxes and computer maintenance agreements. · Decrease in accounts payable of $2.2 million. · Increase in customer deposits of $3.9 million. Cash flows used in investing activities. Net cash used in investing activities was $19.0 million, $21.5 million, and $13.2 million for 2018, 2017 and 2016, respectively. In each of these years, the amounts of cash used in investing activities consisted principally of capital expenditures related to store construction and improvements, distribution, and information technology projects, refer to our Store Expansion and Capital Expenditures discussion below. During 2018, we received $2.4 million in proceeds from sales of property and equipment. During 2017, we received approximately $2.0 million in insurance proceeds to offset costs of rebuilding and repairing two stores. During 2016, partly offsetting the expenditures for new stores and the expansion of the Florida distribution center we had $12.7 million of investments which matured and received $3.0 million in insurance proceeds for the destroyed Lubbock store. Cash flows used in financing activities. Net cash used in financing activities was $59.2 million for 2018, $14.8 million for 2017 and $54.0 million for 2016. During 2018, we purchased $18.7 million in treasury stock, paid $15.0 million in dividends, and paid $20.4 million as a special dividend. During 2017, we paid $11.4 million in dividends. During 2016, we purchased $21.3 million in treasury stock, paid $9.4 million in dividends, and paid $21.0 million as a special dividend. Long-Term Debt In March 2016 Havertys entered into an Amended and Restated Credit Agreement (the “Credit Agreement”) with a bank. Refer to Note 5, “Credit Arrangement” of the Notes to Consolidated Financial Statements for information about our Credit Agreement. Off-Balance Sheet Arrangements We have not entered into agreements which meet the SEC’s definition of an off-balance sheet arrangement other than operating leases and have made no financial commitments to or guarantees with respect to any unconsolidated entities or financial partnerships or special purpose entities. Contractual Obligations The following summarizes our contractual obligations and commercial commitments as of December 31, 2018 (in thousands): (1) These amounts are for our lease obligations recorded in our consolidated balance sheets, including interest amounts. For additional information about our leases, refer to Note 8, “Long-Term Debt and Lease Obligations” of the Notes to the Consolidated Financial Statements. (2) The contractual obligations do not include any amounts related to retirement benefits. For additional information about our plans, refer to Note 10, “Benefit Plans” of the Notes to the Consolidated Financial Statements. Store Expansion and Capital Expenditures We have entered new markets and made continued improvements and relocations of our store base. The following outlines the change in our selling square footage for each of the three years ended December 31 (square footage in thousands): The following table summarizes our store activity in 2018 and plans for 2019. These plans and other changes should increase net selling space in 2019 by approximately 2.0% assuming the new stores open and existing store closes as planned. Our investing activities in stores and operations in 2018, 2017 and 2016 and planned outlays for 2019 are categorized in the table below. Capital expenditures for stores in the years noted do not necessarily coincide with the years in which the stores open. Critical Accounting Estimates and Assumptions Our discussion and analysis is based upon our consolidated financial statements, which have been prepared in accordance with U.S. generally accepted accounting principles. The preparation of these financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses, and related disclosures. On an on-going basis, we evaluate our estimates, including those related to self-insurance and income taxes. We base our estimates on historical experience and on various other assumptions that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions. An accounting policy is deemed to be critical if it requires an accounting estimate to be made based on assumptions about matters that are highly uncertain at the time the estimate is made, and if different estimates that reasonably could have been used or changes in the accounting estimate that are reasonably likely to occur could materially change the financial statements. We believe the following critical accounting policy reflects our more significant estimates and assumptions used in the preparation of our consolidated financial statements: Self-Insurance. We are self-insured for certain losses related to worker’s compensation, general liability and vehicle claims for amounts up to a deductible per occurrence. Our reserve is developed based on historical claims data and contains an actuarially developed incurred but not reported component. The resulting estimate is discounted and recorded as a liability. Our actuarial assumptions and discount rates are reviewed periodically and compared with actual claims experience and external benchmarks to ensure appropriateness. A one-percentage-point change in the actuarial assumption for the discount rate would impact 2018 expense for insurance by approximately $80,000, a 1.1% change. We are primarily self-insured for employee group health care claims. We have purchased insurance coverage in order to establish certain limits to our exposure on a per claim basis. We record an accrual for the estimated amount of self-insured health care claims incurred by all participants but not yet reported (IBNR) using an actuarial method of applying a development factor to the reported monthly claims amounts. The Company's risk management and accounting management utilize a consistent methodology which involves various assumptions, judgment and other factors. The most significant factors which impact the determination of a required accrual are the historical pattern of the timeliness of claims processing, any changes in the nature or types of benefit plans, changes in the plan benefit designs, and medical trends and inflation. Historical experience is continually monitored, and accruals are adjusted when warranted by changes in facts and circumstances. The Company believes that the total health care cost accruals are reasonable and adequate to cover future payments on incurred claims.

<s>[INST] Industry The retail residential furniture industry's results are influenced by the overall strength of the economy, new and existing housing sales, consumer confidence, spending on large ticket items, interest rates, and availability of credit. These factors remain tempered by rising consumer debt, home inventory constraints, and tight access to home mortgage credit, all of which provide impediments to industry growth. Our Business We sell home furnishings in our retail stores and via our website and record revenue when the products are delivered to our customer. Our products are selected to appeal to a middle to uppermiddle income consumer across a variety of styles. Our commissioned sales associates receive a high level of product training and are provided a number of tools with which to serve our customers. We also have over 120 inhome designers serving most of our stores. These individuals work with our sales associates to provide customers additional confidence and inspiration in their furniture purchase journey. We do not outsource the delivery function, something common in the industry, but instead ensure that the “last contact” is handled by a customeroriented Havertys delivery team. We are recognized as a provider of highquality fashionable products and exceptional service in the markets we serve. Sales were slightly lower in 2018 than in 2017, falling 0.3% or $2.2 million. Our average ticket increased 4.4% but store traffic was down midsingle digits. Gross profit as a percent of net sales increased 30 basis points. SG&A costs increased less than 1% but with less leverage increased 40 basis points as a percent of sales. Our pretax income was $40.4 million, a decrease of 6.5% or $2.8 million. Our fourth quarter results were pretax income of $12.3 million, down from $14.1 million in the prior year period. We made $21.5 million in important capital expenditure investments in our business and returned $54.2 million to shareholders with $15.0 million in dividends, $20.5 million in special cash dividends, and $18.7 million in purchases of common stock. Management Objectives Management is focused on capturing more market share and increasing sales per square foot of showroom space. This organic growth will be driven by concentrating our efforts on our customers with improved interactions highlighted by new products, services, enhanced stores and better technology. The Company’s strategies for profitability include targeted marketing initiatives, productivity and process improvements, and efficiency and costsaving measures. Our focus is to serve our customers better and distinguish ourselves in the marketplace. Key Performance Indicators We evaluate our performance based on several key metrics which include net sales, comparable store sales, sales per square foot, gross profit, operating costs as a percentage of sales, EBITDA, cash flow, total debt to total capital, and earnings per share. The goal of utilizing these measurements is to provide tools in economic decisionmaking such as store growth, capital allocation and product pricing. We also employ metrics that are customer focused (customer satisfaction score, ontimedelivery and quality), and internal effectiveness and efficiency metrics (sales per employee, average sale per ticket, closing ratios per customer store visit, inventory outofstock, exceptions per deliveries, and lost time incident rate). These measurements aid us in determining areas of our operations that are in need of additional attention but are not evaluated in isolation from others, so as not to conflict with our company goals. Net Sales Comparablestore or “compstore” sales is a measure which indicates the performance of our existing stores and website by comparing the growth in sales in store and online for a particular period over the corresponding period in the prior year. Stores are considered noncomparable if open for less than 12 full calendar months or if the selling square footage has been changed significantly during the past 12 full calendar months. Large clearance sales events from warehouses or temporary locations are also excluded from comparable store sales, as are periods when stores are closed or being remodeled. As a retailer, compstore sales is an indicator of relative customer spending and store performance. Total sales decreased $2.2 million or 0.3% in 2018 and $1.7 million or 0.2% in 2017. Comparable store sales, which includes online sales, increased 0.3% or $2.2 million in 2018 and decreased 1. [/INST] Negative. </s>

HAVERTY FURNITURE COMPANIES INC

2020-03-05

2019-12-31

ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Overview Industry The retail residential furniture industry's results are influenced by the overall strength of the economy, new and existing housing sales, consumer confidence, spending on large ticket items, interest rates, and availability of credit. These factors remain tempered by rising consumer debt, home inventory constraints, and tight access to home mortgage credit, all of which provide impediments to industry growth. Our Business We sell home furnishings in our retail stores and via our website and record revenue when the products are delivered to our customer. Our products are selected to appeal to a middle to upper-middle income consumer across a variety of styles. Our commissioned sales associates receive a high level of product training and are provided a number of tools with which to serve our customers. We also have over 120 in-home designers serving most of our stores. These individuals work with our sales associates to provide customers additional confidence and inspiration in their furniture purchase journey. We do not outsource the delivery function, something common in the industry, but instead ensure that the “last contact” is handled by a customer-oriented Havertys delivery team. We are recognized as a provider of high-quality fashionable products and exceptional service in the markets we serve. Sales were slightly lower in 2019 than in 2018, falling 1.9% or $15.4 million. Our average ticket increased 6.4% but store traffic was down mid-single digits. Gross profit as a percent of net sales decreased 40 basis points to 54.2%. SG&A costs, excluding a $2.4 million impairment charge, were relatively flat but with less leverage increased 98 basis points as a percent of sales. Our pre-tax income was $28.7 million, a decrease of 29.0% or $11.7 million. Our fourth quarter results were pre-tax income of $7.6 million, down from $12.3 million in the prior year period. We made $16.8 million in important capital expenditure investments in our business and returned $44.8 million to shareholders with $15.0 million in dividends and $29.8 million in repurchases of common stock. Management Objectives Management is focused on capturing more market share and increasing sales per square foot of showroom space. This organic growth will be driven by concentrating our efforts on our customers with improved interactions highlighted by new products, services, enhanced stores and better technology. The Company’s strategies for profitability include targeted marketing initiatives, productivity and process improvements, and efficiency and cost-saving measures. Our focus is to serve our customers better and distinguish ourselves in the marketplace. Key Performance Indicators We evaluate our performance based on several key metrics which include net sales, comparable store sales, sales per square foot, gross profit, operating costs as a percentage of sales, EBITDA, cash flow, total debt to total capital, and earnings per share. The goal of utilizing these measurements is to provide tools in economic decision-making such as store growth, capital allocation and product pricing. We also employ metrics that are customer focused (customer satisfaction score, on-time-delivery and quality), and internal effectiveness and efficiency metrics (sales per employee, average sale per ticket, closing ratios per customer store visit, inventory out-of-stock, exceptions per deliveries, and lost time incident rate). These measurements aid us in determining areas of our operations that are in need of additional attention but are not evaluated in isolation from others, so as not to conflict with our company goals. Net Sales Comparable-store or “comp-store” sales is a measure which indicates the performance of our existing stores and website by comparing the growth in sales in store and online for a particular period over the corresponding period in the prior year. Stores are considered non-comparable if open for less than 12 full calendar months or if the selling square footage has been changed significantly during the past 12 full calendar months. Large clearance sales events from warehouses or temporary locations are also excluded from comparable store sales, as are periods when stores are closed or being remodeled. As a retailer, comp-store sales is an indicator of relative customer spending and store performance. Total sales decreased $15.4 million or 1.9% in 2019 and $2.2 million or 0.3% in 2018. Comparable store sales, which includes online sales, decreased 1.4% or $11.6 million in 2019 and increased 0.3% or $2.2 million in 2018. The remaining $3.8 million in 2019 and $4.4 million in 2018 of the changes were from closed, new and otherwise non-comparable stores. The following outlines our sales and comp-store sales increases and decreases for the periods indicated. (Amounts and percentages may not always add to totals due to rounding.) Sales in 2019 declined for the year due to severe supply-chain disruptions as we moved several product lines out of China due to the increased tariffs. Although these changes will not be fully resolved until the first quarter of 2020, we did see improvement late in the third quarter of 2019. Revenues by product category reflected the supply-chain disruption with a drop in case goods sales. Our mattress business saw an increase of 6.5% over 2018 due to customer purchases of new higher price point offerings. We offer a number of custom upholstery items and sales in this category rose 6.8% in 2019 over 2018. Our average ticket increased 6.4% to $2,323. The average ticket for our in-home designers was $4,666 and were part of 25.3% of our sales. Sales in 2018 declined for the year as business slowed markedly in the last half of the fourth quarter. Our revenues by category remained relatively consistent with prior years with increases in our accessories sales and delivery revenue. Our average ticket increased 4.4% to $2,184 which helped offset the decline in the number of transactions. Our in-home designers were part of 21.5% of our sales and their average ticket was $4,466. Sales in 2017 declined slightly as the level of our store traffic weakened throughout the year. Our average ticket increased 2.1% allowing our sales results to not moderate at the same pace as traffic. Our in-home designers were part of 20.6% of our sales, with their average ticket twice the overall average. 2020 Outlook We believe as the general economic outlook continues to improve, and consumer spending and the housing market strengthens, our business will benefit. We have an appealing online presence and upgraded stores, and we offer on-trend merchandise, knowledgeable salespeople, free in-home design service, and special order capabilities which will be important drivers for our 2020 sales results. We do not expect our retail square footage to increase in 2020. Gross Profit Our cost of goods sold consists primarily of the purchase price of the merchandise together with inbound freight, handling within our distribution centers and transportation costs to the local markets we serve. Our gross profit is primarily dependent upon vendor pricing, the mix of products sold and promotional pricing activity. Substantially all of our occupancy and home delivery costs are included in selling, general and administrative expenses as is a portion of our warehousing expenses. Accordingly, our gross profit may not be comparable to those entities that include some of these expenses in cost of goods sold. Year-to-Year Comparisons Gross profit as a percentage of net sales was 54.2% in 2019 compared to 54.6% in 2018. This decrease was driven by higher product and freight costs. Tariffs on products imported from China began in September 2018 and increased to 25% in March 2019. The use of the LIFO method generated a $1.8 million charge in 2019 versus $0.8 million in 2018. These negative impacts were partly offset by the increasing sales generated by our in-home designers. These sales generally have a higher margin driven by custom upholstery and accessories sales. Gross profit as a percentage of net sales was 54.6% in 2018 compared to 54.3% in 2017. This improvement was predominately driven by our execution on product mix and pricing. The imposition of tariffs of 10.0% on products imported from China began in late September 2018. We raised the selling prices on some impacted products and worked with our suppliers to minimize cost increases. 2020 Outlook Our expectations for 2020 are for annual gross profit margins of approximately 54.6%. This assumes no changes in tariffs for imported goods. Selling, General and Administrative Expenses SG&A expenses are comprised of five categories: selling, occupancy, delivery and certain warehousing costs, advertising, and administrative. Selling expenses primarily are comprised of compensation of sales associates and sales support staff, and fees paid to credit card and third-party finance companies. Occupancy costs include rents, depreciation charges, insurance and property taxes, repairs and maintenance expense and utility costs. Delivery costs include personnel, fuel costs, and depreciation and rental charges for rolling stock. Warehouse costs include supplies, depreciation, and rental charges for equipment. Advertising expenses are primarily media production and space, direct mail costs, market research expenses and agency fees. Administrative expenses are comprised of compensation costs for store personnel exclusive of sales associates, information systems, executive, accounting, merchandising, advertising, supply chain, real estate and human resource departments. We classify our SG&A expenses as either variable or fixed and discretionary. Our variable expenses include the costs in the selling and delivery categories and certain warehouse expenses as these amounts will generally move in tandem with our level of sales. The remaining categories and expenses are classified as fixed and discretionary because these costs do not fluctuate with sales. The following table outlines our SG&A expenses by classification: Year-to-Year Comparisons Our SG&A as a percent of sales increased 130 basis points to 50.8% in 2019 from 49.5% in 2018. Our fixed and discretionary expenses increased $5.2 million or 2.0% in 2019 over 2018. This change was primarily due to an impairment loss of $2.4 million for a retail store and increases in our advertising and marketing expenses of $1.5 million. Our administrative costs rose $1.4 million driven primarily by increases in benefit costs including group medical expenses partly offset by lower incentive compensation. Our variable expenses increased slightly as a percent of sales due to higher selling costs. Our SG&A costs as a percent of sales increased 40 basis points to 49.5% in 2018 from 49.1% in 2017. Our fixed and discretionary expenses increased $1.7 million or 0.7% in 2018 over 2017. This change was primarily due to increases in administrative costs of $1.5 million which included a $2.0 million increase in group medical expenses. We also had increases in our advertising and marketing expenses, warehouse costs and other occupancy costs totaling $1.4 million. These increases were partly offset by $0.7 million in lower depreciation expense and rent expense. Our variable expenses increased slightly due to higher transportation and delivery costs. 2020 Outlook Fixed and discretionary type expenses within SG&A are expected to be in the $265.0 to $267.0 million range for 2020. We anticipate higher advertising and marketing costs in 2020, increased compensation and incentive expense, and additional costs associated with new stores. Fixed and discretionary type expenses are expected to be at similar quarterly levels in 2020 as in 2019, as adjusted for the overall increases. Variable costs within SG&A for 2020 are expected to be between 18.4% and 18.6% as a percent of sales. Interest Expense Our interest expense for the years 2018 and 2017 is primarily driven by amounts related to our lease obligations. For leases accounted for as capital and financing lease obligations under prior lease guidance, we recorded straight-line rent expense for the land portion in occupancy costs in SG&A along with amortization on the additional asset recorded. Rental payments were recognized as a reduction of the obligations and as interest expense during 2017 and 2018. Refer to Note 1, “Description of Business and Summary of Significant Accounting Policies, Recently Adopted Accounting Pronouncements, Leases” of the Notes to Consolidated Financial Statements for information about the impact of the changes in lease accounting. Provision for Income Taxes The Tax Cuts and Jobs Act (the “Tax Act”) was signed into law on December 22, 2017. The Tax Act significantly revised the U.S. corporate income tax by lowering the statutory corporate tax rate from 35% to 21%. It also eliminated certain deductions and enhanced and extended through 2026 the option to claim accelerated depreciation deductions on qualified property. We estimated the effects of the Tax Act and recorded in our financial statements as of December 31, 2017 approximately $5.9 million in additional tax expense for the remeasurement of net deferred tax assets and liabilities. We completed our analysis in 2018 and no additional adjustments were made for the impact of the Tax Act. Our effective tax rate was 23.9% in 2019, 25.0% in 2018 and 51.2% in 2017. The 2019 and 2018 rates vary from the U.S. federal statutory rate primarily due to state income taxes. The 2017 rate is impacted by the negative effect of $5.9 million from the Tax Act. Liquidity and Capital Resources Overview of Liquidity Our primary cash requirements include working capital needs, contractual obligations, benefit plan contributions, income tax obligations and capital expenditures. We have funded these requirements exclusively through cash generated from operations and have not used our credit facility since 2008. We believe funds generated from our expected results of operations and available cash and cash equivalents will be sufficient to fund our primary obligations and complete projects that we have underway or currently contemplate for the next fiscal and foreseeable future years. At December 31, 2019, our cash, cash equivalents and restricted cash equivalents balance was $82.4 million, an increase of $2.6 million compared to December 31, 2018. This change primarily resulted from solid operating results offset by purchases of property and equipment and dividends paid to stockholders and repurchases of common stock. Additional discussion of our cash flow results, including the comparison of 2019 activity to 2018, is set forth in the Analysis of Cash Flows section. At December 31, 2019, we had no amounts outstanding and $54.3 million available under our revolving credit facility. Capital Expenditures Our primary capital requirements have been focused on our stores, distribution centers, and the development of both proprietary and purchased information systems. We have successfully concluded our store remodeling program and in 2018 we completed the expansion of our Western Distribution Center. Our capital expenditures were $16.8 million in 2019, $4.6 million less than in 2018. Our future capital requirements will depend in large part on the number of and timing for new stores we open within a given year, the investments we make for the maintenance of our existing stores, and our investment in new information systems to support our key strategies. In 2020, we anticipate that our capital expenditures will be approximately $17.0 million, refer to our Store Expansion and Capital Expenditures discussion below. Analysis of Cash Flows The following table illustrates the main components of our cash flows (in thousands): Cash flows from operating activities. During 2019, net cash provided by operating activities was $63.4 million. The primary components of the changes in operating assets and liabilities are listed below: • Decrease in inventories of $1.0 million as we returned operating inventory to a more normalized level. • Increase in customer deposits of $5.7 million. • Increase in accounts payable of $8.0 million • Decrease in other liabilities of $7.6 million primarily due to a transition adjustment of $9.5 million to comply with ASU 2016-02. During 2018, net cash provided by operating activities was $70.4 million. The primary components of the changes in operating assets and liabilities are listed below: • Increase in inventories of $2.4 million as we increased stock in advance of Chinese New Year when suppliers are closed and before the imposition of tariffs on goods imported from China. • Decrease in prepaid expenses of $3.2 million primarily associated with income taxes. • Decrease in customer deposits of $3.3 million. • Increase in other liabilities of $3.8 million primarily due to receipt of incentives that will amortize over six years. During 2017, net cash provided by operating activities was $52.5 million. The primary components of the changes in operating assets and liabilities are listed below: • Increase in inventories of $2.1 million as we increased stocking levels in the distribution centers in advance of Chinese New Year and added a new store. • Increase in prepaid expenses of $2.5 million primarily from the timing of the payment of taxes and computer maintenance agreements. • Increase in customer deposits of $2.9 million. • Decrease in accounts payable of $5.2 million. • Decrease in accrued liabilities of $4.3 million primarily from the timing of payments for compensation and real estate and property taxes. Cash flows used in investing activities. Net cash used in investing activities was $14.6 million, $19.0 million, and $21.5 million for 2019, 2018 and 2017, respectively. In each of these years, the amounts of cash used in investing activities consisted principally of capital expenditures related to store construction and improvements, distribution, and information technology projects, refer to our Store Expansion and Capital Expenditures discussion below. During 2019 and 2018, we received $2.3 million and $2.4 million, respectively, in proceeds from sales of property and equipment. During 2017, we received approximately $2.0 million in insurance proceeds to offset costs of rebuilding and repairing two stores. Cash flows used in financing activities. Net cash used in financing activities was $46.3 million for 2019, $59.2 million for 2018 and $14.8 million for 2017. During 2019, we spent $29.8 million for treasury stock purchases and paid $15.1 million in dividends. During 2018, we purchased $18.7 million in treasury stock, paid $15.0 million in dividends, and paid $20.4 million as a special dividend. During 2017, we paid $11.4 million in dividends. Long-Term Debt In September 2019, we entered into the Second Amendment to our Amended and Restated Credit Agreement (as amended, the “Credit Agreement”) with a bank. The Credit Agreement amends our credit facility to extend the maturity date to September 27, 2024 from March 31, 2021 and changes certain collateral reporting requirements. The Credit Agreement provides for a $60.0 million revolving credit facility. Refer to Note 6, “Credit Arrangement” of the Notes to Consolidated Financial Statements for information about our Credit Agreement. Off-Balance Sheet Arrangements We have not entered into agreements which meet the SEC’s definition of an off-balance sheet arrangement other than operating leases and have made no financial commitments to or guarantees with respect to any unconsolidated entities or financial partnerships or special purpose entities. Contractual Obligations The following summarizes our contractual obligations and commercial commitments as of December 31, 2019 (in thousands): (1) These amounts are for our undiscounted lease obligations recorded in our consolidated balance sheets, as lease liabilities. For additional information about our leases, refer to Note 9, “Leases” of the Notes to the Consolidated Financial Statements. (2) The contractual obligations do not include any amounts related to retirement benefits. For additional information about our plans, refer to Note 12, “Benefit Plans” of the Notes to the Consolidated Financial Statements Store Expansion and Capital Expenditures We have entered new markets and made continued improvements and relocations of our store base. The following outlines the change in our selling square footage for each of the three years ended December 31 (square footage in thousands): The following table summarizes our store activity in 2019 and plans for 2020. These plans and other changes should keep net selling space in 2020 the same as in 2019 assuming the new stores open and existing stores close as planned. Our investing activities in stores and operations in 2019, 2018 and 2017 and planned outlays for 2020 are categorized in the table below. Capital expenditures for stores in the years noted do not necessarily coincide with the years in which the stores open. Critical Accounting Estimates and Assumptions Our discussion and analysis is based upon our consolidated financial statements, which have been prepared in accordance with U.S. generally accepted accounting principles. The preparation of these financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses, and related disclosures. On an on-going basis, we evaluate our estimates, including those related to self-insurance. We base our estimates on historical experience and on various other assumptions that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions. An accounting policy is deemed to be critical if it requires an accounting estimate to be made based on assumptions about matters that are highly uncertain at the time the estimate is made, and if different estimates that reasonably could have been used or changes in the accounting estimate that are reasonably likely to occur could materially change the financial statements. We believe the following critical accounting policy reflects our more significant estimates and assumptions used in the preparation of our consolidated financial statements: Self-Insurance. We are self-insured for certain losses related to worker’s compensation, general liability and vehicle claims for amounts up to a deductible per occurrence. Our reserve is developed based on historical claims data and contains an actuarially developed incurred but not reported component. The resulting estimate is discounted and recorded as a liability. Our actuarial assumptions and discount rates are reviewed periodically and compared with actual claims experience and external benchmarks to ensure appropriateness. A one-percentage-point change in the actuarial assumption for the discount rate would impact 2019 expense for insurance by approximately $72,000, a 1.0% change. We are primarily self-insured for employee group health care claims. We have purchased insurance coverage in order to establish certain limits to our exposure on a per claim basis. We record an accrual for the estimated amount of self-insured health care claims incurred by all participants but not yet reported (IBNR) using an actuarial method of applying a development factor to the reported monthly claims amounts. The Company's risk management and accounting management utilize a consistent methodology which involves various assumptions, judgment and other factors. The most significant factors which impact the determination of a required accrual are the historical pattern of the timeliness of claims processing, any changes in the nature or types of benefit plans, changes in the plan benefit designs, and medical trends and inflation. Historical experience is continually monitored, and accruals are adjusted when warranted by changes in facts and circumstances. The Company believes that the total health care cost accruals are reasonable and adequate to cover future payments on incurred claims.

<s>[INST] Industry The retail residential furniture industry's results are influenced by the overall strength of the economy, new and existing housing sales, consumer confidence, spending on large ticket items, interest rates, and availability of credit. These factors remain tempered by rising consumer debt, home inventory constraints, and tight access to home mortgage credit, all of which provide impediments to industry growth. Our Business We sell home furnishings in our retail stores and via our website and record revenue when the products are delivered to our customer. Our products are selected to appeal to a middle to uppermiddle income consumer across a variety of styles. Our commissioned sales associates receive a high level of product training and are provided a number of tools with which to serve our customers. We also have over 120 inhome designers serving most of our stores. These individuals work with our sales associates to provide customers additional confidence and inspiration in their furniture purchase journey. We do not outsource the delivery function, something common in the industry, but instead ensure that the “last contact” is handled by a customeroriented Havertys delivery team. We are recognized as a provider of highquality fashionable products and exceptional service in the markets we serve. Sales were slightly lower in 2019 than in 2018, falling 1.9% or $15.4 million. Our average ticket increased 6.4% but store traffic was down midsingle digits. Gross profit as a percent of net sales decreased 40 basis points to 54.2%. SG&A costs, excluding a $2.4 million impairment charge, were relatively flat but with less leverage increased 98 basis points as a percent of sales. Our pretax income was $28.7 million, a decrease of 29.0% or $11.7 million. Our fourth quarter results were pretax income of $7.6 million, down from $12.3 million in the prior year period. We made $16.8 million in important capital expenditure investments in our business and returned $44.8 million to shareholders with $15.0 million in dividends and $29.8 million in repurchases of common stock. Management Objectives Management is focused on capturing more market share and increasing sales per square foot of showroom space. This organic growth will be driven by concentrating our efforts on our customers with improved interactions highlighted by new products, services, enhanced stores and better technology. The Company’s strategies for profitability include targeted marketing initiatives, productivity and process improvements, and efficiency and costsaving measures. Our focus is to serve our customers better and distinguish ourselves in the marketplace. Key Performance Indicators We evaluate our performance based on several key metrics which include net sales, comparable store sales, sales per square foot, gross profit, operating costs as a percentage of sales, EBITDA, cash flow, total debt to total capital, and earnings per share. The goal of utilizing these measurements is to provide tools in economic decisionmaking such as store growth, capital allocation and product pricing. We also employ metrics that are customer focused (customer satisfaction score, ontimedelivery and quality), and internal effectiveness and efficiency metrics (sales per employee, average sale per ticket, closing ratios per customer store visit, inventory outofstock, exceptions per deliveries, and lost time incident rate). These measurements aid us in determining areas of our operations that are in need of additional attention but are not evaluated in isolation from others, so as not to conflict with our company goals. Net Sales Comparablestore or “compstore” sales is a measure which indicates the performance of our existing stores and website by comparing the growth in sales in store and online for a particular period over the corresponding period in the prior year. Stores are considered noncomparable if open for less than 12 full calendar months or if the selling square footage has been changed significantly during the past 12 full calendar months. Large clearance sales events from warehouses or temporary locations are also excluded from comparable store sales, as are periods when stores are closed or being remodeled. As a retailer, compstore sales is an indicator of relative customer spending and store performance. Total sales decreased $15.4 million or 1.9% in 2019 and $2.2 million or 0.3% in 2018. Comparable store sales, which includes online sales, decreased 1.4% or $11.6 million in 2 [/INST] Positive. </s>

PILGRIMS PRIDE CORP

2015-02-12

2014-12-28

Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations Our Company We are one of the largest chicken producers in the world, with operations in the U.S., Mexico and Puerto Rico. We are primarily engaged in the production, processing, marketing and distribution of fresh, frozen and value-added chicken products to retailers, distributors and foodservice operators. We offer a wide range of products to our customers through strong national and international distribution channels. Pilgrim's fresh chicken products consist of refrigerated (non-frozen) whole chickens, whole cut-up chickens and selected chicken parts that are either marinated or non-marinated. The Company's prepared chicken products include fully cooked, ready-to-cook and individually frozen chicken parts, strips, nuggets and patties, some of which are either breaded or non-breaded and either marinated or non-marinated. We market our balanced portfolio of fresh, prepared and value-added chicken products to a diverse set of over 5,000 customers across the U.S., Mexico and in approximately 95 other countries, with no single one accounting for more than 10% of total sales. We have become a valuable partner to our customers and a recognized industry leader by consistently providing high-quality products and services designed to meet their needs and enhance their business. Our sales efforts are largely targeted towards the foodservice industry, principally chain restaurants and food processors such as Chick-fil-A® and Yum! Brands®, distributors such as US Foods and Sysco® and retail customers, including grocery store chains and wholesale clubs such as Kroger®, Wal-Mart®, Costco®, Publix® and Sam’s Club®. As a vertically integrated company, we control every phase of the production process, which helps us better manage food safety and quality, as well as more effectively control margins and improve customer service. We operate feed mills, hatcheries, processing plants and distribution centers in 12 U.S. states, Puerto Rico and Mexico. Our plants are strategically located to ensure that customers timely receive fresh products. With our global network of approximately 3,750 growers, 28 feed mills, 36 hatcheries, 27 processing plants, five prepared foods cook plants, 14 distribution centers, eight rendering facilities and three pet food plants, we believe we are well positioned to supply the growing demand for our products. We are one of the largest, and we believe one of the most efficient, producers and sellers of chicken in Mexico. Our presence in Mexico provides access to a market with growing demand and has enabled us to leverage our operational strengths within the region. The market for chicken products in Mexico is still developing with most sales attributed to fresh, commodity-oriented, market price-based business. We believe our Mexico business is well positioned to continue benefiting from these trends in the Mexican consumer market. Additionally, we are an important player in the live market, which accounted for approximately 33% of the industry’s chicken sales in Mexico in 2014. Pilgrim's has approximately 35,000 employees and has the capacity to process more than 34.7 million birds per week for a total of more than 10.2 billion pounds of live chicken annually. In 2014, we produced 7.5 billion pounds of chicken products, generating approximately $8.6 billion in net revenues and approximately $711.6 million in net income attributable to Pilgrim’s. We operate on a 52/53-week fiscal year that ends on the Sunday falling on or before December 31. The reader should assume any reference we make to a particular year (for example, 2014) in this report applies to our fiscal year and not the calendar year. Executive Summary We reported net income attributable to Pilgrim’s Pride Corporation of $711.6 million, or $2.74 per diluted common share, for 2014. These operating results included gross profit of $1.4 billion. During 2014, we generated $1.1 billion of cash from operations. Market prices for feed ingredients remain volatile. Consequently, there can be no assurance that our feed ingredients prices will not increase materially and that such increases would not negatively impact our financial position, results of operations and cash flow. The following table compares the highest and lowest prices reached on nearby futures for one bushel of corn and one ton of soybean meal during the current year and previous two years: We purchase derivative financial instruments, specifically exchange-traded futures and options, in an attempt to mitigate price risk related to our anticipated consumption of commodity inputs such as corn, soybean meal, sorghum, wheat, soybean oil and natural gas. We will sometimes take a short position on a derivative instrument to minimize the impact of a commodity's price volatility on our operating results. We will also occasionally purchase derivative financial instruments in an attempt to mitigate currency exchange rate exposure related to the financial statements of our Mexico operations that are denominated in Mexican pesos. We do not designate derivative financial instruments that we purchase to mitigate commodity purchase or currency exchange rate exposures as cash flow hedges; therefore, we recognize changes in the fair value of these derivative financial instruments immediately in earnings. We recognized $16.1 million, $25.1 million and $8.3 million in net gains related to changes in the fair value of derivative financial instruments during 2014, 2013 and 2012. Although changes in the market price paid for feed ingredients impact cash outlays at the time we purchase the ingredients, such changes do not immediately impact cost of sales. The cost of feed ingredients is recognized in cost of sales, on a first in first-out basis, at the same time that the sales of the chickens that consume the feed grains are recognized. Thus, there is a lag between the time cash is paid for feed ingredients and the time the cost of such feed ingredients is reported in cost of goods sold.For example, corn delivered to a feed mill and paid for one week might be used to manufacture feed the following week.However,the chickens that eat that feed might not be processed and sold for another 42-63 days, and only at that time will the costs of the feed consumed by the chicken become included in cost of goods sold. Commodities such as corn, soybean meal, sorghum, wheat and soybean oil are actively traded through various exchanges with future market prices quoted on a daily basis. These quoted market prices, although a good indicator of the commodity's base price, do not represent the final price for which we can purchase these commodities. There are several components in addition to the quoted market price, such as freight, storage and seller premiums, that are included in the final price that we pay for grain.Although changes in quoted market prices may be a good indicator of the commodity’s base price, the components mentioned above may have a significant impact on the total change in grain costs recognized from period to period. Prices related to these individual components of the total price of corn were especially high in late 2013 as we transitioned from a year of record low corn stocks, primarily caused by drought conditions, to a year with normal corn stocks. Prices related to these individual components of the total price of corn returned to normal levels in the first quarter of 2014. Prices related to these individual components of the total price of soybean meal remain near historically high levels due to low soybean stocks in the U.S. Market prices for chicken products are currently at levels sufficient to offset the costs of feed ingredients. However, there can be no assurance that chicken prices will not decrease due to such factors as competition from other proteins and substitutions by consumers of non-protein foods because of uncertainty surrounding the general economy and unemployment. Recent Developments MOFCOM Proceedings. During the first quarter of 2014, we participated in antidumping and countervailing duty proceedings initiated by the Ministry of Commerce of the People’s Republic of China (“MOFCOM”). In these proceedings, MOFCOM re-examined whether US chicken producers, including us, were dumping certain chicken products into the People’s Republic of China (excluding the Special Administrative Region of Hong Kong), and whether US chicken producers, including us, were receiving countervailable subsidies in respect of those chicken products. Following review in World Trade Organization (“WTO”) dispute settlement proceedings, MOFCOM concluded their most recent proceedings in June 2014 and imposed antidumping and countervailing duties on the US chicken producers. The combined antidumping and countervailing duties imposed range from 50.6% to 78.0%. The rate imposed on us is 77.9%. Until these duties are modified or eliminated, the duty rates can be expected to deter Chinese importers from purchases of US-origin chicken products, including our chicken products, and can be expected to diminish the volume of such purchases. The basis for imposing the duties may be challenged by the U.S. in further WTO dispute settlement proceedings. The assessment of these duty rates on our sales to Chinese importers has not had a material impact on our operating results. Tyson Mexico Acquisition. On July 28, 2014, the Company entered into a definitive agreement to purchase Provemex Holdings LLC and its subsidiaries (together, “Tyson Mexico”) from Tyson Foods, Inc. and certain of its subsidiaries for approximately $400.0 million,which is subject to adjustment for closing date working capital. The transaction is expected to be completed during the the first quarter of 2015, subject to customary closing conditions, including regulatory approvals. We expect to fund the purchase price from available cash balances and bank credit. Tyson Mexico is a vertically integrated poultry business based in Gomez Palacio, Durango, Mexico. It has a production capacity of 3 million birds per week in its three plants and employs more than 5,400 in its plants, offices and seven distribution centers. The acquisition further strengthens our strategic position in the Mexico chicken market. Once the acquisition is completed, we expect to maintain the operations working to capacity with the existing workforce, maintaining labor contracts in place. The financial information included into this annual report does not give pro forma effect to the Tyson Mexico acquisition unless specifically identified. Amended and Restated U.S. Credit Facility. On February 11, 2015, the Company and certain of its subsidiaries entered into a Second Amended and Restated Credit Agreement (the “U.S. Credit Facility”) with Coöperatieve Centrale Raiffeisen-Boerenleenbank B.A., Rabobank Nederland, New York Branch (“Rabobank”), as administrative agent, and the other lenders party thereto. The U.S. Credit Facility amends and restates the Company’s existing credit agreement dated August 7, 2013 with CoBank, ACB, as administrative agent and collateral agent, and other lenders party thereto. The U.S. Credit Facility provides for a revolving loan commitment of at least $700 million and a term loan commitment of up to $1.0 billion (the “Term Loan”). The U.S. Credit Facility also includes an accordion feature that allows us, at any time, to increase the aggregate revolving loan and term loan commitments by up to an additional $1.0 billion, subject to the satisfaction of certain conditions, including obtaining the lenders’ agreement to participate in the increase. For additional information regarding the U.S. Credit Facility, see “ - Liquidity and Capital Resources - Debt Obligations - U.S. Credit Facility.” Special Cash Dividend. On January 14, 2015, we declared a special cash dividend of $5.77 per share with a total payment amount of approximately $1.5 billion based on the number of shares outstanding. The special cash dividend is payable on February 17, 2015, to stockholders of record as of January 30, 2015. We anticipate that proceeds from certain borrowings under the U.S. Credit Facility, along with cash on hand, will be used to pay the special cash dividend to our stockholders on February 17, 2015. For additional information, see “Note 13. Stockholders' Equity - Special Cash Dividend” of our Consolidated Financial Statements included in this annual report. Business Segment and Geographic Reporting We operate in one reportable business segment, as a producer and seller of chicken products we either produce or purchase for resale in the U.S., Puerto Rico and Mexico. We conduct separate operations in the U.S., Puerto Rico and Mexico; however, for geographic reporting purposes, we include Puerto Rico within our U.S. operations. Corporate expenses are allocated to Mexico based upon various apportionment methods for specific expenditures incurred related thereto with the remaining amounts allocated to the U.S. For additional information, see “Note 18. Business Segment and Geographic Reporting” of our Consolidated Financial Statements included in this annual report. Results of Operations 2014 Compared to 2013 Net sales. Net sales for 2014 increased $172.2 million, or 2.0%, from 2013. The following table provides additional information regarding net sales: (a) U.S. sales generated in 2014 increased $146.8 million, or 2.0%, from U.S. sales generated in 2013, primarily because of an increase in the net revenue per pound sold that was partially offset by a decrease in pounds sold. Increased net revenue per pound sold, which resulted primarily from an increase in market prices due to continued healthy demand for chicken products in combination with constrained supply, contributed $217.8 million, or 2.9 percentage points, to the revenue increase. A decrease in pounds sold partially offset the increase in revenue per pound sold by $70.8 million, or 0.9 percentage points. Included in U.S. sales generated during 2014 and 2013 were sales to JBS USA, LLC totaling $39.7 million and $61.9 million, respectively. (b) Mexico sales generated in 2014 increased $25.4 million, or 2.8%, from Mexico sales generated in 2013, primarily because of an increase in the net revenue per pound sold and an increase in sales volume partially offset by the impact of foreign currency translation. The increase in net revenue per pound contributed $42.4 million, or 4.7%, to the increase in sales. The increase in volume contributed $24.2 million, or 2.7 percentage points, to the increase in sales, partially offset by the unfavorable impact of foreign currency translation contributed $41.2 million, or 4.4 percentage points, to the revenue decrease. Gross profit. Gross profit increased by $548.6 million, or 64.9%, from $845.7 million generated in 2013 to $1.4 billion generated in 2014. The following tables provide gross profit information: (a) Cost of sales incurred by our U.S. operations in 2014 decreased $339.0 million, or 5.0%, from cost of sales incurred by our U.S. operations in 2013. Cost of sales decreased primarily because of a $464.7 million decrease in feed ingredients costs, a $23.6 million decrease in wages and benefits, a $17.2 million decrease in co-pack labor, a $15.4 million decrease in freight and storage and a $5.1 million decrease in repairs and maintenance. Decreases to cost of sales were partially offset by a decrease in derivative gains from $23.4 million in 2013 to $16.0 million in 2014, a $6.2 million increase in utilities costs, a $5.8 million increase in contract labor costs and a $2.6 million increase in lease costs. Other factors affecting U.S. cost of sales were immaterial. (b) Cost of sales incurred by the Mexico operations during 2014 decreased $37.3 million, or 4.8%, from cost of sales incurred by the Mexico operations during 2013. Cost of sales decreased primarily because of lower feed ingredients costs partially offset by the impact of foreign currency translation. The impact of lower feed ingredients costs contributed $41.6 million, or 6.8 percentage points, to the decrease in costs of sales. The impact of foreign currency translation contributed $31.9 million, or 4.1 percentage points, to the decrease in cost of sales. Cost of sales also decreased because of a $1.7 million decrease in wages and benefits offset by an increase of $4.1 million in freight and storage costs, a $2.4 million increase in contract labor costs, a $2.4 million increase in utilities costs, a $2.2 million increase in grower costs and a decrease in derivative gains from $1.8 million in 2013 to $0.2 million in 2014. Other factors affecting cost of sales were individually immaterial. Operating income. Operating income increased $544.3 million, or 82.6%, from $658.8 million generated for 2013 to $1.2 billion generated for 2014. The following tables provide operating income information: (a) SG&A expense incurred by the U.S. operations during 2014 increased $9.2 million, or 5.7%, from SG&A expense incurred by the U.S. operations during 2013 primarily because of an $8.2 million increase in employee wages and benefits, a $6.2 million increase in management fees charged for administrative functions shared with JBS USA, LLC and a $1.6 million increase in legal services expenses that were partially offset by a $2.2 million gain on asset disposals, a $1.4 million decrease in outside services expenses, a $1.4 million decrease in depreciation expenses, recognition of a $1.1 million bad debt recovery, a $1.0 million decrease in brokerage expenses and a $1.0 million decrease in contract labor expenses. Other factors affecting SG&A expense were individually immaterial. (b) SG&A expense incurred by the Mexico operations during 2014 decreased $1.5 million, or 7.2%, from SG&A expense incurred by the Mexico operations during 2013 primarily because of a $2.7 million decrease in contract labor expenses, a $2.0 million decrease in government fees and a $1.1 million decrease in management fees charged by the U.S. operations that were partially offset by a $2.8 million increase in employee wages and benefits, a $0.6 million loss recognized on asset disposals, a $0.4 million increase in marketing expenses and a $0.4 million increase in legal services expenses. Other factors affecting SG&A expense were individually immaterial. (c) Administrative restructuring charges incurred during 2014 decreased $3.4 million, or 59.6%, from administrative restructuring charges incurred during 2013. During 2014, we incurred administrative restructuring charges composed of (i) live operations rationalization costs of $0.9 million, (ii) employee-related costs of $0.6 million, (iii) other exit or disposal costs of $0.4 million and (iv) inventory valuation costs of $0.3 million. Interest expense. Consolidated interest expense decreased 5.6% to $82.1 million in 2014 from $87.0 million in 2013 primarily because of decreased average borrowings of $526.7 million in 2014 compared to $990.5 million in 2013 and a decrease in the weighted average interest rate to 6.45% in 2014 from 7.10% in 2013. As a percent of net sales, interest expense in 2014 and 2013 was 0.96% and 1.03%. Income taxes. Our consolidated income tax expense in 2014 was $390.9 million, compared to income tax expense of $24.2 million in 2013. The income tax expense in 2014 resulted primarily from an increase in income partially offset by decreases in valuation allowance and reserves for unrecognized tax benefits during 2013. We expect a future effective tax rate that is comparative to 2014. 2013 Compared to 2012 Net sales. Net sales for 2013 increased $289.8 million, or 3.6%, from 2012. The following table provides additional information regarding net sales: (a) U.S. sales generated in 2013 increased $250.7 million, or 3.5%, from U.S. sales generated in 2012, despite a decrease in the number of weeks included in the fiscal year from 53 in 2012 to 52 in 2013, primarily because of an increase in the net revenue per pound sold that was partially offset by a decrease in pounds sold. Increased net revenue per pound sold, which resulted primarily from an increase in market prices due to continued healthy demand for chicken products in combination with constrained supply, contributed $484.3 million, or 6.7 percentage points, to the revenue increase. A decrease in pounds sold partially offset the increase in revenue per pound sold by $233.6 million, or 3.2 percentage points. Included in U.S. sales generated during 2013 and 2012 were sales to JBS USA, LLC totaling $61.9 million and $206.7 million, respectively. (b) Mexico sales generated in 2013 increased $39.0 million, or 4.5%, from Mexico sales generated in 2012, despite a decrease in the number of weeks included in the respective fiscal years, primarily because of the favorable impact of foreign currency translation and an increase in market prices that were partially offset by a decrease in unit sales volume. The favorable impact of foreign currency translation contributed $28.3 million, or 3.2 percentage points, to the revenue increase. An increase in market prices contributed $19.8 million, or 2.3 percentage points to the revenue increase. A decrease in pounds sold partially offset the favorable impact of foreign currency translation and the increase in market prices by $9.1 million, or 1.0 percentage points, and resulted primarily from the lack of broiler eggs following the H7N3 influenza outbreak in Mexico in late 2012 and early 2013. Gross profit. Gross profit increased by $409.6 million, or 94.0%, from $435.8 million generated in 2012 to $845.4 million generated in 2013. The following tables provide gross profit information: (a) Cost of sales incurred by our U.S. operations in 2013 decreased $134.5 million, or 1.9%, from cost of sales incurred by our U.S. operations in 2012. Along with a decrease in the number of weeks included in the respective fiscal years, the reduction in cost of sales resulted from (i) a $57.9 million decrease in co-pack labor and meat, which resulted primarily from the decrease in sales volume, (ii) a $24.1 million decrease in insurance costs resulting primarily from improved workers compensation loss performance, (iii) a $14.6 million decrease in live production costs, which were lower primarily because of a reduction in feed ingredient costs, (iv) a $13.6 million increase in derivative gains, (v) the August 2012 disposal of our commercial egg business, which incurred cost of sales totaling $12.0 million in 2012, (vi) a $10.1 million decrease in freight and storage costs, (vii) a $9.7 million decrease in compensation and employee relations costs and (viii) a $5.2 million decrease in rental and lease costs. Other factors affecting U.S. cost of sales were immaterial. (b) Cost of sales incurred by the Mexico operations during 2013 increased $13.8 million, or 1.8%, from cost of sales incurred by the Mexico operations during 2012 despite the decrease in the number of weeks included in the respective fiscal years. The unfavorable impact of foreign currency translation contributed $24.3 million, or 3.2 percentage points, to the increase in cost of sales. Fertile egg purchases contributed $4.7 million, or 0.6% percentage points, and increased feed costs contributed $3.0 million, or 0.4 percentage points, to the increase in cost of sales. The impact of decreased sales volume, which resulted primarily from the lack of broiler eggs following the H7N3 influenza outbreak in Mexico, offset the increase in cost of sales by $10.0 million, or 1.3 percentage points. Finally, improved processing performance offset the increase in cost of sales by $8.8 million, or 1.1 percentage points. Other factors affecting Mexico cost of sales were immaterial. Operating income. Operating income increased $408.5 million, or 163.2%, from $250.3 million generated for 2012 to $658.9 million generated for 2013. The following tables provide operating income information: (a) SG&A expenses incurred by the U.S. operations during 2013 increased $0.8 million, or 0.5%, from SG&A expenses incurred by the U.S. operations during 2012, despite a decrease in the number of weeks included in the respective fiscal years from 53 in 2012 to 52 in 2013, primarily because of a $15.0 million increase in payroll and related benefits expenses resulting primarily from higher incentive compensation and pension costs. This increase in SG&A expenses was partially offset by (i) an $8.2 million decrease in outside services and professional fees, (ii) a $3.5 million decrease in brokerage expenses and (iii) a $2.0 million decrease in depreciation and amortization expenses. Other factors affecting U.S. SG&A expenses were immaterial. (b) SG&A expense incurred by the Mexico operations during 2013 increased $3.1 million, or 17.3%, from SG&A expense incurred by the Mexico operations during 2012, despite a decrease in the number of weeks included in the respective fiscal years, primarily because of a $2.1 million fine assessed by a commission of the Mexican government that we are currently appealing. The unfavorable impact of foreign currency translation also contributed $0.6 million, or 3.6 percentage points, to the increase in SG&A expenses. Other factors affecting Mexico SG&A expenses were immaterial. (c) Administrative restructuring charges incurred during 2013 decreased $2.7 million, or 33.0%, from administrative restructuring charges incurred during 2012. During 2013, we incurred administrative restructuring charges related to noncash impairment charges of $3.7 million and live operations rationalization totaling $2.0 million. During 2012, we incurred administrative restructuring charges composed of (i) flock rationalization costs of $3.7 million related to our Dallas, Texas plant closure, (ii) impairment costs of $2.8 million and (iii) a loss resulting from the disposal of certain unused assets of $2.0 million. Interest expense. Consolidated interest expense decreased 17.1% to $87.0 million in 2013 from $104.9 million in 2012 primarily because of decreased average borrowings of $990.5 million in 2013 compared to $1,242.2 million in 2012 partially offset by an increase in the weighted average interest rate to 7.10% in 2013 from 7.00% in 2012. As a percent of net sales, interest expense in 2013 and 2012 was 1.0% and 1.3%, respectively. Income taxes. Our consolidated income tax expense in 2013 was $24.2 million, compared to income tax benefit of $21.0 million in 2012. The income tax expense in 2013 resulted primarily from an increase in income and a decrease in the valuation allowance. The net change in the total valuation allowance for 2013 was a decrease of $178.0 million, resulting primarily from the utilization of almost all of our domestic net operating losses. Liquidity and Capital Resources The following table presents our available sources of liquidity as of December 28, 2014, after giving effect to the payment of our approximately $1.5 billion special cash dividend to our stockholders, consummation of our acquisition of Tyson Mexico and the entry into our U.S. Credit Facility: (a) We believe that the assumptions used provide a reasonable basis on which to present our available sources of liquidity as of December 28, 2014 after giving effect to the payment of the special cash dividend, the consummation of our acquisition of Tyson Mexico and the entry into our U.S. Credit Facility. The resulting presentation does not purport to be indicative of the available sources of liquidity that would actually have resulted if payment of the special cash dividend, consummation of our acquisition of Tyson Mexico and the related borrowings necessary to fund the special cash dividend and our acquisition of Tyson Mexico had been completed as of such date or that may result in the future. This presentation should be viewed in conjunction with the Consolidated Financial Statements and the Notes to Consolidated Financial Statements in this annual report. (b) We have assumed that $566.1 million of our cash and cash equivalents on hand at December 28, 2014 will be used to (i) fund a portion of the special cash dividend, (ii) fund a portion of our acquisition of Tyson Mexico and (iii) pay financing fees on our credit facilities. (c) Actual borrowings by us under the revolving loan commitment of the U.S. Credit Facility will be subject to a borrowing base, which is a formula based on certain eligible inventory and eligible receivables. Had the borrowing base under the U.S. Credit Facility been in effect on December 28, 2014, it would have totaled $700.0 million. Availability under the revolving loan commitment of the U.S. Credit Facility will also be reduced by our outstanding standby letters of credit. Standby letters of credit outstanding at December 28, 2014 totaled $20.1 million. We have also assumed that proceeds of $1.33 billion from borrowings under the U.S. Credit Facility will be used to (i) fund a portion of the special cash dividend and (ii) fund a portion of our acquisition of Tyson Mexico. (d) The loan commitment under the Mexico Credit Facility is $560.0 million Mexican pesos. As of December 28, 2014, the U.S. dollar-equivalent of the loan commitment under the Mexico Credit Facility was $38.1 million. Debt Obligations Senior and Subordinated Notes. On December 15, 2014, we redeemed all of our outstanding $500,000,000 principal amount of 7.875% senior notes due 2018 (the “2018 Notes”) for a redemption price of 103.9375% of the principal amount, plus accrued and unpaid interest to the redemption date. As a result, at December 28, 2014, no 2018 Notes remained outstanding. Additionally, we have an aggregate principal balance of $3.6 million of 7 5/8% senior unsecured notes and 8 3/8% senior subordinated unsecured notes outstanding at December 28, 2014. JBS Subordinated Loan Agreement. On June 23, 2011, we entered into a Subordinated Loan Agreement with JBS USA (the “Subordinated Loan Agreement”). Pursuant to the terms of the Subordinated Loan Agreement, we agreed to reimburse JBS USA up to $56.5 million for draws upon any letters of credit issued for JBS USA's account that support certain obligations of our company or its subsidiaries. JBS USA agreed to arrange for letters of credit to be issued on its account in the amount of $56.5 million to an insurance company serving us in order to allow that insurance company to return cash it held as collateral against potential workers compensation, auto and general liability claims. In return for providing this letter of credit, we agreed to reimburse JBS USA for the letter of credit cost we would otherwise incur under our U.S. Credit Facility (as defined below). The total amount we paid in 2014, 2013 and 2012 to reimburse JBS USA was $1.3 million, $2.2 million and $2.2 million, respectively. As of December 28, 2014, we have accrued an obligation of $0.1 million to reimburse JBS USA for letter of credit costs incurred on our behalf. There remains no other commitment to make advances by JBS USA under the Subordinated Loan Agreement. U.S. Credit Facility. We and certain of our subsidiaries entered into the U.S. Credit Facility with Rabobank, as administrative agent, and the other lenders party thereto on February 11, 2015. The U.S. Credit Facility provides for a $700.0 million revolving loan commitment and a term loan commitment of up to $1.0 billion (the “Term Loan”). The U.S. Credit Facility also includes an accordion feature that allows us, at any time, to increase the aggregate revolving loan and term loan commitments by up to an additional $1.0 billion, subject to the satisfaction of certain conditions, including obtaining the lenders’ agreement to participate in the increase. The revolving loan commitment under the U.S. Credit Facility matures on February 10, 2020. Beginning on April 2, 2015, the Term Loan will be payable in quarterly installments equal to 1.25% of the principal outstanding as of closing, with all remaining principal and interest due at maturity on February 10, 2020. Covenants in the U.S. Credit Facility also require us to use the proceeds we receive from certain asset sales and specified debt or equity issuances and upon the occurrence of other events to repay outstanding borrowings under the U.S. Credit Facility. The U.S. Credit Facility includes a $75 million sub-limit for swingline loans and a $125 million sub-limit for letters of credit. Outstanding borrowings under the revolving loan commitment and the Term Loan bear interest at a per annum rate equal to (i) in the case of LIBOR loans, LIBOR plus 1.50% through March 29, 2015 and, based on our net senior secured leverage ratio, between LIBOR plus 1.25% and LIBOR plus 2.75% thereafter and (ii) in the case of alternate base rate loans, the base rate plus 0.50% through March 29, 2015 and, based on our net senior secured leverage ratio, between the base rate plus 0.25% and base rate plus 1.75% thereafter. Actual borrowings by us under the U.S. Credit Facility are subject to a borrowing base, which is a formula based on certain eligible inventory, eligible receivables and restricted cash under the control of Rabobank, in its capacity as administrative agent. The borrowing base formula will be reduced by the sum of (i) inventory reserves, (ii) rent and collateral access reserves, and (iii) any amount more than 15 days past due that is owed by our company or its subsidiaries to any person on account of the purchase price of agricultural products or services (including poultry and livestock) if that person is entitled to any grower's or producer's lien or other security arrangement. The U.S. Credit Facility contains financial covenants and various other covenants that may adversely affect our ability to, among other things, incur additional indebtedness, incur liens, pay dividends or make certain restricted payments, consummate certain assets sales, enter into certain transactions with JBS USA and our other affiliates, merge, consolidate and/or sell or dispose of all or substantially all of our assets. The U.S. Credit Facility requires us to comply with a minimum level of tangible net worth covenant. We are currently in compliance with this financial covenant. The U.S. Credit Facility also provides that we may not incur capital expenditures in excess of $500.0 million in any fiscal year. All obligations under the U.S. Credit Facility are unconditionally guaranteed by certain of our subsidiaries and are secured by a first priority lien on (i) the accounts receivable and inventories of our company and its non-Mexico subsidiaries, (ii) 100% of the equity interests in our domestic subsidiaries, To-Ricos, Ltd. and To-Ricos Distribution Ltd., and 65% of the equity interests in our direct foreign subsidiaries, (iii) substantially all of the personal property and intangibles of the borrowers and guarantors under the U.S. Credit Facility and (iv) substantially all of the real estate and fixed assets of our company and the guarantors under the U.S. Credit Facility. Mexico Credit Facility. On July 23, 2014, Avícola and certain other Mexico subsidiaries entered into an unsecured credit agreement (the “Mexico Credit Facility”) with BBVA Bancomer, S.A. Institución de Banca Multiple, Grupo Financiero BBVA Bancomer, as lender. The loan commitment under the Mexico Credit Facility is $560.0 million Mexican pesos. Outstanding borrowings under the Mexico Credit Facility will accrue interest at a rate equal to the TIIE rate plus 1.05%. The Mexico Credit Facility will mature on July 23, 2017. As of December 28, 2014, the U.S. dollar-equivalent of the loan commitment under the Mexico Credit Facility was $38.1 million. There are currently no outstanding borrowings under the Mexico Credit Facility. The Mexico Credit facility replaced our amended and restated credit agreement with ING Bank (México), S.A. Institucíon de Banca Múltiple, ING Grupo Financiero, as lender and ING Capital LLC, as administrative agent, which was terminated on July 23, 2014. Collateral Substantially all of our domestic inventories and domestic fixed assets are pledged as collateral to secure the obligations under the U.S. Credit Facility. Off-Balance Sheet Arrangements We maintain operating leases for various types of equipment, some of which contain residual value guarantees for the market value of assets at the end of the term of the lease. The terms of the lease maturities range from one to ten years. We estimate the maximum potential amount of the residual value guarantees is approximately $2.6 million; however, the actual amount would be offset by any recoverable amount based on the fair market value of the underlying leased assets. No liability has been recorded related to this contingency as the likelihood of payments under these guarantees is not considered to be probable, and the fair value of the guarantees is immaterial. We historically have not experienced significant payments under similar residual guarantees. We are a party to many routine contracts in which we provide general indemnities in the normal course of business to third parties for various risks. Among other considerations, we have not recorded a liability for any of these indemnities as, based upon the likelihood of payment, the fair value of such indemnities would not have a material impact on our financial condition, results of operations and cash flows. Capital Expenditures We anticipate spending between $165.0 million and $185.0 million on the acquisition of property, plant and equipment in 2015. Capital expenditures will primarily be incurred to improve efficiencies and reduce costs. We expect to fund these capital expenditures with cash flow from operations and proceeds from the revolving lines of credit under our various debt facilities. Indefinite Reinvestment of Mexico Subsidiaries' Undistributed Earnings We have determined that the undistributed earnings of our Mexico subsidiaries will be indefinitely reinvested and not distributed to the U.S. The undistributed earnings of our Mexico subsidiaries totaled $435.7 million at December 28, 2014. Contractual Obligations In addition to our debt commitments at December 28, 2014, we had other commitments and contractual obligations that obligate us to make specified payments in the future. The following table summarizes the total amounts due as of December 28, 2014, under all debt agreements, commitments and other contractual obligations. The table indicates the years in which payments are due under the contractual obligations. (a) The total amount of our unrecognized tax benefits at December 28, 2014 was $17.4 million. We did not include this amount in the contractual obligations table above as reasonable estimates cannot be made at this time of the amounts or timing of future cash outflows. The table above does not include estimated funding of our unfunded pension and other postretirement benefits obligations totaling approximately $78.5 million at December 28, 2014 as discussed in “Note 12. Pension and Other Postretirement Benefits” to the Consolidated Financial Statements. (b) As discussed in “- Executive Summary - Recent Developments”, we declared a special cash dividend of $1.5 billion on January 15, 2015. The table above does not reflect payment of the dividend or the related financing as such transactions will occur in 2015. (c) Long-term debt excludes $20.1 million in letters of credit outstanding related to normal business transactions. (d) Interest expense in the table above assumes the continuation of interest rates and outstanding borrowings under our credit facilities as of December 28, 2014. (e) Includes (i) agreements to purchase goods or services that are enforceable and legally binding on us and that specify all significant terms, including fixed or minimum quantities to be purchased; fixed, minimum, or variable price provisions; and the approximate timing of the transaction and (ii) our obligation to purchase Tyson Mexico for approximately $400.0 million. During the first quarter of 2015, we anticipate we will incur additional secured indebtedness of approximately $1.12 billion under our U.S. Credit Facility in order to partially finance the $1.5 billion special cash dividend to our stockholders and our pending acquisition of Tyson Mexico. Following the completion of those transactions, we anticipate we will have the ability to borrow approximately $595.0 million under our credit agreements. For additional information, see “- Executive Summary - Recent Developments” and “Note 13. Stockholders’ Equity - Special Cash Dividend” of our Consolidated Financial Statements included in this annual report. Historical Flow of Funds Fiscal Year 2014 Cash provided by operating activities was $1.1 billion and $878.5 million in 2014 and 2013, respectively. The increase in cash flows provided by operating activities was primarily from net income of $711.4 million for 2014 as compared to net income of $549.7 million for 2013 and changes in working capital (excluding the impacts as a result of changes in foreign currency exchange rates). Our net working capital position, which we define as current assets less current liabilities, increased $294.6 million to a surplus of $1.1 billion and a current ratio of 2.53 at December 28, 2014 compared to a surplus of $845.6 million and a current ratio of 1.78 at December 29, 2013. The increase in working capital was caused by the generation of cash from operations. Trade accounts and other receivables, including accounts receivable from JBS USA, increased $5.1 million, or 1.3%, to $384.1 million at December 28, 2014 from $379.1 million at December 29, 2013. Inventories decreased $18.5 million, or 2.3%, to $790.3 million at December 28, 2014 from $808.8 million at December 29, 2013. The change in inventories was primarily due to decreased costs for feed grains and their impact on the value of our live chicken inventories. Prepaid expenses and other current assets increased $33.6 million, or 54.3%, to $95.4 million at December 28, 2014 from $61.8 million at December 29, 2013. This change resulted primarily from a $27.9 million increase in open derivative positions and margin cash on deposit with our derivatives traders. Accounts payable and accrued expenses, including accounts payable to JBS USA, increased $58.6 million, or 8.9%, to $716.2 million at December 28, 2014 from $657.6 million at December 29, 2013. This change resulted primarily from the timing of payments disbursed to vendors around December 28, 2014. Cash used in investing activities was $63.4 million and $181.8 million in 2014 and 2013, respectively. We incurred capital expenditures of $171.4 million and $116.2 million for 2014 and 2013, respectively. In both 2014 and 2013, capital expenditures were primarily incurred for the routine replacement of equipment and to improve efficiencies and reduce costs. Capital expenditures for 2014 could not exceed $350 million under the terms of our U.S. credit facility. Cash proceeds generated from property disposals in 2014 and 2013 totaled $11.1 million and $31.3 million, respectively. Cash was used to purchase investment securities totaling $55.1 million and $96.9 million in 2014 and 2013, respectively. Cash proceeds generated in 2014 from the sale or maturity of investment securities totaled $152.0 million. Cash used in financing activities was $905.6 million and $250.2 million in 2014 and 2013, respectively. Cash proceeds in 2013 from long-term debt totaled $505.6 million. Cash was used to repay long-term debt totaling $910.2 million and $758.6 million in 2014 and 2013, respectively. Cash proceeds in 2014 and 2013 resulting from tax benefits related to share-based compensation totaled $0.5 million and $7.7 million, respectively. Cash proceeds in 2014 from an equity contribution under a tax sharing agreement between JBS USA and our company totaled $3.8 million. Cash proceeds in 2014 from the sale of subsidiary common stock totaled $0.3 million. Additionally, cash was used to pay capitalized loan costs totaling $5.0 million in 2013. Fiscal Year 2013 Cash provided by operating activities was $878.5 million for 2013 and cash provided by operating activities was $199.6 million for 2012. The increase in cash flows provided by operating activities was primarily from net income of $549.7 million for 2013 as compared to net income of $174.0 million for 2012 and changes in working capital (excluding the impacts as a result of changes in foreign currency exchange rates). Our net working capital position, which we define as current assets less current liabilities, increased $33.0 million to a surplus of $845.6 million and a current ratio of 1.78 at December 29, 2013 compared to a surplus of $812.5 million and a current ratio of 2.11 at December 30, 2012. The increase in working capital was caused by the generation of cash from operations. Trade accounts and other receivables, including accounts receivable from JBS USA, decreased $7.3 million, or 1.9%, to $379.1 million at December 29, 2013 from $386.4 million at December 30, 2012. The change in trade accounts and other receivables resulted primarily from improved collections. Inventories decreased $141.5 million, or 14.9%, to $808.8 million at December 29, 2013 from $950.3 million at December 30, 2012. The change in inventories was primarily due to decreased costs for feed grains and their impact on the value of our live chicken inventories. Prepaid expenses and other current assets increased $5.8 million, or 10.4%, to $61.8 million at December 29, 2013 from $56.0 million at December 30, 2012. This change resulted primarily from a $5.2 million increase in open derivative positions and margin cash on deposit with our derivatives traders. Accounts payable and accrued expenses, including accounts payable to JBS USA, increased $48.3 million, or 7.9%, to $657.6 million at December 29, 2013 from $609.3 million at December 30, 2012. This change resulted primarily from the timing of payments disbursed to vendors around December 29, 2013. Cash used in investing activities was $181.8 million and $60.4 million in 2013 and 2012, respectively. We incurred capital expenditures of $116.2 million and $90.3 million for 2013 and 2012, respectively. In both 2013 and 2012, capital expenditures were primarily incurred for the routine replacement of equipment and to improve efficiencies and reduce costs. Cash was used to purchase investment securities totaling $96.9 million and $0.2 million in 2013 and 2012, respectively. Capital expenditures for 2013 could not exceed $350 million under the terms of the U.S. Credit Facility. Cash proceeds generated from property disposals in 2013 and 2012 totaled $31.3 million and $29.4 million, respectively. Cash proceeds generated in 2012 from the sale or maturity of investment securities totaled $0.7 million. Cash used in financing activities was $250.2 million in 2013. Cash provided by financing activities was $111.0 million in 2012. Cash proceeds in 2013 and 2012 from long-term debt were $505.6 million and $851.4 million, respectively. Cash was used to repay long-term debt totaling $758.6 million and $1,110.7 million in 2013 and 2012, respectively. Cash proceeds in 2013 resulting from a tax benefit related to share-based compensation totaled $7.7 million. Cash was used to pay capitalized loan costs totaling $5.0 million in 2013. Cash proceeds generated in 2012 from the sale of common stock totaled $198.3 million. Cash was used in 2012 to repay a $50.0 million note payable issued to JBS USA under the Subordinated Loan Agreement. Recent Accounting Pronouncements In May 2014, the Financial Accounting Standards Board (“FASB”) issued new accounting guidance on revenue recognition, which provides for a single five-step model to be applied to all revenue contracts with customers. The new standard also requires additional financial statement disclosures that will enable users to understand the nature, amount, timing and uncertainty of revenue and cash flows relating to customer contracts. Companies have an option to use either a retrospective approach or cumulative effect adjustment approach to implement the standard. There is no option for early adoption. The provisions of the new guidance will be effective as of the beginning of our 2017 fiscal year. We are currently evaluating the impact of the new guidance on our financial statements and have not yet selected a transition approach to implement the standard. Critical Accounting Policies and Estimates General. Our discussion and analysis of our financial condition and results of operations are based upon our financial statements, which have been prepared in accordance with U.S. GAAP. The preparation of these financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses. On an ongoing basis, we evaluate our estimates, including those related to revenue recognition, customer programs and incentives, allowance for doubtful accounts, inventories, income taxes and product recall accounting. We base our estimates on historical experience and on various other assumptions that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions. We believe the following critical accounting policies affect our more significant judgments and estimates used in the preparation of our financial statements. Revenue Recognition. We recognize revenue when all of the following circumstances are satisfied: (i) persuasive evidence of an arrangement exists, (ii) price is fixed or determinable, (iii) collectability is reasonably assured and (iv) delivery has occurred. Delivery occurs in the period in which the customer takes title and assumes the risks and rewards of ownership of the products specified in the customer's purchase order or sales agreement. Revenue is recorded net of estimated incentive offerings including special pricing agreements, promotions and other volume-based incentives. Revisions to these estimates are charged back to net sales in the period in which the facts that give rise to the revision become known. Inventory. Live chicken inventories are stated at the lower of cost or market and breeder hens at the lower of cost, less accumulated amortization, or market. The costs associated with breeder hens are accumulated up to the production stage and amortized over their productive lives using the unit-of-production method. Finished poultry products, feed, eggs and other inventories are stated at the lower of cost (average) or market. We record valuations and adjustments for our inventory and for estimated obsolescence at or equal to the difference between the cost of inventory and the estimated market value based upon known conditions affecting inventory obsolescence, including significantly aged products, discontinued product lines, or damaged or obsolete products. We allocate meat costs between our various finished chicken products based on a by-product costing technique that reduces the cost of the whole bird by estimated yields and amounts to be recovered for certain byproduct parts. This primarily includes leg quarters, wings, tenders and offal, which are carried in inventory at the estimated recovery amounts, with the remaining amount being reflected as our breast meat cost. Generally, we perform an evaluation of whether any lower of cost or market adjustments are required at the country level based on a number of factors, including: (i) pools of related inventory, (ii) product continuation or discontinuation, (iii) estimated market selling prices and (iv) expected distribution channels. If actual market conditions or other factors are less favorable than those projected by management, additional inventory adjustments may be required. Property, Plant and Equipment. We record impairment charges on long-lived assets held for use when events and circumstances indicate that the assets may be impaired and the undiscounted cash flows estimated to be generated by those assets are less than the carrying amount of those assets. The impairment charge is determined based upon the amount by which the net book value of the assets exceeds their fair market value. In making these determinations, we utilize certain assumptions, including, but not limited to: (i) future cash flows estimated to be generated by these assets, which are based on additional assumptions such as asset utilization, remaining length of service and estimated salvage values, (ii) estimated fair market value of the assets, and (iii) determinations with respect to the lowest level of cash flows relevant to the respective impairment test, generally groupings of related operational facilities. Given the interdependency of our individual facilities during the production process, which operate as a vertically integrated network, we evaluate impairment of assets held for use at the country level (i.e., the U.S. and Mexico). Management believes this is the lowest level of identifiable cash flows for our assets that are held for use in production activities. At the present time, our forecasts indicate that we can recover the carrying value of our assets held for use based on the projected undiscounted cash flows of the operations. We record impairment charges on long-lived assets held for sale when the carrying amount of those assets exceeds their fair value less appropriate selling costs. Fair value is based on amounts documented in sales contracts or letters of intent accepted by us, amounts included in counteroffers initiated by us, or, in the absence of current contract negotiations, amounts determined using a sales comparison approach for real property and amounts determined using a cost approach for personal property. Under the sales comparison approach, sales and asking prices of reasonably comparable properties are considered to develop a range of unit prices within which the current real estate market is operating. Under the cost approach, a current cost to replace the asset new is calculated and then the estimated replacement cost is reduced to reflect the applicable decline in value resulting from physical deterioration, functional obsolescence and economic obsolescence. Appropriate selling costs includes reasonable broker's commissions, costs to produce title documents, filing fees, legal expenses and the like. We estimate appropriate closing costs as 4% to 6% of asset fair value. This range of rates is considered reasonable for our assets held for sale based on historical experience. We recognized impairment charges related to assets held for sale of $4.0 million and $2.8 million during 2013 and 2012, respectively. Litigation and Contingent Liabilities. We are subject to lawsuits, investigations and other claims related to employment, environmental, product, and other matters. We are required to assess the likelihood of any adverse judgments or outcomes, as well as potential ranges of probable losses, to these matters. We estimate the amount of reserves required for these contingencies when losses are determined to be probable and after considerable analysis of each individual issue. We expense legal costs related to such loss contingencies as they are incurred. With respect to our environmental remediation obligations, the accrual for environmental remediation liabilities is measured on an undiscounted basis. These reserves may change in the future due to changes in our assumptions, the effectiveness of strategies, or other factors beyond our control. Accrued Self Insurance. Insurance expense for casualty claims and employee-related health care benefits are estimated using historical and current experience and actuarial estimates. Stop-loss coverage is maintained with third-party insurers to limit our total exposure. Certain categories of claim liabilities are actuarially determined. The assumption used to arrive at periodic expenses is reviewed regularly by management. However, actual expenses could differ from these estimates and could result in adjustments to be recognized. Income Taxes. Starting in 2011, we follow provisions under ASC 740-10-30-27 in the Expenses-Income Taxes topic with regard to members of a group that file a consolidated tax return but issue separate financial statements. We file our own U.S. federal tax return, but we are included in certain state consolidated returns with JBS USA. The income tax expense of our company is computed using the separate return method. The provision for income taxes has been determined using the asset and liability approach of accounting for income taxes. Under this approach, deferred income taxes reflect the net tax effect of temporary differences between the book and tax bases of recorded assets and liabilities, net operating losses and tax credit carry forwards. The amount of deferred tax on these temporary differences is determined using the tax rates expected to apply to the period when the asset is realized or the liability is settled, as applicable, based on the tax rates and laws in the respective tax jurisdiction enacted as of the balance sheet date. We recognize potential interest and penalties related to income tax positions as a part of the income tax provision. Realizability of Deferred Tax Assets. We review our deferred tax assets for recoverability and establish a valuation allowance based on historical taxable income, potential for carry back of tax losses, projected future taxable income, applicable tax strategies, and the expected timing of the reversals of existing temporary differences. A valuation allowance is provided when it is more likely than not that some or all of the deferred tax assets will not be realized. Valuation allowances have been established primarily for net operating loss carry forwards. See “Note 11. Income Taxes” to the Consolidated Financial Statements. Indefinite Reinvestment in Foreign Subsidiaries. We deem our earnings from Mexico as of December 28, 2014 to be permanently reinvested. As such, U.S. deferred income taxes have not been provided on these earnings. If such earnings were not considered indefinitely reinvested, certain deferred foreign and U.S. income taxes would be provided. For activity after 2008, we did not permanently reinvest our earnings in Puerto Rico. Therefore, net earnings generated in Puerto Rico have U.S. taxes provided as if the earnings were distributed. Accounting for Uncertainty in Income Taxes. We follow provisions under ASC 740-10-25 that provide a recognition threshold and measurement criteria for the financial statement recognition of a tax benefit taken or expected to be taken in a tax return. Tax benefits are recognized only when it is more likely than not, based on the technical merits, that the benefits will be sustained on examination. Tax benefits that meet the more-likely-than-not recognition threshold are measured using a probability weighting of the largest amount of tax benefit that has greater than 50% likelihood of being realized upon settlement. Whether the more-likely-than-not recognition threshold is met for a particular tax benefit is a matter of judgment based on the individual facts and circumstances evaluated in light of all available evidence as of the balance sheet date. See “Note 11. Income Taxes” to the Consolidated Financial Statements in this annual report. Pension and Other Postretirement Benefits. Our pension and other postretirement benefit costs and obligations are dependent on the various actuarial assumptions used in calculating such amounts. These assumptions relate to discount rates, salary growth, long-term return on plan assets and other factors. We base the discount rate assumptions on current investment yields on high-quality corporate long-term bonds. Long-term return on plan assets is determined based on historical portfolio results and management’s expectation of the future economic environment. Actual results that differ from our assumptions are accumulated and, if in excess of the lesser of 10% of the projected benefit obligation or the fair market value of plan assets, amortized over either (i) the estimated average future service period of active plan participants if the plan is active or (ii) the estimated average future life expectancy of all plan participants if the plan is frozen.

<s>[INST] We are one of the largest chicken producers in the world, with operations in the U.S., Mexico and Puerto Rico. We are primarily engaged in the production, processing, marketing and distribution of fresh, frozen and valueadded chicken products to retailers, distributors and foodservice operators. We offer a wide range of products to our customers through strong national and international distribution channels. Pilgrim's fresh chicken products consist of refrigerated (nonfrozen) whole chickens, whole cutup chickens and selected chicken parts that are either marinated or nonmarinated. The Company's prepared chicken products include fully cooked, readytocook and individually frozen chicken parts, strips, nuggets and patties, some of which are either breaded or nonbreaded and either marinated or nonmarinated. We market our balanced portfolio of fresh, prepared and valueadded chicken products to a diverse set of over 5,000 customers across the U.S., Mexico and in approximately 95 other countries, with no single one accounting for more than 10% of total sales. We have become a valuable partner to our customers and a recognized industry leader by consistently providing highquality products and services designed to meet their needs and enhance their business. Our sales efforts are largely targeted towards the foodservice industry, principally chain restaurants and food processors such as ChickfilA® and Yum! Brands®, distributors such as US Foods and Sysco® and retail customers, including grocery store chains and wholesale clubs such as Kroger®, WalMart®, Costco®, Publix® and Sam’s Club®. As a vertically integrated company, we control every phase of the production process, which helps us better manage food safety and quality, as well as more effectively control margins and improve customer service. We operate feed mills, hatcheries, processing plants and distribution centers in 12 U.S. states, Puerto Rico and Mexico. Our plants are strategically located to ensure that customers timely receive fresh products. With our global network of approximately 3,750 growers, 28 feed mills, 36 hatcheries, 27 processing plants, five prepared foods cook plants, 14 distribution centers, eight rendering facilities and three pet food plants, we believe we are well positioned to supply the growing demand for our products. We are one of the largest, and we believe one of the most efficient, producers and sellers of chicken in Mexico. Our presence in Mexico provides access to a market with growing demand and has enabled us to leverage our operational strengths within the region. The market for chicken products in Mexico is still developing with most sales attributed to fresh, commodityoriented, market pricebased business. We believe our Mexico business is well positioned to continue benefiting from these trends in the Mexican consumer market. Additionally, we are an important player in the live market, which accounted for approximately 33% of the industry’s chicken sales in Mexico in 2014. Pilgrim's has approximately 35,000 employees and has the capacity to process more than 34.7 million birds per week for a total of more than 10.2 billion pounds of live chicken annually. In 2014, we produced 7.5 billion pounds of chicken products, generating approximately $8.6 billion in net revenues and approximately $711.6 million in net income attributable to Pilgrim’s. We operate on a 52/53week fiscal year that ends on the Sunday falling on or before December 31. The reader should assume any reference we make to a particular year (for example, 2014) in this report applies to our fiscal year and not the calendar year. Executive Summary We reported net income attributable to Pilgrim’s Pride Corporation of $711.6 million, or $2.74 per diluted common share, for 2014. These operating results included gross profit of $1.4 billion. During 2014, we generated $1.1 billion of cash from operations. Market prices for feed ingredients remain volatile. Consequently, there can be no assurance that our feed ingredients prices will not increase materially and that such increases would not negatively impact our financial position, results of operations and cash flow. The following table compares the highest and lowest prices reached on [/INST] Positive. </s>

PILGRIMS PRIDE CORP

2016-02-12

2015-12-27

Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations Our Company We are one of the largest chicken producers in the world, with operations in the U.S., Mexico and Puerto Rico. We are primarily engaged in the production, processing, marketing and distribution of fresh, frozen and value-added chicken products to retailers, distributors and foodservice operators. We offer a wide range of products to our customers through strong national and international distribution channels. Pilgrim's fresh chicken products consist of refrigerated (non-frozen) whole chickens, whole cut-up chickens and selected chicken parts that are either marinated or non-marinated. The Company's prepared chicken products include fully cooked, ready-to-cook and individually frozen chicken parts, strips, nuggets and patties, some of which are either breaded or non-breaded and either marinated or non-marinated. We market our balanced portfolio of fresh, prepared and value-added chicken products to a diverse set of over 5,000 customers across the U.S., Mexico and in approximately 90 other countries, with no single one accounting for more than 10% of total sales. We have become a valuable partner to our customers and a recognized industry leader by consistently providing high-quality products and services designed to meet their needs and enhance their business. Our sales efforts are largely targeted towards the foodservice industry, principally chain restaurants and food processors such as Chick-fil-A® and Yum! Brands®, distributors such as US Foods and Sysco® and retail customers, including grocery store chains and wholesale clubs such as Kroger®, Wal-Mart®, Costco®, Publix®, Albertsons®, H-E-B® and Sam’s Club®. As a vertically integrated company, we control every phase of the production process, which helps us better manage food safety and quality, as well as more effectively control margins and improve customer service. We operate feed mills, hatcheries, processing plants and distribution centers in 12 U.S. states, Puerto Rico and Mexico. Our plants are strategically located to ensure that customers timely receive fresh products. With our global network of approximately 4,130 growers, 35 feed mills, 40 hatcheries, 30 processing plants, six prepared foods cook plants, 23 distribution centers, eight rendering facilities and three pet food plants, we believe we are well positioned to supply the growing demand for our products. We are one of the largest, and we believe one of the most efficient, producers and sellers of chicken in Mexico. Our presence in Mexico provides access to a market with growing demand and has enabled us to leverage our operational strengths within the region. The market for chicken products in Mexico is still developing with most sales attributed to fresh, commodity-oriented, market price-based business. We believe our Mexico business is well positioned to continue benefiting from these trends in the Mexican consumer market. Additionally, we are an important player in the live market, which accounted for approximately 25% of the industry’s chicken sales in Mexico in 2015. Pilgrim's has approximately 39,000 employees and has the capacity to process more than 37 million birds per week for a total of more than 10.8 billion pounds of live chicken annually. In 2015, we produced 7.9 billion pounds of chicken products, generating approximately $8.2 billion in net revenues and approximately $645.9 million in net income attributable to Pilgrim’s. We operate on a 52/53-week fiscal year that ends on the Sunday falling on or before December 31. The reader should assume any reference we make to a particular year (for example, 2015) in this report applies to our fiscal year and not the calendar year. Executive Summary We reported net income attributable to Pilgrim’s Pride Corporation of $645.9 million, or $2.50 per diluted common share, for 2015. These operating results included gross profit of $1.3 billion. During 2015, we generated $976.8 million of cash from operations. Market prices for feed ingredients remain volatile. Consequently, there can be no assurance that our feed ingredients prices will not increase materially and that such increases would not negatively impact our financial position, results of operations and cash flow. The following table compares the highest and lowest prices reached on nearby futures for one bushel of corn and one ton of soybean meal during the current year and previous two years: We purchase derivative financial instruments, specifically exchange-traded futures and options, in an attempt to mitigate price risk related to our anticipated consumption of commodity inputs such as corn, soybean meal, sorghum, wheat, soybean oil and natural gas. We will sometimes take a short position on a derivative instrument to minimize the impact of a commodity's price volatility on our operating results. We will also occasionally purchase derivative financial instruments in an attempt to mitigate currency exchange rate exposure related to the financial statements of our Mexico operations that are denominated in Mexican pesos. We do not designate derivative financial instruments that we purchase to mitigate commodity purchase or currency exchange rate exposures as cash flow hedges; therefore, we recognize changes in the fair value of these derivative financial instruments immediately in earnings. We recognized $21.8 million, $16.1 million and $25.1 million in net gains related to changes in the fair value of derivative financial instruments during 2015, 2014 and 2013. Although changes in the market price paid for feed ingredients impact cash outlays at the time we purchase the ingredients, such changes do not immediately impact cost of sales. The cost of feed ingredients is recognized in cost of sales, on a first-in-first-out basis, at the same time that the sales of the chickens that consume the feed grains are recognized. Thus, there is a lag between the time cash is paid for feed ingredients and the time the cost of such feed ingredients is reported in cost of goods sold. For example, corn delivered to a feed mill and paid for one week might be used to manufacture feed the following week. However, the chickens that eat that feed might not be processed and sold for another 42 to 63 days, and only at that time will the costs of the feed consumed by the chicken become included in cost of goods sold. Commodities such as corn, soybean meal, sorghum, wheat and soybean oil are actively traded through various exchanges with future market prices quoted on a daily basis. These quoted market prices, although a good indicator of the commodity's base price, do not represent the final price for which we can purchase these commodities. There are several components in addition to the quoted market price, such as freight, storage and seller premiums, that are included in the final price that we pay for grain. Although changes in quoted market prices may be a good indicator of the commodity’s base price, the components mentioned above may have a significant impact on the total change in grain costs recognized from period to period. Market prices for chicken products are currently at levels sufficient to offset the costs of feed ingredients. However, there can be no assurance that chicken prices will not decrease due to such factors as competition from other proteins and substitutions by consumers of non-protein foods because of uncertainty surrounding the general economy and unemployment. Recent Developments Tyson Mexico Acquisition. On June 29, 2015, we acquired Tyson Mexico from Tyson Foods, Inc. and certain of its subsidiaries for cash. Tyson Mexico is a vertically integrated poultry business based in Gomez Palacio, Durango, Mexico. The acquired business has a production capacity of three million birds per week in its three plants and currently employs more than 4,500 people in its plants, offices and seven distribution centers. The acquisition further strengthens our strategic position in the Mexico chicken market. We expect to maintain these operations working to capacity with the existing workforce. We plan to keep all current labor contracts in place. The results of operations of the acquired business since June 29, 2015 are included in the our Consolidated Statements of Operations in this annual report. Net sales generated by the acquired business from the acquisition date through December 27, 2015 totaled $250.6 million. The acquired business incurred a net loss from the acquisition date through December 27, 2015 totaling $13.7 million. Senior Notes Due 2025. On March 11, 2015, we completed a sale of $500.0 million aggregate principal amount of our 5.75% senior notes due 2025 (the “Senior Notes”). We used the net proceeds from the sale of the Senior Notes to repay $350.0 million and $150.0 million of the term loan indebtedness under the U.S. Credit Facility on March 12, 2015 and April 22, 2015, respectively. For additional information regarding the Senior Notes due 2025, see “ - Liquidity and Capital Resources - Long-Term Debt and Other Borrowing Arrangements - Senior Notes.” Amended and Restated U.S. Credit Facility. On February 11, 2015, we and certain of our subsidiaries entered into a Second Amended and Restated Credit Agreement (the “U.S. Credit Facility”) with Coöperatieve Centrale Raiffeisen-Boerenleenbank B.A., Rabobank Nederland, New York Branch (“Rabobank”), as administrative agent, and the other lenders party thereto. The U.S. Credit Facility amends and restates our existing credit agreement dated August 7, 2013 with CoBank, ACB, as administrative agent and collateral agent, and other lenders party thereto. The U.S. Credit Facility provides for a revolving loan commitment of up to $700.0 million and a term loan commitment of up to $1.0 billion. The U.S. Credit Facility also includes an accordion feature that allows us, at any time, to increase the aggregate revolving loan and term loan commitments by up to an additional $1.0 billion, subject to the satisfaction of certain conditions, including obtaining the lenders’ agreement to participate in the increase. For additional information regarding the U.S. Credit Facility, see “ - Liquidity and Capital Resources - Long-Term Debt and Other Borrowing Arrangements - U.S. Credit Facility.” Special Cash Dividend. On January 14, 2015, we declared a special cash dividend of $5.77 per share with a total payment amount of approximately $1.5 billion. The special cash dividend was paid on February 17, 2015 to stockholders of record as of January 30, 2015 using proceeds from certain borrowings under the U.S. Credit Facility and cash on hand. For additional information, see “Note 14. Stockholders' Equity - Special Cash Dividend” of our Consolidated Financial Statements included in this annual report. Business Segment and Geographic Reporting We operate in one reportable business segment, as a producer and seller of chicken products we either produce or purchase for resale in the U.S., Puerto Rico and Mexico. We conduct separate operations in the U.S., Puerto Rico and Mexico; however, for geographic reporting purposes, we include Puerto Rico within our U.S. operations. Corporate expenses are allocated to Mexico based upon various apportionment methods for specific expenditures incurred related thereto with the remaining amounts allocated to the U.S. For additional information, see “Note 19. Business Segment and Geographic Reporting” of our Consolidated Financial Statements included in this annual report. Results of Operations 2015 Compared to 2014 Net sales. Net sales for 2015 decreased $403.3 million, or 4.7%, from 2014. The following table provides additional information regarding net sales: (a) U.S. net sales generated in 2015 decreased $503.7 million, or 6.6%, from U.S. net sales generated in 2014 primarily because of a decrease in net sales per pound. Lower net sales per pound, which reflects a slight shift in product mix toward lower-priced fresh chicken products when compared to the same period in the prior year, contributed $681.8 million, or 8.9 percentage points, to the sales decrease. An increase in sales volume partially offset the net decrease by $178.2 million, or 2.3 percentage points. Included in U.S. sales generated during 2015 and 2014 were sales to JBS USA Food Company totaling $21.7 million and $39.7 million, respectively. (b) Mexico sales generated in 2015 increased $100.4 million, or 10.7%, from Mexico sales generated in 2014, primarily because of net sales generated by the recently acquired Tyson Mexico operations and an increase in sales volume experienced by our existing operations. The impact of the acquired business contributed $250.6 million, or 26.8 percentage points, to the increase in net sales. The sales volume increase experienced by our existing operations contributed $24.7 million, or 2.6 percentage points, to the increase in net sales. The impact of of the acquired business and the sales volume increase experienced by our existing operations were partially offset by a decrease in net sales per pound experienced by our existing operations and the impact of foreign currency translation on our existing operations. The decrease in net sales per pound experienced by our existing operations offset the impact of the acquired business and the sales volume increase experienced by our existing operations by $24.1 million, or 2.6 percentage points. The impact of foreign currency translation on our existing operation offset the impact of the acquired business and the sales volume increase experienced by our existing operations by $150.7 million, or 16.1 percentage points. Gross profit. Gross profit decreased by $139.6 million, or 10.0%, from $1.4 billion generated in 2014 to $1.3 billion generated in 2015. The following tables provide gross profit information: (a) Cost of sales incurred by our U.S. operations in 2015 decreased $427.7 million, or 6.6%, from cost of sales incurred by our U.S. operations in 2014. Cost of sales decreased primarily because of a $358.2 million decrease in feed ingredients costs, a $33.2 million decrease in wages and benefits, a $17.0 million decrease in utilities costs and a $13.3 million decrease in vehicle costs partially offset by a $24.4 million increase in co-pack labor costs, a $20.9 million increase in contract labor costs, a $20.6 million increase in contract grower costs and a $19.7 million increase in supplies and equipment costs. Other factors affecting U.S. cost of sales were immaterial. (b) Cost of sales incurred by the Mexico operations during 2015 increased $164.2 million, or 22.0%, from cost of sales incurred by the Mexico operations during 2014 primarily because of costs incurred by the acquired Tyson Mexico operations, partially offset by a decrease in cost of sales incurred by our existing operations. Cost of sales incurred by the acquired Tyson Mexico operations contributed $249.1 million, or 33.4 percentage points, to the overall increase in cost of sales incurred by the Mexican operations. The decrease in cost of sales incurred by our existing operations partially offset the impact of the cost of sales incurred by the acquired business by $85.0 million, or 11.4 percentage points. The impact of foreign currency translation contributed $126.5 million, or 17.0 percentage points, to the decrease in cost of sales incurred by our existing operations. Decreases in both wage and benefits costs and utilities costs along with a gain related to the sale of property, plant and equipment also contributed $18.0 million, or 2.4 percentage points, to the decrease in cost of sales incurred by our existing operations. The favorable impact that the items listed above had on cost of sales incurred by our existing operations was partially offset by $59.6 million, or 8.0 percentage points, because of higher feed ingredients costs. Other factors affecting cost of sales were individually immaterial. (c) Our Consolidated Financial Statements include the accounts of our company and its majority owned subsidiaries. We eliminate all significant affiliate accounts and transactions upon consolidation. Operating income. Operating income decreased $158.2 million, or 13.2%, from $1.2 billion generated for 2014 to $1.0 billion generated for 2015. The following tables provide operating income information: (a) SG&A expense incurred by the U.S. operations during 2015 increased $2.3 million, or 1.3%, from SG&A expense incurred by the U.S. operations during 2014 primarily because of an $7.4 million increase in employee wages and benefits, and a $2.6 million increase in management fees charged for administrative functions shared with JBS USA Food Company Holdings that were partially offset by a $5.3 million decrease in brokerage expenses, a $2.0 million decrease in legal services expenses and a $0.5 million decrease in advertising and promotion costs. Other factors affecting SG&A expense were individually immaterial. (b) SG&A expense incurred by the Mexico operations during 2015 increased $13.0 million, or 67.9%, from SG&A expense incurred by the Mexico operations during 2014 primarily because of expenses incurred by the acquired Tyson Mexico operations and an increase in SG&A expense incurred by our existing operations. Expenses incurred by the acquired Tyson Mexico business contributed $10.3 million, or 53.5 percentage points, to the overall increase in SG&A expense. An increase in expenses incurred by our existing operations contributed $3.1 million, or 16.3 percentage points, to the overall increase in SG&A expense. SG&A expense incurred by our existing operations increased primarily because of a $1.8 million increase in contract labor, a $1.2 million increase in bad debt expense and a $1.1 million increase in legal services expense . Other factors affecting SG&A expense were individually immaterial. (c) Administrative restructuring charges incurred by the U.S. operations during 2015 increased $3.3 million, or 145.2%, from administrative restructuring charges incurred during 2014. During 2015 administrative restructuring charges represented impairment costs of $4.8 million related to assets held for sale in Louisiana and Texas and a loss of $0.8 million related to the sale of a rendering plant in Arkansas. (d) Our Consolidated Financial Statements include the accounts of both our company and its majority owned subsidiaries. We eliminate all significant affiliate accounts and transactions upon consolidation. Interest expense. Consolidated interest expense decreased 54.3% to $37.5 million in 2015 from $82.1 million in 2014, primarily because of a decrease in the weighted average interest rate to 4.02% in 2015 from 6.45% in 2014, partially offset by an increase in average borrowings of $933.6 million in 2015 compared to $526.7 million in 2014. As a percent of net sales, interest expense in 2015 and 2014 was 0.46% and 0.96%, respectively. Income taxes. Our consolidated income tax expense in 2015 was $346.8 million, compared to income tax expense of $390.9 million in 2014. The decrease in income tax expense in 2015 resulted primarily from a decrease in income. We expect a future effective tax rate that is comparative to 2015. 2014 Compared to 2013 Net sales. Net sales for 2014 increased $172.2 million, or 2.0%, from 2013. The following table provides additional information regarding net sales: (a) U.S. sales generated in 2014 increased $146.8 million, or 2.0%, from U.S. sales generated in 2013, primarily because of an increase in the net revenue per pound sold that was partially offset by a decrease in pounds sold. Increased net revenue per pound sold, which resulted primarily from an increase in market prices due to continued healthy demand for chicken products in combination with constrained supply, contributed $217.8 million, or 2.9 percentage points, to the revenue increase. A decrease in pounds sold partially offset the increase in revenue per pound sold by $70.8 million, or 0.9 percentage points. Included in U.S. sales generated during 2014 and 2013 were sales to JBS USA Food Company totaling $39.7 million and $61.9 million, respectively. (b) Mexico sales generated in 2014 increased $25.4 million, or 2.8%, from Mexico sales generated in 2013, primarily because of an increase in the net revenue per pound sold and an increase in sales volume partially offset by the impact of foreign currency translation. The increase in net revenue per pound contributed $42.4 million, or 4.7%, to the increase in sales. The increase in volume contributed $24.2 million, or 2.7 percentage points, to the increase in sales, partially offset by the unfavorable impact of foreign currency translation contributed $41.2 million, or 4.4 percentage points, to the revenue decrease. Gross profit. Gross profit increased by $548.6 million, or 64.9%, from $845.7 million generated in 2013 to $1.4 billion generated in 2014. The following tables provide gross profit information: (a) Cost of sales incurred by our U.S. operations in 2014 decreased $339.0 million, or 5.0%, from cost of sales incurred by our U.S. operations in 2013. Cost of sales decreased primarily because of a $464.7 million decrease in feed ingredients costs, a $23.6 million decrease in wages and benefits, a $17.2 million decrease in co-pack labor, a $15.4 million decrease in freight and storage and a $5.1 million decrease in repairs and maintenance. Decreases to cost of sales were partially offset by a decrease in derivative gains from $23.4 million in 2013 to $16.0 million in 2014, a $6.2 million increase in utilities costs, a $5.8 million increase in contract labor costs and a $2.6 million increase in lease costs. Other factors affecting U.S. cost of sales were immaterial. (b) Cost of sales incurred by the Mexico operations during 2014 decreased $37.3 million, or 4.8%, from cost of sales incurred by the Mexico operations during 2013. Cost of sales decreased primarily because of lower feed ingredients costs partially offset by the impact of foreign currency translation. The impact of lower feed ingredients costs contributed $41.6 million, or 6.8 percentage points, to the decrease in costs of sales. The impact of foreign currency translation contributed $31.9 million, or 4.1 percentage points, to the decrease in cost of sales. Cost of sales also decreased because of a $1.7 million decrease in wages and benefits offset by an increase of $4.1 million in freight and storage costs, a $2.4 million increase in contract labor costs, a $2.4 million increase in utilities costs, a $2.2 million increase in grower costs and a decrease in derivative gains from $1.8 million in 2013 to $0.2 million in 2014. Other factors affecting cost of sales were individually immaterial. Operating income. Operating income increased $544.3 million, or 82.6%, from $658.8 million generated for 2013 to $1.2 billion generated for 2014. The following tables provide operating income information: (a) SG&A expense incurred by the U.S. operations during 2014 increased $9.2 million, or 5.7%, from SG&A expense incurred by the U.S. operations during 2013 primarily because of an $8.2 million increase in employee wages and benefits, a $6.2 million increase in management fees charged for administrative functions shared with JBS USA Food Company Holdings and a $1.6 million increase in legal services expenses that were partially offset by a $2.2 million gain on asset disposals, a $1.4 million decrease in outside services expenses, a $1.4 million decrease in depreciation expenses, recognition of a $1.1 million bad debt recovery, a $1.0 million decrease in brokerage expenses and a $1.0 million decrease in contract labor expenses. Other factors affecting SG&A expense were individually immaterial. (b) SG&A expense incurred by the Mexico operations during 2014 decreased $1.5 million, or 7.2%, from SG&A expense incurred by the Mexico operations during 2013 primarily because of a $2.7 million decrease in contract labor expenses, a $2.0 million decrease in government fees and a $1.1 million decrease in management fees charged by the U.S. operations that were partially offset by a $2.8 million increase in employee wages and benefits, a $0.6 million loss recognized on asset disposals, a $0.4 million increase in marketing expenses and a $0.4 million increase in legal services expenses. Other factors affecting SG&A expense were individually immaterial. (c) Administrative restructuring charges incurred during 2014 decreased $3.4 million, or 59.6%, from administrative restructuring charges incurred during 2013. During 2014, we incurred administrative restructuring charges composed of (i) live operations rationalization costs of $0.9 million, (ii) employee-related costs of $0.6 million, (iii) other exit or disposal costs of $0.4 million and (iv) inventory valuation costs of $0.3 million. (d) Our Consolidated Financial Statements include the accounts of our company and its majority owned subsidiaries. We eliminate all significant affiliate accounts and transactions upon consolidation. In 2013, we eliminated a gain of $880.0 thousand recognized by our U.S, operations on the sale of equipment to our Mexican operations. Interest expense. Consolidated interest expense decreased 5.6% to $82.1 million in 2014 from $87.0 million in 2013 primarily because of decreased average borrowings of $526.7 million in 2014, compared to $990.5 million in 2013, and a decrease in the weighted average interest rate to 6.45% in 2014, from 7.10% in 2013. As a percent of net sales, interest expense in 2014 and 2013 was 0.96% and 1.03%. respectively. Income taxes. Our consolidated income tax expense in 2014 was $390.9 million, compared to income tax expense of $24.2 million in 2013. The income tax expense in 2014 resulted primarily from an increase in income partially offset by decreases in valuation allowance and reserves for unrecognized tax benefits during 2013. Liquidity and Capital Resources The following table presents our available sources of liquidity as of December 27, 2015: (a) Actual borrowings under the revolving loan commitment of our U.S. Credit Facility are subject to a borrowing base, which is a formula based on certain eligible inventory and eligible receivables. The borrowing base in effect at December 27, 2015 was $690.8 million. Availability under the U.S. Credit Facility is also reduced by our outstanding standby letters of credit. Standby letters of credit outstanding at December 27, 2015 totaled $20.1 million. (b) As of December 27, 2015, the U.S. dollar-equivalent of the amount available under the Mexico Credit Facility (as described below) was $58.6 million. The Mexico Credit Facility provides for a loan commitment of $1.5 billion Mexican pesos. Long-Term Debt and Other Borrowing Arrangements Senior and Subordinated Notes On March 11, 2015, we completed a sale of the Senior Notes. We used the net proceeds from the sale of the Senior Notes to repay $350.0 million and $150.0 million of the term loan indebtedness under the U.S. Credit Facility on March 12, 2015 and April 22, 2015, respectively. The Notes were sold to qualified institutional buyers pursuant to Rule 144A under the Securities Act of 1933, as amended, and outside the U.S. to non-U.S. persons pursuant to Regulation S under the Securities Act. The Senior Notes are governed by, and were issued pursuant to, an indenture dated as of March 11, 2015 by and among us, our guarantor subsidiary and Wells Fargo Bank, National Association, as trustee (the “Indenture”). The Indenture provides, among other things, that the Senior Notes bear interest at a rate of 5.75% per annum from the date of issuance until maturity, payable semi-annually in cash in arrears, beginning on September 15, 2015. The Senior Notes are guaranteed on a senior unsecured basis by our guarantor subsidiary. In addition, any of our other existing or future domestic restricted subsidiaries that incur or guarantee any other indebtedness (with limited exceptions) must also guarantee the Senior Notes. The Senior Notes and related guarantees are our and our guarantor subsidiary's unsecured senior obligations and rank equally with all of our and our guarantor subsidiary's other unsubordinated indebtedness. The Senior Notes and the Indenture also contain customary covenants and events of default, including failure to pay principal or interest on the Senior Notes when due, among others. U.S. Credit Facility On February 11, 2015, our company and two of its subsidiaries, To-Ricos, Ltd. and To-Ricos Distribution, Ltd., entered into the U.S. Credit Facility with Rabobank. The U.S. Credit Facility provides for a revolving loan commitment of up to $700.0 million and a term loan commitment of up to $1.0 billion (the “Term Loans”). The term loan commitment is no longer available for additional loans. The U.S. Credit Facility also includes an accordion feature that allows us, at any time, to increase the aggregate revolving loan and term loan commitments by up to an additional $1.0 billion, subject to the satisfaction of certain conditions, including obtaining the lenders’ agreement to participate in the increase. The revolving loan commitment under the U.S. Credit Facility matures on February 10, 2020. All principal on the Term Loans is due at maturity on February 10, 2020. Because we prepaid $500.0 million of the Term Loans with proceeds from the Senior Notes, we are not required to pay quarterly installments. Covenants in the U.S. Credit Facility also require us to use the proceeds we receive from certain asset sales and specified debt or equity issuances and upon the occurrence of other events to repay outstanding borrowings under the U.S. Credit Facility. We had Term Loans outstanding totaling $500.0 million as of December 27, 2015. The U.S. Credit Facility includes a $75.0 million sub-limit for swingline loans and a $125.0 million sub-limit for letters of credit. Outstanding borrowings under the revolving loan commitment and the Term Loans bear interest at a per annum rate equal to (i) in the case of LIBOR loans, LIBOR plus 1.50% through September 27, 2015 and, based on our net senior secured leverage ratio, between LIBOR plus 1.25% and LIBOR plus 2.75% and (ii) in the case of alternate base rate loans, the base rate plus 0.50% through December 27, 2015 and, based on our net senior secured leverage ratio, between the base rate plus 0.25% and base rate plus 1.75% thereafter. Actual borrowings by us under the revolving loan commitment of the U.S. Credit Facility are subject to a borrowing base, which is a formula based on certain eligible inventory, eligible receivables and restricted cash under the control of Rabobank, in its capacity as administrative agent. The borrowing base formula will be reduced by the sum of (i) inventory reserves, (ii) rent and collateral access reserves, and (iii) any amount more than 15 days past due that is owed by us or our subsidiaries to any person on account of the purchase price of agricultural products or services (including poultry and livestock) if that person is entitled to any grower's or producer's lien or other security arrangement. As of December 27, 2015, the applicable borrowing base was $690.8 million and the amount available for borrowing under the revolving loan commitment was $670.7 million. We had letters of credit of $20.1 million and no outstanding borrowings under the revolving loan commitment as of December 27, 2015. The U.S. Credit Facility contains financial covenants and various other covenants that may adversely affect our ability to, among other things, incur additional indebtedness, incur liens, pay dividends or make certain restricted payments, consummate certain assets sales, enter into certain transactions with JBS and our other affiliates, merge, consolidate and/or sell or dispose of all or substantially all of our assets. The U.S. Credit Facility requires us to comply with a minimum level of tangible net worth covenant. The U.S. Credit Facility also provides that we may not incur capital expenditures in excess of $500.0 million in any fiscal year. We are currently in compliance with the covenants under the U.S. Credit Facility. All obligations under the U.S. Credit Facility are unconditionally guaranteed by certain of our subsidiaries and are secured by a first priority lien on (i) the accounts receivable and inventory of our company and its non-Mexico subsidiaries, (ii) 100% of the equity interests in our domestic subsidiaries, To-Ricos, Ltd. and To-Ricos Distribution, Ltd., and 65% of the equity interests in our direct foreign subsidiaries and (iii) substantially all of the assets of our Company and the guarantors under the U.S. Credit Facility. Subordinated Loan Agreement We have entered into a Subordinated Loan Agreement with JBS USA Food Company Holdings (“JBS USA Holdings”) dated June 23, 2011 (the “Subordinated Loan Agreement”). Pursuant to the terms of the Subordinated Loan Agreement, we agreed to reimburse JBS USA Holdings up to $56.5 million for draws upon any letters of credit issued for JBS USA Holdings’ account that support certain obligations of our company or its subsidiaries. JBS USA Holdings agreed to arrange for letters of credit to be issued on its account in the amount of $56.5 million to an insurance company serving us in order to allow that insurance company to return cash it held as collateral against potential workers compensation, auto and general liability claims. In return for providing this letter of credit, we agreed to reimburse JBS USA Holdings for the letter of credit cost we would otherwise incur under our U.S. Credit Facility (as defined below). The total amount we paid in 2015, 2014 and 2013 to reimburse JBS USA Holdings was $0.9 million, $1.3 million and $2.2 million, respectively. As of December 27, 2015, we have accrued an obligation of $0.1 million to reimburse JBS USA Holdings for letter of credit costs incurred on its behalf. There remains no other commitment of JBS USA Holdings to make advances under the Subordinated Loan Agreement. Mexico Credit Facility On July 23, 2014, certain of our Mexican subsidiaries entered into an unsecured credit agreement (the “Mexico Credit Facility”) with BBVA Bancomer, S.A. Institución de Banca Múltiple, Grupo Financiero BBVA Bancomer, as lender. The loan commitment under the Mexico Credit Facility is $1.5 billion Mexican pesos. Outstanding borrowings under the Mexico Credit Facility will accrue interest at a rate equal to the Interbank Equilibrium Interest Rate plus 0.90%. The Mexico Credit Facility will mature on July 23, 2017. As of December 27, 2015, the U.S. dollar-equivalent of the loan commitment under the Mexico Credit Facility was $87.3 million, and there were $28.7 million outstanding borrowings under the Mexico Credit Facility that bear interest at a per annum rate of 4.33%. As of December 27, 2015, the U.S. dollar-equivalent borrowing availability was $58.6 million. Collateral Substantially all of our domestic inventories and domestic fixed assets are pledged as collateral to secure the obligations under the U.S. Credit Facility. Off-Balance Sheet Arrangements We maintain operating leases for various types of equipment, some of which contain residual value guarantees for the market value of assets at the end of the term of the lease. The terms of the lease maturities range from one to ten years. We estimate the maximum potential amount of the residual value guarantees is approximately $8.0 million; however, the actual amount would be offset by any recoverable amount based on the fair market value of the underlying leased assets. No liability has been recorded related to this contingency as the likelihood of payments under these guarantees is not considered to be probable, and the fair value of the guarantees is immaterial. We historically have not experienced significant payments under similar residual guarantees. We are a party to many routine contracts in which we provide general indemnities in the normal course of business to third parties for various risks. Among other considerations, we have not recorded a liability for any of these indemnities as, based upon the likelihood of payment, the fair value of such indemnities would not have a material impact on our financial condition, results of operations and cash flows. Capital Expenditures We anticipate spending between $180.0 million and $200.0 million on the acquisition of property, plant and equipment in 2016. Capital expenditures will primarily be incurred to improve efficiencies and reduce costs. We expect to fund these capital expenditures with cash flow from operations and proceeds from the revolving lines of credit under our various debt facilities. Indefinite Reinvestment of Foreign Subsidiaries' Undistributed Earnings We have determined that the undistributed earnings of our Mexico and Puerto Rico subsidiaries will be indefinitely reinvested and not distributed to the U.S. The undistributed earnings of our Mexico, and Puerto Rico subsidiaries totaled $508.1 million and $17.8 million, respectively, at December 27, 2015. Contractual Obligations In addition to our debt commitments at December 27, 2015, we had other commitments and contractual obligations that obligate us to make specified payments in the future. The following table summarizes the total amounts due as of December 27, 2015, under all debt agreements, commitments and other contractual obligations. The table indicates the years in which payments are due under the contractual obligations. (a) The total amount of unrecognized tax benefits at December 27, 2015 was $17.1 million. We did not include this amount in the contractual obligations table above as reasonable estimates cannot be made at this time of the amounts or timing of future cash outflows. (b) Long-term debt is presented at face value and excludes $20.1 million in letters of credit outstanding related to normal business transactions. (c) Interest expense in the table above assumes the continuation of interest rates and outstanding borrowings as of December 27, 2015. (d) Includes agreements to purchase goods or services that are enforceable and legally binding on us and that specify all significant terms, including fixed or minimum quantities to be purchased; fixed, minimum, or variable price provisions; and the approximate timing of the transaction. We expect cash flows from operations, combined with availability under the U.S. Credit Facility, to provide sufficient liquidity to fund current obligations, projected working capital requirements, maturities of long-term debt and capital spending for at least the next twelve months. Historical Flow of Funds Fiscal Year 2015 Cash provided by operating activities was $976.8 million and $1.1 billion in 2015 and 2014, respectively. The decrease in cash flows provided by operating activities was primarily from net income of $646.0 million for 2015, as compared to net income of $711.4 million for 2014, and changes in working capital (excluding the impacts as a result of changes in foreign currency exchange rates). Our net working capital position, which we define as current assets less current liabilities, decreased $238.9 million to a surplus of $899.2 million and a current ratio of 2.06 at December 27, 2015, compared to a surplus of $1.1 billion and a current ratio of 2.58 at December 28, 2014. The decrease in working capital was caused by the generation of cash from operations. Trade accounts and other receivables, including accounts receivable from related parties, decreased $32.5 million, or 8.5%, to $351.7 million at December 27, 2015 from $384.1 million at December 28, 2014 due to a decrease in sales. Inventories increased $11.1 million, or 1.4%, to $801.5 million at December 27, 2015 from $790.3 million at December 28, 2014. This change in inventories resulted primarily from the impact of the Tyson Mexico acquisition. Prepaid expenses and other current assets decreased $19.8 million, or 20.8%, to $75.6 million at December 27, 2015 from $95.4 million at December 28, 2014. This change resulted primarily from a $25.1 million decrease in open derivative positions and margin cash on deposit with our derivatives traders. Accounts payable and accrued expenses, including accounts payable to related parties, increased $88.7 million, or 12.4%, to $804.9 million at December 27, 2015 from $716.2 million at December 28, 2014. This change resulted primarily from the impact of the Tyson Mexico acquisition and use of a financing vehicle that extends the terms of many of our payables. Cash used in investing activities was $534.7 million and $63.4 million in 2015 and 2014, respectively. We incurred capital expenditures of $175.8 million and $171.4 million for 2015 and 2014, respectively. In both 2015 and 2014, capital expenditures were primarily incurred for the routine replacement of equipment and to improve efficiencies and reduce costs. Capital expenditures for 2015 could not exceed $500 million under the terms of our U.S. credit facility. Cash proceeds generated from property disposals in 2015 and 2014 totaled $14.6 million and $11.1 million, respectively. Cash was used to purchase investment securities totaling $55.1 million in 2014. Cash proceeds generated in 2014 from the sale or maturity of investment securities totaled $152.0 million. Cash used in financing activities was $578.6 million and $905.6 million in 2015 and 2014, respectively. Cash proceeds in 2015 from long-term debt totaled $1.7 billion. Cash was used to repay long-term debt totaling $683.8 million and $910.2 million in 2015 and 2014, respectively. Cash proceeds in 2015 and 2014 resulting from tax benefits related to share-based compensation totaled $6.5 million and $0.5 million, respectively. Cash proceeds in 2014 resulting from an equity contribution under a tax sharing agreement between JBS USA Holdings and our company totaled $3.8 million. Cash proceeds in 2014 from the sale of subsidiary common stock totaled $0.3 million. Cash was used to pay capitalized loan costs totaling $12.4 million in 2015. Additionally, cash was used in 2015 to pay a special cash dividend of approximately $1.5 billion and to purchase treasury stock of $99.2 million. Fiscal Year 2014 Cash provided by operating activities was $1.1 billion and $878.5 million in 2014 and 2013, respectively. The increase in cash flows provided by operating activities was primarily from net income of $711.4 million for 2014, as compared to net income of $549.7 million for 2013, and changes in working capital (excluding the impacts as a result of changes in foreign currency exchange rates). Our net working capital position, which we define as current assets less current liabilities, increased $294.6 million to a surplus of $1.1 billion and a current ratio of 2.53 at December 28, 2014, compared to a surplus of $845.6 million and a current ratio of 1.78 at December 29, 2013. The increase in working capital was caused by the generation of cash from operations. Trade accounts and other receivables, including accounts receivable from related parties, increased $5.1 million, or 1.3%, to $384.1 million at December 28, 2014 from $379.1 million at December 29, 2013. Inventories decreased $18.5 million, or 2.3%, to $790.3 million at December 28, 2014 from $808.8 million at December 29, 2013. The change in inventories was primarily due to decreased costs for feed grains and their impact on the value of our live chicken inventories. Prepaid expenses and other current assets increased $33.6 million, or 54.3%, to $95.4 million at December 28, 2014 from $61.8 million at December 29, 2013. This change resulted primarily from a $27.9 million increase in open derivative positions and margin cash on deposit with our derivatives traders. Accounts payable and accrued expenses, including accounts payable to related parties, increased $58.6 million, or 8.9%, to $716.2 million at December 28, 2014 from $657.6 million at December 29, 2013. This change resulted primarily from the timing of payments disbursed to vendors around December 28, 2014. Cash used in investing activities was $63.4 million and $181.8 million in 2014 and 2013, respectively. We incurred capital expenditures of $171.4 million and $116.2 million for 2014 and 2013, respectively. In both 2014 and 2013, capital expenditures were primarily incurred for the routine replacement of equipment and to improve efficiencies and reduce costs. Capital expenditures for 2014 could not exceed $350 million under the terms of our U.S. credit facility. Cash proceeds generated from property disposals in 2014 and 2013 totaled $11.1 million and $31.3 million, respectively. Cash was used to purchase investment securities totaling $55.1 million and $96.9 million in 2014 and 2013, respectively. Cash proceeds generated in 2014 from the sale or maturity of investment securities totaled $152.0 million. Cash used in financing activities was $905.6 million and $250.2 million in 2014 and 2013, respectively. Cash proceeds in 2013 from long-term debt totaled $505.6 million. Cash was used to repay long-term debt totaling $910.2 million and $758.6 million in 2014 and 2013, respectively. Cash proceeds in 2014 and 2013 resulting from tax benefits related to share-based compensation totaled $0.5 million and $7.7 million, respectively. Cash proceeds in 2014 from an equity contribution under a tax sharing agreement between JBS USA Holdings and our company totaled $3.8 million. Cash proceeds in 2014 from the sale of subsidiary common stock totaled $0.3 million. Additionally, cash was used to pay capitalized loan costs totaling $5.0 million in 2013. Recently Adopted Accounting Pronouncements During the thirteen weeks ended December 27, 2015, we early adopted the Financial Accounting Standards Board (“FASB”) presentation guidance for debt issuance costs, which requires that debt issuance costs related to a recognized debt liability be presented in the balance sheet as a direct deduction from the carrying amount of that debt liability, consistent with debt discounts. This change in accounting principal should reduce the unnecessary complexity created by having different balance sheet presentation requirements for debt issuance costs and debt discount and premium and conform U.S. GAAP with the guidance in International Financial Reporting Standards (“IFRS”). The guidance did not address presentation or subsequent measurement of debt issuance costs related to line-of-credit arrangements. Given the absence of authoritative guidance for debt issuance costs related to line-of-credit arrangements, the Securities and Exchange Commission staff indicated they would not object to an entity deferring and presenting debt issuance costs as an asset and subsequently amortizing the deferred debt issuance costs ratably over the term of the line-of-credit arrangement, regardless of whether there were any outstanding borrowings on the line-of-credit arrangement. We held deferred debt issuance costs of $7.6 million at December 28, 2014 related to a line-of-credit arrangement for which there was no corresponding outstanding borrowing. Rather than retrospectively presenting these debt issuance costs in its Consolidated Balance Sheet as a direct deduction from the carrying amount of the associated debt liability, we will continue to present these costs as an asset. During the thirteen weeks ended December 27, 2015, we early adopted the FASB guidance for balance sheet classification of deferred taxes, which requires that deferred tax liabilities and assets be classified as noncurrent in a classified balance sheet. This change in accounting principal should reduce the unnecessary complexity created by separating deferred income tax liabilities and assets into current and noncurrent amounts. This change should also eliminate costs incurred by an entity to separate deferred income tax liabilities and assets into a current and noncurrent amount. We adopted this guidance with retrospective application. A description of the prior-period information that has been retrospectively adjusted, and the effect of the change on the financial statement line items is included below: During the thirteen weeks ended December 27, 2015, we early adopted the FASB's new accounting and presentation for adjustments to provisional amounts recognized in business combinations, which, in an effort to reduce the cost and complexity of financial reporting, requires an acquiring entity in a business combination to recognize adjustments to provisional amounts identified during the measurement period in the reporting period in which the adjustment amounts are determined. The guidance also requires an acquiring entity in a business combination to present separately on the face of the income statement or disclose in the notes the portion of the amount recorded in current-period earnings by line item that would have been recorded in previous reporting periods if the adjustment to the provisional amounts had been recognized as of the acquisition date. The adoption of this guidance did not have a material impact on our financial statements. Recently Issued Accounting Standards Not Adopted as of December 27, 2015 In May 2014, the FASB issued new accounting guidance on revenue recognition, which provides for a single five-step model to be applied to all revenue contracts with customers. The new standard also requires additional financial statement disclosures that will enable users to understand the nature, amount, timing and uncertainty of revenue and cash flows relating to customer contracts. Companies have an option to use either a retrospective approach or cumulative effect adjustment approach to implement the standard. In June 2015, the FASB agreed to defer by one year the mandatory effective date of this standard, but will also provide entities the option to adopt the new guidance as of the original effective date. The provisions of the new guidance will be effective as of the beginning of our 2018 fiscal year, but we have the option to adopt the guidance as early as the beginning of our 2017 fiscal year. We are currently evaluating the impact of the new guidance on our financial statements and have not yet selected either a transition approach to implement the standard or an adoption date. In July 2015, the FASB issued new accounting guidance on the subsequent measurement of inventory, which, in an effort to simplify unnecessarily complicated accounting guidance that can result in several potential outcomes, requires an entity to measure inventory at the lower of cost or net realizable value. Net realizable value is the estimated selling prices in the ordinary course of business, less reasonably predictable costs of completion, disposal and transportation. Current accounting guidance requires an entity to measure inventory at the lower of cost or market. Market could be replacement cost, net realizable value, or net realizable value less an approximately normal profit margin. The provisions of the new guidance will be effective as of the beginning of our 2017 fiscal year. We are currently evaluating the impact of the new guidance on our financial statements. Critical Accounting Policies and Estimates General. Our discussion and analysis of our financial condition and results of operations are based upon our financial statements, which have been prepared in accordance with U.S. GAAP. The preparation of these financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses. On an ongoing basis, we evaluate our estimates, including those related to revenue recognition, customer programs and incentives, allowance for doubtful accounts, inventories, income taxes and product recall accounting. We base our estimates on historical experience and on various other assumptions that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions. We believe the following critical accounting policies affect our more significant judgments and estimates used in the preparation of our financial statements. Revenue Recognition. We recognize revenue when all of the following circumstances are satisfied: (i) persuasive evidence of an arrangement exists, (ii) price is fixed or determinable, (iii) collectability is reasonably assured and (iv) delivery has occurred. Delivery occurs in the period in which the customer takes title and assumes the risks and rewards of ownership of the products specified in the customer's purchase order or sales agreement. Revenue is recorded net of estimated incentive offerings including special pricing agreements, promotions and other volume-based incentives. Revisions to these estimates are charged back to net sales in the period in which the facts that give rise to the revision become known. Inventory. Live chicken inventories are stated at the lower of cost or market and breeder hen inventories at the lower of cost, less accumulated amortization, or market. The costs associated with breeder hen inventories are accumulated up to the production stage and amortized over their productive lives using the unit-of-production method. Finished poultry products, feed, eggs and other inventories are stated at the lower of cost (average) or market. We record valuations and adjustments for our inventory and for estimated obsolescence at or equal to the difference between the cost of inventory and the estimated market value based upon known conditions affecting inventory obsolescence, including significantly aged products, discontinued product lines, or damaged or obsolete products. We allocate meat costs between our various finished chicken products based on a by-product costing technique that reduces the cost of the whole bird by estimated yields and amounts to be recovered for certain by-product parts. This primarily includes leg quarters, wings, tenders and offal, which are carried in inventory at the estimated recovery amounts, with the remaining amount being reflected as our breast meat cost. Generally, we perform an evaluation of whether any lower of cost or market adjustments are required at the country level based on a number of factors, including: (i) pools of related inventory, (ii) product continuation or discontinuation, (iii) estimated market selling prices and (iv) expected distribution channels. If actual market conditions or other factors are less favorable than those projected by management, additional inventory adjustments may be required. Property, Plant and Equipment. We record impairment charges on long-lived assets held for use when events and circumstances indicate that the assets may be impaired and the undiscounted cash flows estimated to be generated by those assets are less than the carrying amount of those assets. The impairment charge is determined based upon the amount by which the net book value of the assets exceeds their fair market value. In making these determinations, we utilize certain assumptions, including, but not limited to: (i) future cash flows estimated to be generated by these assets, which are based on additional assumptions such as asset utilization, remaining length of service and estimated salvage values, (ii) estimated fair market value of the assets, and (iii) determinations with respect to the lowest level of cash flows relevant to the respective impairment test, generally groupings of related operational facilities. Given the interdependency of our individual facilities during the production process, which operate as a vertically integrated network, we evaluate impairment of assets held for use at the country level (i.e., the U.S. and Mexico). Management believes this is the lowest level of identifiable cash flows for our assets that are held for use in production activities. At the present time, our forecasts indicate that we can recover the carrying value of our assets held for use based on the projected undiscounted cash flows of the operations. We record impairment charges on long-lived assets held for sale when the carrying amount of those assets exceeds their fair value less appropriate selling costs. Fair value is based on amounts documented in sales contracts or letters of intent accepted by us, amounts included in counteroffers initiated by us, or, in the absence of current contract negotiations, amounts determined using a sales comparison approach for real property and amounts determined using a cost approach for personal property. Under the sales comparison approach, sales and asking prices of reasonably comparable properties are considered to develop a range of unit prices within which the current real estate market is operating. Under the cost approach, a current cost to replace the asset new is calculated and then the estimated replacement cost is reduced to reflect the applicable decline in value resulting from physical deterioration, functional obsolescence and economic obsolescence. Appropriate selling costs includes reasonable broker's commissions, costs to produce title documents, filing fees, legal expenses and the like. We estimate appropriate closing costs as 4% to 6% of asset fair value. This range of rates is considered reasonable for our assets held for sale based on historical experience. Litigation and Contingent Liabilities. We are subject to lawsuits, investigations and other claims related to employment, environmental, product, and other matters. We are required to assess the likelihood of any adverse judgments or outcomes, as well as potential ranges of probable losses, to these matters. We estimate the amount of reserves required for these contingencies when losses are determined to be probable and after considerable analysis of each individual issue. We expense legal costs related to such loss contingencies as they are incurred. With respect to our environmental remediation obligations, the accrual for environmental remediation liabilities is measured on an undiscounted basis. These reserves may change in the future due to changes in our assumptions, the effectiveness of strategies, or other factors beyond our control. Accrued Self Insurance. Insurance expense for casualty claims and employee-related health care benefits are estimated using historical and current experience and actuarial estimates. Stop-loss coverage is maintained with third-party insurers to limit our total exposure. Certain categories of claim liabilities are actuarially determined. The assumption used to arrive at periodic expenses is reviewed regularly by management. However, actual expenses could differ from these estimates and could result in adjustments to be recognized. Income Taxes. We follow provisions under ASC 740-10-30-27 in the Expenses-Income Taxes topic with regard to members of a group that file a consolidated tax return but issue separate financial statements. We file our own U.S. federal tax return, but we are included in certain state consolidated returns with JBS USA Holdings. The income tax expense of our company is computed using the separate return method. The provision for income taxes has been determined using the asset and liability approach of accounting for income taxes. Under this approach, deferred income taxes reflect the net tax effect of temporary differences between the book and tax bases of recorded assets and liabilities, net operating losses and tax credit carry forwards. The amount of deferred tax on these temporary differences is determined using the tax rates expected to apply to the period when the asset is realized or the liability is settled, as applicable, based on the tax rates and laws in the respective tax jurisdiction enacted as of the balance sheet date. We recognize potential interest and penalties related to income tax positions as a part of the income tax provision. Realizability of Deferred Tax Assets. We review our deferred tax assets for recoverability and establish a valuation allowance based on historical taxable income, potential for carry back of tax losses, projected future taxable income, applicable tax strategies, and the expected timing of the reversals of existing temporary differences. A valuation allowance is provided when it is more likely than not that some or all of the deferred tax assets will not be realized. Valuation allowances have been established primarily for net operating loss carry forwards. See “Note 12. Income Taxes” to the Consolidated Financial Statements in this annual report. Indefinite Reinvestment in Foreign Subsidiaries. We deem our earnings from Mexico and Puerto Rico as of December 27, 2015 to be permanently reinvested. As such, U.S. deferred income taxes have not been provided on these earnings. If such earnings were not considered indefinitely reinvested, certain deferred foreign and U.S. income taxes would be provided. Accounting for Uncertainty in Income Taxes. We follow provisions under ASC 740-10-25 that provide a recognition threshold and measurement criteria for the financial statement recognition of a tax benefit taken or expected to be taken in a tax return. Tax benefits are recognized only when it is more likely than not, based on the technical merits, that the benefits will be sustained on examination. Tax benefits that meet the more-likely-than-not recognition threshold are measured using a probability weighting of the largest amount of tax benefit that has greater than 50% likelihood of being realized upon settlement. Whether the more-likely-than-not recognition threshold is met for a particular tax benefit is a matter of judgment based on the individual facts and circumstances evaluated in light of all available evidence as of the balance sheet date. See “Note 12. Income Taxes” to the Consolidated Financial Statements in this annual report. Pension and Other Postretirement Benefits. Our pension and other postretirement benefit costs and obligations are dependent on the various actuarial assumptions used in calculating such amounts. These assumptions relate to discount rates, salary growth, long-term return on plan assets and other factors. We base the discount rate assumptions on current investment yields on high-quality corporate long-term bonds. Long-term return on plan assets is determined based on historical portfolio results and management’s expectation of the future economic environment. Actual results that differ from our assumptions are accumulated and, if in excess of the lesser of 10% of the projected benefit obligation or the fair market value of plan assets, amortized over either (i) the estimated average future service period of active plan participants if the plan is active or (ii) the estimated average future life expectancy of all plan participants if the plan is frozen.

<s>[INST] We are one of the largest chicken producers in the world, with operations in the U.S., Mexico and Puerto Rico. We are primarily engaged in the production, processing, marketing and distribution of fresh, frozen and valueadded chicken products to retailers, distributors and foodservice operators. We offer a wide range of products to our customers through strong national and international distribution channels. Pilgrim's fresh chicken products consist of refrigerated (nonfrozen) whole chickens, whole cutup chickens and selected chicken parts that are either marinated or nonmarinated. The Company's prepared chicken products include fully cooked, readytocook and individually frozen chicken parts, strips, nuggets and patties, some of which are either breaded or nonbreaded and either marinated or nonmarinated. We market our balanced portfolio of fresh, prepared and valueadded chicken products to a diverse set of over 5,000 customers across the U.S., Mexico and in approximately 90 other countries, with no single one accounting for more than 10% of total sales. We have become a valuable partner to our customers and a recognized industry leader by consistently providing highquality products and services designed to meet their needs and enhance their business. Our sales efforts are largely targeted towards the foodservice industry, principally chain restaurants and food processors such as ChickfilA® and Yum! Brands®, distributors such as US Foods and Sysco® and retail customers, including grocery store chains and wholesale clubs such as Kroger®, WalMart®, Costco®, Publix®, Albertsons®, HEB® and Sam’s Club®. As a vertically integrated company, we control every phase of the production process, which helps us better manage food safety and quality, as well as more effectively control margins and improve customer service. We operate feed mills, hatcheries, processing plants and distribution centers in 12 U.S. states, Puerto Rico and Mexico. Our plants are strategically located to ensure that customers timely receive fresh products. With our global network of approximately 4,130 growers, 35 feed mills, 40 hatcheries, 30 processing plants, six prepared foods cook plants, 23 distribution centers, eight rendering facilities and three pet food plants, we believe we are well positioned to supply the growing demand for our products. We are one of the largest, and we believe one of the most efficient, producers and sellers of chicken in Mexico. Our presence in Mexico provides access to a market with growing demand and has enabled us to leverage our operational strengths within the region. The market for chicken products in Mexico is still developing with most sales attributed to fresh, commodityoriented, market pricebased business. We believe our Mexico business is well positioned to continue benefiting from these trends in the Mexican consumer market. Additionally, we are an important player in the live market, which accounted for approximately 25% of the industry’s chicken sales in Mexico in 2015. Pilgrim's has approximately 39,000 employees and has the capacity to process more than 37 million birds per week for a total of more than 10.8 billion pounds of live chicken annually. In 2015, we produced 7.9 billion pounds of chicken products, generating approximately $8.2 billion in net revenues and approximately $645.9 million in net income attributable to Pilgrim’s. We operate on a 52/53week fiscal year that ends on the Sunday falling on or before December 31. The reader should assume any reference we make to a particular year (for example, 2015) in this report applies to our fiscal year and not the calendar year. Executive Summary We reported net income attributable to Pilgrim’s Pride Corporation of $645.9 million, or $2.50 per diluted common share, for 2015. These operating results included gross profit of $1.3 billion. During 2015, we generated $976.8 million of cash from operations. Market prices for feed ingredients remain volatile. Consequently, there can be no assurance that our feed ingredients prices will not increase materially and that such increases would not negatively impact our financial position, results of operations and cash flow. The following table [/INST] Positive. </s>

PILGRIMS PRIDE CORP

2017-02-09

2016-12-25

Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations Our Company We are one of the largest chicken producers in the world, with operations in the U.S., Mexico and Puerto Rico. We are primarily engaged in the production, processing, marketing and distribution of fresh, frozen and value-added chicken products to retailers, distributors and foodservice operators. We offer a wide range of products to our customers through strong national and international distribution channels. Pilgrim’s fresh chicken products consist of refrigerated (non-frozen) whole chickens, whole cut-up chickens and selected chicken parts that are either marinated or non-marinated. The Company’s prepared chicken products include fully cooked, ready-to-cook and individually frozen chicken parts, strips, nuggets and patties, some of which are either breaded or non-breaded and either marinated or non-marinated. We market our balanced portfolio of fresh, prepared and value-added chicken products to a diverse set of over 5,000 customers across the U.S., Mexico and in approximately 80 other countries, with no single one accounting for more than 10% of total sales. We have become a valuable partner to our customers and a recognized industry leader by consistently providing high-quality products and services designed to meet their needs and enhance their business. Our sales efforts are largely targeted towards the foodservice industry, principally chain restaurants and food processors such as Chick-fil-A®, distributors such as US Foods and Sysco® and retail customers, including grocery store chains and wholesale clubs such as Kroger®, Costco®, Publix®, and H-E-B®. As a vertically integrated company, we control every phase of the production process, which helps us better manage food safety and quality, as well as more effectively control margins and improve customer service. We operate feed mills, hatcheries, processing plants and distribution centers in 12 U.S. states, Puerto Rico and Mexico. Our plants are strategically located to ensure that customers timely receive fresh products. With our global network of approximately 4,045 growers, 32 feed mills, 39 hatcheries, 30 processing plants, six prepared foods cook plants, 20 distribution centers, eight rendering facilities and three pet food plants, we believe we are well positioned to supply the growing demand for our products. We are one of the largest, and we believe one of the most efficient, producers and sellers of chicken in Mexico. Our presence in Mexico provides access to a market with growing demand and has enabled us to leverage our operational strengths within the region. The market for chicken products in Mexico is still developing with most sales attributed to fresh, commodity-oriented, market price-based business. We believe our Mexico business is well positioned to continue benefiting from these trends in the Mexican consumer market. Additionally, we are an important player in the live market, which accounted for approximately 35% of the industry’s chicken sales in Mexico in 2016. As of December 25, 2016, we had approximately 39,600 employees and the capacity to process more than 36.7 million birds per week for a total of more than 10.7 billion pounds of live chicken annually. In 2016, we produced 8.1 billion pounds of chicken products, generating approximately $7.9 billion in net revenues and approximately $440.5 million in net income attributable to Pilgrim’s. We operate on a 52/53-week fiscal year that ends on the Sunday falling on or before December 31. Any reference we make to a particular year (for example, 2016) in this report applies to our fiscal year and not the calendar year. Executive Summary We reported net income attributable to Pilgrim’s Pride Corporation of $440.5 million, or $1.73 per diluted common share, for 2016. These operating results included gross profit of $914.4 million. During 2016, we generated $755.5 million of cash from operations. Market prices for feed ingredients remain volatile. Consequently, there can be no assurance that our feed ingredients prices will not increase materially and that such increases would not negatively impact our financial position, results of operations and cash flow. The following table compares the highest and lowest prices reached on nearby futures for one bushel of corn and one ton of soybean meal during the current year and previous two years: We purchase derivative financial instruments, specifically exchange-traded futures and options, in an attempt to mitigate price risk related to our anticipated consumption of commodity inputs such as corn, soybean meal, sorghum, wheat, soybean oil and natural gas. We will sometimes take a short position on a derivative instrument to minimize the impact of a commodity's price volatility on our operating results. We will also occasionally purchase derivative financial instruments in an attempt to mitigate currency exchange rate exposure related to the financial statements of our Mexico operations that are denominated in Mexican pesos. We do not designate derivative financial instruments that we purchase to mitigate commodity purchase or currency exchange rate exposures as cash flow hedges; therefore, we recognize changes in the fair value of these derivative financial instruments immediately in earnings. We recognized $4.3 million in net losses related to changes in the fair value of its derivative financial instruments during 2016. We recognized $21.8 million and $16.1 million in net gains related to changes in the fair value of its derivative financial instruments during 2015 and 2014, respectively. Although changes in the market price paid for feed ingredients impact cash outlays at the time we purchase the ingredients, such changes do not immediately impact cost of sales. The cost of feed ingredients is recognized in cost of sales, on a first-in-first-out basis, at the same time that the sales of the chickens that consume the feed grains are recognized. Thus, there is a lag between the time cash is paid for feed ingredients and the time the cost of such feed ingredients is reported in cost of goods sold. For example, corn delivered to a feed mill and paid for one week might be used to manufacture feed the following week. However, the chickens that eat that feed might not be processed and sold for another 42 to 63 days, and only at that time will the costs of the feed consumed by the chicken become included in cost of goods sold. Commodities such as corn, soybean meal, sorghum, wheat and soybean oil are actively traded through various exchanges with future market prices quoted on a daily basis. These quoted market prices, although a good indicator of the commodity's base price, do not represent the final price for which we can purchase these commodities. There are several components in addition to the quoted market price, such as freight, storage and seller premiums, that are included in the final price that we pay for grain. Although changes in quoted market prices may be a good indicator of the commodity’s base price, the components mentioned above may have a significant impact on the total change in grain costs recognized from period to period. Market prices for chicken products are currently at levels sufficient to offset the costs of feed ingredients. However, there can be no assurance that chicken prices will not decrease due to such factors as competition from other proteins and substitutions by consumers of non-protein foods because of uncertainty surrounding the general economy and unemployment. Recent Developments Special Cash Dividend. On May 18, 2016, the Company paid a special cash dividend from retained earnings of approximately $700.0 million, or $2.75 per share, to stockholders of record on May 10, 2016. The Company used proceeds from the U.S. Credit Facility, along with cash on hand, to fund the special cash dividend. For additional information, see “Note 14. Stockholders’ Equity - Special Cash Dividends” of our Consolidated Financial Statements included in this annual report. Prepared Foods Recall and Production. During April and May 2016, we ordered recalls of approximately 5.6 million pounds of cooked chicken products after consumers and federal meat inspectors found contamination by certain foreign materials, including wood, plastic, rubber and metal, at one of our prepared foods facilities. At this time, there have been no confirmed reports of adverse reactions from the consumption of the recalled products. We are still assessing the full impact of this recall, and we have not included any of these expenses in our 2016 results. To date, the recall and its direct effects have not had a material impact on our financial position or results of operations. Unrelated to the recall, we also made operational improvements in one of our prepared foods facilities that negatively impacted production during 2016, but positioned that facility for future long-term growth. GNP Acquisition. On January 6, 2017, we acquired 100% of the membership interests of GNP from Maschhoff Family Foods, LLC for a cash purchase price of $350 million, subject to customary working capital adjustments. GNP is a vertically integrated poultry business based in St. Cloud, Minnesota. The acquired business has a production capacity of 2.1 million birds per five-day work week in its three plants and currently employs approximately 1,775 people. This acquisition further strengthens our strategic position in the U.S. chicken market. Business Segment and Geographic Reporting We operate in one reportable business segment, as a producer and seller of chicken products we either produce or purchase for resale in the U.S., Puerto Rico and Mexico. We conduct separate operations in the U.S., Puerto Rico and Mexico; however, for geographic reporting purposes, we include Puerto Rico within our U.S. operations. Corporate expenses are allocated to Mexico based upon various apportionment methods for specific expenditures incurred related thereto with the remaining amounts allocated to the U.S. For additional information, see “Note 19. Business Segment and Geographic Reporting” of our Consolidated Financial Statements included in this annual report. Results of Operations 2016 Compared to 2015 Net sales. Net sales for 2016 decreased $249.0 million, or 3.0%, from 2015. The following table provides additional information regarding net sales: (a) U.S. net sales generated in 2016 decreased $472.0 million, or 6.6%, from U.S. net sales generated in 2015 primarily because of decreases in both sales volume and net sales per pound. The decrease in sales volume, which resulted from the unfavorable impact that ongoing operational improvements in one of our prepared foods facilities had on production during the period and lower product demand from our commercial customers, contributed $300.5 million, or 4.2 percentage points, to the net sales decrease. Lower net sales per pound, which resulted primarily from lower market prices, contributed $171.4 million, or 2.3 percentage points, to the net sales decrease. Included in U.S. sales generated during 2016 and 2015 were sales to JBS USA Food Company totaling $16.5 million and $21.7 million, respectively. (b) Mexico sales generated in 2016 increased $223.0 million, or 21.5%, from Mexico sales generated in 2015, primarily because of an increase in sales volume and an increase in net sales per pound partially offset by the impact of foreign currency translation. The increase in sales volume contributed $310.6 million, or 30.0 percentage points, to the increase in Mexico net sales. The increase in net sales per pound contributed $133.7 million, or 12.9 percentage points, to the increase in Mexico net sales. The increases to net sales was partially offset by the impact of foreign currency translation, which contributed $221.3 million, or 21.3 percentage points, to the decrease in Mexico net sales. Other factors affecting the increase in Mexico net sales were individually immaterial. Gross profit. Gross profit decreased by $340.0 million, or 27.1%, from $1.3 billion generated in 2015 to $914.4 million generated in 2016. The following tables provide gross profit information: (a) Cost of sales incurred by our U.S. operations in 2016 decreased $87.2 million, or 1.4%, from cost of sales incurred by our U.S. operations in 2015. Cost of sales primarily decreased because of lower sales volume, an $81.5 million decrease in feed ingredients costs and a $17.9 million decrease in freight and storage costs. These costs were partially offset by a $27.0 million increase in contract labor costs, derivative losses of $5.0 million in 2016 compared to derivative gains of $21.3 million in 2015, a $21.3 million increase in wages and benefits, and an $18.1 million increase in co-pack labor costs. Other factors affecting U.S. cost of sales were individually immaterial. (b) Cost of sales incurred by the Mexico operations during 2016 increased $178.2 million, or 19.6%, from cost of sales incurred by the Mexico operations during 2015 primarily because of increased sales volume and a $33.3 million increase in feed ingredient costs. Mexico cost of sales also increased because of a $22.9 million increase in wages and benefits, a $11.9 million increase in freight and storage costs, and a $11.2 increase in in depreciation and amortization costs. These costs were partially offset by the impact of foreign currency translation which contributed $191.9 million, or 21.1 percentage points, to the decrease in cost of sales incurred by our Mexico operations. Other factors affecting cost of sales were individually immaterial. (c) Our Consolidated Financial Statements include the accounts of our company and its majority owned subsidiaries. We eliminate all significant affiliate accounts and transactions upon consolidation. Operating income. Operating income decreased $331.4 million, or 31.7%, from $949.6 billion generated for 2015 to $572.5 million generated for 2016. The following tables provide operating income information: (a) SG&A expense incurred by the U.S. operations during 2016 decreased $3.2 million, or 1.9%, from SG&A expense incurred by the U.S. operations during 2015 primarily because of a $5.2 million decrease in brokerage expenses, a $2.6 million decrease in management fees charged for administrative functions shared with JBS USA Food Company Holdings, and a $2.0 million decrease in employee wages and benefits that were partially offset by a a $3.1 million increase in contract labor expenses, and a $2.6 million increase in professional fees expenses. Other factors affecting SG&A expense were individually immaterial. (b) SG&A expense incurred by the Mexico operations during 2016 decreased $0.9 million, or 2.8%, from SG&A expense incurred by the Mexico operations during 2015 primarily because of a $15.0 million decrease in management fees charged for administrative functions shared with JBS USA Food Company Holdings, and a $2.6 million decrease in professional fees expenses. These decreases to SG&A expense were partially offset by a $15.9 increase in employee wages and benefits. Other factors affecting SG&A expense were individually immaterial. (c) Administrative restructuring charges incurred by the U.S. operations during 2016 decreased $4.5 million, or 80.9%, from administrative restructuring charges incurred during 2015. During 2016, administrative restructuring charges represented impairment costs of $0.8 million related to assets held for sale in Texas and impairment costs of $0.3 million related to the sale of an asset in Louisiana. During 2015, administrative restructuring charges represented impairment costs of $4.8 million related to assets held for sale in Louisiana and Texas and a loss of $0.8 million related to the sale of a rendering plant in Arkansas. (d) Our Consolidated Financial Statements include the accounts of both our company and its majority owned subsidiaries. We eliminate all significant affiliate accounts and transactions upon consolidation. Interest expense. Consolidated interest expense increased 22.3% to $45.9 million in 2016 from $37.5 million in 2015, primarily because of an increase in the weighted average interest rate to 4.97% in 2016 from 4.02% in 2015 and an increase in average borrowings of $1.4 billion in 2016 from $933.6 million in 2015. As a percent of net sales, interest expense in 2016 and 2015 was 0.58% and 0.46%, respectively. Income taxes. Our consolidated income tax expense in 2016 was $232.9 million, compared to income tax expense of $346.8 million in 2015. The decrease in income tax expense in 2016 resulted primarily from a decrease in income. We expect a future effective tax rate that is comparative to 2016. 2015 Compared to 2014 Net sales. Net sales for 2015 decreased $403.3 million, or 4.7%, from 2014. The following table provides additional information regarding net sales: (a) U.S. net sales generated in 2015 decreased $503.7 million, or 6.6%, from U.S. net sales generated in 2014 primarily because of a decrease in net sales per pound. Lower net sales per pound, which reflects a slight shift in product mix toward lower-priced fresh chicken products when compared to the same period in the prior year, contributed $681.8 million, or 8.9 percentage points, to the sales decrease. An increase in sales volume partially offset the net decrease by $178.2 million, or 2.3 percentage points. Included in U.S. sales generated during 2015 and 2014 were sales to JBS USA Food Company totaling $21.7 million and $39.7 million, respectively. (b) Mexico sales generated in 2015 increased $100.4 million, or 10.7%, from Mexico sales generated in 2014, primarily because of net sales generated by the acquired Tyson Mexico operations and an increase in sales volume experienced by our existing operations. The impact of the acquired business contributed $250.6 million, or 26.8 percentage points, to the increase in net sales. The sales volume increase experienced by our existing operations contributed $24.7 million, or 2.6 percentage points, to the increase in net sales. The impact of of the acquired business and the sales volume increase experienced by our existing operations were partially offset by a decrease in net sales per pound experienced by our existing operations and the impact of foreign currency translation on our existing operations. The decrease in net sales per pound experienced by our existing operations offset the impact of the acquired business and the sales volume increase experienced by our existing operations by $24.1 million, or 2.6 percentage points. The impact of foreign currency translation on our existing operation offset the impact of the acquired business and the sales volume increase experienced by our existing operations by $150.7 million, or 16.1 percentage points. Gross profit. Gross profit decreased by $139.6 million, or 10.0%, from $1.4 billion generated in 2014 to $1.3 billion generated in 2015. The following tables provide gross profit information: (a) Cost of sales incurred by our U.S. operations in 2015 decreased $427.7 million, or 6.6%, from cost of sales incurred by our U.S. operations in 2014. Cost of sales decreased primarily because of a $358.2 million decrease in feed ingredients costs, a $33.2 million decrease in wages and benefits, a $17.0 million decrease in utilities costs and a $13.3 million decrease in vehicle costs partially offset by a $24.4 million increase in co-pack labor costs, a $20.9 million increase in contract labor costs, a $20.6 million increase in contract grower costs and a $19.7 million increase in supplies and equipment costs. Other factors affecting U.S. cost of sales were individually immaterial. (b) Cost of sales incurred by the Mexico operations during 2015 increased $164.2 million, or 22.0%, from cost of sales incurred by the Mexico operations during 2014 primarily because of costs incurred by the acquired Tyson Mexico operations, partially offset by a decrease in cost of sales incurred by our existing operations. Cost of sales incurred by the acquired Tyson Mexico operations contributed $249.1 million, or 33.4 percentage points, to the overall increase in cost of sales incurred by the Mexican operations. The decrease in cost of sales incurred by our existing operations partially offset the impact of the cost of sales incurred by the acquired business by $85.0 million, or 11.4 percentage points. The impact of foreign currency translation contributed $126.5 million, or 17.0 percentage points, to the decrease in cost of sales incurred by our existing operations. Decreases in both wage and benefits costs and utilities costs along with a gain related to the sale of property, plant and equipment also contributed $18.0 million, or 2.4 percentage points, to the decrease in cost of sales incurred by our existing operations. The favorable impact that the items listed above had on cost of sales incurred by our existing operations was partially offset by $59.6 million, or 8.0 percentage points, because of higher feed ingredients costs. Other factors affecting cost of sales were individually immaterial. (c) Our Consolidated Financial Statements include the accounts of our company and its majority owned subsidiaries. We eliminate all significant affiliate accounts and transactions upon consolidation. Operating income. Operating income decreased $158.2 million, or 13.2%, from $1.2 billion generated for 2014 to $1.0 billion generated for 2015. The following tables provide operating income information: (a) SG&A expense incurred by the U.S. operations during 2015 increased $2.3 million, or 1.3%, from SG&A expense incurred by the U.S. operations during 2014 primarily because of an $7.4 million increase in employee wages and benefits, and a $2.6 million increase in management fees charged for administrative functions shared with JBS USA Food Company Holdings that were partially offset by a $5.3 million decrease in brokerage expenses, a $2.0 million decrease in legal services expenses and a $0.5 million decrease in advertising and promotion costs. Other factors affecting SG&A expense were individually immaterial. (b) SG&A expense incurred by the Mexico operations during 2015 increased $13.0 million, or 67.9%, from SG&A expense incurred by the Mexico operations during 2014 primarily because of expenses incurred by the acquired Tyson Mexico operations and an increase in SG&A expense incurred by our existing operations. Expenses incurred by the acquired Tyson Mexico business contributed $10.3 million, or 53.5 percentage points, to the overall increase in SG&A expense. An increase in expenses incurred by our existing operations contributed $3.1 million, or 16.3 percentage points, to the overall increase in SG&A expense. SG&A expense incurred by our existing operations increased primarily because of a $1.8 million increase in contract labor, a $1.2 million increase in bad debt expense and a $1.1 million increase in legal services expense . Other factors affecting SG&A expense were individually immaterial. (c) Administrative restructuring charges incurred by the U.S. operations during 2015 increased $3.3 million, or 145.2%, from administrative restructuring charges incurred during 2014. During 2015 administrative restructuring charges represented impairment costs of $4.8 million related to assets held for sale in Louisiana and Texas and a loss of $0.8 million related to the sale of a rendering plant in Arkansas. (d) Our Consolidated Financial Statements include the accounts of both our company and its majority owned subsidiaries. We eliminate all significant affiliate accounts and transactions upon consolidation. Interest expense. Consolidated interest expense decreased 54.3% to $37.5 million in 2015 from $82.1 million in 2014, primarily because of a decrease in the weighted average interest rate to 4.02% in 2015 from 6.45% in 2014, partially offset by an increase in average borrowings of $933.6 million in 2015 compared to $526.7 million in 2014. As a percent of net sales, interest expense in 2015 and 2014 was 0.46% and 0.96%, respectively. Income taxes. Our consolidated income tax expense in 2015 was $346.8 million, compared to income tax expense of $390.9 million in 2014. The decrease in income tax expense in 2015 resulted primarily from a decrease in income. Liquidity and Capital Resources The following table presents our available sources of liquidity as of December 25, 2016: (a) Actual borrowings under the revolving loan commitment of our U.S. Credit Facility are subject to a borrowing base, which is a formula based on certain eligible inventory and eligible receivables. The borrowing base in effect at December 25, 2016 was $675.8 million. Availability under the U.S. Credit Facility is also reduced by our outstanding standby letters of credit. Standby letters of credit outstanding at December 25, 2016 totaled $42.7 million. (b) As of December 25, 2016, the U.S. dollar-equivalent of the amount available under the Mexico Credit Facility (as described below) was $49.5 million. The Mexico Credit Facility provides for a loan commitment of $1.5 billion Mexican pesos. Long-Term Debt and Other Borrowing Arrangements Senior and Subordinated Notes On March 11, 2015, the Company completed a sale of $500.0 million aggregate principal amount of its 5.75% senior notes due 2025 (the “Senior Notes”). The Company used the net proceeds from the sale of the Senior Notes to repay $350.0 million and $150.0 million of the term loan indebtedness under the U.S. Credit Facility (defined below) on March 12, 2015 and April 22, 2015, respectively. The Notes were sold to qualified institutional buyers pursuant to Rule 144A under the Securities Act of 1933, as amended (the “Securities Act”), and outside the U.S. to non-U.S. persons pursuant to Regulation S under the Securities Act. The Senior Notes are governed by, and were issued pursuant to, an indenture dated as of March 11, 2015 by and among the Company, its guarantor subsidiary and Wells Fargo Bank, National Association, as trustee (the “Indenture”). The Indenture provides, among other things, that the Senior Notes bear interest at a rate of 5.75% per annum from the date of issuance until maturity, payable semi-annually in cash in arrears, beginning on September 15, 2015. The Senior Notes are guaranteed on a senior unsecured basis by the Company's guarantor subsidiary. In addition, any of the Company’s other existing or future domestic restricted subsidiaries that incur or guarantee any other indebtedness (with limited exceptions) must also guarantee the Senior Notes. The Senior Notes and related guarantees are unsecured senior obligations of the Company and its guarantor subsidiary and rank equally with all of the Company’s and its guarantor subsidiary's other unsubordinated indebtedness. The Senior Notes and the Indenture also contain customary covenants and events of default, including failure to pay principal or interest on the Senior Notes when due, among others. U.S. Credit Facility On February 11, 2015, the Company and its subsidiaries, To-Ricos, Ltd. and To-Ricos Distribution, Ltd., entered into a Second Amended and Restated Credit Agreement (the “U.S. Credit Facility”) with Coöperatieve Centrale Raiffeisen-Boerenleenbank B.A., Rabobank Nederland, New York Branch (“Rabobank”), as administrative agent, and the other lenders party thereto. The U.S. Credit Facility provides for a revolving loan commitment of up to $700.0 million and a term loan commitment of up to $1.0 billion (the “Term Loans”). The U.S. Credit Facility also includes an accordion feature that allows us, at any time, to increase the aggregate revolving loan and term loan commitments by up to an additional $1.0 billion, subject to the satisfaction of certain conditions, including obtaining the lenders’ agreement to participate in the increase. The revolving loan commitment under the U.S. Credit Facility matures on February 10, 2020. All principal on the Term Loans is due at maturity on February 10, 2020. No installments of principal are required to be made prior to the maturity date of the Term Loans. Covenants in the U.S. Credit Facility also require the Company to use the proceeds it receives from certain asset sales and specified debt or equity issuances and upon the occurrence of other events to repay outstanding borrowings under the U.S. Credit Facility. The Company had Term Loans outstanding totaling $500.0 million as of December 25, 2016. The U.S. Credit Facility includes a $75.0 million sub-limit for swingline loans and a $125.0 million sub-limit for letters of credit. Outstanding borrowings under the revolving loan commitment and the Term Loans bear interest at a per annum rate equal to (i) in the case of LIBOR loans, LIBOR plus 1.50% through December 25, 2016 and, based on the Company’s net senior secured leverage ratio, between LIBOR plus 1.25% and LIBOR plus 2.75% and (ii) in the case of alternate base rate loans, the base rate plus 0.50% through December 25, 2016 and, based on the Company’s net senior secured leverage ratio, between the base rate plus 0.25% and base rate plus 1.75% thereafter. Actual borrowings by the Company under the revolving loan commitment of the U.S. Credit Facility are subject to a borrowing base, which is a formula based on certain eligible inventory, eligible receivables and restricted cash under the control of Rabobank, in its capacity as administrative agent. The borrowing base formula will be reduced by the sum of (i) inventory reserves, (ii) rent and collateral access reserves, and (iii) any amount more than 15 days past due that is owed by the Company or its subsidiaries to any person on account of the purchase price of agricultural products or services (including poultry and livestock) if that person is entitled to any grower's or producer's lien or other security arrangement. As of December 25, 2016, the applicable borrowing base was $675.8 million and the amount available for borrowing under the revolving loan commitment was $633.1 million. The Company had letters of credit of $42.7 million and no outstanding borrowings under the revolving loan commitment as of December 25, 2016. The U.S. Credit Facility contains financial covenants and various other covenants that may adversely affect the Company’s ability to, among other things, incur additional indebtedness, incur liens, pay dividends or make certain restricted payments, consummate certain assets sales, enter into certain transactions with JBS and the Company’s other affiliates, merge, consolidate and/or sell or dispose of all or substantially all of the Company’s assets. The U.S. Credit Facility requires the Company to comply with a minimum level of tangible net worth covenant. The U.S. Credit Facility also provides that the Company may not incur capital expenditures in excess of $500.0 million in any fiscal year. The Company is currently in compliance with the covenants under the U.S. Credit Facility. All obligations under the U.S. Credit Facility will continue to be unconditionally guaranteed by certain of the Company’s subsidiaries and continue to be secured by a first priority lien on (i) the accounts receivable and inventory of our Company and its non-Mexico subsidiaries, (ii) 100% of the equity interests in the Company’s domestic subsidiaries, To-Ricos, Ltd. and To-Ricos Distribution, Ltd., and 65% of the equity interests in the Company’s direct foreign subsidiaries and (iii) substantially all of the assets of the Company and the guarantors under the U.S. Credit Facility. Mexico Credit Facility On September 27, 2016, certain of our Mexican subsidiaries entered into an unsecured credit agreement (the “Mexico Credit Facility”) with BBVA Bancomer, S.A. Institución de Banca Múltiple, Grupo Financiero BBVA Bancomer, as lender. The loan commitment under the Mexico Credit Facility is $1.5 billion Mexican pesos. Outstanding borrowings under the Mexico Credit Facility will accrue interest at a rate equal to the Interbank Equilibrium Interest Rate plus 0.95%. The Mexico Credit Facility will mature on September 27, 2019. As of December 25, 2016, the U.S. dollar-equivalent of the loan commitment under the Mexico Credit Facility was $72.8 million, and there were $23.3 million outstanding borrowings under the Mexico Credit Facility that bear interest at a per annum rate of 7.05%. As of December 25, 2016, the U.S. dollar-equivalent borrowing availability was $49.5 million. Collateral Substantially all of our domestic inventories and domestic fixed assets are pledged as collateral to secure the obligations under the U.S. Credit Facility. Off-Balance Sheet Arrangements We maintain operating leases for various types of equipment, some of which contain residual value guarantees for the market value of assets at the end of the term of the lease. The terms of the lease maturities range from one to ten years. We estimate the maximum potential amount of the residual value guarantees is approximately $34.7 million; however, the actual amount would be offset by any recoverable amount based on the fair market value of the underlying leased assets. No liability has been recorded related to this contingency as the likelihood of payments under these guarantees is not considered to be probable, and the fair value of the guarantees is immaterial. We historically have not experienced significant payments under similar residual guarantees. We are a party to many routine contracts in which we provide general indemnities in the normal course of business to third parties for various risks. Among other considerations, we have not recorded a liability for any of these indemnities as, based upon the likelihood of payment, the fair value of such indemnities would not have a material impact on our financial condition, results of operations and cash flows. Capital Expenditures We anticipate spending between $250 million and $280 million on the acquisition of property, plant and equipment in 2017. Capital expenditures will primarily be incurred to improve efficiencies and reduce costs. We expect to fund these capital expenditures with cash flow from operations and proceeds from the revolving lines of credit under our various debt facilities. Indefinite Reinvestment of Foreign Subsidiaries’ Undistributed Earnings We have determined that the undistributed earnings of our Mexico and Puerto Rico subsidiaries will be indefinitely reinvested and not distributed to the U.S. The undistributed earnings of our Mexico, and Puerto Rico subsidiaries totaled $647.8 million and $24.9 million, respectively, at December 25, 2016. Contractual Obligations In addition to our debt commitments at December 25, 2016, we had other commitments and contractual obligations that obligate us to make specified payments in the future. The following table summarizes the total amounts due as of December 25, 2016, under all debt agreements, commitments and other contractual obligations. The table indicates the years in which payments are due under the contractual obligations. (a) The total amount of unrecognized tax benefits at December 25, 2016 was $16.8 million. We did not include this amount in the contractual obligations table above as reasonable estimates cannot be made at this time of the amounts or timing of future cash outflows. (b) Long-term debt is presented at face value and excludes $42.7 million in letters of credit outstanding related to normal business transactions. (c) Interest expense in the table above assumes the continuation of interest rates and outstanding borrowings as of December 25, 2016. (d) Includes agreements to purchase goods or services that are enforceable and legally binding on us and that specify all significant terms, including fixed or minimum quantities to be purchased; fixed, minimum, or variable price provisions; and the approximate timing of the transaction. We expect cash flows from operations, combined with availability under the U.S. Credit Facility, to provide sufficient liquidity to fund current obligations, projected working capital requirements, maturities of long-term debt and capital spending for at least the next twelve months. Historical Flow of Funds Fiscal Year 2016 Cash provided by operating activities was $755.5 million and $976.8 million in 2016 and 2015, respectively. The decrease in cash flows provided by operating activities was primarily from net income of $440.0 million for 2016, as compared to net income of $646.0 million for 2015, and changes in working capital (excluding the impacts as a result of changes in foreign currency exchange rates). Our net working capital position, which we define as current assets less current liabilities, decreased $445.2 million to a surplus of $454.1 million and a current ratio of 1.52 at December 25, 2016, compared to a surplus of $899.2 million and a current ratio of 2.06 at December 27, 2015. The decrease in working capital was primarily caused by cash used in operations. Trade accounts and other receivables, including accounts receivable from related parties, decreased $30.6 million, or 8.7%, to $321.1 million at December 25, 2016 from $351.7 million at December 27, 2015, primarily due to a decrease in sales. Inventories increased $11.9 million, or 1.5%, to $813.3 million at December 25, 2016 from $801.4 million at December 27, 2015. The change in inventories was primarily due to slightly increased costs for feed grains and their impact on the value of our live chicken inventories. Prepaid expenses and other current assets decreased $18.1 million, or 24.0%, to $57.5 million at December 25, 2016 from $75.6 million at December 27, 2015. This change resulted primarily from a $7.6 million decrease in prepaid insurance, a $6.3 million decrease in value-added tax receivables and a $4.2 million reclassification of margin cash from other current assets to restricted cash and cash equivalents. Accounts payable and accrued expenses, including accounts payable to related parties, increased $42.3 million, or 5.2%, to $847.2 million at December 25, 2016 from $804.9 million at December 27, 2015. This change resulted primarily from the timing of payments. Cash used in investing activities was $261.7 million and $534.7 million in 2016 and 2015, respectively. We incurred capital expenditures of $272.5 million and $175.8 million for 2016 and 2015, respectively. In both 2016 and 2015, capital expenditures were primarily incurred for the routine replacement of equipment and to improve efficiencies and reduce costs. Capital expenditures for 2016 and 2015 could not exceed $500 million under the terms of our U.S. credit facility. Cash proceeds generated from property disposals in 2016 and 2015 totaled $10.8 million and $14.6 million, respectively. Cash used in financing activities was $813.1 million and $578.6 million in 2016 and 2015, respectively. Cash proceeds from long-term debt totaled $616.7 million and $1.7 billion for 2016 and 2015,respectively. Cash was used to repay long-term debt totaling $556.7 million and $683.8 million in 2016 and 2015, respectively. Cash proceeds in 2015 resulting from tax benefits related to share-based compensation totaled $6.5 million. Cash proceeds in 2016 resulting from noncontrolling interests totaled $7.3 million. Cash was used to pay capitalized loan costs totaling $0.7 million and $12.4 million in 2016 and 2015, respectively. Cash was used to pay a special cash dividend of $699.9 million and approximately $1.5 billion in 2016 and 2015, respectively. Additionally, cash was used to purchase common stock of $117.9 million and $99.2 million in 2016 and 2015, respectively. Fiscal Year 2015 Cash provided by operating activities was $976.8 million and $1.1 billion in 2015 and 2014, respectively. The decrease in cash flows provided by operating activities was primarily from net income of $646.0 million for 2015, as compared to net income of $711.4 million for 2014, and changes in working capital (excluding the impacts as a result of changes in foreign currency exchange rates). Our net working capital position, which we define as current assets less current liabilities, decreased $238.9 million to a surplus of $899.2 million and a current ratio of 2.06 at December 27, 2015, compared to a surplus of $1.1 billion and a current ratio of 2.58 at December 28, 2014. The decrease in working capital was primarily caused by the use of cash in operations. Trade accounts and other receivables, including accounts receivable from related parties, decreased $32.5 million, or 8.5%, to $351.7 million at December 27, 2015 from $384.1 million at December 28, 2014 primarily due to a decrease in sales. Inventories increased $11.1 million, or 1.4%, to $801.5 million at December 27, 2015 from $790.3 million at December 28, 2014. This change in inventories resulted primarily from the impact of the Tyson Mexico acquisition. Prepaid expenses and other current assets decreased $19.8 million, or 20.8%, to $75.6 million at December 27, 2015 from $95.4 million at December 28, 2014. This change resulted primarily from a $25.1 million decrease in open derivative positions and margin cash on deposit with our derivatives traders. Accounts payable and accrued expenses, including accounts payable to related parties, increased $88.7 million, or 12.4%, to $804.9 million at December 27, 2015 from $716.2 million at December 28, 2014. This change resulted primarily from the impact of the Tyson Mexico acquisition and the timing of payments. Cash used in investing activities was $534.7 million and $63.4 million in 2015 and 2014, respectively. We incurred capital expenditures of $175.8 million and $171.4 million for 2015 and 2014, respectively. In both 2015 and 2014, capital expenditures were primarily incurred for the routine replacement of equipment and to improve efficiencies and reduce costs. Capital expenditures for 2015 could not exceed $500 million under the terms of our U.S. credit facility. Cash proceeds generated from property disposals in 2015 and 2014 totaled $14.6 million and $11.1 million, respectively. Cash was used to purchase investment securities totaling $55.1 million in 2014. Cash proceeds generated in 2014 from the sale or maturity of investment securities totaled $152.0 million. Cash used in financing activities was $578.6 million and $905.6 million in 2015 and 2014, respectively. Cash proceeds in 2015 from long-term debt totaled $1.7 billion. Cash was used to repay long-term debt totaling $683.8 million and $910.2 million in 2015 and 2014, respectively. Cash proceeds in 2015 and 2014 resulting from tax benefits related to share-based compensation totaled $6.5 million and $0.5 million, respectively. Cash proceeds in 2014 resulting from a capital contribution under a tax sharing agreement between JBS USA Holdings and our company totaled $3.8 million. Cash proceeds in 2014 from the sale of subsidiary common stock totaled $0.3 million. Cash was used to pay capitalized loan costs totaling $12.4 million in 2015. Additionally, cash was used in 2015 to pay a special cash dividend of approximately $1.5 billion and to purchase common stock of $99.2 million. Recently Issued Accounting Standards Not Adopted as of December 25, 2016 In May 2014, the Financial Accounting Standards Board (“FASB”) issued new accounting guidance on revenue recognition, which provides for a single five-step model to be applied to all revenue contracts with customers. The new standard also requires additional financial statement disclosures that will enable users to understand the nature, amount, timing and uncertainty of revenue and cash flows relating to customer contracts. Companies have an option to use either a retrospective approach or cumulative effect adjustment approach to implement the standard. In June 2015, the FASB agreed to defer by one year the mandatory effective date of this standard, but will also provide entities the option to adopt the new guidance as of the original effective date. The provisions of the new guidance will be effective as of the beginning of our 2018 fiscal year, but we have the option to adopt the guidance as early as the beginning of our 2017 fiscal year. We are currently identifying and cataloging the various types of revenue transactions to which we are a party. We also continue to evaluate the impact of the new guidance on our financial statements and have not yet selected either a transition approach to implement the standard or an adoption date. In July 2015, the FASB issued new accounting guidance on the subsequent measurement of inventory, which, in an effort to simplify unnecessarily complicated accounting guidance that can result in several potential outcomes, requires an entity to measure inventory at the lower of cost or net realizable value. Net realizable value is the estimated selling prices in the ordinary course of business, less reasonably predictable costs of completion, disposal and transportation. Current accounting guidance requires an entity to measure inventory at the lower of cost or market. Market could be replacement cost, net realizable value, or net realizable value less an approximately normal profit margin. The provisions of the new guidance will be effective as of the first quarter of our 2017 fiscal year. The initial adoption of this guidance is not expected to have a material impact on our financial statements. In February 2016, the FASB issued new accounting guidance on lease arrangements, which, in an effort to increase transparency and comparability among organizations utilizing leasing, requires an entity that is a lessee to recognize the assets and liabilities arising from leases on the balance sheet. This guidance also requires disclosures about the amount, timing and uncertainty of cash flows arising from leases. In transition, the entity is required to recognize and measure leases at the beginning of the earliest period presented using a modified retrospective approach. The provisions of the new guidance will be effective as of the beginning of our 2019 fiscal year. Early adoption is permitted. We are currently evaluating the impact of the new guidance on our financial statements and have not yet selected an adoption date. In March 2016, the FASB issued new accounting guidance on employee share-based payments, which, in an effort to simplify unnecessarily complicated aspects of accounting and reporting for share-based payment transactions, requires an entity to amend accounting and reporting methodology for areas such as the income tax consequences of share-based payments, classification of share-based awards as either equity or liabilities, and classification of share-based payment transactions in the statement of cash flows. The transition approach will vary depending on the area of accounting and reporting methodology to be amended. The provisions of the new guidance will be effective as of the first quarter of our 2017 fiscal year. The initial adoption of this guidance is not expected to have a material impact on our financial statements. In June 2016, the FASB issued new accounting guidance on the measurement of credit losses on financial instruments, which, in an effort to provide financial statement users with more decision-useful information about the expected credit losses on financial instruments, replaces the current incurred loss impairment methodology with a methodology that reflects expected credit losses and requires consideration of a broader range of reasonable and supportable information to inform credit loss estimates. The amendments affect loans, debt securities, trade receivables, net investments in leases, off-balance sheet credit exposures, reinsurance receivables and any other financial assets not excluded from the scope that have the contractual right to receive cash. The provisions of the new guidance will be effective as of the beginning of our 2020 fiscal year. Early adoption is permitted after our 2018 fiscal year. We are currently evaluating the impact of the new guidance on our financial statements and have not yet selected an adoption date. In November 2016, the FASB issued new accounting guidance on the classification and presentation of restricted cash in the statement of cash flows in order to eliminate the discrepancies that currently exist in how companies present these changes. The new guidance requires restricted cash to be included with cash and cash equivalents when explaining the changes in cash in the statement of cash flows. The new guidance will be effective as of the beginning of our 2018 fiscal year. Early adoption is permitted. We are currently evaluating the impact of the new guidance on our financial statements and have not yet selected an adoption date. Critical Accounting Policies and Estimates General. Our discussion and analysis of our financial condition and results of operations are based upon our financial statements, which have been prepared in accordance with U.S. GAAP. The preparation of these financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses. On an ongoing basis, we evaluate our estimates, including those related to revenue recognition, customer programs and incentives, allowance for doubtful accounts, inventories, income taxes and product recall accounting. We base our estimates on historical experience and on various other assumptions that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions. We believe the following critical accounting policies affect our more significant judgments and estimates used in the preparation of our financial statements. Revenue Recognition. We recognize revenue when all of the following circumstances are satisfied: (i) persuasive evidence of an arrangement exists, (ii) price is fixed or determinable, (iii) collectability is reasonably assured and (iv) delivery has occurred. Delivery occurs in the period in which the customer takes title and assumes the risks and rewards of ownership of the products specified in the customer’s purchase order or sales agreement. Revenue is recorded net of estimated incentive offerings including special pricing agreements, promotions and other volume-based incentives. Revisions to these estimates are charged back to net sales in the period in which the facts that give rise to the revision become known. Inventory. Live chicken inventories are stated at the lower of cost or market and breeder hen inventories at the lower of cost, less accumulated amortization, or market. The costs associated with breeder hen inventories are accumulated up to the production stage and amortized over their productive lives using the unit-of-production method. Finished poultry products, feed, eggs and other inventories are stated at the lower of cost (average) or market. We record valuations and adjustments for our inventory and for estimated obsolescence at or equal to the difference between the cost of inventory and the estimated market value based upon known conditions affecting inventory obsolescence, including significantly aged products, discontinued product lines, or damaged or obsolete products. We allocate meat costs between our various finished chicken products based on a by-product costing technique that reduces the cost of the whole bird by estimated yields and amounts to be recovered for certain by-product parts. This primarily includes leg quarters, wings, tenders and offal, which are carried in inventory at the estimated recovery amounts, with the remaining amount being reflected as our breast meat cost. Generally, we perform an evaluation of whether any lower of cost or market adjustments are required at the country level based on a number of factors, including: (i) pools of related inventory, (ii) product continuation or discontinuation, (iii) estimated market selling prices and (iv) expected distribution channels. If actual market conditions or other factors are less favorable than those projected by management, additional inventory adjustments may be required. Property, Plant and Equipment. We record impairment charges on long-lived assets held for use when events and circumstances indicate that the assets may be impaired and the undiscounted cash flows estimated to be generated by those assets are less than the carrying amount of those assets. The impairment charge is determined based upon the amount by which the net book value of the assets exceeds their fair market value. In making these determinations, we utilize certain assumptions, including, but not limited to: (i) future cash flows estimated to be generated by these assets, which are based on additional assumptions such as asset utilization, remaining length of service and estimated salvage values, (ii) estimated fair market value of the assets, and (iii) determinations with respect to the lowest level of cash flows relevant to the respective impairment test, generally groupings of related operational facilities. Given the interdependency of our individual facilities during the production process, which operate as a vertically integrated network, we evaluate impairment of assets held for use at the country level (i.e., the U.S. and Mexico). Management believes this is the lowest level of identifiable cash flows for our assets that are held for use in production activities. At the present time, our forecasts indicate that we can recover the carrying value of our assets held for use based on the projected undiscounted cash flows of the operations. We record impairment charges on long-lived assets held for sale when the carrying amount of those assets exceeds their fair value less appropriate selling costs. Fair value is based on amounts documented in sales contracts or letters of intent accepted by us, amounts included in counteroffers initiated by us, or, in the absence of current contract negotiations, amounts determined using a sales comparison approach for real property and amounts determined using a cost approach for personal property. Under the sales comparison approach, sales and asking prices of reasonably comparable properties are considered to develop a range of unit prices within which the current real estate market is operating. Under the cost approach, a current cost to replace the asset new is calculated and then the estimated replacement cost is reduced to reflect the applicable decline in value resulting from physical deterioration, functional obsolescence and economic obsolescence. Appropriate selling costs includes reasonable broker's commissions, costs to produce title documents, filing fees, legal expenses and the like. We estimate appropriate closing costs as 4% to 6% of asset fair value. This range of rates is considered reasonable for our assets held for sale based on historical experience. Litigation and Contingent Liabilities. We are subject to lawsuits, investigations and other claims related to employment, environmental, product, and other matters. We are required to assess the likelihood of any adverse judgments or outcomes, as well as potential ranges of probable losses, to these matters. We estimate the amount of reserves required for these contingencies when losses are determined to be probable and after considerable analysis of each individual issue. We expense legal costs related to such loss contingencies as they are incurred. With respect to our environmental remediation obligations, the accrual for environmental remediation liabilities is measured on an undiscounted basis. These reserves may change in the future due to changes in our assumptions, the effectiveness of strategies, or other factors beyond our control. Accrued Self Insurance. Insurance expense for casualty claims and employee-related health care benefits are estimated using historical and current experience and actuarial estimates. Stop-loss coverage is maintained with third-party insurers to limit our total exposure. Certain categories of claim liabilities are actuarially determined. The assumption used to arrive at periodic expenses is reviewed regularly by management. However, actual expenses could differ from these estimates and could result in adjustments to be recognized. Income Taxes. We follow provisions under ASC No. 740-10-30-27 in the Expenses-Income Taxes topic with regard to members of a group that file a consolidated tax return but issue separate financial statements. We file our own U.S. federal tax return, but we are included in certain state unitary returns with JBS USA Holdings. The income tax expense of our company is computed using the separate return method. The provision for income taxes has been determined using the asset and liability approach of accounting for income taxes. For the unitary states, we have an obligation to make tax payments to JBS USA Holdings for our share of the unitary taxable income, which is included in taxes payable in our Consolidated Balance Sheets. Under this approach, deferred income taxes reflect the net tax effect of temporary differences between the book and tax bases of recorded assets and liabilities, net operating losses and tax credit carry forwards. The amount of deferred tax on these temporary differences is determined using the tax rates expected to apply to the period when the asset is realized or the liability is settled, as applicable, based on the tax rates and laws in the respective tax jurisdiction enacted as of the balance sheet date. We recognize potential interest and penalties related to income tax positions as a part of the income tax provision. Realizability of Deferred Tax Assets. We review our deferred tax assets for recoverability and establish a valuation allowance based on historical taxable income, potential for carry back of tax losses, projected future taxable income, applicable tax strategies, and the expected timing of the reversals of existing temporary differences. A valuation allowance is provided when it is more likely than not that some or all of the deferred tax assets will not be realized. Valuation allowances have been established primarily for net operating loss carry forwards. See “Note 12. Income Taxes” to the Consolidated Financial Statements in this annual report. Indefinite Reinvestment in Foreign Subsidiaries. We deem our earnings from Mexico and Puerto Rico as of December 25, 2016 to be permanently reinvested. As such, U.S. deferred income taxes have not been provided on these earnings. If such earnings were not considered indefinitely reinvested, certain deferred foreign and U.S. income taxes would be provided. Accounting for Uncertainty in Income Taxes. We follow provisions under ASC No. 740-10-25 that provide a recognition threshold and measurement criteria for the financial statement recognition of a tax benefit taken or expected to be taken in a tax return. Tax benefits are recognized only when it is more likely than not, based on the technical merits, that the benefits will be sustained on examination. Tax benefits that meet the more-likely-than-not recognition threshold are measured using a probability weighting of the largest amount of tax benefit that has greater than 50% likelihood of being realized upon settlement. Whether the more-likely-than-not recognition threshold is met for a particular tax benefit is a matter of judgment based on the individual facts and circumstances evaluated in light of all available evidence as of the balance sheet date. See “Note 12. Income Taxes” to the Consolidated Financial Statements in this annual report. Pension and Other Postretirement Benefits. Our pension and other postretirement benefit costs and obligations are dependent on the various actuarial assumptions used in calculating such amounts. These assumptions relate to discount rates, salary growth, long-term return on plan assets and other factors. We base the discount rate assumptions on current investment yields on high-quality corporate long-term bonds. Long-term return on plan assets is determined based on historical portfolio results and management’s expectation of the future economic environment. Actual results that differ from our assumptions are accumulated and, if in excess of the lesser of 10% of the projected benefit obligation or the fair market value of plan assets, amortized over either (i) the estimated average future service period of active plan participants if the plan is active or (ii) the estimated average future life expectancy of all plan participants if the plan is frozen.

<s>[INST] We are one of the largest chicken producers in the world, with operations in the U.S., Mexico and Puerto Rico. We are primarily engaged in the production, processing, marketing and distribution of fresh, frozen and valueadded chicken products to retailers, distributors and foodservice operators. We offer a wide range of products to our customers through strong national and international distribution channels. Pilgrim’s fresh chicken products consist of refrigerated (nonfrozen) whole chickens, whole cutup chickens and selected chicken parts that are either marinated or nonmarinated. The Company’s prepared chicken products include fully cooked, readytocook and individually frozen chicken parts, strips, nuggets and patties, some of which are either breaded or nonbreaded and either marinated or nonmarinated. We market our balanced portfolio of fresh, prepared and valueadded chicken products to a diverse set of over 5,000 customers across the U.S., Mexico and in approximately 80 other countries, with no single one accounting for more than 10% of total sales. We have become a valuable partner to our customers and a recognized industry leader by consistently providing highquality products and services designed to meet their needs and enhance their business. Our sales efforts are largely targeted towards the foodservice industry, principally chain restaurants and food processors such as ChickfilA®, distributors such as US Foods and Sysco® and retail customers, including grocery store chains and wholesale clubs such as Kroger®, Costco®, Publix®, and HEB®. As a vertically integrated company, we control every phase of the production process, which helps us better manage food safety and quality, as well as more effectively control margins and improve customer service. We operate feed mills, hatcheries, processing plants and distribution centers in 12 U.S. states, Puerto Rico and Mexico. Our plants are strategically located to ensure that customers timely receive fresh products. With our global network of approximately 4,045 growers, 32 feed mills, 39 hatcheries, 30 processing plants, six prepared foods cook plants, 20 distribution centers, eight rendering facilities and three pet food plants, we believe we are well positioned to supply the growing demand for our products. We are one of the largest, and we believe one of the most efficient, producers and sellers of chicken in Mexico. Our presence in Mexico provides access to a market with growing demand and has enabled us to leverage our operational strengths within the region. The market for chicken products in Mexico is still developing with most sales attributed to fresh, commodityoriented, market pricebased business. We believe our Mexico business is well positioned to continue benefiting from these trends in the Mexican consumer market. Additionally, we are an important player in the live market, which accounted for approximately 35% of the industry’s chicken sales in Mexico in 2016. As of December 25, 2016, we had approximately 39,600 employees and the capacity to process more than 36.7 million birds per week for a total of more than 10.7 billion pounds of live chicken annually. In 2016, we produced 8.1 billion pounds of chicken products, generating approximately $7.9 billion in net revenues and approximately $440.5 million in net income attributable to Pilgrim’s. We operate on a 52/53week fiscal year that ends on the Sunday falling on or before December 31. Any reference we make to a particular year (for example, 2016) in this report applies to our fiscal year and not the calendar year. Executive Summary We reported net income attributable to Pilgrim’s Pride Corporation of $440.5 million, or $1.73 per diluted common share, for 2016. These operating results included gross profit of $914.4 million. During 2016, we generated $755.5 million of cash from operations. Market prices for feed ingredients remain volatile. Consequently, there can be no assurance that our feed ingredients prices will not increase materially and that such increases would not negatively impact our financial position, results of operations and cash flow. The following table compares the highest and lowest prices reached on nearby futures for one [/INST] Positive. </s>

PILGRIMS PRIDE CORP

2018-02-16

2017-12-31

Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations Our Company We are one of the largest chicken producers in the world, with operations in the United States (“U.S.”), United Kingdom (“U.K.”), Mexico, France, Puerto Rico, and The Netherlands. We are primarily engaged in the production, processing, marketing and distribution of fresh, frozen and value-added chicken products to retailers, distributors and foodservice operators. We offer a wide range of products to our customers through strong national and international distribution channels. Pilgrim’s fresh chicken products consist of refrigerated (non-frozen) whole chickens, whole cut-up chickens and selected chicken parts that are either marinated or non-marinated. The Company's prepared chicken products include fully cooked, ready-to-cook and individually frozen chicken parts, strips, nuggets and patties, some of which are either breaded or non-breaded and either marinated or non-marinated, ready-to-eat meals, multi-protein frozen foods, vegetarian foods and desserts. We market our balanced portfolio of fresh, prepared and value-added chicken products to a diverse set of over 5,500 customers across the U.S., the U.K. and Europe, Mexico and in approximately 100 other countries, with no single customer accounting for more than 10% of total sales. We have become a valuable partner to our customers and a recognized industry leader by consistently providing high-quality products and services designed to meet their needs and enhance their business. Our sales efforts are largely targeted towards the foodservice industry, principally chain restaurants and food processors, such as Chick-fil-A® and retail customers, including grocery store chains and wholesale clubs, such as Kroger®, Costco®, Publix®, and H-E-B®. As a vertically integrated company, we control every phase of the production process, which helps us better manage food safety and quality, as well as more effectively control margins and improve customer service. We operate feed mills, hatcheries, processing plants and distribution centers in 14 U.S. states, the U.K. and Europe, Puerto Rico and Mexico. Our plants are strategically located to ensure that customers timely receive fresh products. With our global network of approximately 5,200 growers, 39 feed mills, 50 hatcheries, 36 processing plants, 16 prepared foods cook plants, 20 distribution centers, nine rendering facilities and four pet food plants, we believe we are well-positioned to supply the growing demand for our products. Our U.K. and Europe segment reflects the operations of Granite Holdings Sàrl and its subsidiaries (together, “Moy Park”), which we acquired on September 8, 2017. Moy Park is a leading and highly regarded U.K. food company, providing fresh, high quality and locally farmed poultry and convenience food products. Moy Park has operated in the U.K. retail market for over 50 years and delivers a range of fresh, ready-to-cook, coated and ready-to-eat poultry products to major retailers and large foodservice customers throughout the United Kingdom, Ireland, France and The Netherlands. We believe that we operate one of the most efficient business models for chicken production in the U.K. and Europe. We are one of the largest, and we believe one of the most efficient, producers and sellers of chicken in Mexico. Our presence in Mexico provides access to a market with growing demand and has enabled us to leverage our operational strengths within the region. The market for chicken products in Mexico is still developing, with most sales attributed to fresh, commodity-oriented, market price-based business. Additionally, we are an important player in the live market in Mexico. We believe our Mexico business is well positioned to continue benefiting from these trends in the Mexican consumer market. As of December 31, 2017, we had approximately 51,300 employees and the capacity to process more than 45.2 million birds per week for a total of more than 13.3 billion pounds of live chicken annually. In 2017, we produced 10.0 billion pounds of chicken products, generating approximately $10.8 billion in net sales and approximately $694.6 million in net income attributable to Pilgrim’s. We operate on a 52/53-week fiscal year that ends on the Sunday falling on or before December 31. Any reference we make to a particular year (for example, 2017) in this report applies to our fiscal year and not the calendar year. Fiscal 2017 was a 53-week fiscal year. Executive Summary We reported net income attributable to Pilgrim’s Pride Corporation of $694.6 million, or $2.79 per diluted common share, for 2017. These operating results included gross profit of $1,471.6 million. During 2017, we generated $801.3 million of cash from operations. The following table compares the highest and lowest prices reached on nearby futures for one bushel of corn and one ton of soybean meal during the current year and previous two years: We purchase derivative financial instruments, specifically exchange-traded futures and options, in an attempt to mitigate price risk related to our anticipated consumption of commodity inputs such as corn, soybean meal, wheat, soybean oil and natural gas. We will sometimes purchase a derivative instrument to minimize the impact of a commodity’s price volatility on our operating results. We will also purchase derivative financial instruments in an attempt to mitigate currency exchange rate exposure related to the financial statements of our Mexico segment that are denominated in Mexican pesos and our U.K. and Europe segment that are denominated in British pounds. For our Mexico segment, we do not designate derivative financial instruments that we purchase to mitigate commodity purchase or currency exchange rate exposures as cash flow hedges; therefore, we recognize changes in the fair value of these derivative financial instruments immediately in earnings. For our U.K. and Europe segment, we do designate certain derivative financial instruments that we have purchased to mitigate foreign currency transaction exposures as cash flow hedges; therefore, before the settlement date of the financial derivative instruments, we recognize changes in the fair value of the effective portion of the cash flow hedge in accumulated other comprehensive income (loss) while we recognize changes in the fair value of the ineffective portion immediately in earnings. When the derivative financial instruments associated with the effective portion are settled, the amount in accumulated other comprehensive income (loss) is then reclassified to earnings. Gains or losses related to these derivative financial instruments are included in the line item Cost of sales in the Consolidated and Combined Statements of Income. We recognized $6.7 million in net gains related to changes in the fair value of our derivative financial instruments during 2017. We recognized $4.3 million in net losses and $21.6 million in net gains related to changes in the fair value of our derivative financial instruments during 2016 and 2015, respectively. Although changes in the market price paid for feed ingredients impact cash outlays at the time we purchase the ingredients, such changes do not immediately impact cost of sales. The cost of feed ingredients is recognized in cost of sales, on a first-in-first-out basis, at the same time that the sales of the chickens that consume the feed grains are recognized. Thus, there is a lag between the time cash is paid for feed ingredients and the time the cost of such feed ingredients is reported in cost of goods sold. For example, corn delivered to a feed mill and paid for one week might be used to manufacture feed the following week. However, the chickens that eat that feed might not be processed and sold for another 42 to 63 days, and only at that time will the costs of the feed consumed by the chickens become included in cost of goods sold. Commodities such as corn, soybean meal, and soybean oil are actively traded through various exchanges with future market prices quoted on a daily basis. These quoted market prices, although a good indicator of the commodity's base price, do not represent the final price for which we can purchase these commodities. There are several components in addition to the quoted market price, such as freight, storage and seller premiums, that are included in the final price that we pay for grain. Although changes in quoted market prices may be a good indicator of the commodity’s base price, the components mentioned above may have a significant impact on the total change in grain costs recognized from period to period. Market prices for chicken products are currently at levels sufficient to offset the costs of feed ingredients. However, there can be no assurance that chicken prices will not decrease due to such factors as competition from other proteins and substitutions by consumers of non-protein foods because of uncertainty surrounding the general economy and unemployment. Recent Developments Moy Park Acquisition. On September 8, 2017, we acquired 100% of the issued and outstanding shares of Moy Park from JBS S.A. for cash of $301.3 million and a note payable to the seller in the amount of £562.5 million. Moy Park is one of the top-ten food companies in the U.K., Northern Ireland's largest private sector business and one of Europe's leading poultry producers. With 4 fresh processing plants, 10 prepared foods cook plants, 3 feed mills, 7 hatcheries and 1 rendering facility in the U.K., France and The Netherlands, the acquired business processes 6.0 million birds per seven-day work week, in addition to producing around 456.0 million pounds of prepared foods per year. Moy Park currently has approximately 10,200 employees. See “Note 2. Business Acquisitions” of our Consolidated and Combined Financial Statements included in this annual report for additional information relating to this acquisition. The Moy Park operations constitutes our U.K. and Europe segment. The acquisition was treated as a common-control transaction under U.S. GAAP. A common-control transaction is a transfer of net assets or an exchange of equity interests between entities under the control of the same parent. The accounting and reporting for a transaction between entities under common control is not to be considered a business combination under U.S. GAAP. Accordingly, for the period from September 30, 2015 through September 7, 2017, the Consolidated and Combined Financial Statements includes the accounts of the Company and its majority-owned subsidiaries combined with the accounts of Moy Park. For the period from September 8, 2017 through September 24, 2017, the Consolidated and Combined Financial Statements includes the accounts of the Company and its majority-owned subsidiaries, including Moy Park. GNP Acquisition. On January 6, 2017, we acquired 100% of the membership interests of GNP from Maschhoff Family Foods, LLC for a cash purchase price of $350 million, subject to customary working capital adjustments. GNP is a vertically integrated poultry business based in St. Cloud, Minnesota. The acquired business has a production capacity of 2.1 million birds per five-day work week in its two plants and currently employs approximately 1,500 people. This acquisition further strengthens our strategic position in the U.S. chicken market. The GNP operations are included in our U.S. segment. 2017 Tax Reform On December 22, 2017, the U.S. government enacted comprehensive tax legislation (the “Tax Act”), which significantly revises the ongoing U.S. corporate income tax law by lowering the U.S. federal corporate income tax rate from 35.0% to 21.0%, implementing a territorial tax system, imposing one-time tax on foreign unremitted earnings and setting limitations on deductibility of certain costs (e.g., interest expense), among other things. Due to the complexities involved in accounting for the recently enacted Tax Act, the U.S. Securities and Exchange Commission’s Staff Accounting Bulletin (“SAB”) 118, requires that the Company include in its financial statements the reasonable estimate of the impact of the Tax Act on earnings to the extent such reasonable estimate has been determined. Accordingly, the Company accrued $41.5 million in provisional tax benefit related to the net change in deferred tax liabilities stemming from the Tax Act’s reduction of the U.S. federal tax rate from 35.0% to 21.0% for the year ended December 31, 2017. Additionally, the Company is currently estimating a zero tax liability on foreign unremitted earnings due to a net earnings and profits (“E&P”) deficit on accumulated post-1986 deferred foreign income. Therefore, the Company has not accrued any amount of tax expense for the Tax Act’s one-time transition tax on the foreign subsidiaries’ accumulated, unremitted earnings going back to 1986 for the year ended December 31, 2017. The Company will continue to analyze historical E&P on accumulated post-1986 deferred foreign income and will record any resulting tax adjustment during 2018. All other accounting as required by the Tax Act as of December 31, 2017 is complete The Tax Act also includes a provision to tax global intangible low-taxed income (“GILTI”) of foreign subsidiaries and a base erosion anti-abuse tax (“BEAT”) measure that taxes certain payments between a U.S. corporation and its subsidiaries. The Company may be subject to the GILTI and BEAT provisions effective beginning January 1, 2018 and is in the process of analyzing their effects, including how to account for the GILTI provision from an accounting policy standpoint. The final impact on the Company from the Tax Act’s transition tax legislation may differ from the aforementioned one-time transition tax amount due to the complexity of calculating and supporting with primary evidence such U.S. tax attributes as accumulated foreign earnings and profits, foreign tax paid, and other tax components involved in foreign tax credit calculations for prior years back to 1986. Such differences could be material, due to, among other things, changes in interpretations of the Tax Act, future legislative action to address questions that arise because of the Tax Act, changes in accounting standards for income taxes or related interpretations in response to the Tax Act, or any updates or changes to estimates the company has utilized to calculate the one-time transition tax. Business Segment and Geographic Reporting We operate in three reportable business segments: the U.S., the U.K. and Europe, and Mexico. We measure segment profit as operating income. Corporate expenses are allocated to Mexico based upon various apportionment methods for specific expenditures incurred related thereto with the remaining amounts allocated to the U.S. For additional information, see “Note 21. Business Segment and Geographic Reporting” of our Consolidated and Combined Financial Statements included in this annual report. Results of Operations 2017 Compared to 2016 Net sales. Net sales for 2017 increased $889.3 million, or 9.0%, from 2016. The following table provides additional information regarding net sales: (a) U.S. net sales generated in 2017 increased $771.8 million, or 11.6%, from U.S. net sales generated in 2016 primarily because of net sales generated by the recently acquired GNP operations and an increase in net sales per pound experienced by our existing customers offset by a decrease in sales volume. The impact of the acquired business contributed $433.9 million, or 6.5 percentage points, to the increase in net sales. Higher net sales per pound, which resulted primarily from higher market prices, contributed $533.0 million, or 8.0 percentage points, to the net sales increase. Decreased sales volume, which resulted from the unfavorable impact that ongoing operational improvements in one of our prepared foods facilities had on production, the conversion of our Sanford, North Carolina facility to an organic operation, as well as more deboning of leg quarters in several of our facilities, offset the overall net sales increase by $195.2 million, or 2.9 percentage points. Included in U.S. sales generated during 2017 and 2016 were sales to JBS USA Food Company totaling $15.3 million and $16.5 million, respectively. (b) U.K. and Europe sales generated in 2017 increased $48.9 million, or 2.5%, from U.K. and Europe sales generated in 2016, primarily because of an increase in sales volume and an increase in net sales per pound partially offset by the impact of foreign currency translation. The increase in sales volume contributed $80.5 million, or 4.1 percentage points, to the increase in U.K. and Europe net sales. The increase in net sales per pound contributed $151.6 million, or 7.8 percentage points, to the increase in U.K. and Europe net sales. The increase to net sales was partially offset by the impact of foreign currency translation, which reduced U.K. and Europe net sales by $183.3 million, or 9.4 percentage points. Other factors affecting the increase in U.K. and Europe net sales were individually immaterial. (c) Mexico sales generated in 2017 increased $68.6 million, or 5.4%, from Mexico sales generated in 2016, primarily because of an increase in sales volume and an increase in net sales per pound partially offset by the impact of foreign currency translation. The increase in sales volume contributed $50.1 million, or 4.0 percentage points, to the increase in Mexico net sales. The increase in net sales per pound contributed $69.6 million, or 5.5 percentage points, to the increase in Mexico net sales. The impact of foreign currency translation partially offset the overall net sales increase by $51.1million, or 4.1 percentage points. Other factors affecting the increase in Mexico net sales were individually immaterial. Gross profit. Gross profit increased by $367.6 million, or 33.3%, from $1.1 billion generated in 2016 to $1.5 billion generated in 2017. The following tables provide gross profit information: (a) Cost of sales incurred by our U.S. operations in 2017 increased $419.1 million, or 7.1%, from cost of sales incurred by our U.S. operations in 2016. Cost of sales primarily increased because of costs incurred by the acquired GNP operations and, to a lesser extent, by increases in cost of sales incurred by our existing U.S. operations. Cost of sales incurred by the acquired GNP operations contributed $363.5 million, or 6.2 percentage points, to the increase in U.S. cost of sales. Cost of sales related to the existing U.S. operations increased due to $88.7 million in increased labor costs, $25.7 million in increased chick costs, $19.7 million in increased depreciation, $19.1 million in increased health care costs and $25.7 million in increased freight. These increases were offset by associated lower sales volume, a $79.6 million decrease in feed ingredients costs and $20.6 million of commodity derivative gains. Other factors affecting U.S. cost of sales were individually immaterial. (b) Cost of sales incurred by the U.K. and Europe operations during 2017 increased $50.3 million, or 2.9%, from cost of sales incurred by the U.K. and Europe operations during 2016 primarily because of increased sales volume and a $64.5 million increase in feed ingredient costs. U.K. and Europe cost of sales also increased because of a $4.5 million increase in freight and storage costs, a $3.5 million increase in other costs, and a $0.8 million increase in utilities costs. These costs were partially offset by a decline in depreciation of $15.4 million and a decline of wages and benefits by $8.3 million from 2016 amounts. Other factors affecting cost of sales were individually immaterial. (c) Cost of sales incurred by the Mexico operations during 2017 increased $52.3 million, or 4.8%, from cost of sales incurred by the Mexico operations during 2016 primarily because of increased sales volume and a $37.1 million increase in contract services. Mexico cost of sales also increased because of a $12.9 million increase in wages and benefits, a $9.3 million increase in warehousing costs, an $8.6 million increase in utilities costs, a $6.6 million increase in transportation costs and a $1.8 million increase in in depreciation and amortization costs. These costs were partially offset by the $21.5 million favorable impact of foreign currency translation on inventory, a $1.3 million gain in commodity derivatives and a $1.1 million decrease in travel and entertainment costs. Other factors affecting cost of sales were individually immaterial. (d) Our Consolidated and Combined Financial Statements include the accounts of our company and its majority owned subsidiaries. We eliminate all significant affiliate accounts and transactions upon consolidation. Operating income. Operating income increased $280.2 million, or 35.4%, from $792.1 million generated for 2016 to $1.1 billion generated for 2017. The following tables provide operating income information: (a) SG&A expense incurred by the U.S. operations during 2017 increased $76.6 million, or 45.5%, from SG&A expense incurred by the U.S. operations during 2016 primarily because of expenses incurred by the acquired GNP operations and, to a lesser extent, by increases in SG&A expense incurred by our existing U.S. operations. Expenses incurred by the acquired GNP business contributed $35.5 million, or 21.2 percentage points, to the overall increase in SG&A expenses. Expenses incurred by our existing U.S. operations increased primarily because of an $18.7 million increase in transaction costs associated with the Moy Park acquisition, a $6.0 million increase in professional fees expenses, a $5.7 million increase in management fees charged for administrative functions shared with JBS USA Food Company, a $5.0 million increase in advertising and promotional expenses, a $4.4 million increase in employee wages and benefits and a $1.4 million increase in depreciation and amortization expenses. Other factors affecting SG&A expense were individually immaterial. (b) SG&A expense incurred by the U.K. and Europe operations during 2017 decreased $1.5 million, or 1.3%, from SG&A expense incurred by the U.K. and Europe operations during 2016 primarily because of a $9.0 million decrease in advertising and promotion costs and a $4.0 million decrease in management fees charged for administrative functions shared with JBS S.A. These decreases to SG&A expense were partially offset by a $7.4 million increase in employee wages and benefits, a $2.3 million increase in miscellaneous expenses and a $1.6 million increase in depreciation and amortization. Other factors affecting SG&A expense were individually immaterial. (c) SG&A expense incurred by the Mexico operations during 2017 increased $3.6 million, or 11.4%, from SG&A expense incurred by the Mexico operations during 2016 primarily because of a $1.7 million increase in wages and benefits and a $1.9 million increase in advertising and promotion expenses. These increases to SG&A expense were partially offset by a $0.3 million benefit from a decline in foreign exchange rates. Other factors affecting SG&A expense were individually immaterial. (d) Administrative restructuring charges incurred by the U.S. operations during 2017 increased $7.2 million, or 672.6%, from administrative restructuring charges incurred during 2016. Administrative restructuring charges incurred by the U.S. segment during 2017 included a $3.5 million impairment of the aggregate carrying amount of an asset group held for sale in Alabama, $2.6 million in severance costs related to the GNP operations, the elimination of prepaid costs totaling $0.7 million related to obsolete software assumed in the GNP acquisition, and $0.9 million in costs associated with the plant closure in Luverne, Minnesota. Administrative restructuring charges incurred by the U.S. operations during 2016 represented impairment costs of $0.8 million related to assets held for sale in Texas and impairment costs of $0.3 million related to the sale of an asset in Louisiana. (e) Administrative restructuring charges incurred by the U.K. and Europe operations during 2017 increased $1.5 million, or 100.0%, from administrative restructuring charges incurred during 2016. During 2017, administrative restructuring charges represented impairment costs of $1.5 million related to to a property in Dublin, Ireland. (f) Our Consolidated and Combined Financial Statements include the accounts of both our company and its majority owned subsidiaries. We eliminate all significant affiliate accounts and transactions upon consolidation. Interest expense. Consolidated and combined interest expense increased 41.7% to $107.2 million in 2017 from $75.6 million in 2016, primarily because of an increase in the weighted average interest rate to 4.54% in 2017 from 4.39% in 2016 and an increase in average borrowings of $2.0 billion in 2017 from $1.5 billion in 2016. Borrowings increased primarily to fund both the GNP and Moy Park acquisitions during 2017. As a percent of net sales, interest expense in 2017 and 2016 was 1.00% and 0.77%, respectively. Income taxes. Our consolidated and combined income tax expense in 2017 was $263.9 million, compared to income tax expense of $243.9 million in 2016. The increase in income tax expense in 2017 resulted from an increase in pre-tax income during 2017, partially offset by the recognition of a future reduction in the U.S. tax rate during 2017. As a result of the future reduction in the U.S. tax rate, we expect a future effective tax rate of approximately 24%. 2016 Compared to 2015 Net sales. Net sales for 2016 increased $1.1 billion, or 12.9%, from 2015. The following table provides additional information regarding net sales: (a) U.S. net sales generated in 2016 decreased $472.0 million, or 6.6%, from U.S. net sales generated in 2015 primarily because of decreases in both sales volume and net sales per pound. The decrease in sales volume, which resulted from the unfavorable impact that ongoing operational improvements in one of our prepared foods facilities had on production during the period and lower product demand from our commercial customers, contributed $300.5 million, or 4.2 percentage points, to the net sales decrease. Lower net sales per pound, which resulted primarily from lower market prices, contributed $171.4 million, or 2.3 percentage points, to the net sales decrease. Included in U.S. sales generated during 2016 and 2015 were sales to JBS USA Food Company totaling $16.5 million and $21.7 million, respectively. (b) U.K. and Europe sales generated in 2016 increased $1.4 billion, or 240.1%, from U.K. and Europe sales generated in 2015, primarily due to the common- control acquisition of Moy Park on September 30, 2015. (c) Mexico sales generated in 2016 increased $223.0 million, or 21.5%, from Mexico sales generated in 2015, primarily because of an increase in sales volume and an increase in net sales per pound partially offset by the impact of foreign currency translation. The increase in sales volume contributed $310.6 million, or 30.0 percentage points, to the increase in Mexico net sales. The increase in net sales per pound contributed $133.7 million, or 12.9 percentage points, to the increase in Mexico net sales. The increases to net sales was partially offset by the impact of foreign currency translation, which contributed $221.3 million, or 21.3 percentage points, to the decrease in Mexico net sales. Other factors affecting the increase in Mexico net sales were individually immaterial. Gross profit. Gross profit decreased by $194.7 million, or 15.0%, from $1.3 billion generated in 2015 to $1.1 billion generated in 2016. The following tables provide gross profit information: (a) Cost of sales incurred by our U.S. operations in 2016 decreased $87.2 million, or 1.4%, from cost of sales incurred by our U.S. operations in 2015. Cost of sales primarily decreased because of lower sales volume, an $81.5 million decrease in feed ingredients costs and a $17.9 million decrease in freight and storage costs. These costs were partially offset by a $27.0 million increase in contract labor costs, derivative losses of $5.0 million in 2016 compared to derivative gains of $21.3 million in 2015, a $21.3 million increase in wages and benefits, and an $18.1 million increase in co-pack labor costs. Other factors affecting U.S. cost of sales were individually immaterial. (b) Cost of sales incurred by the U.K. and Europe operations during 2016 increased $1.2 billion, or 232.8%, from cost of sales incurred by the U.K. and Europe operations during 2015 primarily due to the common-control acquisition of Moy Park on September 30, 2015. (c) Cost of sales incurred by the Mexico operations during 2016 increased $178.2 million, or 19.6%, from cost of sales incurred by the Mexico operations during 2015 primarily because of increased sales volume and a $33.3 million increase in feed ingredient costs. Mexico cost of sales also increased because of a $22.9 million increase in wages and benefits, a $11.9 million increase in freight and storage costs, and a $11.2 increase in in depreciation and amortization costs. These costs were partially offset by the impact of foreign currency translation which contributed $191.9 million, or 21.1 percentage points, to the decrease in cost of sales incurred by our Mexico operations. Other factors affecting cost of sales were individually immaterial. (d) Our Consolidated and Combined Financial Statements include the accounts of our company and its majority owned subsidiaries. We eliminate all significant affiliate accounts and transactions upon consolidation. Operating income. Operating income decreased $269.1 million, or 25.4%, from $1.1 billion generated for 2015 to $0.8 billion generated for 2016. The following tables provide operating income information: (a) SG&A expense incurred by the U.S. operations during 2016 decreased $3.2 million, or 1.9%, from SG&A expense incurred by the U.S. operations during 2015 primarily because of a $5.2 million decrease in brokerage expenses, a $2.6 million decrease in management fees charged for administrative functions shared with JBS USA Food Company, and a $2.0 million decrease in employee wages and benefits that were partially offset by a a $3.1 million increase in contract labor expenses, and a $2.6 million increase in professional fees expenses. Other factors affecting SG&A expense were individually immaterial. (b) SG&A expense incurred by the U.K. and Europe operations during 2016 increased $83.1 million, or 297.2%, from SG&A expense incurred by the U.K. and Europe operations during 2015 primarily due to the common-control acquisition of Moy Park on September 30, 2015. (c) SG&A expense incurred by the Mexico operations during 2016 decreased $0.9 million, or 2.8%, from SG&A expense incurred by the Mexico operations during 2015 primarily because of a $15.0 million decrease in management fees charged for administrative functions shared with JBS USA Food Company and a $2.6 million decrease in professional fees expenses. These decreases to SG&A expense were partially offset by a $15.9 increase in employee wages and benefits. Other factors affecting SG&A expense were individually immaterial. (d) Administrative restructuring charges incurred by the U.S. operations during 2016 decreased $4.5 million, or 80.9%, from administrative restructuring charges incurred during 2015. During 2016, administrative restructuring charges represented impairment costs of $0.8 million related to assets held for sale in Texas and impairment costs of $0.3 million related to the sale of an asset in Louisiana. During 2015, administrative restructuring charges represented impairment costs of $4.8 million related to assets held for sale in Louisiana and Texas and a loss of $0.8 million related to the sale of a rendering plant in Arkansas. (e) Our Consolidated and Combined Financial Statements include the accounts of both our company and its majority owned subsidiaries. We eliminate all significant affiliate accounts and transactions upon consolidation. Interest expense. Consolidated and combined interest expense increased 62.5% to $75.6 million in 2016 from $46.6 million in 2015, primarily because of an increase in the weighted average interest rate to 4.39% in 2016 from 4.09% in 2015 and an increase in average borrowings of $1.5 billion in 2016 from $1.1 billion in 2015. As a percent of net sales, interest expense in 2016 and 2015 was 0.77% and 0.53%, respectively. Income taxes. Our consolidated and combined income tax expense in 2016 was $243.9 million, compared to income tax expense of $338.4 million in 2015. The decrease in income tax expense in 2016 resulted primarily from a decrease in income. Liquidity and Capital Resources The following table presents our available sources of liquidity as of December 31, 2017: (a) Availability under the U.S. Credit Facility is also reduced by our outstanding standby letters of credit. Standby letters of credit outstanding at December 31, 2017 totaled $44.8 million. (b) As of December 31, 2017, the U.S. dollar-equivalent of the amount available under the Mexico Credit Facility (as described below) was less than $0.1 million. The Mexico Credit Facility provides for a loan commitment of $1.5 billion Mexican pesos. (c) The U.K. and Europe Credit Facilities consist of the Moy Park Multicurrency Revolving Facility Agreement, the Moy Park Receivables Finance Agreement, and the Moy Park France Invoice Discounting Facility, as described below. As of December 31, 2017, the U.S. dollar-equivalent of the amount available under the U.K. and Europe Credit Facilities totaled $112.3 million. The facilities provide for a combined loan commitment amount of £65 million pound sterling and €30 million euro. Long-Term Debt and Other Borrowing Arrangements U.S. Senior Notes On March 11, 2015, the Company completed a sale of $500.0 million aggregate principal amount of its 5.75% senior notes due 2025 (the “Senior Notes due 2025”). The Company used the net proceeds from the sale of the Senior Notes to repay $350.0 million and $150.0 million of the term loan indebtedness under the U.S. Credit Facility on March 12, 2015 and April 22, 2015, respectively. On September 29, 2017, the Company completed an add-on offering of $250.0 million of the Senior Notes due 2025 (the “Additional Senior Notes due 2025”). The issuance price of the add-on offering was 102.0% which created gross proceeds of $255.0 million. The additional $5.0 million will be amortized over the life of the bond. The Company used the net proceeds from the sale of the Additional Senior Notes due 2025 to repay in full the JBS S.A. Promissory Note (as described below) issued as part of the Moy Park acquisition and for general corporate purposes. The Additional Senior Notes due 2025 will be treated as a single class with the existing Senior Notes due 2025 for all purposes under the 2015 Indenture (defined below) and will have the same terms as those of the existing Senior Notes due 2025. The Additional Senior Notes due 2025 were sold to qualified institutional buyers pursuant to Rule 144A under the Securities Act of 1933, as amended (the “Securities Act”), and outside the United States to non-U.S. persons pursuant to Regulation S under the Securities Act. The Senior Notes due 2025 and the Additional Senior Notes due 2025 are governed by, and were issued pursuant to, an indenture dated as of March 11, 2015 by and among the Company, its guarantor subsidiary and Wells Fargo Bank, National Association, as trustee (the “2015 Indenture”). The 2015 Indenture provides, among other things, that the Senior Notes due 2025 and the Additional Senior Notes due 2025 bear interest at a rate of 5.75% per annum from the date of issuance until maturity, payable semi-annually in cash in arrears, beginning on September 15, 2015 for the Senior Notes due 2025 and March, 15 2018 for the Additional Senior Notes due 2025. The Senior Notes due 2025 and the Additional Senior Notes due 2025 are guaranteed on a senior unsecured basis by the Company’s guarantor subsidiary. In addition, any of the Company’s other existing or future domestic restricted subsidiaries that incur or guarantee any other indebtedness (with limited exceptions) must also guarantee the Senior Notes due 2025 and the Additional Senior Notes due 2025. The Senior Notes due 2025 and the Additional Senior Notes due 2025 and related guarantees are unsecured senior obligations of the Company and its guarantor subsidiary and rank equally with all of the Company’s and its guarantor subsidiary’s other unsubordinated indebtedness. The Senior Notes due 2025 and the Additional Senior Notes due 2025 and the 2015 Indenture also contain customary covenants and events of default, including failure to pay principal or interest on the Senior Notes due 2025 and the Additional Senior Notes due 2025 when due, among others. On September 29, 2017, the Company completed a sale of $600.0 million aggregate principal amount of its 5.875% senior notes due 2027 (the “Senior Notes due 2027”). The Company used the net proceeds from the sale of the Senior Notes due 2027 to repay in full the JBS S.A. Promissory Note issued as part of the Moy Park acquisition and for general corporate purposes. The Senior Notes due 2027 were sold to qualified institutional buyers pursuant to Rule 144A under the Securities Act, and outside the United States to non-U.S. persons pursuant to Regulation S under the Securities Act. The Senior Notes due 2027 are governed by, and were issued pursuant to, an indenture dated as of September 29, 2017 by and among the Company, its guarantor subsidiary and U.S. Bank National Association, as trustee (the “2017 Indenture”). The 2017 Indenture provides, among other things, that the Senior Notes due 2027 bear interest at a rate of 5.875% per annum from the date of issuance until maturity, payable semi-annually in cash in arrears, beginning on March 30, 2018. The Senior Notes due 2027 are guaranteed on a senior unsecured basis by the Company’s guarantor subsidiary. In addition, any of the Company’s other existing or future domestic restricted subsidiaries that incur or guarantee any other indebtedness (with limited exceptions) must also guarantee the Senior Notes due 2027. The Senior Notes due 2027 and related guarantees are unsecured senior obligations of the Company and its guarantor subsidiary and rank equally with all of the Company’s and its guarantor subsidiary’s other unsubordinated indebtedness. The Senior Notes due 2027 and the 2017 Indenture also contain customary covenants and events of default, including failure to pay principal or interest on the Senior Notes due 2027 when due, among others. Moy Park Senior Notes On May 29, 2014, Moy Park (Bondco) Plc, a subsidiary of Granite Holdings Sàrl, completed the sale of a £200.0 million aggregate principal amount of its 6.25% senior notes due 2021 (the “Moy Park Notes”). On April 17, 2015, an add-on offering of £100.0 million of the Moy Park Notes (the “Additional Moy Park Notes”) was completed. The Moy Park Notes and the Additional Moy Park Notes were sold to qualified institutional buyers pursuant to Rule 144A under the Securities Act, and outside the United States to non-U.S. persons pursuant to Regulation S under the Securities Act. The Moy Park Notes and the Additional Moy Park Notes are governed by, and were issued pursuant to, an indenture dated as of May 29, 2014 by Moy Park (Bondco) Plc, as issuer, Moy Park Holdings (Europe) Limited, Moy Park (Newco) Limited, Moy Park Limited, O’Kane Poultry Limited, as guarantors, and The Bank of New York Mellon, as trustee (the “Moy Park Indenture”). The Moy Park Indenture provides, among other things, that the Moy Park Notes and the Additional Moy Park Notes bear interest at a rate of 6.25% per annum from the date of issuance until maturity, payable semiannually in cash in arrears, beginning on November 29, 2014 for the Moy Park Notes and May 28, 2015 for the Additional Moy Park Notes. The Moy Park Notes and the Additional Moy Park Notes are guaranteed by each of the subsidiary guarantors described above. The Moy Park Indenture contains customary covenants and events of default that may limit Moy Park (Bondco) Plc’s ability and the ability of certain subsidiaries to incur additional debt, declare or pay dividends or make certain investments, among others. On November 2, 2017, Moy Park (Bondco) Plc announced the final results of its previously announced tender offer to purchase for cash any and all of its issued and outstanding Moy Park Notes and Moy Park Additional Notes. As of November 2, 2017, £1,185,000 principal amount of Moy Park Notes and Moy Park Additional Notes had been validly tendered (and not validly withdrawn). Moy Park (Bondco) Plc has purchased all validly tendered (and not validly withdrawn) Moy Park Notes and Moy Park Additional Notes on or prior to November 2, 2017, with such settlement occurring on November 3, 2017. U.S. Credit Facility On May 8, 2017, the Company and certain of its subsidiaries entered into a Third Amended and Restated Credit Agreement (the “U.S. Credit Facility”) with Coöperatieve Rabobank U.A., New York Branch (“Rabobank”), as administrative agent and collateral agent, and the other lenders party thereto. The U.S. Credit Facility provides for a revolving loan commitment of up to$750.0 million and a term loan commitment of up to $800.0 million (the “Term Loans”). The U.S. Credit Facility also includes an accordion feature that allows the Company, at any time, to increase the aggregate revolving loan and term loan commitments by up to an additional $1.0 billion, subject to the satisfaction of certain conditions, including obtaining the lenders’ agreement to participate in the increase. The revolving loan commitment under the U.S. Credit Facility matures on May 6, 2022. All principal on the Term Loans is due at maturity on May 6, 2022. Installments of principal are required to be made, in an amount equal to 1.25% of the original principal amount of the Term Loans, on a quarterly basis prior to the maturity date of the Term Loans. Covenants in the U.S. Credit Facility also require the Company to use the proceeds it receives from certain asset sales and specified debt or equity issuances and upon the occurrence of other events to repay outstanding borrowings under the U.S. Credit Facility. As of December 31, 2017, the company had Term Loans outstanding totaling $780.0 million and the amount available for borrowing under the revolving loan commitment was $631.9 million. The Company had letters of credit of $44.8 million and borrowings of $73.3 million outstanding under the revolving loan commitment as of December 31, 2017. The U.S. Credit Facility includes a $75.0 million sub-limit for swingline loans and a $125.0 million sub-limit for letters of credit. Outstanding borrowings under the revolving loan commitment and the Term Loans bear interest at a per annum rate equal to (i) in the case of LIBOR loans, LIBOR plus 1.50% through December 31, 2017 and, thereafter, based on the Company’s net senior secured leverage ratio, between LIBOR plus 1.25% and LIBOR plus 2.75% and (ii) in the case of alternate base rate loans, the base rate plus 0.50% through December 31, 2017 and, based on the Company’s net senior secured leverage ratio, between the base rate plus 0.25% and base rate plus 1.75% thereafter. The U.S. Credit Facility contains financial covenants and various other covenants that may adversely affect the Company’s ability to, among other things, incur additional indebtedness, incur liens, pay dividends or make certain restricted payments, consummate certain assets sales, enter into certain transactions with JBS and the Company’s other affiliates, merge, consolidate and/or sell or dispose of all or substantially all of our assets. The U.S. Credit Facility requires the Company to comply with a minimum level of tangible net worth covenant. The U.S. Credit Facility also provides that we may not incur capital expenditures in excess of $500.0 million in any fiscal year. The Company is currently in compliance with the covenants under the U.S. Credit Facility. All obligations under the U.S. Credit Facility continue to be unconditionally guaranteed by certain of the Company’s subsidiaries and continue to be secured by a first priority lien on (i) the accounts receivable and inventory of our company and its non-Mexico subsidiaries, (ii) 100% of the equity interests in our domestic subsidiaries, To-Ricos, Ltd. and To-Ricos Distribution, Ltd., and 65% of the equity interests in our direct foreign subsidiaries and (iii) substantially all of the assets of the Company and the guarantors under the U.S. Credit Facility. Mexico Credit Facility On September 27, 2016, certain of our Mexican subsidiaries entered into an unsecured credit agreement (the “Mexico Credit Facility”) with BBVA Bancomer, S.A. Institución de Banca Múltiple, Grupo Financiero BBVA Bancomer, as lender. The loan commitment under the Mexico Credit Facility was $1.5 billion Mexican pesos. Outstanding borrowings under the Mexico Credit Facility accrued interest at a rate equal to the Interbank Equilibrium Interest Rate plus 0.95%. The Mexico Credit Facility will mature on September 27, 2019. As of December 31, 2017, the U.S. dollar-equivalent of the loan commitment under the Mexico Credit Facility was $76.3 million, and there were $76.3 million outstanding borrowings under the Mexico Credit Facility that bear interest at a per annum rate of 8.34%. As of December 31, 2017, the U.S. dollar-equivalent borrowing availability was less than $0.1 million. Moy Park Multicurrency Revolving Facility Agreement On March 19, 2015, Moy Park Holdings (Europe) Limited, a subsidiary of Granite Holdings Sàrl, and its subsidiaries, entered into an agreement with Barclays Bank plc which matures on March 19, 2018. The agreement provides for a multicurrency revolving loan commitment of up to £20.0 million. As of December 31, 2017, the U.S. dollar-equivalent loan commitment under Moy Park multicurrency revolving facility was $27.0 million and there were $9.6 million outstanding borrowings. Outstanding borrowings under the facility bear interest at a per annum rate equal to LIBOR plus a margin determined by Moy Park’s Net Debt to EBITDA ratio. The current margin stands at 2.2%. As of December 31, 2017, the U.S. dollar-equivalent borrowing availability was $17.4 million. The facility contains financial covenants and various other covenants that may adversely affect Moy Park's ability to, among other things, incur additional indebtedness, consummate certain assets sales, enter into certain transactions with JBS and the Company's other affiliates, merge, consolidate and/or sell or dispose of all or substantially all of the Moy Park's assets. Moy Park Receivables Finance Agreement Moy Park Limited, a subsidiary of Granite Holdings Sàrl, entered into a £45.0 million receivables finance agreement on January 29, 2016 (the “Receivables Finance Agreement”), with Barclays Bank plc, which matures on January 29, 2020. As of December 31, 2017, the U.S. dollar-equivalent loan commitment under the Receivables Finance Agreement was $60.8 million and there were no outstanding borrowings. Outstanding borrowings under the facility bear interest at a per annum rate equal to LIBOR plus 1.5%. The Receivables Finance Agreement includes an accordion feature that allows us, at any time, to increase the commitments by up to an additional £15.0 million (U.S. dollar-equivalent $20.3 million as of December 31, 2017), subject to the satisfaction of certain conditions. The Receivables Finance Agreement contains financial covenants and various other covenants that may adversely affect Moy Park's ability to, among other things, incur additional indebtedness, consummate certain asset sales, enter into certain transactions with JBS and the Company's other affiliates, merge, consolidate and/or sell or dispose of all or substantially all of Moy Park's assets. Moy Park France Invoice Discounting Facility In June 2009, Moy Park France Sàrl, a subsidiary of Granite Holdings Sàrl, entered into a €20.0 million invoice discounting facility with GE De Facto (the “Invoice Discounting Facility”). The facility limit was increased €10.0 million in September 2016 to €30.0 million. The Invoice Discounting Facility is payable on demand and the term is extended on an annual basis. The agreement can be terminated with three months’ notice. As of December 31, 2017, the U.S. dollar-equivalent loan commitment under the Invoice Discounting Facility was $36.0 million and there were $1.8 million outstanding borrowings. As of December 31, 2017, the U.S. dollar-equivalent borrowing availability was $34.2 million. Outstanding borrowings under the Invoice Discounting Facility bear interest at a per annum rate equal to EURIBOR plus a margin of 0.80%. The Invoice Discounting Facility contains financial covenants and various other covenants that may adversely affect Moy Park's ability to, among other things, incur additional indebtedness, consummate certain asset sales, enter into certain transactions with JBS and the Company's other affiliates, merge, consolidate and/or sell or dispose of all or substantially all of Moy Park's assets. JBS S.A. Promissory Note On September 8, 2017, Onix Investments UK Ltd., a wholly owned subsidiary of Pilgrim’s Pride Corporation, executed a subordinated promissory note payable to JBS S.A. (the “JBS S.A. Promissory Note”) for £562.5 million, which had a maturity date of September 6, 2018. Interest on the outstanding principal balance of the JBS S.A. Promissory Note accrued at the rate per annum equal to (i) from and after November 8, 2017 and prior to January 7, 2018, 4.00%, (ii) from and after January 7, 2018 and prior to March 8, 2018, 6.00% and (iii) from and after March 8, 2018, 8.00%. The JBS S.A. Promissory Note was repaid in full on October 2, 2017 using the net proceeds from the sale of Senior Notes due 2027 and the Additional Senior Notes due 2025. Collateral Substantially all of our domestic inventories and domestic fixed assets are pledged as collateral to secure the obligations under the U.S. Credit Facility. Off-Balance Sheet Arrangements We maintain operating leases for various types of equipment, some of which contain residual value guarantees for the market value of assets at the end of the term of the lease. The terms of the lease maturities range from one to ten years. We estimate the maximum potential amount of the residual value guarantees is approximately $48.5 million; however, the actual amount would be offset by any recoverable amount based on the fair market value of the underlying leased assets. No liability has been recorded related to this contingency as the likelihood of payments under these guarantees is not considered to be probable, and the fair value of the guarantees is immaterial. We historically have not experienced significant payments under similar residual guarantees. We are a party to many routine contracts in which we provide general indemnities in the normal course of business to third parties for various risks. Among other considerations, we have not recorded a liability for any of these indemnities as, based upon the likelihood of payment, the fair value of such indemnities would not have a material impact on our financial condition, results of operations and cash flows. Capital Expenditures We anticipate spending between $315 million and $325 million on the acquisition of property, plant and equipment in 2018. Capital expenditures will primarily be incurred to improve efficiencies and reduce costs. We expect to fund these capital expenditures with cash flow from operations and proceeds from the revolving lines of credit under our various debt facilities. Indefinite Reinvestment of Foreign Subsidiaries’ Undistributed Earnings We have determined that the undistributed earnings of our Mexico, Puerto Rico and U.K. subsidiaries will be indefinitely reinvested and not distributed to the U.S. The undistributed earnings of our Mexico, Puerto Rico and U.K. subsidiaries totaled $805.9 million, $21.3 million and $12.6 million, respectively, at December 31, 2017. Contractual Obligations In addition to our debt commitments at December 31, 2017, we had other commitments and contractual obligations that obligate us to make specified payments in the future. The following table summarizes the total amounts due as of December 31, 2017, under all debt agreements, commitments and other contractual obligations. The table indicates the years in which payments are due under the contractual obligations. (a) The total amount of unrecognized tax benefits at December 31, 2017 was $11.9 million. We did not include this amount in the contractual obligations table above as reasonable estimates cannot be made at this time of the amounts or timing of future cash outflows. (b) Long-term debt is presented at face value and excludes $44.8 million in letters of credit outstanding related to normal business transactions. (c) Interest expense in the table above assumes the continuation of interest rates and outstanding borrowings as of December 31, 2017. (d) Includes agreements to purchase goods or services that are enforceable and legally binding on us and that specify all significant terms, including fixed or minimum quantities to be purchased; fixed, minimum, or variable price provisions; and the approximate timing of the transaction. We expect cash flows from operations, combined with availability under the U.S. Credit Facility, and U.K. and Europe Credit Facilities to provide sufficient liquidity to fund current obligations, projected working capital requirements, maturities of long-term debt and capital spending for at least the next twelve months. Historical Flow of Funds Calendar Year 2017 Cash provided by operating activities was $801.3 million during 2017. The cash flows provided by operating activities were primarily from net income of $718.2 million, proceeds of $277.8 million related to depreciation and amortization, partially offset by a use of $207.4 million in cash related to inventories. Trade accounts and other receivables, including accounts receivable from related parties, used cash of $82.2 million related to operating activities during 2017. The change in operating cash related to trade accounts and other receivables is primarily due to a decrease in outstanding receivables and customer payment timing. Inventories had uses of cash of $207.4 million related to operating activities during 2017. The change in cash related to inventories was primarily due to increases in our live chicken and finished chicken products and inventories related to the GNP acquisition. Prepaid expenses and other current assets had uses of cash of $14.8 million related to operating activities during 2017. The change resulted primarily from a net increase in value-added tax receivables, as well as increases in prepaid expenses and other current assets related to the GNP acquisition. Accounts payable and accrued expenses, including accounts payable to related parties, had uses of cash of $22.8 million related to operating activities during 2017. This change resulted primarily from the timing of payments. Income taxes, which includes income taxes receivables, income taxes payable, deferred tax assets, deferred tax liabilities, reserves for uncertain tax positions and the tax components within accumulated other comprehensive loss, had proceeds of cash of $188.1 million. This change resulted primarily from the timing of estimated tax payments. Net non-cash expenses provided $233.9 million in cash during 2017. Net non-cash expense items increased primarily because of $277.8 million in cash related to depreciation and amortization, partially offset by a deferred income tax benefit of $50.0 million. Cash used in investing activities was $992.1 million during 2017. This change resulted primarily because of cash used in business acquisitions totaling $658.5 million and the use of cash for capital expenditures totaling $339.9 million. Capital expenditures were primarily incurred to improve operational efficiencies, reduce costs and tailor processes to meet specific customer needs in order to further solidify our competitive advantages. Capital expenditures for 2017 could not exceed $500.0 million under the terms of our U.S. credit facility. Cash proceeds generated from property disposals and proceeds from settlement of life insurance totaled $4.5 million and $1.8 million, respectively. Cash proceeds from financing activities was $466.4 million during 2017. Cash proceeds from long-term debt totaled $1,871.8 million and proceeds from equity contributions under the Tax Sharing Agreement with JBS USA Food Company Holdings totaled $5.0 million. Cash was used for payment of note payable to affiliate totaling $753.5 million, repayment of long-term debt totaling $628.7 million, purchase common stock under our share repurchase program totaling $14.6 million and payment of capitalized loan costs totaling $13.6 million. Calendar Year 2016 Cash provided by operating activities was $795.4 million during 2016. The cash flows provided by operating activities were primarily from net income of $480.1 million and proceeds of $231.7 million related to depreciation and amortization. Trade accounts and other receivables, including accounts receivable from related parties, used cash of $32.4 million related to operating activities during 2016. The change in operating cash related to trade accounts and other receivables is primarily due to a decrease in outstanding receivables and customer payment timing. Inventories had uses of cash of $33.1 million related to operating activities during 2016. The use of cash related to inventories was primarily due to a build up of freezer inventories. Prepaid expenses and other current assets had cash proceeds of $19.3 million related to operating activities during 2016. The proceeds of cash related to prepaid expenses and other current assets is primarily attributable to a decrease in value-added tax receivables and a decline in prepaid insurance. Accounts payable and accrued expenses, including accounts payable to related parties, had proceeds of cash of $75.9 million related to operating activities during 2016. This change resulted primarily from the timing of payments. Income taxes, which include income taxes receivables, income taxes payable, deferred tax assets, deferred tax liabilities, reserves for uncertain tax positions, and the tax components within accumulated other comprehensive loss, had proceeds of cash of $75.2 million during 2016. This change resulted primarily from the timing of estimated tax payments and the impact of the Moy Park acquisition. Net non-cash expenses provided $225.1 million in cash during 2016. Net non-cash expense items increased primarily because of $231.7 million in cash proceeds related to depreciation and amortization. Cash used in investing activities was $327.6 million during 2016, primarily because of incurred capital expenditures of $341.0 million. Capital expenditures were primarily incurred for the routine replacement of equipment and to improve efficiencies and reduce costs. Capital expenditures for 2016 could not exceed $500 million under the terms of our U.S. credit facility. Additionally, cash proceeds generated from property disposals totaled $13.4 million. Cash used by financing activities was $828.2 million during 2016. Cash was used to pay a special cash dividend and purchase common stock under share repurchase program for $714.8 million and $117.9 million, respectively. Cash proceeds from long-term debt totaled $593.0 million, partially offset by cash used on payments of long-term borrowings of $570.0 million. Recently Issued Accounting Pronouncements In May 2014, the Financial Accounting Standards Board (“FASB”) issued new accounting guidance on revenue recognition, which provides for a single five-step model to be applied to all revenue contracts with customers. In July 2015, the FASB issued new accounting guidance on the subsequent measurement of inventory, which, in an effort to simplify unnecessarily complicated accounting guidance that can result in several potential outcomes, requires an entity to measure inventory at the lower of cost or net realizable value. In February 2016, the FASB issued new accounting guidance on lease arrangements, which, in an effort to increase transparency and comparability among organizations utilizing leasing, requires an entity that is a lessee to recognize the assets and liabilities arising from leases on the balance sheet. In March 2016, the FASB issued new accounting guidance on employee share-based payments, which, in an effort to simplify unnecessarily complicated aspects of accounting and reporting for share-based payment transactions, requires an entity to amend accounting and reporting methodology for areas such as the income tax consequences of share-based payments, classification of share-based awards as either equity or liabilities, and classification of share-based payment transactions in the statement of cash flows. In June 2016, the FASB issued new accounting guidance on the measurement of credit losses on financial instruments, which, in an effort to provide financial statement users with more decision-useful information about the expected credit losses on financial instruments, replaces the current incurred loss impairment methodology with a methodology that reflects expected credit losses and requires consideration of a broader range of reasonable and supportable information to inform credit loss estimates. In November 2016, the FASB issued new accounting guidance on the classification and presentation of restricted cash in the statement of cash flows in order to eliminate the discrepancies that currently exist in how companies present these changes. In March 2017, the FASB issued new accounting guidance on the presentation of net periodic pension cost and net periodic postretirement benefit cost, which requires the service cost component of net benefit cost to be reported in the same line of the income statement as other compensation costs earned by the employee and the other components of net benefit cost to be reported below income from operations. In August 2017, the FASB issued an accounting standard update that simplifies the application of hedge accounting guidance in current GAAP and improves the reporting of hedging relationships to better portray the economic results of an entity’s risk management activities in its financial statements. See “Note 1. Description of Business and Basis of Presentation” of our Consolidated and Combined Financial Statements included in this annual report for additional information relating to these new accounting pronouncements. Critical Accounting Policies and Estimates General. Our discussion and analysis of our financial condition and results of operations are based upon our financial statements, which have been prepared in accordance with U.S. GAAP. The preparation of these financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses. On an ongoing basis, we evaluate our estimates, including those related to revenue recognition, customer programs and incentives, allowance for doubtful accounts, inventories, income taxes and product recall accounting. We base our estimates on historical experience and on various other assumptions that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions. We believe the following critical accounting policies affect our more significant judgments and estimates used in the preparation of our financial statements. Revenue Recognition. We recognize revenue when all of the following circumstances are satisfied: (i) persuasive evidence of an arrangement exists, (ii) price is fixed or determinable, (iii) collectability is reasonably assured and (iv) delivery has occurred. Delivery occurs in the period in which the customer takes title and assumes the risks and rewards of ownership of the products specified in the customer’s purchase order or sales agreement. Revenue is recorded net of estimated incentive offerings including special pricing agreements, promotions and other volume-based incentives. Revisions to these estimates are charged back to net sales in the period in which the facts that give rise to the revision become known. Inventory. Live chicken inventories are stated at the lower of cost or market and breeder hen inventories at the lower of cost, less accumulated amortization, or market. The costs associated with breeder hen inventories are accumulated up to the production stage and amortized over their productive lives using the unit-of-production method. Finished poultry products, feed, eggs and other inventories are stated at the lower of cost (average) or market. We record valuations and adjustments for our inventory and for estimated obsolescence at or equal to the difference between the cost of inventory and the estimated market value based upon known conditions affecting inventory obsolescence, including significantly aged products, discontinued product lines, or damaged or obsolete products. We allocate meat costs between our various finished chicken products based on a by-product costing technique that reduces the cost of the whole bird by estimated yields and amounts to be recovered for certain by-product parts. This primarily includes leg quarters, wings, tenders and offal, which are carried in inventory at the estimated recovery amounts, with the remaining amount being reflected as our breast meat cost. Generally, we perform an evaluation of whether any lower of cost or market adjustments are required at the country level based on a number of factors, including: (i) pools of related inventory, (ii) product continuation or discontinuation, (iii) estimated market selling prices and (iv) expected distribution channels. If actual market conditions or other factors are less favorable than those projected by management, additional inventory adjustments may be required. Property, Plant and Equipment. We record impairment charges on long-lived assets held for use when events and circumstances indicate that the assets may be impaired and the undiscounted cash flows estimated to be generated by those assets are less than the carrying amount of those assets. The impairment charge is determined based upon the amount by which the net book value of the assets exceeds their fair market value. In making these determinations, we utilize certain assumptions, including, but not limited to: (i) future cash flows estimated to be generated by these assets, which are based on additional assumptions such as asset utilization, remaining length of service and estimated salvage values, (ii) estimated fair market value of the assets, and (iii) determinations with respect to the lowest level of cash flows relevant to the respective impairment test, generally groupings of related operational facilities. Given the interdependency of our individual facilities during the production process, which operate as a vertically integrated network, we evaluate impairment of assets held for use at the country level (i.e., the U.S. and Mexico). Management believes this is the lowest level of identifiable cash flows for our assets that are held for use in production activities. At the present time, our forecasts indicate that we can recover the carrying value of our assets held for use based on the projected undiscounted cash flows of the operations. We record impairment charges on long-lived assets held for sale when the carrying amount of those assets exceeds their fair value less appropriate selling costs. Fair value is based on amounts documented in sales contracts or letters of intent accepted by us, amounts included in counteroffers initiated by us, or, in the absence of current contract negotiations, amounts determined using a sales comparison approach for real property and amounts determined using a cost approach for personal property. Under the sales comparison approach, sales and asking prices of reasonably comparable properties are considered to develop a range of unit prices within which the current real estate market is operating. Under the cost approach, a current cost to replace the asset new is calculated and then the estimated replacement cost is reduced to reflect the applicable decline in value resulting from physical deterioration, functional obsolescence and economic obsolescence. Appropriate selling costs includes reasonable broker's commissions, costs to produce title documents, filing fees, legal expenses and the like. We estimate appropriate closing costs as 4% to 6% of asset fair value. This range of rates is considered reasonable for our assets held for sale based on historical experience. Goodwill and Other Intangibles, net. Goodwill represents the excess of the aggregate purchase price over the fair value of the net identifiable assets acquired in a business combination. Identified intangible assets represent trade names, customer relationships and non-compete agreements arising from acquisitions that are recorded at fair value as of the date acquired less accumulated amortization, if any. The Company uses various market valuation techniques to determine the fair value of its identified intangible assets. Goodwill and other intangible assets with indefinite lives are not amortized but are tested for impairment on an annual basis in the fourth quarter of each fiscal year or more frequently if impairment indicators arise. For goodwill, an impairment loss is recognized for any excess of the carrying amount of a reporting unit’s goodwill over the implied fair value of that goodwill. Management first reviews relevant qualitative factors to determine if an indication of impairment exists for a reporting unit. If management determines there is an indication that the carrying amount of reporting unit goodwill might be impaired, a quantitative analysis is performed. Management performed a qualitative analysis noting no indications of goodwill impairment in any of its reporting units as of December 31, 2017. For indefinite-lived intangible assets, an impairment loss is recognized if the carrying amount of an indefinite-lived intangible asset exceeds the estimated fair value of that intangible asset. Management first reviews relevant qualitative factors to determine if an indication of impairment exists. If management determines there is an indication that the carrying amount of the intangible asset might be impaired, and quantitative analysis is performed. Management performed a qualitative analysis noting no indications of impairment for any of its indefinite-lived intangible assets as of December 31, 2017. Identifiable intangible assets with definite lives, such as customer relationships, non-compete agreements and trade names that the Company expects to use for a limited amount of time, are amortized over their estimated useful lives on a straight-line basis. The useful lives range from three to 20 years for trade names and non-compete agreements and 5 to 16 years for customer relationships. Identified intangible assets with definite lives are tested for recoverability whenever events or changes in circumstances indicate that their carrying amount may not be recoverable. Management assessed if events or changes in circumstances indicated that the aggregate carrying amount of its identified intangible assets with definite lives might not be recoverable and determined that there were no impairment indicators during the fifty-three weeks ended December 31, 2017 and fifty-two weeks ended December 25, 2016. Derivative Financial Instruments. The Company uses derivative financial instruments (e.g., futures, forwards and options) for the purpose of mitigating exposure to changes in commodity prices and foreign currency exchange rates. • Commodity Price Risk - The Company utilizes various raw materials, which are all considered commodities, in its operations, including corn, soybean meal, soybean oil, wheat, natural gas, electricity and diesel fuel. The Company considers these raw materials to be generally available from a number of different sources and believes it can obtain them to meet its requirements. These commodities are subject to price fluctuations and related price risk due to factors beyond our control, such as economic and political conditions, supply and demand, weather, governmental regulation and other circumstances. Generally, the Company enters into derivative contracts such as physical forward contracts and exchange-traded futures or option contracts in an attempt to mitigate price risk related to its anticipated consumption of commodity inputs for periods up to 12 months. The Company may enter into longer-term derivatives on particular commodities if deemed appropriate. • Foreign Currency Risk - The Company has foreign operations and, therefore, has exposure to foreign exchange risk when the financial results of those operations are translated to US dollars. The Company will occasionally purchase derivative financial instruments such as foreign currency forward contracts in an attempt to mitigate currency exchange rate exposure related to the net assets of its Mexico operations that are denominated in Mexican pesos. The Company’s Moy Park operation also attempts to mitigate foreign currency exposure on certain euro- and U.S. dollar-denominated transactions through the use of derivative financial instruments. Pilgrim’s recognizes all commodity derivative instruments that qualify for derivative accounting treatment as either assets or liabilities and measures those instruments at fair value unless they qualify for, and we elect, the normal purchases and normal sales scope exception (“NPNS”). The permitted accounting treatments include: cash flow hedge; fair value hedge; and undesignated contracts. Undesignated contract accounting is the default accounting treatment for all derivatives unless they qualify, and we specifically designate them, for one of the other accounting treatments. Derivatives designated for any of the elective accounting treatments must meet specific, restrictive criteria both at the time of designation and on an ongoing basis. The Company has generally applied the NPNS exception to its forward physical grain purchase contracts. NPNS contracts are accounted for using the accrual method of accounting; therefore, there were no amounts recorded in the Consolidated and Combined Financial Statements at December 31, 2017 and December 25, 2016. Undesignated contracts may include contracts not designated as a hedge or for which the NPNS exception was not elected, contracts that do not qualify for hedge accounting and derivatives that do not or no longer qualify for the NPNS scope exception. The fair value of these derivatives is recognized in the Consolidated and Combined Balance Sheets within Prepaid expenses and other current assets or Accrued expenses and other current liabilities. Changes in fair value of these derivatives are recognized immediately in the Consolidated and Combined Statements of Income within Net sales, Cost of sales or Selling, general and administrative expense, depending on the risk they are intended to mitigate. While management believes these instruments help mitigate various market risks, they are not designated nor accounted for as hedges as a result of the extensive recordkeeping requirements. The Company designated a British pound-denominated promissory note payable issued to JBS S.A. in conjunction with the Moy Park acquisition as a hedge of its net investment in Moy Park. The remeasurement of the note is reported as a foreign currency translation adjustment in accumulated other comprehensive loss in the Consolidated and Combined Balance Sheets and will be reclassified into earnings only if the Company divests its investment in Moy Park. The Company paid the promissory note payable in full with proceeds from the sale of senior notes (See “Note 11. Long-Term Debt and Other Borrowing Arrangements” to the Consolidated and Combined Financial Statements). At December 31, 2017, the remeasurement adjustment was a loss of $13.5 million and is included in accumulated other comprehensive loss, net of tax. Pilgrim’s has designated a portion of its foreign currency derivatives as cash flow hedges and the effective portion of the gain or loss on these derivatives is reported as a component of Accumulated other comprehensive loss within the Consolidated and Combined Balance Sheets and reclassified into earnings in the same period or periods during which the hedged transactions affect earnings. The derivatives are designated as hedging the variability in expected future cash flows from foreign currency exchange risk related to sales and purchases denominated in nonfunctional currencies. Litigation and Contingent Liabilities. We are subject to lawsuits, investigations and other claims related to employment, environmental, product, and other matters. We are required to assess the likelihood of any adverse judgments or outcomes, as well as potential ranges of probable losses, to these matters. We estimate the amount of reserves required for these contingencies when losses are determined to be probable and after considerable analysis of each individual issue. We expense legal costs related to such loss contingencies as they are incurred. With respect to our environmental remediation obligations, the accrual for environmental remediation liabilities is measured on an undiscounted basis. These reserves may change in the future due to changes in our assumptions, the effectiveness of strategies, or other factors beyond our control. Accrued Self Insurance. Insurance expense for casualty claims and employee-related health care benefits are estimated using historical and current experience and actuarial estimates. Stop-loss coverage is maintained with third-party insurers to limit our total exposure. Certain categories of claim liabilities are actuarially determined. The assumption used to arrive at periodic expenses is reviewed regularly by management. However, actual expenses could differ from these estimates and could result in adjustments to be recognized. Income Taxes. We follow provisions under ASC No. 740-10-30-27 in the Expenses-Income Taxes topic with regard to members of a group that file a consolidated tax return but issue separate financial statements. We file our own U.S. federal tax return, but we are included in certain state unitary returns with JBS USA Holdings. The income tax expense of our company is computed using the separate return method. The provision for income taxes has been determined using the asset and liability approach of accounting for income taxes. For the unitary states, we have an obligation to make tax payments to JBS USA Holdings for our share of the unitary taxable income, which is included in taxes payable in our Consolidated and Combined Balance Sheets. Under this approach, deferred income taxes reflect the net tax effect of temporary differences between the book and tax bases of recorded assets and liabilities, net operating losses and tax credit carry forwards. The amount of deferred tax on these temporary differences is determined using the tax rates expected to apply to the period when the asset is realized or the liability is settled, as applicable, based on the tax rates and laws in the respective tax jurisdiction enacted as of the balance sheet date. We recognize potential interest and penalties related to income tax positions as a part of the income tax provision. Realizability of Deferred Tax Assets. We review our deferred tax assets for recoverability and establish a valuation allowance based on historical taxable income, potential for carry back of tax losses, projected future taxable income, applicable tax strategies, and the expected timing of the reversals of existing temporary differences. A valuation allowance is provided when it is more likely than not that some or all of the deferred tax assets will not be realized. Valuation allowances have been established primarily for net operating loss carry forwards. See “Note 12. Income Taxes” to the Consolidated Financial Statements in this annual report. Indefinite Reinvestment in Foreign Subsidiaries. We deem our earnings from foreign subsidiaries as of December 31, 2017 to be permanently reinvested. As such, U.S. deferred income taxes have not been provided on these earnings. If such earnings were not considered indefinitely reinvested, certain deferred foreign and U.S. income taxes would be provided. Accounting for Uncertainty in Income Taxes. We follow provisions under ASC No. 740-10-25 that provide a recognition threshold and measurement criteria for the financial statement recognition of a tax benefit taken or expected to be taken in a tax return. Tax benefits are recognized only when it is more likely than not, based on the technical merits, that the benefits will be sustained on examination. Tax benefits that meet the more-likely-than-not recognition threshold are measured using a probability weighting of the largest amount of tax benefit that has greater than 50% likelihood of being realized upon settlement. Whether the more-likely-than-not recognition threshold is met for a particular tax benefit is a matter of judgment based on the individual facts and circumstances evaluated in light of all available evidence as of the balance sheet date. See “Note 12. Income Taxes” to the Consolidated Financial Statements in this annual report. Pension and Other Postretirement Benefits. Our pension and other postretirement benefit costs and obligations are dependent on the various actuarial assumptions used in calculating such amounts. These assumptions relate to discount rates, salary growth, long-term return on plan assets and other factors. We base the discount rate assumptions on current investment yields on high-quality corporate long-term bonds. Long-term return on plan assets is determined based on historical portfolio results and management’s expectation of the future economic environment. Actual results that differ from our assumptions are accumulated and, if in excess of the lesser of 10% of the projected benefit obligation or the fair market value of plan assets, amortized over either (i) the estimated average future service period of active plan participants if the plan is active or (ii) the estimated average future life expectancy of all plan participants if the plan is frozen.

<s>[INST] We are one of the largest chicken producers in the world, with operations in the United States (“U.S.”), United Kingdom (“U.K.”), Mexico, France, Puerto Rico, and The Netherlands. We are primarily engaged in the production, processing, marketing and distribution of fresh, frozen and valueadded chicken products to retailers, distributors and foodservice operators. We offer a wide range of products to our customers through strong national and international distribution channels. Pilgrim’s fresh chicken products consist of refrigerated (nonfrozen) whole chickens, whole cutup chickens and selected chicken parts that are either marinated or nonmarinated. The Company's prepared chicken products include fully cooked, readytocook and individually frozen chicken parts, strips, nuggets and patties, some of which are either breaded or nonbreaded and either marinated or nonmarinated, readytoeat meals, multiprotein frozen foods, vegetarian foods and desserts. We market our balanced portfolio of fresh, prepared and valueadded chicken products to a diverse set of over 5,500 customers across the U.S., the U.K. and Europe, Mexico and in approximately 100 other countries, with no single customer accounting for more than 10% of total sales. We have become a valuable partner to our customers and a recognized industry leader by consistently providing highquality products and services designed to meet their needs and enhance their business. Our sales efforts are largely targeted towards the foodservice industry, principally chain restaurants and food processors, such as ChickfilA® and retail customers, including grocery store chains and wholesale clubs, such as Kroger®, Costco®, Publix®, and HEB®. As a vertically integrated company, we control every phase of the production process, which helps us better manage food safety and quality, as well as more effectively control margins and improve customer service. We operate feed mills, hatcheries, processing plants and distribution centers in 14 U.S. states, the U.K. and Europe, Puerto Rico and Mexico. Our plants are strategically located to ensure that customers timely receive fresh products. With our global network of approximately 5,200 growers, 39 feed mills, 50 hatcheries, 36 processing plants, 16 prepared foods cook plants, 20 distribution centers, nine rendering facilities and four pet food plants, we believe we are wellpositioned to supply the growing demand for our products. Our U.K. and Europe segment reflects the operations of Granite Holdings Sàrl and its subsidiaries (together, “Moy Park”), which we acquired on September 8, 2017. Moy Park is a leading and highly regarded U.K. food company, providing fresh, high quality and locally farmed poultry and convenience food products. Moy Park has operated in the U.K. retail market for over 50 years and delivers a range of fresh, readytocook, coated and readytoeat poultry products to major retailers and large foodservice customers throughout the United Kingdom, Ireland, France and The Netherlands. We believe that we operate one of the most efficient business models for chicken production in the U.K. and Europe. We are one of the largest, and we believe one of the most efficient, producers and sellers of chicken in Mexico. Our presence in Mexico provides access to a market with growing demand and has enabled us to leverage our operational strengths within the region. The market for chicken products in Mexico is still developing, with most sales attributed to fresh, commodityoriented, market pricebased business. Additionally, we are an important player in the live market in Mexico. We believe our Mexico business is well positioned to continue benefiting from these trends in the Mexican consumer market. As of December 31, 2017, we had approximately 51,300 employees and the capacity to process more than 45.2 million birds per week for a total of more than 13.3 billion pounds of live chicken annually. In 2017, we produced 10.0 billion pounds of chicken products, generating approximately $10.8 billion in net sales and approximately $694.6 million in net income attributable to Pilgrim’s. We operate on a 52/53week fiscal year that ends [/INST] Positive. </s>

PILGRIMS PRIDE CORP

2019-02-14

2018-12-30

Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations Our Company We are one of the largest chicken producers in the world, with operations in the United States (“U.S.”), the United Kingdom (“U.K.”), Mexico, France, Puerto Rico and the Netherlands. We are primarily engaged in the production, processing, marketing and distribution of fresh, frozen and value-added chicken products to retailers, distributors and foodservice operators. We offer a wide range of products to our customers through strong national and international distribution channels. Pilgrim’s fresh chicken products consist of refrigerated (non-frozen) whole chickens, whole cut-up chickens and selected chicken parts that are either marinated or non-marinated. Our prepared chicken products include fully cooked, ready-to-cook and individually frozen chicken parts, strips, nuggets and patties, some of which are either breaded or non-breaded and either marinated or non-marinated, ready-to-eat meals, multi-protein frozen foods, vegetarian foods and desserts. We market our balanced portfolio of fresh, prepared and value-added chicken products to a diverse set of over 6,000 customers across the U.S., the U.K. and Europe, Mexico and in approximately 100 other countries, with no single customer accounting for more than ten percent of total sales. We have become a valuable partner to our customers and a recognized industry leader by consistently providing high-quality products and services designed to meet their needs and enhance their business. Our sales efforts are largely targeted towards the foodservice industry, principally chain restaurants and food processors, such as Chick-fil-A® and retail customers, including grocery store chains and wholesale clubs, such as Kroger®, Costco®, Publix®, and H-E-B®. As a vertically integrated company, we control every phase of the production process, which helps us better manage food safety and quality, as well as more effectively control margins and improve customer service. We operate feed mills, hatcheries, processing plants and distribution centers in 14 U.S. states, the U.K., Mexico, France, Puerto Rico and the Netherlands. Our plants are strategically located to ensure that customers timely receive fresh products. With our global network of approximately 5,300 growers, 38 feed mills, 49 hatcheries, 36 processing plants, 16 prepared foods cook plants, 22 distribution centers, nine rendering facilities and four pet food plants, we believe we are well-positioned to supply the growing demand for our products. Our U.K. and Europe segment reflects the operations of Granite Holdings Sàrl and its subsidiaries (together, “Moy Park”), which we acquired on September 8, 2017. Moy Park is a leading and highly regarded U.K. food company, providing fresh, high quality and locally farmed poultry and convenience food products. Moy Park has operated in the U.K. retail market for over 50 years and delivers a range of fresh, ready-to-cook, coated and ready-to-eat poultry products to major retailers and large foodservice customers throughout the United Kingdom, Ireland, France and the Netherlands. We believe that we operate one of the most efficient business models for chicken production in the U.K. and Europe. We are one of the largest, and we believe one of the most efficient, producers and sellers of chicken in Mexico. Our presence in Mexico provides access to a market with growing demand and has enabled us to leverage our operational strengths within the region. The market for chicken products in Mexico is still developing, with most sales attributed to fresh, commodity-oriented, market price-based business. Additionally, we are an important player in the live market in Mexico. We believe our Mexico business is well positioned to continue benefiting from these trends in the Mexican consumer market. As of December 30, 2018, we had approximately 52,100 employees and the capacity to process more than 45.3 million birds per week for a total of more than 13.4 billion pounds of live chicken annually. In 2018, we produced 10.7 billion pounds of chicken products, generating approximately $10.9 million in net sales and approximately $246.8 million in net income attributable to Pilgrim’s. We operate on a 52/53-week fiscal year that ends on the Sunday falling on or before December 31. Any reference we make to a particular year (for example, 2018) in this report applies to our fiscal year and not the calendar year. Fiscal 2018 was a 52-week fiscal year. Executive Summary We reported net income attributable to Pilgrim’s Pride Corporation of $247.9 million, or $1.00 per diluted common share, for 2018. These operating results included gross profit of $843.5 million. During 2018, we generated $491.7 million of cash from operations. Our U.S. and Mexico segments use corn and soybean meal as the main ingredients for feed production, while our U.K. and Europe segment uses wheat and soybean meal as the main ingredients for feed production. The following table compares the highest and lowest prices reached on nearby futures for one bushel of corn, one ton of soybean meal and one metric ton of wheat during the current and previous years: (a) We obtain corn and soybean prices from the Chicago Board of Trade, and we obtain wheat prices from the London International Financial Futures and Options Exchange. We purchase derivative financial instruments, specifically exchange-traded futures and options, in an attempt to mitigate price risk related to our anticipated consumption of commodity inputs such as corn, soybean meal, wheat, soybean oil and natural gas. We will sometimes purchase a derivative instrument to minimize the impact of a commodity’s price volatility on our operating results. We will also purchase derivative financial instruments in an attempt to mitigate currency exchange rate exposure related to the financial statements of our Mexico segment that are denominated in Mexican pesos and our U.K. and Europe segment that are denominated in British pounds. For our Mexico segment, we do not designate derivative financial instruments that we purchase to mitigate commodity purchase or currency exchange rate exposures as cash flow hedges; therefore, we recognize changes in the fair value of these derivative financial instruments immediately in earnings. For our U.K. and Europe segment, we do designate certain derivative financial instruments that we have purchased to mitigate foreign currency transaction exposures as cash flow hedges; therefore, before the settlement date of the financial derivative instruments, we recognize changes in the fair value of the effective portion of the cash flow hedge in accumulated other comprehensive income (loss), while we recognize changes in the fair value of the ineffective portion immediately in earnings. When the derivative financial instruments associated with the effective portion are settled, the amount in accumulated other comprehensive income (loss) is then reclassified to earnings. Gains or losses related to these derivative financial instruments are included in the line item Cost of sales in the Consolidated and Combined Statements of Income. We recognized $27.1 million in net losses related to changes in the fair value of our derivative financial instruments during 2018. We recognized $6.7 million in net gains and $4.3 million in net losses related to changes in the fair value of our derivative financial instruments during 2017 and 2016, respectively. Although changes in the market price paid for feed ingredients impact cash outlays at the time we purchase the ingredients, such changes do not immediately impact cost of sales. The cost of feed ingredients is recognized in cost of sales, on a first-in-first-out basis, at the same time that the sales of the chickens that consume the feed grains are recognized. Thus, there is a lag between the time cash is paid for feed ingredients and the time the cost of such feed ingredients is reported in cost of goods sold. For example, corn delivered to a feed mill and paid for one week might be used to manufacture feed the following week. However, the chickens that eat that feed might not be processed and sold for another 42 to 63 days, and only at that time will the costs of the feed consumed by the chickens become included in cost of goods sold. Commodities such as corn, soybean meal, and soybean oil are actively traded through various exchanges with future market prices quoted on a daily basis. These quoted market prices, although a good indicator of the commodity's base price, do not represent the final price for which we can purchase these commodities. There are several components in addition to the quoted market price, such as freight, storage and seller premiums, that are included in the final price that we pay for grain. Although changes in quoted market prices may be a good indicator of the commodity’s base price, the components mentioned above may have a significant impact on the total change in grain costs recognized from period to period. Market prices for chicken products are currently at levels sufficient to offset the costs of feed ingredients. However, there can be no assurance that chicken prices will not decrease due to such factors as competition from other proteins and substitutions by consumers of non-protein foods because of uncertainty surrounding the general economy and unemployment. Acquisition Activity Moy Park Acquisition. On September 8, 2017, we acquired 100% of the issued and outstanding shares of Moy Park from JBS S.A. for cash of $301.3 million and a note payable to the seller in the amount of £562.5 million. Moy Park is one of the top-ten food companies in the U.K., Northern Ireland's largest private sector business and one of Europe's leading poultry producers. With 4 fresh processing plants, 10 prepared foods cook plants, 3 feed mills, 7 hatcheries and 1 rendering facility in the U.K., France and the Netherlands, the acquired business processes 6.0 million birds per seven-day work week, in addition to producing around 456.0 million pounds of prepared foods per year. Moy Park currently has approximately 10,200 employees. See “Note 2. Business Acquisitions” of our Consolidated and Combined Financial Statements included in this annual report for additional information relating to this acquisition. The Moy Park operations constitutes our U.K. and Europe segment. The acquisition was treated as a common-control transaction under U.S. GAAP. A common-control transaction is a transfer of net assets or an exchange of equity interests between entities under the control of the same parent. The accounting and reporting for a transaction between entities under common control is not to be considered a business combination under U.S. GAAP. Accordingly, for the period from September 30, 2015 through September 7, 2017, the Consolidated and Combined Financial Statements includes the accounts of our company and our majority-owned subsidiaries combined with the accounts of Moy Park. For the periods subsequent to September 8, 2017, the Consolidated and Combined Financial Statements includes the accounts of our company and our majority-owned subsidiaries, including Moy Park. GNP Acquisition. On January 6, 2017, we acquired 100% of the membership interests of GNP from Maschhoff Family Foods, LLC for a cash purchase price of $350 million, subject to customary working capital adjustments. GNP is a vertically integrated poultry business based in St. Cloud, Minnesota. The acquired business has a production capacity of 2.1 million birds per five-day work week in its two plants and employed approximately 1,600 people at the time of acquisition. This acquisition further strengthens our strategic position in the U.S. chicken market. The GNP operations are included in our U.S. segment. 2017 Tax Reform On December 22, 2017, the U.S. government enacted comprehensive tax legislation (the “Tax Act”), which significantly revises the ongoing U.S. corporate income tax law by lowering the U.S. federal corporate income tax rate from 35.0% to 21.0%, implementing a territorial tax system, imposing one-time tax on foreign unremitted earnings and setting limitations on deductibility of certain costs (e.g., interest expense), among other things. We applied the guidance in Staff Accounting Bulletin (“SAB”) 118 when accounting for the enactment date effects of the Tax Act. As of December 30, 2018, we have completed our accounting for all of the tax effects of the Tax Act. As further discussed below, during 2018, we recognized adjustments of $18.2 million to the provisional amounts recorded at December 31, 2017 and included these adjustments as a component of income tax expense. As of December 31, 2017, we estimated no tax liability on foreign unremitted earnings due to a net earnings and profits (“E&P”) deficit on accumulated post-1986 deferred foreign income. Therefore, we did not accrue any amount of tax expense for the Tax Act’s one-time transition tax on the foreign subsidiaries’ accumulated, unremitted earnings going back to 1986 for the year ended December 31, 2017. Upon further analysis of certain aspects of the Tax Act and a refinement of the historical calculation of E&P on accumulated post-1986 deferred foreign income during 2018, we finalized the E&P analysis of our foreign subsidiaries and recalculated significant overall positive E&P. Therefore, due to this recalculation, we recorded a $26.4 million tax liability for the one-time transition tax. This one-time transition tax adjustment increased the 2018 effective tax rate by approximately 7.9%. We have elected to pay this liability over the eight-year period provided in the Tax Act. As of December 30, 2018 the remaining balance of our transition tax obligation is $7.7 million, which will be paid over the next seven years. No additional income taxes have been provided for any remaining undistributed foreign earnings not subject to the one-time transition tax or any additional outside basis difference inherent in these foreign subsidiaries, as these amounts continue to be permanently reinvested in foreign operations. The undistributed earnings of our Mexico, Puerto Rico and U.K. subsidiaries totaled $683.0 million, $13.2 million and $2.2 million, respectively, at December 30, 2018. As of December 31, 2017, we accrued $41.5 million in provisional tax benefit related to the net change in deferred tax liabilities stemming from the Tax Act’s reduction of the U.S. federal tax rate from 35% to 21% for the year ended December 31, 2017. Due to return to provision adjustments which resulted from the filing of our 2017 federal income tax return, we recorded an additional $8.2 million tax benefit resulting from the Tax Act’s rate reduction. This benefit reduced the 2018 effective tax rate by approximately 2.5%. The Tax Act subjects a U.S. shareholder to tax on global intangible low-taxed income (“GILTI”) earned by certain foreign subsidiaries. The FASB Staff Q&A, Topic 740, No. 5, Accounting for GILTI, states that an entity can make an accounting policy election to either recognize deferred taxes for temporary basis differences expected to reverse as GILTI in future years or provide for the tax expense related to GILTI in the year the tax is incurred as a period expense only. We have elected to account for GILTI in the year the tax is incurred. As of December 30, 2018, we recorded a $5.4 million federal GILTI tax liability, which increased the 2018 effective tax rate by approximately 1.6%. The Tax Act provides for a foreign-derived intangible income (“FDII”) deduction, which is available to domestic C corporations that derive income from the export of property and services. As of December 30, 2018, we recorded a $0.1 million federal FDII benefit, which decreased the 2018 effective tax rate by an immaterial amount. Potential Impact of Tariffs We continue to monitor recent trade and tariff activity and its potential impact to exports and inputs costs across our segments. Currently, we are experiencing impacts to domestic and export prices of chicken resulting from uncertainty in trade policies and increased tariffs. We are unable to give any assurance as to the scope, duration, or impact of any changes in trade policies or tariffs, how successful any mitigation efforts will be, or the extent to which mitigation will be necessary, and accordingly, changes in trade policies and increased tariffs could have a material adverse effect on our business and results of operations. Business Segment and Geographic Reporting We operate in three reportable business segments: the U.S., the U.K. and Europe, and Mexico. We measure segment profit as operating income. Corporate expenses are allocated to Mexico based upon various apportionment methods for specific expenditures incurred related thereto with the remaining amounts allocated to the U.S. For additional information, see “Note 22. Business Segment and Geographic Reporting” of our Consolidated and Combined Financial Statements included in this annual report. Results of Operations 2018 Compared to 2017 Net sales. Net sales for 2018 increased $169.9 million, or 1.6%, from $10.8 billion generated in 2017 to $10.9 billion generated in 2018. The following table provides additional information regarding net sales: (a) U.S. net sales generated in 2018 decreased $17.6 million, or 0.2%, from U.S. net sales generated in 2017 primarily because of a decrease in net sales per pound partially offset by an increase in sales volume. The decrease in net sales per pound, which resulted primarily from lower market prices, contributed $120.5 million, or 1.6 percentage points, to the decrease in net sales. This decrease in net sales per pound was partially offset by increased sales volume of $102.9 million, or 5.0 percentage points. Included in U.S. sales generated during 2018 and 2017 were sales to JBS USA Food Company totaling $13.8 million and $15.3 million, respectively. (b) U.K. and Europe sales generated in 2018 increased $152.3 million, or 7.6%, from U.K. and Europe sales generated in 2017, primarily because of the positive impact of foreign currency translation, an increase in net sales per pound and an increase in sales volume. The positive impact of foreign currency translation contributed $74.4 million, or 3.7 percentage points to the increase in U.K. and Europe net sales. The increase in net sales per pound contributed $53.5 million, or 2.7 percentage points, to the increase in U.K. and Europe net sales. The increase in sales volume contributed $24.5 million, or 1.2 percentage points, to the increase in U.K. and Europe net sales. (c) Mexico sales generated in 2018 increased $35.1 million, or 2.6%, from Mexico sales generated in 2017 primarily because of an increase in net sales per pound and an increase in sales volume, partially offset by the impact of foreign currency translation. The increase in net sales per pound contributed $46.1 million, or 3.5 percentage points, to the increase in Mexico net sales. The increase in sales volume contributed $10.0 million, or 0.8 percentage points, to the increase in Mexico net sales. The impact of foreign currency translation partially offset the overall net sales increase by $21.0 million, or 1.6 percentage points. Gross profit. Gross profit decreased by $628.1 million, or 42.7%, from $1.5 billion generated in 2017 to $843.5 million generated in 2018. The following tables provide gross profit information: (a) Cost of sales incurred by our U.S. operations in 2018 increased $561.4 million, or 8.8%, from cost of sales incurred by our U.S. operations in 2017. Cost of sales primarily increased because of increased cost per pound sold, increased poultry sales volume, increased freight and storage costs, and increased grower costs. Increased cost per pound contributed $353.0 million mainly due to increased feed costs of $143.2 million and increased poultry sales volume contributed $78.2 million to the increase in cost of sales. The increased freight and storage costs contributed $77.2 million mainly due to driver shortages and the impact of new federal regulations. The increased grower costs contributed $51.8 million to the increase in cost of sales, mainly due to increased grower pay rates, feed delivery costs and utility costs. Other factors affecting U.S. cost of sales were individually immaterial. (b) Cost of sales incurred by the U.K. and Europe operations during 2018 increased $169.7 million, or 9.4%, from cost of sales incurred by the U.K. and Europe operations during 2017 primarily because of increased sales volume and a $74.3 million increase in feed ingredient and raw material costs. U.K. and Europe cost of sales also increased because of a $68.0 million increase in payroll costs resulting from an increase in minimum wage and a $25.1 million increase in freight and storage costs. Other factors affecting cost of sales were individually immaterial. (c) Cost of sales incurred by the Mexico operations during 2018 increased $67.0 million, or 5.9%, from cost of sales incurred by the Mexico operations during 2017 primarily because of increased sales volume and increased cost per pound with a $34.7 million increase in feed costs. Mexico cost of sales also increased because of a $14.1 million increase in grower costs, a $10.4 million increase in freight costs, a $4.0 million increase in natural gas costs, a $4.0 million increase in transportation costs and a $2.0 million increase in employee relations costs. Other factors affecting cost of sales were individually immaterial. (d) Our Consolidated and Combined Financial Statements include the accounts of our company and our majority owned subsidiaries. We eliminate all significant affiliate accounts and transactions upon consolidation. Operating income. Operating income decreased $576.6 million, or 53.8%, from $1.1 billion generated for 2017 to $495.7 million generated for 2018. The following tables provide operating income information: (a) SG&A expense incurred by the U.S. operations during 2018 decreased $22.7 million, or 9.3%, from SG&A expense incurred by the U.S. operations during 2017 primarily because of an $18.4 million decrease in transaction costs associated with the Moy Park acquisition and a $17.9 million decrease in benefit expenses, partially offset by an increase in legal fees of $9.5 million related to pending litigation and a $7.2 million increase in payroll expenses. Other factors affecting SG&A expense were individually immaterial. (b) SG&A expense incurred by the U.K. and Europe operations during 2018 decreased $25.9 million, or 23.6%, from SG&A expense incurred by the U.K. and Europe operations during 2017 primarily because of a $10.6 million decrease in payroll expenses, a $7.2 million decrease in storage expenses, a $4.0 million decrease in pallet expenses, a $3.8 million decrease in management fees charged for administrative functions shared with JBS S.A. and a $2.3 million decrease in vehicle expenses. These decreases to SG&A expense were partially offset by a $2.6 million increase in expenses related to severance. Other factors affecting SG&A expense were individually immaterial. (c) SG&A expense incurred by the Mexico operations during 2018 increased $2.1 million, or 6.0%, from SG&A expense incurred by the Mexico operations during 2017 primarily because of a $1.8 million increase in employee relations expenses and a $1.4 million increase in media marketing expenses. These increases to SG&A expense were partially offset by a $1.1 million decrease in the loss from sale of assets. Other factors affecting SG&A expense were individually immaterial. (d) Administrative restructuring charges incurred by the U.S. operations during 2018 decreased $6.1 million, or 74.1%, from administrative restructuring charges incurred during 2017. Administrative restructuring charges incurred by the U.S. segment during 2018 included severance costs totaling $1.0 million related to GNP, facility closure costs totaling $0.5 million related to the Luverne, Minnesota facility and severance, asset and impairment and lease obligations costs totaling $0.7 million that resulted from the termination of the 40 North Foods operation. Administrative restructuring charges incurred by the U.S. segment during 2017 included asset impairment costs of $3.5 million related to the Athens, Alabama facility, severance costs of $2.6 million related to GNP, the elimination of prepaid costs totaling $0.7 million related to obsolete software assumed in the GNP acquisition, and facility closure costs totaling $0.9 million related to the Luverne, Minnesota facility. (e) Administrative restructuring charges incurred by the U.K. and Europe operations during 2018 increased $1.1 million, or 73.2%, from administrative restructuring charges incurred during 2017. During 2018, administrative restructuring charges represented impairment costs of $2.6 million related to Rose Energy Ltd. During 2017, administrative restructuring charges represented impairment costs of $1.5 million related to to a property in Dublin, Ireland. Interest expense. Consolidated and combined interest expense increased 51.9% to $162.8 million in 2018 from $107.2 million in 2017, primarily because of an increase in the weighted average interest rate to 5.20% in 2018 from 4.54% in 2017 and an increase in average borrowings of $2.5 billion in 2018 from $2.0 billion in 2017. As a percent of net sales, interest expense in 2018 and 2017 was 1.5% and 1.0%, respectively. Income taxes. Our consolidated and combined income tax expense in 2018 was $85.4 million, compared to income tax expense of $263.9 million in 2017. The decrease in income tax expense in 2018 resulted from a decrease in pre-tax income during 2018. 2017 Compared to 2016 Net sales. Net sales for 2017 increased $889.3 million, or 9.0%, from 2016. The following table provides additional information regarding net sales: (a) U.S. net sales generated in 2017 increased $771.8 million, or 11.6%, from U.S. net sales generated in 2016 primarily because of net sales generated by the acquired GNP operations and an increase in net sales per pound experienced by our existing customers, partially offset by a decrease in sales volume. The impact of the acquired GNP business contributed $433.9 million, or 6.5 percentage points, to the increase in net sales. Higher net sales per pound, which resulted primarily from higher market prices, contributed $533.0 million, or 8.0 percentage points, to the net sales increase. Decreased sales volume, which resulted from the unfavorable impact that ongoing operational improvements in one of our prepared foods facilities had on production, the conversion of our Sanford, North Carolina facility to an organic operation, as well as more deboning of leg quarters in several of our facilities, offset the overall net sales increase by $195.2 million, or 2.9 percentage points. Included in U.S. sales generated during 2017 and 2016 were sales to JBS USA Food Company totaling $15.3 million and $16.5 million, respectively. (b) U.K. and Europe sales generated in 2017 increased $48.9 million, or 2.5%, from U.K. and Europe sales generated in 2016, primarily because of an increase in sales volume and an increase in net sales per pound, partially offset by the impact of foreign currency translation. The increase in sales volume contributed $80.5 million, or 4.1 percentage points, to the increase in U.K. and Europe net sales. The increase in net sales per pound contributed $151.6 million, or 7.8 percentage points, to the increase in U.K. and Europe net sales. The increase to net sales was partially offset by the impact of foreign currency translation, which reduced U.K. and Europe net sales by $183.3 million, or 9.4 percentage points. Other factors affecting the increase in U.K. and Europe net sales were individually immaterial. (c) Mexico sales generated in 2017 increased $68.6 million, or 5.4%, from Mexico sales generated in 2016, primarily because of an increase in sales volume and an increase in net sales per pound partially offset by the impact of foreign currency translation. The increase in sales volume contributed $50.1 million, or 4.0 percentage points, to the increase in Mexico net sales. The increase in net sales per pound contributed $69.6 million, or 5.5 percentage points, to the increase in Mexico net sales. The impact of foreign currency translation partially offset the overall net sales increase by $51.1million, or 4.1 percentage points. Other factors affecting the increase in Mexico net sales were individually immaterial. Gross profit. Gross profit increased by $367.6 million, or 33.3%, from $1.1 billion generated in 2016 to $1.5 billion generated in 2017. The following tables provide gross profit information: (a) Cost of sales incurred by our U.S. operations in 2017 increased $419.1 million, or 7.1%, from cost of sales incurred by our U.S. operations in 2016. Cost of sales primarily increased because of costs incurred by the acquired GNP operations and, to a lesser extent, by increases in cost of sales incurred by our existing U.S. operations. Cost of sales incurred by the acquired GNP operations contributed $363.5 million, or 6.2 percentage points, to the increase in U.S. cost of sales. Cost of sales related to the existing U.S. operations increased due to $88.7 million in increased labor costs, $25.7 million in increased chick costs, $19.7 million in increased depreciation, $19.1 million in increased health care costs and $25.7 million in increased freight. These increases were partially offset by associated lower sales volume, a $79.6 million decrease in feed ingredients costs and $20.6 million of commodity derivative gains. Other factors affecting U.S. cost of sales were individually immaterial. (b) Cost of sales incurred by the U.K. and Europe operations during 2017 increased $50.3 million, or 2.9%, from cost of sales incurred by the U.K. and Europe operations during 2016 primarily because of increased sales volume and a $64.5 million increase in feed ingredient costs. U.K. and Europe cost of sales also increased because of a $4.5 million increase in freight and storage costs, a $3.5 million increase in other costs, and a $0.8 million increase in utilities costs. These costs were partially offset by a decline in depreciation of $15.4 million and a decline of wages and benefits by $8.3 million from 2016 amounts. Other factors affecting cost of sales were individually immaterial. (c) Cost of sales incurred by the Mexico operations during 2017 increased $52.3 million, or 4.8%, from cost of sales incurred by the Mexico operations during 2016 primarily because of increased sales volume and a $37.1 million increase in contract services. Mexico cost of sales also increased because of a $12.9 million increase in wages and benefits, a $9.3 million increase in warehousing costs, an $8.6 million increase in utilities costs, a $6.6 million increase in transportation costs and a $1.8 million increase in in depreciation and amortization costs. These costs were partially offset by the $21.5 million favorable impact of foreign currency translation on inventory, a $1.3 million gain in commodity derivatives and a $1.1 million decrease in travel and entertainment costs. Other factors affecting cost of sales were individually immaterial. (d) Our Consolidated and Combined Financial Statements include the accounts of our company and our majority owned subsidiaries. We eliminate all significant affiliate accounts and transactions upon consolidation. Operating income. Operating income increased $280.2 million, or 35.4%, from $792.1 million generated for 2016 to $1.1 billion generated for 2017. The following tables provide operating income information: (a) SG&A expense incurred by the U.S. operations during 2017 increased $76.6 million, or 45.5%, from SG&A expense incurred by the U.S. operations during 2016 primarily because of expenses incurred by the acquired GNP operations and, to a lesser extent, by increases in SG&A expense incurred by our existing U.S. operations. Expenses incurred by the acquired GNP business contributed $35.5 million, or 21.2 percentage points, to the overall increase in SG&A expenses. Expenses incurred by our existing U.S. operations increased primarily because of an $18.7 million increase in transaction costs associated with the Moy Park acquisition, a $6.0 million increase in professional fees expenses, a $5.7 million increase in management fees charged for administrative functions shared with JBS USA Food Company, a $5.0 million increase in advertising and promotional expenses, a $4.4 million increase in employee wages and benefits and a $1.4 million increase in depreciation and amortization expenses. Other factors affecting SG&A expense were individually immaterial. (b) SG&A expense incurred by the U.K. and Europe operations during 2017 decreased $1.5 million, or 1.3%, from SG&A expense incurred by the U.K. and Europe operations during 2016 primarily because of a $9.0 million decrease in advertising and promotion costs and a $4.0 million decrease in management fees charged for administrative functions shared with JBS S.A. These decreases to SG&A expense were partially offset by a $7.4 million increase in employee wages and benefits, a $2.3 million increase in miscellaneous expenses and a $1.6 million increase in depreciation and amortization. Other factors affecting SG&A expense were individually immaterial. (c) SG&A expense incurred by the Mexico operations during 2017 increased $3.6 million, or 11.4%, from SG&A expense incurred by the Mexico operations during 2016 primarily because of a $1.7 million increase in wages and benefits and a $1.9 million increase in advertising and promotion expenses. These increases to SG&A expense were partially offset by a $0.3 million benefit from a decline in foreign exchange rates. Other factors affecting SG&A expense were individually immaterial. (d) Administrative restructuring charges incurred by the U.S. operations during 2017 increased $7.2 million, or 672.6%, from administrative restructuring charges incurred during 2016. Administrative restructuring charges incurred by the U.S. segment during 2017 included asset impairment costs of $3.5 million related to the Athens, Alabama facility, severance costs of $2.6 million related to GNP, the elimination of prepaid costs totaling $0.7 million related to obsolete software assumed in the GNP acquisition, and facility closure costs totaling $0.9 million related to the Luverne, Minnesota facility. Administrative restructuring charges incurred by the U.S. operations during 2016 represented impairment costs of $0.8 million related to assets held for sale in Texas and impairment costs of $0.3 million related to the sale of an asset in Louisiana. (e) Administrative restructuring charges incurred by the U.K. and Europe operations during 2017 increased $1.5 million, or 100.0%, from administrative restructuring charges incurred during 2016. During 2017, administrative restructuring charges represented impairment costs of $1.5 million related to to a property in Dublin, Ireland. (f) Our Consolidated and Combined Financial Statements include the accounts of both our company and our majority owned subsidiaries. We eliminate all significant affiliate accounts and transactions upon consolidation. Interest expense. Consolidated and combined interest expense increased 41.7% to $107.2 million in 2017 from $75.6 million in 2016, primarily because of an increase in the weighted average interest rate to 4.54% in 2017 from 4.39% in 2016 and an increase in average borrowings of $2.0 billion in 2017 from $1.5 billion in 2016. Borrowings increased primarily to fund both the GNP and Moy Park acquisitions during 2017. As a percent of net sales, interest expense in 2017 and 2016 was 1.00% and 0.77%, respectively. Income taxes. Our consolidated income tax expense in 2017 was $263.9 million, compared to income tax expense of $243.9 million in 2016. The increase in income tax expense in 2017 resulted from an increase in pre-tax income during 2017, partially offset by the recognition of a future reduction in the U.S. tax rate during 2017. Liquidity and Capital Resources The following table presents our available sources of liquidity as of December 30, 2018: (a) Availability under the U.S. Credit Facility is also reduced by our outstanding standby letters of credit. Standby letters of credit outstanding at December 30, 2018 totaled $41.6 million. (b) As of December 30, 2018, the U.S. dollar-equivalent of the amount available under the 2018 Mexican Credit Facility (as described below) was $76.3 million. The 2018 Mexican Credit Facility provides for a loan commitment of $1.5 billion Mexican pesos. (c) The U.K. and Europe Credit Facilities provide for loan commitments of £100.0 million (or $127.0 million U.S. dollar-equivalent) and €10.0 million (or $11.4 million U.S. dollar-equivalent). Long-Term Debt and Other Borrowing Arrangements U.S. Senior Notes On March 11, 2015, we completed a sale of $500.0 million aggregate principal amount of our 5.75% senior notes due 2025. On September 29, 2017, we completed an add-on offering of $250.0 million of these senior notes. The issuance price of this add-on offering was 102.0%, which created gross proceeds of $255.0 million. The additional $5.0 million will be amortized over the remaining life of the senior notes. On March 7, 2018, we completed another add-on offering of $250.0 million of these senior notes (together with the senior notes issued in March 2015 and September 2017, the “Senior Notes due 2025”). The issuance price of this add-on offering was 99.25%, which created gross proceeds of $248.1 million. The $1.9 million discount will be amortized over the remaining life of the senior notes. Each issuance of the Senior Notes due 2025 is treated as a single class for all purposes under the 2015 Indenture (defined below) and have the same terms. The Senior Notes due 2025 are governed by, and were issued pursuant to, an indenture dated as of March 11, 2015 by and among us, our guarantor subsidiary and Wells Fargo Bank, National Association, as trustee (the “2015 Indenture”). The 2015 Indenture provides, among other things, that the Senior Notes due 2025 bear interest at a rate of 5.75% per annum from the date of issuance until maturity, payable semi-annually in cash in arrears, beginning on September 15, 2015 for the Senior Notes due 2025 that were issued in March 2015 and beginning on March 15, 2018 for the Senior Notes due 2025 that were issued in September 2017 and March 2018. On September 29, 2017, we completed a sale of $600.0 million aggregate principal amount of its 5.875% senior notes due 2027. On March 7, 2018, we completed an add-on offering of $250.0 million of these senior notes (together with the senior notes issued in September 2017, the “Senior Notes due 2027”). The issuance price of this add-on offering was 97.25%, which created gross proceeds of $243.1 million. The $6.9 million discount will be amortized over the remaining life of the Senior Notes due 2027. Each issuance of the Senior Notes due 2027 is treated as a single class for all purposes under the 2017 Indenture (defined below) and have the same terms. The Senior Notes due 2027 are governed by, and were issued pursuant to, an indenture dated as of September 29, 2017 by and among us, our guarantor subsidiary and U.S. Bank National Association, as trustee (the “2017 Indenture”). The 2017 Indenture provides, among other things, that the Senior Notes due 2027 bear interest at a rate of 5.875% per annum from the date of issuance until maturity, payable semi-annually in cash in arrears, beginning on March 30, 2018 for the Senior Notes due 2027 that were issued in September 2017 and beginning on March 15, 2018 for the Senior Notes due 2027 that were issued in March 2018. The Senior Notes due 2025 and the Senior Notes due 2027 are each guaranteed on a senior unsecured basis by our guarantor subsidiary. In addition, any of our other existing or future domestic restricted subsidiaries that incur or guarantee any other indebtedness (with limited exceptions) must also guarantee the Senior Notes due 2025 and the Senior Notes due 2027. The Senior Notes due 2025 and the Senior Notes due 2027 and related guarantees are unsecured senior obligations of our company and our guarantor subsidiary and rank equally with all of our and our guarantor subsidiary’s other unsubordinated indebtedness. The Senior Notes due 2025, the 2015 Indenture, the Senior Notes due 2027 and the 2017 Indenture also contain customary covenants and events of default, including failure to pay principal or interest on the Senior Notes due 2025 and the Senior Notes due 2027, respectively, when due, among others. We used the net proceeds from the sale of the Senior Notes due 2025 and the Senior Notes due 2027 that were issued in September 2017 to repay in full the JBS S.A. Promissory Note issued as part of the Moy Park acquisition and for general corporate purposes. We used the net proceeds from the sale of the Senior Notes due 2025 and the Senior Notes due 2027 that were issued in March 2018 to pay the second tender price of Moy Park Notes (as described below), repay a portion of outstanding secured debt, and for general corporate purposes. The Senior Notes due 2025 and the Senior Notes due 2027 were sold to qualified institutional buyers pursuant to Rule 144A under the Securities Act of 1933, as amended (the “Securities Act”), and outside the United States to non-U.S. persons pursuant to Regulation S under the Securities Act. Moy Park Senior Notes Between May 29, 2014 and April 17, 2015, Moy Park (Bondco) plc completed the sale of £300.0 million aggregate principal amount of its 6.25% senior notes due 2021 (the “Moy Park Senior Notes”). Between November 3, 2017 and March 8, 2018, Moy Park (Bondco) plc completed the purchase for cash of the Moy Park Senior Notes through a tender offer. As of March 8, 2018, £234.3 million principal amount of Moy Park Senior Notes had been validly tendered and purchased by Moy Park (Bondco) plc. On May 29, 2018, Moy Park (Bondco) plc redeemed all remaining Moy Park Senior Notes outstanding at the redemption price equal to 101.56% of the principal amount, plus accrued and unpaid interest. The aggregate principal amount of the Moy Park Senior Notes redeemed on May 29, 2018 was £65.7 million. As of December 30, 2018, there are no Moy Park Senior Notes outstanding. U.S. Credit Facility On July 20, 2018, we, and certain of our subsidiaries entered into a Fourth Amended and Restated Credit Agreement (the “U.S. Credit Facility”) with CoBank, ACB, as administrative agent and collateral agent, and the other lenders party thereto. The U.S. Credit Facility provides for a $750.0 million revolving credit commitment and a term loan commitment of up to $500.0 million (the “Term Loans”). We used the proceeds from the term loan commitment under the U.S. Credit Facility, together with cash on hand, to repay the outstanding loans under our previous credit agreement with Coöperatieve Rabobank U.A., New York Branch, as administrative agent, and the other lenders and financial institutions party thereto. The U.S. Credit Facility includes an accordion feature that allows us, at any time, to increase the aggregate revolving loan and term loan commitments by up to an additional $1.25 billion, subject to the satisfaction of certain conditions, including obtaining the lenders’ agreement to participate in the increase. The revolving loan commitment under the U.S. Credit Facility matures on July 20, 2023. All principal on the Term Loans is due at maturity on July 20, 2023. Installments of principal are required to be made, in an amount equal to 1.25% of the original principal amount of the Term Loans, on a quarterly basis prior to the maturity date of the Term Loans. Covenants in the U.S. Credit Facility also require us to use the proceeds it receives from certain asset sales and specified debt or equity issuances and upon the occurrence of other events to repay outstanding borrowings under the U.S. Credit Facility. As of December 30, 2018, we had Term Loans outstanding totaling $500.0 million and the amount available for borrowing under the revolving loan commitment was $708.4 million. We had letters of credit of $41.6 million and no borrowings outstanding under the revolving loan commitment as of December 30, 2018. The U.S. Credit Facility includes a $75.0 million sub-limit for swingline loans and a $125.0 million sub-limit for letters of credit. Outstanding borrowings under the revolving loan commitment and the Term Loans bear interest at a per annum rate equal to (i) in the case of LIBOR loans, LIBOR plus 1.25% through August 2, 2018 and, thereafter, based on our net senior secured leverage ratio, between LIBOR plus 1.25% and LIBOR plus 2.75% and (ii) in the case of alternate base rate loans, the base rate plus 0.25% through August 2, 2018 and, based on our net senior secured leverage ratio, between the base rate plus 0.25% and base rate plus 1.75% thereafter. The U.S. Credit Facility contains customary financial and other various covenants for transactions of this type, including restrictions on our ability to incur additional indebtedness, incur liens, pay dividends, make certain restricted payments, consummate certain asset sales, enter into certain transactions with our affiliates, or merge, consolidate and/or sell or dispose of all or substantially all of our assets, among other things. The U.S. Credit Facility requires us to comply with a minimum level of tangible net worth covenant. The U.S. Credit Facility also provides that we may not incur capital expenditures in excess of $500.0 million in any fiscal year. All obligations under the U.S. Credit Facility continue to be unconditionally guaranteed by certain of our subsidiaries and continue to be secured by a first priority lien on (i) the accounts receivable and inventory of our company and our non-Mexico subsidiaries, (ii) 100% of the equity interests in our domestic subsidiaries, To-Ricos, Ltd. and To-Ricos Distribution, Ltd., and 65% of the equity interests in its direct foreign subsidiaries and (iii) substantially all of the assets of us and the guarantors under the U.S. Credit Facility. We are currently in compliance with the covenants under the U.S. Credit Facility. Mexico Credit Facility On December 14, 2018, certain of our Mexican subsidiaries entered into an unsecured credit agreement (the “2018 Mexico Credit Facility”) with Banco del Bajio, Sociedad Anónima, Institución de Banca Múltiple, as lender. The loan commitment under the 2018 Mexico Credit Facility is $1.5 billion Mexican pesos and can be borrowed on a revolving basis. The U.S. dollar-equivalent of the loan commitment under the 2018 Mexico Credit Facility is $76.3 million. Outstanding borrowings under the 2018 Mexico Credit Facility accrue interest at a rate equal to the 28-Day Interbank Equilibrium Interest Rate plus 1.50%. The 2018 Mexico Credit Facility contains covenants and defaults that we believe are customary for transactions of this type. The 2018 Mexico Credit Facility will be used for general corporate and working capital purposes. The 2018 Mexico Credit Facility will mature on December 14, 2023. The 2018 Mexico Credit Facility replaced the unsecured credit agreement (the “2016 Mexico Credit Facility”) between certain of our Mexican subsidiaries and BBVA Bancomer, S.A. Institución de Banca Múltiple, Grupo Financiero BBVA Bancomer, as lender, dated September 27, 2016. The 2016 Mexico Credit Facility was terminated on December 19, 2018. Moy Park Bank of Ireland Revolving Facility Agreement On June 2, 2018, Moy Park Holdings (Europe) Ltd. and its subsidiaries entered into an unsecured multicurrency revolving facility agreement (the “Bank of Ireland Facility Agreement”) with the Governor and Company of the Bank of Ireland, as agent, and the other lenders party thereto. The Bank of Ireland Facility Agreement provides for a multicurrency revolving loan commitment of up to £100.0 million. The multicurrency revolving loan commitments under the Bank of Ireland Facility Agreement matures on June 2, 2023. Outstanding borrowings under the Bank of Ireland Facility Agreement bear interest at a rate per annum equal to the sum of (i) LIBOR or, in relation to any loan in euros, EURIBOR, plus (ii) a margin, ranging from1.25% to 2.00% based on Leverage (as defined in the Bank of Ireland Facility Agreement). All obligations under the Bank of Ireland Facility Agreement are guaranteed by certain of Moy Park's subsidiaries. As of December 30, 2018, the U.S. dollar-equivalent loan commitment and borrowing availability were both $127.0 million. There were no outstanding borrowings under the Bank of Ireland Facility Agreement as of December 30, 2018. The Bank of Ireland Facility Agreement contains representations and warranties, covenants, indemnities and conditions that we believe are customary for transactions of this type. Pursuant to the terms of the Bank of Ireland Facility Agreement, Moy Park is required to meet certain financial and other restrictive covenants. Additionally, Moy Park is prohibited from taking certain actions without consent of the lenders, including, without limitation, incurring additional indebtedness, entering into certain mergers or other business combination transactions, permitting liens or other encumbrances on its assets and making restricted payments, including dividends, in each case except as expressly permitted under the Bank of Ireland Facility Agreement. The Bank of Ireland Facility Agreement contains events of default that we believe are customary for transactions of this type. If a default occurs, any outstanding obligations under the Bank of Ireland Facility Agreement may be accelerated. Moy Park France Invoice Discounting Facility In June 2009, Moy Park France Sàrl entered into a €20.0 million invoice discounting facility with GE De Facto (the “Invoice Discounting Facility”). The facility limit was decreased by 50 percent in June 2018. The Invoice Discounting Facility is payable on demand and the term is extended on an annual basis. The agreement can be terminated by either party with three months’ notice. Outstanding borrowings under the Invoice Discounting Facility bear interest at a per annum rate equal to EURIBOR plus 0.80%. As of December 30, 2018, the U.S. dollar-equivalent loan commitment, borrowing availability, and outstanding borrowings under the Invoice Discounting Facility were $11.4 million, $9.2 million and $2.2 million, respectively. The Invoice Discounting Facility contains financial covenants and various other covenants that may adversely affect Moy Park's ability to, among other things, incur additional indebtedness, consummate certain asset sales, enter into certain transactions with JBS and our other affiliates, merge, consolidate and/or sell or dispose of all or substantially all of Moy Park's assets. Moy Park Credit Agricole Bank Overdraft On December 3, 2018, Moy Park entered into an unsecured €0.5 million bank overdraft agreement (the “Overdraft Agreement”) with Credit Agricole. The Overdraft Agreement is payable on demand and can be cancelled anytime by us or Credit Agricole. Outstanding borrowings under the Overdraft Agreement bear interest at a per annum rate equal to EURIBOR plus 1.50%. As of December 30, 2018, the U.S. dollar-equivalent outstanding borrowing under the Overdraft Agreement was less than $0.1 million. Moy Park Multicurrency Revolving Facility Agreement On March 19, 2015, Moy Park Holdings (Europe) Ltd. and its subsidiaries, entered into an agreement with Barclays Bank plc, which expired on March 19, 2018. The agreement provided for a multicurrency revolving loan commitment of up to £20.0 million. Moy Park Receivables Finance Agreement Moy Park Ltd., entered into a £45.0 million receivables finance agreement on January 29, 2016 (the “Receivables Finance Agreement”), with Barclays Bank plc. Moy Park Holdings (Europe) Ltd. repaid the Receivables Finance Agreement in full using available cash and proceeds from the Bank of Ireland Facility Agreement and terminated the Receivables Finance Agreement with Barclays Bank plc on June 4, 2018. Collateral Substantially all of our domestic inventories and domestic fixed assets are pledged as collateral to secure the obligations under the U.S. Credit Facility. Off-Balance Sheet Arrangements We maintain operating leases for various types of equipment, some of which contain residual value guarantees for the market value of assets at the end of the term of the lease. The terms of the lease maturities range from one to ten years. We estimate the maximum potential amount of the residual value guarantees is approximately $55.9 million; however, the actual amount would be offset by any recoverable amount based on the fair market value of the underlying leased assets. No liability has been recorded related to this contingency as the likelihood of payments under these guarantees is not considered to be probable, and the fair value of the guarantees is immaterial. We historically have not experienced significant payments under similar residual guarantees. We are a party to many routine contracts in which we provide general indemnities in the normal course of business to third parties for various risks. Among other considerations, we have not recorded a liability for any of these indemnities as, based upon the likelihood of payment, the fair value of such indemnities would not have a material impact on our financial condition, results of operations and cash flows. Capital Expenditures We anticipate spending between $260 million and $280 million on the acquisition of property, plant and equipment in 2019. Capital expenditures will primarily be incurred to improve efficiencies and reduce costs. We expect to fund these capital expenditures with cash flow from operations and proceeds from the revolving lines of credit under our various debt facilities. Contractual Obligations In addition to our debt commitments at December 30, 2018, we had other commitments and contractual obligations that obligate us to make specified payments in the future. The following table summarizes the total amounts due as of December 30, 2018, under all debt agreements, commitments and other contractual obligations. The table indicates the years in which payments are due under the contractual obligations. (a) The total amount of unrecognized tax benefits at December 30, 2018 was $12.4 million. We did not include this amount in the contractual obligations table above as reasonable estimates cannot be made at this time of the amounts or timing of future cash outflows. (b) Long-term debt is presented at face value and excludes $41.6 million in letters of credit outstanding related to normal business transactions. (c) Interest expense in the table above assumes the continuation of interest rates and outstanding borrowings as of December 30, 2018. (d) Includes agreements to purchase goods or services that are enforceable and legally binding on us and that specify all significant terms, including fixed or minimum quantities to be purchased; fixed, minimum, or variable price provisions; and the approximate timing of the transaction. We expect cash flows from operations, combined with availability under the U.S. Credit Facility, and U.K. and Europe Credit Facilities to provide sufficient liquidity to fund current obligations, projected working capital requirements, maturities of long-term debt and capital spending for at least the next twelve months. Historical Flow of Funds Calendar Year 2018 Cash provided by operating activities was $491.7 million during 2018. The cash flows provided by operating activities resulted primarily from net income of $246.8 million, net noncash expenses of $348.1 million, a change in accounts payable, accrued expenses and other current liabilities of $86.8 million and a change in inventories of $83.2 million. These cash flows were partially offset by the use of $248.5 million in cash related to income taxes, the use of $11.6 million in cash related to prepaid expenses and other current assets, the use of $10.9 million in cash related to trade accounts and other receivables and the use of $6.8 million in cash related to long-term pension and other postretirement obligations. Accounts payable and accrued expenses, including accounts payable to related parties, had proceeds of $86.8 million related to operating activities during 2018. This change resulted primarily from the timing of payments. The change in inventories represented a $83.2 million source of cash related to operating activities during 2018. The change in cash related to a decrease in our finished products inventory. Trade accounts and other receivables, including accounts receivable from related parties, used cash of $10.9 million related to operating activities during 2018. This change is primarily due to customer payment timing. Prepaid expenses and other current assets had uses of cash of $11.6 million related to operating activities during 2018. This change resulted primarily from a net increase in both commodity derivatives and value-added tax receivables. Income taxes, which includes income taxes receivables, income taxes payable, deferred tax assets, deferred tax liabilities, reserves for uncertain tax positions and the tax components within accumulated other comprehensive loss, had proceeds of cash of $248.5 million. This change resulted primarily from the timing of estimated tax payments. Net non-cash expenses provided $348.1 million in operating cash flows during 2018. Net non-cash expense items increased primarily because of $279.7 million related to depreciation and amortization, $32.5 million related to deferred income tax expense, noncash loss on early extinguishment of debt of $15.8 million, share-based compensation of $13.2 million, and foreign currency transaction loss related to borrowing arrangements of $5.3 million. Cash used in investing activities was $338.9 million during 2018. Cash used to acquire property, plant and equipment totaled $348.7 million. Capital expenditures were primarily incurred to improve operational efficiencies and reduce costs. Capital expenditures for 2018 could not exceed $500.0 million under the terms of our U.S. credit facility. Cash proceeds generated from property disposals for the period totaled $9.8 million. Cash used in financing activities was $384.2 million during 2018. Cash proceeds from long-term debt totaled $748.4 million, cash proceeds from equity contributions under a tax sharing agreement with JBS USA Food Company Holdings totaled $5.6 million and capital contributions to subsidiary by noncontrolling stockholders totaled $1.4 million. These sources of cash were offset by $1.1 billion in cash used for payments on revolving lines of credit, long-term borrowings and capital lease obligations, $12.6 million in cash used to pay capitalized loan costs, $9.8 million in cash used for payments relating to early extinguishment of debt and $0.2 million in cash used to purchase common stock under the share repurchase program. Calendar Year 2017 Cash provided by operating activities was $801.3 million during 2017. The cash flows provided by operating activities were primarily from net income of $718.2 million, net noncash expenses of $233.9 million and changes in income taxes of $188.1 million. These cash flows were partially offset by the use of $207.4 million in cash related to inventories, the use of $82.2 million in cash related to trade accounts and other receivables, deferred income tax benefit of $50.0 million and the use of $22.8 million in cash related to accounts payable, accrued expenses and other current liabilities. The change in trade accounts and other receivables, including accounts receivable from related parties, represented an $82.2 million use of cash related to operating activities for 2017. This change is primarily due to customer payment timing. The change in inventories represented a $207.4 million use of cash related to operating activities for 2017. This change in cash related to inventories was primarily due to increases in our live chicken and finished chicken products and inventories related to the GNP acquisition. The change in prepaid expenses and other current assets represented a $14.8 million use of cash related to operating activities for 2017. This change resulted primarily from a net increase in value-added tax receivables, as well as increases in prepaid expenses and other current assets related to the GNP acquisition. The change in accounts payable, revenue contract liabilities, accrued expenses and other current liabilities, including accounts payable to related parties, represented a $22.8 million use of cash related to operating activities for 2017. This change resulted primarily from the timing of payments. The change in income taxes, which includes income taxes receivable, income taxes payable, deferred tax assets, deferred tax liabilities reserves for uncertain tax positions, and the tax components within accumulated other comprehensive loss, represented a $188.1 million source of cash related to operating activities for 2017. This change resulted primarily from the timing of estimated tax payments. Net non-cash expenses provided $233.9 million in cash related to operating activities for 2017. Net non-cash expense items included depreciation and amortization of $277.8 million, partially offset by a deferred income tax benefit of $50.0 million. Cash used in investing activities totaled $992.1 million during 2017. Cash used to acquire GNP, net of cash acquired, totaled $658.5 million and cash used to acquire property, plant and equipment totaled $339.9 million. Capital expenditures were primarily incurred to improve operational efficiencies, reduce costs and tailor processes to meet specific customer needs in order to further solidify our competitive advantages. Capital expenditures for 2017 could not exceed $500.0 million under the terms of our U.S. credit facility. Cash proceeds from property disposals and from settlement of life insurance totaled $4.5 million and $1.8 million, respectively. Cash proceeds from financing activities totaled $466.4 million during 2017. Cash proceeds from long-term debt totaled $1.9 billion and cash proceeds from equity contributions under the Tax Sharing Agreement with JBS USA Food Company Holdings totaled $5.0 million. These sources of cash were offset by the $753.5 million in cash used for the payment of note payable to affiliate, the $628.7 million repayment of long-term debt, $14.6 million used for the purchase of common stock under a share repurchase program and for the payment of capitalized loan costs totaling $13.6 million. Recent Accounting Pronouncements Adopted in 2018 In May 2014, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update (“ASU”) 2014-09, Revenue from Contracts with Customers (Topic 606), which provides for a single five-step model to be applied to all revenue contracts with customers. The new standard also requires additional financial statement disclosures that will enable users to understand the nature, amount, timing and uncertainty of revenue and cash flows relating to customer contracts. Companies have an option to use either a retrospective approach or cumulative effect adjustment approach to implement the standard. We adopted this standard as of January 1, 2018, the beginning of our 2018 fiscal year, using the cumulative effect adjustment, often referred to as modified retrospective approach. Under this method, we did not restate the prior financial statements presented, and would record any adjustments in the opening balance sheet for January 2018. There was no cumulative effect to be recorded as an adjustment to the opening balance of retained earnings. The comparative information was not restated and continues to be presented under the accounting standards in effect for those periods. Additional disclosures will include the amount by which each financial statement line item is affected in the current reporting period during 2018, as compared to the prior guidance. We expect minimal impact from the adoption of the new standard to the financial statements on a go forward basis, except for expanded disclosures. Revenue is currently recognized at destination and will continue to be recognized at point in time under the new guidance. Additional information regarding revenue recognition is included in “Note 13. Revenue Recognition.” In March 2017, the FASB issued ASU 2017-07, Compensation-Retirement Benefits (Topic 715): Improving the Presentation of Net Periodic Pension Cost and Net Periodic Postretirement Benefit Cost, which, in an effort to improve consistency and transparency, requires the service cost component of defined benefit pension cost and postretirement benefit cost (“net benefit cost”) to be reported in the same line of the income statement as other compensation costs earned by the employee and the other components of net benefit cost to be reported below income from operations. We adopted this standard as of January 1, 2018, the beginning of our 2018 fiscal year. The initial adoption of this guidance did not have a material impact on our financial statements. Recent Accounting Pronouncements Not Yet Adopted as of December 30, 2018 In February 2016, the FASB issued ASU 2016-02, Leases (Topic 842), along with several updates, which, in an effort to increase transparency and comparability among organizations utilizing leasing, requires an entity that is a lessee to recognize the assets and liabilities arising from operating leases on the balance sheet. This guidance also requires disclosures about the amount, timing and uncertainty of cash flows arising from leases. In transition, the entity may elect to recognize and measure leases at the beginning of the earliest period presented using a modified retrospective approach or the beginning of the period of adoption using a cumulative-effect adjustment approach. The provisions of the new guidance will be effective as of the beginning of our 2019 fiscal year. We will adopt the new standard as of December 31, 2018, the beginning of our 2019 fiscal year and recognize and measure leases at the beginning of the period of adoption. We will elect the package of practical expedients available under the transition guidance which, among other things, allows the carry-forward of historical lease classification. We will make an accounting policy election to not apply the new guidance to leases with a term of 12 months or less and will recognize those payments in the Consolidated Statement of Income on a straight-line basis over the lease term. We have implemented a system solution for administering our leases and facilitating compliance with the new guidance. Adoption of the standard will have a material impact on our Consolidated Balance Sheet as a result of the increase in assets and liabilities from recognition of right-of-use assets and lease liabilities. However, we do not believe the standard will have a material impact on our Consolidated Statement of Income. In June 2016, the FASB issued ASU 2016-13, Financial Instruments-Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments, which, in an effort to provide financial statement users with more decision-useful information about the expected credit losses on financial instruments, replaces the current incurred loss impairment methodology with a methodology that reflects expected credit losses and requires consideration of a broader range of reasonable and supportable information to inform credit loss estimates. The amendments affect loans, debt securities, trade receivables, net investments in leases, off-balance sheet credit exposures, reinsurance receivables and any other financial assets not excluded from the scope that have the contractual right to receive cash. The provisions of the new guidance will be effective as of the beginning of our 2020 fiscal year. Early adoption is permitted after our 2018 fiscal year. We are currently evaluating the impact of the new guidance on our financial statements and have not yet selected an adoption date. In August 2017, the FASB issued ASU 2017-12, Derivatives and Hedging (Topic 815): Targeted Improvements to Accounting for Hedging Activities, an accounting standard update that simplifies the application of hedge accounting guidance in current GAAP and improves the reporting of hedging relationships to better portray the economic results of an entity’s risk management activities in its financial statements. Among the simplification updates, the standard eliminates the requirement in current GAAP to separately recognize periodic hedge ineffectiveness. Mismatches between the changes in value of the hedged item and hedging instrument may still occur but they will no longer be separately reported. The standard requires the presentation of the earnings effect of the hedging instrument in the same income statement line item in which the earnings effect of the hedged item is reported. The standard is effective for annual and interim reporting periods beginning after December 15, 2018, but early adoption is permitted. We have elected to adopt this standard as of December 31, 2018, the beginning of our 2019 fiscal year. We do not expect the initial adoption of this guidance did not have a material impact on our financial statements. In February 2018, the FASB issued ASU 2018-02, Income Statement-Reporting Comprehensive Income (Topic 220): Reclassification of Certain Tax Effects from Accumulated Other Comprehensive Income, an accounting standard update that allows a reclassification from accumulated other comprehensive income to retained earnings for stranded tax effects resulting from the U.S. Tax Cuts and Jobs Act. We will need to decide whether to reclassify the stranded tax effects associated with the U.S. Tax Cuts and Jobs Act from accumulated other comprehensive income to retained earnings. If we choose to reclassify we will need to calculate the amount of the reclassification and prepare the related disclosures. We have elected to adopt this standard as of December 31, 2018, the beginning of our 2019 fiscal year. We do not expect the initial adoption of this guidance did not have a material impact on our financial statements. In July 2018, the FASB issued ASU 2018-07, Compensation-Stock Compensation (Topic 718): Improvements to Nonemployee Share-Based Payment Accounting, an accounting standard update to improve non-employee share-based payment accounting. The accounting standard update more closely aligns the accounting for employee and non-employee share based payments. The accounting standards update is effective as of the beginning of our 2019 calendar year with early adoption permitted. We have elected to adopt this standard as of December 31, 2018, the beginning of our 2019 fiscal year. We do not expect the initial adoption of this guidance did not have a material impact on our financial statements. In August 2018, the FASB issued ASU 2018-13, Fair Value Measurement (Topic 820): Disclosure Framework-Changes to the Disclosure Requirements for Fair Value Measurement, new accounting guidance to improve the effectiveness of disclosures related to fair value measurements. The new guidance removes certain disclosure requirements related to transfers between Level 1 and Level 2 of the fair value hierarchy along with the policy for timing of transfers between levels and the valuation processes for Level 3 fair value measurements. Additions to the disclosure requirements include more quantitative information related to significant unobservable inputs used in Level 3 fair value measurements and gains and losses included in other comprehensive income. The new guidance will be effective as of our 2020 fiscal year with early adoption permitted. We are currently evaluating the impact of the new guidance on our financial statements and have not yet selected an adoption date. In August 2018, the FASB issued ASU 2018-14, Compensation-Retirement Benefits-Defined Benefit Plans-General (Subtopic 715-20): Disclosure Framework-Changes to the Disclosure Requirements for Defined Benefit Plans, new accounting guidance to improve the effectiveness of disclosures related to defined benefit plans by eliminating certain required disclosures, clarifying existing disclosures, and adding new disclosures. Changes include removing disclosures related to the amounts in accumulated other comprehensive income expected to be recognized in the next fiscal year, adding narrative disclosure of the reasons for significant gains and losses related to changes in the defined benefit obligation, and clarifying the disclosures required for plans with projected and accumulated benefit obligations in excess of plan assets. The new guidance will be effective as of our 2020 fiscal year with early adoption permitted. We are currently evaluating the impact of the new guidance on our financial statements and have not yet selected an adoption date. Critical Accounting Policies and Estimates General. Our discussion and analysis of our financial condition and results of operations are based upon our financial statements, which have been prepared in accordance with U.S. GAAP. The preparation of these financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses. On an ongoing basis, we evaluate our estimates, including those related to revenue recognition, inventory, goodwill and other intangible assets, litigation and income taxes. We base our estimates on historical experience and on various other assumptions that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions. We believe the following critical accounting policies affect our more significant judgments and estimates used in the preparation of our financial statements. Revenue Recognition. The vast majority of our revenue is derived from contracts which are based upon a customer ordering our products. While there may be master agreements, the contract is only established when the customer’s order is accepted by us. We account for a contract, which may be verbal or written, when it is approved and committed by both parties, the rights of the parties are identified along with payment terms, the contract has commercial substance and collectability is probable. We evaluate the transaction for distinct performance obligations, which are the sale of our products to customers. Since our products are commodity market-priced, the sales price is representative of the observable, standalone selling price. Each performance obligation is recognized based upon a pattern of recognition that reflects the transfer of control to the customer at a point in time, which is upon destination (customer location or port of destination) and faithfully depicts the transfer of control and recognition of revenue. There are instances of customer pick-up at our facilities, in which case control transfers to the customer at that point and we recognize revenue. Our performance obligations are typically fulfilled within days to weeks of the acceptance of the order. We make judgments regarding the nature, amount, timing and uncertainty of revenue and cash flows arising from revenue and cash flows with customers. Determination of a contract requires evaluation and judgment along with the estimation of the total contract value and if any of the contract value is constrained. Due to the nature of our business, there is minimal variable consideration, as the contract is established at the acceptance of the order from the customer. When applicable, variable consideration is estimated at contract inception and updated on a regular basis until the contract is completed. Allocating the transaction price to a specific performance obligation based upon the relative standalone selling prices includes estimating the standalone selling prices including discounts and variable consideration. Inventory. Live chicken inventories are stated at the lower of cost or market and breeder hen inventories at the lower of cost, less accumulated amortization, or market. The costs associated with breeder hen inventories are accumulated up to the production stage and amortized over their productive lives using the unit-of-production method. Finished poultry products, feed, eggs and other inventories are stated at the lower of cost (average) or market. We record valuations and adjustments for our inventory and for estimated obsolescence at or equal to the difference between the cost of inventory and the estimated market value based upon known conditions affecting inventory obsolescence, including significantly aged products, discontinued product lines, or damaged or obsolete products. We allocate meat costs between our various finished chicken products based on a by-product costing technique that reduces the cost of the whole bird by estimated yields and amounts to be recovered for certain by-product parts. This primarily includes leg quarters, wings, tenders and offal, which are carried in inventory at the estimated recovery amounts, with the remaining amount being reflected as our breast meat cost. Generally, we perform an evaluation of whether any lower of cost or market adjustments are required at the country level based on a number of factors, including: (i) pools of related inventory, (ii) product continuation or discontinuation, (iii) estimated market selling prices and (iv) expected distribution channels. If actual market conditions or other factors are less favorable than those projected by management, additional inventory adjustments may be required. Goodwill and Other Intangibles, net. Goodwill represents the excess of the aggregate purchase price over the fair value of the net identifiable assets acquired in a business combination. Identified intangible assets represent trade names, customer relationships and non-compete agreements arising from acquisitions that are recorded at fair value as of the date acquired less accumulated amortization, if any. We use various market valuation techniques to determine the fair value of its identified intangible assets. Goodwill and other intangible assets with indefinite lives are not amortized but are tested for impairment on an annual basis in the fourth quarter of each fiscal year or more frequently if impairment indicators arise. For goodwill, an impairment loss is recognized for any excess of the carrying amount of a reporting unit’s goodwill over the implied fair value of that goodwill. Management first reviews relevant qualitative factors to determine if an indication of impairment exists for a reporting unit. If management determines there is an indication that the carrying amount of reporting unit goodwill might be impaired, a quantitative analysis is performed. Management performed a qualitative analysis noting no indications of goodwill impairment in any of its reporting units as of December 30, 2018. For indefinite-lived intangible assets, an impairment loss is recognized if the carrying amount of an indefinite-lived intangible asset exceeds the estimated fair value of that intangible asset. Management first reviews relevant qualitative factors to determine if an indication of impairment exists. If management determines there is an indication that the carrying amount of the intangible asset might be impaired, and quantitative analysis is performed. Management performed a qualitative analysis noting no indications of impairment for any of its indefinite-lived intangible assets as of December 30, 2018. Identifiable intangible assets with definite lives, such as customer relationships, non-compete agreements and trade names that we expect to use for a limited amount of time, are amortized over their estimated useful lives on a straight-line basis. The useful lives range from three to 20 years for trade names and non-compete agreements and 5 to 16 years for customer relationships. Identified intangible assets with definite lives are tested for recoverability whenever events or changes in circumstances indicate that their carrying amount may not be recoverable. Management assessed if events or changes in circumstances indicated that the aggregate carrying amount of its identified intangible assets with definite lives might not be recoverable and determined that there were no impairment indicators during the fifty-two weeks ended December 30, 2018 and fifty-three weeks ended December 31, 2017. Litigation and Contingent Liabilities. We are subject to lawsuits, investigations and other claims related to employment, environmental, product, and other matters. We are required to assess the likelihood of any adverse judgments or outcomes, as well as potential ranges of probable losses, to these matters. We estimate the amount of reserves required for these contingencies when losses are determined to be probable and after considerable analysis of each individual issue. We expense legal costs related to such loss contingencies as they are incurred. With respect to our environmental remediation obligations, the accrual for environmental remediation liabilities is measured on an undiscounted basis. These reserves may change in the future due to changes in our assumptions, the effectiveness of strategies, or other factors beyond our control. Income Taxes. We follow provisions under ASC No. 740-10-30-27 in the Expenses-Income Taxes topic with regard to members of a group that file a consolidated tax return but issue separate financial statements. We file our own U.S. federal tax return, but we are included in certain state unitary returns with JBS USA Holdings. Our income tax expense is computed using the separate return method. The provision for income taxes has been determined using the asset and liability approach of accounting for income taxes. For the unitary states, we have an obligation to make tax payments to JBS USA Holdings for our share of the unitary taxable income, which is included in taxes payable in our Consolidated Balance Sheets. Under this approach, deferred income taxes reflect the net tax effect of temporary differences between the book and tax bases of recorded assets and liabilities, net operating losses and tax credit carry forwards. The amount of deferred tax on these temporary differences is determined using the tax rates expected to apply to the period when the asset is realized or the liability is settled, as applicable, based on the tax rates and laws in the respective tax jurisdiction enacted as of the balance sheet date. We recognize potential interest and penalties related to income tax positions as a part of the income tax provision.

<s>[INST] We are one of the largest chicken producers in the world, with operations in the United States (“U.S.”), the United Kingdom (“U.K.”), Mexico, France, Puerto Rico and the Netherlands. We are primarily engaged in the production, processing, marketing and distribution of fresh, frozen and valueadded chicken products to retailers, distributors and foodservice operators. We offer a wide range of products to our customers through strong national and international distribution channels. Pilgrim’s fresh chicken products consist of refrigerated (nonfrozen) whole chickens, whole cutup chickens and selected chicken parts that are either marinated or nonmarinated. Our prepared chicken products include fully cooked, readytocook and individually frozen chicken parts, strips, nuggets and patties, some of which are either breaded or nonbreaded and either marinated or nonmarinated, readytoeat meals, multiprotein frozen foods, vegetarian foods and desserts. We market our balanced portfolio of fresh, prepared and valueadded chicken products to a diverse set of over 6,000 customers across the U.S., the U.K. and Europe, Mexico and in approximately 100 other countries, with no single customer accounting for more than ten percent of total sales. We have become a valuable partner to our customers and a recognized industry leader by consistently providing highquality products and services designed to meet their needs and enhance their business. Our sales efforts are largely targeted towards the foodservice industry, principally chain restaurants and food processors, such as ChickfilA® and retail customers, including grocery store chains and wholesale clubs, such as Kroger®, Costco®, Publix®, and HEB®. As a vertically integrated company, we control every phase of the production process, which helps us better manage food safety and quality, as well as more effectively control margins and improve customer service. We operate feed mills, hatcheries, processing plants and distribution centers in 14 U.S. states, the U.K., Mexico, France, Puerto Rico and the Netherlands. Our plants are strategically located to ensure that customers timely receive fresh products. With our global network of approximately 5,300 growers, 38 feed mills, 49 hatcheries, 36 processing plants, 16 prepared foods cook plants, 22 distribution centers, nine rendering facilities and four pet food plants, we believe we are wellpositioned to supply the growing demand for our products. Our U.K. and Europe segment reflects the operations of Granite Holdings Sàrl and its subsidiaries (together, “Moy Park”), which we acquired on September 8, 2017. Moy Park is a leading and highly regarded U.K. food company, providing fresh, high quality and locally farmed poultry and convenience food products. Moy Park has operated in the U.K. retail market for over 50 years and delivers a range of fresh, readytocook, coated and readytoeat poultry products to major retailers and large foodservice customers throughout the United Kingdom, Ireland, France and the Netherlands. We believe that we operate one of the most efficient business models for chicken production in the U.K. and Europe. We are one of the largest, and we believe one of the most efficient, producers and sellers of chicken in Mexico. Our presence in Mexico provides access to a market with growing demand and has enabled us to leverage our operational strengths within the region. The market for chicken products in Mexico is still developing, with most sales attributed to fresh, commodityoriented, market pricebased business. Additionally, we are an important player in the live market in Mexico. We believe our Mexico business is well positioned to continue benefiting from these trends in the Mexican consumer market. As of December 30, 2018, we had approximately 52,100 employees and the capacity to process more than 45.3 million birds per week for a total of more than 13.4 billion pounds of live chicken annually. In 2018, we produced 10.7 billion pounds of chicken products, generating approximately $10.9 million in net sales and approximately $246.8 million in net income attributable to Pilgrim’s. We operate on a 52/53week fiscal year that ends on the Sunday [/INST] Negative. </s>

PILGRIMS PRIDE CORP

2020-02-21

2019-12-29

Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations Executive Summary Overview As a vertically integrated company, we’re able to better manage food quality and safety, allowing us to seek opportunities to diversify and grow our business, while meeting the needs of consumers, customers and team members. This gives us the opportunity to continue to create growth and development opportunities, further increasing our position as a leading domestic and global protein company. With the acquisition of Tulip and Moy Park in 2019 and 2017, respectively, we solidified ourselves as a leading European food company while diversifying our product mix with introduction into the pork market. With the acquisition GNP in 2017, we further solidified ourselves as a leading poultry company within the U.S. See “Note 2. Business Acquisitions” of our Consolidated and Combined Financial Statements included in this annual report for additional information relating to these acquisitions. We reported net income attributable to Pilgrim’s Pride Corporation of $455.9 million, or $1.83 per diluted common share, and profit before tax totaling $617.5 million, for 2019. These operating results included gross profit of $1.1 billion and generated $666.5 million of cash from operations. We generated operating margins of 6.1% with operating margins of 6.4%, 3.3% and 8.9% in our U.S., U.K. and Europe, and Mexico reportable segments, respectively. During 2019, we generated EBITDA and Adjusted EBITDA of $1.0 billion and $973.8 million, respectively. A reconciliation of net income to EBITDA and Adjusted EBITDA is included in “Item 6. Selected Financial Data” in this annual report. We operate on the basis of a 52/53-week fiscal year that ends on the Sunday falling on or before December 31. Any reference we make to a particular year applies to our fiscal year and not the calendar year. Fiscal 2019 and 2018 were 52-week accounting cycles and fiscal 2017 was a 53-week accounting cycle. Raw Materials Our U.S. and Mexico reportable segments use corn and soybean meal as the main ingredients for feed production, while our U.K. and Europe reportable segment uses wheat, soybean meal and barley as the main ingredients for feed production. Market prices for animal-based protein products are currently at levels sufficient to offset the costs of feed ingredients. However, there can be no assurance that animal-based protein prices will not decrease due to such factors as competition from plant-based proteins and substitutions by consumers of non-protein foods because of uncertainty surrounding the general economy, animal-based diseases and unemployment. Tulip Acquisition On October 15, 2019, we acquired 100% of the equity of Tulip Limited and its subsidiaries from Danish Crown AmbA for £310.0 million, or $391.5 million, subject to customary working capital adjustments. The acquisition was funded with cash on hand. Tulip Limited, a leading, integrated prepared pork supplier, is headquartered in Warwick, U.K., operates 14 fresh and value-added facilities in that country and employs approximately 5,400 people as of December 29, 2019. The acquisition solidifies us as a leading European food company, creating one of the largest integrated prepared foods businesses in the U.K. The Tulip operations are included in our U.K. and Europe reportable segment. See “Note 2. Business Acquisitions” of our Consolidated and Combined Financial Statements included in this annual report for additional information relating to this acquisition. Potential Impact of Tariffs We continue to monitor recent trade and tariff activity and its potential impact to exports and inputs costs across our reportable segments. Currently, we are experiencing impacts to domestic and export prices of chicken resulting from uncertainty in trade policies and increased tariffs. We are unable to give any assurance as to the scope, duration, or impact of any changes in trade policies or tariffs, how successful any mitigation efforts will be, or the extent to which mitigation will be necessary, and accordingly, changes in trade policies and increased tariffs could have a material adverse effect on our business and results of operations. Reportable Segments We operate in three reportable segments: the U.S., the U.K. and Europe, and Mexico. We measure segment profit as operating income. Corporate expenses are allocated to Mexico and U.K. and Europe reportable segments based upon various apportionment methods for specific expenditures incurred related thereto with the remaining amounts allocated to the U.S. For additional information, see “Note 22. Reportable Segments” of our Consolidated and Combined Financial Statements included in this annual report. Results of Operations 2019 Compared to 2018 Net sales. Net sales for 2019 increased $471.4 million, or 4.3%, from $10.9 billion generated in 2018 to $11.4 billion generated in 2019. The following table provides additional information regarding net sales: U.S. Reportable Segment. U.S. net sales generated in 2019 increased $211.1 million, or 2.8%, from U.S. net sales generated in 2018 primarily because of an increase in sales volume and an increase in net sales per pound. The increase in sales volume contributed $139.6 million, or 1.8 percentage points, to the increase in net sales. The increase in net sales per pound contributed $71.5 million, or 1.0 percentage points, to the increase in net sales. U.K. and Europe Reportable Segment. U.K. and Europe sales generated in 2019 increased $235.1 million, or 10.9%, from U.K. and Europe sales generated in 2018, primarily because of the recently acquired Tulip operations, partially offset by a decrease in net sales by our existing U.K. and Europe operations. The impact of the acquired business contributed $306.7 million, or 14.2 percentage points, to the increase in net sales. The decrease in our existing U.K. and Europe operations was mainly due to the unfavorable impact of foreign currency translation of $94.4 million, or 4.4 percentage points. The unfavorable impact of foreign currency translation was partially offset by an increase in sales volume and net sales per pound of $15.3 million, or 0.7 percentage points, and $7.6 million, or 0.4 percentage points, respectively. Mexico Reportable Segment. Mexico sales generated in 2019 increased $25.3 million, or 1.9%, from Mexico sales generated in 2018 primarily because of an increase in net sales per pound, partially offset by a decrease in sales volume and the unfavorable impact of foreign currency remeasurement. The increase in net sales per pound contributed $59.2 million, or 4.4 percentage points, to the increase in Mexico net sales. The decrease in sales volume and unfavorable impact of foreign currency remeasurement partially offset the increase in net sales per pound by $32.1 million, or 2.4 percentage points, and $1.8 million, or 0.1 percentage points, respectively. Gross profit. Gross profit increased by $226.9 million, or 26.9%, from $843.5 million generated in 2018 to $1.1 billion generated in 2019. The following tables provide gross profit information: (a) Our Consolidated and Combined Financial Statements include the accounts of our company and our majority owned subsidiaries. We eliminate all significant affiliate accounts and transactions upon consolidation. U.S. Reportable Segment. Cost of sales incurred by our U.S. operations in 2019 decreased $6.5 million, or 0.1%, from cost of sales incurred by our U.S. operations in 2018. Cost of sales primarily decreased because of reduced cost per pound sold, partially offset by increased poultry sales volume. The decrease in cost per pound sold contributed $92.6 million to the decrease in cost of sales. This decrease is partially offset by an increase in poultry sales volume of $86.0 million. Included in the decrease in cost per pound sold and increased sales volume was an $81.2 million increase in hourly labor due to an increase in required labor for reduced use of third-party poultry processors and a $15.1 million increase in contracted processing labor. Partially offsetting these increases in cost of sales was a $16.0 million decrease in freight cost due to decreased contract rates, $14.9 million in costs in 2018 relating to Hurricane Michael and Hurricane Maria, a $14.8 million decrease in commodity and currency derivative losses, an $11.3 million decrease in feed costs, a $9.2 million decrease in cost relating to third-party poultry processors and a $5.7 million decrease in property taxes. Other factors affecting U.S. cost of sales were individually immaterial. U.K. and Europe Reportable Segment. Cost of sales incurred by the U.K. and Europe operations during 2019 increased $234.2 million, or 11.8%, from cost of sales incurred by the U.K. and Europe operations during 2018 primarily because of costs incurred by the acquired Tulip operations, partially offset by decreases in cost of sales incurred by our existing U.K. and Europe operations. Cost of sales incurred by the acquired Tulip operations contributed $297.5 million to the increase in cost of sales. Cost of sales related to the existing U.K. and Europe operations decreased due to the favorable impact of foreign currency translation of $87.1 million, partially offset by an increase in poultry sales volume of $14.1 million and an increase in cost per pound sold of $9.6 million. Included in the increase in sales volume and cost per pound was a $22.8 million increase in payroll cost due to national minimum wage increases, a $7.8 million increase in maintenance costs due to additional equipment and production lines and a $4.4 million increase in utilities as a result of increased rates. Partially offsetting these increases in cost of sales was a $12.7 million decrease in live costs mainly due to increased efficiencies. Other factors affecting cost of sales were individually immaterial. Mexico Reportable Segment. Cost of sales incurred by the Mexico operations during 2019 increased $16.8 million, or 1.4%, from cost of sales incurred by the Mexico operations during 2018 primarily because of increased cost per pound sold. The increase in cost per pound sold was partially offset by a decrease in sales volume and the favorable impact of foreign currency remeasurement. The increase in cost per pound sold contributed $46.8 million to the increase in cost of sales. Partially offsetting this increase in cost of sales was the decrease in sales volume of $28.4 million and favorable impact of foreign currency remeasurement of $1.6 million. Included in the increase in cost per pound sold and sales volume decrease was a $16.1 million increase in grower pay due to increased live operations and a $5.7 million increase in freight costs. Partially offsetting these increases in cost of sales was a $6.6 million increase in gains on sale of assets during 2019. Other factors affecting cost of sales were individually immaterial. Operating income. Operating income increased $194.9 million, or 39.3%, from $495.7 million generated for 2018 to $690.6 million generated for 2019. The following tables provide operating income information: U.S. Reportable Segment. Selling, general and administrative (“SG&A”) expense incurred by the U.S. operations during 2019 increased $23.9 million, or 10.8%, from SG&A expense incurred by the U.S. operations during 2018 primarily because of a $17.7 million increase in incentive compensation expenses and a $7.0 million increase in legal fees due to increased litigation. Other factors affecting SG&A expense were individually immaterial. Administrative restructuring activities incurred by the U.S. operations during 2019 decreased $2.2 million, or 103.9%, from administrative restructuring activities incurred during 2018. Administrative restructuring activities incurred by the U.S. reportable segment during 2019 included $84,000 of sublease income related to the termination of 40 North Foods operations. Administrative restructuring activities incurred by the U.S. reportable segment during 2018 included severance costs totaling $1.0 million related to GNP, facility closure costs totaling $0.5 million related to the Luverne, Minnesota facility and severance, asset impairment and lease obligations costs totaling $0.7 million that resulted from the termination of the 40 North Foods operation. U.K. and Europe Reportable Segment. SG&A expense incurred by the U.K. and Europe operations during 2019 increased $8.9 million, or 10.6%, from SG&A expense incurred by the U.K. and Europe operations during 2018 primarily because of expenses incurred by the acquired Tulip operations, partially offset by a decrease in SG&A expense incurred from our existing U.K. and Europe operations. SG&A expense incurred by the acquired Tulip operations contributed $13.1 million to the increase in SG&A expense. The decrease in SG&A expense in our existing U.K. and Europe was mainly due to favorable impact of foreign currency translation of $3.3 million. Other factors affecting SG&A expense were individually immaterial. Administrative restructuring activities incurred by the U.K. and Europe operations during 2019 decreased $2.6 million, or 100.0%, from administrative restructuring activities incurred during 2018. During 2018, administrative restructuring activities represented impairment costs of $2.6 million related to Rose Energy Ltd. Mexico Reportable Segment. SG&A expense incurred by the Mexico operations during 2019 increased $4.1 million, or 11.0%, from SG&A expense incurred by the Mexico operations during 2018 primarily because of a $2.3 million increase in payroll mainly due to increased rates and a $1.1 million increase marketing expenses due to increased brand development. Other factors affecting SG&A expense were individually immaterial. Interest expense. Consolidated and combined interest expense decreased 18.5% to $132.6 million in 2019 from $162.8 million in 2018, primarily because of a decrease in average borrowings to $2.3 billion in 2019 from $2.5 billion in 2018. As a percent of net sales, interest expense in 2019 and 2018 was 1.2% and 1.5%, respectively. Income taxes. Our consolidated and combined income tax expense in 2019 was $161.0 million, compared to income tax expense of $85.4 million in 2018. The increase in income tax expense in 2019 resulted from an increase in pre-tax income during 2019. 2018 Compared to 2017 Net sales. Net sales for 2018 increased $169.9 million, or 1.6%, from 2017. The following table provides additional information regarding net sales: U.S. Reportable Segment. U.S. net sales generated in 2018 decreased $17.6 million, or 0.2%, from U.S. net sales generated in 2017 primarily because of a decrease in net sales per pound partially offset by an increase in sales volume. The decrease in net sales per pound, which resulted primarily from lower market prices, contributed $120.5 million, or 1.6 percentage points, to the decrease in net sales. This decrease in net sales per pound was partially offset by increased sales volume of $102.9 million, or 1.4 percentage points. Included in U.S. sales generated during 2018 and 2017 were sales to JBS USA Food Company totaling $13.8 million and $15.3 million, respectively. U.K. and Europe Reportable Segment. U.K. and Europe sales generated in 2018 increased $152.3 million, or 7.6%, from U.K. and Europe sales generated in 2017, primarily because of the positive impact of foreign currency translation, an increase in net sales per pound and an increase in sales volume. The positive impact of foreign currency translation contributed $74.4 million, or 3.7 percentage points to the increase in U.K. and Europe net sales. The increase in net sales per pound contributed $53.5 million, or 2.7 percentage points, to the increase in U.K. and Europe net sales. The increase in sales volume contributed $24.5 million, or 1.2 percentage points, to the increase in U.K. and Europe net sales. Mexico Reportable Segment. Mexico sales generated in 2018 increased $35.1 million, or 2.6%, from Mexico sales generated in 2017 primarily because of an increase in net sales per pound and an increase in sales volume, partially offset by the impact of foreign currency translation. The increase in net sales per pound contributed $46.1 million, or 3.5 percentage points, to the increase in Mexico net sales. The increase in sales volume contributed $10.0 million, or 0.8 percentage points, to the increase in Mexico net sales. The impact of foreign currency translation partially offset the overall net sales increase by $21.0 million, or 1.6 percentage points. Gross profit. Gross profit decreased by $628.1 million, or 42.7%, from $1.5 billion generated in 2017 to $843.5 million generated in 2018. The following tables provide gross profit information: (a) Our Consolidated and Combined Financial Statements include the accounts of our company and our majority owned subsidiaries. We eliminate all significant affiliate accounts and transactions upon consolidation. U.S. Reportable Segment. Cost of sales incurred by our U.S. operations in 2018 increased $561.4 million, or 8.8%, from cost of sales incurred by our U.S. operations in 2017. Cost of sales primarily increased because of increased cost per pound sold, increased poultry sales volume, increased freight and storage costs, and increased grower costs. Increased cost per pound contributed $353.0 million mainly due to increased feed costs of $143.2 million and increased poultry sales volume contributed $78.2 million to the increase in cost of sales. The increased freight and storage costs contributed $77.2 million mainly due to driver shortages and the impact of new federal regulations. The increased grower costs contributed $51.8 million to the increase in cost of sales, mainly due to increased grower pay rates, feed delivery costs and utility costs. Other factors affecting U.S. cost of sales were individually immaterial. U.K. and Europe Reportable Segment. Cost of sales incurred by the U.K. and Europe operations during 2018 increased $169.7 million, or 9.4%, from cost of sales incurred by the U.K. and Europe operations during 2017 primarily because of increased sales volume and a $74.3 million increase in feed ingredient and raw material costs. U.K. and Europe cost of sales also increased because of a $68.0 million increase in payroll costs resulting from an increase in minimum wage and a $25.1 million increase in freight and storage costs. Other factors affecting cost of sales were individually immaterial. Mexico Reportable Segment. Cost of sales incurred by the Mexico operations during 2018 increased $67.0 million, or 5.9%, from cost of sales incurred by the Mexico operations during 2017 primarily because of increased sales volume and increased cost per pound with a $34.7 million increase in feed costs. Mexico cost of sales also increased because of a $14.1 million increase in grower costs, a $10.4 million increase in freight costs, a $4.0 million increase in natural gas costs, a $4.0 million increase in transportation costs and a $2.0 million increase in employee relations costs. Other factors affecting cost of sales were individually immaterial. Operating income. Operating income decreased $576.6 million, or 53.8%, from $1.1 billion generated for 2017 to $495.7 million generated for 2018. The following tables provide operating income information: (a) Our Consolidated and Combined Financial Statements include the accounts of our company and our majority owned subsidiaries. We eliminate all significant affiliate accounts and transactions upon consolidation. U.S. Reportable Segment. SG&A expense incurred by the U.S. operations during 2018 decreased $22.7 million, or 9.3%, from SG&A expense incurred by the U.S. operations during 2017 primarily because of an $18.4 million decrease in transaction costs associated with the Moy Park acquisition and a $17.9 million decrease in benefit expenses, partially offset by an increase in legal fees of $9.5 million related to pending litigation and a $7.2 million increase in payroll expenses. Other factors affecting SG&A expense were individually immaterial. Administrative restructuring activities incurred by the U.S. operations during 2018 decreased $6.1 million, or 74.1%, from administrative restructuring activities incurred during 2017. Administrative restructuring activities incurred by the U.S. reportable segment during 2018 included severance costs totaling $1.0 million related to GNP, facility closure costs totaling $0.5 million related to the Luverne, Minnesota facility and severance, asset and impairment and lease obligations costs totaling $0.7 million that resulted from the termination of the 40 North Foods operation. Administrative restructuring activities incurred by the U.S. reportable segment during 2017 included asset impairment costs of $3.5 million related to the Athens, Alabama facility, severance costs of $2.6 million related to GNP, the elimination of prepaid costs totaling $0.7 million related to obsolete software assumed in the GNP acquisition, and facility closure costs totaling $0.9 million related to the Luverne, Minnesota facility. U.K. and Europe Reportable Segment. SG&A expense incurred by the U.K. and Europe operations during 2018 decreased $25.9 million, or 23.6%, from SG&A expense incurred by the U.K. and Europe operations during 2017 primarily because of a $10.6 million decrease in payroll expenses, a $7.2 million decrease in storage expenses, a $4.0 million decrease in pallet expenses, a $3.8 million decrease in management fees charged for administrative functions shared with JBS S.A. and a $2.3 million decrease in vehicle expenses. These decreases to SG&A expense were partially offset by a $2.6 million increase in expenses related to severance. Other factors affecting SG&A expense were individually immaterial. Administrative restructuring activities incurred by the U.K. and Europe operations during 2018 increased $1.1 million, or 73.2%, from administrative restructuring activities incurred during 2017. During 2018, administrative restructuring activities represented impairment costs of $2.6 million related to Rose Energy Ltd. During 2017, administrative restructuring activities represented impairment costs of $1.5 million related to a property in Dublin, Ireland. Mexico Reportable Segment. SG&A expense incurred by the Mexico operations during 2018 increased $2.1 million, or 6.0%, from SG&A expense incurred by the Mexico operations during 2017 primarily because of a $1.8 million increase in employee relations expenses and a $1.4 million increase in media marketing expenses. These increases to SG&A expense were partially offset by a $1.1 million decrease in the loss from sale of assets. Other factors affecting SG&A expense were individually immaterial. Interest expense. Consolidated and combined interest expense increased 51.9% to $162.8 million in 2018 from $107.2 million in 2017, primarily because of an increase in the weighted average interest rate to 5.20% in 2018 from 4.54% in 2017 and an increase in average borrowings of $2.5 billion in 2018 from $2.0 billion in 2017. As a percent of net sales, interest expense in 2018 and 2017 was 1.5% and 1.0%, respectively. Income taxes. Our consolidated and combined income tax expense in 2018 was $85.4 million, compared to income tax expense of $263.9 million in 2017. The decrease in income tax expense in 2018 resulted from a decrease in pre-tax income during 2018. Liquidity and Capital Resources Our principal sources of liquidity are cash generated from operations, funds from borrowings, and existing cash on hand. The following table presents our available sources of liquidity as of December 29, 2019: (a) Availability under the U.S. Credit Facility is also reduced by our outstanding standby letters of credit. Standby letters of credit outstanding at December 29, 2019 totaled $41.6 million. (b) As of December 29, 2019, the U.S. dollar-equivalent of the amount available under the Mexican Credit Facility was $79.6 million. The Mexican Credit Facility provides for a loan commitment of $1.5 billion Mexican pesos. (c) As of December 29, 2019, the U.S. dollar-equivalent of the amount available under the U.K. and Europe Credit Facilities were $141.9 million. The U.K. and Europe Credit Facilities provide for loan commitments of £100.0 million (or $130.8 million U.S. dollar-equivalent) under the Bank of Ireland Facility Agreement and €10.0 million (or $11.1 million U.S. dollar-equivalent) under the Invoice Discounting Facility. Historical Flow of Funds Calendar Year 2019 Cash provided by operating activities was $666.5 million during 2019. The cash flows provided by operating activities resulted primarily from net income of $456.5 million, net noncash expenses of $272.2 million, a change in accounts payable and accrued expenses of $119.9 million and a change of $5.8 million related to other operating assets and liabilities. These cash flows were partially offset by the use of cash of $111.7 million related to inventories, $26.4 million related to income taxes, use of cash of $25.0 million related to trade accounts and other receivables, the use of cash of $15.5 million related to prepaid expenses and other current assets and the use of cash of $9.2 million related to long-term pension and other postretirement obligations. Accounts payable and accrued expenses, including accounts payable to related parties, had proceeds of $119.9 million related to operating activities during 2019. This change resulted primarily from the timing of payments. The change in inventories represented a $111.7 million use of cash related to operating activities during 2019. The change in cash related to an increase in our finished products inventory. Trade accounts and other receivables, including accounts receivable from related parties, used cash of $25.0 million related to operating activities during 2019. This change is primarily due to the timing of customer payments. Prepaid expenses and other current assets had uses of cash of $15.5 million related to operating activities during 2019. This change resulted primarily from a net increase in both commodity derivatives and value-added tax receivables. Income taxes, which includes income taxes receivables, income taxes payable, deferred tax assets, deferred tax liabilities, reserves for uncertain tax positions and the tax components within accumulated other comprehensive loss, had uses of cash of $26.4 million. This change resulted primarily from the timing of estimated tax payments. Net noncash expenses totaled $272.2 million in 2019, with net noncash expense items increasing primarily because of $287.2 million related to depreciation and amortization, $42.5 million related to deferred income tax expense, share-based compensation of $10.1 million and loan cost amortization of $4.8 million. Partially offsetting the net noncash expenses are a $56.9 million gain on bargain purchase related to the Tulip acquisition, $10.9 million gain on property disposals and foreign currency transaction gain related to borrowing arrangements of $5.0 million. Cash used in investing activities was $717.1 million during 2019. Cash used to acquire Tulip totaled $384.7 million and cash used to acquire property, plant and equipment totaled $348.1 million. Capital expenditures were primarily incurred to improve operational efficiencies and reduce costs. Capital expenditures for 2019 could not exceed $500.0 million under the terms of our U.S. credit facility. Cash proceeds generated from property disposals for the period totaled $15.8 million. Cash used in financing activities was $34.5 million during 2019. Cash used for payments on revolving lines of credit, long-term borrowings and capital lease obligations totaled $289.9 million, cash used to purchase common stock under the share repurchase program totaled $2.9 million, cash used to pay capitalized loan costs $0.7 million and cash used to make equity distributions under a tax sharing agreement with JBS USA Food Company Holdings totaled $0.5 million. These uses of cash were offset by cash proceeds from long-term debt that totaled $259.5 million. Calendar Year 2018 Cash provided by operating activities was $491.7 million during 2018. The cash flows provided by operating activities resulted primarily from net income of $246.8 million, net noncash expenses of $348.1 million, a change in accounts payable, accrued expenses and other current liabilities of $86.8 million and a change in inventories of $83.2 million. These cash flows were partially offset by the use of $248.5 million in cash related to income taxes, the use of $11.6 million in cash related to prepaid expenses and other current assets, the use of $10.9 million in cash related to trade accounts and other receivables and the use of $6.8 million in cash related to long-term pension and other postretirement obligations. Accounts payable and accrued expenses, including accounts payable to related parties, had proceeds of $86.8 million related to operating activities during 2018. This change resulted primarily from the timing of payments. The change in inventories represented a $83.2 million source of cash related to operating activities during 2018. The change in cash related to a decrease in our finished products inventory. Trade accounts and other receivables, including accounts receivable from related parties, used cash of $10.9 million related to operating activities during 2018. This change is primarily due to customer payment timing. Prepaid expenses and other current assets had uses of cash of $11.6 million related to operating activities during 2018. This change resulted primarily from a net increase in both commodity derivatives and value-added tax receivables. Income taxes, which includes income taxes receivables, income taxes payable, deferred tax assets, deferred tax liabilities, reserves for uncertain tax positions and the tax components within accumulated other comprehensive loss, had proceeds of cash of $248.5 million. This change resulted primarily from the timing of estimated tax payments. Net noncash expenses totaled $348.1 million in 2018, increasing primarily because of $274.1 million related to depreciation and amortization, $32.5 million related to deferred income tax expense, noncash loss on early extinguishment of debt of $15.8 million, share-based compensation of $13.2 million, and foreign currency transaction loss related to borrowing arrangements of $5.3 million. Cash used in investing activities was $338.9 million during 2018. Cash used to acquire property, plant and equipment totaled $348.7 million. Capital expenditures were primarily incurred to improve operational efficiencies and reduce costs. Capital expenditures for 2018 could not exceed $500.0 million under the terms of our U.S. credit facility. Cash proceeds generated from property disposals for the period totaled $9.8 million. Cash used in financing activities was $384.2 million during 2018. Cash proceeds from long-term debt totaled $748.4 million, cash proceeds from equity contributions under a tax sharing agreement with JBS USA Food Company Holdings totaled $5.6 million and capital contributions to subsidiary by noncontrolling stockholders totaled $1.4 million. These sources of cash were offset by $1.1 billion in cash used for payments on revolving lines of credit, long-term borrowings and capital lease obligations, $12.6 million in cash used to pay capitalized loan costs, $9.8 million in cash used for payments relating to early extinguishment of debt and $0.2 million in cash used to purchase common stock under the share repurchase program. Long-Term Debt and Other Borrowing Arrangements Our long-term debt and other borrowing arrangements consist of senior notes, revolving credit facilities and and other term loan agreements. For a description, refer to Part II, Item 8, Notes to Consolidated Financial Statements, “Note 12. Long-Term Debt and other Borrowing Arrangements.” Collateral Substantially all of our domestic inventories and domestic fixed assets are pledged as collateral to secure the obligations under the U.S. Credit Facility. Capital Expenditures We anticipate spending between $340 million and $360 million on the acquisition of property, plant and equipment in 2020. Capital expenditures will primarily be incurred to improve efficiencies and reduce costs. We expect to fund these capital expenditures with cash flow from operations and proceeds from the revolving lines of credit under our various debt facilities. Contractual Obligations In addition to our debt commitments at December 29, 2019, we had other commitments and contractual obligations that obligate us to make specified payments in the future. The following table summarizes the total amounts due as of December 29, 2019, under all debt agreements, commitments and other contractual obligations. The table indicates the years in which payments are due under the contractual obligations. (a) The total amount of unrecognized tax benefits at December 29, 2019 was $12.8 million. We did not include this amount in the contractual obligations table above as reasonable estimates cannot be made at this time of the amounts or timing of future cash outflows. (b) Long-term debt is presented at face value and excludes $41.6 million in letters of credit outstanding related to normal business transactions. (c) Interest expense in the table above assumes the continuation of interest rates and outstanding borrowings as of December 29, 2019. (d) Includes agreements to purchase goods or services that are enforceable and legally binding on us and that specify all significant terms, including fixed or minimum quantities to be purchased; fixed, minimum, or variable price provisions; and the approximate timing of the transaction. We expect cash flows from operations, combined with availability under the U.S. Credit Facility, and U.K. and Europe Credit Facilities to provide sufficient liquidity to fund current obligations, projected working capital requirements, maturities of long-term debt and capital spending for at least the next twelve months. Recent Accounting Pronouncements Refer to Part II, Item 8, Notes to Consolidated Financial Statements, “Note 1. Business and Summary of Significant Accounting Policies.” Critical Accounting Policies and Estimates General. Our discussion and analysis of our financial condition and results of operations are based upon our financial statements, which have been prepared in accordance with U.S. GAAP. The preparation of these financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses. On an ongoing basis, we evaluate our estimates, including those related to revenue recognition, inventory, goodwill and other intangible assets, litigation and income taxes. We base our estimates on historical experience and on various other assumptions that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions. We believe the following critical accounting policies affect our more significant judgments and estimates used in the preparation of our financial statements. Revenue Recognition. The vast majority of our revenue is derived from contracts which are based upon a customer ordering our products. While there may be master agreements, the contract is only established when the customer’s order is accepted by us. We account for a contract, which may be verbal or written, when it is approved and committed by both parties, the rights of the parties are identified along with payment terms, the contract has commercial substance and collectability is probable. We evaluate the transaction for distinct performance obligations, which are the sale of our products to customers. Since our products are commodity market-priced, the sales price is representative of the observable, standalone selling price. Each performance obligation is recognized based upon a pattern of recognition that reflects the transfer of control to the customer at a point in time, which is upon destination (customer location or port of destination) and depicts the transfer of control and recognition of revenue. There are instances of customer pick-up at our facilities, in which case control transfers to the customer at that point and we recognize revenue. Our performance obligations are typically fulfilled within days to weeks of the acceptance of the order. We make judgments regarding the nature, amount, timing and uncertainty of revenue and cash flows arising from revenue and cash flows with customers. Determination of a contract requires evaluation and judgment along with the estimation of the total contract value and if any of the contract value is constrained. Due to the nature of our business, there is minimal variable consideration, as the contract is established at the acceptance of the order from the customer. When applicable, variable consideration is estimated at contract inception and updated on a regular basis until the contract is completed. Allocating the transaction price to a specific performance obligation based upon the relative standalone selling prices includes estimating the standalone selling prices including discounts and variable consideration. Inventory. Live chicken inventories are stated at the lower of cost or net realizable value and breeder hen inventories at the lower of cost, less accumulated amortization, or net realizable value. The costs associated with breeder hen inventories are accumulated up to the production stage and amortized over their productive lives using the unit-of-production method. Finished poultry products, feed, eggs and other inventories are stated at the lower of cost (average) or net realizable value. Inventory typically transfers from one stage of production to another at a standard cost, where it accumulates additional cost directly incurred with the production of inventory, including overhead. The standard cost at which each type of inventory transfers is set by management to reflect the actual costs incurred in the prior steps. We monitor and adjust standard costs throughout the year to ensure that standard costs reasonably reflect the actual average cost of the inventory produced. We allocate meat costs between our various finished chicken products based on a by-product costing technique that reduces the cost of the whole bird by estimated yields and amounts to be recovered for certain by-product parts. This primarily includes leg quarters, wings, tenders and offal, which are carried in inventory at the estimated recovery amounts, with the remaining amount being reflected as our breast meat cost. Generally, we perform an evaluation of whether any lower of cost or market adjustments are required at the country level based on a number of factors, including: (1) pools of related inventory, (2) product continuation or discontinuation, (3) estimated market selling prices and (4) expected distribution channels. If actual market conditions or other factors are less favorable than those projected by management, additional inventory adjustments may be required. We also record valuation adjustments, when necessary, for estimated obsolescence at or equal to the difference between the cost of inventory and the estimated market value based upon known conditions affecting inventory obsolescence, including significantly aged products, discontinued product lines, or damaged or obsolete products. Goodwill and Other Intangibles, net. Goodwill represents the excess of the aggregate purchase price over the fair value of the net identifiable assets acquired in a business combination. Identified intangible assets represent trade names, customer relationships and non-compete agreements arising from acquisitions that are recorded at fair value as of the date acquired less accumulated amortization, if any. We use various market valuation techniques to determine the fair value of its identified intangible assets. Goodwill and other intangible assets with indefinite lives are not amortized but are tested for impairment on an annual basis in the fourth quarter of each fiscal year or more frequently if impairment indicators arise. For goodwill, an impairment loss is recognized for any excess of the carrying amount of a reporting unit’s goodwill over the implied fair value of that goodwill. Management first reviews relevant qualitative factors to determine if an indication of impairment exists for a reporting unit. If management determines there is an indication that the carrying amount of reporting unit goodwill might be impaired, a quantitative analysis is performed. Management performed a qualitative analysis noting no indications of goodwill impairment in any of its reporting units as of December 29, 2019. For indefinite-lived intangible assets, an impairment loss is recognized if the carrying amount of an indefinite-lived intangible asset exceeds the estimated fair value of that intangible asset. Management first reviews relevant qualitative factors to determine if an indication of impairment exists. If management determines there is an indication that the carrying amount of the intangible asset might be impaired, and quantitative analysis is performed. Management performed a qualitative analysis noting no indications of impairment for any of its indefinite-lived intangible assets as of December 29, 2019. Identifiable intangible assets with definite lives, such as customer relationships, non-compete agreements and trade names that we expect to use for a limited amount of time, are amortized over their estimated useful lives on a straight-line basis. The useful lives range from three to 20 years for trade names and non-compete agreements and 5 to 16 years for customer relationships. Identified intangible assets with definite lives are tested for recoverability whenever events or changes in circumstances indicate that their carrying amount may not be recoverable. Management assessed if events or changes in circumstances indicated that the aggregate carrying amount of its identified intangible assets with definite lives might not be recoverable and determined that there were no impairment indicators during the fifty-two weeks ended December 29, 2019 and fifty-two weeks ended December 31, 2018. Litigation and Contingent Liabilities. We are subject to lawsuits, investigations and other claims related to employment, environmental, product, and other matters. We are required to assess the likelihood of any adverse judgments or outcomes, as well as potential ranges of probable losses, to these matters. We estimate the amount of reserves required for these contingencies when losses are determined to be probable and after considerable analysis of each individual issue. We expense legal costs related to such loss contingencies as they are incurred. With respect to our environmental remediation obligations, the accrual for environmental remediation liabilities is measured on an undiscounted basis. These reserves may change in the future due to changes in our assumptions, the effectiveness of strategies, or other factors beyond our control. Income Taxes. We follow provisions under ASC No. 740-10-30-27 in the Expenses-Income Taxes topic with regard to members of a group that file a consolidated tax return but issue separate financial statements. We file our own U.S. federal tax return, but we are included in certain state unitary returns with JBS USA Holdings. Our income tax expense is computed using the separate return method. The provision for income taxes has been determined using the asset and liability approach of accounting for income taxes. For the unitary states, we have an obligation to make tax payments to JBS USA Holdings for our share of the unitary taxable income, which is included in taxes payable in our Consolidated Balance Sheets. Under this approach, deferred income taxes reflect the net tax effect of temporary differences between the book and tax bases of recorded assets and liabilities, net operating losses and tax credit carry forwards. The amount of deferred tax on these temporary differences is determined using the tax rates expected to apply to the period when the asset is realized or the liability is settled, as applicable, based on the tax rates and laws in the respective tax jurisdiction enacted as of the balance sheet date. We recognize potential interest and penalties related to income tax positions as a part of the income tax provision.

<s>[INST] Overview As a vertically integrated company, we’re able to better manage food quality and safety, allowing us to seek opportunities to diversify and grow our business, while meeting the needs of consumers, customers and team members. This gives us the opportunity to continue to create growth and development opportunities, further increasing our position as a leading domestic and global protein company. With the acquisition of Tulip and Moy Park in 2019 and 2017, respectively, we solidified ourselves as a leading European food company while diversifying our product mix with introduction into the pork market. With the acquisition GNP in 2017, we further solidified ourselves as a leading poultry company within the U.S. See “Note 2. Business Acquisitions” of our Consolidated and Combined Financial Statements included in this annual report for additional information relating to these acquisitions. We reported net income attributable to Pilgrim’s Pride Corporation of $455.9 million, or $1.83 per diluted common share, and profit before tax totaling $617.5 million, for 2019. These operating results included gross profit of $1.1 billion and generated $666.5 million of cash from operations. We generated operating margins of 6.1% with operating margins of 6.4%, 3.3% and 8.9% in our U.S., U.K. and Europe, and Mexico reportable segments, respectively. During 2019, we generated EBITDA and Adjusted EBITDA of $1.0 billion and $973.8 million, respectively. A reconciliation of net income to EBITDA and Adjusted EBITDA is included in “Item 6. Selected Financial Data” in this annual report. We operate on the basis of a 52/53week fiscal year that ends on the Sunday falling on or before December 31. Any reference we make to a particular year applies to our fiscal year and not the calendar year. Fiscal 2019 and 2018 were 52week accounting cycles and fiscal 2017 was a 53week accounting cycle. Raw Materials Our U.S. and Mexico reportable segments use corn and soybean meal as the main ingredients for feed production, while our U.K. and Europe reportable segment uses wheat, soybean meal and barley as the main ingredients for feed production. Market prices for animalbased protein products are currently at levels sufficient to offset the costs of feed ingredients. However, there can be no assurance that animalbased protein prices will not decrease due to such factors as competition from plantbased proteins and substitutions by consumers of nonprotein foods because of uncertainty surrounding the general economy, animalbased diseases and unemployment. Tulip Acquisition On October 15, 2019, we acquired 100% of the equity of Tulip Limited and its subsidiaries from Danish Crown AmbA for £310.0 million, or $391.5 million, subject to customary working capital adjustments. The acquisition was funded with cash on hand. Tulip Limited, a leading, integrated prepared pork supplier, is headquartered in Warwick, U.K., operates 14 fresh and valueadded facilities in that country and employs approximately 5,400 people as of December 29, 2019. The acquisition solidifies us as a leading European food company, creating one of the largest integrated prepared foods businesses in the U.K. The Tulip operations are included in our U.K. and Europe reportable segment. See “Note 2. Business Acquisitions” of our Consolidated and Combined Financial Statements included in this annual report for additional information relating to this acquisition. Potential Impact of Tariffs We continue to monitor recent trade and tariff activity and its potential impact to exports and inputs costs across our reportable segments. Currently, we are experiencing impacts to domestic and export prices of chicken resulting from uncertainty in trade policies and increased tariffs. We are unable to give any assurance as to the scope, duration, or impact of any changes in trade policies or tariffs, how successful any mitigation efforts will be, or the extent to which mitigation will be necessary, and accordingly, changes in trade policies and increased tar [/INST] Negative. </s>

RYLAND GROUP INC

2015-02-25

2014-12-31

Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations The following management's discussion and analysis is intended to assist the reader in understanding the Company's business and is provided as a supplement to, and should be read in conjunction with, the Company's consolidated financial statements and accompanying notes. The Company's results of operations discussed below are presented in conformity with U.S. generally accepted accounting principles ("GAAP"). Forward-Looking Statements Certain statements in this Annual Report may be regarded as "forward-looking statements" within the meaning of the Private Securities Litigation Reform Act of 1995, and may qualify for the safe harbor provided for in Section 21E of the Exchange Act. These forward-looking statements represent the Company's expectations and beliefs concerning future events, and no assurance can be given that the results described in this Annual Report will be achieved. These forward-looking statements can generally be identified by the use of statements that include words such as "anticipate," "believe," "could," "estimate," "expect," "foresee," "goal," "intend," "likely," "may," "plan," "project," "should," "target," "will" or other similar words or phrases. All forward-looking statements contained herein are based upon information available to the Company on the date of this Annual Report. Except as may be required under applicable law, the Company does not undertake any obligation to update or revise any forward-looking statements, whether as a result of new information, future events or otherwise. These forward-looking statements are subject to risks, uncertainties and other factors, many of which are outside of the Company's control that could cause actual results to differ materially from the results discussed in the forward-looking statements. The factors and assumptions upon which any forward-looking statements herein are based are subject to risks and uncertainties which include, among others: •economic changes nationally or in the Company's local markets, including volatility and increases in interest rates, the impact of, and changes in, governmental stimulus, tax and deficit reduction programs, inflation, changes in consumer demand and confidence levels and the state of the market for homes in general;•changes and developments in the mortgage lending market, including revisions to underwriting standards for borrowers and lender requirements for originating and holding mortgages, changes in government support of and participation in such market, and delays or changes in terms and conditions for the sale of mortgages originated by the Company;•the availability and cost of land and the future value of land held or under development;•increased land development costs on projects under development;•shortages of skilled labor or raw materials used in the production of homes;•increased prices for labor, land and materials used in the production of homes;•increased competition;•failure to anticipate or react to changing consumer preferences in home design;•increased costs and delays in land development or home construction resulting from adverse weather conditions or other factors;•potential delays or increased costs in obtaining necessary permits as a result of changes to laws, regulations or governmental policies (including those that affect zoning, density, building standards, the environment and the residential mortgage industry);•delays in obtaining approvals from applicable regulatory agencies and others in connection with the Company's communities and land activities;•changes in the Company's effective tax rate and assumptions and valuations related to its tax accounts;•the risk factors set forth in this Annual Report on Form 10-K; and•other factors over which the Company has little or no control. Results of Operations Overview During 2014, the Company saw continued improvement in most of the economic indicators salient to the homebuilding industry: employment rates continued to rise, consumer confidence improved and interest rates remained at historically low levels. Sales pace, however, continued to be a challenge amidst slower household formation growth and a restrictive mortgage underwriting environment. The Company believes that the housing market as a whole is likely to move forward in its recovery as affordability remains attractive and homeownership remains near historically low levels. It believes that continued improvement in employment levels; low interest rates; slow relaxation of the mortgage underwriting environment; historically low production of single-family homes; and a steady increase of potential buyers due, in part, to an expected rise in the number of household formations should eventually drive more attractive sales absorption rates that will facilitate a healthier, sustainable long-term recovery. The Company remains structurally lean and, as a result of community count growth over the last several years, expects to achieve greater leverage with comparable volume levels than in past years. Throughout 2014, the Company's strategic homebuilding initiatives continued to generate year-over-year improvements in volume, operational efficiencies and profitability while, at the same time, maintaining a strong balance sheet. The Company made significant progress in achieving its operational goals in 2014 with a 22.2 percent increase in consolidated revenues; a 1.0 percent rise in housing gross profit margin; and a 1.0 percent decrease in the selling, general and administrative expense ratio, all of which led to an improvement in homebuilding operations profitability, compared to the same period in the prior year. The Company reported increases of 9.3 percent in closings and 5.6 percent in sales for the year ended December 31, 2014, compared to 2013. The Company believes that continued revenue growth and improved financial performance will most likely come from a greater presence in its established markets, improvements in operational leverage and a return to more traditional sales absorption rates should economic progress continue. The Company continues to maintain a geographically diverse footprint in order to manage risk and believes that it is well positioned to take advantage of favorable trends and opportunities in all of its markets. The number of active communities rose 21.0 percent to 351 active communities at December 31, 2014, from 290 active communities at December 31, 2013. Significant ongoing land acquisitions in its existing markets should enhance the Company's ability to establish additional market penetration and create a platform for future growth. Investments in new communities increased consolidated inventory owned by $397.5 million, or 24.3 percent, at December 31, 2014, compared to December 31, 2013. The Company's net income from continuing operations totaled $175.8 million, or $3.09 per diluted share, for the year ended December 31, 2014, compared to $379.1 million, or $6.79 per diluted share, for 2013 and $42.4 million, or $0.88 per diluted share, for 2012. The decrease in net income for 2014, compared to 2013, was primarily due to a $258.9 million tax benefit related to the reversal of the Company's deferred tax valuation allowance in 2013, which also restored income tax expense in 2014. The increase in net income for 2013, compared to 2012, was primarily due to a reversal of the Company's deferred tax asset valuation allowance; a rise in closing volume; higher housing gross profit margin, including lower inventory valuation adjustments and write-offs; a reduced selling, general and administrative expense ratio; pretax charges related to early retirement of debt in 2012; and a decline in interest expense. Pretax charges related to inventory and other valuation adjustments and write-offs totaled $2.4 million, $2.0 million and $6.3 million for the years ended December 31, 2014, 2013 and 2012, respectively. The Company's consolidated revenues rose 22.2 percent to $2.6 billion for the year ended December 31, 2014, from $2.1 billion for 2013. This increase was primarily attributable to a 9.3 percent rise in closings and to a 12.5 percent higher average closing price. The increase in average closing price was due to a change in the product and geographic mix of homes delivered, as well as to a more accommodating price environment during 2014, versus 2013. The Company's consolidated revenues rose 63.6 percent to $2.1 billion for the year ended December 31, 2013, from $1.3 billion for the same period in the prior year. This increase was primarily attributable to a 46.1 percent rise in closings and to a 12.5 percent higher average closing price. The increase in average closing price was due to price increases in existing communities, as well as to a change in the product and geographic mix of homes delivered during 2013, versus 2012. Revenues for the homebuilding and financial services segments totaled $2.6 billion and $45.2 million in 2014, compared to $2.1 billion and $51.4 million in 2013 and $1.3 billion and $37.6 million in 2012, respectively. The Company reported a rise in closing volume for the year ended December 31, 2014, compared to 2013, primarily due to higher backlog at the beginning of the year, as well as to an increase in sales. New orders rose 5.6 percent to 7,668 units for the year ended December 31, 2014, from 7,262 units for 2013 primarily due to an increase in the number of active communities, partially offset by lower sales absorption rates. New order dollars increased 15.2 percent for the year ended December 31, 2014, compared to 2013. The Company's average monthly sales absorption rate was 2.0 homes per community for the year ended December 31, 2014, versus 2.3 homes per community for 2013. The Company's average monthly sales absorption rate is calculated as the net new orders in the period divided by the average number of active communities during the period divided by the number of months in that period. Selling, general and administrative expense totaled 11.2 percent of homebuilding revenues for the year ended December 31, 2014, compared to 12.2 percent and 15.0 percent for the same periods in 2013 and 2012, respectively. The year-over-year decreases were primarily attributable to higher leverage that resulted from increased revenues. The financial services segment reported pretax earnings of $7.4 million, $20.1 million and $13.1 million for the years ended December 31, 2014, 2013 and 2012, respectively. The decrease in pretax earnings for 2014, compared to 2013, was primarily attributable to a decrease in locked loan pipeline volume, which was due, in part, to the reversal of the accelerated timing of loan locks during 2013; an increase in litigation expense; and higher expense related to a change in estimate of ultimate insurance loss liability. The rise in pretax earnings for 2013, compared to 2012, was primarily due to increases in locked loan pipeline and origination volumes, as well as to a rise in title income, partially offset by increased personnel costs and by higher expense related to estimates of ultimate insurance loss liability. The Company maintained a strong balance sheet, ending the year with $580.0 million in cash, cash equivalents and marketable securities. After the maturity of the $126.5 million of 5.4 percent senior notes in January 2015, which were paid after year end with existing cash, the Company's earliest senior debt maturity is in 2017. Its net debt-to-capital ratio, including marketable securities, was 43.1 percent at December 31, 2014, compared to 45.8 percent at December 31, 2013. Stockholders' equity per share rose 19.3 percent to $23.43 at December 31, 2014, compared to $19.64 at December 31, 2013. The net debt-to-capital ratio, including marketable securities, is a non-GAAP financial measure that is calculated as debt, net of cash, cash equivalents and marketable securities, divided by the sum of debt and total stockholders' equity, net of cash, cash equivalents and marketable securities. The Company believes that the net debt-to-capital ratio, including marketable securities, is useful in understanding the leverage employed in its operations and in comparing it with other homebuilders. Homebuilding Overview The combined homebuilding operations reported pretax earnings from continuing operations of $303.5 million, $201.8 million and $62.6 million for 2014, 2013 and 2012, respectively. Homebuilding results in 2014 improved from those in 2013 primarily due to a rise in revenues; higher housing gross profit margin; a reduced selling, general and administrative expense ratio; and a decline in interest expense. Homebuilding results in 2013 improved from those in 2012 primarily due to a rise in closing volume; higher housing gross profit margin, including lower inventory and other valuation adjustments and write-offs; a decline in interest expense; and a reduced selling, general and administrative expense ratio. STATEMENTS OF EARNINGS YEAR ENDED DECEMBER 31, (in thousands, except units) REVENUES Housing $ 2,555,967 $ 2,082,838 $ 1,263,120 Land and other 13,934 6,537 7,727 TOTAL REVENUES 2,569,901 2,089,375 1,270,847 EXPENSES Housing cost of sales Cost of sales 1,998,379 1,649,223 1,017,124 Valuation adjustments and write-offs (77 ) 5,166 Total housing cost of sales 1,998,302 1,649,369 1,022,290 Land and other cost of sales 9,342 4,827 5,182 Total cost of sales 2,007,644 1,654,196 1,027,472 Selling, general and administrative 258,781 224,995 164,688 Interest - 8,358 16,118 TOTAL EXPENSES 2,266,425 1,887,549 1,208,278 PRETAX EARNINGS $ 303,476 $ 201,826 $ 62,569 Closings (units) 7,677 7,027 4,809 Housing gross profit margin 21.8 % 20.8 % 19.1 % Selling, general and administrative ratio 10.1 % 10.8 % 13.0 % Homebuilding revenues increased 23.0 percent to $2.6 billion for 2014 from $2.1 billion for 2013 primarily due to a 9.3 percent rise in closings and to a 12.5 percent increase in average closing price. The increase in closings was due to a higher backlog at the beginning of the year and to a 5.6 percent rise in new orders during 2014, versus 2013. The increase in average closing price was due to a change in the product and geographic mix of homes delivered during 2014, versus 2013, as well as to a more accommodating price environment. Homebuilding revenues increased 64.4 percent to $2.1 billion for 2013 from $1.3 billion for 2012 primarily due to a 46.1 percent rise in closings and to a 12.5 percent increase in average closing price. The increase in closings was due to a 27.0 percent rise in new orders during 2013, versus 2012. The increase in average closing price was due to price increases in existing communities, as well as to a change in the product and geographic mix of homes delivered during 2013, versus 2012. In order to manage its risk and return of land investments and monetize certain land positions, the Company executed several land and lot sales during the year. Homebuilding revenues included $13.9 million from land and lot sales for the year ended December 31, 2014, compared to $6.5 million for 2013 and $7.7 million for 2012, which resulted in pretax earnings of $4.6 million, $1.7 million and $2.5 million for 2014, 2013 and 2012, respectively. Gross profit margin from land and lot sales was 33.0 percent, 26.2 percent and 32.9 percent for the years ended December 31, 2014, 2013 and 2012, respectively. Fluctuations in revenues and gross profit percentages from land and lot sales are a product of local market conditions and changing land portfolios. The Company generally purchases land and lots with the intent to build homes on those lots and sell them; it will, however, occasionally sell a portion of its land to other homebuilders or third parties. Housing gross profit margin was 21.8 percent for the year ended December 31, 2014, compared to 20.8 percent for 2013. This improvement in housing gross profit margin was attributable to a relative decline in direct construction costs of 1.0 percent. Housing gross profit margin was 20.8 percent for the year ended December 31, 2013, compared to 19.1 percent for the year ended December 31, 2012. This improvement was primarily attributable to a relative reduction in direct construction costs of 1.7 percent and to lower inventory valuation adjustments and write-offs of 0.4 percent, partially offset by increased land costs of 0.5 percent. Inventory and other valuation adjustments and write-offs affecting housing gross profit margin decreased to $146,000 for the year ended December 31, 2013, from $5.2 million for 2012. The homebuilding segments' selling, general and administrative expense ratio totaled 10.1 percent of homebuilding revenues for 2014, 10.8 percent for 2013 and 13.0 percent for 2012. The year-over-year decreases in the selling, general and administrative expense ratio was primarily attributable to higher leverage resulting from increased revenues. In 2014, the homebuilding segment capitalized all interest incurred, resulting in no interest expense for the year ended December 31, 2014, compared to $8.4 million and $16.1 million of interest expense for the years ended December 31, 2013 and 2012, respectively. The year-over-year decreases in interest expense were primarily due to an increase in the amount of interest capitalized resulting from higher levels of inventory under development. Interest incurred, principally to finance land acquisitions, land development and home construction, totaled $68.8 million, $67.6 million and $58.4 million for the years ended December 31, 2014, 2013 and 2012, respectively. (See "Housing Inventories" within Note A, "Summary of Significant Accounting Policies.") New orders represent sales contracts that have been signed by the homebuyer and approved by the Company, subject to cancellations. The dollar value of new orders increased $345.9 million, or 15.2 percent, to $2.6 billion for 2014 from $2.3 billion for 2013. The dollar value of new orders increased due to a rise in new order units and to a higher average closing price. Unit orders increased 5.6 percent to 7,668 new orders in 2014, compared to 7,262 new orders in 2013. This increase in new orders was primarily attributable to a 21.0 percent increase in the number of active communities, partially offset by a 13.0 percent decline in sales absorption rates. The dollar value of new orders increased $729.5 million, or 47.2 percent, to $2.3 billion for the year ended December 31, 2013, from $1.5 billion for the year ended December 31, 2012. Unit orders increased 27.0 percent to 7,262 new orders in 2013, compared to 5,719 new orders in 2012. This increase in new orders was primarily attributable to a 21.8 percent increase in the number of active communities and to a 4.5 percent rise in sales absorption rates. For the years ended December 31, 2014, 2013 and 2012, cancellation rates totaled 18.9 percent, 17.7 percent and 19.0 percent, respectively. Consolidated inventory owned by the Company, which includes homes under construction; land under development and improved lots; and cash deposits related to consolidated inventory not owned, rose 24.3 percent to $2.0 billion at December 31, 2014, from $1.6 billion at December 31, 2013. Homes under construction increased 18.9 percent to $764.9 million at December 31, 2014, from $643.4 million at December 31, 2013. Land under development and improved lots increased 28.5 percent to $1.3 billion at December 31, 2014, compared to $973.3 million at December 31, 2013, as the Company opened more communities during 2014. The Company had 449 model homes with inventory values totaling $132.3 million at December 31, 2014, compared to 370 model homes with inventory values totaling $99.3 million at December 31, 2013. In addition, it had 1,024 started and unsold homes with inventory values totaling $252.4 million at December 31, 2014, compared to 977 started and unsold homes with inventory values totaling $196.2 million at December 31, 2013. The following table provides certain information with respect to the Company's number of residential communities and lots under development at December 31, 2014: COMMUNITIES ACTIVE NEW AND NOT YET OPEN INACTIVE HELD- FOR-SALE TOTAL TOTAL LOTS CONTROLLED1 North 13,886 Southeast 12,181 Texas - 7,263 West - - 6,266 Total 39,596 1Includes lots controlled through the Company's investments in joint ventures. Inactive communities consist of projects either under development or on hold for future home sales. At December 31, 2014, of the 9 communities that were held-for-sale, 6 communities had fewer than 20 lots remaining. Favorable affordability levels and slowly improving economic conditions in most housing submarkets have allowed the Company to focus on growing its number of active communities and increasing profitability, all while balancing those two objectives with cash preservation. During the year ended December 31, 2014, it secured 14,573 owned or optioned lots, opened 162 communities and closed 101 communities. The Company operated from 21.0 percent more active communities at December 31, 2014, than it did at December 31, 2013. The number of lots controlled was 38,973 lots at December 31, 2014, compared to 38,142 lots at December 31, 2013. Optioned lots, as a percentage of total lots controlled, were 35.1 percent and 38.3 percent at December 31, 2014 and December 31, 2013, respectively. In addition, the Company controlled 623 lots and 628 lots under joint venture agreements at December 31, 2014 and 2013, respectively. Homebuilding Segment Information The Company's homebuilding operations consist of four geographically determined regions, or reporting segments: North, Southeast, Texas and West. STATEMENTS OF EARNINGS The following table provides a summary of the results for the homebuilding segments for the years ended December 31, 2014, 2013 and 2012: (in thousands) NORTH Revenues $ 703,094 $ 617,550 $ 393,238 Expenses Cost of sales 554,634 498,084 324,572 Selling, general and administrative 72,106 63,990 51,120 Interest - 3,414 6,101 Total expenses 626,740 565,488 381,793 Pretax earnings $ 76,354 $ 52,062 $ 11,445 Housing gross profit margin 21.1 % 19.3 % 17.5 % SOUTHEAST Revenues $ 691,141 $ 597,933 $ 355,621 Expenses Cost of sales 525,311 467,494 286,450 Selling, general and administrative 70,393 64,451 46,774 Interest - 4,206 Total expenses 595,704 532,915 337,430 Pretax earnings $ 95,437 $ 65,018 $ 18,191 Housing gross profit margin 24.1 % 21.8 % 19.5 % TEXAS Revenues $ 550,916 $ 448,828 $ 323,162 Expenses Cost of sales 439,702 356,768 257,402 Selling, general and administrative 60,616 51,956 40,075 Interest - 1,277 2,876 Total expenses 500,318 410,001 300,353 Pretax earnings $ 50,598 $ 38,827 $ 22,809 Housing gross profit margin 20.2 % 20.5 % 20.4 % WEST Revenues $ 624,750 $ 425,064 $ 198,826 Expenses Cost of sales 487,997 331,850 159,048 Selling, general and administrative 55,666 44,598 26,719 Interest - 2,697 2,935 Total expenses 543,663 379,145 188,702 Pretax earnings $ 81,087 $ 45,919 $ 10,124 Housing gross profit margin 21.6 % 21.8 % 19.4 % TOTAL Revenues $ 2,569,901 $ 2,089,375 $ 1,270,847 Expenses Cost of sales 2,007,644 1,654,196 1,027,472 Selling, general and administrative 258,781 224,995 164,688 Interest - 8,358 16,118 Total expenses 2,266,425 1,887,549 1,208,278 Pretax earnings $ 303,476 $ 201,826 $ 62,569 Housing gross profit margin 21.8 % 20.8 % 19.1 % Homebuilding Segments 2014 versus 2013 North-Homebuilding revenues increased 13.9 percent to $703.1 million in 2014 from $617.6 million in 2013 primarily due to a 9.3 percent increase in the number of homes delivered and to a 4.3 percent rise in average closing price. The increase in the number of homes delivered was most impacted by the Company's entry into the Philadelphia market during July 2013. The rise in average closing price was primarily attributable to an increase in the Indianapolis and Baltimore markets, partially offset by a lower average closing price in the Philadelphia and Washington, D.C., markets due to a change in product mix. Gross profit margin on home sales was 21.1 percent in 2014, compared to 19.3 percent in 2013. This improvement in housing gross profit margin was primarily due to a relative decline in land costs of 2.1 percent and to a reduction in the fair value of acquisition-related contingent liabilities resulting in a 0.5 percent benefit to gross profit margin, partially offset by a relative increase in direct construction costs of 0.7 percent and by lower leverage of direct overhead expense of 0.3 percent. As a result, the North region generated pretax earnings of $76.4 million in 2014, compared to pretax earnings of $52.1 million in 2013. Southeast-Homebuilding revenues increased 15.6 percent to $691.1 million in 2014 from $597.9 million in 2013 primarily due to a 17.1 percent rise in average closing price, partially offset by a 1.3 percent decline in the number of homes delivered. All markets reported an increase in average closing price, except for Charlotte, which was relatively flat. The largest contributors to the increase in average closing price were the Atlanta, Charleston and Orlando markets. The increase in average closing price was due to the introduction of newer, higher-priced communities during 2014, as well as to a favorable pricing environment. Home deliveries declined in the Tampa, Orlando and Charleston markets due to a reduction in sales absorption rates. Gross profit margin on home sales was 24.1 percent in 2014, compared to 21.8 percent in 2013. This improvement in housing gross profit margin was primarily due to a relative decline in direct construction costs of 2.2 percent. As a result, the Southeast region generated pretax earnings of $95.4 million in 2014, compared to pretax earnings of $65.0 million in 2013. Texas-Homebuilding revenues increased 22.7 percent to $550.9 million in 2014 from $448.8 million in 2013 primarily due to an 11.7 percent rise in the number of homes delivered and to a 10.2 percent increase in average closing price. The rise in the number of homes delivered was primarily attributable to the Company's re-entry into the Dallas market in June 2013. The increase in average closing price was broad-based across all markets. Gross profit margin on home sales was 20.2 percent in 2014, compared to 20.5 percent in 2013. This decline in housing gross profit margin was primarily due to a relative increase in direct construction costs of 0.9 percent, partially offset by a relative decrease in land costs of 0.7 percent. As a result, the Texas region generated pretax earnings of $50.6 million in 2014, compared to pretax earnings of $38.8 million in 2013. West-Homebuilding revenues increased 47.0 percent to $624.8 million in 2014 from $425.1 million in 2013 primarily due to a 27.1 percent increase in the number of homes delivered and to a 14.3 percent rise in average closing price. The increase in the number of homes delivered was most impacted by significantly higher closings in the Southern California, Denver and Phoenix markets. The increase in average closing price was primarily attributable to a change in geographic and product mix, with the largest contribution coming from the Southern California market. Gross profit margin on home sales was 21.6 percent in 2014, compared to 21.8 percent in 2013. Gross profit margins decreased slightly due to higher relative land costs of 2.9 percent primarily in Southern California, partially offset by a relative decline in direct construction costs of 2.1 percent primarily due to leverage associated with increased base prices and to higher leverage of direct overhead expense of 0.2 percent. As a result, the West region generated pretax earnings of $81.1 million in 2014, compared to pretax earnings of $45.9 million in 2013. Homebuilding Segments 2013 versus 2012 North-Homebuilding revenues increased 57.0 percent to $617.6 million in 2013 from $393.2 million in 2012 primarily due to a 48.1 percent rise in the number of homes delivered and to a 5.9 percent increase in average closing price. The increase in the number of homes delivered was broad-based across all markets, with the largest contributions coming from the Chicago, Washington, D.C., and Indianapolis markets. The rise in average closing price was primarily attributable to modest price increases and to the mix of homes delivered in the Baltimore market. Gross profit margin on home sales was 19.3 percent in 2013, compared to 17.5 percent in 2012. This improvement was primarily due to reduced relative direct construction costs of 1.5 percent and to lower option deposit write-offs of 0.8 percent, partially offset by higher land costs of 0.5 percent. As a result, the North region generated pretax earnings of $52.1 million in 2013, compared to pretax earnings of $11.4 million in 2012. Southeast-Homebuilding revenues increased 68.1 percent to $597.9 million in 2013 from $355.6 million in 2012 primarily due to a 46.9 percent rise in the number of homes delivered and to a 14.7 percent increase in average closing price. The increases in the number of homes delivered and average closing price were broad-based across all markets, as general market conditions improved in the region. Gross profit margin on home sales was 21.8 percent in 2013, compared to 19.5 percent in 2012. This improvement was primarily due to reduced relative direct construction costs of 1.3 percent; lower land costs of 0.6 percent; and higher leverage of direct overhead expense of 0.4 percent, which was due to an increase in the number of homes delivered and to a higher average closing price. As a result, the Southeast region generated pretax earnings of $65.0 million in 2013, compared to pretax earnings of $18.2 million in 2012. Texas-Homebuilding revenues increased 38.9 percent to $448.8 million in 2013 from $323.2 million in 2012 primarily due to a 21.9 percent rise in the number of homes delivered and to a 13.9 percent increase in average closing price. The rise in the number of homes delivered was impacted by the Company's re-entry into the Dallas market in the second quarter of 2013 and to increases in demand and the number of communities in the Houston market. The increase in average closing price was broad-based across all markets. Gross profit margin on home sales was 20.5 percent in 2013, compared to 20.4 percent in 2012. This improvement was primarily due to reduced relative direct construction costs of 0.1 percent; lower land costs of 0.1 percent; and a decrease in warranty costs of 0.1 percent, partially offset by higher mortgage and closing costs of 0.2 percent. As a result, the Texas region generated pretax earnings of $38.8 million in 2013, compared to pretax earnings of $22.8 million in 2012. West-Homebuilding revenues increased 113.8 percent to $425.1 million in 2013 from $198.8 million in 2012 primarily due to an 88.4 percent rise in the number of homes delivered and to a 15.6 percent increase in average closing price. The increase in the number of homes delivered was broad-based across all markets, with the largest contributions coming from the Las Vegas and Southern California markets and from the Company's re-entry into the Phoenix market in the fourth quarter of 2012. The increase in average closing price was most dramatic in the Southern California and Las Vegas markets, partially offset by a slightly lower price mix of homes in the Denver market. Gross profit margin on home sales was 21.8 percent in 2013, compared to 19.4 percent in 2012. This improvement was primarily due to reduced relative direct construction costs of 2.0 percent and to lower inventory valuation adjustments of 1.0 percent, partially offset by increased land costs of 0.8 percent. As a result, the West region generated pretax earnings of $45.9 million in 2013, compared to pretax earnings of $10.1 million in 2012. New Orders Historically, new order activity is higher in the spring and summer months. As a result, the Company typically has more homes under construction, closes more homes, and has greater revenues and operating income in the third and fourth quarters of its fiscal year. Historical results, however, are not necessarily indicative of current or future homebuilding activities. The following table provides the Company's new orders (units and aggregate sales values) for the years ended December 31, 2014, 2013 and 2012: % CHG % CHG % CHG UNITS North 2,185 (2.7 )% 2,245 42.9 % 1,571 32.0 % Southeast 2,265 1.3 2,236 15.5 1,936 65.2 Texas 1,629 (1.3 ) 1,651 28.4 1,286 19.4 West 1,589 40.6 1,130 22.0 182.3 Total 7,668 5.6 % 7,262 27.0 % 5,719 51.8 % DOLLARS (in millions) North $ (0.4 )% $ 50.9 % $ 41.5 % Southeast 16.7 36.2 79.3 Texas 7.1 47.7 26.7 West 46.5 58.2 177.1 Total $ 2,620 15.2 % $ 2,274 47.2 % $ 1,545 61.9 % New orders increased 5.6 percent to 7,668 units for the year ended December 31, 2014, from 7,262 units for 2013, and new order dollars rose 15.2 percent for 2014, compared to 2013. The overall increase in new orders was primarily due to a 21.0 percent rise in active communities, partially offset by a decrease in sales absorption rates. The Company's Phoenix, Raleigh, Southern California, Denver and Philadelphia markets had the largest year-over-year increases in new orders. Additionally, the Company's entry into Philadelphia and re-entry into Dallas in the latter half of 2013 contributed to its overall increase in new orders for 2014. The Company's average monthly sales absorption rate was 2.0 homes per community for 2014, versus 2.3 and 2.2 homes per community for the same periods in 2013 and 2012, respectively. New orders for 2014 declined 2.7 percent in the North, compared to the same period in 2013, primarily due to a decrease in the sales absorption rate, partially offset by an increase in the number of active communities. New orders for 2014 rose 1.3 percent in the Southeast, compared to the same period in 2013, primarily due an increase in the number of active communities. New orders for 2014 declined 1.3 percent in Texas, compared to 2013, primarily due to a decrease in the sales absorption rate, partially offset by an increase in the number of active communities. New orders for 2014 rose 40.6 percent in the West, compared to the same period in 2013, primarily due to an increase in the number of active communities and to a rise in the sales absorption rate. New orders for 2013 rose 42.9 percent in the North, compared to 2012, primarily due to an increase in the number of active communities and to higher sales absorption rates. New orders for 2013 rose 15.5 percent in the Southeast, compared to 2012, primarily due to an increase in the number of active communities, partially offset by lower sales absorption rates. New orders for 2013 rose 28.4 percent in Texas, compared to 2012, primarily due to an increase in the number of active communities and to higher sales absorption rates. New orders for 2013 rose 22.0 percent in the West, compared to 2012, primarily due to an increase in the number of active communities, partially offset by lower sales absorption rates. The following table provides the number of the Company's active communities: DECEMBER 31, % CHG % CHG % CHG North 23.8 % 25.4 % 8.1 % Southeast 16.9 4.7 39.3 Texas 10.8 45.6 (14.9 ) West 50.0 17.2 38.1 Total 21.0 % 21.8 % 12.8 % The following table provides the Company's cancellation rates for the years ended December 31, 2014, 2013 and 2012: North 18.4 % 15.8 % 19.4 % Southeast 17.9 18.0 18.3 Texas 21.2 20.4 22.2 West 18.4 16.7 14.9 Total 18.9 % 17.7 % 19.0 % The Company reported an overall slight increase in cancellation rates during 2014, compared to the same period in 2013. Cancellation rates increased the most in the Baltimore, Philadelphia, Chicago, Orlando and Dallas markets. Cancellations were primarily due to continued challenges in the availability of homeowner financing and in the ability to qualify homebuyers. The following table provides the Company's sales incentives and price concessions (average dollar value per unit closed and percentage of revenues) for the years ended December 31, 2014, 2013 and 2012: (in thousands) AVG $ PER UNIT % OF REVENUES AVG $ PER UNIT % OF REVENUES AVG $ PER UNIT % OF REVENUES North $ 6.2 % $ 5.4 % $ 8.0 % Southeast 6.9 7.2 9.3 Texas 9.4 10.9 13.5 West 4.4 3.8 6.3 Total $ 6.7 % $ 6.8 % $ 9.6 % Closings The following table provides the Company's closings and average closing prices for the years ended December 31, 2014, 2013 and 2012: % CHG % CHG % CHG UNITS North 2,220 9.3 % 2,032 48.1 % 1,372 23.9 % Southeast 2,284 (1.3 ) 2,315 46.9 1,576 59.5 Texas 1,691 11.7 1,514 21.9 1,242 19.0 West 1,482 27.1 1,166 88.4 125.9 Total 7,677 9.3 % 7,027 46.1 % 4,809 40.9 % AVERAGE PRICE (in thousands) North $ 4.3 % $ 5.9 % $ 5.5 % Southeast 17.1 14.7 3.2 Texas 10.2 13.9 3.2 West 14.3 15.6 7.2 Total $ 12.5 % $ 12.5 % $ 4.8 % Outstanding Contracts Outstanding contracts denote the Company's backlog of homes sold, but not closed, which are generally built and closed, subject to cancellations, over the subsequent two quarters. At December 31, 2014, the Company's outstanding contracts were flat at 2,617 units, compared to 2,626 units at December 31, 2013. The $919.0 million value of outstanding contracts at December 31, 2014, represented a 7.5 percent increase from $854.8 million at December 31, 2013, primarily due to a 7.7 percent rise in average sales price. The following table provides the Company's outstanding contracts (units, aggregate dollar values and average prices) at December 31, 2014, 2013 and 2012: UNITS DOLLARS (in millions) AVERAGE PRICE (in thousands) UNITS DOLLARS (in millions) AVERAGE PRICE (in thousands) UNITS DOLLARS (in millions) AVERAGE PRICE (in thousands) North $ $ $ $ $ $ Southeast Texas West Total 2,617 $ $ 2,626 $ $ 2,391 $ $ At December 31, 2014, the Company anticipates that approximately 49 percent of its outstanding contracts will close during the first quarter of 2015, subject to cancellations. Impairments As required by the Financial Accounting Standards Board's ("FASB") Accounting Standards Codification ("ASC") No. 360 ("ASC 360"), "Property, Plant and Equipment," inventory is reviewed for potential impairments on an ongoing basis. ASC 360 requires that, in the event that impairment indicators are present and undiscounted cash flows signify that the carrying amount of an asset is not recoverable, impairment charges must be recorded if the fair value of the asset is less than its carrying amount. (See "Housing Inventories" within Note A, "Summary of Significant Accounting Policies.") There were no inventory valuation adjustments for the years ended December 31, 2014 or 2013, compared to $1.9 million in inventory valuation adjustments in 2012 that were due to declining prices resulting from the competitive pressures of new, resale and distressed properties. The Company periodically writes off earnest money deposits and preacquisition feasibility costs related to land and lot option purchase contracts that it no longer plans to pursue. The Company wrote off $2.5 million, $1.9 million, and $996,000 in preacquisition feasibility costs during the years ended 2014, 2013 and 2012, respectively. Additionally, the Company wrote off $3.2 million of earnest money deposits during 2012. Should homebuilding market conditions weaken or the Company be unsuccessful in renegotiating certain land option purchase contracts, it may write off additional earnest money deposits and preacquisition feasibility costs in future periods. During 2014 and 2013, no communities were impaired. During 2012, one community in the West where the Company expects to build homes was impaired for a total of $1.9 million. Should market conditions deteriorate or costs increase, it is possible that the Company's estimates of undiscounted cash flows from its communities could decline, resulting in additional future impairment charges. Additionally, the Company recorded $1.9 million of inventory and other valuation adjustments and write-offs associated with its discontinued operations in 2012. Investments in Joint Ventures As of December 31, 2014, the Company participated in six active homebuilding joint ventures in the Austin, Chicago, Denver, San Antonio and Washington, D.C., markets. These joint ventures exist for the purpose of acquisition and co-development of land parcels and lots, which are then sold to the Company, its joint venture partners or others at market prices. The Company's investments in its unconsolidated joint ventures totaled $12.6 million at December 31, 2014, compared to $13.6 million at December 31, 2013, which included $837,000 and $987,000 of capitalized interest, respectively. The Company's equity in earnings from its unconsolidated joint ventures totaled $1.4 million for the year ended December 31, 2014, and $1.2 million for the years ended December 31, 2013 and 2012. (See "Investments in Joint Ventures" within Note A, "Summary of Significant Accounting Policies.") Financial Services The Company's financial services segment provides mortgage-related products and services, as well as title and escrow services, to its homebuyers. By aligning its operations with the Company's homebuilding segments, the financial services segment leverages this relationship to offer its lending services to homebuyers, which, in turn, helps the Company monitor its backlog and closing process. RMC's mortgage origination operations consisted primarily of mortgage loans originated in connection with sales of the Company's homes. The mortgage capture rate represents the percentage of homes closed and available to capture by the Company that were financed with mortgage loans obtained by RMC. Substantially all of the loans the Company originates are sold to third party investors within a short period of time in the secondary mortgage market on a servicing-released basis. The third-party investor then services and manages the loans. The fair values of the Company's mortgage loans held-for-sale totaled $153.4 million and $139.6 million at December 31, 2014 and 2013, respectively. STATEMENTS OF EARNINGS YEAR ENDED DECEMBER 31, (in thousands, except units) REVENUES Income from origination and sale of mortgage loans, net $ 32,529 $ 39,158 $ 28,634 Title, escrow and insurance 10,406 9,990 7,199 Interest and other 2,233 2,232 1,786 TOTAL REVENUES 45,168 51,380 37,619 EXPENSES 37,860 31,312 24,477 OTHER INCOME - - PRETAX EARNINGS $ 7,447 $ 20,068 $ 13,142 Originations (units) 3,914 4,007 3,039 Ryland Homes origination capture rate 61.0 % 66.3 % 68.1 % Mortgage originations totaled 3,914 in 2014, compared to 4,007 in 2013 and 3,039 in 2012. During 2014 and 2013, origination volume totaled $1.1 billion and $1.0 billion, respectively. The capture rate of mortgages originated for customers of the Company's homebuilding operations was 61.0 percent in 2014, compared to 66.3 percent in 2013 and 68.1 percent in 2012. These declines in capture rates were primarily due to increased competition in the mortgage marketplace, as well as to the gradual introduction of mortgage-related products and services into new markets. Approximately nine percent of the Company's homebuyers did not finance their home purchase with a mortgage. The financial services segment reported pretax earnings of $7.4 million, $20.1 million and $13.1 million for the years ended December 31, 2014, 2013 and 2012, respectively. The decrease in pretax earnings for 2014, compared to 2013, was primarily attributable to a decrease in locked loan pipeline volume, which was due, in part, to the reversal of the accelerated timing of loan locks during 2013; an increase in litigation expense; and higher expense related to a change in estimate of ultimate insurance loss liability. The rise in pretax earnings for 2013, compared to 2012, was primarily due to increases in locked loan pipeline and origination volumes, as well as to a rise in title income, partially offset by increased personnel costs and higher expense related to estimates of ultimate insurance loss liability. The increase in the locked loan pipeline was due, in part, to an acceleration in the timing of loan locks during the second and third quarters of 2013, which resulted from a rapid increase in mortgage interest rates during that period. Reversion of the unusually high level of the Company's locked loan pipeline to more typical levels began in the fourth quarter of 2013 and continued in 2014. Revenues for the financial services segment totaled $45.2 million in 2014, compared to $51.4 million in 2013 and $37.6 million in 2012. The 12.1 percent decrease in revenues for 2014, compared to 2013, was primarily attributable to the decrease in new lock volume and to a 5.3 percent reduction in capture rate, partially offset by a 5.0 percent increase in origination volume and higher title income. The 36.6 percent increase in revenues for 2013, compared to 2012, was primarily due to increases in locked loan pipeline and origination volumes, as well as to a rise in title income. Interest income is earned from the date a mortgage loan is originated until the loan is sold. During 2014, financial services expense totaled $37.9 million and included $16.0 million related to direct expenses of RMC's mortgage operations; $8.7 million in title and insurance expenses; $7.6 million in corporate and other general and administrative expenses; and $5.6 million in loan indemnification and related litigation expense. The increase in financial services expense for 2014, compared to 2013, was primarily due to an increase in litigation expense resulting from the Countrywide settlement, as well as to $1.8 million higher expense related to a change in estimate of ultimate insurance loss liability. Financial services expense totaled $31.3 million and $24.5 million for 2013 and 2012, respectively. The rise in financial services expense for 2013 from 2012 was primarily attributable to increased personnel costs and higher expense related to estimates of ultimate insurance loss liability. (See Note L, "Commitments and Contingencies.") In 2014, 96.0 percent of the loans originated by RMC had fixed interest rates. Of the mortgage loans it originated, 67.6 percent were prime loans and 32.4 percent were government loans. Prime mortgage loans are generally defined as agency-eligible loans (Fannie Mae/Freddie Mac) and any nonconforming loans that would otherwise meet agency criteria. In 2014, the Company's borrowers had Fair Isaac Corporation ("FICO") credit scores that averaged 732. During 2014, RMC did not originate mortgage loans classified as subprime, reduced documentation or pay-option adjustable-rate. During 2014, the mortgage loans originated by RMC were sold to third-party investors. The Company has two repurchase credit facilities to fund, and are secured by, mortgages that were originated by RMCMC and are pending sale. Generally, the Company is required to indemnify its investors to which mortgage loans are sold if it is shown that there has been undiscovered fraud on the part of the borrower; if there are losses due to origination deficiencies attributable to RMC; or if the borrower does not make a first payment. RMC is typically not required to repurchase mortgage loans. Income Taxes Deferred tax assets are recognized for estimated tax effects that are attributable to deductible temporary differences and tax carryforwards related to tax credits and NOLs. They are realized when existing temporary differences are carried back to a profitable year(s) and/or carried forward to a future year(s) having taxable income. Deferred tax assets are reduced by a valuation allowance if an assessment of their components indicates that it is more likely than not that all or some portion of these assets will not be realized. In the assessment for a valuation allowance, appropriate consideration is given to all positive and negative evidence related to the realization of the deferred tax assets. This assessment considers, among other matters, the nature, frequency and severity of current and cumulative losses; actual earnings; forecasts of future earnings; the duration of statutory carryforward periods; the Company's experience with NOL carryforwards not expiring unused; and tax planning alternatives. In 2013, the Company determined that it was more likely than not that its deferred tax assets would be realized, which resulted in a $258.9 million reversal of the valuation allowance against its deferred tax assets. At December 31, 2014, the Company had no federal NOL carryforwards remaining and no valuation allowance against its deferred tax assets. (See Note I, "Income Taxes.") Financial Condition and Liquidity The Company has historically funded its homebuilding and financial services operations with cash flows from operating activities; the issuance of new debt securities; borrowings from revolving credit facilities; and borrowings under financial services credit facilities. Under current market conditions, the Company is focused on maintaining a strong balance sheet by generating cash from existing communities and by extending debt maturities when market conditions are favorable, as well as by investing in new communities to facilitate continued growth and profitability. As a result of this strategy, the Company opened 162 new communities during 2014; has senior debt and convertible senior debt with various maturities until 2022 (See Note H, "Debt and Credit Facilities."); and ended the year with $580.0 million in cash, cash equivalents and marketable securities. Additionally, the Company had $232.3 million available under an unsecured revolving credit facility at December 31, 2014. DECEMBER 31, (in millions) Cash, cash equivalents and marketable securities $ $ Housing inventories1 2,031 1,634 Debt 1,403 1,397 Stockholders' equity $ 1,085 $ Net debt-to-capital ratio, including marketable securities 43.1 % 45.8 % 1Excludes consolidated inventory not owned, net of cash deposits. Consolidated inventory owned by the Company increased 24.3 percent to $2.0 billion at December 31, 2014, compared to $1.6 billion at December 31, 2013. The Company continues to grow at a healthy rate and strives to maintain a projected four- to five-year supply of land. At December 31, 2014, it controlled 38,973 lots, with 25,303 lots owned and 13,670 lots, or 35.1 percent, under option. Lots controlled increased 2.2 percent at December 31, 2014, from 38,142 lots controlled at December 31, 2013. The Company also controlled 623 lots and 628 lots under joint venture agreements at December 31, 2014 and December 31, 2013, respectively. (See "Housing Inventories" and "Investments in Joint Ventures" within Note A, "Summary of Significant Accounting Policies.") At December 31, 2014, the Company's net debt-to-capital ratio, including marketable securities, decreased to 43.1 percent from 45.8 percent at December 31, 2013. The Company remains focused on maintaining its liquidity so that it can be flexible in reacting to changing market conditions. The Company had $580.0 million and $631.2 million in cash, cash equivalents and marketable securities at December 31, 2014 and 2013, respectively. During 2014, the Company used $95.3 million of cash for operating activities, which included cash outflows related to a $406.8 million increase in inventories and a $13.8 million increase in mortgage loans held-for-sale, partially offset by cash inflows of $219.8 million from current period net income from continuing operations; $94.1 million from a decline in deferred income taxes; and a net cash inflow of $11.4 million from changes in other assets, liabilities, excess tax benefits and other operating activities. Investing activities provided $277.6 million, which included cash inflows of $298.2 million related to net reductions in investments in marketable securities and $2.6 million related to a net return of investments in unconsolidated joint ventures, partially offset by cash outflows of $23.1 million related to an increase in property, plant and equipment. Financing activities provided $110.9 million, which included cash inflows of $56.3 million from borrowings against the Company's financial services revolving credit facilities; $54.3 million related to a decrease in restricted cash; $33.9 million from the issuance of common stock under stock-based compensation; and $5.1 million from an increase in short-term borrowings, partially offset by cash outflows of $29.7 million for common stock repurchases; payments of $5.6 million for dividends; and $3.3 million of other financing activities. Net cash provided by continuing operations during 2014 totaled $293.2 million. During 2013, the Company used $260.0 million of cash for operating activities from continuing operations, which included cash outflows related to a $542.0 million increase in inventories and a $31.6 million increase in mortgage loans held-for-sale, partially offset by net cash inflows of $162.3 million from current year net income from continuing operations, which included a $258.9 million decrease in the deferred tax valuation allowance; $78.3 million from net changes in assets and liabilities, and other operating activities; and $73.0 million from a decline in deferred income taxes. Investing activities from continuing operations used $907,000, which included cash outflows of $50.9 million related to business acquisitions; $19.9 million related to property, plant and equipment; and $3.2 million related to net contributions to unconsolidated joint ventures, partially offset by cash inflows of $73.1 million related to net reductions in investments in marketable securities. Financing activities from continuing operations provided $330.8 million, which included cash inflows of a $262.2 million related to a net increase in senior debt and short-term borrowings; $73.1 million in borrowings against the Company's financial services credit facility; and $28.2 million from the issuance of common stock under stock-based compensation, partially offset by cash outflows related to an increase of $19.1 million in restricted cash; $8.0 million in other financing activities; and payments of $5.5 million for dividends. Net cash provided by continuing operations during 2013 totaled $69.9 million. During 2012, the Company used $111.1 million of cash for operating activities from continuing operations, which included cash outflows related to a $236.5 million increase in inventories and a $25.6 million increase in mortgage loans held-for-sale, partially offset by net cash inflows of $79.4 million from current year net income from continuing operations, which included an $11.6 million decrease in the deferred tax valuation allowance, and $71.6 million from changes in assets and liabilities, and other operating activities. Investing activities from continuing operations used $125.1 million, which included cash outflows of $80.2 million related to business acquisitions; $35.1 million related to net investments in marketable securities; and $12.2 million related to property, plant and equipment, partially offset by cash inflows of $2.3 million related to a net return of investment in unconsolidated joint ventures and to $109,000 of other investing activities. Financing activities from continuing operations provided $235.0 million, which included cash inflows related to a $299.9 million net increase in senior debt and short-term borrowings and to $14.4 million from the issuance of common stock under stock-based compensation, partially offset by cash outflows related to a $49.9 million decrease in borrowings against the Company's financial services credit facility; an increase of $13.8 million in restricted cash; $10.1 million in other financing activities; and payments of $5.4 million for dividends. Net cash used for continuing operations during 2012 totaled $1.2 million. Dividends declared totaled $0.12 per share for the annual periods ended December 31, 2014, 2013 and 2012. For the year ended December 31, 2014, borrowing arrangements for the Company included senior notes, convertible senior notes, a revolving credit facility, financial services credit facilities and nonrecourse secured notes payable. Senior Notes and Convertible Senior Notes Senior notes outstanding, net of discount, totaled $1.4 billion at December 31, 2014 and 2013. In January 2015, the Company used existing cash of $126.5 million to settle its 5.4 percent senior notes that matured. (See Note P, "Subsequent Event.") During 2013, the Company issued $267.5 million of 0.25 percent convertible senior notes due June 2019. The Company will pay interest on the notes on June 1 and December 1 of each year, which commenced on December 1, 2013. The notes, which mature on June 1, 2019, are initially convertible into shares of the Company's common stock at a conversion rate of 13.3307 shares per $1,000 of their principal amount. This corresponds to an initial conversion price of approximately $75.01 per share. The conversion rate of the notes is subject to adjustment for a notice of redemption or for certain events. The Company received net proceeds of $260.1 million from this offering prior to offering expenses. The Company used these proceeds for general corporate purposes. (See Note H, "Debt and Credit Facilities.") During 2012, the Company issued $250.0 million of 5.4 percent senior notes due October 2022. The Company will pay interest on the notes on April 1 and October 1 of each year, which commenced on April 1, 2013. The notes will mature on October 1, 2022, and may be redeemed at the stated redemption price, in whole or in part, at the option of the Company at any time. (See Note H, "Debt and Credit Facilities.") Additionally during 2012, the Company issued $225.0 million of 1.6 percent convertible senior notes due May 2018. The Company will pay interest on the notes on May 15 and November 15 of each year, which commenced on November 15, 2012. At any time prior to the close of business on the business day immediately preceding the stated maturity date, holders may convert all or any portion of their convertible senior notes. These notes will mature on May 15, 2018, unless converted earlier by the holder, at its option, or purchased by the Company upon the occurrence of a fundamental change. These notes are initially convertible into shares of the Company's common stock at a conversion rate of 31.2168 shares per $1,000 of their principal amount. This corresponds to an initial conversion price of approximately $32.03 per share. The conversion rate of the notes is subject to adjustment for a notice of redemption or for certain events. (See Note H, "Debt and Credit Facilities.") Senior notes and indenture agreements are subject to certain covenants that include, among other things, restrictions on additional secured debt and the sale of assets. The Company was in compliance with these covenants at December 31, 2014. The Company's obligations to pay principal, premium and interest under its senior notes and convertible senior notes are guaranteed on a joint and several basis by substantially all of its 100 percent-owned homebuilding subsidiaries ("the Guarantor Subsidiaries"). Such guarantees are full and unconditional. (See Note M, "Supplemental Guarantor Information.") Unsecured Revolving Credit Facility During 2014, the Company entered into a $300.0 million unsecured four-year revolving credit facility agreement (the "Credit Facility"). The Credit Facility provides for a $300.0 million revolving credit facility (the "Revolving Credit Facility"), which includes a $150.0 million letter of credit subfacility (the "Letter of Credit Subfacility") and a $25.0 million swing line facility. In addition, the Credit Facility includes an accordion feature pursuant to which the commitments under the Revolving Credit Facility may be increased, from time to time, up to a principal amount not to exceed $450.0 million, subject to the terms and conditions set forth in the agreement. The commitments for the Letter of Credit Subfacility are not to exceed half of the amount of the commitments for the Revolving Credit Facility. The Credit Facility, which matures on November 21, 2018, provides for the commitments to be extended for up to two additional one-year periods, subject to satisfaction of the terms and conditions set forth therein. The obligation of the lenders to make advances or issue letters of credit under the Credit Facility is subject to the satisfaction of certain conditions set forth in the credit agreement. If the leverage ratio of the Company and its homebuilding segment subsidiaries exceeds certain thresholds as set forth in the Credit Facility, availability under the Revolving Credit Facility will be subject to a borrowing base as set forth in the agreement. The Credit Facility contains various representations and warranties, as well as affirmative, negative and financial covenants that the Company considers customary for financings of this type. The financial covenants in the Credit Facility include a maximum leverage ratio covenant; a minimum net worth test; and a minimum interest coverage test or a minimum liquidity test. The financial services segment subsidiaries of the Company are unrestricted subsidiaries under the Credit Facility and certain covenants of the agreement do not apply to the unrestricted subsidiaries. The Credit Facility includes event of default provisions that the Company considers customary for financings of this type. If an event of default under the Credit Facility occurs and is continuing, the commitments under the agreement may be terminated; the amounts outstanding, including all accrued interest and unpaid fees, may be declared payable immediately; and the Company may be required to cash collateralize the outstanding letters of credit issued under this facility. The Credit Facility will be used for general corporate purposes. Certain letters of credit issued and outstanding prior to the Company's entry into the Credit Facility have been deemed letters of credit under the facility and made subject to its terms. Amounts borrowed under the Credit Facility are guaranteed on a joint and several basis by substantially all of the Company's 100 percent-owned homebuilding subsidiaries. Such guarantees are full and unconditional. (See Note M, "Supplemental Guarantor Information.") Outstanding borrowings under the Credit Facility will bear interest at a fluctuating rate per annum that is equal to the base rate or the reserve adjusted LIBOR rate in each case, plus an applicable margin determined based on changes in the leverage ratio of the Company and its homebuilding segment subsidiaries. The Company did not have any outstanding borrowings against the Revolving Credit Facility at December 31, 2014. Under the Letter of Credit Subfacility, however, the Company had unsecured letters of credit outstanding that totaled $67.7 million at December 31, 2014. The unused borrowing capacity of the Credit Facility at December 31, 2014, totaled $232.3 million. Financial Services Credit Facilities During 2014, RMCMC entered into a $50.0 million warehouse line of credit with Comerica Bank, which will expire in April 2015. This facility is used to fund, and is secured by, mortgages that were originated by RMCMC and are pending sale. Under the terms of this facility, RMCMC is required to maintain various financial and other covenants and to satisfy certain requirements relating to the mortgages securing the facility. At December 31, 2014, RMCMC was in compliance with these covenants and had outstanding borrowings against this facility that totaled $48.5 million. The weighted-average effective interest rate on the outstanding borrowings against this facility was 3.0 percent at December 31, 2014. During 2011, RMCMC entered into a $50.0 million repurchase credit facility with JPMorgan Chase Bank, N.A. ("JPM"), which was subsequently increased to $75.0 million during 2012 and to $100.0 million during 2014, and will expire in November 2015. This facility is used to fund, and is secured by, mortgages that were originated by RMCMC and are pending sale. Under the terms of the facility, RMCMC is required to maintain various financial and other covenants and to satisfy certain requirements relating to the mortgages securing the facility. At December 31, 2014, RMCMC was in compliance with these covenants and had outstanding borrowings against this facility that totaled $80.9 million and $73.1 million at December 31, 2014 and 2013, respectively. The weighted-average effective interest rates on the outstanding borrowings against this facility were 3.2 percent and 3.4 percent at December 31, 2014 and 2013, respectively. Letter of Credit Agreements To provide letters of credit required in the ordinary course of its business, the Company has various secured letter of credit agreements requiring it to maintain restricted cash deposits for outstanding letters of credit. Outstanding letters of credit totaled $33.3 million and $93.6 million under these agreements at December 31, 2014 and 2013, respectively. Additionally, the Company had unsecured letters of credit outstanding that totaled $67.7 million at December 31, 2014, under its revolving credit facility. Nonrecourse Secured Notes Payable To finance its land purchases, the Company may also use nonrecourse secured notes payable. At December 31, 2014 and 2013, outstanding seller-financed nonrecourse secured notes payable totaled $5.8 million and $689,000, respectively. Financial Services Subsidiaries The financial services segment uses funds made available under the repurchase credit facilities, cash generated internally and existing equity to finance its operations. Other In January 2015, the Company filed a shelf registration with the SEC. The registration statement provides that securities may be offered, from time to time, in one or more series and in the form of senior, subordinated or convertible debt; preferred stock; preferred stock represented by depository shares; common stock; stock purchase contracts; stock purchase units; and warrants to purchase both debt and equity securities. The Company filed this registration statement to replace the prior registration statement that expired January 27, 2015. In the future, the Company intends to continue to maintain effective shelf registration statements that will facilitate access to the capital markets. The timing and amount of future offerings, if any, will depend on market and general business conditions. The Company repurchased 860,000 shares of its outstanding common stock during 2014. The Company had existing authorization of $112.6 million from its Board of Directors to purchase 2.9 million additional shares, based on its stock price at December 31, 2014. This authorization does not have an expiration date. During 2013, the Company did not repurchase any shares of its outstanding common stock. Outstanding shares of common stock totaled 46,296,045 and 46,234,809 at December 31, 2014 and 2013, respectively. The following table provides a summary of the Company's contractual cash obligations and commercial commitments at December 31, 2014, and the effect such obligations are expected to have on its future liquidity and cash flow: (in thousands) TOTAL 2016-2017 2018-2019 AFTER 2019 Debt, principal maturities $ 1,534,141 $ 257,854 $ 233,787 $ 492,500 $ 550,000 Interest on debt 284,318 60,357 104,255 69,456 50,250 Operating leases 16,747 5,224 7,306 3,325 Land option contracts1 1,283 1,283 - - - Total at December 31, 2014 $ 1,836,489 $ 324,718 $ 345,348 $ 565,281 $ 601,142 1Represents obligations under option contracts with specific performance provisions, net of cash deposits. The Company is focused on managing overhead expense, land acquisition, development and homebuilding construction activity in conjunction with opportunistic debt offerings in order to maintain liquidity and appropriate debt levels commensurate with its existing business and growth expectations. The Company believes that it will be able to continue to fund its homebuilding and financial services operations through its existing cash resources, cash generation capabilities, amounts available under its credit facilities, and issuances of replacement and new debt. Off-Balance Sheet Arrangements In the ordinary course of business, the Company enters into land and lot option purchase contracts in order to procure land or lots for the construction of homes. Land and lot option purchase contracts enable the Company to control significant lot positions with a minimal capital investment, thereby reducing the risks associated with land ownership and development. At December 31, 2014, the Company had $72.8 million in cash deposits and letters of credit outstanding pertaining to land and lot option purchase contracts with an aggregate purchase price of $847.1 million, of which option contracts totaling $1.4 million contained specific performance provisions. At December 31, 2013, the Company had $73.0 million in cash deposits and letters of credit outstanding pertaining to land and lot option purchase contracts with an aggregate purchase price of $869.1 million, of which option contracts totaling $2.5 million contained specific performance provisions. Additionally, the Company's liability is generally limited to forfeiture of nonrefundable deposits, letters of credit and other nonrefundable amounts incurred. Pursuant to ASC No. 810 ("ASC 810"), "Consolidation," the Company consolidated $30.8 million and $33.2 million of inventory not owned related to land and lot option purchase contracts at December 31, 2014 and 2013, respectively. (See "Variable Interest Entities" within Note A, "Summary of Significant Accounting Policies.") At December 31, 2014 and 2013, the Company had outstanding letters of credit under secured letter of credit agreements that totaled $33.3 million and $93.6 million, respectively. Additionally, the Company had $67.7 million of unsecured letters of credit under its Credit Facility at December 31, 2014. The Company had development or performance bonds that totaled $189.4 million, issued by third parties, to secure performance under various contracts and obligations related to land or municipal improvements at December 31, 2014, compared to $138.9 million at December 31, 2013. The Company expects that the obligations secured by these letters of credit and performance bonds will generally be satisfied in the ordinary course of business and in accordance with applicable contractual terms. To the extent that the obligations are fulfilled, the related letters of credit and performance bonds will be released, and the Company will not have any continuing obligations. The Company has no material third-party guarantees other than those associated with its senior notes. (See Note M, "Supplemental Guarantor Information.") Critical Accounting Policies Preparation of the Company's consolidated financial statements requires the use of judgment in the application of accounting policies and estimates of inherently uncertain matters. Listed below are those policies that management believes are critical and require the use of complex judgment in their application. There are items within the financial statements that require estimation, but they are not considered critical. Management has discussed the critical accounting policies with the Audit Committee of its Board of Directors, and the Audit Committee has reviewed the disclosure. Use of Estimates In budgeting land acquisitions, development and homebuilding construction costs associated with real estate projects, the Company evaluates market conditions; material and labor costs; buyer preferences; construction timing; and provisions for insurance, mortgage loan reserves and warranty obligations. The Company accrues its best estimate of probable cost for the resolution of legal claims. Estimates, which are based on historical experience and other assumptions, are reviewed continually, updated when necessary and believed to be reasonable under the circumstances. Management believes that the timing and scope of its evaluation procedures are proper and adequate. Changes in assumptions relating to such factors, however, could have a material effect on the Company's results of operations for a particular quarterly or annual period. Income Recognition As required by ASC No. 976 ("ASC 976"), "Real Estate-Retail Land," revenues and cost of sales are recorded at the time each home or lot is closed; title and possession are transferred to the buyer; and there is no significant continuing involvement from the homebuilder. In order to match revenues with related expenses, land, land development, interest, taxes and other related costs (both incurred and estimated to be incurred in the future) are allocated to the cost of homes closed, in accordance with ASC No. 970 ("ASC 970"), "Real Estate-General." Changes to estimated costs, subsequent to the commencement of the delivery of homes, are allocated to the remaining undelivered homes in the community. Home construction and related costs are charged to the cost of homes closed under the specific-identification method. Marketable Securities The Company invests a portion of its available cash and cash equivalent balances in marketable securities having maturities in excess of three months in a managed portfolio. These investments are primarily held in the custody of a single financial institution. To be considered for investment, securities must meet certain minimum requirements as to their credit ratings, maturity terms and other risk-related criteria as defined by the Company's investment policies. The primary objectives of these investments are the preservation of capital and the maintenance of a high degree of liquidity, with a secondary objective being the attainment of yields higher than those earned on the Company's cash and cash equivalent balances. The Company considers its investment portfolio to be available-for-sale. Accordingly, these investments are recorded at their fair values, with unrealized gains and losses included in "Accumulated other comprehensive loss" within the Consolidated Balance Sheets. The Company periodically reviews its available-for-sale securities for other-than-temporary declines in fair values that are below their cost basis, as well as whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. This evaluation is based on factors such as the length of time and extent to which the fair value has been less than the security's cost basis and the adverse conditions specifically related to the security, including any changes to the rating of the security by a rating agency. A temporary impairment results in an unrealized loss being recorded in "Accumulated other comprehensive loss" within the Consolidated Balance Sheets. An other-than-temporary impairment charge is recorded as a realized loss within the Consolidated Statements of Earnings. At December 31, 2014, none of these securities were in a gross unrealized loss position. The Company believes that the cost bases for its marketable securities, available-for-sale, were recoverable in all material respects at December 31, 2014 and 2013. (See Note G, "Fair Values of Financial and Nonfinancial Instruments.") Inventory Valuation Housing inventory includes land and development costs; direct construction costs; capitalized indirect construction costs; capitalized interest; and real estate taxes. The costs of acquiring and developing land and constructing certain related amenities are allocated to the parcels to which these costs relate. Inventories to be held and used are stated at cost unless a community is determined to be impaired, in which case the impaired inventories are written down to their fair values. As required by ASC 360, inventory is reviewed for potential write-downs on an ongoing basis. Once a community is considered to be impaired, the Company's determinations of fair value and new cost basis are primarily based on discounting estimated cash flows at rates commensurate with inherent risks associated with the assets. Due to the fact that estimates and assumptions included in cash flow models are based on historical results and projected trends, unexpected changes in market conditions that may lead to additional impairment charges in the future cannot be anticipated. Management believes its processes are designed to properly assess the market and the carrying values of assets. (See "Housing Inventories" within Note A, "Summary of Significant Accounting Policies.") Warranty Reserves The Company's homes are sold with limited third-party warranties. As homes close warranty reserves are established for an amount estimated to adequately cover the expected costs of materials and outside labor during warranty periods. Certain factors are considered in determining the reserves, including the historical range of amounts paid per house; experience with respect to similar home designs and geographic areas; the historical amount paid as a percentage of home construction costs; any warranty expenditures not considered to be normal and recurring; and conditions that may affect certain subdivisions. Improvements in quality control and construction techniques expected to impact future warranty expenditures are also considered. Accordingly, the process of determining the Company's warranty reserves balance requires estimates associated with various assumptions, each of which can positively or negatively impact this balance. Generally, warranty reserves are reviewed monthly to determine the reasonableness and adequacy of both the aggregate reserve amount and the per unit reserve amount originally included in housing cost of sales, as well as to note the timing of any reversals of the original reserve. General warranty reserves not utilized for a particular house are evaluated for reasonableness in the aggregate on both a market-by-market basis and a consolidated basis. Warranty payments for an individual house may exceed the related reserve. Payments in excess of the related reserve are evaluated in the aggregate to determine if an adjustment to the warranty reserve should be recorded, which could result in a corresponding adjustment to housing cost of sales. The Company continues to evaluate the adequacy of its warranty reserves and believes that its existing estimation process is materially accurate. Since the Company's warranty reserves can be impacted by a significant number of factors, it is possible that changes to the Company's assumptions could have a material impact on its warranty reserve balance. (See Note L, "Commitments and Contingencies.") Income Taxes The Company calculates a provision for its income taxes by using the asset and liability method, under which deferred tax assets and liabilities are recognized by identifying temporary differences arising from the diverse treatment of items for tax and general accounting purposes. The Company evaluates its deferred tax assets on a quarterly basis to determine whether a valuation allowance is required. In accordance with ASC No. 740 ("ASC 740"), "Income Taxes," the Company assesses whether a valuation allowance should be established based on available evidence indicating whether it is more likely than not that all or some portion of the deferred tax assets will not be realized. Significant judgment is required in estimating valuation allowances for deferred tax assets. The realization of a deferred tax asset ultimately depends on the existence of sufficient taxable income in either the carryback or carryforward periods under U.S. tax laws. This assessment considers, among other matters, current and cumulative income and loss; future profitability; the duration of statutory carryback or carryforward periods; asset turns; and tax planning alternatives. The Company bases its estimate of deferred tax assets and liabilities on current tax laws and rates. In certain cases, it also bases this estimate on business plan forecasts and other expectations about future outcomes. Changes in existing tax laws or rates could affect the Company's actual tax results, and future business results may affect the amount of its deferred tax liabilities or the valuation of its deferred tax assets over time. Due to uncertainties in the estimation process, particularly with respect to changes in facts and circumstances in future reporting periods, as well as to the residential homebuilding industry's cyclicality and sensitivity to changes in economic conditions, it is possible that actual results could differ from the estimates used in the Company's historical analyses. These differences could have a material impact on the Company's consolidated results of operations or financial position. Changes in positive and negative evidence, including differences between the Company's future operating results and estimates, could result in the establishment of a valuation allowance against its deferred tax assets. Accounting for deferred taxes is based upon estimates of future results. Differences between the anticipated and actual outcomes of these future results could have a material impact on the Company's consolidated results of operations or financial position. Also, changes in existing federal and state tax laws and tax rates could affect future tax results and the valuation allowance against the Company's deferred tax assets. (See Note I, "Income Taxes.") Mortgage Loan Loss Reserves Reserves are created to address repurchase and indemnity claims by third-party investors that arise primarily if the borrower obtained the loan through fraudulent information or omissions; if there are origination deficiencies attributable to RMC; or if the borrower does not make a first payment. Reserves are determined based on pending claims received that are associated with previously sold mortgage loans and discussions with investors and analysis of mortgages originated. Estimating loss is difficult due to the inherent uncertainty in predicting loss activity, as well as to delays in processing and requests for payment related to the loan loss by agencies and financial institutions. Recorded reserves represent the Company's best estimates of current and future unpaid losses as of December 31, 2014, based on existing conditions and available information. The Company continues to evaluate the adequacy of its mortgage loan loss reserves and believes that its existing estimation process provides a reasonable estimate of probable loss. Since the Company's mortgage loan loss reserves can be impacted by a significant number of factors, it is possible that subsequent changes in conditions or available information may change assumptions and estimates, which could have a material impact on its mortgage loan loss reserve balance. (See Note L, "Commitments and Contingencies.") Share-Based Payments The Company follows the provisions of ASC No. 718 ("ASC 718"), "Compensation-Stock Compensation," which requires that compensation expense be measured and recognized at an amount equal to the fair value of share-based payments granted under compensation arrangements. The Company calculates the fair value of stock options by using the Black-Scholes-Merton option-pricing model. Determination of the fair value of share-based awards at the grant date requires judgment in developing assumptions and involves a number of variables. These variables include, but are not limited to, expected price volatility of the stock over the term of the awards, expected dividend yield and expected stock option exercise behavior. Additionally, judgment is required in estimating the number of share-based awards that are expected to forfeit. Since accounting for stock-based compensation requires the use of complex judgment in its application, if actual results differ significantly from these estimates, stock-based compensation expense and the Company's consolidated results of operations could be materially impacted. (See Note K, "Stock-Based Compensation.") Outlook Although rates of improvement in housing markets can vary, the Company believes that the housing market as a whole may continue to progress due to overall improvement in the economy; rising employment levels; accessible financing; attractive housing affordability levels; and positive demographic trends. Absent unexpected changes in economic conditions and other unforeseeable circumstances, these developments, combined with additional leverage of overhead expenditures from higher volumes, should allow the Company to improve its performance. While any future steps taken by the Federal Reserve to increase interest rates may have a tempering effect on overall home sales and prices, the Company believes it is well positioned to capture potential increases in demand stemming from a stronger macroeconomic environment that would be expected to accompany any interest rate increases. Although the recent significant decline in oil prices may negatively impact certain localized markets, lower gas prices should result in more disposable income for households and could prove to be positive for the national economy and the Company as a whole. The Company anticipates steady growth in its community count during 2015 and will remain focused on maintaining strong operating profit margins. At December 31, 2014, the Company's backlog of orders for new homes totaled 2,617 units, with a projected dollar value of $919.0 million, reflecting a 7.5 percent increase in projected dollar value from $854.8 million at December 31, 2013. The pace at which the Company acquires new land and opens additional communities will depend on market and economic conditions, timing of governmental approval processes and future sales absorption rates. Although the Company's outlook remains cautiously optimistic, the strength of its balance sheet, liquidity and improved operating leverage have positioned it to successfully take advantage of any continued advancements in economic trends and in the demand for new homes.

<s>[INST] ForwardLooking Statements Certain statements in this Annual Report may be regarded as "forwardlooking statements" within the meaning of the Private Securities Litigation Reform Act of 1995, and may qualify for the safe harbor provided for in Section 21E of the Exchange Act. These forwardlooking statements represent the Company's expectations and beliefs concerning future events, and no assurance can be given that the results described in this Annual Report will be achieved. These forwardlooking statements can generally be identified by the use of statements that include words such as "anticipate," "believe," "could," "estimate," "expect," "foresee," "goal," "intend," "likely," "may," "plan," "project," "should," "target," "will" or other similar words or phrases. All forwardlooking statements contained herein are based upon information available to the Company on the date of this Annual Report. Except as may be required under applicable law, the Company does not undertake any obligation to update or revise any forwardlooking statements, whether as a result of new information, future events or otherwise. These forwardlooking statements are subject to risks, uncertainties and other factors, many of which are outside of the Company's control that could cause actual results to differ materially from the results discussed in the forwardlooking statements. The factors and assumptions upon which any forwardlooking statements herein are based are subject to risks and uncertainties which include, among others: economic changes nationally or in the Company's local markets, including volatility and increases in interest rates, the impact of, and changes in, governmental stimulus, tax and deficit reduction programs, inflation, changes in consumer demand and confidence levels and the state of the market for homes in general;changes and developments in the mortgage lending market, including revisions to underwriting standards for borrowers and lender requirements for originating and holding mortgages, changes in government support of and participation in such market, and delays or changes in terms and conditions for the sale of mortgages originated by the Company;the availability and cost of land and the future value of land held or under development;increased land development costs on projects under development;shortages of skilled labor or raw materials used in the production of homes;increased prices for labor, land and materials used in the production of homes;increased competition;failure to anticipate or react to changing consumer preferences in home design;increased costs and delays in land development or home construction resulting from adverse weather conditions or other factors;potential delays or increased costs in obtaining necessary permits as a result of changes to laws, regulations or governmental policies (including those that affect zoning, density, building standards, the environment and the residential mortgage industry);delays in obtaining approvals from applicable regulatory agencies and others in connection with the Company's communities and land activities;changes in the Company's effective tax rate and assumptions and valuations related to its tax accounts;the risk factors set forth in this Annual Report on Form 10K; andother factors over which the Company has little or no control. Results of Operations Overview During 2014, the Company saw continued improvement in most of the economic indicators salient to the homebuilding industry: employment rates continued to rise, consumer confidence improved and interest rates remained at historically low levels. Sales pace, however, continued to be a challenge amidst slower household formation growth and a restrictive mortgage underwriting environment. The Company believes that the housing market as a whole is likely to move forward in its recovery as affordability remains attractive and homeownership remains near historically low levels. It believes that continued improvement in employment levels; low interest rates; slow relaxation of the mortgage underwriting environment; historically low production of singlefamily homes; and a steady increase of potential buyers due, in part, to an expected rise in the number of household formations should eventually drive more attractive sales absorption rates that will facilitate a healthier, sustainable longterm recovery. The Company remains structurally lean and, as a result of community count growth over the last several years, expects to achieve greater leverage with comparable volume levels than in past years. Throughout 2014, the Company's strategic homebuilding initiatives continued to generate yearoveryear improvements in volume, operational efficiencies and profitability while, at the same time, maintaining a strong balance sheet. The Company made significant progress in achieving its operational [/INST] Negative. </s>

AMREP CORP.

2015-07-29

2015-04-30

Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations INTRODUCTION For a description of the Company’s business, refer to Item 1 of Part I of this annual report on Form 10-K. As indicated in Item 1, the Company, through its subsidiaries, is primarily engaged in two business segments: the real estate business operated by AMREP Southwest and its subsidiaries and the Fulfillment Services business operated by Palm Coast and its subsidiary. Data concerning industry segments is set forth in Note 20 of the notes to the consolidated financial statements included in this annual report on Form 10-K. The Company’s foreign sales and activities are not significant. Prior to February 9, 2015, the Company was also engaged in the Newsstand Distribution Services business and the Product Packaging and Fulfillment Services business. On February 9, 2015, the Newsstand Distribution Services business and the Product Packaging and Fulfillment Services business were sold (refer to Item 1 of Part I of this annual report on Form 10-K for more detail). In addition, prior to April 10, 2015, the Company was also engaged in the Staffing Services business. On April 10, 2015, the Staffing Services business was sold (refer to Item 1 of Part I of this annual report on Form 10-K for more detail). The Company’s Newsstand Distribution Services business, Product Packaging and Fulfillment Services business and Staffing Services business have been classified as discontinued operations in the financial statements included in this Form 10-K. The following provides information that management believes is relevant to an assessment and understanding of the Company’s consolidated results of operations and financial condition. The discussion should be read in conjunction with the consolidated financial statements and accompanying notes. CRITICAL ACCOUNTING POLICIES AND ESTIMATES The Company prepares its financial statements in conformity with accounting principles generally accepted in the United States of America. The Company discloses its significant accounting policies in the notes to its audited consolidated financial statements. The preparation of such financial statements requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosures of contingent assets and liabilities at the dates of those financial statements as well as the reported amounts of revenues and expenses during the reporting periods. Areas that require significant judgments and estimates to be made include: (i) allowances for doubtful accounts; (ii) real estate cost of sales calculations, which are based on land development budgets and estimates of costs to complete; (iii) cash flow and valuation assumptions in performing asset impairment tests of long-lived assets and assets held for sale; (iv) actuarially determined defined benefit pension plan obligations and other pension plan accounting and disclosures; (v) risk assessment of uncertain tax positions; and (vi) the determination of the recoverability of net deferred tax assets. Actual results could differ from those estimates. There are numerous critical assumptions that may influence accounting estimates in these and other areas. Management bases its critical assumptions on historical experience, third-party data and various other estimates that it believes to be reasonable under the circumstances. The most critical assumptions made in arriving at these accounting estimates include the following: · management determines the allowance for doubtful accounts by attempting to identify troubled accounts by analyzing the credit risk of specific customers and by using historical experience applied to the aging of accounts and, where appropriate within the real estate business, by reviewing any collateral which may secure a receivable; · real estate development costs are incurred throughout the life of a project, and the costs of initial sales from a project frequently must include a portion of costs that have been budgeted based on engineering estimates or other studies, but not yet incurred; · asset impairment determinations are based upon the intended use of assets, the grouping of those assets, the expected future cash flows and estimates of fair value of assets. For real estate projects under development, an estimate of future cash flows on an undiscounted basis is determined using estimated future expenditures necessary to complete such projects and using management’s best estimates about sales prices and holding periods. Testing of long-lived assets includes an estimate of future cash flows on an undiscounted basis using estimated revenue streams, operating margins, administrative expenses and terminal values. The estimation process involved in determining if assets have been impaired and in the determination of estimated future cash flows is inherently uncertain because it requires estimates of future revenues and costs, as well as future events and conditions. If the excess of undiscounted cash flows over the carrying value of a particular asset group is small, there is a greater risk of future impairment and any resulting impairment charges could be material; · defined benefit pension plan obligations and plan accounting and disclosures are based upon numerous assumptions and estimates, including the expected rate of investment return on pension plan assets, the discount rate used to determine the present value of liabilities, and certain employee-related factors such as turnover, retirement age and mortality; · the Company assesses risk for uncertain tax positions and recognizes the financial statement effects of a tax position when it is more likely than not that the position will be sustained upon examination by tax authorities; and · projected Company earnings (including currently unrealized gains on real estate inventory) for the future recoverability of net deferred tax assets ($5,837,000 as of April 30, 2015). RESULTS OF OPERATIONS Year Ended April 30, 2015 Compared to Year Ended April 30, 2014 Prior to February 9, 2015, the Company had been engaged in the Newsstand Distribution Services business and the Product Packaging and Fulfillment Services business. On February 9, 2015, the Newsstand Distribution Services business and the Product Packaging and Fulfillment Services business were sold (refer to Item 1 of Part I of this annual report on Form 10-K for more detail). In addition, prior to April 10, 2015, the Company had also been engaged in the Staffing Services business. On April 10, 2015, the Staffing Services business was sold (refer to Item 1 of Part I of this annual report on Form 10-K for more detail). The Newsstand Distribution Services business, the Product Packaging and Fulfillment Services business and the Staffing Services business have been classified as “discontinued operations” in the Company’s financial statements for the year ended April 30, 2015. Financial information from prior periods has been reclassified to conform to this presentation. For 2015, the Company reported total net income of $11,320,000, or $1.43 per share, compared to a net loss of $2,939,000, or $0.42 per share, in 2014. Results consisted of (i) a net loss from continuing operations of $3,584,000, or $0.45 per share, in 2015 compared to a net loss of $647,000, or $0.09 per share, in 2014 and (ii) net income from discontinued operations of $14,904,000, or $1.88 per share in 2015 compared to a net loss of $2,292,000, or $0.33 per share, for 2014. A discussion of continuing operations and discontinued operations follows. Continuing Operations For 2015, the Company’s continuing operations recorded a net loss of $3,584,000, or $0.45 per share, compared to a net loss of $647,000, or $0.09 per share, in 2014. The results for 2015 included pre-tax, non-cash impairment charges of $2,580,000 ($1,625,000 after tax, or $0.21 per share), while the results for 2014 included pre-tax, non-cash impairment charges of $686,000 ($432,000 after tax, or $0.06 per share), with the charges in both years reflecting the write-down primarily of certain real estate inventory and investment assets. Excluding the impairment charges in both years, results of continuing operations for 2015 were a net loss of $1,959,000, or $0.25 per share, compared to a net loss of $215,000, or $0.03 per share, for 2014. Revenues for 2015 were $49,790,000 compared to $62,197,000 in 2014. Revenues from the Company’s Fulfillment Services operations decreased from $58,479,000 for 2014 to $43,684,000 for 2015. The decrease in revenues was due in part to lower revenues in 2015 of $5,841,000 from a significant customer that changed fulfillment service providers. Magazine publishers are the principal customers of the Company’s Fulfillment Services operations, and these customers have continued to be negatively impacted by increased competition from new media sources, alternative technologies for the distribution, storage and consumption of media content, weakness in advertising revenues, increases in paper costs, printing costs and postal rates and weakness in the U.S. economy. The result has been reduced subscription sales, which has caused publishers to close some magazine titles, change subscription fulfillment providers and seek more favorable terms from Palm Coast and its competitors when contracts are up for bid or renewal. Should the adverse Fulfillment Services business conditions continue, the Fulfillment Services business may experience future impairment charges related to its long-lived assets. In addition, the Fulfillment Services business recorded impairment charges of $771,000 due to the discontinuance of the development of certain software in 2015. This impairment charge included previously capitalized software costs, internal labor costs and third party consulting costs. Although there are multiple revenue streams in the Fulfillment Services business, including revenues from the maintenance of customer computer files and the performance of other fulfillment-related activities, including telephone call center support and graphic arts and lettershop services, a customer generally contracts for and utilizes all available services as a total package, and the Company would not normally provide ancillary services to a customer unless it is also providing the core service of maintaining a database of subscriber names. Thus, variations in Fulfillment Services revenues are primarily the result of fluctuations in the number and sizes of customers rather than in the demand for a particular service. The Company competes with other companies, including two larger companies in the Fulfillment Services business, and the competition for new customers is intense, which results in a price sensitivity that makes it difficult for the Company to increase or even maintain its prices. Revenues from land sales at AMREP Southwest increased from $3,634,000 in 2014 to $5,883,000 in 2015. The number of new construction single family residential starts in Rio Rancho by AMREP Southwest customers and other builders decreased from 471 in 2014 to 410 in 2015, and the Company still is confronted with builders using their existing inventories of lots previously purchased from the Company and others in Rio Rancho. In Rio Rancho, the Company offers for sale both developed and undeveloped lots to national, regional and local homebuilders, commercial and industrial property developers and others. The Company sold 186 acres of land in 2015 at an average selling price of $32,000 per acre compared to 89 acres of land in 2014 at an average selling price of $41,000 per acre. The decrease in the average selling price per acre was due to the higher proportion of undeveloped land sold in 2015 compared to 2014. The average gross profit percentage on land sales before indirect costs was 26% for 2015 compared to 23% for 2014. As a result of many factors, including the nature and timing of specific transactions and the type and location of land being sold, revenues, average selling prices and related average gross profits from land sales can vary significantly from period to period and prior results are not necessarily a good indication of what may occur in future periods. In addition, AMREP Southwest recorded impairment charges on certain real estate inventory and investment assets of $1,809,000 in 2015 and $686,000 in 2014. In both years, the impairment charges were primarily related to take-back lots reacquired in prior years that initially were recorded at fair market value less estimated costs to sell and are subsequently measured at the lower of cost or fair market value less estimated costs to sell. Fair value was based on appraisals of portions of AMREP Southwest’s real estate that in each year showed deterioration in the fair market value from the prior year. Should the adverse real estate market conditions continue, AMREP Southwest may experience future impairment charges. Other revenues increased by $139,000 in 2015 as compared to 2014. The increase was due to revenue recognized as a result of AMREP Southwest and one of its subsidiaries entering into an oil and gas lease during the second quarter of 2015. For further detail regarding the oil and gas lease, refer to Note 11 in the footnotes to the financial statements included in this annual report on Form 10-K. Operating expenses for the Company’s Fulfillment Services business were $37,265,000 (85.3% of related revenues) for 2015 compared to $47,233,000 (80.8% of related revenues) for 2014. The decrease of $9,968,000 (21.1%) was primarily due to lower payroll and benefits and supplies expense, both reflecting the lower business volumes. Other operating expenses decreased $773,000 (35.8%) for 2015 compared to the prior year, primarily due to lower real estate taxes in Rio Rancho, as well as lower land maintenance costs. General and administrative expenses of the Fulfillment Services operations decreased $680,000 (13.5%) in 2015 compared to the prior year, primarily due to the net effect of decreased legal expenses, decreased facilities expenses and decreased payroll and benefits. Real estate operations and corporate general and administrative expenses increased $169,000 (4.8%) in 2015 compared to the prior year, primarily due to increased pension costs resulting from the accelerated recognition of deferred actuarial losses due to a settlement of certain plan liabilities. The Company's effective tax rate for continuing operations was 37.3% in 2015 compared to 46.7% in 2014. The difference between the statutory tax rate and the effective rate of the tax benefit in 2014 was due to the recognition of valuation allowances that totaled $600,000 for deferred tax assets related to certain state net operating loss carryforwards that were deemed not likely to be realized. The effect of the valuation allowance was to reduce the tax benefit in 2014. The Company expects to utilize net operating loss carry forwards of approximately $14,416,000 as of April 30, 2015 to offset current federal taxable income. The total tax effect of gross unrecognized tax benefits in the accompanying financial statements at both April 30, 2015 and 2014 was $58,000, which, if recognized, would have an impact on the effective tax rate. The Company believes it is reasonably possible that the liability for unrecognized tax benefits will not change in the next twelve months. During 2014, the Company reached a settlement with the Internal Revenue Service (the “IRS”) with respect to the examination of the Company’s fiscal year 2012 and 2011 federal income tax returns. The Company did not have to pay any additional federal taxes as a result of the IRS’s examination of the two years due to the Company’s existing net operating losses, which were reduced by approximately $2,400,000. As a result of the completion of the examinations, the Company reduced its liability for uncertain tax positions by $160,000, including accrued interest. This reduction had the effect of increasing the tax benefit in the accompanying financial statements in 2014. Discontinued Operations Net income from discontinued operations was $14,904,000, or $1.88 per share, in 2015 compared to a net loss of $2,292,000, or $0.33 per share, for 2014. The results from discontinued operations for 2015 included a pretax gain of $11,155,000 ($7,028,000 after tax, or $0.89 per share) from a previously disclosed settlement agreement in the Newsstand Distribution business with a major customer in the first quarter of the year and a pretax gain of $10,729,000 (or $7,608,000 after tax, or $0.96 per share) resulting from the sales of the Newsstand Distribution Services business, the Product Packaging and Fulfillment Services business and the Staffing Services business. The results for 2015 were also favorably impacted by the reversal of a previously recorded bad debt reserve of $1,500,000 ($945,000 after tax, or $0.12 per share) in the Newsstand Distribution business as a result of revised estimates of magazine returns and other customer statement credits. Excluding the gains from the sales of the businesses, the settlement agreement with the major customer and the reversal of the bad debt reserve, the pretax loss from discontinued operations was $1,247,000 ($677,000 after tax, or $0.09 per share). LIQUIDITY AND CAPITAL RESOURCES AMREP Corporation is a holding company that conducts substantially all of its operations through subsidiaries. As a holding company, AMREP Corporation is dependent on its available funds and on distributions of funds from subsidiaries to pay expenses and fund operations. The Company’s primary sources of funding for working capital requirements are cash flow from operations and a revolving credit facility (the “PNC Credit Facility”) between certain subsidiaries and PNC Bank, National Association. The Company’s liquidity is affected by many factors, including some that are based on normal operations and some that are related to the industries in which the Company operates and the economy generally. Real Estate The primary sources of funding for working capital requirements of the Company’s real estate business are cash flow from operations, which has been minimal in recent years due to the conditions in its real estate markets, and from advances made to it by its parent. AMREP Southwest also has a loan agreement that matures December 1, 2017, which does not allow for additional borrowings. Land investments generally cannot be sold quickly, and the ability of the Company’s real estate business to sell properties has been and will continue to be affected by market conditions. The ability of the Company’s real estate business to pay down debt, reduce interest costs or acquire properties is dependent upon its ability to sell the properties it has selected for disposition at the prices and within the deadlines AMREP Southwest has established for each property. AMREP Southwest has a loan from a company owned by Nicholas G. Karabots, a significant shareholder of the Company and in which another major shareholder and director of the Company has a 20% participation. The loan had an outstanding principal amount of $14,003,000 at April 30, 2015, is scheduled to mature on December 1, 2017, bears interest payable monthly at 8.5% per annum, is secured by a mortgage on certain real property of AMREP Southwest in Rio Rancho and by a pledge of the stock of its subsidiary, Outer Rim Investments, Inc. (which owns approximately 12,000 acres, for the most part scattered lots, in Sandoval County, New Mexico and which are not currently being offered for sale), requires that a cash reserve of at least $500,000 be maintained with the lender to fund interest payments and is subject to a number of restrictive covenants including a requirement that AMREP Southwest maintain a minimum tangible net worth and a restriction on AMREP Southwest making distributions and other payments to its parent company beyond a stated management fee. The total book value of the real property collateralizing the loan was approximately $63,786,000 as of April 30, 2015. A sale transaction by AMREP Southwest of certain mortgaged land requires the approval of the lender. Otherwise, the lender is required to release the lien of its mortgage on any land being sold at market price by AMREP Southwest in the ordinary course to an unrelated party on terms AMREP Southwest believes to be commercially reasonable. The loan may be prepaid at any time without premium or penalty except that if the prepayment is in connection with the disposition of AMREP Southwest or substantially all of its assets there is a prepayment premium, initially 5% of the amount prepaid, with the percentage declining by 1% each year. No payments of principal are required until maturity, except that 25% of the net proceeds, as defined, from any sales of real property by AMREP Southwest are required to be applied to the payment of the loan. No new borrowings are permitted under this loan. At April 30, 2015, AMREP Southwest was in compliance with the covenants of the loan. Fulfillment Services The primary source of funding for working capital requirements of the Company’s Fulfillment Services business is cash flow from operations. The Fulfillment Services business also has had access to the PNC Credit Facility for any additional liquidity that it may need. The PNC Credit Facility provides the Fulfillment Services business with a revolving credit loan and letter of credit facility of up to $5,000,000, with availability within that limit based upon the lesser of (i) a percentage of the borrowers’ eligible accounts receivable or (ii) the recent level of collections of accounts receivable. Subject to certain terms, funds may be borrowed, repaid and re-borrowed at any time. The PNC Credit Facility matures on August 12, 2015. As the Fulfillment Services business does not regularly use the liquidity provided by the PNC Credit Facility, the Company expects that the PNC Credit Facility will expire by its terms on August 12, 2015. If the Fulfillment Services business needs additional liquidity, the Company expects that the parent of the Fulfillment Services business will make advances available. At April 30, 2015, the borrowing availability under the PNC Credit Facility was $2,447,000; however, there were no borrowings against this availability. The borrowers’ obligations under the PNC Credit Facility are secured by substantially all of their assets other than real property. The revolving loans under the PNC Credit Facility may be fluctuating rate borrowings or Eurodollar fixed rate based borrowings or a combination of the two as the borrowers may select. Fluctuating rate borrowings bear interest at a rate which is, at the borrowers’ option, either (i) the reserve adjusted daily published rate for one month LIBOR loans plus a margin of 3% or (ii) the highest of two daily published market rates and the bank lender’s base commercial lending rate in effect from time to time, but in any case not less than 3% plus a margin of 2% (that is, not less than 5%). Eurodollar fixed rate based borrowings may be for one, two or six months and bear interest at the reserve adjusted Eurodollar interest rates for borrowings of such durations, plus a margin of 3%, which may be reduced to 2.75% depending on the borrowers’ financial condition. The borrowers may make payments (based upon a prescribed formula) on certain indebtedness due the borrowing group’s parent company that is not a party to the PNC Credit Facility, which payments would be subject to the minimum fixed charge coverage ratio (as defined) required by the PNC Credit Facility. If there is a violation of a covenant and during the continuance of such violation, or if the borrowers do not maintain the prescribed minimum fixed charge coverage ratio, the Fulfillment Services companies are prohibited from repaying indebtedness to or otherwise distributing funds to the borrowing group’s parent company and the lender is entitled to terminate the PNC Credit Facility and seek immediate payment of any outstanding borrowing. At April 30, 2015, the borrowers were in compliance with the covenants of the PNC Credit Facility. The Fulfillment Services business relies on a small number of large clients; a loss of one or more of its largest clients, or if revenues from its largest clients decline, the liquidity of the Fulfillment Services business could be adversely affected. The five largest clients in the Fulfillment Services business accounted for 37% of its revenues for the fiscal year ended April 30, 2015. The Fulfillment Services business operates in a very competitive environment with changes in service providers by customers not being unusual. The Fulfillment Services business has experienced, and expects to continue to experience, such customer changes. Based on information received from customers, the Fulfillment Services business currently expects a limited number of significant customers to change service providers for certain services during fiscal year 2016 representing in aggregate approximately 9% of the Company’s consolidated revenues for the year ended April 30, 2015 and during fiscal year 2017 representing in aggregate an additional approximately 8% of the Company’s consolidated revenues for the year ended April 30, 2015. As expected in a competitive environment, the Fulfillment Services business has been successful in obtaining new customer contracts. Approximately 11% of the number of customers of the Fulfillment Services business as of the end of fiscal year 2015 were new customers during fiscal year 2015, but the revenue to be generated by these new customers during fiscal years 2016 and 2017 is expected to be significantly less than the revenue expected to be lost from customers changing service providers during fiscal year 2016 and 2017. In June 2009, Palm Coast received $3,000,000 pursuant to an agreement with the State of Florida (the “Award Agreement”) as part of the incentives made available in connection with the Company’s project, completed in the second quarter of fiscal year 2011, to consolidate its Fulfillment Services operations at its Palm Coast, Florida location. The Award Agreement includes certain performance requirements in terms of job retention, job creation and capital investment which, if not met by Palm Coast, entitle the State of Florida to obtain the return of a portion, or all, of the $3,000,000. Accordingly, the $3,000,000 has been recorded as a liability in the accompanying balance sheet. The award monies, if any, to which Palm Coast becomes irrevocably entitled will be amortized into income through a reduction of depreciation over the life of the assets acquired with those funds. Palm Coast has not met certain of the performance requirements, in large part due to the adverse economic conditions experienced by the magazine publishing industry since the Award Agreement was executed, and as a result, is expecting to have to repay up to $2,527,000 of the award to the State of Florida. Palm Coast has had discussions with the State of Florida regarding the timing of the repayment of the $2,527,000, but the amount and timing of any such repayment have not been resolved. The Fulfillment Services business has recently eliminated the use of two operating facilities. In April 2015, FulCircle ceased using its leased facility in Denver, Colorado comprising approximately 12,000 square feet of space and terminated the lease scheduled to expire in August 2016 with a termination payment of $134,000, which represented 55% of the expected remaining lease payments through the scheduled expiration date. Also in April 2015, Palm Coast exited its leased facility in Palm Coast, Florida comprising approximately 42,000 square feet of space and Palm Coast expects to pay amounts due under the lease through its scheduled expiration in April 2016. Palm Coast accrued approximately $125,000 related to this lease termination. Discontinued Operations In connection with the sale, the Newsstand Distribution Services business and the Product Packaging and Fulfillment Services business retained substantially all of their pre-closing assets, liabilities, rights and obligations. At February 9, 2015, the Newsstand Distribution Services business and the Product Packaging and Fulfillment Services business had assets of $4,564,000 and liabilities of $15,732,000, which included $11,605,000 of negative working capital with respect to the Newsstand Distribution Services business further described below. The negative working capital of Kable Distribution represented its net payment obligation due to publisher clients and other third parties, which amount varied from period to period based on the level of magazine distribution. The negative working capital of Kable Distribution was calculated by deducting (a) the sum of the cash held by Kable Distribution plus the accounts receivable (net of estimated magazine returns to Kable Distribution) owed to Kable Distribution from wholesalers, retailers and other third parties from (b) the accounts payable (net of estimated magazine returns to publishers) and accrued expenses owed by Kable Distribution to publisher clients and other third parties plus outstanding bank borrowings of Kable Distribution under the PNC Credit Facility. During the first quarter of 2015, the Company and its indirect subsidiaries, Kable Distribution and Palm Coast, entered into a settlement agreement (the “Settlement Agreement”) with a significant customer, Heinrich Bauer (USA) LLC (“Bauer”). Kable Distribution and Bauer were parties to an ordinary course of business contract pursuant to which Kable Distribution distributed certain magazines of Bauer in return for a commission. Palm Coast and Bauer were parties to an ordinary course of business contract pursuant to which Palm Coast provided certain fulfillment services to Bauer in return for service fees. During the first quarter of 2014, Kable Distribution received notice that its ordinary course of business contract with Bauer, which provided Kable Distribution with a substantial amount of negative working capital liquidity, would not be renewed upon its scheduled expiration in June 2014. Pursuant to the Settlement Agreement, Kable Distribution agreed to eliminate the commission paid by Bauer to Kable Distribution for distribution services through expiration of the contract period at June 30, 2014 and to amend the payment procedures with respect to amounts received by Kable Distribution from wholesalers or retailers relating to the domestic sale by Kable Distribution of Bauer magazines to such wholesalers or retailers; Palm Coast agreed to reduce certain fees charged to Bauer for fulfillment services, with Bauer agreeing to extend the term of its fulfillment agreement to at least December 31, 2018; and the Company agreed to issue to Bauer 825,000 shares of common stock of the Company, with a fair market value of $4,274,000 and which represented approximately 10.3% of the outstanding shares of common stock of the Company following such issuance, with Bauer agreeing to not sell or transfer such shares for a period of six months. In return for such consideration, Bauer released all claims it may have had against each of Kable Distribution, Palm Coast, the Company and its related persons, other than the obligations of Kable Distribution, Palm Coast and the Company under the Settlement Agreement, the future obligations of Kable Distribution under its distribution agreement as amended by the Settlement Agreement and the future obligations of Palm Coast under its fulfillment agreement as amended by the Settlement Agreement. In particular, the Settlement Agreement transferred to Bauer all amounts and accounts receivable owing from wholesalers to Kable Distribution relating to the domestic sale by Kable Distribution of Bauer magazines ($22,626,000) and released Kable Distribution from having to pay the accounts payable owed to Bauer relating to the domestic sale by Kable Distribution of Bauer magazines other than to the extent amounts had been received by Kable Distribution or Bauer on or after May 14, 2014 from wholesalers or retailers relating to the domestic sale by Kable Distribution of Bauer magazines to such wholesalers or retailers ($38,214,000). After considering the value of the various components of the Settlement Agreement, Kable Distribution recorded a pretax gain of $11,155,000 during the first quarter of 2015. Variable Interest As a result of the sale of the Newsstand Distribution Services business and the Product Packaging and Fulfillment Services business and the related debt agreements securing the sales transaction, the Company is considered to have a variable interest in the Company Group (refer to Item 1 of Part I of this annual report on Form 10-K for more detail), as determined by Accounting Standards Codification 810. The Company, however, is not a primary beneficiary of the Company Group and, as such, the Company Group is not considered a variable interest entity that the Company would otherwise be required to consolidate the Company Group’s financial statements with the Company’s financial statements. The Company’s determination that it is not the primary beneficiary of the Company Group was based on the fact that (i) it was not involved in the formation or original investment of the companies that acquired the Company Group, (ii) it has no ownership rights in the companies that acquired the Company Group, (iii) it is not involved in the management of the Company Group and (iv) it has no obligation to absorb losses and has no expectation to receive residual returns of the Company Group. In addition, the Company has not provided, and does not intend in the future to provide, financial support to the Company Group that it was not previously contractually required to provide. Equity Offering During the first quarter of 2014, the Company completed a rights offering to holders of the Company’s common stock. As a result of the offering, the Company issued 1,199,242 shares of common stock at a price of $6.25 per share and raised net proceeds of approximately $7,144,000, net of expenses of approximately $350,000. The net proceeds of the offering are being used for corporate and working capital purposes, including a payment of $3,243,000 in September 2013 to the Company’s pension plan. The shares of common stock were issued from the Company’s treasury stock, which reduced the recorded values of retained earnings by $15,298,000 and of treasury stock by $22,442,000. Pension Plan The Company has a defined benefit pension plan for which accumulated benefits were frozen and future service credits were curtailed as of March 1, 2004. Under generally accepted accounting principles, the Company’s defined benefit pension plan was underfunded at April 30, 2015 by $11,259,000, with $27,044,000 of assets and $38,303,000 of liabilities. The pension plan liabilities were determined using a weighted average discount interest rate of 3.48% per year, which is based on the Citigroup yield curve as it corresponds to the projected liability requirements of the pension plan. As of April 30, 2015, for each 0.25% increase in the weighted average discount interest rate, the pension plan liabilities are forecasted to decrease by approximately $956,000 and for each 0.25% decrease in the weighted average discount interest rate, the pension plan liabilities are forecasted to increase by approximately $1,000,000. As of April 30, 2015, the effect of every 0.25% change in the investment rate of return on pension plan assets would increase or decrease the subsequent year’s pension expense by approximately $64,000 and the effect of every 0.25% change in the weighted average discount interest rate would increase or decrease the subsequent year’s pension expense by approximately $39,000. Due to the closing of certain facilities in 2011 in connection with the consolidation of the Company’s Fulfillment Services business and the associated work force reduction in 2011, the Employee Retirement Income Security Act of 1974, as amended (“ERISA”), and the regulations thereunder, gave the PBGC the right to require the Company to accelerate the funding of approximately $11,688,000 of accrued pension-related obligations to the Company’s defined benefit pension plan. In August 2012, the Company and the PBGC reached an initial agreement with respect to this funding obligation, and as a result, the Company made a $3,000,000 cash contribution to the pension plan on August 16, 2012, thereby leaving a remaining accelerated funding liability of $8,688,000. On August 30, 2013, the Company entered into a settlement agreement with the PBGC. In the settlement agreement, the PBGC agreed to forbear from asserting certain rights to obtain payment of the remaining $8,688,000 accelerated funding liability granted to it by ERISA, and the Company agreed (a) to pay $3,243,000 of the accelerated funding liability as a cash contribution to its pension plan, which payment was made on September 4, 2013, and (b) to provide first lien mortgages on certain real property with an aggregate appraised value of $10,039,000 in favor of the PBGC to secure the remaining unpaid amount of the accelerated funding liability. The total book value of the real property subject to the mortgages was approximately $8,192,000 as of April 30, 2015. In addition, the PBGC agreed to credit $426,000 of contributions made by the Company to the pension plan in excess of the 2012 minimum funding requirements towards the accelerated funding liability, so that, after this credit and the $3,243,000 payment referred to above, the remaining accelerated funding liability was $5,019,000. On an annual basis, the Company is required to provide updated appraisals on each mortgaged property and, if the appraised value of the mortgaged properties is less than two times the amount of the accelerated funding liability then outstanding, the Company is required to make a payment to its pension plan in an amount equal to one-half of the amount of the shortfall. The mortgages in favor of the PBGC will be discharged following the termination date of the settlement agreement. In connection with the settlement agreement, the Company made certain representations and warranties and is required to comply with various covenants, reporting requirements and other requirements, including making all required minimum funding contributions to its pension plan. Any failure by the Company to comply with its obligations under the settlement agreement may result in an event of default, which would permit the PBGC to repossess, sell or foreclose on the properties that have been mortgaged in favor of the PBGC; however, if the Company complies with the terms of the settlement agreement, including making all future required minimum funding contributions to its pension plan and any payments required due to any shortfall in the appraised value of real property covered by the mortgages described above, the Company will not be required to make any further cash payments to its pension plan with respect to the remaining accelerated funding liability. The settlement agreement is scheduled to terminate on the earlier of the date the accelerated funding liability has been paid in full or on August 30, 2018. Effective on the termination date of the settlement agreement, the PBGC will be deemed to have released and discharged the Company and any other members of its controlled group from any claims in connection with such members’ liability or obligations with respect to the accelerated funding liability. The settlement agreement does not address any future events that may accelerate any other accrued pension plan obligations. The Company may become subject to additional acceleration of its remaining accrued obligations to the pension plan if the Company closes other facilities and further reduces its work force of active pension plan participants. Any such acceleration could negatively impact the Company’s limited financial resources and could have a material adverse effect on the Company’s financial condition. Other Financing Activities El Dorado Utilities, Inc. (“El Dorado”), a subsidiary of the Company, has a market rate lease agreement with a term that expires in November 2018 for a warehouse facility owned by El Dorado in Fairfield, Ohio, with Kable Product Services, Inc., a member of the Company Group sold February 9, 2015 (refer to Item 1 of Part I of this annual report on Form 10-K for more detail). The warehouse facility is subject to a promissory note issued by El Dorado to a third party lender with an outstanding principal amount of $4,087,000 at April 30, 2015. The promissory note is scheduled to mature on February 15, 2018 with a required balloon payment of approximately $3,716,000, bears interest payable monthly at 6.35% per annum, is secured by a mortgage on the warehouse facility owned by El Dorado in Fairfield, Ohio and is subject to a prepayment penalty if the principal balance is prepaid more than 120 days prior to the maturity date. The book value of the warehouse facility owned by El Dorado in Fairfield, Ohio collateralizing the promissory note was approximately $5,631,000 as of April 30, 2015. No new borrowings are permitted under the promissory note. At April 30, 2015, El Dorado was in compliance with the covenants of the promissory note and related mortgage. Operating Activities Receivables from trade customers decreased from $10,956,000 at April 30, 2014 to $7,549,000 at April 30, 2015, due primarily to lower business volumes of the Fulfillment Services business. Real estate inventory totaled $66,321,000 at April 30, 2015 compared to $71,289,000 at April 30, 2014. Inventory in AMREP Southwest’s core real estate market of Rio Rancho decreased from $66,997,000 at April 30, 2014 to $61,438,000 at April 30, 2015, primarily as a result of land sales and also included an impairment charge of $1,504,000 on certain take-back lots (i.e., lots where the buyers defaulted on their obligation to pay AMREP Southwest and which were then repossessed by AMREP Southwest). The balance of real estate inventory consisted of properties in Colorado. Investment assets decreased from $16,010,000 at April 30, 2014 to $15,364,000 at April 30, 2015, primarily as a result of land sales and an impairment charge of $305,000 on certain lots. Property, plant and equipment decreased from $17,222,000 at April 30, 2014 to $15,763,000 at April 30, 2015, primarily due to depreciation charges, offset in part by $1,127,000 of capital expenditures. Intangible and other assets decreased from $12,643,000 at April 30, 2014 to $10,440,000 at April 30, 2015, primarily due to amortization. Accounts payable and accrued expenses decreased from $12,439,000 at April 30, 2014 to $10,284,000 at April 30, 2015, primarily from the timing of billings and payments to publishers and vendors, as well as lower business volumes. The unfunded pension liability of the Company’s frozen defined benefit pension plan increased from $7,349,000 at April 30, 2014 to $11,259,000 at April 30, 2015, due to changes in the discount rate and mortality tables when determining pension benefit obligations. The Company recorded other comprehensive loss of $1,658,000 in 2015 and other comprehensive income of $2,389,000 in 2014, reflecting the change in the unfunded pension liability in each year net of the related deferred tax and unrecognized prepaid pension amounts. Investing Activities Capital expenditures for property, plant and equipment for continuing operations were approximately $1,127,000 and $1,259,000 in 2015 and 2014, primarily for upgrades related to technology in both years for the Fulfillment Services business. The Company believes that it has adequate cash flows from operations and financing capability to provide for anticipated capital expenditures in fiscal year 2016, which are expected to be in both the real estate business and the Fulfillment Services business. RECENT ACCOUNTING PRONOUNCEMENTS In May 2014, the Financial Accounting Standards Board (the “FASB”) issued Accounting Standards Update No. 2014-09, Revenue from Contracts with Customers. This guidance defines how companies report revenues from contracts with customers and also requires enhanced disclosures. In July 2015, the FASB voted to defer the effective date by one year, with early adoption on the original effective date permitted. The Company will be required to adopt the standard as of May 1, 2018 and early adoption is permitted as of May 1, 2017. The Company has not determined the transition approach that will be utilized or estimated the impact of adopting the new accounting standard. SEGMENT INFORMATION Information by industry segment is presented in Note 20 to the consolidated financial statements included in this annual report on Form 10-K. Industry segment information is prepared in a manner consistent with the manner in which financial information is prepared and evaluated by management for making operating decisions. A number of assumptions and estimates are required to be made in the determination of segment data, including the need to make certain allocations of common costs and expenses among segments. On an annual basis, management evaluates the basis upon which costs are allocated, and has periodically made revisions to these methods of allocation. Accordingly, the determination of “net income (loss)” of each segment as summarized in Note 20 to the consolidated financial statements is presented for informational purposes only, and is not necessarily the amount that would be reported if the segment were an independent company. IMPACT OF INFLATION Operations of the Company can be impacted by inflation. Within the industries in which the Company operates, inflation can cause increases in the cost of materials, services, interest and labor. Unless such increased costs are recovered through increased sales prices or improved operating efficiencies, operating margins will decrease. Within the land development industry, the Company encounters particular risks. A large part of the Company’s real estate sales are to homebuilders who face their own inflationary concerns that rising housing costs, including interest costs, may substantially outpace increases in the incomes of potential purchasers and make it difficult for them to purchase a new home or sell an owned home. If this situation were to exist, the demand for the Company’s land by these homebuilder customers could decrease. In general, in recent years interest rates have been at historically low levels and other price increases have been commensurate with the general rate of inflation in the Company’s markets, and as a result the Company has not found the inflation risk to be a significant problem in any of its businesses. FORWARD-LOOKING STATEMENTS The Private Securities Litigation Reform Act of 1995 (the “Act”) provides a safe harbor for forward-looking statements made by or on behalf of the Company. The Company and its representatives may from time to time make written or oral statements that are “forward-looking”, including statements contained in this report and other filings with the Securities and Exchange Commission, reports to the Company’s shareholders and news releases. All statements that express expectations, estimates, forecasts or projections are forward-looking statements within the meaning of the Act. In addition, other written or oral statements, which constitute forward-looking statements, may be made by or on behalf of the Company. Words such as “expects”, “anticipates”, “intends”, “plans”, “believes”, “seeks”, “estimates”, “projects”, “forecasts”, “may”, “should”, variations of such words and similar expressions are intended to identify such forward-looking statements. These statements are not guarantees of future performance and involve certain risks, uncertainties and contingencies that are difficult to predict. All forward-looking statements speak only as of the date of this report or, in the case of any document incorporated by reference, the date of that document. All subsequent written and oral forward-looking statements attributable to the Company or any person acting on behalf of the Company are qualified by the cautionary statements in this section. Many of the factors that will determine the Company’s future results are beyond the ability of management to control or predict. Therefore, actual outcomes and results may differ materially from what is expressed or forecasted in or suggested by such forward-looking statements. The forward-looking statements contained in this report include, but are not limited to, statements regarding (i) the Company’s ability to finance its future working capital and capital expenditure needs, (ii) anticipated future development of the Company’s real estate holdings, (iii) the development and construction of possible future commercial properties to be marketed to tenants, (iv) the timing and extent of the Company’s required return of incentive monies to the State of Florida, (v) the expected loss of any material customer contract and the material adverse effect of any such loss, (vi) expected liquidity sources, (vii) the impact of greater than average selling pressure on the Company’s common stock price and (viii) the expected expiration of the term of the PNC Credit Facility. The Company undertakes no obligation to update or publicly release any revisions to forward-looking statements to reflect events, circumstances or changes in expectations after the date of such forward-looking statement, or to make any other forward-looking statements, whether as a result of new information, future events or otherwise.

<s>[INST] For a description of the Company’s business, refer to Item 1 of Part I of this annual report on Form 10K. As indicated in Item 1, the Company, through its subsidiaries, is primarily engaged in two business segments: the real estate business operated by AMREP Southwest and its subsidiaries and the Fulfillment Services business operated by Palm Coast and its subsidiary. Data concerning industry segments is set forth in Note 20 of the notes to the consolidated financial statements included in this annual report on Form 10K. The Company’s foreign sales and activities are not significant. Prior to February 9, 2015, the Company was also engaged in the Newsstand Distribution Services business and the Product Packaging and Fulfillment Services business. On February 9, 2015, the Newsstand Distribution Services business and the Product Packaging and Fulfillment Services business were sold (refer to Item 1 of Part I of this annual report on Form 10K for more detail). In addition, prior to April 10, 2015, the Company was also engaged in the Staffing Services business. On April 10, 2015, the Staffing Services business was sold (refer to Item 1 of Part I of this annual report on Form 10K for more detail). The Company’s Newsstand Distribution Services business, Product Packaging and Fulfillment Services business and Staffing Services business have been classified as discontinued operations in the financial statements included in this Form 10K. The following provides information that management believes is relevant to an assessment and understanding of the Company’s consolidated results of operations and financial condition. The discussion should be read in conjunction with the consolidated financial statements and accompanying notes. CRITICAL ACCOUNTING POLICIES AND ESTIMATES The Company prepares its financial statements in conformity with accounting principles generally accepted in the United States of America. The Company discloses its significant accounting policies in the notes to its audited consolidated financial statements. The preparation of such financial statements requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosures of contingent assets and liabilities at the dates of those financial statements as well as the reported amounts of revenues and expenses during the reporting periods. Areas that require significant judgments and estimates to be made include: (i) allowances for doubtful accounts; (ii) real estate cost of sales calculations, which are based on land development budgets and estimates of costs to complete; (iii) cash flow and valuation assumptions in performing asset impairment tests of longlived assets and assets held for sale; (iv) actuarially determined defined benefit pension plan obligations and other pension plan accounting and disclosures; (v) risk assessment of uncertain tax positions; and (vi) the determination of the recoverability of net deferred tax assets. Actual results could differ from those estimates. There are numerous critical assumptions that may influence accounting estimates in these and other areas. Management bases its critical assumptions on historical experience, thirdparty data and various other estimates that it believes to be reasonable under the circumstances. The most critical assumptions made in arriving at these accounting estimates include the following: · management determines the allowance for doubtful accounts by attempting to identify troubled accounts by analyzing the credit risk of specific customers and by using historical experience applied to the aging of accounts and, where appropriate within the real estate business, by reviewing any collateral which may secure a receivable; · real estate development costs are incurred throughout the life of a project, and the costs of initial sales from a project frequently must include a portion of costs that have been budgeted based on engineering estimates or other studies, but not yet incurred; · asset impairment determinations are based upon the intended use of assets, the grouping of those assets, the expected future cash flows and estimates of fair value of assets. For real estate projects under development, an estimate of future cash flows on an undiscounted basis is determined using estimated future expenditures necessary to complete such projects and using management’s best estimates about sales prices and holding periods. Testing of longlived assets includes an estimate of future cash flows on an undiscounted basis using estimated revenue streams, operating margins, administrative expenses and terminal values. The estimation process involved in determining if assets have been impaired and in the determination of estimated future cash flows is inherently uncertain because it requires estimates of future revenues and costs, as well [/INST] Positive. </s>

AMREP CORP.

2016-07-29

2016-04-30

Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations INTRODUCTION For a description of the Company’s business, refer to Item 1 of Part I of this annual report on Form 10-K. As indicated in Item 1, the Company, through its subsidiaries, is primarily engaged in two business segments: the real estate business operated by AMREP Southwest and its subsidiaries and the Fulfillment Services business operated by Palm Coast and its affiliates. Data concerning industry segments is set forth in Note 20 of the notes to the consolidated financial statements included in this annual report on Form 10-K. The Company’s foreign sales and activities are not significant. Prior to February 9, 2015, the Company was also engaged in the Newsstand Distribution Services business and the Product Packaging and Fulfillment Services business. On February 9, 2015, the Newsstand Distribution Services business and the Product Packaging and Fulfillment Services business were sold (refer to Item 1 of Part I of this annual report on Form 10-K for more detail). In addition, prior to April 10, 2015, the Company was also engaged in the Staffing Services business. On April 10, 2015, the Staffing Services business was sold (refer to Item 1 of Part I of this annual report on Form 10-K for more detail). The Company’s Newsstand Distribution Services business, Product Packaging and Fulfillment Services business and Staffing Services business have been classified as discontinued operations in the financial statements included in this annual report on Form 10-K. The following provides information that management believes is relevant to an assessment and understanding of the Company’s consolidated results of operations and financial condition. The discussion should be read in conjunction with the consolidated financial statements and accompanying notes. CRITICAL ACCOUNTING POLICIES AND ESTIMATES The Company prepares its financial statements in conformity with accounting principles generally accepted in the United States of America. The Company discloses its significant accounting policies in the notes to its audited consolidated financial statements. The preparation of such financial statements requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosures of contingent assets and liabilities at the dates of those financial statements as well as the reported amounts of revenues and expenses during the reporting periods. Areas that require significant judgments and estimates to be made include: (i) allowances for doubtful accounts; (ii) real estate cost of sales calculations, which are based on land development budgets and estimates of costs to complete; (iii) cash flow, asset groupings and valuation assumptions in performing asset impairment tests of long-lived assets (including real estate inventories) and assets held for sale; (iv) actuarially determined defined benefit pension plan obligations and other pension plan accounting and disclosures; (v) risk assessment of uncertain tax positions; and (vi) the determination of the recoverability of net deferred tax assets. Actual results could differ from those estimates. There are numerous critical assumptions that may influence accounting estimates in these and other areas. Management bases its critical assumptions on historical experience, third-party data and various other estimates that it believes to be reasonable under the circumstances. The most critical assumptions made in arriving at these accounting estimates include the following: · management determines the allowance for doubtful accounts by attempting to identify troubled accounts by analyzing the credit risk of specific customers and by using historical experience applied to the aging of accounts and, where appropriate within the real estate business, by reviewing any collateral which may secure a receivable; · real estate development costs are incurred throughout the life of a project, and the costs of initial sales from a project frequently must include a portion of costs that have been budgeted based on engineering estimates or other studies, but not yet incurred; · asset impairment determinations are based upon the intended use of assets, the grouping of those assets, the expected future cash flows and estimates of fair value of assets. For real estate projects under development, an estimate of future cash flows on an undiscounted basis is determined using estimated future expenditures necessary to complete such projects and using management’s best estimates about sales prices and holding periods. Testing of long-lived assets includes an estimate of future cash flows on an undiscounted basis using estimated revenue streams, operating margins, administrative expenses and terminal values. The estimation process involved in determining if assets have been impaired and in the determination of estimated future cash flows is inherently uncertain because it requires estimates of future revenues and costs, as well as future events and conditions. If the excess of undiscounted cash flows over the carrying value of a particular asset group is small, there is a greater risk of future impairment and any resulting impairment charges could be material; · defined benefit pension plan obligations and plan accounting and disclosures are based upon numerous assumptions and estimates, including the expected rate of investment return on pension plan assets, the discount rate used to determine the present value of liabilities, and certain employee-related factors such as turnover, retirement age and mortality; · the Company assesses risk for uncertain tax positions and recognizes the financial statement effects of a tax position when it is more likely than not that the position will be sustained upon examination by tax authorities; and · The Company provides a valuation allowance against net deferred tax assets unless, based upon the available evidence, it is more likely than not that the deferred tax assets will be realized. In making this determination, the Company projects its future earnings (including currently unrealized gains on real estate inventory) for the future recoverability of net deferred tax assets ($11,283,000 as of April 30, 2016). RESULTS OF OPERATIONS Year Ended April 30, 2016 Compared to Year Ended April 30, 2015 For 2016, the Company reported a total net loss of $10,224,000, or $1.27 per share, compared to total net income of $11,320,000, or $1.43 per share for 2015. Results for 2016 were solely from continuing operations. Results for 2015 consisted of (i) a net loss from continuing operations of $3,584,000, or $0.45 per share and (ii) net income from discontinued operations of $14,904,000, or $1.88 per share. A discussion of continuing operations and discontinued operations follows. Continuing Operations For 2016, the Company’s continuing operations recorded a net loss of $10,224,000, or $1.27 per share, compared to a net loss of $3,584,000, or $0.45 per share, in 2015. The results for 2016 included a pretax, non-cash impairment charge of $7,900,000 ($4,977,000 after tax, or $0.62 per share), which was comprised of impairment charges of $3,094,000 in property, plant and equipment and $4,806,000 in intangible and other assets, and in each case related to the recoverability of long-lived assets of the Fulfillment Services business. In addition, the results for 2016 included pretax, non-cash impairment charges of $2,506,000 ($1,579,000 after tax, or $0.20 per share), reflecting primarily the write-down of certain real estate inventory. The results for 2015 included pretax, non-cash impairment charges of $2,580,000 ($1,625,000 after tax, or $0.21 per share), reflecting primarily the write-down of certain real estate inventory and discontinuance of the development of certain software in the Fulfillment Services business. Excluding the impairment charges in both years, results of continuing operations for 2016 were a net loss of $3,668,000, or $0.46 per share, compared to a net loss of $1,959,000, or $0.25 per share, for 2015. Revenues for 2016 were $41,664,000 compared to $49,790,000 in 2015. Revenues from land sales at AMREP Southwest decreased from $5,883,000 in 2015 to $5,697,000 in 2016, which included revenue from developed residential land sales of $4,660,000 in 2015 and $5,214,000 in 2016. The number of new construction single family residential starts in Rio Rancho by AMREP Southwest customers and other builders increased from 410 in 2015 to 534 in 2016, an increase of 30%. In Rio Rancho, the Company offers for sale both developed and undeveloped lots to national, regional and local homebuilders, commercial and industrial property developers and others. The Company sold 61 acres of land in 2016 at an average selling price of $93,000 per acre compared to 186 acres of land in 2015 at an average selling price of $32,000 per acre. The increase in the average selling price per acre was due to the higher proportion of developed land sold in 2016 compared to 2015 when most acres sold were undeveloped land. The average gross profit percentage on land sales before indirect costs was 14% for 2016 compared to 26% for 2015. As a result of many factors, including the nature and timing of specific transactions and the type and location of land being sold, revenues, average selling prices and related average gross profits from land sales can vary significantly from period to period and prior results are not necessarily a good indication of what may occur in future periods. In addition, AMREP Southwest recorded pretax, non-cash impairment charges on certain real estate inventory and investment assets of $2,506,000 in 2016 and $1,809,000 in 2015. In both years, the impairment charges were primarily related to take-back lots reacquired in prior years that initially were recorded at fair market value less estimated costs to sell and are subsequently measured at the lower of cost or fair market value less estimated costs to sell. In addition, 2016 included impairment charges related to certain holdings of AMREP Southwest in the Hawk Site subdivision. Fair market value was based on third party appraisals of portions of AMREP Southwest’s real estate that in each year showed a reduction in the fair market value from the prior year. AMREP Southwest may experience future impairment charges. Revenues from the Company’s Fulfillment Services operations decreased from $43,684,000 for 2015 to $34,757,000 for 2016. Magazine publishers are one of the principal customers of the Company’s Fulfillment Services operations, and these customers have continued to be negatively impacted by increased competition from new media sources, alternative technologies for the distribution, storage and consumption of media content, weakness in advertising revenues, and increases in paper costs, printing costs and postal rates. The result has been reduced subscription sales, which has caused publishers to close some magazine titles, change subscription fulfillment providers and seek more favorable terms from Palm Coast and its competitors when contracts are up for bid or renewal. This, in turn, resulted in lower than expected 2016 revenues and operating results for the Fulfillment Services business and a change in the Company’s internally projected future cash flows from that segment. As a result, the Company reassessed the recoverability of the Fulfillment Services long-lived assets and determined that a $7,900,000 non-cash impairment charge was necessary in the quarter ended April 30, 2016. The Fulfillment Services business recorded an impairment charge of $771,000 in 2015 due to the discontinuance of the development of certain software. This impairment charge included previously capitalized software costs, internal labor costs and third party consulting costs. There are a number of companies that perform fulfillment and contact center services for consumer publications, trade (business) publications, membership organizations, non-profit organizations, government agencies and other direct marketers and with which the Company’s Fulfillment Services business competes, including two fulfillment service providers that are larger than the Company’s Fulfillment Services business. There is intense competition to obtain fulfillment and contact center services customers, which results in price sensitivity that makes it difficult for the Company to increase or even maintain its prices. Other revenues increased by $987,000 in 2016 as compared to 2015. The increase was primarily due to (i) revenues from the rental of a warehouse facility in Fairfield, Ohio, (ii) a gain recognized on the sale of the same warehouse in February 2016 and (iii) increased revenue recognized by one of AMREP Southwest’s subsidiaries from an oil and gas lease entered into during the second quarter of 2015. For further detail regarding the oil and gas lease, refer to Note 11 in the footnotes to the financial statements included in this annual report on Form 10-K. Operating expenses for the Company’s Fulfillment Services business were $31,764,000 (91.4% of related revenues) for 2016 compared to $37,265,000 (85.3% of related revenues) for 2015. The decrease of $5,501,000 (14.8%) was primarily due to decreased payroll and benefits and supplies expense, both reflecting the lower business volumes, together with reduced facilities costs. Other operating expenses increased $138,000 (9.9%) for 2016 compared to the prior year, primarily due to increased real estate taxes in Rio Rancho, as well as increased legal and professional fees incurred in the formation of public improvement districts for certain development areas in Rio Rancho. General and administrative expenses of the Fulfillment Services operations decreased $1,190,000 (27.2%) for 2016 compared to the prior year, primarily due to decreased payroll and benefits and one-time facilities expenses incurred in April 2015 related to exiting leased facilities in Colorado. Interest expense decreased by $254,000 (15.7%) for 2016 compared to the prior year, primarily due to lower principal amounts borrowed by AMREP Southwest. The Company’s effective tax rate for continuing operations was 33.8% in 2016 compared to 37.3% in 2015. The difference between the statutory tax rate and the effective rate of the tax benefit in 2016 was due to the recognition of valuation allowances that totaled $910,000 for certain state deferred tax assets that were deemed not likely to be realized. The total tax effect of gross unrecognized tax benefits in the accompanying financial statements at both April 30, 2016 and 2015 was $58,000, which, if recognized, would have an impact on the effective tax rate. The Company believes it is reasonably possible that the liability for unrecognized tax benefits will not change in the next twelve months. Discontinued Operations Net income from discontinued operations was $14,904,000, or $1.88 per share, in 2015. There were no results for discontinued operations for 2016. The results from discontinued operations for 2015 included a pretax gain of $11,155,000 ($7,028,000 after tax, or $0.89 per share) from a settlement agreement in the Newsstand Distribution business with a major customer and a pretax gain of $10,729,000 (or $7,608,000 after tax, or $0.96 per share) resulting from the sales of the Newsstand Distribution Services business, the Product Packaging and Fulfillment Services business and the Staffing Services business. The results for 2015 were also favorably impacted by the reversal of a previously recorded bad debt reserve of $1,500,000 ($945,000 after tax, or $0.12 per share) in the Newsstand Distribution business as a result of revised estimates of magazine returns and other customer statement credits. Excluding the gains from the settlement agreement with the major customer, the sales of the businesses and the reversal of the bad debt reserve, the pretax loss from discontinued operations was $1,247,000 ($677,000 after tax, or $0.09 per share). LIQUIDITY AND CAPITAL RESOURCES AMREP Corporation is a holding company that conducts substantially all of its operations through subsidiaries. As a holding company, AMREP Corporation is dependent on its available funds and on distributions of funds from subsidiaries to pay expenses and fund operations. The Company’s primary sources of funding for working capital requirements are cash flow from operations and existing cash balances. The Company’s liquidity is affected by many factors, including some that are based on normal operations and some that are related to the industries in which the Company operates and the economy generally. Real Estate The primary sources of funding for working capital requirements of the Company’s real estate business are cash flow from operations, which has been minimal in recent years due to the conditions in its real estate markets, and cash advances made to it by its parent. AMREP Southwest also has a loan agreement that matures December 1, 2017, which does not allow for additional borrowings. Land investments generally cannot be sold quickly, and the ability of the Company’s real estate business to sell properties has been and will continue to be affected by market conditions. The ability of the Company’s real estate business to pay down debt, reduce interest costs or acquire properties is dependent upon its ability to sell the properties it has selected for disposition at the prices and within the deadlines AMREP Southwest has established for each property. AMREP Southwest has a loan from a company owned by Nicholas G. Karabots, a significant shareholder of the Company and in which another major shareholder and director of the Company has a 20% participation. The loan had an outstanding principal amount of $12,384,000 at April 30, 2016 and of $7,983,000 at July 15, 2016, is scheduled to mature on December 1, 2017, bears interest payable monthly at 8.5% per annum, is secured by a mortgage on certain real property of AMREP Southwest in Rio Rancho and by a pledge of the stock of its subsidiary, Outer Rim Investments, Inc. (which owns approximately 12,000 acres, for the most part scattered lots, in Sandoval County, New Mexico and which are not currently being offered for sale), requires that a cash reserve of at least $500,000 be maintained with the lender to fund interest payments and is subject to a number of restrictive covenants including a requirement that AMREP Southwest maintain a minimum tangible net worth and a restriction on AMREP Southwest making distributions and other payments to its parent company beyond a stated management fee. The total book value of the real property collateralizing the loan was approximately $59,361,000 as of April 30, 2016. A sale transaction by AMREP Southwest of certain mortgaged land requires the approval of the lender. Otherwise, the lender is required to release the lien of its mortgage on any land being sold at market price by AMREP Southwest in the ordinary course to an unrelated party on terms AMREP Southwest believes to be commercially reasonable. The loan may be prepaid at any time without premium or penalty except that if the prepayment is in connection with the disposition of AMREP Southwest or substantially all of its assets there is a prepayment premium, initially 5% of the amount prepaid, with the percentage declining by 1% each year. No payments of principal are required until maturity, except that the following amounts are required to be applied to the payment of the loan: (a) 25% of the net cash proceeds from any sales of real property by AMREP Southwest and (b) 25% of any royalty payments received by AMREP Southwest under the oil and gas lease described in Note 11 in the footnotes to the financial statements included in this annual report on Form 10-K. No new borrowings are permitted under this loan. At April 30, 2016, AMREP Southwest was in compliance with the covenants of the loan. During November 2015, Las Fuentes Village, LLC (“LFV”), a subsidiary of AMREP Southwest, entered into a loan agreement with U.S. Bank National Association to permit the borrowing from time to time by LFV of a maximum principal amount of $933,000 for the construction of a 2,200 square foot, single tenant retail building in Rio Rancho, New Mexico. The construction loan was scheduled to mature on October 31, 2016, bore interest payable monthly on the outstanding principal amount at 0.5% plus the prime rate, was secured by a mortgage on the real property of approximately one acre where construction of the building had occurred, contained customary events of default, representations, warranties and covenants for a loan of this nature and was guaranteed by AMREP Southwest. As of April 30, 2016, the outstanding principal balance of the loan was $555,000 and the book value of the real property collateralizing the loan was approximately $609,000. No payments of principal of the construction loan were required until maturity. At April 30, 2016, LFV was in compliance with the covenants of the loan. In the first quarter of fiscal year 2017, the Company sold this property and received approximately $1,466,000 after expenses and payment in full of the outstanding principal balance of the loan of approximately $891,000. Fulfillment Services The primary source of funding for working capital requirements of the Company’s Fulfillment Services business is cash flow from operations. If the Fulfillment Services business needs additional liquidity, the parent of the Fulfillment Services business may in its discretion make cash advances available. The Fulfillment Services business relies on a small number of large clients; if it should lose one or more of its largest clients, or if revenues from its largest clients decline, the liquidity of the Fulfillment Services business could be adversely affected. The five largest clients in the Fulfillment Services business accounted for 42% of its 2016 revenues. The Fulfillment Services business operates in a very competitive environment with changes in service providers by customers not being unusual. The Fulfillment Services business has experienced, and expects to continue to experience, such customer changes. Based on information received from customers, the Fulfillment Services business currently expects a limited number of significant customers to change service providers for certain services (a) during fiscal year 2017 representing in aggregate approximately 15% of the Company’s consolidated 2016 revenues and (b) during fiscal year 2018 representing in aggregate an additional approximately 4% of the Company’s consolidated 2016 revenues. As expected in a competitive environment, the Fulfillment Services business has been successful in obtaining new customer contracts. Approximately 10% of the number of customers of the Fulfillment Services business as of the end of fiscal year 2016 were new customers during fiscal year 2016, but the revenue to be generated by these new customers during fiscal years 2017 and 2018 is expected to be significantly less than the revenue expected to be lost from customers changing service providers or those reducing services the Fulfillment Services business provides them during fiscal years 2017 and 2018. In June 2009, Palm Coast received $3,000,000 pursuant to an agreement with the State of Florida (the “Award Agreement”) as part of the incentives made available in connection with the Company’s project, completed in the second quarter of fiscal year 2011, to consolidate its Fulfillment Services operations at its Palm Coast, Florida location. The Award Agreement includes certain performance requirements in terms of job retention, job creation and capital investment which, if not met by Palm Coast, entitle the State of Florida to obtain the return of a portion, or all, of the $3,000,000. Accordingly, the $3,000,000 has been recorded as a liability in the accompanying balance sheet. The award monies, if any, to which Palm Coast becomes irrevocably entitled will be amortized into income through a reduction of depreciation over the life of the assets acquired with those funds. Palm Coast has not met certain of the performance requirements in the Award Agreement, in large part due to the adverse economic conditions experienced by the magazine publishing industry since the Award Agreement was executed, and as a result, is expecting to have to repay up to $2,527,000 of the award to the State of Florida. Palm Coast has had discussions with the State of Florida regarding the timing of the repayment of the $2,527,000, but the amount and timing of any such repayment have not been resolved. The Fulfillment Services business has eliminated the use of two operating facilities during 2015 and 2016. In April 2015, the Fulfillment Services business ceased using a leased facility in Denver, Colorado comprising approximately 12,000 square feet of space and terminated the lease scheduled to expire in August 2016 with a termination payment of $134,000. Also in April 2015, the Fulfillment Services business exited a leased facility in Palm Coast, Florida comprising approximately 42,000 square feet of space and in October 2015 terminated the lease that was scheduled to expire in April 2016 with a termination payment of $122,000. Pension Plan The Company has a defined benefit pension plan for which accumulated benefits were frozen and future service credits were curtailed as of March 1, 2004. Under generally accepted accounting principles, the Company’s defined benefit pension plan was underfunded at April 30, 2016 by $12,710,000, with $23,708,000 of assets and $36,418,000 of liabilities. The pension plan liabilities were determined using a weighted average discount interest rate of 3.27% per year, which is based on the Citigroup yield curve as it corresponds to the projected liability requirements of the pension plan. As of April 30, 2016, for each 0.25% increase in the weighted average discount interest rate, the pension plan liabilities are forecasted to decrease by approximately $891,000 and for each 0.25% decrease in the weighted average discount interest rate, the pension plan liabilities are forecasted to increase by approximately $931,000. As of April 30, 2016, the effect of every 0.25% change in the investment rate of return on pension plan assets would increase or decrease the subsequent year’s pension expense by approximately $56,000 and the effect of every 0.25% change in the weighted average discount interest rate would increase or decrease the subsequent year’s pension expense by approximately $34,000. Due to the closing of certain facilities in 2011 in connection with the consolidation of the Company’s Fulfillment Services business and the associated work force reduction in 2011, the Employee Retirement Income Security Act of 1974, as amended (“ERISA”), and the regulations thereunder, gave the PBGC the right to require the Company to accelerate the funding of approximately $11,688,000 of accrued pension-related obligations to the Company’s defined benefit pension plan. In August 2012, the Company and the PBGC reached an initial agreement with respect to this funding obligation, and as a result, the Company made a $3,000,000 cash contribution to the pension plan in August 2012, thereby leaving a remaining accelerated funding liability of $8,688,000. In August 2013, the Company entered into a settlement agreement with the PBGC. In the settlement agreement, the PBGC agreed to forbear from asserting certain rights to obtain payment of the remaining $8,688,000 accelerated funding liability granted to it by ERISA, and the Company agreed (a) to pay $3,243,000 of the accelerated funding liability as a cash contribution to its pension plan, which payment was made in September 2013, and (b) to provide first lien mortgages on certain real property with an aggregate appraised value of $10,039,000 in favor of the PBGC to secure the remaining unpaid amount of the accelerated funding liability. The total book value of the real property subject to the mortgages was approximately $11,822,000 as of April 30, 2016. In addition, the PBGC agreed to credit $426,000 of contributions made by the Company to the pension plan in excess of the 2012 minimum funding requirements towards the accelerated funding liability, so that, after this credit and the $3,243,000 payment referred to above, the remaining accelerated funding liability was $5,019,000. On an annual basis, the Company is required to provide updated appraisals on each mortgaged property and, if the appraised value of the mortgaged properties is less than two times the amount of the accelerated funding liability then outstanding, the Company is required to make a payment to its pension plan in an amount equal to one-half of the amount of the shortfall. Upon the sale by the Company of any property mortgaged in favor of the PBGC, the Company is required to deposit in its pension plan 50% of the lesser of (i) the amount equal to the total purchase price of the mortgaged property minus certain transaction costs or (ii) the appraised value of the mortgaged property. The mortgages in favor of the PBGC will be discharged following the termination date of the settlement agreement. In connection with the settlement agreement, the Company made certain representations and warranties and is required to comply with various covenants, reporting requirements and other requirements, including making all required minimum funding contributions to its pension plan. Any failure by the Company to comply with its obligations under the settlement agreement may result in an event of default, which would permit the PBGC to repossess, sell or foreclose on the properties that have been mortgaged in favor of the PBGC; however, if the Company complies with the terms of the settlement agreement, including making all future required minimum funding contributions to its pension plan and any payments required due to any shortfall in the appraised value of real property covered by the mortgages described above, the Company will not be required to make any further cash payments to its pension plan with respect to the remaining accelerated funding liability. The settlement agreement is scheduled to terminate on the earlier of the date the accelerated funding liability has been paid in full or on August 30, 2018. Effective on the termination date of the settlement agreement, the PBGC will be deemed to have released and discharged the Company and any other members of its controlled group from any claims in connection with such members’ liability or obligations with respect to the accelerated funding liability. The settlement agreement does not address any future events that may accelerate any other accrued pension plan obligations. The Company may become subject to additional acceleration of its remaining accrued obligations to the pension plan if the Company closes other facilities and further reduces its work force of active pension plan participants. Any such acceleration could negatively impact the Company’s limited financial resources and could have a material adverse effect on the Company’s financial condition. Other Financing Activities In February 2016, a subsidiary of the Company sold to a third party the warehouse leased to the Product Packaging and Fulfillment Services business and the promissory note to a third party lender related thereto with an outstanding principal balance of $3,992,000 was paid in full from the proceeds of the sale. The Company recorded a gain on the sale of $252,000. Operating Activities Receivables from trade customers decreased from $7,549,000 at April 30, 2015 to $7,271,000 at April 30, 2016, primarily due to lower business volumes of the Fulfillment Services business. There was also a $3,600,000 reduction of receivables from April 30, 2015 as amounts due under the buyer promissory note and line of credit issued in connection with the sale of the Newsstand Distribution Services business and the Product Packaging and Fulfillment Services business were collected in full during 2016. For more detail on the sale of the Newsstand Distribution Services business and the Product Packaging and Fulfillment Services business, refer to Item 1 of Part I of this annual report on Form 10-K. Real estate inventory totaled $61,663,000 at April 30, 2016 compared to $66,321,000 at April 30, 2015. Inventory in AMREP Southwest’s core real estate market of Rio Rancho decreased from $61,438,000 at April 30, 2015 to $57,017,000 at April 30, 2016, primarily as a result of land sales and also included a pretax, non-cash impairment charge of $2,506,000 on certain developed and take-back lots (i.e., lots where the buyers defaulted on their obligation to pay AMREP Southwest and which were then repossessed by AMREP Southwest). The balance of real estate inventory consisted of properties in Colorado. Investment assets decreased from $15,364,000 at April 30, 2015 to $10,326,000 at April 30, 2016, primarily as a result of the sale of the Company’s Fairfield, Ohio warehouse. Property, plant and equipment decreased from $15,763,000 at April 30, 2015 to $11,997,000 at April 30, 2016, primarily due to a non-cash impairment charge of $3,094,000, as well as depreciation charges, which were offset in part by $798,000 of capital expenditures. Intangible and other assets decreased from $10,440,000 at April 30, 2015 to $3,478,000 at April 30, 2016, primarily due to a non-cash impairment charge of $4,806,000, as well as the amortization of these assets. Taxes receivable, net was $48,000 at April 30, 2016 compared to taxes payable, net of $653,000 at April 30, 2015, primarily due to an estimated payment of federal taxes following April 30, 2015. In February 2016, the Company received a refund of $1,056,000 following the filing of its federal income tax return for 2015. The $48,000 includes approximately $66,000 for the anticipated recovery of taxes paid after the Company files its federal tax return for 2016, offset in part by state taxes payable of $18,000. Accounts payable and accrued expenses decreased from $10,284,000 at April 30, 2015 to $8,453,000 at April 30, 2016, primarily due to lower business volumes and the timing of payments to vendors in the Company’s Fulfillment Services business. Notes payable decreased from $18,090,000 at April 30, 2015 to $12,939,000 at April 30, 2016, primarily due to the satisfaction of a mortgage note payable with the sale of the Company’s Fairfield, Ohio warehouse in February 2016. Other liabilities and deferred revenue decreased from $4,827,000 at April 30, 2015 to $3,682,000 at April 30, 2016. In connection with the sale of the Company’s discontinued operations noted above, a subsidiary of the Company retained its ownership of a warehouse leased to the Product Packaging and Fulfillment Services business with a term that expired in November 2018. At the inception of the lease in November 2008, the subsidiary of the Company recorded deferred revenue and the Product Packaging and Fulfillment Services business recorded an Other asset amount, which amounts were being amortized over the lease term and, prior to January 31, 2015, were eliminated in consolidation. As a result of the sale of the Product Packaging and Fulfillment Services business, deferred rent revenue was no longer eliminated in consolidation and is included in Other liabilities in the accompanying balance sheet at April 30, 2015 and totaled $1,042,000. The credit related to the amortization of the deferred rent revenue had been accounted for as a reduction of general and administrative expenses for real estate operations and corporate in the accompanying financial statements. In February 2016, the warehouse was sold to a third party and, as a result of the sale, the Company reduced the deferred rent revenue to zero and recognized a pretax gain of $252,000 during the quarter ending April 30, 2016. The unfunded pension liability of the Company’s frozen defined benefit pension plan increased from $11,259,000 at April 30, 2015 to $12,710,000 at April 30, 2016, due to changes in the discount rate and mortality tables when determining pension benefit obligations. The Company recorded, net of tax, other comprehensive loss of $268,000 and $1,658,000 in 2016 and 2015, reflecting the change in the unfunded pension liability in each year net of the related deferred tax and unrecognized prepaid pension amounts. During the third quarter of 2016, an oil and gas lease became effective with respect to minerals and mineral rights owned by a subsidiary of AMREP Southwest in and under approximately 80 surface acres of land in Brighton, Colorado. As partial consideration for entering into the lease, the Company received $128,000 during the third quarter of 2016. The lease will be in force for an initial term of five years and for as long thereafter as oil or gas is produced and marketed in paying quantities from the property or for additional limited periods of time if the lessee undertakes certain operations or makes certain de minimis shut-in royalty payments. The lease does not require the lessee to drill any oil or gas wells. The lessee has agreed to pay the Company a royalty on oil and gas produced from the property of 18.75% of the sales proceeds received by the lessee from the sale of such oil and gas and such royalty will be charged with 18.75% of any post-production costs associated with such oil and gas. No drilling has commenced with respect to this property. Investing Activities Capital expenditures for property, plant and equipment for continuing operations were approximately $798,000 and $1,127,000 in 2016 and 2015, primarily for upgrades related to technology in both years for the Fulfillment Services business. The Company believes that it has adequate cash and cash flows from operations to provide for anticipated capital expenditures and land development spending in fiscal year 2017. RECENT ACCOUNTING PRONOUNCEMENTS In March 2016, the Financial Accounting Standards Board (the “FASB”) issued Accounting Standards Update (“ASU”) No. 2016-09, Compensation - Stock Compensation: Improvements to Employee Share-Based Payment Accounting. The update simplifies several aspects of accounting for employee share-based payment transactions for both public and nonpublic entities, including the accounting for income taxes, forfeitures, and statutory tax withholding requirements, as well as classification in the statement of cash flows. The ASU is effective for annual reporting periods beginning after December 15, 2016, including interim periods within those annual reporting periods. The adoption of ASU 2016-09 by the Company is not expected to have a material effect on its consolidated financial statements. In February 2016, the FASB issued ASU No. 2016-02, Leases. ASU 2016-02 requires that a lessee recognize the assets and liabilities that arise from operating leases. A lessee should recognize in its balance sheet a liability to make lease payments (the lease liability) and a right-of-use asset representing its right to use the underlying asset for the lease term. For leases with a term of twelve months or less, a lessee is permitted to make an accounting policy election by class of underlying asset not to recognize lease assets and lease liabilities. In transition, lessees and lessors are required to recognize and measure leases at the beginning of the earliest period presented using a modified retrospective approach. The amendments in the ASU will be effective for the Company for fiscal year 2020 beginning on May 1, 2019. In May 2014, the FASB issued ASU No. 2014-09, Revenue from Contracts with Customers. This guidance defines how companies report revenues from contracts with customers and also requires enhanced disclosures. In July 2015, the FASB voted to defer the effective date by one year, with early adoption on the original effective date permitted. The Company will be required to adopt the standard as of May 1, 2018 and early adoption is permitted as of May 1, 2017. The Company has not determined the transition approach that will be utilized or estimated the impact of adopting the new accounting standard. SEGMENT INFORMATION Information by industry segment is presented in Note 20 to the consolidated financial statements included in this annual report on Form 10-K. Industry segment information is prepared in a manner consistent with the manner in which financial information is prepared and evaluated by management for making operating decisions. A number of assumptions and estimates are required to be made in the determination of segment data, including the need to make certain allocations of common costs and expenses among segments. On an annual basis, management evaluates the basis upon which costs are allocated, and has periodically made revisions to these methods of allocation. Accordingly, the determination of “net income (loss)” of each segment as summarized in Note 20 to the consolidated financial statements is presented for informational purposes only, and is not necessarily the amount that would be reported if the segment were an independent company. IMPACT OF INFLATION Operations of the Company can be impacted by inflation. Within the industries in which the Company operates, inflation can cause increases in the cost of materials, services, interest and labor. Unless such increased costs are recovered through increased sales prices or improved operating efficiencies, operating margins will decrease. Within the land development industry, the Company encounters particular risks. A large part of the Company’s real estate sales are to homebuilders who face their own inflationary concerns that rising housing costs, including interest costs, may substantially outpace increases in the incomes of potential purchasers and make it difficult for them to purchase a new home or sell an owned home. If this situation were to exist, the demand for the Company’s land by these homebuilder customers could decrease. In general, in recent years interest rates have been at historically low levels and other price increases have been commensurate with the general rate of inflation in the Company’s markets, and as a result the Company has not found the inflation risk to be a significant problem in any of its businesses. FORWARD-LOOKING STATEMENTS The Private Securities Litigation Reform Act of 1995 (the “Act”) provides a safe harbor for forward-looking statements made by or on behalf of the Company. The Company and its representatives may from time to time make written or oral statements that are “forward-looking”, including statements contained in this annual report on Form 10-K and other filings with the Securities and Exchange Commission, reports to the Company’s shareholders and news releases. All statements that express expectations, estimates, forecasts or projections are forward-looking statements within the meaning of the Act. In addition, other written or oral statements, which constitute forward-looking statements, may be made by or on behalf of the Company. Words such as “expects”, “anticipates”, “intends”, “plans”, “believes”, “seeks”, “estimates”, “projects”, “forecasts”, “may”, “should”, variations of such words and similar expressions are intended to identify such forward-looking statements. These statements are not guarantees of future performance and involve certain risks, uncertainties and contingencies that are difficult to predict. All forward-looking statements speak only as of the date of this annual report on Form 10-K or, in the case of any document incorporated by reference, the date of that document. All subsequent written and oral forward-looking statements attributable to the Company or any person acting on behalf of the Company are qualified by the cautionary statements in this section. Many of the factors that will determine the Company’s future results are beyond the ability of management to control or predict. Therefore, actual outcomes and results may differ materially from what is expressed or forecasted in or suggested by such forward-looking statements. The forward-looking statements contained in this annual report on Form 10-K include, but are not limited to, statements regarding (i) the Company’s ability to finance its future working capital, land development and capital expenditure needs, (ii) the Company’s expected liquidity sources, (iii) anticipated future development of the Company’s real estate holdings, (iv) the development and construction of possible future commercial properties to be marketed to tenants, (v) the timing of reimbursements under, and the general effectiveness of, the public improvement district over a portion of the Lomas Encantadas subdivision and a portion of the Enchanted Hills/Commerce Center subdivision, (vi) the number of planned residential lots in the Company’s subdivisions, (vii) the timing and extent of the Company’s required return of incentive monies to the State of Florida, (viii) the expected loss of any material customer contract and the material adverse effect of any such loss, (ix) the effect of recent accounting pronouncements on the Company, (x) the anticipated contributions by the Company to the pension plan and the amount of future annual benefit payments to the pension plan, (xi) the effect of changes on the weighted average discount interest rate on the amount of pension plan liabilities, (xii) the timing of recognizing unrecognized compensation expense related to shares of common stock issued under the Equity Plan, (xiii) the timing and amount of recovery of taxes paid after the Company files its federal tax return for 2016, (xiv) the liability for unrecognized tax benefits not changing in the next twelve months and (xv) the adequacy of the Company’s facilities. The Company undertakes no obligation to update or publicly release any revisions to forward-looking statements to reflect events, circumstances or changes in expectations after the date of such forward-looking statement, or to make any other forward-looking statements, whether as a result of new information, future events or otherwise.

<s>[INST] For a description of the Company’s business, refer to Item 1 of Part I of this annual report on Form 10K. As indicated in Item 1, the Company, through its subsidiaries, is primarily engaged in two business segments: the real estate business operated by AMREP Southwest and its subsidiaries and the Fulfillment Services business operated by Palm Coast and its affiliates. Data concerning industry segments is set forth in Note 20 of the notes to the consolidated financial statements included in this annual report on Form 10K. The Company’s foreign sales and activities are not significant. Prior to February 9, 2015, the Company was also engaged in the Newsstand Distribution Services business and the Product Packaging and Fulfillment Services business. On February 9, 2015, the Newsstand Distribution Services business and the Product Packaging and Fulfillment Services business were sold (refer to Item 1 of Part I of this annual report on Form 10K for more detail). In addition, prior to April 10, 2015, the Company was also engaged in the Staffing Services business. On April 10, 2015, the Staffing Services business was sold (refer to Item 1 of Part I of this annual report on Form 10K for more detail). The Company’s Newsstand Distribution Services business, Product Packaging and Fulfillment Services business and Staffing Services business have been classified as discontinued operations in the financial statements included in this annual report on Form 10K. The following provides information that management believes is relevant to an assessment and understanding of the Company’s consolidated results of operations and financial condition. The discussion should be read in conjunction with the consolidated financial statements and accompanying notes. CRITICAL ACCOUNTING POLICIES AND ESTIMATES The Company prepares its financial statements in conformity with accounting principles generally accepted in the United States of America. The Company discloses its significant accounting policies in the notes to its audited consolidated financial statements. The preparation of such financial statements requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosures of contingent assets and liabilities at the dates of those financial statements as well as the reported amounts of revenues and expenses during the reporting periods. Areas that require significant judgments and estimates to be made include: (i) allowances for doubtful accounts; (ii) real estate cost of sales calculations, which are based on land development budgets and estimates of costs to complete; (iii) cash flow, asset groupings and valuation assumptions in performing asset impairment tests of longlived assets (including real estate inventories) and assets held for sale; (iv) actuarially determined defined benefit pension plan obligations and other pension plan accounting and disclosures; (v) risk assessment of uncertain tax positions; and (vi) the determination of the recoverability of net deferred tax assets. Actual results could differ from those estimates. There are numerous critical assumptions that may influence accounting estimates in these and other areas. Management bases its critical assumptions on historical experience, thirdparty data and various other estimates that it believes to be reasonable under the circumstances. The most critical assumptions made in arriving at these accounting estimates include the following: · management determines the allowance for doubtful accounts by attempting to identify troubled accounts by analyzing the credit risk of specific customers and by using historical experience applied to the aging of accounts and, where appropriate within the real estate business, by reviewing any collateral which may secure a receivable; · real estate development costs are incurred throughout the life of a project, and the costs of initial sales from a project frequently must include a portion of costs that have been budgeted based on engineering estimates or other studies, but not yet incurred; · asset impairment determinations are based upon the intended use of assets, the grouping of those assets, the expected future cash flows and estimates of fair value of assets. For real estate projects under development, an estimate of future cash flows on an undiscounted basis is determined using estimated future expenditures necessary to complete such projects and using management’s best estimates about sales prices and holding periods. Testing of longlived assets includes an estimate of future cash flows on an undiscounted basis using estimated revenue streams, operating margins, administrative expenses and terminal values. The estimation process involved in determining if assets have been impaired and in the determination of estimated future cash flows is inherently uncertain [/INST] Negative. </s>

AMREP CORP.

2017-07-18

2017-04-30

Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations INTRODUCTION For a description of the Company’s business, refer to Item 1 of Part I of this annual report on Form 10-K. As indicated in Item 1, the Company, through its subsidiaries, is primarily engaged in two business segments: the real estate business operated by AMREP Southwest and its subsidiaries and the fulfillment services business operated by Palm Coast and its affiliates. Data concerning industry segments is set forth in Note 18 of the notes to the consolidated financial statements included in this annual report on Form 10-K. The Company’s foreign sales and activities are not significant. The following provides information that management believes is relevant to an assessment and understanding of the Company’s consolidated results of operations and financial condition. The discussion should be read in conjunction with the consolidated financial statements and accompanying notes. CRITICAL ACCOUNTING POLICIES AND ESTIMATES The Company prepares its financial statements in conformity with accounting principles generally accepted in the United States of America. The Company discloses its significant accounting policies in the notes to its audited consolidated financial statements. The preparation of such financial statements requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosures of contingent assets and liabilities at the dates of those financial statements as well as the reported amounts of revenues and expenses during the reporting periods. Areas that require significant judgments and estimates to be made include: (i) allowances for doubtful accounts; (ii) real estate cost of sales calculations, which are based on land development budgets and estimates of costs to complete; (iii) cash flows, asset groupings and valuation assumptions in performing asset impairment tests of long-lived assets (including real estate inventories) and assets held for sale; (iv) actuarially determined defined benefit pension plan obligations and other pension plan accounting and disclosures; (v) risk assessment of uncertain tax positions; and (vi) the determination of the recoverability of net deferred tax assets. Actual results could differ from those estimates. There are numerous critical assumptions that may influence accounting estimates in these and other areas. Management bases its critical assumptions on historical experience, third-party data and various other estimates that it believes to be reasonable under the circumstances. The most critical assumptions made in arriving at these accounting estimates include the following: · management determines the allowance for doubtful accounts by attempting to identify troubled accounts by analyzing the credit risk of specific customers and by using historical experience applied to the aging of accounts and, where appropriate within the real estate business, by reviewing any collateral which may secure a receivable; · real estate development costs are incurred throughout the life of a project, and the costs of initial sales from a project frequently must include a portion of costs that have been budgeted based on engineering estimates or other studies, but not yet incurred; · when events or changes in circumstances indicate the carrying value of an asset may not be recoverable a test for asset impairment may be required. Asset impairment determinations are based upon the intended use of assets, the grouping of those assets, the expected future cash flows and estimates of fair value of assets. For real estate projects under development, an estimate of future cash flows on an undiscounted basis is determined using estimated future expenditures necessary to complete such projects and using management’s best estimates about sales prices and holding periods. Testing of long-lived assets includes an estimate of future cash flows on an undiscounted basis using estimated revenue streams, operating margins, administrative expenses and terminal values. The estimation process involved in determining if assets have been impaired and in the determination of estimated future cash flows is inherently uncertain because it requires estimates of future revenues and costs, as well as future events and conditions. If the excess of undiscounted cash flows over the carrying value of a particular asset group is small, there is a greater risk of future impairment and any resulting impairment charges could be material; · defined benefit pension plan obligations and plan accounting and disclosures are based upon numerous assumptions and estimates, including the expected rate of investment return on pension plan assets, the discount rate used to determine the present value of liabilities, and certain employee-related factors such as turnover, retirement age and mortality; · the Company assesses risk for uncertain tax positions and recognizes the financial statement effects of a tax position when it is more likely than not that the position will be sustained upon examination by tax authorities; and · the Company provides a valuation allowance against net deferred tax assets unless, based upon the available evidence, it is more likely than not that the deferred tax assets will be realized. In making this determination, the Company projects its future earnings (including currently unrealized gains on real estate inventory) for the future recoverability of net deferred tax assets ($9,519,000 as of April 30, 2017). The Company will need to generate taxable income of approximately $28,000,000 for federal purposes prior to the expiration of net operating loss carryforward. RESULTS OF OPERATIONS Year Ended April 30, 2017 Compared to Year Ended April 30, 2016 For 2017, the Company reported a net loss of $15,000, or $0.00 per share, compared to a net loss of $10,224,000, or $1.27 per share for 2016. The results for 2017 included a pre-tax, non-cash impairment charge of $150,000 ($95,000 after tax, or $0.01 per share), reflecting the write-down of certain real estate inventory. The results for 2016 included a pretax, non-cash impairment charge of $7,900,000 ($4,977,000 after tax, or $0.62 per share), which was comprised of impairment charges of $3,094,000 in property, plant and equipment and $4,806,000 in intangible and other assets, in each case related to the recoverability of certain long-lived assets of the fulfillment services business. In addition, the results for 2016 included a pretax, non-cash impairment charge of $2,506,000 ($1,579,000 after tax, or $0.20 per share), reflecting primarily the write-down of certain real estate inventory. Excluding the impairment charges in both years, results of continuing operations for 2017 was net income of $80,000, or $0.01 per share, compared to a net loss of $3,668,000, or $0.46 per share, for 2016. Revenues for 2017 were $42,368,000 compared to $41,664,000 in 2016. Revenues from land sales at AMREP Southwest increased from $5,697,000 in 2016 to $9,381,000 in 2017, which included revenue from developed residential land sales of $5,214,000 in 2016 and $8,795,000 in 2017. The number of new construction single family residential starts in Rio Rancho by AMREP Southwest customers and other builders was 534 in 2016 and 532 in 2017. In Rio Rancho, the Company offers for sale both developed and undeveloped lots to national, regional and local homebuilders, commercial and industrial property developers and others. The Company sold 37 acres of land in 2017 at an average selling price of $254,000 per acre compared to 61 acres of land in 2016 at an average selling price of $93,000 per acre. The increase in the average selling price per acre was due primarily to the 2017 sale of one commercial tract with no similar sale in 2016. Excluding the sale of the commercial tract, the sale price per acre for developed land decreased from $372,000 in 2016 to $352,000 in 2017. The average gross profit percentage on land sales before indirect costs was 18% for 2017 compared to 14% for 2016. As a result of many factors, including the nature and timing of specific transactions and the type and location of land being sold, revenues, average selling prices and related average gross profits from land sales can vary significantly from period to period and prior results are not necessarily a good indication of what may occur in future periods. During 2017, AMREP Southwest recorded pretax, non-cash impairment charges on certain real estate inventory of $150,000 compared to $2,506,000 in 2016. Due to volatility in market conditions and development costs, AMREP Southwest may experience future impairment charges. Revenues from the Company’s fulfillment services operations decreased from $34,757,000 for 2016 to $31,030,000 for 2017. Magazine publishers are one of the principal customers of the Company’s fulfillment services operations, and these customers have continued to be negatively impacted by increased competition from new media sources, alternative technologies for the distribution, storage and consumption of media content, weakness in advertising revenues, and increases in paper costs, printing costs and postal rates. The result has been reduced subscription sales, which has caused publishers to close some magazine titles, change subscription fulfillment providers and seek more favorable terms from Palm Coast and its competitors when contracts are up for bid or renewal. This, in turn, resulted in lower revenues and operating results in both 2017 and 2016 for the Company’s fulfillment services business and a change in the Company’s internally projected future cash flows from that segment. As a result, the Company reassessed the recoverability of the fulfillment services business long-lived assets in both years. During 2016, the fulfillment services business had a non-cash impairment charge of $7,900,000 related to its long-lived assets. In 2017, there was no impairment charge related to the fulfillment services business’s long-lived assets. Should the adverse fulfillment services business conditions continue, the fulfillment services business may experience future impairment charges related to its long-lived assets. There are a number of companies that perform fulfillment and contact center services for consumer publications, trade (business) publications, membership organizations, non-profit organizations, government agencies and other direct marketers and with which the Company’s fulfillment services business competes, including two fulfillment service providers that are larger than the Company’s fulfillment services business. There is intense competition to obtain fulfillment and contact center services customers, which results in price sensitivity that makes it difficult for the Company to increase or even maintain its prices. Other revenues increased by $747,000 in 2017 as compared to 2016. The increase was due primarily to the 2017 sale of a single tenant retail commercial building in Rio Rancho by a subsidiary of AMREP Southwest, which resulted in a pre-tax gain of $1,496,000, while 2016 revenues included rent from a warehouse facility in Fairfield, Ohio, and a gain recognized on the 2016 sale of that warehouse facility. Operating expenses for the Company’s fulfillment services business were $26,628,000 (85.8% of related revenues) for 2017 compared to $31,764,000 (91.4% of related revenues) for 2016. The decrease of $5,136,000 (16.2%) was primarily due to decreased payroll and benefits and supplies expense, both reflecting the lower business volumes, together with reduced consulting costs. Other operating expenses decreased $83,000 (5.4%) for 2017 compared to the prior year, primarily due to the capitalization of certain engineering department costs related to land development, offset in part by increased payroll and benefits. General and administrative expenses of the fulfillment services operations decreased by $1,807,000 (57.0%) for 2017 compared to the prior year primarily due to reduced (i) amortization of intangible assets that were written off in 2016, (ii) costs related to the 2016 exit of a leased facility, (iii) consulting costs and (iv) payroll and benefit costs. Real estate operations general and administrative expenses decreased by $158,000 (23.7%) for 2017 compared to the prior year primarily due to lower warranty costs as well as reduced rent and depreciation expense. Corporate operations general and administrative expenses increased by $36,000 (1.2%) for 2017 compared to the prior year primarily due to increased pension and consulting costs, offset in part by reduced payroll and benefit costs. Interest expense decreased by $1,028,000 (75.5%) for 2017 compared to the prior year, due to the satisfaction in full of two notes payable of AMREP Southwest during the course of 2017. The Company’s effective tax rate was 101.5% in 2017 compared to 33.8% in 2016. The difference between the statutory tax rate and the effective rate of tax in 2017 was primarily due to the use and elimination of certain state operating loss carryforwards which were wholly or partially reserved with a valuation allowance, as well as a change in deferred tax rates in certain states. The difference between the statutory tax rate and the effective rate of the tax benefit in 2016 was due to the recognition of valuation allowances that totaled $910,000 for certain state deferred tax assets that were deemed not likely to be realized. The total tax effect of gross unrecognized tax benefits in the accompanying financial statements at both April 30, 2017 and 2016 was $58,000, which, if recognized, would have an impact on the effective tax rate. The Company believes it is reasonably possible that the liability for unrecognized tax benefits will not change in fiscal year 2018. LIQUIDITY AND CAPITAL RESOURCES AMREP Corporation is a holding company that conducts substantially all of its operations through subsidiaries. As a holding company, AMREP Corporation is dependent on its available funds and on distributions of funds from subsidiaries to pay expenses and fund operations. The Company’s primary sources of funding for working capital requirements are cash flow from operations and existing cash balances. The Company’s liquidity is affected by many factors, including some that are based on normal operations and some that are related to the industries in which the Company operates and the economy generally. Real Estate The primary sources of funding for working capital requirements of the Company’s real estate business are cash flow from operations and cash advances made to it by its parent. Land investments generally cannot be sold quickly, and the ability of the Company’s real estate business to sell properties has been and will continue to be affected by market conditions. The ability of the Company’s real estate business to generate cash flow from operations is dependent upon its ability to sell the properties it has selected for disposition at the prices and within the timeframes AMREP Southwest has established for each property. Prior to February 2017, AMREP Southwest had a loan from a company owned by Nicholas G. Karabots, a significant shareholder of the Company and in which another major shareholder and a director of the Company had a 20% participation. The loan was scheduled to mature in December 2017 and bore interest payable monthly at 8.5% per annum. The balance of this loan was paid in full in February 2017. Commencing in 2016, a subsidiary of AMREP Southwest had a loan agreement with a third party lender for the construction of a 2,200 square foot, single tenant retail building in Rio Rancho, New Mexico. The loan was scheduled to mature in October 2016 and bore interest payable monthly at 0.5% plus the prime rate. In 2017, the Company sold this property, recognizing a pre-tax gain of $1,496,000, and repaid the loan with the proceeds of the sale. Fulfillment Services The primary source of funding for working capital requirements of the Company’s fulfillment services business is cash flow from operations. If the fulfillment services business needs additional liquidity, the parent of the fulfillment services business may in its discretion make cash advances available. The fulfillment services business relies on a small number of large clients; if it should lose one or more of its largest clients, or if revenues from its largest clients decline, the liquidity of the fulfillment services business could be adversely affected. The five largest clients in the fulfillment services business accounted for 42% of its 2017 revenues. The fulfillment services business operates in a very competitive environment with changes in service providers by customers not being unusual. The fulfillment services business has experienced, and expects to continue to experience, such customer changes. Based on information received from customers, the fulfillment services business currently expects a limited number of significant customers to change service providers for certain services (a) during fiscal year 2018 representing in aggregate approximately 9% of the Company’s consolidated 2017 revenues and (b) during fiscal year 2019 representing in aggregate an additional approximately 4% of the Company’s consolidated 2017 revenues. Of the significant customers expected to change service providers for certain services in fiscal year 2018, one customer was expected to change service providers for certain services in 2016 (representing approximately 7% of the Company’s consolidated 2017 revenues) but continues to be delayed in effectuating such change. As expected in a competitive environment, the fulfillment services business has been successful in obtaining new customer contracts. Approximately 7% of the number of customers of the fulfillment services business as of the end of fiscal year 2017 were new customers during fiscal year 2017, but the revenue to be generated by these new customers during fiscal years 2018 and 2019 is expected to be significantly less than the revenue expected to be lost from customers changing service providers or those reducing services the fulfillment services business provides them during fiscal years 2018 and 2019. In June 2009, Palm Coast received $3,000,000 pursuant to an agreement with the State of Florida (the “Award Agreement”) as part of the incentives made available in connection with the Company’s project, completed in the second quarter of fiscal year 2011, to consolidate its fulfillment services operations at its Palm Coast, Florida location. The Award Agreement included certain performance requirements in terms of job retention, job creation and capital investment which, if not met by Palm Coast, entitled the State of Florida to obtain the return of a portion, or all, of the $3,000,000. Palm Coast had not met certain of the performance requirements in the Award Agreement, in large part due to the adverse economic conditions experienced by the magazine publishing industry since the Award Agreement was executed. On December 30, 2016, the State of Florida filed a complaint in the Circuit Court of the Second Judicial Circuit in and for Leon County, Florida against Palm Coast seeking repayment of amounts under the Award Agreement. In May 2017, Palm Coast entered into a Settlement Agreement and Mutual General Release (the “Settlement Agreement”) with the State of Florida. Pursuant to the Settlement Agreement, · Palm Coast agreed to pay the State of Florida $1,763,000 as follows: (1) $163,000 within 30 days after May 4, 2017 and (2) 40 quarterly payments of $40,000 each, without interest, on the first business day of each calendar quarter, with the first payment of $40,000 scheduled to be made on October 1, 2017 and the last payment of $40,000 scheduled to be made on July 1, 2027; provided that, the timing of the payment of all such quarterly payments may be accelerated by the State of Florida following Palm Coast’s failure to timely pay any such amounts; · the Award Agreement was terminated; · each of the parties released all claims relating to the Award Agreement that the releasing party may have had against the other party; and · the complaint filed in the Circuit Court of the Second Judicial Circuit in and for Leon County, Florida relating to the Award Agreement was dismissed and discontinued by the State of Florida. In May 2017, the Company entered into a Guaranty Agreement (the “Guaranty”) with the State of Florida. Pursuant to the Guaranty, the Company guaranteed the payment by Palm Coast of amounts due to the State of Florida under the Settlement Agreement. As a result of the Settlement Agreement, Palm Coast expects that it will recognize in the first quarter of fiscal year 2018 a pre-tax gain of approximately $1,318,000 and deferred revenue of approximately $302,000. The pre-tax gain was determined based on depreciation previously taken on assets acquired with Award Agreement funds that were retained by Palm Coast. The deferred revenue will be recognized over the remaining life of these assets. In April 2015, the fulfillment services business exited a leased facility in Palm Coast, Florida comprising approximately 42,000 square feet of space and in October 2015 terminated the lease that was scheduled to expire in April 2016 with a termination payment of $122,000. Pension Plan The Company has a defined benefit pension plan for which accumulated benefits were frozen and future service credits were curtailed as of March 1, 2004. Under generally accepted accounting principles, the Company’s defined benefit pension plan was underfunded at April 30, 2017 by $10,967,000, with $23,277,000 of assets and $34,244,000 of liabilities. The pension plan liabilities were determined using a weighted average discount interest rate of 3.52% per year, which is based on the Citigroup yield curve as it corresponds to the projected liability requirements of the pension plan. As of April 30, 2017, for each 0.25% increase in the weighted average discount interest rate, the pension plan liabilities are forecasted to decrease by approximately $783,000 and for each 0.25% decrease in the weighted average discount interest rate, the pension plan liabilities are forecasted to increase by approximately $816,000. As of April 30, 2017, the effect of every 0.25% change in the investment rate of return on pension plan assets would increase or decrease the subsequent year’s pension expense by approximately $56,000, and the effect of every 0.25% change in the weighted average discount interest rate would increase or decrease the subsequent year’s pension expense by approximately $26,000. Due to the closing of certain facilities in 2011 in connection with the consolidation of the Company’s fulfillment services business and the associated work force reduction in 2011, the Employee Retirement Income Security Act of 1974, as amended (“ERISA”), and the regulations thereunder, gave the PBGC the right to require the Company to accelerate the funding of approximately $11,688,000 of accrued pension-related obligations to the Company’s defined benefit pension plan. In August 2012, the Company and the PBGC reached an initial agreement with respect to this funding obligation, and as a result, the Company made a $3,000,000 cash contribution to the pension plan in August 2012, thereby leaving a remaining accelerated funding liability of $8,688,000. In August 2013, the Company entered into a settlement agreement with the PBGC. In the settlement agreement, the PBGC agreed to forbear from asserting certain rights to obtain payment of the remaining $8,688,000 accelerated funding liability granted to it by ERISA, and the Company agreed (a) to pay $3,243,000 of the accelerated funding liability as a cash contribution to its pension plan, which payment was made in September 2013, and (b) to provide first lien mortgages on certain real property with an aggregate appraised value of $10,039,000 in favor of the PBGC to secure the remaining unpaid amount of the accelerated funding liability. The total book value of the real property subject to the mortgages was approximately $10,034,000 as of April 30, 2017. In addition, the PBGC agreed to credit $426,000 of contributions made by the Company to the pension plan in excess of the 2012 minimum funding requirements towards the accelerated funding liability, so that, after this credit and the $3,243,000 payment referred to above, the remaining accelerated funding liability was $5,019,500. In May 2017, the Company sold certain real property subject to the mortgage in favor of the PBGC resulting in a payment of $485,000 to the pension plan and a remaining accelerated funding liability of $4,534,500. On an annual basis, the Company is required to provide updated appraisals on each mortgaged property and, if the appraised value of the mortgaged properties is less than two times the amount of the accelerated funding liability then outstanding, the Company is required to make a payment to its pension plan in an amount equal to one-half of the amount of the shortfall. Upon the sale by the Company of any property mortgaged in favor of the PBGC, the Company is required to deposit in its pension plan 50% of the lesser of (i) the amount equal to the total purchase price of the mortgaged property minus certain transaction costs or (ii) the appraised value of the mortgaged property. The mortgages in favor of the PBGC will be discharged following the termination date of the settlement agreement. In connection with the settlement agreement, the Company made certain representations and warranties and is required to comply with various covenants, reporting requirements and other requirements, including making all required minimum funding contributions to its pension plan. Any failure by the Company to comply with its obligations under the settlement agreement may result in an event of default, which would permit the PBGC to repossess, sell or foreclose on the properties that have been mortgaged in favor of the PBGC; however, if the Company complies with the terms of the settlement agreement, including making all future required minimum funding contributions to its pension plan and any payments required due to any shortfall in the appraised value of real property covered by the mortgages described above, the Company will not be required to make any further cash payments to its pension plan with respect to the remaining accelerated funding liability. The settlement agreement is scheduled to terminate on the earlier of the date the accelerated funding liability has been paid in full or on August 30, 2018. Effective on the termination date of the settlement agreement, the PBGC will be deemed to have released and discharged the Company and all other members of its controlled group from any claims in connection with such members’ liability or obligations with respect to the accelerated funding liability. The settlement agreement does not address any future events that may accelerate any other accrued pension plan obligations. The Company may become subject to additional acceleration of its remaining accrued obligations to the pension plan if the Company closes other facilities and further reduces its work force of active pension plan participants. Any such acceleration could negatively impact the Company’s limited financial resources and could have a material adverse effect on the Company’s financial condition. Other Financing Activities A subsidiary of the Company had a promissory note issued to a third party lender with respect to a warehouse in Fairfield, Ohio. The loan was scheduled to mature in February 2018 and bore interest payable monthly at 6.35%. In 2016, this property was sold and the promissory note related thereto with an outstanding principal balance of $3,992,000 was paid in full from the proceeds of the sale. The Company recorded a gain on the sale of $252,000. Operating Activities Receivables from trade customers decreased from $7,271,000 at April 30, 2016 to $6,379,000 at April 30, 2017, primarily due to lower business volumes of the fulfillment services business. Real estate inventory totaled $56,090,000 at April 30, 2017 compared to $61,663,000 at April 30, 2016. Inventory in AMREP Southwest’s core real estate market of Rio Rancho decreased from $57,013,000 at April 30, 2016 to $51,429,000 at April 30, 2017, primarily as a result of land sales and also included a pretax, non-cash impairment charge of $150,000 on certain real estate inventory. The balance of real estate inventory consisted of properties in Colorado. Investment assets decreased from $10,326,000 at April 30, 2016 to $9,715,000 at April 30, 2017, primarily as a result of the sale of a single tenant retail building by a subsidiary of AMREP Southwest. Property, plant and equipment decreased from $11,997,000 at April 30, 2016 to $10,852,000 at April 30, 2017, primarily due to depreciation charges, which were offset in part by $249,000 of capital expenditures. Other assets decreased from $3,478,000 at April 30, 2016 to $2,310,000 at April 30, 2017, partially due to a reduction of prepaid interest associated with the satisfaction of a related party loan during 2017. Taxes receivable, net was $48,000 at April 30, 2016 compared to taxes payable, net of $465,000 at April 30, 2017, primarily due to tax loss benefits and income in the respective years. Accounts payable and accrued expenses decreased from $8,453,000 at April 30, 2016 to $7,035,000 at April 30, 2017, primarily due to lower business volumes and the timing of payments to vendors in the Company’s fulfillment services business. Notes payable decreased from $12,939,000 at April 30, 2016 to none at April 30, 2017, due to the satisfaction of two notes payable. Other liabilities and deferred revenue decreased from $3,682,000 at April 30, 2016 to $3,376,000 at April 30, 2017, primarily due to the amortization of deferred revenue related to an oil and gas lease payment received in fiscal year 2015. The unfunded pension liability of the Company’s frozen defined benefit pension plan decreased from $12,710,000 at April 30, 2016 to $10,967,000 at April 30, 2017, primarily due to changes in the discount rate and mortality tables when determining pension benefit obligations together with the favorable investment results of plan assets during 2017. The Company recorded, net of tax, other comprehensive income of $1,861,000 in 2017 and other comprehensive loss of $268,000 in 2016, reflecting the change in the unfunded pension liability in each year net of the related deferred tax and unrecognized prepaid pension amounts. In 2016, an oil and gas lease became effective with respect to minerals and mineral rights owned by a subsidiary of AMREP Southwest in and under approximately 80 surface acres of land in Brighton, Colorado. As partial consideration for entering into the lease, the Company received $128,000 in 2016. The lease will be in force for an initial term of five years and for as long thereafter as oil or gas is produced and marketed in paying quantities from the property or for additional limited periods of time if the lessee undertakes certain operations or makes certain de minimis shut-in royalty payments. The lease does not require the lessee to drill any oil or gas wells. The lessee has agreed to pay the Company a royalty on oil and gas produced from the property of 18.75% of the sales proceeds received by the lessee from the sale of such oil and gas and such royalty will be charged with 18.75% of any post-production costs associated with such oil and gas. No drilling has commenced with respect to this property. Investing Activities Capital expenditures for property, plant and equipment for continuing operations were approximately $249,000 and $798,000 in 2017 and 2016, primarily for upgrades related to technology in both years for the fulfillment services business. The Company believes that it has adequate cash and cash flows from operations to provide for anticipated capital expenditures and land development spending in fiscal year 2018. RECENT ACCOUNTING PRONOUNCEMENTS In May 2014, the Financial Accounting Standards Board (the “FASB”) issued Accounting Standards Update (“ASU”) No. 2014-09, Revenue from Contracts with Customers. Since that date, the FASB has issued additional ASUs providing further revenue recognition guidance (collectively, “Topic 606”). Topic 606 clarifies the principles for recognizing revenue and costs related to obtaining and fulfilling customer contracts, with the objective of improving financial reporting. The core principle of Topic 606 is to recognize revenues when promised goods or services are transferred to customers in an amount that reflects the consideration the Company expects to receive in exchange for those goods or services. Topic 606 defines a five-step process to achieve this core principle, and more judgment and estimates may be required under Topic 606 than are currently required under generally accepted accounting principles. The two permitted transition methods under Topic 606 are (i) the full retrospective method, in which case the standard would be applied to each prior reporting period presented, or the modified retrospective method, in which case the cumulative effect of applying the standard would be recognized at the date of adoption. In August 2015, the FASB issued ASU No. 2015-14, Revenue from Contracts with Customers (Topic 606): Deferral of the Effective Date, which deferred the required adoption date until May 1, 2018, although an earlier adoption is permitted. The Company does not intend to early adopt Topic 606. The Company is currently evaluating the impact of Topic 606 on the Company’s accounting policies, processes and system requirements, as well as its consolidated financial statements. The Company is also evaluating the transition method it will select upon adoption. Depending on the results of the evaluation, there could be changes to the timing of recognition of revenues and related costs. As the Company considers itself to be in the initial stages of evaluation of the impact of Topic 606, the Company does not know and cannot reasonably estimate quantitative information related to the impact of these new ASUs on its consolidated financial statements, including the effect on the Company’s operating results. In August 2014, the FASB issued ASU No. 2014-15, Presentation of Financial Statements - Going Concern (“ASU 2014-15), which provides guidance on management’s responsibility to evaluate whether there are conditions or events, considered in the aggregate, that raise a substantial doubt about the entity’s ability to continue as a going concern within one year after the date that the financial statements are issued. Management’s evaluation should be based on relevant conditions and events that are known and likely to occur at the date that the financial statements are issued. ASU 2014-15 was effective for the Company for fiscal year ended April 30, 2017. The adoption of ASU 2014-15 by the Company did not have a material effect on its consolidated financial statements. In February 2016, the FASB issued ASU No. 2016-02, Leases. ASU 2016-02 requires that a lessee recognize the assets and liabilities that arise from operating leases. A lessee should recognize in its balance sheet a liability to make lease payments (the lease liability) and a right-of-use asset representing its right to use the underlying asset for the lease term. For leases with a term of twelve months or less, a lessee is permitted to make an accounting policy election by class of underlying asset not to recognize lease assets and lease liabilities. In transition, lessees and lessors are required to recognize and measure leases at the beginning of the earliest period presented using a modified retrospective approach. The amendments in the ASU will be effective for the Company for fiscal year 2020 beginning on May 1, 2019. The Company has not yet concluded how the new standard will impact its consolidated financial statements. In March 2016, the FASB issued ASU No. 2016-09, Compensation - Stock Compensation: Improvements to Employee Share-Based Payment Accounting. ASU 2016-09 simplifies several aspects of accounting for employee share-based payment transactions, including the accounting for income taxes, forfeitures, and statutory tax withholding requirements, as well as classification in the statement of cash flows. ASU 2016-09 is effective for the Company’s fiscal year 2018 beginning May 1, 2017, including interim periods within that fiscal year. The adoption of ASU 2016-09 by the Company is not expected to have a material effect on its consolidated financial statements. In August 2016, the FASB issued ASU 2016-15, Statement of Cash Flows (Topic 230): Classification of Certain Cash Receipts and Cash Payments. The purpose of ASU 2016-15 is to reduce the diversity in practice regarding how certain cash receipts and cash payments are presented and classified in the statement of cash flows. ASU 2016-15 is effective for the Company’s fiscal year 2019 beginning May 1, 2018. Early adoption is permitted. A retrospective transition method is to be used in the application of this amendment. The adoption of ASU 2016-15 by the Company is not expected to have a material effect on its consolidated financial statements. In December 2016, the FASB issued ASU No. 2016-19, Technical Corrections and Improvements. ASU 2016-19 clarifies and improves ease of understanding for existing guidance under the Accounting Standards Codification by making the text more uniform and streamlined. ASU 2016-19 was effective when issued. The adoption of ASU 2016-19 by the Company did not have a material effect on its consolidated financial statements. SEGMENT INFORMATION Information by industry segment is presented in Note 18 to the consolidated financial statements included in this annual report on Form 10-K. Industry segment information is prepared in a manner consistent with the manner in which financial information is prepared and evaluated by management for making operating decisions. A number of assumptions and estimates are required to be made in the determination of segment data, including the need to make certain allocations of common costs and expenses among segments. On an annual basis, management evaluates the basis upon which costs are allocated, and has periodically made revisions to these methods of allocation. Accordingly, the determination of “net income (loss)” of each segment as summarized in Note 18 to the consolidated financial statements is presented for informational purposes only, and is not necessarily the amount that would be reported if the segment were an independent company. IMPACT OF INFLATION Operations of the Company can be impacted by inflation. Within the industries in which the Company operates, inflation can cause increases in the cost of materials, services, interest and labor. Unless such increased costs are recovered through increased sales prices or improved operating efficiencies, operating margins will decrease. Within the land development industry, the Company encounters particular risks. A large part of the Company’s real estate sales are to homebuilders who face their own inflationary concerns that rising housing costs, including interest costs, may substantially outpace increases in the incomes of potential purchasers and make it difficult for them to purchase a new home or sell an owned home. If this situation were to exist, the demand for the Company’s land by these homebuilder customers could decrease. In general, in recent years interest rates have been at historically low levels and other price increases have been commensurate with the general rate of inflation in the Company’s markets, and as a result the Company has not found the inflation risk to be a significant problem in any of its businesses. FORWARD-LOOKING STATEMENTS The Private Securities Litigation Reform Act of 1995 (the “Act”) provides a safe harbor for forward-looking statements made by or on behalf of the Company. The Company and its representatives may from time to time make written or oral statements that are “forward-looking”, including statements contained in this annual report on Form 10-K and other filings with the Securities and Exchange Commission, reports to the Company’s shareholders and news releases. All statements that express expectations, estimates, forecasts or projections are forward-looking statements within the meaning of the Act. In addition, other written or oral statements, which constitute forward-looking statements, may be made by or on behalf of the Company. Words such as “expects”, “anticipates”, “intends”, “plans”, “believes”, “seeks”, “estimates”, “projects”, “forecasts”, “may”, “should”, variations of such words and similar expressions are intended to identify such forward-looking statements. These statements are not guarantees of future performance and involve certain risks, uncertainties and contingencies that are difficult to predict. All forward-looking statements speak only as of the date of this annual report on Form 10-K or, in the case of any document incorporated by reference, the date of that document. All subsequent written and oral forward-looking statements attributable to the Company or any person acting on behalf of the Company are qualified by the cautionary statements in this section. Many of the factors that will determine the Company’s future results are beyond the ability of management to control or predict. Therefore, actual outcomes and results may differ materially from what is expressed or forecasted in or suggested by such forward-looking statements. The forward-looking statements contained in this annual report on Form 10-K include, but are not limited to, statements regarding (i) the Company’s ability to finance its future working capital, land development and capital expenditure needs, (ii) the Company’s expected liquidity sources, (iii) anticipated future development of the Company’s real estate holdings, (iv) the development and construction of possible future commercial properties to be marketed to tenants, (v) the timing of reimbursements under, and the general effectiveness of, the public improvement district over a portion of the Lomas Encantadas subdivision and a portion of the Enchanted Hills/Commerce Center subdivision, (vi) the number of planned residential lots in the Company’s subdivisions, (vii) estimates and assumptions used in determining future cash flows of real estate projects, (viii) the expected loss of any material customer contract and the material adverse effect of any such loss, (ix) the effect of recent accounting pronouncements on the Company, (x) the anticipated contributions by the Company to the pension plan, the amount of future annual benefit payments to the pension plan, the appropriateness of valuation methods to determine the fair value of financial instruments in the pension plan, the expected return on assets in the pension plan, the expected long-term rate of return on assets in the pension plan and the effect of changes on the weighted average discount interest rate on the amount of pension plan liabilities, (xi) the timing of recognizing unrecognized compensation expense related to shares of common stock issued under the AMREP Corporation 2006 Equity Compensation Plan or the AMREP Corporation 2016 Equity Compensation Plan, (xii) the liability for unrecognized tax benefits not changing in fiscal year 2018, (xiii) the adequacy of the Company’s facilities, (xiv) the gain on settlement of, and deferred revenue with respect to, the Settlement Agreement and (xv) the materiality of claims and legal actions arising in the normal course of the Company’s business. The Company undertakes no obligation to update or publicly release any revisions to forward-looking statements to reflect events, circumstances or changes in expectations after the date of such forward-looking statement, or to make any other forward-looking statements, whether as a result of new information, future events or otherwise.

<s>[INST] For a description of the Company’s business, refer to Item 1 of Part I of this annual report on Form 10K. As indicated in Item 1, the Company, through its subsidiaries, is primarily engaged in two business segments: the real estate business operated by AMREP Southwest and its subsidiaries and the fulfillment services business operated by Palm Coast and its affiliates. Data concerning industry segments is set forth in Note 18 of the notes to the consolidated financial statements included in this annual report on Form 10K. The Company’s foreign sales and activities are not significant. The following provides information that management believes is relevant to an assessment and understanding of the Company’s consolidated results of operations and financial condition. The discussion should be read in conjunction with the consolidated financial statements and accompanying notes. CRITICAL ACCOUNTING POLICIES AND ESTIMATES The Company prepares its financial statements in conformity with accounting principles generally accepted in the United States of America. The Company discloses its significant accounting policies in the notes to its audited consolidated financial statements. The preparation of such financial statements requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosures of contingent assets and liabilities at the dates of those financial statements as well as the reported amounts of revenues and expenses during the reporting periods. Areas that require significant judgments and estimates to be made include: (i) allowances for doubtful accounts; (ii) real estate cost of sales calculations, which are based on land development budgets and estimates of costs to complete; (iii) cash flows, asset groupings and valuation assumptions in performing asset impairment tests of longlived assets (including real estate inventories) and assets held for sale; (iv) actuarially determined defined benefit pension plan obligations and other pension plan accounting and disclosures; (v) risk assessment of uncertain tax positions; and (vi) the determination of the recoverability of net deferred tax assets. Actual results could differ from those estimates. There are numerous critical assumptions that may influence accounting estimates in these and other areas. Management bases its critical assumptions on historical experience, thirdparty data and various other estimates that it believes to be reasonable under the circumstances. The most critical assumptions made in arriving at these accounting estimates include the following: · management determines the allowance for doubtful accounts by attempting to identify troubled accounts by analyzing the credit risk of specific customers and by using historical experience applied to the aging of accounts and, where appropriate within the real estate business, by reviewing any collateral which may secure a receivable; · real estate development costs are incurred throughout the life of a project, and the costs of initial sales from a project frequently must include a portion of costs that have been budgeted based on engineering estimates or other studies, but not yet incurred; · when events or changes in circumstances indicate the carrying value of an asset may not be recoverable a test for asset impairment may be required. Asset impairment determinations are based upon the intended use of assets, the grouping of those assets, the expected future cash flows and estimates of fair value of assets. For real estate projects under development, an estimate of future cash flows on an undiscounted basis is determined using estimated future expenditures necessary to complete such projects and using management’s best estimates about sales prices and holding periods. Testing of longlived assets includes an estimate of future cash flows on an undiscounted basis using estimated revenue streams, operating margins, administrative expenses and terminal values. The estimation process involved in determining if assets have been impaired and in the determination of estimated future cash flows is inherently uncertain because it requires estimates of future revenues and costs, as well as future events and conditions. If the excess of undiscounted cash flows over the carrying value of a particular asset group is small, there is a greater risk of future impairment and any resulting impairment charges could be material; · defined benefit pension plan obligations and plan accounting and disclosures are based upon numerous assumptions and estimates, including the expected rate of investment return on pension plan assets, the discount rate used to determine the present value of liabilities, and certain employeerelated factors such as turnover, retirement age and mortality; · the Company assesses risk for uncertain tax positions and recognizes the financial statement effects of a tax position when it is more likely than not that the position will be sustained upon examination by tax authorities; and [/INST] Negative. </s>

AMREP CORP.

2018-07-20

2018-04-30

Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations INTRODUCTION For a description of the Company’s business, refer to Item 1. As indicated in Item 1, the Company, through its subsidiaries, is primarily engaged in two business segments: the real estate business operated by AMREP Southwest and its subsidiaries and the fulfillment services business operated by Palm Coast and its affiliates. Data concerning industry segments is set forth in Note 17 of the notes to the consolidated financial statements included in this annual report on Form 10-K. The Company’s foreign sales and activities are not significant. The following provides information that management believes is relevant to an assessment and understanding of the Company’s consolidated results of operations and financial condition. The discussion should be read in conjunction with the consolidated financial statements and accompanying notes. CRITICAL ACCOUNTING POLICIES AND ESTIMATES The Company prepares its financial statements in conformity with accounting principles generally accepted in the United States of America. The Company discloses its significant accounting policies in the notes to its audited consolidated financial statements. The preparation of such financial statements requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosures of contingent assets and liabilities at the dates of those financial statements as well as the reported amounts of revenues and expenses during the reporting periods. Areas that require significant judgments and estimates to be made include: (i) allowances for doubtful accounts; (ii) real estate cost of sales calculations, which are based on land development budgets and estimates of costs to complete; (iii) cash flows, asset groupings and valuation assumptions in performing asset impairment tests of long-lived assets (including real estate inventories) and assets held for sale; (iv) actuarially determined defined benefit pension plan obligations and other pension plan accounting and disclosures; (v) risk assessment of uncertain tax positions; and (vi) the determination of the recoverability of net deferred tax assets. Actual results could differ from those estimates. There are numerous critical assumptions that may influence accounting estimates in these and other areas. Management bases its critical assumptions on historical experience, third-party data and various other estimates that it believes to be reasonable under the circumstances. The most critical assumptions made in arriving at these accounting estimates include the following: · management determines the allowance for doubtful accounts by attempting to identify troubled accounts by analyzing the credit risk of specific customers and by using historical experience applied to the aging of accounts and, where appropriate within the real estate business, by reviewing any collateral which may secure a receivable; · real estate development costs are incurred throughout the life of a project, and the costs of initial sales from a project frequently must include a portion of costs that have been budgeted based on engineering estimates or other studies, but not yet incurred; · when events or changes in circumstances indicate the carrying value of an asset may not be recoverable a test for asset impairment may be required. Asset impairment determinations are based upon the intended use of assets, the grouping of those assets, the expected future cash flows and estimates of fair value of assets. For real estate projects under development, an estimate of future cash flows on an undiscounted basis is determined using estimated future expenditures necessary to complete such projects and using management’s best estimates about sales prices and holding periods. Testing of long-lived assets includes an estimate of future cash flows on an undiscounted basis using estimated revenue streams, operating margins, administrative expenses and terminal values. The estimation process involved in determining if assets have been impaired and in the determination of estimated future cash flows is inherently uncertain because it requires estimates of future revenues and costs, as well as future events and conditions. If the excess of undiscounted cash flows over the carrying value of a particular asset group is small, there is a greater risk of future impairment and any resulting impairment charges could be material; · defined benefit pension plan obligations and plan accounting and disclosures are based upon numerous assumptions and estimates, including the expected rate of investment return on pension plan assets, the discount rate used to determine the present value of liabilities, and certain employee-related factors such as turnover, retirement age and mortality; · the Company assesses risk for uncertain tax positions and recognizes the financial statement effects of a tax position when it is more likely than not that the position will be sustained upon examination by tax authorities; and · the Company provides a valuation allowance against net deferred tax assets unless, based upon the available evidence, it is more likely than not that the deferred tax assets will be realized. In making this determination, the Company projects its future earnings (including currently unrealized gains on real estate inventory) for the future recoverability of net deferred tax assets ($5,060,000 as of April 30, 2018). RESULTS OF OPERATIONS Year Ended April 30, 2018 Compared to Year Ended April 30, 2017 For 2018, the Company reported net income of $238,000, or $0.03 per share, compared to a net loss of $15,000, or $0.00 per share, for 2017. Results for 2018 included a non-cash increase in income tax expense of $2,710,000, or $0.34 per share, as a result of federal tax law changes enacted during 2018. Results for 2017 included a pre-tax, non-cash impairment charge of $150,000 ($95,000 after tax, or $0.01 per share), reflecting the write-down of certain real estate inventory. Excluding the impact of tax law changes in 2018 and the impairment charge in 2017, results for 2018 were net income of $2,948,000, or $0.37 per share, compared to net income of $80,000, or $0.01 per share, for 2017. Revenues were $40,178,000 for 2018 compared to $42,368,000 for 2017. Revenues from land sales at AMREP Southwest and its subsidiaries were $8,439,000 for 2018 compared to $9,381,000 for 2017. $2,044,000 of the $8,439,000 of revenues from land sales for 2018 was for an approximate five acre undeveloped commercial property in Colorado, which had a gross profit percentage of 65%. The number of new construction single-family residential starts in Rio Rancho by AMREP Southwest customers and other builders was 473 in 2018 and 532 in 2017. AMREP Southwest and its subsidiaries offer for sale both developed and undeveloped lots to national, regional and local homebuilders, commercial and industrial property developers and others. AMREP Southwest and its subsidiaries sold 27 acres of residential land in 2018 at an average selling price of $237,000 per acre compared to 36 acres of residential land in 2017 at an average selling price of $248,000 per acre. The decrease in the average selling price per acre of residential land in 2018 compared to 2017 was primarily due to the location of the sold lots. A subsidiary of AMREP Southwest sold a one-acre commercial tract in 2017 for $467,000. The average gross profit percentage on land sales in New Mexico before indirect costs was 16% for 2018 compared to 18% for 2017. As a result of many factors, including the nature and timing of specific transactions and the type and location of land being sold, revenues, average selling prices and related average gross profits from land sales can vary significantly from period to period and prior results are not necessarily a good indication of what may occur in future periods. During 2017, AMREP Southwest recorded a pretax, non-cash impairment charge on certain real estate inventory of $150,000. Due to volatility in market conditions and development costs, AMREP Southwest may experience future impairment charges. Revenues from the Company’s fulfillment services operations decreased from $31,030,000 for 2017 to $29,441,000 for 2018. The lower revenues were attributable to reduced business volumes from existing customers, price concessions on renewed contracts and lost business. Magazine publishers are one of the principal customers of the Company’s fulfillment services operations, and these customers have continued to be negatively impacted by increased competition from new media sources, alternative technologies for the distribution, storage and consumption of media content, weakness in advertising revenues and increases in paper costs, printing costs and postal rates. The result has been reduced subscription sales, which has caused publishers to close some magazine titles, change subscription fulfillment providers and seek more favorable terms from the Company’s fulfillment services operations and its competitors when contracts are up for bid or renewal. There is intense competition to obtain fulfillment and contact center services customers, which results in price sensitivity that makes it difficult for the Company’s fulfillment services operations to increase or even maintain its prices. Other revenues were $2,298,000 for 2018 compared to $1,957,000 for 2017. Other revenues for 2018 were primarily due to a pre-tax gain of $1,810,000 related to a settlement agreement with the State of Florida by Palm Coast. Other revenues for 2017 were primarily the result of the sale of a retail commercial property by AMREP Southwest, which resulted in a pre-tax gain of $1,496,000. In addition to these pre-tax gains, Other revenues includes the recognition of deferred revenue related to an oil and gas lease, fees and forfeited deposits from customers earned by AMREP Southwest and miscellaneous other income items. Operating and selling expenses for the Company’s real estate business were $1,652,000 for 2018 compared to $1,527,000 for 2017. The increase of $125,000 was primarily due to commissions on a Colorado land sale and lower capitalized engineering costs. Operating and selling expenses for the Company’s fulfillment services business were $24,016,000 for 2018 compared to $26,628,000 for 2017. The decrease of $2,612,000 was primarily due to decreased payroll and benefits and supplies expense, both reflecting lower business volumes, together with reduced consulting costs. General and administrative expenses for the Company’s real estate business increased from $510,000 for 2017 to $578,000 for 2018, primarily due to increased travel, outside service costs and professional fees for software implementation. General and administrative expenses for the Company’s fulfillment services business decreased from $1,362,000 for 2017 to $1,306,000 for 2018, primarily due to lower payroll and benefits, professional fees, bank fees and travel expenses. Corporate general and administrative expenses decreased from $3,161,000 for 2017 to $3,052,000 for 2018, primarily due to lower pension costs, consulting fees and legal expenses, offset in part by higher payroll costs. Interest expense was $57,000 for 2018 compared to $333,000 for 2017. Interest expense in 2018 was primarily related to the settlement of the remaining liability with the State of Florida noted above and interest expense in 2017 was primarily related to two notes payable of AMREP Southwest that were paid in full during 2017. There was $13,000 of capitalized interest for 2018 and $83,000 for 2017. The U.S. Tax Cuts and Jobs Act (the “Act”) was signed into law on December 22, 2017. The Act significantly revised the future ongoing U.S. corporate income tax by, among other things, lowering U.S. corporate income tax rates. The Act reduced the federal corporate tax rate from 35.0% to 21.0% effective January 1, 2018. Since the Company’s tax year ended on April 30, 2018, the lower corporate income tax rate is phased in, resulting in a U.S. statutory federal corporate tax rate of approximately 29.7% for 2018. The 29.7% federal corporate tax rate is a blended rate based on the number of days prior and subsequent to the January 1, 2018 effective date of the rate reduction. In December 2017, the SEC staff issued Staff Accounting Bulletin No. 118 (“SAB 118”), which addresses how a company recognizes provisional amounts when a company does not have the necessary information available, prepared or analyzed (including computations) in reasonable detail to complete its accounting for the effect of the changes in the Act. SAB 118 provides for a measurement period that should not extend beyond one year from the Act enactment date for companies to complete the accounting under Accounting Standards Codification Topic 740, Income Taxes. As of April 30, 2018, the Company had not completed its accounting for the tax effects of the Act; however, as described below, the Company has made a reasonable estimate of the Act’s effects on the Company’s existing deferred tax balances. Provisional amounts The Company remeasured its deferred tax assets and liabilities based on the rates at which the deferred tax assets and liabilities are expected to reverse in the future, which is generally 21.0%. As a result, the Company recognized income tax expense of $2,710,000. However, the Company is still analyzing certain aspects of the Act and refining the Company’s calculations, which could potentially affect the measurement of these balances or potentially give rise to new deferred tax amounts. The Company’s effective tax rate was 93.1% for 2018 primarily due to the effect of the income tax expense increase of $2,710,000. The difference between the statutory tax rate and the effective tax rate for 2018 was primarily due to state taxes after excluding the $2,710,000 income tax expense increase. The Company’s effective tax rate was 101.5% for 2017. The difference between the statutory tax rate and the effective tax rate for 2017 was primarily due to the use and elimination of certain state net operating loss carryforwards, which were wholly or partially reserved with a valuation allowance, as well as a change in deferred tax rates in certain states. The total tax effect of gross unrecognized tax benefits at April 30, 2018 and 2017 was $58,000 as of each date that, if recognized, would have an impact on the effective tax rate. The Company believes it is reasonably possible that the liability for unrecognized tax benefits will not change in fiscal year 2019. LIQUIDITY AND CAPITAL RESOURCES AMREP Corporation is a holding company that conducts substantially all of its operations through subsidiaries. As a holding company, AMREP Corporation is dependent on its available funds and on distributions of funds from subsidiaries to pay expenses and fund operations. The Company’s primary sources of funding for working capital requirements are cash flow from operations, bank financing for specific real estate projects and existing cash balances. The Company’s liquidity is affected by many factors, including some that are based on normal operations and some that are related to the industries in which the Company operates and the economy generally. Real Estate The primary sources of funding for working capital requirements of the Company’s real estate business are cash flow from operations, bank financing for specific real estate projects and cash advances made to it by its parent. Land investments generally cannot be sold quickly, and the ability of the Company’s real estate business to sell properties has been and will continue to be affected by market conditions. The ability of the Company’s real estate business to generate cash flow from operations is dependent upon its ability to sell the properties it has selected for disposition at the prices and within the timeframes AMREP Southwest has established for each property. The development of additional lots for sale or other real estate projects will require financing or other sources of funding, which may not be available on acceptable terms (or at all). If the Company’s real estate business is unable to obtain such financing, the Company’s results of operations could be adversely affected. Fulfillment Services The primary source of funding for working capital requirements of the Company’s fulfillment services business is cash flow from operations. If the fulfillment services business needs additional liquidity, the parent of the fulfillment services business may in its discretion make cash advances available. The fulfillment services business relies on a small number of large clients; if it should lose one or more of its largest clients, or if revenues from its largest clients decline, the liquidity of the fulfillment services business could be adversely affected. The five largest clients in the fulfillment services business accounted for 41% of its 2018 revenues from operations. The fulfillment services business operates in a very competitive environment with changes in service providers by customers not being unusual. The fulfillment services business has experienced, and expects to continue to experience, such customer changes. Based on information received from customers, the fulfillment services business currently expects a limited number of customers to change service providers for certain services (a) during fiscal year 2019 representing in aggregate approximately 8% of the Company’s consolidated 2018 revenues and (b) during fiscal year 2020 representing in aggregate an additional approximately 5% of the Company’s consolidated 2018 revenues. Of the customers expected to change service providers for certain services in fiscal year 2019, one customer was expected to change service providers for certain services in 2019 (representing approximately 10.8% of the Company’s consolidated 2018 revenues) but has been delayed in effectuating such change. As expected in a competitive environment, the fulfillment services business has been successful in obtaining new customer contracts. Approximately 5.8% of the number of customers of the fulfillment services business as of the end of fiscal year 2018 were new customers during fiscal year 2018, but the revenue to be generated by these new customers during fiscal years 2019 and 2020 is expected to be less than the revenue expected to be lost from customers changing service providers or those reducing services the fulfillment services business provides them during fiscal years 2019 and 2020. Resolution with State of Florida In 2009, Palm Coast received $3,000,000 pursuant to an award agreement with the State of Florida as part of the incentives made available in connection with the consolidation of the Company’s fulfillment services operations at its Palm Coast, Florida location. The award agreement included certain performance requirements in terms of job retention, job creation and capital investment, which, if not met by Palm Coast, entitled the State of Florida to obtain the return of a portion, or all, of the $3,000,000. Palm Coast had not met certain of the performance requirements in the award agreement. In May 2017, Palm Coast entered into a Settlement Agreement and Mutual General Release with the State of Florida. Pursuant to the settlement agreement, (1) the award agreement was terminated, (2) each of the parties released all claims relating to the award agreement that the releasing party may have had against the other party and (3) Palm Coast agreed to pay the State of Florida $1,763,000 as follows: (a) $163,000 during the first quarter of 2018 and (b) 40 quarterly payments of $40,000 each, without interest, on the first business day of each calendar quarter starting on October 1, 2017 and ending on July 1, 2027. Palm Coast timely paid the State of Florida $163,000 during the first quarter of 2018, $40,000 during the second quarter of 2018 and $40,000 during the third quarter of 2018. In February 2018, Palm Coast and the Company entered into a Release Agreement with the State of Florida. Pursuant to the release agreement, (1) Palm Coast paid the State of Florida $956,000, (2) each of the parties released all claims relating to the payment obligations under the settlement agreement that the releasing party may have had against each of the other parties and (3) the payment obligations under the settlement agreement were deemed terminated and none of the parties had any further liabilities or obligations with respect thereto. In the Company’s consolidated financial statements and as a result of entering into the settlement agreement and the release agreement, Palm Coast eliminated its previously recorded liability of $3,000,000 and a related $26,000 interest accrual and recognized a pre-tax gain of $1,810,000, which was included in Other revenues during 2018. Pension Plan The Company has a defined benefit pension plan for which accumulated benefits were frozen and future service credits were curtailed as of March 1, 2004. Under generally accepted accounting principles, the Company’s defined benefit pension plan was underfunded at April 30, 2018 by $9,051,000, with $23,372,000 of assets and $32,423,000 of liabilities and was underfunded at April 30, 2017 by $10,967,000, with $23,277,000 of assets and $34,244,000 of liabilities. The pension plan liabilities were determined using a weighted average discount interest rate of 3.82% per year at April 30, 2018 and 3.52% per year at April 30, 2017, which are based on the Citigroup yield curve as of such dates as it corresponds to the projected liability requirements of the pension plan. As of April 30, 2018, for a 0.25% increase in the weighted average discount interest rate, the pension plan liabilities are forecasted to decrease by approximately $701,000 and for a 0.25% decrease in the weighted average discount interest rate, the pension plan liabilities are forecasted to increase by approximately $730,000. As of April 30, 2018, the effect of every 0.25% change in the investment rate of return on pension plan assets would increase or decrease the subsequent year’s pension expense by approximately $55,000, and the effect of every 0.25% change in the weighted average discount interest rate would increase or decrease the subsequent year’s pension expense by approximately $55,000. Due to the closing of certain facilities in fiscal year 2011 in connection with the consolidation of the Company’s fulfillment services business and the associated work force reduction in fiscal year 2011, the Employee Retirement Income Security Act of 1974, as amended (“ERISA”), and the regulations thereunder, gave the PBGC the right to require the Company to accelerate the funding of approximately $11,688,000 of accrued pension-related obligations to the Company’s defined benefit pension plan. In fiscal year 2013, the Company and the PBGC reached an initial agreement with respect to this funding obligation, and as a result, the Company made a $3,000,000 cash contribution to the pension plan in fiscal year 2013, thereby leaving a remaining accelerated funding liability of $8,688,000. In fiscal year 2014, the Company entered into a settlement agreement with the PBGC. In the settlement agreement, the PBGC agreed to forbear from asserting certain rights to obtain payment of the remaining $8,688,000 accelerated funding liability granted to it by ERISA, and the Company (a) paid $3,243,000 of the accelerated funding liability as a cash contribution to its pension plan and (b) provided first lien mortgages on certain real property with an aggregate appraised value of $10,039,000 in favor of the PBGC to secure the remaining unpaid amount of the accelerated funding liability. In addition, the PBGC agreed to credit $426,000 of contributions made by the Company to the pension plan in excess of the 2012 minimum funding requirements towards the accelerated funding liability, so that, after this credit and the $3,243,000 payment referred to above, the remaining accelerated funding liability was $5,019,500. In 2018, the Company sold certain real property subject to the mortgage in favor of the PBGC resulting in a payment of $485,000 to the pension plan and a remaining accelerated funding liability of $4,534,500. The total book value of the real property subject to the mortgages was approximately $7,690,000 as of April 30, 2018. On an annual basis, the Company is required to provide updated appraisals on each mortgaged property and, if the appraised value of the mortgaged properties is less than two times the amount of the accelerated funding liability then outstanding, the Company is required to make a payment to its pension plan in an amount equal to one-half of the amount of the shortfall. Upon the sale by the Company of any property mortgaged in favor of the PBGC, the Company is required to deposit in its pension plan 50% of the lesser of (i) the amount equal to the total purchase price of the mortgaged property minus certain transaction costs or (ii) the appraised value of the mortgaged property. The mortgages in favor of the PBGC will be discharged following the termination date of the settlement agreement. In connection with the settlement agreement, the Company made certain representations and warranties and is required to comply with various covenants, reporting requirements and other requirements, including making all required minimum funding contributions to its pension plan. Any failure by the Company to comply with its obligations under the settlement agreement may result in an event of default, which would permit the PBGC to repossess, sell or foreclose on the properties that have been mortgaged in favor of the PBGC; however, if the Company complies with the terms of the settlement agreement, including making all future required minimum funding contributions to its pension plan and any payments required due to any shortfall in the appraised value of real property covered by the mortgages described above, the Company will not be required to make any further cash payments to its pension plan with respect to the remaining accelerated funding liability. The settlement agreement is scheduled to terminate on the earlier of the date the accelerated funding liability has been paid in full or on August 30, 2018. Effective on the termination date of the settlement agreement, the PBGC will be deemed to have released and discharged the Company and all other members of its controlled group from any claims in connection with such members’ liability or obligations with respect to the accelerated funding liability. The settlement agreement does not address any future events that may accelerate any other accrued pension plan obligations. The Company may become subject to additional acceleration of its remaining accrued obligations to the pension plan if the Company closes other facilities and further reduces its work force of active pension plan participants. Any such acceleration could have a material adverse effect on the Company’s financial condition. Oil and Gas Leases · New Mexico. During fiscal year 2015, AMREP Southwest and one of its subsidiaries entered into an oil and gas lease with respect to all minerals and mineral rights owned by the Company or for which the Company has executive rights in and under approximately 55,000 surface acres of land in Sandoval County, New Mexico. As partial consideration for entering into the lease, the Company received approximately $1,010,000 in fiscal year 2015. The lease has an initial term ending in September 2018 and for as long thereafter as oil or gas is produced and marketed in paying quantities from the property or for additional limited periods of time if the lessee undertakes certain operations or makes certain de minimis shut-in royalty payments. The lessee may extend the initial term of the lease for an additional four years by paying the Company another payment of approximately $1,010,000. The lease does not require lessee to drill any oil or gas wells. The lessee has agreed to pay the Company a royalty on oil and gas produced from the property of 1/7th of the proceeds received by the lessee from the sale of such oil and gas and such royalty will be charged with 1/7th of certain post-production costs associated with such oil and gas. No royalties under the lease were received during 2018 or 2017. Amounts payable under the Lease will not be reduced by any payments made to other holders of mineral rights or other production royalty payment interests in the property, other than payments pursuant to rights granted by the Company in deeds transferring portions of the property to third parties, primarily in the 1960s and 1970s. · Colorado. During fiscal year 2016, a subsidiary of AMREP Southwest entered into an oil and gas lease with respect to all minerals and mineral rights owned by the subsidiary in and under approximately 80 surface acres of land in Brighton, Colorado. As partial consideration for entering into the lease, the Company received $128,000 in fiscal year 2016. The lease has an initial term ending in September 2020 and for as long thereafter as oil or gas is produced and marketed in paying quantities from the property or for additional limited periods of time if the lessee undertakes certain operations or makes certain de minimis shut-in royalty payments. The lease does not require the lessee to drill any oil or gas wells. The lessee has agreed to pay the Company a royalty on oil and gas produced from the property of 18.75% of the proceeds received by the lessee from the sale of such oil and gas, and such royalty will be charged with 18.75% of certain post-production costs associated with such oil and gas. No royalties under the lease were received during 2018 or 2017. Operating Activities Receivables from trade customers decreased from $6,379,000 at April 30, 2017 to $5,901,000 at April 30, 2018, primarily due to lower business volumes of the fulfillment services business. Real estate inventory increased from $56,090,000 at April 30, 2017 to $58,874,000 at April 30, 2018. Inventory in AMREP Southwest’s core real estate market of Rio Rancho increased from $51,429,000 at April 30, 2017 to $54,929,000 at April 30, 2018, primarily due to an increase in land development activity and the acquisition of property, which were offset in part by real estate land sales. The balance of real estate inventory consisted primarily of properties in Colorado. Investment assets decreased from $9,715,000 at April 30, 2017 to $9,714,000 at April 30, 2018. Property, plant and equipment decreased from $10,852,000 at April 30, 2017 to $9,745,000 at April 30, 2018, primarily due to depreciation charges, which were offset in part by $139,000 of capital expenditures. Other assets increased from $2,310,000 at April 30, 2017 to $2,321,000 at April 30, 2018. Taxes receivable, net was $209,000 at April 30, 2018 compared to taxes payable, net of $465,000 at April 30, 2017, primarily due to tax loss benefits and income in the respective years. Accounts payable and accrued expenses increased from $7,035,000 at April 30, 2017 to $8,215,000 at April 30, 2018, primarily due to an increase in land development activity in New Mexico, which was offset in part by lower business volumes and the timing of payments to vendors in the Company’s fulfillment services business. Notes payable increased from none at April 30, 2017 to $1,843,000 at April 30, 2018, due to borrowings made by the Company’s real estate business. Other liabilities and deferred revenue decreased from $3,376,000 at April 30, 2017 to $149,000 at April 30, 2018, primarily due to the settlement agreement between Palm Coast and the State of Florida and the amortization of deferred revenue related to an oil and gas lease payment received in fiscal year 2015. The unfunded pension liability of the Company’s frozen defined benefit pension plan decreased from $10,967,000 at April 30, 2017 to $9,051,000 at April 30, 2018, primarily due to $1,040,000 of Company contributions to the pension plan, as well as favorable investment results of plan assets during 2018. The Company recorded, net of tax, other comprehensive income of $1,306,000 in 2018 and other comprehensive income of $1,861,000 in 2017, reflecting the change in the unfunded pension liability in each year net of the related deferred tax and unrecognized prepaid pension amounts. Financing Activities In December 2017, Lomas Encantadas Development Company LLC (“LEDC”), a subsidiary of AMREP Southwest, entered into a Development Loan Agreement with BOKF, NA dba Bank of Albuquerque (“Lender”). The Development Loan Agreement is evidenced by a Non-Revolving Line of Credit Promissory Note and is secured by a Mortgage, Security Agreement and Financing Statement, between LEDC and Lender with respect to certain planned residential lots within the Lomas Encantadas subdivision (the “Mortgaged Property”) located in Rio Rancho, New Mexico. Pursuant to a Guaranty Agreement, entered into by AMREP Southwest in favor of Lender, AMREP Southwest has guaranteed LEDC’s obligations under each of the above agreements. The Development Loan Agreement, Non-Revolving Line of Credit Promissory Note, Mortgage, Security Agreement and Financing Statement, Guaranty Agreement and other related transaction documents are collectively referred to as the “Loan Documentation.” Pursuant to the Loan Documentation, Lender agrees to lend up to $4,750,000 to LEDC on a non-revolving line of credit basis to partially fund the development of the Mortgaged Property. LEDC expects to fully utilize the $4,750,000 for its land development activities. Interest on the outstanding principal amount of the loan is payable monthly at the annual rate equal to the London Interbank Offered Rate for a thirty-day interest period plus a spread of 3.0%, adjusted monthly. Lender is required to release the lien of its mortgage on any lot included in the Mortgaged Property upon LEDC making a principal payment of $43,000 or $53,000 depending on the location of the lot. The outstanding principal amount of the loan as of April 30, 2018 was $1,887,000 and no principal repayments have been made by LEDC as of April 30, 2018. The outstanding principal amount of the loan as of July 2, 2018 was $2,483,000. LEDC is required to make periodic principal repayments of borrowed funds not previously repaid as follows: $1,370,000 on or before August 18, 2019, $599,000 on or before November 18, 2019, $599,000 on or before February 18, 2020, $599,000 on or before May 18, 2020, $599,000 on or before August 18, 2020 and $599,000 on or before November 18, 2020. The outstanding principal amount of the loan may be prepaid at any time without penalty. The loan is scheduled to mature in December 2021. LEDC incurred certain customary costs and expenses and paid certain fees to Lender in connection with the loan. LEDC and AMREP Southwest have made certain representations and warranties in the Loan Documentation and are required to comply with various covenants, reporting requirements and other customary requirements for similar loans. The Loan Documentation contains customary events of default for similar financing transactions, including: LEDC’s failure to make principal, interest or other payments when due; the failure of LEDC or AMREP Southwest to observe or perform their respective covenants under the Loan Documentation; the representations and warranties of LEDC or AMREP Southwest being false; the insolvency or bankruptcy of LEDC or AMREP Southwest; and the failure of AMREP Southwest to maintain a tangible net worth of at least $35 million. Upon the occurrence and during the continuance of an event of default, Lender may declare the outstanding principal amount and all other obligations under the Loan Documentation immediately due and payable. At April 30, 2018, both LEDC and AMREP Southwest were in compliance with the covenants contained within the Loan Documentation. Investing Activities Capital expenditures for property, plant and equipment for continuing operations were approximately $139,000 for 2018 and $249,000 for 2017, primarily for upgrades related to technology in both years. The Company believes that it has adequate cash, bank financing and cash flows from operations to provide for anticipated capital expenditures and land development spending in fiscal year 2019. RECENT ACCOUNTING PRONOUNCEMENTS In May 2014, the Financial Accounting Standards Board (the “FASB”) issued Accounting Standards Update (“ASU”) No. 2014-09, Revenue from Contracts with Customers. Since that date, the FASB has issued additional ASUs providing further revenue recognition guidance (collectively, “Topic 606”). Topic 606 clarifies the principles for recognizing revenues and costs related to obtaining and fulfilling customer contracts, with the objective of improving financial reporting. The core principle of Topic 606 is to recognize revenues when promised goods or services are transferred to customers in an amount that reflects the consideration the Company expects to receive in exchange for those goods or services. Topic 606 defines a five-step process to achieve this core principle, and more judgment and estimates may be required under Topic 606 than are currently required under generally accepted accounting principles. The two permitted transition methods under Topic 606 are (i) the full retrospective method, in which case the standard would be applied to each prior reporting period presented, or (ii) the modified retrospective method, in which case the cumulative effect of applying the standard would be recognized at the date of adoption. The Company intends to use the modified retrospective transition method upon adoption. Topic 606 is effective for the Company’s fiscal year 2019 beginning May 1, 2018. The Company had established an implementation team to evaluate the impact of Topic 606 on the Company’s accounting policies, processes and system requirements, as well as its consolidated financial statements. The implementation team has reported the progress and status of its evaluation to the Audit Committee of the Company’s Board of Directors. The adoption of Topic 606 will not have an impact on the Company’s consolidated financial statements. In February 2016, the FASB issued ASU No. 2016-02, Leases. ASU 2016-02 requires that a lessee recognize the assets and liabilities that arise from operating leases. A lessee should recognize in its balance sheet a liability to make lease payments (the lease liability) and a right-of-use asset representing its right to use the underlying asset for the lease term. For leases with a term of twelve months or less, a lessee is permitted to make an accounting policy election by class of underlying asset not to recognize lease assets and lease liabilities. In transition, lessees and lessors are required to recognize and measure leases at the beginning of the earliest period presented using a modified retrospective approach. The amendments in the ASU will be effective for the Company for fiscal year 2020 beginning on May 1, 2019. The Company has not yet concluded how the new standard will impact its consolidated financial statements. In March 2016, the FASB issued ASU No. 2016-09, Compensation - Stock Compensation: Improvements to Employee Share-Based Payment Accounting. ASU 2016-09 simplifies several aspects of accounting for employee share-based payment transactions, including the accounting for income taxes, forfeitures, and statutory tax withholding requirements, as well as classification in the statement of cash flows. ASU 2016-09 was effective for the Company’s fiscal year 2018 beginning May 1, 2017. The adoption of ASU 2016-09 by the Company did not have a material effect on its consolidated financial statements. In August 2016, the FASB issued ASU No. 2016-15, Statement of Cash Flows (Topic 230): Classification of Certain Cash Receipts and Cash Payments. ASU 2016-15 reduces the diversity in practice regarding how certain cash receipts and cash payments are presented and classified in the statement of cash flows. ASU 2016-15 is effective for the Company’s fiscal year 2019 beginning May 1, 2018. A retrospective transition method is to be used in the application of this amendment. The adoption of ASU 2016-15 by the Company is not expected to have a material effect on its consolidated financial statements. In January 2018, the FASB issued ASU 2018-02, Income Statement - Reporting Comprehensive Income (Topic 220): Reclassification of Certain Tax Effects from Accumulated Other Comprehensive Income, which permits the reclassification to retained earnings of certain tax effects resulting from the U.S. Tax Cuts and Jobs Act related to items in accumulated other comprehensive income. ASU 2018-02 may be applied retrospectively to each period in which the effect of the U.S. Tax Cuts and Jobs Act is recognized or may be applied in the period of adoption. ASU 2018-02 is effective for the Company’s fiscal year 2020 beginning May 1, 2019. The Company has not determined whether it will elect to reclassify such tax effects. The adoption of ASU 2018-02 by the Company is not expected to have a material effect on its consolidated financial statements. In March 2018, the FASB issued ASU No. 2018-05, Income Taxes (Topic 740) - Amendments to SEC Paragraphs Pursuant to SEC Staff Accounting Bulletin No. 118, which reflects the income tax accounting implications of the U.S. Tax Cuts and Jobs Act. In June 2018, the FASB issued ASU No. 2018-07, Compensation - Stock Compensation (Topic 718) - Improvements to Nonemployee Share-based Payment Accounting. ASU 2018-07 addresses several aspects of the accounting for nonemployee share-based payment transactions, including share-based payment transactions for acquiring goods and services from nonemployees. ASU 2018-07 is effective for the Company’s fiscal year 2020 beginning May 1, 2019. The adoption of ASU 2018-07 by the Company is not expected to have a material effect on its consolidated financial statements. SEGMENT INFORMATION Information by industry segment is presented in Note 17 to the consolidated financial statements included in this annual report on Form 10-K. Industry segment information is prepared in a manner consistent with the manner in which financial information is prepared and evaluated by management for making operating decisions. A number of assumptions and estimates are required to be made in the determination of segment data, including the need to make certain allocations of common costs and expenses among segments. On an annual basis, management evaluates the basis upon which costs are allocated, and has periodically made revisions to these methods of allocation. Accordingly, the determination of “net income (loss)” of each segment as summarized in Note 17 to the consolidated financial statements is presented for informational purposes only, and is not necessarily the amount that would be reported if the segment were an independent company. IMPACT OF INFLATION Operations of the Company can be impacted by inflation. Within the industries in which the Company operates, inflation can cause increases in the cost of materials, services, interest and labor. Unless such increased costs are recovered through increased sales prices or improved operating efficiencies, operating margins will decrease. Within the land development industry, the Company encounters particular risks. A large part of the Company’s real estate sales are to homebuilders who face their own inflationary concerns that rising housing costs, including interest costs, may substantially outpace increases in the incomes of potential purchasers and make it difficult for them to purchase a new home or sell an owned home. If this situation were to exist, the demand for the Company’s land by these homebuilder customers could decrease. In general, in recent years interest rates have been at historically low levels and other price increases have been commensurate with the general rate of inflation in the Company’s markets, and as a result the Company has not found the inflation risk to be a significant problem in any of its businesses. Despite low inflation, the Company’s real estate operations are experiencing price increases as a result of recent tariffs and labor and material shortages. FORWARD-LOOKING STATEMENTS The Private Securities Litigation Reform Act of 1995 provides a safe harbor for forward-looking statements made by or on behalf of the Company. The Company and its representatives may from time to time make written or oral statements that are “forward-looking”, including statements contained in this annual report on Form 10-K and other filings with the Securities and Exchange Commission, reports to the Company’s shareholders and news releases. All statements that express expectations, estimates, forecasts or projections are forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. In addition, other written or oral statements, which constitute forward-looking statements, may be made by or on behalf of the Company. Words such as “expects”, “anticipates”, “intends”, “plans”, “believes”, “seeks”, “estimates”, “projects”, “forecasts”, “may”, “should”, variations of such words and similar expressions are intended to identify such forward-looking statements. These statements are not guarantees of future performance and involve certain risks, uncertainties and contingencies that are difficult to predict. All forward-looking statements speak only as of the date of this annual report on Form 10-K or, in the case of any document incorporated by reference, the date of that document. All subsequent written and oral forward-looking statements attributable to the Company or any person acting on behalf of the Company are qualified by the cautionary statements in this section. Many of the factors that will determine the Company’s future results are beyond the ability of management to control or predict. Therefore, actual outcomes and results may differ materially from what is expressed or forecasted in or suggested by such forward-looking statements. The forward-looking statements contained in this annual report on Form 10-K include, but are not limited to, statements regarding (i) the Company’s ability to finance its future working capital, land development and capital expenditure needs, (ii) the Company’s expected liquidity sources, (iii) anticipated future development of the Company’s real estate holdings, (iv) the development and construction of possible future commercial properties to be marketed to tenants, (v) the timing of reimbursements under, and the general effectiveness of, the public improvement district over a portion of the Lomas Encantadas subdivision and a portion of the Enchanted Hills/Commerce Center subdivision, (vi) the number of planned residential lots in the Company’s subdivisions, (vii) estimates and assumptions used in determining future cash flows of real estate projects, (viii) the utilization of existing bank financing, (ix) the expected loss of any customer contract in the Company’s fulfillment services business and the adverse effect of any such loss, (x) the expected revenue from any new customer contracts in the Company’s fulfillment services business, (xi) the effect of recent accounting pronouncements, (xii) the anticipated contributions by the Company to the pension plan, the amount of future annual benefit payments to the pension plan, the appropriateness of valuation methods to determine the fair value of financial instruments in the pension plan, the expected return on assets in the pension plan, the expected long-term rate of return on assets in the pension plan, the effect of changes in the weighted average discount interest rate on the amount of pension plan liabilities and the effect of changes in the investment rate of return on pension plan assets with respect to pension expense, (xiii) the timing of recognizing unrecognized compensation expense related to shares of common stock issued under the AMREP Corporation 2006 Equity Compensation Plan or the AMREP Corporation 2016 Equity Compensation Plan, (xiv) the future issuance of deferred stock units to directors of the Company, (xv) the liability for unrecognized tax benefits not changing in fiscal year 2019, (xvi) the adequacy of the Company’s facilities, (xvii) estimates related to the U.S. Tax Cuts and Jobs Act and (xviii) the materiality of claims and legal actions arising in the normal course of the Company’s business. The Company undertakes no obligation to update or publicly release any revisions to forward-looking statements to reflect events, circumstances or changes in expectations after the date of such forward-looking statement, or to make any other forward-looking statements, whether as a result of new information, future events or otherwise.

<s>[INST] For a description of the Company’s business, refer to Item 1. As indicated in Item 1, the Company, through its subsidiaries, is primarily engaged in two business segments: the real estate business operated by AMREP Southwest and its subsidiaries and the fulfillment services business operated by Palm Coast and its affiliates. Data concerning industry segments is set forth in Note 17 of the notes to the consolidated financial statements included in this annual report on Form 10K. The Company’s foreign sales and activities are not significant. The following provides information that management believes is relevant to an assessment and understanding of the Company’s consolidated results of operations and financial condition. The discussion should be read in conjunction with the consolidated financial statements and accompanying notes. CRITICAL ACCOUNTING POLICIES AND ESTIMATES The Company prepares its financial statements in conformity with accounting principles generally accepted in the United States of America. The Company discloses its significant accounting policies in the notes to its audited consolidated financial statements. The preparation of such financial statements requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosures of contingent assets and liabilities at the dates of those financial statements as well as the reported amounts of revenues and expenses during the reporting periods. Areas that require significant judgments and estimates to be made include: (i) allowances for doubtful accounts; (ii) real estate cost of sales calculations, which are based on land development budgets and estimates of costs to complete; (iii) cash flows, asset groupings and valuation assumptions in performing asset impairment tests of longlived assets (including real estate inventories) and assets held for sale; (iv) actuarially determined defined benefit pension plan obligations and other pension plan accounting and disclosures; (v) risk assessment of uncertain tax positions; and (vi) the determination of the recoverability of net deferred tax assets. Actual results could differ from those estimates. There are numerous critical assumptions that may influence accounting estimates in these and other areas. Management bases its critical assumptions on historical experience, thirdparty data and various other estimates that it believes to be reasonable under the circumstances. The most critical assumptions made in arriving at these accounting estimates include the following: · management determines the allowance for doubtful accounts by attempting to identify troubled accounts by analyzing the credit risk of specific customers and by using historical experience applied to the aging of accounts and, where appropriate within the real estate business, by reviewing any collateral which may secure a receivable; · real estate development costs are incurred throughout the life of a project, and the costs of initial sales from a project frequently must include a portion of costs that have been budgeted based on engineering estimates or other studies, but not yet incurred; · when events or changes in circumstances indicate the carrying value of an asset may not be recoverable a test for asset impairment may be required. Asset impairment determinations are based upon the intended use of assets, the grouping of those assets, the expected future cash flows and estimates of fair value of assets. For real estate projects under development, an estimate of future cash flows on an undiscounted basis is determined using estimated future expenditures necessary to complete such projects and using management’s best estimates about sales prices and holding periods. Testing of longlived assets includes an estimate of future cash flows on an undiscounted basis using estimated revenue streams, operating margins, administrative expenses and terminal values. The estimation process involved in determining if assets have been impaired and in the determination of estimated future cash flows is inherently uncertain because it requires estimates of future revenues and costs, as well as future events and conditions. If the excess of undiscounted cash flows over the carrying value of a particular asset group is small, there is a greater risk of future impairment and any resulting impairment charges could be material; · defined benefit pension plan obligations and plan accounting and disclosures are based upon numerous assumptions and estimates, including the expected rate of investment return on pension plan assets, the discount rate used to determine the present value of liabilities, and certain employeerelated factors such as turnover, retirement age and mortality; · the Company assesses risk for uncertain tax positions and recognizes the financial statement effects of a tax position when it is more likely than not that the position will be sustained upon examination by tax authorities; and · the Company provides a valuation allowance against net deferred [/INST] Positive. </s>

AMREP CORP.

2019-07-26

2019-04-30

Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations INTRODUCTION For a description of the Company’s business, refer to Item 1. As indicated in Item 1, the Company, through its subsidiaries, is primarily engaged in one business segment: the real estate business. The Company has no foreign sales. The following provides information that management believes is relevant to an assessment and understanding of the Company’s consolidated results of operations and financial condition. The discussion should be read in conjunction with the consolidated financial statements and accompanying notes. CRITICAL ACCOUNTING POLICIES AND ESTIMATES The Company prepares its financial statements in conformity with accounting principles generally accepted in the United States of America. The Company discloses its significant accounting policies in the notes to its audited consolidated financial statements. The preparation of such financial statements requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosures of contingent assets and liabilities at the dates of those financial statements as well as the reported amounts of revenues and expenses during the reporting periods. Areas that require significant judgments and estimates to be made include: (1) real estate cost of sales calculations, which are based on land development budgets and estimates of costs to complete; (2) cash flows, asset groupings and valuation assumptions in performing asset impairment tests of long-lived assets (including real estate inventories) and assets held for sale; (3) actuarially determined defined benefit pension plan obligations and other pension plan accounting and disclosures; (4) risk assessment of uncertain tax positions; and (5) the determination of the recoverability of net deferred tax assets. Actual results could differ from those estimates. There are numerous critical assumptions that may influence accounting estimates in these and other areas. Management bases its critical assumptions on historical experience, third-party data and various other estimates that it believes to be reasonable under the circumstances. The most critical assumptions made in arriving at these accounting estimates include the following: · real estate development costs are incurred throughout the life of a project, and the costs of initial sales from a project frequently must include a portion of costs that have been budgeted based on engineering estimates or other studies, but not yet incurred; · when events or changes in circumstances indicate the carrying value of an asset may not be recoverable, a test for asset impairment may be required. Asset impairment determinations are based upon the intended use of assets, the grouping of those assets, the expected future cash flows and estimates of fair value of assets. For real estate projects under development, an estimate of future cash flows on an undiscounted basis is determined using estimated future expenditures necessary to complete such projects and using management’s best estimates about sales prices and holding periods. Testing of long-lived assets includes an estimate of future cash flows on an undiscounted basis using estimated revenue streams, operating margins, administrative expenses and terminal values. The estimation process involved in determining if assets have been impaired and in the determination of estimated future cash flows is inherently uncertain because it requires estimates of future revenues and costs, as well as future events and conditions. If the excess of undiscounted cash flows over the carrying value of a particular asset group is small, there is a greater risk of future impairment and any resulting impairment charges could be material; · defined benefit pension plan obligations and plan accounting and disclosures are based upon numerous assumptions and estimates, including the expected rate of investment return on pension plan assets, the discount rate used to determine the present value of liabilities, and certain employee-related factors such as turnover, retirement age and mortality; · the Company assesses risk for uncertain tax positions and recognizes the financial statement effects of a tax position when it is more likely than not that the position will be sustained upon examination by tax authorities; and · the Company provides a valuation allowance against net deferred tax assets unless, based upon the available evidence, it is more likely than not that the deferred tax assets will be realized. In making this determination, the Company projects its future earnings (including currently unrealized gains on real estate inventory) for the future recoverability of net deferred tax assets ($4,536,000 as of April 30, 2019). RESULTS OF OPERATIONS Year Ended April 30, 2019 Compared to Year Ended April 30, 2018 Prior to April 26, 2019, the Company had been engaged in the fulfillment services business. On April 26, 2019, the fulfillment services business was sold (refer to Item 1 of Part I of this annual report on Form 10-K for more detail). The Company’s fulfillment services business has been classified as discontinued operations in the financial statements included in this Form 10-K. Financial information from prior periods has been reclassified to conform to this presentation. For 2019, the Company reported net income of $1,527,000, or $0.19 per share, compared to net income of $238,000, or $0.03 per share, in 2018. Results consisted of (i) a net loss from continuing operations of $2,465,000, or $0.30 per share, in 2019 compared to a net loss of $2,564,000, or $0.32 per share, in 2018 and (ii) net income from discontinued operations of $3,992,000, or $0.49 per share, in 2019 compared to net income of $2,802,000, or $0.35 per share, for 2018. A discussion of continuing operations and discontinued operations follows. Continuing Operations For 2019, the Company’s continuing operations reported a net loss of $2,465,000, or $0.30 per share, compared to a net loss of $2,564,000, or $0.32 per share, in 2018. Revenues were $12,831,000 for 2019 compared to $8,927,000 for 2018. Revenues from land sales were $12,313,000 for 2019 compared to $8,439,000 for 2018. For 2018, $2,044,000 of the $8,439,000 of revenues from land sales was for an approximate five acre undeveloped commercial property in Colorado, which had a gross profit percentage of 65%. The number of new construction single-family residential starts in Rio Rancho by the Company’s customers and other builders was 443 in 2019 and 473 in 2018. The Company offers for sale both developed and undeveloped lots to national, regional and local homebuilders, commercial and industrial property developers and others. The Company sold 65 acres of residential land in 2019 at an average selling price of $190,000 per acre compared to 27 acres of residential land in 2018 at an average selling price of $237,000 per acre. The decrease in the average selling price per acre of residential land in 2019 compared to 2018 was primarily due to the location of the sold lots. The average gross profit percentage on land sales in New Mexico before indirect costs was 12% for 2019 compared to 16% for 2018. As a result of many factors, including the nature and timing of specific transactions and the type and location of land being sold, revenues, average selling prices and related average gross profits from land sales can vary significantly from period to period and prior results are not necessarily a good indication of what may occur in future periods. The Company did not record any non-cash impairment charges on real estate inventory or investment assets in 2019 or 2018. Due to volatility in market conditions and development costs, the Company may experience future impairment charges. Other revenues were $518,000 for 2019 compared to $488,000 for 2018. Other revenues for 2019 primarily consisted of fees and forfeited deposits from customers, leasehold income and miscellaneous other income items. Other revenues for 2018 were primarily due to the recognition of deferred revenue related to an oil and gas lease, fees and forfeited deposits from customers and miscellaneous other income items. Operating expenses for the Company’s real estate business were $990,000 for 2019 compared to $1,652,000 for 2018. Operating expenses for 2019 primarily consisted of payroll and benefits, real estate taxes, land maintenance costs and depreciation. The decrease of $662,000 was primarily due to lower real estate taxes and land maintenance costs offset in part by higher payroll and benefits. General and administrative expenses for the Company’s real estate business were $625,000 for 2019, an increase from $578,000 for 2018, primarily due to increased professional fees. Corporate general and administrative expenses were $3,589,000 for 2019, an increase from $3,474,000 for 2018, primarily due to higher depreciation expense, offset in part by lower pension expense. Interest expense was $25,000 for 2019 compared to $5,000 for 2018. Interest expense in both years is related to the amortization of debt issuance costs related to land development activities. There was $115,000 of capitalized interest for 2019 and $13,000 for 2018. The U.S. Tax Cuts and Jobs Act (the “Act”) was signed into law in December 2017. The Act significantly revised the future ongoing U.S. corporate income tax by, among other things, lowering U.S. corporate income tax rates. The Act reduced the federal corporate tax rate to 21.0% effective January 1, 2018. As the Company has an April 30 fiscal year-end, the lower corporate income tax rate was phased in, resulting in the Company having a blended federal tax rate of 29.7% for 2018. Effective May 1, 2018, the Company’s federal corporate tax rate was 21.0%. The Company completed its accounting for the tax effects of the Act during 2019, including adjustments to its deferred tax balances. The Company’s continuing operations had a benefit for income taxes of $708,000 for 2019 compared to a benefit for income taxes of $279,000 for 2018. During 2018 and as a result of the Act, the Company re-measured its deferred tax assets and liabilities based on the rates at which the deferred tax assets and liabilities were expected to reverse in the future, which is generally 21.0%. During 2018, the Company recognized a provisional income tax expense of $523,000 due to the re-measurement of its deferred tax assets and liabilities. As a result of the lapse of the statute of limitations, the Company’s total tax effect of gross unrecognized tax benefits in the accompanying financial statements of $58,000 at April 30, 2018 was recognized during 2019. Discontinued Operations The Company’s fulfillment services business operated in an industry unrelated to the Company’s continuing operations and had business operations, employees (including its management), customers, suppliers, liquidity and capital resources that were generally different from those of the Company’s continuing operations. The sale of the Company’s fulfillment services business is not expected to have a material impact on the Company’s continuing operations. As noted in Item 1 of Part I of this annual report on Form 10-K, the Company retained ownership of certain real estate in Palm Coast, Florida, which is being leased to the fulfillment services business pursuant to two triple net lease agreements. Net income from discontinued operations was $3,992,000, or $0.49 per share, in 2019 compared to net income of $2,802,000, or $0.35 per share, for 2018. The results from discontinued operations for 2019 included a pretax gain of $2,506,000, or $0.31 per share, resulting from the sale of the fulfillment services business and for 2018 included a pretax gain of $1,318,000, or $0.16 per share, from a previously disclosed settlement agreement with the State of Florida. LIQUIDITY AND CAPITAL RESOURCES AMREP Corporation is a holding company that conducts substantially all of its operations through subsidiaries. As a holding company, AMREP Corporation is dependent on its available funds and on distributions of funds from subsidiaries to pay expenses and fund operations. The Company’s liquidity is affected by many factors, including some that are based on normal operations and some that are related to the industries in which the Company operates and the economy generally. The Company’s primary sources of funding for working capital requirements are cash flow from operations, bank financing for specific real estate projects and existing cash balances. Land investments generally cannot be sold quickly, and the ability of the Company to sell properties has been and will continue to be affected by market conditions. The ability of the Company to generate cash flow from operations is dependent upon its ability to sell the properties it has selected for disposition at the prices and within the timeframes the Company has established for each property. The development of additional lots for sale or other real estate projects will require financing or other sources of funding, which may not be available on acceptable terms (or at all). If the Company is unable to obtain such financing, the Company’s results of operations could be adversely affected. Pension Plan The Company has a defined benefit pension plan for which accumulated benefits were frozen and future service credits were curtailed as of March 1, 2004. Under generally accepted accounting principles, the Company’s defined benefit pension plan was underfunded at April 30, 2019 by $6,401,000, with $23,903,000 of assets and $30,304,000 of liabilities and was underfunded at April 30, 2018 by $9,051,000, with $23,372,000 of assets and $32,423,000 of liabilities. The pension plan liabilities were determined using a weighted average discount interest rate of 3.54% per year at April 30, 2019 and 3.82% per year at April 30, 2018, which are based on the FTSE Pension Discount Curve (formerly known as the Citigroup yield curve) as of such dates as it corresponds to the projected liability requirements of the pension plan. As of April 30, 2019, for a 0.25% increase in the weighted average discount interest rate, the pension plan liabilities are forecasted to decrease by approximately $663,000 and for a 0.25% decrease in the weighted average discount interest rate, the pension plan liabilities are forecasted to increase by approximately $690,000. As of April 30, 2019, the effect of every 0.25% change in the investment rate of return on pension plan assets would increase or decrease the subsequent year’s pension expense by approximately $56,000, and the effect of every 0.25% change in the weighted average discount interest rate would increase or decrease the subsequent year’s pension expense by approximately $13,000. As noted in Item 1 of Part I of this annual report on Form 10-K, the Company retained its obligations under the Company’s defined benefit pension plan following the sale of the Company’s fulfillment services business. The work force reduction with respect to the Company in connection with the sale of the fulfillment services business resulted in the acceleration of the funding of approximately $5,194,000 of accrued pension-related obligations to the Company’s defined benefit pension plan pursuant to ERISA and the regulations thereunder. The Company notified the PBGC of the sale of the fulfillment services business and, as permitted by ERISA, made an election to satisfy this accelerated funding obligation over a period of seven years beginning in fiscal year 2021. The closing of certain facilities in fiscal year 2011 and the associated work force reduction resulted in the PBGC requiring the Company to accelerate the funding of approximately $11,688,000 of accrued pension-related obligations to the Company’s defined benefit pension plan. The Company entered into a settlement agreement with the PBGC in fiscal 2014 with respect to such liability. The settlement agreement with the PBGC terminated by its terms in 2019 with the PBGC being deemed to have released and discharged the Company and all other members of its controlled group from any claims thereunder. Oil and Gas Leases · New Mexico. During fiscal year 2015, the Company entered into an oil and gas lease with respect to all minerals and mineral rights owned by the Company or for which the Company has executive rights in and under approximately 55,000 surface acres of land in Sandoval County, New Mexico. As partial consideration for entering into the lease, the Company received approximately $1,010,000 in fiscal year 2015. Revenue from this transaction was recorded over the initial lease term ending in 2019, which totaled $76,000 in 2019 and $228,000 in 2018. In 2019, the oil and gas lease was amended pursuant to a lease extension agreement. The lease extension agreement extends the expiration date of the initial term of the lease from September 2018 to September 2020. No fee was paid by the lessee to the Company with respect to such extension. If the lessee or any of its affiliates provides any consideration to obtain, enter into, option, extend or renew an interest in any minerals or mineral rights within Sandoval County, Bernalillo County, Santa Fe County or Valencia County in New Mexico at any time from September 2017 through September 2020, lessee shall pay the Company an amount equal to the amount of such consideration paid per acre multiplied by 54,793.24. The lease extension agreement further provides that the lessee shall assign, or shall cause their affiliate to assign, to the Company an overriding royalty interest of 1% with respect to the proceeds derived from any minerals or minerals rights presently or hereinafter owned by, leased by, optioned by or otherwise subject to the control of lessee or any of its affiliates in any part of Sandoval County, Bernalillo County, Santa Fe County or Valencia County in New Mexico. The Company did not record any revenue in 2019 related to the lease extension agreement. · Colorado. The Company owns certain minerals and mineral rights in and under approximately 80 surface acres of land in Brighton, Colorado leased for an initial term ending in September 2020 and for as long thereafter as oil or gas is produced and marketed in paying quantities from the property or for additional limited periods of time if the lessee undertakes certain operations or makes certain de minimis shut-in royalty payments. The lease does not require the lessee to drill any oil or gas wells. The lessee has agreed to pay the Company a royalty on oil and gas produced from the property of 18.75% of the proceeds received by the lessee from the sale of such oil and gas, and such royalty will be charged with 18.75% of certain post-production costs associated with such oil and gas. In addition, the Company owns certain minerals and mineral rights in and under approximately 78 surface acres of land in Brighton, Colorado subject to a historical lease. No royalties under these leases were received during 2019 or 2018. Operating Activities Real estate inventory decreased from $58,874,000 at April 30, 2018 to $57,773,000 at April 30, 2019. Inventory in the Company’s core real estate market of Rio Rancho decreased from $54,929,000 at April 30, 2018 to $53,831,000 at April 30, 2019, primarily due to real estate land sales, which were offset in part by an increase in land development activity and the acquisition of property. The balance of real estate inventory primarily consisted of properties in Colorado. Investment assets decreased from $17,725,000 at April 30, 2018 to $17,227,000 at April 30, 2019, primarily due to depreciation charges. Investment assets include (i) investment land, which represents vacant, undeveloped land not held for development or sale in the normal course of business, and (ii) two facilities located in Palm Coast, Florida that aggregate 204,000 square feet and are leased to a third party. Other assets increased from $594,000 at April 30, 2018 to $6,475,000 at April 30, 2019, primarily due to the present value of expected lease payments deemed to be consideration from sale of the Company’s fulfillment services business. Taxes receivable, net decreased from $764,000 at April 30, 2018 to $283,000 at April 30, 2019, primarily due to the receipt of a federal tax refund of $272,000. Deferred income taxes, net increased from $2,965,000 at April 30, 2018 to $4,536,000 at April 30, 2019, primarily due to the addition of federal net operating loss carry forwards resulting in a deferred tax asset of $2,079,000. Accounts payable and accrued expenses increased from $2,767,000 at April 30, 2018 to $2,964,000 at April 30, 2019, primarily due to an increase in land development activity in New Mexico. Other liabilities and deferred revenue decreased from $134,000 at April 30, 2018 to none at April 30, 2019, due to the amortization of deferred revenue related to an oil and gas lease payment received in fiscal year 2015. The unfunded pension liability of the Company’s frozen defined benefit pension plan decreased from $9,051,000 at April 30, 2018 to $6,401,000 at April 30, 2019, primarily due to Company contributions to the pension plan and favorable investment results of plan assets during 2019. The Company recorded, net of tax, other comprehensive income of $903,000 in 2019 and other comprehensive income of $1,306,000 in 2018, reflecting the change in the unfunded pension liability in each year net of the related deferred tax and unrecognized prepaid pension amounts. Financing Activities Notes payable, net decreased from $1,843,000 at April 30, 2018 to $1,319,000 at April 30, 2019, primarily due to repayments made on financing for land development activity. Given below are descriptions of the Company’s financing arrangements: · Lomas Encantadas Subdivision o In 2018, Lomas Encantadas Development Company LLC (“LEDC”), a subsidiary of the Company, entered into a Development Loan Agreement with BOKF, NA dba Bank of Albuquerque (“Lender”). The Development Loan Agreement was evidenced by a Non-Revolving Line of Credit Promissory Note and was secured by a Mortgage, Security Agreement and Financing Statement, between LEDC and Lender with respect to certain planned residential lots within the Lomas Encantadas subdivision located in Rio Rancho, New Mexico. Pursuant to a Guaranty Agreement entered into by AMREP Southwest Inc. (“ASW”), a subsidiary of the Company, in favor of Lender, ASW guaranteed LEDC’s obligations under each of the above agreements. § Initial Available Principal: Lender agreed to lend up to $4,750,000 to LEDC on a non-revolving line of credit basis to partially fund the development of certain planned residential lots within the Lomas Encantadas subdivision. § Outstanding Principal Amount and Repayments: The outstanding principal amount of the loan as of April 30, 2019 was $181,000 and LEDC made principal repayments of $3,234,000 during 2019. In June 2019, the outstanding principal amount of the loan was fully repaid and the loan was terminated. § Maturity Date: The loan was scheduled to mature in December 2021. § Interest Rate: Interest on the outstanding principal amount of the loan was payable monthly at the annual rate equal to the London Interbank Offered Rate for a thirty-day interest period plus a spread of 3.0%, adjusted monthly. § Lot Release Price: Lender was required to release the lien of its mortgage on any lot upon LEDC making a principal payment of $43,000 or $53,000 depending on the location of the lot. § Book Value: The total book value of the property within the Lomas Encantadas subdivision mortgaged to Lender under this loan was $10,840,000 as of April 30, 2019. § Capitalized Interest: The Company capitalized interest related to this loan of $82,000 in 2019 and $13,000 in 2018. LEDC and ASW made certain representations and warranties in connection with this loan and were required to comply with various covenants, reporting requirements and other customary requirements for similar loans. The loan documentation contained customary events of default for similar financing transactions, including: LEDC’s failure to make principal, interest or other payments when due; the failure of LEDC or ASW to observe or perform their respective covenants under the loan documentation; the representations and warranties of LEDC or ASW being false; the insolvency or bankruptcy of LEDC or ASW; and the failure of ASW to maintain a tangible net worth of at least $35 million. Upon the occurrence and during the continuance of an event of default, Lender had the right to declare the outstanding principal amount and all other obligations under the loan immediately due and payable. LEDC incurred customary costs and expenses and paid certain fees to Lender in connection with the loan. As noted above, in June 2019, the outstanding principal amount of the loan was fully repaid and the loan was terminated. o In June 2019, LEDC entered into another Development Loan Agreement with Lender. This second Development Loan Agreement is evidenced by a Non-Revolving Line of Credit Promissory Note and is secured by a Mortgage, Security Agreement and Financing Statement, between LEDC and Lender with respect to certain planned residential lots within the Lomas Encantadas subdivision located in Rio Rancho, New Mexico. Pursuant to a Guaranty Agreement entered into by ASW in favor of Lender, ASW has guaranteed LEDC’s obligations under each of the above agreements. § Initial Available Principal: Lender agrees to lend up to $2,475,000 to LEDC on a non-revolving line of credit basis to partially fund the development of certain planned residential lots within the Lomas Encantadas subdivision. § Outstanding Principal Amount and Repayments: The outstanding principal amount of the loan as of July 19, 2019 was $29,000. LEDC is required to make periodic principal repayments of borrowed funds not previously repaid as follows: $900,000 on or before March 17, 2021, $300,000 on or before June 17, 2021, $300,000 on or before September 17, 2021, $262,500 on or before December 17, 2021, $525,000 on or before March 17, 2022 and $187,500 on or before June 17, 2022. The outstanding principal amount of the loan may be prepaid at any time without penalty. § Maturity Date: The loan is scheduled to mature in June 2022. § Interest Rate: Interest on the outstanding principal amount of the loan is payable monthly at the annual rate equal to the London Interbank Offered Rate for a thirty-day interest period plus a spread of 3.0%, adjusted monthly. § Lot Release Price: Lender is required to release the lien of its mortgage on any lot upon LEDC making a principal payment of $37,500. § Book Value: The total book value of the property within the Lomas Encantadas subdivision mortgaged to Lender under this loan was $3,395,000 as of April 30, 2019. LEDC and ASW have made certain representations and warranties in connection with this loan and are required to comply with various covenants, reporting requirements and other customary requirements for similar loans. The loan documentation contains customary events of default for similar financing transactions, including: LEDC’s failure to make principal, interest or other payments when due; the failure of LEDC or ASW to observe or perform their respective covenants under the loan documentation; the representations and warranties of LEDC or ASW being false; the insolvency or bankruptcy of LEDC or ASW; and the failure of ASW to maintain a tangible net worth of at least $32 million. Upon the occurrence and during the continuance of an event of default, Lender may declare the outstanding principal amount and all other obligations under the loan immediately due and payable. LEDC incurred customary costs and expenses and paid certain fees to Lender in connection with the loan. · Hawk Site Subdivision o In 2019, Hawksite 27 Development Company, LLC (“HDC”), a subsidiary of the Company, entered into a Business Loan Agreement with Main Bank. The loan under the Business Loan Agreement is evidenced by a Promissory Note and is secured by a Mortgage, between HDC and Main Bank with respect to certain planned residential lots within the Hawk Site subdivision located in Rio Rancho, New Mexico. Pursuant to a Commercial Guaranty entered into by ASW in favor of Main Bank, ASW has guaranteed HDC’s obligations under each of the above agreements. § Initial Available Principal: Main Bank agrees to lend up to $1,800,000 to HDC on a non-revolving line of credit basis to partially fund the development of certain planned residential lots within the Hawk Site subdivision. § Outstanding Principal Amount and Repayments: The outstanding principal amount of the loan as of April 30, 2019 was $1,203,000 and HDC made principal repayments of $390,000 during 2019. The outstanding principal amount of the loan as of July 22, 2019 was $993,000. HDC is required to reduce the principal balance of the loan to a maximum of $1,700,000 in July 2020. The outstanding principal amount of the loan may be prepaid at any time without penalty. § Maturity Date: The loan is scheduled to mature in July 2021. § Interest Rate: Interest on the outstanding principal amount of the loan is payable monthly at the annual rate equal to the Wall Street Journal Prime Rate plus a spread of 2.38%, adjusted annually. § Lot Release Price: Main Bank is required to release the lien of its mortgage on any lot upon HDC making a principal payment equal to the greater of $30,000 or 55% of the sales price of the lot. § Book Value: The total book value of the property within the Hawk Site subdivision mortgaged to Main Bank was $4,874,000 as of April 30, 2019. § Capitalized Interest: The Company capitalized interest related to this borrowing of $33,000 in 2019. HDC and ASW have made certain representations and warranties in connection with this loan and are required to comply with various covenants, reporting requirements and other customary requirements for similar loans. The loan documentation contains customary events of default for similar financing transactions, including: HDC’s failure to make principal, interest or other payments when due; the failure of HDC or ASW to observe or perform their respective covenants under the loan documentation; the representations and warranties of HDC or ASW being false; and the insolvency or bankruptcy of HDC or ASW. Upon the occurrence and during the continuance of an event of default, Main Bank may declare the outstanding principal amount and all other obligations under the loan immediately due and payable. At April 30, 2019, both HDC and ASW were in compliance with the covenants contained in the loan. HDC incurred customary costs and expenses and paid fees to Main Bank in connection with the loan. Investing Activities Capital expenditures were approximately $8,000 for 2019 and $52,000 for 2018, primarily for upgrades related to technology in both years. The Company believes that it has adequate cash, bank financing and cash flows from operations to provide for anticipated capital expenditures and land development spending in fiscal year 2020. Off-Balance Sheet Arrangements As of April 30, 2019, the Company did not have any off-balance sheet arrangements (as defined in Item 303(a)(4)(ii) of Regulation S-K). Recent Accounting Pronouncements See Note 1 to the financial statements included in this Form 10-K for a discussion of recently issued accounting pronouncements. SEGMENT INFORMATION The Company operates in one business segment: real estate. IMPACT OF INFLATION Operations of the Company’s real estate business can be impacted by inflation. Inflation can cause increases in the cost of materials, services, interest and labor. Unless such increased costs are recovered through increased sales prices or improved operating efficiencies, operating margins will decrease. A large part of the Company’s real estate sales are to homebuilders who face their own inflationary concerns that rising housing costs, including interest costs, may substantially outpace increases in the incomes of potential purchasers and make it difficult for them to purchase a new home or sell an owned home. If this situation were to exist, the demand for the Company’s land by these homebuilder customers could decrease. In general, in recent years interest rates have been at historically low levels and other price increases have been commensurate with the general rate of inflation in the Company’s markets, and as a result the Company has not found the inflation risk to be a significant problem in its business. Despite low inflation, the Company’s real estate operations are experiencing price increases as a result of recent tariffs and labor and material shortages. FORWARD-LOOKING STATEMENTS The Private Securities Litigation Reform Act of 1995 provides a safe harbor for forward-looking statements made by or on behalf of the Company. The Company and its representatives may from time to time make written or oral statements that are “forward-looking”, including statements contained in this annual report on Form 10-K and other filings with the Securities and Exchange Commission, reports to the Company’s shareholders and news releases. All statements that express expectations, estimates, forecasts or projections are forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. In addition, other written or oral statements, which constitute forward-looking statements, may be made by or on behalf of the Company. Words such as “expects”, “anticipates”, “intends”, “plans”, “believes”, “seeks”, “estimates”, “projects”, “forecasts”, “may”, “should”, variations of such words and similar expressions are intended to identify such forward-looking statements. These statements are not guarantees of future performance and involve certain risks, uncertainties and contingencies that are difficult to predict. All forward-looking statements speak only as of the date of this annual report on Form 10-K or, in the case of any document incorporated by reference, the date of that document. All subsequent written and oral forward-looking statements attributable to the Company or any person acting on behalf of the Company are qualified by the cautionary statements in this section. Many of the factors that will determine the Company’s future results are beyond the ability of management to control or predict. Therefore, actual outcomes and results may differ materially from what is expressed or forecasted in or suggested by such forward-looking statements. The forward-looking statements contained in this annual report on Form 10-K include, but are not limited to, statements regarding (1) the Company’s ability to finance its future working capital, land development and capital expenditure needs, (2) the Company’s expected liquidity sources, (3) anticipated future development of the Company’s real estate holdings, (4) the development and construction of possible future commercial properties to be marketed to tenants, (5) the timing of reimbursements under, and the general effectiveness of, the Company’s public improvement districts and private infrastructure reimbursement covenants, (6) the number of planned residential lots in the Company’s subdivisions, (7) estimates and assumptions used in determining future cash flows of real estate projects, (8) the utilization of existing bank financing, (9) the effect of recent accounting pronouncements, (10) the anticipated contributions by the Company to the pension plan, the amount of future annual benefit payments to the pension plan, the appropriateness of valuation methods to determine the fair value of financial instruments in the pension plan, the expected return on assets in the pension plan, the expected long-term rate of return on assets in the pension plan, the effect of changes in the weighted average discount interest rate on the amount of pension plan liabilities and the effect of changes in the investment rate of return on pension plan assets with respect to pension expense, (11) the timing of recognizing unrecognized compensation expense related to shares of common stock issued under the AMREP Corporation 2006 Equity Compensation Plan or the AMREP Corporation 2016 Equity Compensation Plan, (12) the future issuance of deferred stock units to directors of the Company, (13) the adequacy of the Company’s facilities, and (14) the materiality of claims and legal actions arising in the normal course of the Company’s business. The Company undertakes no obligation to update or publicly release any revisions to any forward-looking statement to reflect events, circumstances or changes in expectations after the date of such forward-looking statement, or to make any other forward-looking statements, whether as a result of new information, future events or otherwise.

<s>[INST] For a description of the Company’s business, refer to Item 1. As indicated in Item 1, the Company, through its subsidiaries, is primarily engaged in one business segment: the real estate business. The Company has no foreign sales. The following provides information that management believes is relevant to an assessment and understanding of the Company’s consolidated results of operations and financial condition. The discussion should be read in conjunction with the consolidated financial statements and accompanying notes. CRITICAL ACCOUNTING POLICIES AND ESTIMATES The Company prepares its financial statements in conformity with accounting principles generally accepted in the United States of America. The Company discloses its significant accounting policies in the notes to its audited consolidated financial statements. The preparation of such financial statements requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosures of contingent assets and liabilities at the dates of those financial statements as well as the reported amounts of revenues and expenses during the reporting periods. Areas that require significant judgments and estimates to be made include: (1) real estate cost of sales calculations, which are based on land development budgets and estimates of costs to complete; (2) cash flows, asset groupings and valuation assumptions in performing asset impairment tests of longlived assets (including real estate inventories) and assets held for sale; (3) actuarially determined defined benefit pension plan obligations and other pension plan accounting and disclosures; (4) risk assessment of uncertain tax positions; and (5) the determination of the recoverability of net deferred tax assets. Actual results could differ from those estimates. There are numerous critical assumptions that may influence accounting estimates in these and other areas. Management bases its critical assumptions on historical experience, thirdparty data and various other estimates that it believes to be reasonable under the circumstances. The most critical assumptions made in arriving at these accounting estimates include the following: · real estate development costs are incurred throughout the life of a project, and the costs of initial sales from a project frequently must include a portion of costs that have been budgeted based on engineering estimates or other studies, but not yet incurred; · when events or changes in circumstances indicate the carrying value of an asset may not be recoverable, a test for asset impairment may be required. Asset impairment determinations are based upon the intended use of assets, the grouping of those assets, the expected future cash flows and estimates of fair value of assets. For real estate projects under development, an estimate of future cash flows on an undiscounted basis is determined using estimated future expenditures necessary to complete such projects and using management’s best estimates about sales prices and holding periods. Testing of longlived assets includes an estimate of future cash flows on an undiscounted basis using estimated revenue streams, operating margins, administrative expenses and terminal values. The estimation process involved in determining if assets have been impaired and in the determination of estimated future cash flows is inherently uncertain because it requires estimates of future revenues and costs, as well as future events and conditions. If the excess of undiscounted cash flows over the carrying value of a particular asset group is small, there is a greater risk of future impairment and any resulting impairment charges could be material; · defined benefit pension plan obligations and plan accounting and disclosures are based upon numerous assumptions and estimates, including the expected rate of investment return on pension plan assets, the discount rate used to determine the present value of liabilities, and certain employeerelated factors such as turnover, retirement age and mortality; · the Company assesses risk for uncertain tax positions and recognizes the financial statement effects of a tax position when it is more likely than not that the position will be sustained upon examination by tax authorities; and · the Company provides a valuation allowance against net deferred tax assets unless, based upon the available evidence, it is more likely than not that the deferred tax assets will be realized. In making this determination, the Company projects its future earnings (including currently unrealized gains on real estate inventory) for the future recoverability of net deferred tax assets ($4,536,000 as of April 30, 2019). RESULTS OF OPERATIONS Year Ended April 30, 2019 Compared to Year Ended April 30, 2018 Prior to April 26, 2019, [/INST] Negative. </s>

GAP INC

2015-03-23

2015-01-31

Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations. Overview We are a global retailer offering apparel, accessories, and personal care products for men, women, and children under the Gap, Banana Republic, Old Navy, Piperlime, Athleta, and Intermix brands. We have Company-operated stores in the United States, Canada, the United Kingdom, France, Ireland, Japan, Italy, China, Hong Kong, and beginning in March 2014, Taiwan. We also have franchise agreements with unaffiliated franchisees to operate Gap, Banana Republic, and Old Navy stores in many other countries around the world. Under these agreements, third parties operate, or will operate, stores that sell apparel and related products under our brand names. In addition, our products are available to customers online through Company-owned websites and through the use of third parties that provide logistics and fulfillment services. Most of the products sold under our brand names are designed by us and manufactured by independent sources. We also sell products that are designed and manufactured by branded third parties, especially at our Piperlime and Intermix brands. We identify our operating segments according to how our business activities are managed and evaluated. As of January 31, 2015, the Company operated under a global brand structure for our major brands, Gap, Old Navy, and Banana Republic. The Growth, Innovation, and Digital ("GID") division managed our newer brands, Piperlime, Athleta, and Intermix. As each of our operating segments (Gap Global, Old Navy Global, Banana Republic Global, and GID) share similar economic and other qualitative characteristics, the results of our operating segments are aggregated into one reportable segment. In January 2015, we announced our decision to close the Piperlime brand. We expect to close the online platform and the store in New York by the end of the first half of fiscal 2015. In fiscal 2014, we successfully grew both revenue and earnings per share, while delivering progress against our strategic objectives. We continued to execute on our key initiatives, including global growth and omni-channel innovation. While we are pleased with the performance by Old Navy and encouraged by the improvement at Banana Republic, we remain focused on improving the assortment at Gap brand. In the face of challenging results at Gap brand, we demonstrated strong expense and inventory discipline across the Company. Additionally, we generated healthy free cash flow of $1.4 billion and cash flow from operating activities of $2.1 billion and continued our commitment to returning excess cash to shareholders, distributing $1.6 billion through dividends and share repurchases. Despite depreciating foreign currencies, which negatively impacted our operating results, our balanced approach of revenue growth combined with disciplined expense management and cash distribution drove earnings per share growth of 5 percent. Free cash flow is defined as net cash provided by operating activities less purchases of property and equipment. For a reconciliation of free cash flow, a non-GAAP financial measure, from a GAAP financial measure, see the Liquidity and Capital Resources section. Financial results for fiscal 2014 are as follows: • Net sales for fiscal 2014 increased 2 percent to $16.4 billion compared with $16.1 billion for fiscal 2013. Excluding the impact of foreign exchange, our net sales increased 3 percent for fiscal 2014 compared with fiscal 2013. See Net Sales discussion for impact of foreign exchange. • Comparable sales for fiscal 2014 were flat compared with a 2 percent increase last year. • Gross profit was $6.3 billion for fiscal 2014 and fiscal 2013. Gross margin for fiscal 2014 was 38.3 percent compared with 39.0 percent for fiscal 2013. • Operating margin for fiscal 2014 was 12.7 percent compared with 13.3 percent for fiscal 2013. Operating margin is defined as operating income as a percentage of net sales. • Net income was $1.3 billion for both fiscal 2014 and fiscal 2013; however, diluted earnings per share increased 5 percent to $2.87 for fiscal 2014 compared with $2.74 for fiscal 2013 due to share repurchase activities. Fiscal 2014 and 2013 consisted of 52 weeks versus 53 weeks in fiscal 2012. Net sales and operating results for fiscal 2012 reflect the impact of the additional week. In addition, due to the 53rd week in fiscal 2012, comparable ("Comp") sales for fiscal 2013 are compared to the 52-week period ended February 2, 2013. Our business priorities in 2015 include: • offering product that is consistent, brand-appropriate, and on-trend; • evolving our customer experience to reflect the intersection of digital and physical; • attracting, retaining, and training great talent; and • growing globally across our brands and channels. For fiscal 2015, we expect to continue our investment in digital capabilities and to further enhance our shopping experience for our customers. We also plan to continue our global growth, including opening additional stores in Asia with a focus on Gap China, Old Navy China, and Old Navy Japan. In addition, we also expect to open additional Athleta stores in the United States. In fiscal 2015, we expect that foreign exchange rate fluctuations will continue to have a meaningful negative impact on our results, particularly in our largest foreign subsidiaries in Canada and Japan. With the continuing depreciation of the Canadian dollar, Japanese yen, and other foreign currencies, we expect net sales translated into U.S. dollars will decrease and negatively impact our total Company net sales growth. In addition, we expect gross margins for our foreign subsidiaries to be negatively impacted as our merchandise purchases are primarily in U.S. dollars. In addition to the impact of the foreign exchange rate fluctuations, we also expect that delayed merchandise receipts at the U.S. West Coast ports will have meaningful negative impact on our fiscal 2015 operating results. Results of Operations Net Sales See Item 8, Financial Statements and Supplementary Data, Note 17 of Notes to Consolidated Financial Statements for net sales by brand and region. Comparable Sales The percentage change in Comp sales by global brand and for total Company, as compared with the preceding year, is as follows: The Comp sales calculations include sales from stores and online. Comparable online sales favorably impacted total Company Comp sales by 2 percent and 3 percent in fiscal 2014 and 2013, respectively. Only Company-operated stores are included in the calculations of Comp sales. The calculation of total Company Comp sales includes the results of Athleta, Intermix, and the Piperlime store, but excludes the results of our franchise business and Piperlime online. A store is included in the Comp sales calculations when it has been open and operated by Gap Inc. for at least one year and the selling square footage has not changed by 15 percent or more within the past year. A store is included in the Comp sales calculations on the first day it has comparable prior year sales. Stores in which the selling square footage has changed by 15 percent or more as a result of a remodel, expansion, or reduction are excluded from the Comp sales calculations until the first day they have comparable prior year sales. A store is considered non-comparable (“Non-comp”) when it has been open and operated by Gap Inc. for less than one year or has changed its selling square footage by 15 percent or more within the past year. A store is considered “Closed” if it is temporarily closed for three or more full consecutive days or is permanently closed. When a temporarily closed store reopens, the store will be placed in the Comp/Non-comp status it was in prior to its closure. If a store was in Closed status for three or more days in the prior year, the store will be in Non-comp status for the same days the following year. Online Comp sales are defined as sales through online channels in all countries where we have existing Comp store sales. Current year foreign exchange rates are applied to both current year and prior year Comp sales to achieve a consistent basis for comparison. Store Count and Square Footage Information Net sales per average square foot is as follows: __________ (1) Excludes net sales associated with our online and franchise businesses. Store count, openings, closings, and square footage for our stores are as follows: Gap and Banana Republic outlet and factory stores are reflected in each of the respective brands. In fiscal 2015, we expect net openings of about 115 Company-operated store locations. We expect square footage for Company-operated stores to increase about 2.5 percent for fiscal 2015. We expect our franchisees to open about 35 franchise stores in fiscal 2015. Net Sales Discussion Our net sales for fiscal 2014 increased $287 million, or 2 percent, compared with fiscal 2013 primarily due to an increase in net sales at Old Navy and Athleta; partially offset by the unfavorable impact of foreign exchange of about $130 million and a decrease in net sales at Gap. The unfavorable impact of foreign exchange was primarily due to the weakening of the Canadian dollar and Japanese yen against the U.S. dollar. The foreign exchange impact is the translation impact if net sales for fiscal 2013 were translated at exchange rates applicable during fiscal 2014. On this basis, our net sales for fiscal 2014 increased 3 percent compared with fiscal 2013. We believe this metric enhances the visibility of underlying sales trends by excluding the impact of foreign currency exchange rate fluctuations. Our net sales for fiscal 2013 increased $497 million, or 3 percent, compared with fiscal 2012 primarily due to an increase in net sales at Gap Global and our newer brands; partially offset by the unfavorable impact of foreign exchange of about $240 million primarily due to the weakening of the Japanese yen and Canadian dollar against the U.S. dollar. The foreign exchange impact is the translation impact if net sales for fiscal 2012 were translated at exchange rates applicable during fiscal 2013. On this basis, our net sales for fiscal 2013 increased 5 percent compared with fiscal 2012. We believe this metric enhances the visibility of underlying sales trends by excluding the impact of foreign currency exchange rate fluctuations. Fiscal 2013 consisted of 52 weeks compared with 53 weeks in fiscal 2012. Cost of Goods Sold and Occupancy Expenses Cost of goods sold and occupancy expenses as a percentage of net sales increased 0.7 percent in fiscal 2014 compared with fiscal 2013. • Cost of goods sold increased 0.4 percent as a percentage of net sales in fiscal 2014 compared with fiscal 2013, primarily driven by increased promotional activities and markdowns; partially offset by the reclassification of a portion of income related to our credit card program from operating expenses to cost of goods sold. Cost of goods sold as a percentage of net sales in fiscal 2014 for our foreign subsidiaries was also negatively impacted by foreign exchange as our merchandise purchases are primarily in U.S. dollars. • Occupancy expenses increased 0.3 percent as a percentage of net sales in fiscal 2014 compared with fiscal 2013, primarily driven by the incremental cost related to new stores without a corresponding increase in total net sales. Cost of goods sold and occupancy expenses as a percentage of net sales increased 0.4 percent in fiscal 2013 compared with fiscal 2012. • Cost of goods sold increased 0.5 percent as a percentage of net sales in fiscal 2013 compared with fiscal 2012, primarily driven by increased promotional activities. • Occupancy expenses decreased 0.1 percent as a percentage of net sales in fiscal 2013 compared with fiscal 2012, primarily driven by the increase in net sales. In fiscal 2015, we expect that gross margins will continue to be negatively impacted by the continuing depreciation of the Canadian dollar, Japanese yen, and other foreign currencies as our merchandise purchases are primarily in U.S. dollars and also by our continuing expansion of Company-operated stores in international markets, which generally have higher occupancy costs. Operating Expenses and Operating Margin Operating expenses increased $62 million, or decreased 0.1 percent as a percentage of net sales, in fiscal 2014 compared with fiscal 2013. The increase in operating expenses was primarily due to the reclassification of a portion of income related to our credit card program from operating expenses to cost of goods sold and an increase in store payroll; partially offset by the gain on sale of a building owned but no longer occupied by the Company and lower bonus expense. Operating expenses decreased $85 million, or 1.3 percent as a percentage of net sales, in fiscal 2013 compared with fiscal 2012. The decrease in operating expenses was primarily due to lower corporate overhead expenses and store payroll, as well as a decrease in marketing expenses. Interest Expense Interest expense for fiscal 2014 includes interest on overall borrowings and obligations mainly related to our $1.25 billion long-term debt. Interest expense for fiscal 2013 includes $75 million of interest on overall borrowings and obligations mainly related to our $1.25 billion long-term debt, offset by a net reversal of $14 million of interest expense resulting from the favorable resolution of tax matters in fiscal 2013. Interest expense for fiscal 2012 primarily consists of interest expense related to our $1.25 billion long-term debt and $400 million term loan, which was repaid in full in August 2012. Income Taxes The decrease in the effective tax rate for fiscal 2014 compared with fiscal 2013 was primarily due to the recognition of foreign tax credits upon a $473 million distribution of certain foreign earnings that occurred during the third quarter of fiscal 2014. The decrease in the effective tax rate for fiscal 2013 compared with fiscal 2012 was primarily due to the favorable impact of changes in the mix of pre-tax income between our domestic and international operations, partially offset by higher federal and state tax credits recognized in fiscal 2012. Liquidity and Capital Resources Our largest source of cash flows is cash collections from the sale of our merchandise. Our primary uses of cash include merchandise inventory purchases, occupancy costs, personnel-related expenses, purchases of property and equipment, share repurchases, and payment of taxes. We consider the following to be measures of our liquidity and capital resources: As of January 31, 2015, over half of our cash and cash equivalents were held in the United States and are generally accessible without any limitations. We believe that current cash balances and cash flows from our operations will be sufficient to support our business operations, including growth initiatives and planned capital expenditures, for the next 12 months and beyond. We are also able to supplement near-term liquidity, if necessary, with our $500 million revolving credit facility. Cash Flows from Operating Activities Net cash provided by operating activities during fiscal 2014 increased $424 million compared with fiscal 2013, primarily due to the following: • an increase of $284 million related to other current assets and other long-term assets primarily due to the change in timing of payments received related to our credit card program; • an increase of $132 million related to lease incentives and other long-term liabilities primarily due to the receipt of an upfront payment in fiscal 2014 related to the amendment of our credit card program agreement with the third-party financing company, which is being amortized over the term of the contract; and • an increase of $184 million related to merchandise inventory primarily due to timing of receipts; partially offset by • a decrease of $146 million related to accounts payable primarily due to timing of payments; • a decrease of $28 million related to accrued expenses and other current liabilities primarily due to timing of payments; and • a decrease of $18 million in net income. Net cash provided by operating activities during fiscal 2013 decreased $231 million compared with fiscal 2012, primarily due to the following: • a decrease of $220 million related to income taxes payable, net of prepaid income taxes and other tax-related items, in fiscal 2013 compared with fiscal 2012 primarily due to the timing of tax payments; • a decrease of $73 million related to accrued expenses and other current liabilities primarily due to a higher bonus payout in fiscal 2013 compared with fiscal 2012; • a decrease of $71 million related to non-cash and other items primarily due to the realized gain related to our derivative financial instruments in fiscal 2013 compared with a realized loss in fiscal 2012; • a decrease of $67 million related to lease incentives and other long-term liabilities primarily due to the resolution of tax matters, including interest, and an increase in lease incentives in fiscal 2012 related to the relocation of our New York headquarter offices; and • a decrease of $50 million related to merchandise inventory primarily due to volume and timing of receipts; partially offset by • an increase in net income of $145 million; and • a deferred tax provision of $69 million in fiscal 2013 compared with a deferred tax benefit of $37 million in fiscal 2012. We fund inventory expenditures during normal and peak periods through cash flows from operating activities and available cash. Our business follows a seasonal pattern, with sales peaking during the end-of-year holiday period. The seasonality of our operations may lead to significant fluctuations in certain asset and liability accounts between fiscal year-end and subsequent interim periods. Cash Flows from Investing Activities Net cash used for investing activities during fiscal 2014 decreased $28 million compared with fiscal 2013, primarily due to the following: • $121 million of proceeds from the sale of a building owned but no longer occupied by the Company in fiscal 2014; partially offset by • $50 million less maturities of short-term investments in fiscal 2014; and • $44 million more property and equipment purchases in fiscal 2014. Net cash used for investing activities during fiscal 2013 decreased $220 million compared with fiscal 2012, primarily due to the following: • $129 million used for the acquisition of Intermix in fiscal 2012; and • $50 million of maturities of short-term investments in fiscal 2013 compared with $50 million of net purchases in fiscal 2012. In fiscal 2014, cash used for purchases of property and equipment was $714 million. In fiscal 2015, we expect cash spending for purchases of property and equipment to be about $800 million. Cash Flows from Financing Activities Net cash used for financing activities during fiscal 2014 increased $503 million compared with fiscal 2013, primarily due to the following: • $200 million more repurchases of common stock in fiscal 2014; • $144 million proceeds from issuance of long-term debt in fiscal 2013; • $62 million more cash dividends paid in fiscal 2014; and • $59 million less net proceeds from issuances under share-based compensation plans in fiscal 2014. Net cash used for financing activities during fiscal 2013 decreased $477 million compared with fiscal 2012, primarily due to the following: • $419 million of payments of debt in fiscal 2012; • $144 million of proceeds from issuance of long-term debt in fiscal 2013; and • $51 million less repurchases of common stock in fiscal 2013 compared with fiscal 2012, partially offset by • $81 million more dividends paid in fiscal 2013 compared with fiscal 2012; and • $77 million less net proceeds from issuances under share-based compensation plans in fiscal 2013 compared with fiscal 2012. Free Cash Flow Free cash flow is a non-GAAP financial measure. We believe free cash flow is an important metric because it represents a measure of how much cash a company has available for discretionary and non-discretionary items after the deduction of capital expenditures, as we require regular capital expenditures to build and maintain stores and purchase new equipment to improve our business. We use this metric internally, as we believe our sustained ability to generate free cash flow is an important driver of value creation. However, this non-GAAP financial measure is not intended to supersede or replace our GAAP result. The following table reconciles free cash flow, a non-GAAP financial measure, from a GAAP financial measure. Long-Term Debt and Credit Facilities Certain financial information about the Company's long-term debt and credit facilities is set forth under the headings "Long-Term Debt" and "Credit Facilities" in Notes 5 and 6, respectively, of Notes to Consolidated Financial Statements included in Part II, Item 8 of this Form 10-K. Dividend Policy In determining whether and at what level to declare a dividend, we consider a number of factors including sustainability, operating performance, liquidity, and market conditions. We increased our annual dividend from $0.80 per share as of the end of fiscal 2013 to $0.88 per share for fiscal 2014. We intend to increase our annual dividend to $0.92 per share for fiscal 2015. Share Repurchases Certain financial information about the Company's share repurchases is set forth under the heading "Share Repurchases" in Note 9 of Notes to Consolidated Financial Statements included in Part II, Item 8 of this Form 10-K. Contractual Cash Obligations We are party to many contractual obligations involving commitments to make payments to third parties. The following table provides summary information concerning our future contractual obligations as of January 31, 2015. These obligations impact our short-term and long-term liquidity and capital resource needs. Certain of these contractual obligations are reflected in the Consolidated Balance Sheet as of January 31, 2015, while others are disclosed as future obligations. __________ (1) Represents principal maturities, excluding interest. See Note 5 of Notes to Consolidated Financial Statements. (2) Excludes maintenance, insurance, taxes, and contingent rent obligations. See Note 12 of Notes to Consolidated Financial Statements for discussion of our operating leases. (3) Represents estimated open purchase orders to purchase inventory as well as commitments for products and services used in the normal course of business. There is $75 million of long-term liabilities recorded in lease incentives and other long-term liabilities in the Consolidated Balance Sheet as of January 31, 2015 that is being excluded from the table above as the amount relates to uncertain tax positions and we are not able to reasonably estimate the timing of the payments or the amount by which the liability will increase or decrease over time. Commercial Commitments We have commercial commitments, not reflected in the table above, that were incurred in the normal course of business to support our operations, including standby letters of credit of $21 million, surety bonds of $36 million, and bank guarantees of $17 million outstanding (of which $11 million was issued under the unsecured revolving credit facilities for our operations in foreign locations) as of January 31, 2015. Other Cash Obligations Not Reflected in the Consolidated Balance Sheet (Off-Balance Sheet Arrangements) The majority of our contractual obligations relate to operating leases for our stores. Future minimum lease payments represent commitments under non-cancelable operating leases and are disclosed in the table above with additional information provided in Item 8, Financial Statements and Supplementary Data, Note 12 of Notes to Consolidated Financial Statements. Our other off-balance sheet arrangements are disclosed in Item 8, Financial Statements and Supplementary Data, Note 16 of Notes to Consolidated Financial Statements. Critical Accounting Policies and Estimates The preparation of financial statements in accordance with GAAP requires management to adopt accounting policies and make significant judgments and estimates to develop amounts reflected and disclosed in the financial statements. In many cases, there are alternative policies or estimation techniques that could be used. We maintain a thorough process to review the application of our accounting policies and to evaluate the appropriateness of the many estimates that are required to prepare the financial statements of a large, global corporation. However, even under optimal circumstances, estimates routinely require adjustment based on changing circumstances and the receipt of new or better information. Our significant accounting policies can be found in Item 8, Financial Statements and Supplementary Data, Note 1 of Notes to Consolidated Financial Statements. The policies and estimates discussed below include the financial statement elements that are either judgmental or involve the selection or application of alternative accounting policies and are material to our financial statements. Management has discussed the development and selection of these critical accounting policies and estimates with the Audit and Finance Committee of our Board of Directors, which has reviewed our disclosure relating to critical accounting policies and estimates in this annual report on Form 10-K. Merchandise Inventory We value inventory at the lower of cost or market (“LCM”), with cost determined using the weighted-average cost method. We review our inventory levels in order to identify slow-moving merchandise and broken assortments (items no longer in stock in a sufficient range of sizes or colors) and we primarily use promotions and markdowns to clear merchandise. We record an adjustment to inventory when future estimated selling price is less than cost. Our LCM adjustment calculation requires management to make assumptions to estimate the selling price and amount of slow-moving merchandise and broken assortments subject to markdowns, which is dependent upon factors such as historical trends with similar merchandise, inventory aging, forecasted consumer demand, and the promotional environment. In addition, we estimate and accrue shortage for the period between the last physical count and the balance sheet date. Our shortage estimate can be affected by changes in merchandise mix and changes in actual shortage trends. Historically, actual shortage has not differed materially from our estimates. We do not believe there is a reasonable likelihood that there will be a material change in the future estimates or assumptions we use to calculate our LCM or inventory shortage adjustments. However, if estimates regarding consumer demand are inaccurate or actual physical inventory shortage differs significantly from our estimate, our operating results could be affected. We have not made any material changes in the accounting methodology used to calculate our LCM or inventory shortage adjustments in the past three fiscal years. Impairment of Long-Lived Assets, Goodwill, and Intangible Assets We review the carrying amount of long-lived assets for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset or asset group may not be recoverable. Events that result in an impairment review include the decision to close a store, corporate facility, or distribution center, or a significant decrease in the operating performance of the long-lived asset. Long-lived assets are considered impaired if the estimated undiscounted future cash flows of the asset or asset group are less than the carrying amount. For impaired assets, we recognize a loss equal to the difference between the carrying amount of the asset or asset group and its estimated fair value. The estimated fair value of the asset or asset group is based on estimated discounted future cash flows of the asset or asset group using a discount rate commensurate with the risk. The asset group is defined as the lowest level for which identifiable cash flows are available and largely independent of the cash flows of other groups of assets. The asset group for our retail stores is reviewed for impairment primarily at the store level. Our estimate of future cash flows requires management to make assumptions and to apply judgment, including forecasting future sales and expenses and estimating useful lives of the assets. These estimates can be affected by factors such as future store results, real estate demand, and economic conditions that can be difficult to predict. We have not made any material changes in the methodology to assess and calculate impairment of long-lived assets in the past three fiscal years. We recorded a charge for the impairment of long-lived assets of $10 million, $1 million, and $8 million for fiscal 2014, 2013, and 2012, respectively. We also review the carrying amount of goodwill and other indefinite-lived intangible assets for impairment annually and whenever events or changes in circumstances indicate that it is more likely than not that the carrying amount may not be recoverable. Events that result in an impairment review include significant changes in the business climate, declines in our operating results, or an expectation that the carrying amount may not be recoverable. In connection with the acquisitions of Athleta in September 2008 and Intermix in December 2012, we allocated $99 million and $81 million of the respective purchase prices to goodwill. The aggregate carrying amount of goodwill was $180 million as of January 31, 2015. We review goodwill for impairment, as appropriate, by first assessing qualitative factors to determine whether it is more likely than not that the fair value of the reporting unit is less than its carrying amount, including goodwill, as a basis for determining whether it is necessary to perform the two-step goodwill impairment test. If it is determined that it is more likely than not that the fair value of the reporting unit is less than its carrying amount, the two-step test is performed to identify potential goodwill impairment. If it is determined that it is not more likely than not that the fair value of the reporting unit is less than its carrying amount, it is unnecessary to perform the two-step goodwill impairment test. Based on certain circumstances, we may elect to bypass the qualitative assessment and proceed directly to performing the first step of the two-step goodwill impairment test. The first step of the two-step goodwill impairment test compares the fair value of the reporting unit to its carrying amount, including goodwill. The second step includes hypothetically valuing all the tangible and intangible assets of the reporting unit as if the reporting unit had been acquired in a business combination. Then, the implied fair value of the reporting unit’s goodwill is compared to the carrying amount of that goodwill. If the carrying amount of the reporting unit’s goodwill exceeds the implied fair value of the goodwill, we recognize an impairment loss in an amount equal to the excess, not to exceed the carrying amount. A reporting unit is an operating segment or a business unit one level below that operating segment, for which discrete financial information is prepared and regularly reviewed by segment management. We have deemed Athleta and Intermix to be the reporting units at which goodwill is tested for Athleta and Intermix, respectively. During the fourth quarter of fiscal 2014, we completed our annual impairment testing of goodwill and we did not recognize any impairment charges. We determined that the fair value of goodwill attributed to Athleta significantly exceeded its carrying amount as of the date of our annual impairment review. The fair value of goodwill attributed to Intermix exceeded its carrying amount by approximately 20 percent as of the date of our annual impairment review. In connection with the acquisitions of Athleta in September 2008 and Intermix in December 2012, we allocated $54 million and $38 million of the respective purchase prices to trade names. The aggregate carrying amount of the trade names was $92 million as of January 31, 2015. A trade name is considered impaired if the estimated fair value of the trade name is less than the carrying amount. If a trade name is considered impaired, we recognize a loss equal to the difference between the carrying amount and the estimated fair value of the trade name. The fair value of the trade names is determined using the relief from royalty method. During the fourth quarter of fiscal 2014, we completed our annual impairment review of the trade names and we did not recognize any impairment charges. We determined that the fair value of the Athleta trade name significantly exceeded its carrying amount as of the date of our annual impairment review. The fair value of the Intermix trade name exceeded its carrying amount by approximately 30 percent as of the date of our annual impairment review. These analyses require management to make assumptions and to apply judgment, including forecasting future sales and expenses, and selecting appropriate discount rates and royalty rates, which can be affected by economic conditions and other factors that can be difficult to predict. We do not believe there is a reasonable likelihood that there will be a material change in the estimates or assumptions we use to calculate impairment losses of long-lived assets, goodwill, and intangible assets. However, if actual results are not consistent with our estimates and assumptions used in the calculations, we may be exposed to impairment losses that could be material. Revenue Recognition While revenue recognition for the Company does not involve significant judgment, it represents an important accounting policy. We recognize revenue and the related cost of goods sold at the time the products are received by the customers. For sales transacted at stores, revenue is recognized when the customer receives and pays for the merchandise at the register. For sales where we ship the merchandise to the customer from the distribution center or store, revenue is recognized at the time the customer receives the merchandise. We record an allowance for estimated returns based on our historical return patterns and various other assumptions that management believes to be reasonable. We sell merchandise to franchisees under multi-year franchise agreements. We recognize revenue from sales to franchisees at the time merchandise ownership is transferred to the franchisee, which generally occurs when the merchandise reaches the franchisee’s predesignated turnover point. We also receive royalties from franchisees based on a percentage of the total merchandise purchased by the franchisee, net of any refunds or credits due them. Royalty revenue is recognized when merchandise ownership is transferred to the franchisee. We do not believe there is a reasonable likelihood that there will be a material change in the future estimates or assumptions we use to calculate our sales return allowance. However, if the actual rate of sales returns increases significantly, our operating results could be adversely affected. We have not made any material changes in the accounting methodology used to estimate future sales returns in the past three fiscal years. Unredeemed Gift Cards, Gift Certificates, and Credit Vouchers Upon issuance of a gift card, gift certificate, or credit voucher, a liability is established for its cash value. The liability is relieved and net sales are recorded upon redemption by the customer. Over time, some portion of these instruments is not redeemed (“breakage”). We determine breakage income for gift cards, gift certificates, and credit vouchers based on historical redemption patterns. Breakage income is recorded in other income, which is a component of operating expenses in the Consolidated Statements of Income, when we can determine the portion of the liability where redemption is remote, which is three years after the gift card, gift certificate, or credit voucher is issued. When breakage income is recorded, a liability is recognized for any legal obligation to remit the unredeemed portion to relevant jurisdictions. Substantially all of our gift cards, gift certificates, and credit vouchers have no expiration dates. We do not believe there is a reasonable likelihood that there will be a material change in the future estimates or assumptions we use to calculate our breakage income. However, if the actual rate of redemption for gift cards, gift certificates, and credit vouchers increases significantly, our operating results could be adversely affected. We have not made any material changes in the accounting methodology used to estimate breakage income in the past three fiscal years. Income Taxes We record a valuation allowance against our deferred tax assets when it is more likely than not that some portion or all of such deferred tax assets will not be realized. In determining the need for a valuation allowance, management is required to make assumptions and to apply judgment, including forecasting future income, taxable income, and the mix of income or losses in the jurisdictions in which we operate. Our effective tax rate in a given financial statement period may also be materially impacted by changes in the mix and level of income or losses, changes in the expected outcome of audits, or changes in the deferred tax valuation allowance. At any point in time, many tax years are subject to or in the process of being audited by various taxing authorities. To the extent our estimates of settlements change or the final tax outcome of these matters is different from the amounts recorded, such differences will impact the income tax provision in the period in which such determinations are made. Our income tax expense includes changes in our estimated liability for exposures associated with our various tax filing positions. Determining the income tax expense for these potential assessments requires management to make assumptions that are subject to factors such as proposed assessments by tax authorities, changes in facts and circumstances, issuance of new regulations, and resolution of tax audits. We believe the judgments and estimates discussed above are reasonable. However, if actual results are not consistent with our estimates or assumptions, we may be exposed to losses or gains that could be material. Recent Accounting Pronouncements See Item 8, Financial Statements and Supplementary Data, Note 1 of Notes to Consolidated Financial Statements for recent accounting pronouncements, including the expected dates of adoption and estimated effects on our Consolidated Financial Statements.

<s>[INST] We are a global retailer offering apparel, accessories, and personal care products for men, women, and children under the Gap, Banana Republic, Old Navy, Piperlime, Athleta, and Intermix brands. We have Companyoperated stores in the United States, Canada, the United Kingdom, France, Ireland, Japan, Italy, China, Hong Kong, and beginning in March 2014, Taiwan. We also have franchise agreements with unaffiliated franchisees to operate Gap, Banana Republic, and Old Navy stores in many other countries around the world. Under these agreements, third parties operate, or will operate, stores that sell apparel and related products under our brand names. In addition, our products are available to customers online through Companyowned websites and through the use of third parties that provide logistics and fulfillment services. Most of the products sold under our brand names are designed by us and manufactured by independent sources. We also sell products that are designed and manufactured by branded third parties, especially at our Piperlime and Intermix brands. We identify our operating segments according to how our business activities are managed and evaluated. As of January 31, 2015, the Company operated under a global brand structure for our major brands, Gap, Old Navy, and Banana Republic. The Growth, Innovation, and Digital ("GID") division managed our newer brands, Piperlime, Athleta, and Intermix. As each of our operating segments (Gap Global, Old Navy Global, Banana Republic Global, and GID) share similar economic and other qualitative characteristics, the results of our operating segments are aggregated into one reportable segment. In January 2015, we announced our decision to close the Piperlime brand. We expect to close the online platform and the store in New York by the end of the first half of fiscal 2015. In fiscal 2014, we successfully grew both revenue and earnings per share, while delivering progress against our strategic objectives. We continued to execute on our key initiatives, including global growth and omnichannel innovation. While we are pleased with the performance by Old Navy and encouraged by the improvement at Banana Republic, we remain focused on improving the assortment at Gap brand. In the face of challenging results at Gap brand, we demonstrated strong expense and inventory discipline across the Company. Additionally, we generated healthy free cash flow of $1.4 billion and cash flow from operating activities of $2.1 billion and continued our commitment to returning excess cash to shareholders, distributing $1.6 billion through dividends and share repurchases. Despite depreciating foreign currencies, which negatively impacted our operating results, our balanced approach of revenue growth combined with disciplined expense management and cash distribution drove earnings per share growth of 5 percent. Free cash flow is defined as net cash provided by operating activities less purchases of property and equipment. For a reconciliation of free cash flow, a nonGAAP financial measure, from a GAAP financial measure, see the Liquidity and Capital Resources section. Financial results for fiscal 2014 are as follows: Net sales for fiscal 2014 increased 2 percent to $16.4 billion compared with $16.1 billion for fiscal 2013. Excluding the impact of foreign exchange, our net sales increased 3 percent for fiscal 2014 compared with fiscal 2013. See Net Sales discussion for impact of foreign exchange. Comparable sales for fiscal 2014 were flat compared with a 2 percent increase last year. Gross profit was $6.3 billion for fiscal 2014 and fiscal 2013. Gross margin for fiscal 2014 was 38.3 percent compared with 39.0 percent for fiscal 2013. Operating margin for fiscal 2014 was 12.7 percent compared with 13.3 percent for fiscal 2013. Operating margin is defined as operating income as a percentage of net sales. Net income was $1.3 billion for both fiscal 2014 and fiscal 2013; however, diluted earnings per share increased 5 percent to $2.87 for fiscal 2014 compared with $2.74 for fiscal 201 [/INST] Positive. </s>

GAP INC

2016-03-21

2016-01-30

Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations. Overview We are a global retailer offering apparel, accessories, and personal care products for men, women, and children under the Gap, Banana Republic, Old Navy, Athleta, and Intermix brands. We have Company-operated stores in the United States, Canada, the United Kingdom, France, Ireland, Japan, Italy, China, Hong Kong, Taiwan, and beginning in October 2015, Mexico. We have franchise agreements with unaffiliated franchisees to operate Gap, Banana Republic, and Old Navy stores throughout Asia, Australia, Europe, Latin America, the Middle East, and Africa. Under these agreements, third parties operate, or will operate, stores that sell apparel and related products under our brand names. Our products are also available to customers online through Company-owned websites and through the use of third parties that provide logistics and fulfillment services. In addition to operating in the specialty, outlet, online, and franchise channels, we also use our omni-channel capabilities to bridge the digital world and physical stores to further enhance our shopping experience for our customers. Our omni-channel services, including order-in-store, reserve-in-store, find-in-store, and ship-from-store, as well as enhanced mobile experiences, are tailored uniquely across our portfolio of brands. Most of the products sold under our brand names are designed by us and manufactured by independent sources. We also sell products that are designed and manufactured by branded third parties, primarily at our Intermix brand. We identify our operating segments according to how our business activities are managed and evaluated. As of January 30, 2016, our operating segments included Gap Global, Old Navy Global, Banana Republic Global, Athleta, and Intermix. We have determined that each of our operating segments share similar economic and other qualitative characteristics, and therefore the results of our operating segments are aggregated into one reportable segment. As previously announced in January 2015, we closed the Piperlime brand during the first half of fiscal 2015, including its online platform and the store in New York. Financial results for fiscal 2015 are as follows: • Net sales for fiscal 2015 decreased 4 percent to $15.8 billion compared with $16.4 billion for fiscal 2014. Excluding the impact of foreign exchange, our net sales decreased 2 percent for fiscal 2015 compared with fiscal 2014. See Net Sales discussion for impact of foreign exchange. • Comparable ("Comp") sales for fiscal 2015 decreased 4 percent compared with flat for last year. • Gross profit for fiscal 2015 was $5.7 billion compared with $6.3 billion for fiscal 2014. Gross margin for fiscal 2015 was 36.2 percent compared with 38.3 percent for fiscal 2014. • Operating margin for fiscal 2015 was 9.6 percent compared with 12.7 percent for fiscal 2014. Operating margin is defined as operating income as a percentage of net sales. • Net income for fiscal 2015 was $920 million compared with $1.3 billion for fiscal 2014. Diluted earnings per share was $2.23 for fiscal 2015 compared with $2.87 for fiscal 2014. • During fiscal 2015, we distributed $1.4 billion to shareholders through share repurchases and dividends. In June 2015, we announced a series of strategic actions to position Gap brand for improved business performance in the future, including right-sizing the Gap brand store fleet, streamlining the brand's headquarter workforce, and developing a clear, on-brand product aesthetic framework that will help strengthen the Gap brand to compete more successfully on the global stage. During fiscal 2015, the Company completed the closure of about 150 global specialty stores related to the strategic actions. The Company also incurred certain charges during fiscal 2015 in connection with the strategic actions, primarily consisting of impairment of store assets, lease termination fees and lease losses, employee related expenses, and impairment of inventory that did not meet brand standards. The charges incurred related to the Company's strategic actions primarily related to Gap brand are as follows: Our business priorities in 2016 include: • offering product that is consistently brand-appropriate and on-trend with high customer acceptance; • continuing to evolve our customer experience, with particular focus on the mobile and digital expressions of our brands; and • attracting and retaining great talent in our businesses and functions. For fiscal 2016, our top objective is to improve sales performance through a more consistent, on-trend, product offering. To enable this, we have several product initiatives underway, and in addition, we plan to continue focus on our responsive supply chain and inventory management. Further, we expect to continue our investment in our mobile digital capabilities and to enhance our shopping experience for our customers. We also plan to continue growth through new stores with a focus on Asia, outlet, and Athleta. In fiscal 2016, we expect that foreign exchange rate fluctuations will continue to have a meaningful negative impact on our results, particularly in our largest foreign subsidiaries in Canada and Japan. With the depreciation of the Canadian dollar, Japanese yen, and other foreign currencies, we expect net sales translated into U.S. dollars will negatively impact our total Company net sales growth. In addition, we expect gross margins for our foreign subsidiaries to be negatively impacted as our merchandise purchases are primarily in U.S. dollars. We expect this negative impact of foreign exchange rate fluctuations to be partially offset by the favorable impact of translation of expenses in foreign currencies into U.S. dollars. Results of Operations Net Sales See Item 8, Financial Statements and Supplementary Data, Note 16 of Notes to Consolidated Financial Statements for net sales by brand and region. Comparable Sales The percentage change in Comp sales by global brand and for total Company, as compared with the preceding year, is as follows: Comparable online sales favorably impacted total Company Comp sales by 2 percent, 2 percent, and 3 percent in fiscal 2015, 2014, and 2013, respectively. Only Company-operated stores are included in the calculations of Comp sales. The calculation of total Company Comp sales includes the results of Athleta and Intermix but excludes the results of our franchise business. A store is included in the Comp sales calculations when it has been open and operated by the Company for at least one year and the selling square footage has not changed by 15 percent or more within the past year. A store is included in the Comp sales calculations on the first day it has comparable prior year sales. Stores in which the selling square footage has changed by 15 percent or more as a result of a remodel, expansion, or reduction are excluded from the Comp sales calculations until the first day they have comparable prior year sales. A store is considered non-comparable (“Non-comp”) when it has been open and operated by the Company for less than one year or has changed its selling square footage by 15 percent or more within the past year. A store is considered “Closed” if it is temporarily closed for three or more full consecutive days or it is permanently closed. When a temporarily closed store reopens, the store will be placed in the Comp/Non-comp status it was in prior to its closure. If a store was in Closed status for three or more days in the prior year, the store will be in Non-comp status for the same days the following year. Online Comp sales are defined as sales through online channels in those countries where we have existing Comp store sales. Current year foreign exchange rates are applied to both current year and prior year Comp sales to achieve a consistent basis for comparison. Store Count and Square Footage Information Net sales per average square foot is as follows: __________ (1) Excludes net sales associated with our online and franchise businesses. Store count, openings, closings, and square footage for our stores are as follows: Gap and Banana Republic outlet and factory stores are reflected in each of the respective brands. In fiscal 2016, we expect net openings of about 40 Company-operated store locations. We expect square footage for Company-operated stores to be about flat in fiscal 2016 compared with fiscal 2015. Net Sales Discussion Our net sales for fiscal 2015 decreased $638 million, or 4 percent, compared with fiscal 2014 primarily due to the unfavorable impact of foreign exchange of about $363 million and a decrease in net sales primarily at Gap and Banana Republic; partially offset by an increase in net sales at Old Navy. The unfavorable impact of foreign exchange was primarily driven by the weakening of the Canadian dollar and Japanese yen against the U.S. dollar. The foreign exchange impact is the translation impact if net sales for fiscal 2014 were translated at exchange rates applicable during fiscal 2015. On this basis, our net sales for fiscal 2015 decreased 2 percent compared with fiscal 2014. We believe this metric enhances the visibility of underlying sales trends by excluding the impact of foreign currency exchange rate fluctuations. Our net sales for fiscal 2014 increased $287 million, or 2 percent, compared with fiscal 2013 primarily due to an increase in net sales at Old Navy and Athleta; partially offset by the unfavorable impact of foreign exchange of about $130 million and a decrease in net sales at Gap. The unfavorable impact of foreign exchange was primarily due to the weakening of the Canadian dollar and Japanese yen against the U.S. dollar. The foreign exchange impact is the translation impact if net sales for fiscal 2013 were translated at exchange rates applicable during fiscal 2014. On this basis, our net sales for fiscal 2014 increased 3 percent compared with fiscal 2013. We believe this metric enhances the visibility of underlying sales trends by excluding the impact of foreign currency exchange rate fluctuations. Cost of Goods Sold and Occupancy Expenses Cost of goods sold and occupancy expenses increased 2.1 percentage points in fiscal 2015 compared with fiscal 2014. • Cost of goods sold increased 1.3 percent as a percentage of net sales in fiscal 2015 compared with fiscal 2014, primarily driven by increased markdown activities, the charges incurred related to the strategic actions, and incremental shipping costs partially due to the U.S. West Coast port congestion. Cost of goods sold as a percentage of net sales in fiscal 2015 for our foreign subsidiaries was also negatively impacted by foreign exchange as our merchandise purchases are primarily in U.S. dollars. • Occupancy expenses increased 0.8 percentage points in fiscal 2015 compared with fiscal 2014, primarily driven by the decrease in net sales without a corresponding decrease in occupancy expenses. Cost of goods sold and occupancy expenses increased 0.7 percentage points in fiscal 2014 compared with fiscal 2013. • Cost of goods sold increased 0.4 percent as a percentage of net sales in fiscal 2014 compared with fiscal 2013, primarily driven by increased promotional activities and markdowns; partially offset by the reclassification of a portion of income related to our credit card program from operating expenses to cost of goods sold. Cost of goods sold as a percentage of net sales in fiscal 2014 for our foreign subsidiaries was also negatively impacted by foreign exchange as our merchandise purchases are primarily in U.S. dollars. • Occupancy expenses increased 0.3 percentage points in fiscal 2014 compared with fiscal 2013, primarily driven by the incremental cost related to new stores without a corresponding increase in total net sales. In fiscal 2016, we expect that gross margins will continue to be negatively impacted by the continuing depreciation of the Canadian dollar, Japanese yen, and other foreign currencies as our merchandise purchases are primarily in U.S. dollars. Operating Expenses and Operating Margin Operating expenses decreased $10 million, but increased 1.0 percent as a percentage of net sales, in fiscal 2015 compared with fiscal 2014. The decrease in operating expenses was primarily due to a decrease in marketing expenses mainly at Gap and Banana Republic, lower bonus expense, and a favorable translation impact as a result of foreign exchange rate fluctuations; partially offset by charges incurred related to the strategic actions, as well as the gain on sale of a building recognized in fiscal 2014. Operating expenses increased $62 million, but decreased 0.1 percent as a percentage of net sales, in fiscal 2014 compared with fiscal 2013. The increase in operating expenses was primarily due to the reclassification of a portion of income related to our credit card program from operating expenses to cost of goods sold and an increase in store payroll; partially offset by the gain on sale of a building owned but no longer occupied by the Company and lower bonus expense. Interest Expense Interest expense for fiscal 2015 includes $74 million of interest on overall borrowings and obligations mainly related to our $1.25 billion long-term debt, offset by a reversal of approximately $15 million of interest expense primarily resulting from a favorable foreign tax ruling and actions of foreign tax authorities related to transfer pricing matters in fiscal 2015. Interest expense for fiscal 2014 includes interest on overall borrowings and obligations mainly related to our $1.25 billion long-term debt. Interest expense for fiscal 2013 includes $75 million of interest on overall borrowings and obligations mainly related to our $1.25 billion long-term debt, offset by a net reversal of $14 million of interest expense resulting from the favorable resolution of tax matters in fiscal 2013. Income Taxes The increase in the effective tax rate for fiscal 2015 compared with fiscal 2014 was primarily due to the recognition of foreign tax credits upon a distribution of certain foreign earnings that occurred during the third quarter of fiscal 2014, partially offset by the impact of the indefinite reinvestment of certain fiscal 2015 foreign earnings, which will be used to fund our international businesses and their growth. The decrease in the effective tax rate for fiscal 2014 compared with fiscal 2013 was primarily due to the recognition of foreign tax credits upon a distribution of certain foreign earnings that occurred during the third quarter of fiscal 2014. Liquidity and Capital Resources Our largest source of cash flows is cash collections from the sale of our merchandise. Our primary uses of cash include merchandise inventory purchases, occupancy costs, personnel-related expenses, share repurchases, purchases of property and equipment, and payment of taxes. We consider the following to be measures of our liquidity and capital resources: As of January 30, 2016, over half of our cash and cash equivalents were held in the United States and are generally accessible without any limitations. In October 2015, the Company entered into a $400 million unsecured term loan (the "Term Loan"). The Term Loan matures and is payable in full on October 15, 2016, but may be extended until October 15, 2017. In January 2014, the Company entered into a 15 billion Japanese yen, four-year, unsecured term loan ("Japan Term Loan") due January 2018. A repayment of 2.5 billion Japanese yen ($21 million as of January 30, 2016) is payable on January 15, 2017. Working capital as of January 30, 2016 is impacted by the decrease in the operating cash flows discussed below and the adoption of the Financial Accounting Standards Board ("FASB"), accounting standard update ("ASU") No. 2015-17, Income Taxes. The adoption of the ASU was applied prospectively and reduced the current portion of deferred tax assets as a result of classifying all net deferred tax assets as noncurrent as of January 30, 2016. We believe that current cash balances and cash flows from our operations will be sufficient to support our business operations, including growth initiatives, planned capital expenditures, and repayment of debt, for the next 12 months and beyond. We are also able to supplement near-term liquidity, if necessary, with our $500 million revolving credit facility or other available market instruments. Cash Flows from Operating Activities Net cash provided by operating activities during fiscal 2015 decreased $535 million compared with fiscal 2014, primarily due to the following: • a decrease of $342 million in net income; • a decrease of $107 million related to other current assets and other long-term assets primarily due to the change in timing of payments received related to our credit card program, which resulted in increased cash inflow in fiscal 2014; and • a decrease of $150 million related to lease incentives and other long-term liabilities primarily due to the receipt of an upfront payment in fiscal 2014 related to the amendment of our credit card program agreement with the third-party financing company, which is being amortized into income over the term of the contract; partially offset by • an increase of $63 million related to income taxes payable, net of prepaid and other tax-related items, primarily due to timing of payments. Net cash provided by operating activities during fiscal 2014 increased $424 million compared with fiscal 2013, primarily due to the following: • an increase of $284 million related to other current assets and other long-term assets primarily due to the change in timing of payments received related to our credit card program, which resulted in increased cash inflow in fiscal 2014; • an increase of $132 million related to lease incentives and other long-term liabilities primarily due to the receipt of an upfront payment in fiscal 2014 related to the amendment of our credit card program agreement with the third-party financing company, which is being amortized into income over the term of the contract; and • an increase of $184 million related to merchandise inventory primarily due to timing of receipts; partially offset by • a decrease of $146 million related to accounts payable primarily due to timing of payments; • a decrease of $28 million related to accrued expenses and other current liabilities primarily due to timing of payments; and • a decrease of $18 million in net income. We fund inventory expenditures during normal and peak periods through cash flows from operating activities and available cash. Our business follows a seasonal pattern, with sales peaking during the end-of-year holiday period. The seasonality of our operations may lead to significant fluctuations in certain asset and liability accounts between fiscal year-end and subsequent interim periods. Cash Flows from Investing Activities Net cash used for investing activities during fiscal 2015 increased $134 million compared with fiscal 2014, primarily due to the following: • $121 million of proceeds from the sale of a building owned but no longer occupied by the Company in fiscal 2014; and • $12 million more property and equipment purchases. Net cash used for investing activities during fiscal 2014 decreased $28 million compared with fiscal 2013, primarily due to the following: • $121 million of proceeds from the sale of a building owned but no longer occupied by the Company in fiscal 2014; partially offset by • $50 million less maturities of short-term investments; and • $44 million more property and equipment purchases. In fiscal 2015, cash used for purchases of property and equipment was $726 million. In fiscal 2016, we expect cash spending for purchases of property and equipment to be about $650 million. Cash Flows from Financing Activities Net cash used for financing activities during fiscal 2015 decreased $517 million compared with fiscal 2014, primarily due to the following: • $400 million proceeds from the issuance of short-term debt in fiscal 2015; and • $164 million less repurchases of common stock; partially offset by • $4 million net cash out flows for fiscal 2015 compared with $38 million net cash inflows for fiscal 2014 related to issuance under share-based compensation plans and withholding tax payments related to vesting of stock units. Net cash used for financing activities during fiscal 2014 increased $503 million compared with fiscal 2013, primarily due to the following: • $200 million more repurchases of common stock; • $144 million proceeds from issuance of long-term debt in fiscal 2013; • $62 million more cash dividends paid; and • $59 million less net cash inflows for fiscal 2014 related to issuances under share-based compensation plans and withholding tax payments related to vesting of stock units. Free Cash Flow Free cash flow is a non-GAAP financial measure. We believe free cash flow is an important metric because it represents a measure of how much cash a company has available for discretionary and non-discretionary items after the deduction of capital expenditures, as we require regular capital expenditures to build and maintain stores and purchase new equipment to improve our business. We use this metric internally, as we believe our sustained ability to generate free cash flow is an important driver of value creation. However, this non-GAAP financial measure is not intended to supersede or replace our GAAP result. The following table reconciles free cash flow, a non-GAAP financial measure, from a GAAP financial measure. Debt and Credit Facilities Certain financial information about the Company's debt and credit facilities is set forth under the headings "Debt" and "Credit Facilities" in Notes 4 and 5, respectively, of Notes to Consolidated Financial Statements included in Part II, Item 8 of this Form 10-K. Dividend Policy In determining whether and at what level to declare a dividend, we consider a number of factors including sustainability, operating performance, liquidity, and market conditions. We increased our annual dividend from $0.88 per share for fiscal 2014 to $0.92 per share for fiscal 2015. We plan to pay an annual dividend of $0.92 per share in fiscal 2016. Share Repurchases Certain financial information about the Company's share repurchases is set forth under the heading "Share Repurchases" in Note 8 of Notes to Consolidated Financial Statements included in Part II, Item 8 of this Form 10-K. Contractual Cash Obligations We are party to many contractual obligations involving commitments to make payments to third parties. The following table provides summary information concerning our future contractual obligations as of January 30, 2016. These obligations impact our short-term and long-term liquidity and capital resource needs. Certain of these contractual obligations are reflected in the Consolidated Balance Sheet as of January 30, 2016, while others are disclosed as future obligations. __________ (1) Represents principal maturities, excluding interest. See Note 4 of Notes to Consolidated Financial Statements. (2) Excludes maintenance, insurance, taxes, and contingent rent obligations. See Note 11 of Notes to Consolidated Financial Statements for discussion of our operating leases. (3) Represents estimated open purchase orders to purchase inventory as well as commitments for products and services used in the normal course of business. There is $82 million of long-term liabilities recorded in lease incentives and other long-term liabilities in the Consolidated Balance Sheet as of January 30, 2016 that is being excluded from the table above as the amount relates to uncertain tax positions and deferred compensation and we are not able to reasonably estimate the timing of the payments or the amount by which the liability will increase or decrease over time. Commercial Commitments We have commercial commitments, not reflected in the table above, that were incurred in the normal course of business to support our operations, including standby letters of credit of $18 million, surety bonds of $39 million, and bank guarantees of $17 million outstanding (of which $12 million was issued under the unsecured revolving credit facilities for our operations in foreign locations) as of January 30, 2016. Other Cash Obligations Not Reflected in the Consolidated Balance Sheet (Off-Balance Sheet Arrangements) The majority of our contractual obligations relate to operating leases for our stores. Future minimum lease payments represent commitments under non-cancelable operating leases and are disclosed in the table above with additional information provided under the heading "Leases" in Note 11 of Notes to Consolidated Financial Statements included in Part II, Item 8 of this Form 10-K. Our other off-balance sheet arrangements are disclosed under the heading "Commitments and Contingencies" in Note 15 of Notes to Consolidated Financial Statements included in Part II, Item 8 of this Form 10-K. Critical Accounting Policies and Estimates The preparation of financial statements in accordance with GAAP requires management to adopt accounting policies and make significant judgments and estimates to develop amounts reflected and disclosed in the financial statements. In many cases, there are alternative policies or estimation techniques that could be used. We maintain a thorough process to review the application of our accounting policies and to evaluate the appropriateness of the many estimates that are required to prepare the financial statements of a large, global corporation. However, even under optimal circumstances, estimates routinely require adjustment based on changing circumstances and the receipt of new or better information. Our significant accounting policies can be found under the heading "Organization and Summary of Significant Accounting Policies" in Note 1 of Notes to Consolidated Financial Statements included in Part II, Item 8 of this Form 10-K. The policies and estimates discussed below include the financial statement elements that are either judgmental or involve the selection or application of alternative accounting policies and are material to our financial statements. Management has discussed the development and selection of these critical accounting policies and estimates with the Audit and Finance Committee of our Board of Directors, which has reviewed our disclosure relating to critical accounting policies and estimates in this annual report on Form 10-K. Merchandise Inventory We value inventory at the lower of cost or market (“LCM”), with cost determined using the weighted-average cost method. We review our inventory levels in order to identify slow-moving merchandise and broken assortments (items no longer in stock in a sufficient range of sizes or colors) and we primarily use promotions and markdowns to clear merchandise. We record an adjustment to inventory when future estimated selling price is less than cost. Our LCM adjustment calculation requires management to make assumptions to estimate the selling price and amount of slow-moving merchandise and broken assortments subject to markdowns, which is dependent upon factors such as historical trends with similar merchandise, inventory aging, forecasted consumer demand, and the promotional environment. In addition, we estimate and accrue shortage for the period between the last physical count and the balance sheet date. Our shortage estimate can be affected by changes in merchandise mix and changes in actual shortage trends. Historically, actual shortage has not differed materially from our estimates. We do not believe there is a reasonable likelihood that there will be a material change in the future estimates or assumptions we use to calculate our LCM or inventory shortage adjustments. However, if estimates regarding consumer demand are inaccurate or actual physical inventory shortage differs significantly from our estimate, our operating results could be affected. We have not made any material changes in the accounting methodology used to calculate our LCM or inventory shortage adjustments in the past three fiscal years. Impairment of Long-Lived Assets, Goodwill, and Intangible Assets We review the carrying amount of long-lived assets for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset or asset group may not be recoverable. Events that result in an impairment review include the decision to close a store, corporate facility, or distribution center, or a significant decrease in the operating performance of the long-lived asset. Long-lived assets are considered impaired if the carrying amount exceeds the estimated undiscounted future cash flows of the asset or asset group. For impaired assets, we recognize a loss equal to the difference between the carrying amount of the asset or asset group and its estimated fair value. The estimated fair value of the asset or asset group is based on estimated discounted future cash flows of the asset or asset group using a discount rate commensurate with the related risk. The asset group is defined as the lowest level for which identifiable cash flows are available and largely independent of the cash flows of other groups of assets. The asset group for our retail stores is reviewed for impairment primarily at the store level. Our estimate of future cash flows requires management to make assumptions and to apply judgment, including forecasting future sales and expenses and estimating useful lives of the assets. These estimates can be affected by factors such as future store results, real estate demand, and economic conditions that can be difficult to predict. We have not made any material changes in the methodology to assess and calculate impairment of long-lived assets in the past three fiscal years. We recorded a charge for the impairment of long-lived assets of $54 million, $10 million, and $1 million for fiscal 2015, 2014, and 2013, respectively. We also review the carrying amount of goodwill and other indefinite-lived intangible assets for impairment annually and whenever events or changes in circumstances indicate that it is more likely than not that the carrying amount may not be recoverable. Events that result in an impairment review include significant changes in the business climate, declines in our operating results, or an expectation that the carrying amount may not be recoverable. In connection with the acquisitions of Athleta in September 2008 and Intermix in December 2012, we allocated $99 million and $81 million of the respective purchase prices to goodwill. The aggregate carrying amount of goodwill was $180 million as of January 30, 2016. We review goodwill for impairment by first assessing qualitative factors to determine whether it is more likely than not that the fair value of the reporting unit is less than its carrying amount, including goodwill, as a basis for determining whether it is necessary to perform the two-step goodwill impairment test. If it is determined that it is more likely than not that the fair value of the reporting unit is less than its carrying amount, the two-step test is performed to identify potential goodwill impairment. If it is determined that it is not more likely than not that the fair value of the reporting unit is less than its carrying amount, it is unnecessary to perform the two-step goodwill impairment test. Based on certain circumstances, we may elect to bypass the qualitative assessment and proceed directly to performing the first step of the two-step goodwill impairment test. The first step of the two-step goodwill impairment test compares the fair value of the reporting unit to its carrying amount, including goodwill. The second step includes hypothetically valuing all the tangible and intangible assets of the reporting unit as if the reporting unit had been acquired in a business combination. Then, the implied fair value of the reporting unit’s goodwill is compared to the carrying amount of that goodwill. If the carrying amount of the reporting unit’s goodwill exceeds the implied fair value of the goodwill, we recognize an impairment loss in an amount equal to the excess, not to exceed the carrying amount. A reporting unit is an operating segment or a business unit one level below that operating segment, for which discrete financial information is prepared and regularly reviewed by segment management. We have deemed Athleta and Intermix to be the reporting units at which goodwill is tested for Athleta and Intermix, respectively. During the fourth quarter of fiscal 2015, we completed our annual impairment testing of goodwill and we did not recognize any impairment charges. We determined that the fair value of goodwill attributed to Athleta significantly exceeded its carrying amount as of the date of our annual impairment review. The fair value of goodwill attributed to Intermix exceeded its carrying amount by approximately 15 percent as of the date of our annual impairment review. In connection with the acquisitions of Athleta in September 2008 and Intermix in December 2012, we allocated $54 million and $38 million of the respective purchase prices to trade names. The aggregate carrying amount of the trade names was $92 million as of January 30, 2016. A trade name is considered impaired if the carrying amount exceeds its estimated fair value. If a trade name is considered impaired, we recognize a loss equal to the difference between the carrying amount and the estimated fair value of the trade name. The fair value of the trade names is determined using the relief from royalty method. During the fourth quarter of fiscal 2015, we completed our annual impairment review of the trade names and we did not recognize any impairment charges. We determined that the fair value of the Athleta trade name significantly exceeded its carrying amount as of the date of our annual impairment review. The fair value of the Intermix trade name exceeded its carrying amount by approximately 30 percent as of the date of our annual impairment review. These analyses require management to make assumptions and to apply judgment, including forecasting future sales and expenses, and selecting appropriate discount rates and royalty rates, which can be affected by economic conditions and other factors that can be difficult to predict. We do not believe there is a reasonable likelihood that there will be a material change in the estimates or assumptions we use to calculate impairment losses of long-lived assets, goodwill, and intangible assets. However, if actual results are not consistent with our estimates and assumptions used in the calculations, we may be exposed to impairment losses that could be material. Revenue Recognition While revenue recognition for the Company does not involve significant judgment, it represents an important accounting policy. We recognize revenue and the related cost of goods sold at the time the products are received by the customers. For sales transacted at stores, revenue is recognized when the customer receives and pays for the merchandise at the register. For sales where we ship the merchandise to the customer from a distribution center or store, revenue is recognized at the time we estimate the customer receives the merchandise. We sell merchandise to franchisees under multi-year franchise agreements. We recognize revenue from sales to franchisees at the time merchandise ownership is transferred to the franchisee, which generally occurs when the merchandise reaches the franchisee’s predesignated turnover point. We also receive royalties from franchisees primarily based on a percentage of the total merchandise purchased by the franchisee, net of any refunds or credits due them. Royalty revenue is recognized primarily when merchandise ownership is transferred to the franchisee. We record an allowance for estimated returns based on our historical return patterns and various other assumptions that management believes to be reasonable. We do not believe there is a reasonable likelihood that there will be a material change in the future estimates or assumptions we use to calculate our sales return allowance. However, if the actual rate of sales returns increases significantly, our operating results could be adversely affected. We have not made any material changes in the accounting methodology used to estimate future sales returns in the past three fiscal years. Unredeemed Gift Cards, Gift Certificates, and Credit Vouchers Upon issuance of a gift card, gift certificate, or credit voucher, a liability is established for its cash value. The liability is relieved and net sales are recorded upon redemption by the customer. Over time, some portion of these instruments is not redeemed (“breakage”). We determine breakage income for gift cards, gift certificates, and credit vouchers based on historical redemption patterns. Breakage income is recorded in other income, which is a component of operating expenses in the Consolidated Statements of Income, when we can determine the portion of the liability where redemption is remote, which is three years after the gift card, gift certificate, or credit voucher is issued. When breakage income is recorded, a liability is recognized for any legal obligation to remit the unredeemed portion to relevant jurisdictions. Substantially all of our gift cards, gift certificates, and credit vouchers have no expiration dates. We do not believe there is a reasonable likelihood that there will be a material change in the future estimates or assumptions we use to calculate our breakage income. However, if the actual pattern of redemption for gift cards, gift certificates, and credit vouchers changes significantly, our operating results could be adversely affected. We have not made any material changes in the accounting methodology used to estimate breakage income in the past three fiscal years. Income Taxes We record a valuation allowance against our deferred tax assets when it is more likely than not that some portion or all of such deferred tax assets will not be realized. In determining the need for a valuation allowance, management is required to make assumptions and to apply judgment, including forecasting future income, taxable income, and the mix of income or losses in the jurisdictions in which we operate. Our effective tax rate in a given financial statement period may also be materially impacted by changes in the mix and level of income or losses, changes in the expected outcome of audits, or changes in the deferred tax valuation allowance. At any point in time, many tax years are subject to or in the process of being audited by various taxing authorities. To the extent our estimates of settlements change or the final tax outcome of these matters is different from the amounts recorded, such differences will impact the income tax provision in the period in which such determinations are made. Our income tax expense includes changes in our estimated liability for exposures associated with our various tax filing positions. Determining the income tax expense for these potential assessments requires management to make assumptions that are subject to factors such as proposed assessments by tax authorities, changes in facts and circumstances, issuance of new regulations, and resolution of tax audits. We believe the judgments and estimates discussed above are reasonable. However, if actual results are not consistent with our estimates or assumptions, we may be exposed to losses or gains that could be material. Recent Accounting Pronouncements See "Organization and Summary of Significant Accounting Policies" in Note 1 of Notes to Consolidated Financial Statements included in Part II, Item 8 of this Form 10-K for recent accounting pronouncements, including the expected dates of adoption and estimated effects on our Consolidated Financial Statements.

<s>[INST] We are a global retailer offering apparel, accessories, and personal care products for men, women, and children under the Gap, Banana Republic, Old Navy, Athleta, and Intermix brands. We have Companyoperated stores in the United States, Canada, the United Kingdom, France, Ireland, Japan, Italy, China, Hong Kong, Taiwan, and beginning in October 2015, Mexico. We have franchise agreements with unaffiliated franchisees to operate Gap, Banana Republic, and Old Navy stores throughout Asia, Australia, Europe, Latin America, the Middle East, and Africa. Under these agreements, third parties operate, or will operate, stores that sell apparel and related products under our brand names. Our products are also available to customers online through Companyowned websites and through the use of third parties that provide logistics and fulfillment services. In addition to operating in the specialty, outlet, online, and franchise channels, we also use our omnichannel capabilities to bridge the digital world and physical stores to further enhance our shopping experience for our customers. Our omnichannel services, including orderinstore, reserveinstore, findinstore, and shipfromstore, as well as enhanced mobile experiences, are tailored uniquely across our portfolio of brands. Most of the products sold under our brand names are designed by us and manufactured by independent sources. We also sell products that are designed and manufactured by branded third parties, primarily at our Intermix brand. We identify our operating segments according to how our business activities are managed and evaluated. As of January 30, 2016, our operating segments included Gap Global, Old Navy Global, Banana Republic Global, Athleta, and Intermix. We have determined that each of our operating segments share similar economic and other qualitative characteristics, and therefore the results of our operating segments are aggregated into one reportable segment. As previously announced in January 2015, we closed the Piperlime brand during the first half of fiscal 2015, including its online platform and the store in New York. Financial results for fiscal 2015 are as follows: Net sales for fiscal 2015 decreased 4 percent to $15.8 billion compared with $16.4 billion for fiscal 2014. Excluding the impact of foreign exchange, our net sales decreased 2 percent for fiscal 2015 compared with fiscal 2014. See Net Sales discussion for impact of foreign exchange. Comparable ("Comp") sales for fiscal 2015 decreased 4 percent compared with flat for last year. Gross profit for fiscal 2015 was $5.7 billion compared with $6.3 billion for fiscal 2014. Gross margin for fiscal 2015 was 36.2 percent compared with 38.3 percent for fiscal 2014. Operating margin for fiscal 2015 was 9.6 percent compared with 12.7 percent for fiscal 2014. Operating margin is defined as operating income as a percentage of net sales. Net income for fiscal 2015 was $920 million compared with $1.3 billion for fiscal 2014. Diluted earnings per share was $2.23 for fiscal 2015 compared with $2.87 for fiscal 2014. During fiscal 2015, we distributed $1.4 billion to shareholders through share repurchases and dividends. In June 2015, we announced a series of strategic actions to position Gap brand for improved business performance in the future, including rightsizing the Gap brand store fleet, streamlining the brand's headquarter workforce, and developing a clear, onbrand product aesthetic framework that will help strengthen the Gap brand to compete more successfully on the global stage. During fiscal 2015, the Company completed the closure of about 150 global specialty stores related to the strategic actions. The Company also incurred certain charges during fiscal 2015 in connection with the strategic actions, primarily consisting of impairment of store assets, lease termination fees and lease losses, employee related expenses, and impairment of inventory that did not meet brand standards. The charges incurred related to the Company's strategic actions primarily related to Gap [/INST] Negative. </s>

GAP INC

2017-03-20

2017-01-28

Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations. Overview We are a global retailer offering apparel, accessories, and personal care products for men, women, and children under the Gap, Banana Republic, Old Navy, Athleta, and Intermix brands. We have Company-operated stores in the United States, Canada, the United Kingdom, France, Ireland, Japan, Italy, China, Hong Kong, Taiwan, and beginning in October 2015, Mexico. We have franchise agreements with unaffiliated franchisees to operate Gap, Banana Republic, and Old Navy stores throughout Asia, Australia, Europe, Latin America, the Middle East, and Africa. Under these agreements, third parties operate, or will operate, stores that sell apparel and related products under our brand names. Our products are also available to customers online through Company-owned websites and through the use of third parties that provide logistics and fulfillment services. In addition to operating in the specialty, outlet, online, and franchise channels, we also use our omni-channel capabilities to bridge the digital world and physical stores to further enhance our shopping experience for our customers. Our omni-channel services, including order-in-store, reserve-in-store, find-in-store, and ship-from-store, as well as enhanced mobile experiences, are tailored uniquely across our portfolio of brands. Most of the products sold under our brand names are designed by us and manufactured by independent sources. We also sell products that are designed and manufactured by branded third parties, primarily at our Intermix brand. We identify our operating segments according to how our business activities are managed and evaluated. As of January 28, 2017, our operating segments included Gap Global, Old Navy Global, Banana Republic Global, Athleta, and Intermix. We have determined that each of our operating segments share similar economic and other qualitative characteristics, and therefore the results of our operating segments are aggregated into one reportable segment. In May 2016, we announced measures to better align talent and financial resources against our most important priorities to position the Company for improved business performance and long-term success. Our aim is to capture additional market share in our home market, North America, where we have our largest structural advantages, and to focus on international regions with the greatest potential. As part of this effort, we closed the entire fleet of 53 Old Navy stores in Japan during fiscal 2016. Japan remains an important market for the Company's portfolio, with a continued strong presence of more than 200 Gap and Banana Republic stores. Including the Old Navy closures in Japan, the Company closed 67 stores in total related to these measures in fiscal 2016. We also created a more efficient operating model, enabling us to more fully leverage our scale. For example, we centralized or consolidated several brand and corporate functions, allowing us to simplify the organization and operate more efficiently. The Company estimates that its actions will result in annualized pre-tax savings of about $275 million. In connection with the decision to close stores and streamline the Company's operations, the Company incurred $197 million in restructuring costs during fiscal 2016 on a pre-tax basis. The charges primarily include lease termination fees, employee-related costs, and store asset impairment. Certain of these costs incurred in foreign subsidiaries did not result in a tax benefit. On August 29, 2016, a fire occurred in one of the buildings at a Company-owned distribution center campus in Fishkill, New York. Following the fire, the Company immediately activated contingency plans to help mitigate the overall impact to the business. In October 2016, the Company completed construction of a temporary fulfillment site at the Fishkill campus, which was in place to process orders by peak holiday season, and plans to rebuild a permanent building are currently underway. For fiscal 2016, the Company incurred fire-related costs which included $86 million in inventory at cost, $12 million in property, plant, and equipment at net book value, and $35 million in other fire-related costs. In January of fiscal 2016, the Company agreed upon a partial settlement of $159 million related to the inventory and recorded a gain of $73 million, representing the excess over the loss on inventory. Based on the provisions of the Company’s insurance policies, the Company has determined that recovery of certain remaining fire-related costs incurred during fiscal 2016 is probable, and an insurance receivable, net of advance insurance proceeds received, has been recorded as of January 28, 2017 to offset the fire-related costs. The company expects to continue to record additional costs and recoveries until the insurance claim is fully settled. Fiscal 2015 results were impacted by a series of strategic actions to position Gap brand for improved business performance in the future, including rightsizing the Gap brand store fleet primarily in North America, streamlining the brand's headquarter workforce, and developing a clear, on-brand product aesthetic framework to strengthen the Gap brand to compete more successfully on the global stage. During fiscal 2015, the Company completed the closure of about 150 Gap global specialty stores related to the strategic actions. During fiscal 2015, the Company incurred $132 million of charges in connection with the strategic actions, primarily consisting of impairment of store assets related to underperforming stores, lease termination fees and lease losses, employee related expenses, and impairment of inventory that did not meet brand standards. Financial results for fiscal 2016 are as follows: • Net sales for fiscal 2016 decreased 2 percent to $15.5 billion compared with $15.8 billion for fiscal 2015. • Comparable sales ("Comp Sales") for fiscal 2016 decreased 2 percent. • Gross profit for fiscal 2016 was $5.6 billion compared with $5.7 billion for fiscal 2015. Gross margin for fiscal 2016 was 36.3 percent compared with 36.2 percent for fiscal 2015. • Operating margin for fiscal 2016 was 7.7 percent compared with 9.6 percent for fiscal 2015. Operating margin is defined as operating income as a percentage of net sales. • Net income for fiscal 2016 was $676 million compared with $920 million for fiscal 2015, and diluted earnings per share was $1.69 for fiscal 2016 compared with $2.23 for fiscal 2015. Diluted earnings per share for fiscal 2016 included about a $0.41 impact of restructuring costs incurred during fiscal 2016, a non-cash goodwill impairment charge of $0.18 related to Intermix, an $0.11 benefit from the gain from insurance proceeds related to the fire which occurred at the Company's Fishkill distribution center campus, and a favorable income tax impact of a legal structure realignment of about $0.15. Diluted earnings per share for fiscal 2015 included a $0.20 impact of costs related to strategic actions incurred during fiscal 2015. • During fiscal 2016, we distributed $367 million to shareholders through dividends. Our business priorities in 2017 include: • offering product that is consistently brand-appropriate and on-trend with high customer acceptance, with a focus on expanding our advantage in the most promising categories; • delivering meaningful product innovation; • creating a unique and differentiated customer experience that builds loyalty, with focus on both the physical and digital expressions of our brands; and • attracting and retaining great talent in our businesses and functions. In fiscal 2017, we are focused on investing strategically in the business while also maintaining operating expense discipline. One of our primary objectives is to continue transforming our product to market process, with the development of an advantaged operating platform. To enable this, we have several product, supply chain, and IT initiatives underway. Further, we expect to continue our investment in customer experience, both in stores and online, to drive higher customer engagement and loyalty, resulting in market share gains. Finally, we will continue to invest in strengthening brand awareness and customer acquisition. Fiscal 2017 will consist of 53 weeks versus 52 weeks in fiscal 2016. Results of Operations Net Sales See Item 8, Financial Statements and Supplementary Data, Note 17 of Notes to Consolidated Financial Statements for net sales by brand and region. Comparable Sales The percentage change in Comp Sales by global brand and for total Company, as compared with the preceding year, is as follows: Comp Sales include the results of Company-operated stores and sales through online channels in those countries where we have existing comparable store sales. The calculation of The Gap, Inc. Comp Sales includes the results of Athleta and Intermix but excludes the results of our franchise business. A store is included in the Comp Sales calculations when it has been open and operated by the Company for at least one year and the selling square footage has not changed by 15 percent or more within the past year. A store is included in the Comp Sales calculations on the first day it has comparable prior year sales. Stores in which the selling square footage has changed by 15 percent or more as a result of a remodel, expansion, or reduction are excluded from the Comp Sales calculations until the first day they have comparable prior year sales. A store is considered non-comparable (“Non-comp”) when it has been open and operated by the Company for less than one year or has changed its selling square footage by 15 percent or more within the past year. A store is considered “Closed” if it is temporarily closed for three or more full consecutive days or it is permanently closed. When a temporarily closed store reopens, the store will be placed in the Comp/Non-comp status it was in prior to its closure. If a store was in Closed status for three or more days in the prior year, the store will be in Non-comp status for the same days the following year. Current year foreign exchange rates are applied to both current year and prior year Comp Sales to achieve a consistent basis for comparison. Store Count and Square Footage Information Net sales per average square foot is as follows: __________ (1) Excludes net sales associated with our online and franchise businesses. Store count, openings, closings, and square footage for our stores are as follows: Gap and Banana Republic outlet and factory stores are reflected in each of the respective brands. In fiscal 2017, we expect net openings of about 40 Company-operated store locations, primarily for Athleta and Old Navy. Net Sales Discussion Our net sales for fiscal 2016 decreased $281 million, or 2 percent, compared with fiscal 2015 primarily due to a decrease in net sales at Gap and Banana Republic, partially offset by an increase in net sales at Old Navy and Athleta. The translation of net sales in foreign currencies to U.S. dollars had an unfavorable impact of about $20 million for fiscal 2016 and is calculated by translating net sales for fiscal 2015 at exchange rates applicable during fiscal 2016. Our net sales for fiscal 2015 decreased $638 million, or 4 percent, compared with fiscal 2014 primarily due to the unfavorable impact of foreign exchange of about $363 million and a decrease in net sales primarily at Gap and Banana Republic; partially offset by an increase in net sales at Old Navy. The unfavorable impact of foreign exchange was primarily driven by the weakening of the Canadian dollar and Japanese yen against the U.S. dollar. The foreign exchange impact is the translation impact if net sales for fiscal 2014 were translated at exchange rates applicable during fiscal 2015. Cost of Goods Sold and Occupancy Expenses Cost of goods sold and occupancy expenses decreased 0.1 percentage points in fiscal 2016 compared with fiscal 2015. • Cost of goods sold decreased 0.3 percentage points as a percentage of net sales in fiscal 2016 compared with fiscal 2015, primarily driven by higher selling at regular prices at all global brands and improved product acceptance resulting in improved margins at Old Navy. This was offset by a negative foreign exchange impact for our foreign subsidiaries as our merchandise purchases are primarily in U.S. dollars. • Occupancy expenses increased 0.2 percentage points in fiscal 2016 compared with fiscal 2015, primarily driven by the decrease in net sales without a corresponding decrease in occupancy expenses. Cost of goods sold and occupancy expenses increased 2.1 percentage points in fiscal 2015 compared with fiscal 2014. • Cost of goods sold increased 1.3 percent as a percentage of net sales in fiscal 2015 compared with fiscal 2014, primarily driven by increased markdown activities, inventory impairment charges primarily at Gap brand related to the strategic actions, and incremental shipping costs partially due to the U.S. West Coast port congestion. Cost of goods sold as a percentage of net sales in fiscal 2015 for our foreign subsidiaries was also negatively impacted by foreign exchange as our merchandise purchases are primarily in U.S. dollars. • Occupancy expenses increased 0.8 percentage points in fiscal 2015 compared with fiscal 2014, primarily driven by the decrease in net sales without a corresponding decrease in occupancy expenses. In fiscal 2017, we expect that gross margins for our foreign subsidiaries will continue to be negatively impacted by the continuing depreciation of certain foreign currencies as our merchandise purchases are primarily in U.S. dollars. Operating Expenses and Operating Margin Operating expenses increased $253 million or 2.1 percent as a percentage of net sales in fiscal 2016 compared with fiscal 2015 primarily due to the following: • restructuring costs of $197 million in fiscal 2016 compared with the costs related to strategic actions of $98 million in fiscal 2015; • store asset impairment charges of $53 million unrelated to restructuring activities in fiscal 2016 compared with store asset impairment charges of $16 million unrelated to the strategic actions in fiscal 2015; • a goodwill impairment charge related to Intermix in fiscal 2016 of $71 million; and • an increase in bonus and marketing expense; partially offset by • a gain from insurance proceeds of $73 million related to the fire that occurred in one of the buildings at a Company-owned distribution center campus in Fishkill, New York, representing the excess over the loss on inventory; and • higher income from revenue sharing payments from Synchrony. Operating expenses decreased $10 million, but increased 1.0 percent as a percentage of net sales, in fiscal 2015 compared with fiscal 2014 primarily due to the following: • a favorable foreign exchange translation impact of about $85 million, calculated as if operating expenses for fiscal 2014 were translated at exchange rates applicable during fiscal 2015; and • a decrease in bonus and marketing expense; partially offset by • costs related to the strategic actions of $98 million; and • the gain on sale of a building of $39 million recognized in fiscal 2014. Interest Expense Interest expense for fiscal 2016 and 2014 primarily includes interest on overall borrowings and obligations mainly related to our $1.25 billion long-term debt. Interest expense for fiscal 2015 includes $74 million of interest on overall borrowings and obligations mainly related to our $1.25 billion long-term debt, offset by a reversal of $15 million of interest expense primarily resulting from a favorable foreign tax ruling and actions of foreign tax authorities related to transfer pricing matters in fiscal 2015. Income Taxes The increase in the effective tax rate for fiscal 2016 compared with fiscal 2015 was primarily due to the impact of restructuring costs incurred in certain foreign subsidiaries for which the Company was not able to recognize any tax benefit and the impact of a non-deductible goodwill impairment charge related to Intermix. The increase was partially offset by the recognition of certain foreign tax benefits associated with a legal structure realignment. The increase in the effective tax rate for fiscal 2015 compared with fiscal 2014 was primarily due to the recognition of foreign tax credits upon a distribution of certain foreign earnings that occurred during the third quarter of fiscal 2014, partially offset by the impact of the indefinite reinvestment of certain fiscal 2015 foreign earnings, which will be used to fund our international businesses and their growth. Liquidity and Capital Resources Our largest source of cash flows is cash collections from the sale of our merchandise. Our primary uses of cash include merchandise inventory purchases, occupancy costs, personnel-related expenses, purchases of property and equipment, and payment of taxes. In addition, we may have dividend payments, debt repayments, and share repurchases. We consider the following to be measures of our liquidity and capital resources: As of January 28, 2017, the majority of our cash and cash equivalents was held in the United States and is generally accessible without any limitations. In October 2015, the Company entered into a $400 million unsecured term loan (the "Term Loan"), which was fully repaid in January 2017. In January 2014, the Company entered into a 15 billion Japanese yen, four-year, unsecured term loan ("Japan Term Loan") due January 2018. A final repayment of 7.5 billion Japanese yen ($65 million as of January 28, 2017) is payable on January 15, 2018 and is classified as current maturities of debt in the Consolidated Balance Sheet. We believe that current cash balances and cash flows from our operations will be sufficient to support our business operations, including growth initiatives, planned capital expenditures, and repayment of debt, for the next 12 months and beyond. We are also able to supplement near-term liquidity, if necessary, with our $500 million revolving credit facility or other available market instruments. Cash Flows from Operating Activities Net cash provided by operating activities during fiscal 2016 increased $125 million compared with fiscal 2015, primarily due to the following: Net income • a decrease of $244 million in net income. Non-cash items • an increase of $246 million related to non-cash and other items primarily due to the lower gain reclassified into income related to our derivative financial instruments in fiscal 2016 compared with fiscal 2015, a goodwill impairment charge related to Intermix of $71 million during fiscal 2016, and an increase of $53 million related to store asset impairment; partially offset by • a decrease of $155 million related to deferred income taxes driven by fluctuations in book versus tax temporary differences for bonus accruals, depreciation, and share-based compensation. Changes in operating assets and liabilities • an increase of $193 million related to accounts payable primarily due to the timing of merchandise and lease payments; • an increase of $117 million related to accrued expenses and other current liabilities primarily due to bonus accruals; and • an increase of $52 million related to merchandise inventory primarily due to the volume and timing of receipts; partially offset by • a decrease of $79 million related to other current assets and other long-term assets in part due to the insurance claim receivable from the fire of the company-owned distribution center in Fishkill, New York on August 29, 2016. Net cash provided by operating activities during fiscal 2015 decreased $535 million compared with fiscal 2014, primarily due to the following: Net income • a decrease of $342 million in net income. Changes in operating assets and liabilities • a decrease of $107 million related to other current assets and other long-term assets primarily due to the change in timing of payments received related to our credit card programs, which resulted in increased cash inflow in fiscal 2014; and • a decrease of $150 million related to lease incentives and other long-term liabilities primarily due to the receipt of an upfront payment in fiscal 2014 related to the amendment of our credit card program agreement with Synchrony, which is being amortized into income over the term of the contract; partially offset by • an increase of $63 million related to income taxes payable, net of prepaid and other tax-related items, primarily due to timing of payments. We fund inventory expenditures during normal and peak periods through cash flows from operating activities and available cash. Our business follows a seasonal pattern, with sales peaking during the end-of-year holiday period. The seasonality of our operations may lead to significant fluctuations in certain asset and liability accounts between fiscal year-end and subsequent interim periods. Cash Flows from Investing Activities Net cash used for investing activities during fiscal 2016 decreased $201 million compared with fiscal 2015, primarily due to less property and equipment purchases. Net cash used for investing activities during fiscal 2015 increased $134 million compared with fiscal 2014, primarily due to $121 million of proceeds from the sale of a building owned but no longer occupied by the Company in fiscal 2014 and $12 million more property and equipment purchases in fiscal 2015. In fiscal 2016, cash used for purchases of property and equipment was $524 million primarily related to investments in stores, information technology, and supply chain. In fiscal 2017, we expect cash spending for purchases of property and equipment to be about $825 million which includes an estimated $200 million related to rebuilding of the Company's Fishkill, New York distribution center campus, which the Company expects will be covered by insurance proceeds. Cash Flows from Financing Activities Net cash used for financing activities during fiscal 2016 decreased $213 million compared with fiscal 2015, primarily due to the following: • no repurchases of common stock in fiscal 2016 compared with $1 billion cash outflow related to repurchases of common stock in fiscal 2015; partially offset by • no debt issuances in fiscal 2016 compared with the issuance of $400 million in short-term debt in fiscal 2015; and • the repayment of the $400 million short-term debt in fiscal 2016. Net cash used for financing activities during fiscal 2015 decreased $517 million compared with fiscal 2014, primarily due to the following: • $400 million proceeds from the issuance of short-term debt in fiscal 2015; and • $164 million less repurchases of common stock; partially offset by • $4 million net cash out flows for fiscal 2015 compared with $38 million net cash inflows for fiscal 2014 related to issuance under share-based compensation plans and withholding tax payments related to vesting of stock units. Free Cash Flow Free cash flow is a non-GAAP financial measure. We believe free cash flow is an important metric because it represents a measure of how much cash a company has available for discretionary and non-discretionary items after the deduction of capital expenditures, as we require regular capital expenditures to build and maintain stores and purchase new equipment and invest in technology to improve our business. We use this metric internally, as we believe our sustained ability to generate free cash flow is an important driver of value creation. However, this non-GAAP financial measure is not intended to supersede or replace our GAAP result. The following table reconciles free cash flow, a non-GAAP financial measure, from net cash provided by operating activities, a GAAP financial measure. Debt and Credit Facilities Certain financial information about the Company's debt and credit facilities is set forth under the headings "Debt" and "Credit Facilities" in Notes 5 and 6, respectively, of Notes to Consolidated Financial Statements included in Item 8 of this Form 10-K. Dividend Policy In determining whether and at what level to declare a dividend, we consider a number of factors including sustainability, operating performance, liquidity, and market conditions. We paid an annual dividend of $0.92 per share in fiscal 2016 and fiscal 2015. We plan to pay an annual dividend of $0.92 per share in fiscal 2017. Share Repurchases Certain financial information about the Company's share repurchases is set forth under the heading "Share Repurchases" in Note 9 of Notes to Consolidated Financial Statements included in Item 8 of this Form 10-K. In fiscal 2017, the Company intends to re-initiate share repurchases under its existing $1 billion share repurchase authorization. Contractual Cash Obligations We are party to many contractual obligations involving commitments to make payments to third parties. The following table provides summary information concerning our future contractual obligations as of January 28, 2017. These obligations impact our short-term and long-term liquidity and capital resource needs. Certain of these contractual obligations are reflected in the Consolidated Balance Sheet as of January 28, 2017, while others are disclosed as future obligations. __________ (1) Represents principal maturities, excluding interest. See Note 5 of Notes to Consolidated Financial Statements for discussion on debt. (2) Excludes maintenance, insurance, taxes, and contingent rent obligations. See Note 12 of Notes to Consolidated Financial Statements for discussion of our operating leases. (3) Represents estimated open purchase orders to purchase inventory as well as commitments for products and services used in the normal course of business. There is $70 million of long-term liabilities recorded in lease incentives and other long-term liabilities in the Consolidated Balance Sheet as of January 28, 2017 that is excluded from the table above as the amount relates to uncertain tax positions and deferred compensation, and we are not able to reasonably estimate the timing of the payments or the amount by which the liability will increase or decrease over time. Commercial Commitments We have commercial commitments, not reflected in the table above, that were incurred in the normal course of business to support our operations, including standby letters of credit of $16 million, surety bonds of $44 million, and bank guarantees of $18 million outstanding (of which $12 million was issued under the unsecured revolving credit facilities for our operations in foreign locations) as of January 28, 2017. Other Cash Obligations Not Reflected in the Consolidated Balance Sheet (Off-Balance Sheet Arrangements) The majority of our contractual obligations relate to operating leases for our stores. Future minimum lease payments represent commitments under non-cancelable operating leases and are disclosed in the table above with additional information provided under the heading "Leases" in Note 12 of Notes to Consolidated Financial Statements included in Item 8 of this Form 10-K. Critical Accounting Policies and Estimates The preparation of financial statements in accordance with accounting principles generally accepted in the United States of America ("U.S. GAAP") requires management to adopt accounting policies and make significant judgments and estimates to develop amounts reflected and disclosed in the financial statements. In many cases, there are alternative policies or estimation techniques that could be used. We maintain a thorough process to review the application of our accounting policies and to evaluate the appropriateness of the many estimates that are required to prepare the financial statements of a large, global corporation. However, even under optimal circumstances, estimates routinely require adjustment based on changing circumstances and the receipt of new or better information. Our significant accounting policies can be found under the heading "Organization and Summary of Significant Accounting Policies" in Note 1 of Notes to Consolidated Financial Statements included in Item 8 of this Form 10-K. The policies and estimates discussed below include the financial statement elements that are either judgmental or involve the selection or application of alternative accounting policies and are material to our financial statements. Management has discussed the development and selection of these critical accounting policies and estimates with the Audit and Finance Committee of our Board of Directors, which has reviewed our disclosure relating to critical accounting policies and estimates in this annual report on Form 10-K. Merchandise Inventory We value inventory at the lower of cost or market (“LCM”), with cost determined using the weighted-average cost method and market value determined based on the estimated net realizable value. We review our inventory levels in order to identify slow-moving merchandise and broken assortments (items no longer in stock in a sufficient range of sizes or colors), and we primarily use promotions and markdowns to clear merchandise. We record an adjustment to inventory when future estimated selling price is less than cost. Our LCM adjustment calculation requires management to make assumptions to estimate the selling price and amount of slow-moving merchandise and broken assortments subject to markdowns, which is dependent upon factors such as historical trends with similar merchandise, inventory aging, forecasted consumer demand, and the promotional environment. In addition, we estimate and accrue shortage for the period between the last physical count and the balance sheet date. Our shortage estimate can be affected by changes in merchandise mix and changes in actual shortage trends. Historically, actual shortage has not differed materially from our estimates. We do not believe there is a reasonable likelihood that there will be a material change in the future estimates or assumptions we use to calculate our LCM or inventory shortage adjustments. However, if estimates regarding consumer demand are inaccurate or actual physical inventory shortage differs significantly from our estimate, our operating results could be affected. We have not made any material changes in the accounting methodology used to calculate our LCM or inventory shortage adjustments in the past three fiscal years. Impairment of Long-Lived Assets, Goodwill, and Intangible Assets We review the carrying amount of long-lived assets for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset or asset group may not be recoverable. Events that result in an impairment review include a significant decrease in the operating performance of the long-lived asset, or the decision to close a store, corporate facility, or distribution center. Long-lived assets are considered impaired if the carrying amount exceeds the estimated undiscounted future cash flows of the asset or asset group. For impaired assets, we recognize a loss equal to the difference between the carrying amount of the asset or asset group and its estimated fair value. The estimated fair value of the asset or asset group is based on estimated discounted future cash flows of the asset or asset group using a discount rate commensurate with the related risk. The asset group is defined as the lowest level for which identifiable cash flows are available and largely independent of the cash flows of other groups of assets. The asset group for our retail stores is reviewed for impairment primarily at the store level. Our estimate of future cash flows requires management to make assumptions and to apply judgment, including forecasting future sales and expenses and estimating useful lives of the assets. These estimates can be affected by factors such as future store results, real estate demand, and economic conditions that can be difficult to predict. We have not made any material changes in the methodology to assess and calculate impairment of long-lived assets in the past three fiscal years. We recorded a charge for the impairment of long-lived assets of $107 million, $54 million, and $10 million for fiscal 2016, 2015, and 2014, respectively. We also review the carrying amount of goodwill and other indefinite-lived intangible assets for impairment annually in the fourth quarter of the fiscal year and whenever events or changes in circumstances indicate that it is more likely than not that the carrying amount may not be recoverable. Events that result in an impairment review include significant changes in the business climate, declines in our operating results, or an expectation that the carrying amount may not be recoverable. In connection with the acquisitions of Athleta in September 2008 and Intermix in December 2012, we allocated $99 million and $81 million of the respective purchase prices to goodwill. Goodwill is reviewed for impairment using the applicable reporting unit, which is an operating segment or a business unit one level below that operating segment for which discrete financial information is prepared and regularly reviewed by segment management. We have deemed Athleta and Intermix to be the reporting units at which goodwill is tested for Athleta and Intermix, respectively. We review goodwill for impairment by first assessing qualitative factors to determine whether it is more likely than not that the fair value of the reporting unit is less than its carrying amount, including goodwill, as a basis for determining whether it is necessary to perform the two-step goodwill impairment test. If it is determined that it is more likely than not that the fair value of the reporting unit is less than its carrying amount, the two-step test is performed to identify potential goodwill impairment. If it is determined that it is not more likely than not that the fair value of the reporting unit is less than its carrying amount, it is unnecessary to perform the two-step goodwill impairment test. During the fourth quarter of fiscal 2016, we determined that the fair value of the reporting unit for Athleta significantly exceeded its carrying amount as of the date of our annual impairment review and therefore, we did not recognize any impairment charges for Athleta. Based on certain circumstances, we may elect to bypass the qualitative assessment and proceed directly to performing the first step of the two-step goodwill impairment test. The first step of the two-step goodwill impairment test compares the fair value of the reporting unit to its carrying amount, including goodwill. The second step includes hypothetically valuing all of the assets and liabilities of the reporting unit as if the reporting unit had been acquired in a business combination. Then, the implied fair value of the reporting unit’s goodwill is compared to the carrying amount of that goodwill. If the carrying amount of the reporting unit’s goodwill exceeds the implied fair value of the goodwill, we recognize an impairment loss in an amount equal to the excess, not to exceed the carrying amount. At the end of each of the first three quarters of fiscal 2016, given the information available at the time of those assessments, we determined that there were no events or circumstances that indicated any impairment for goodwill related to Intermix. During the fourth quarter of fiscal 2016, management updated the fiscal 2017 budget and financial projections beyond fiscal 2017 for Intermix. There were several factors that caused the financial projections and estimates to significantly decrease from the previous estimates, which included: poor fourth quarter of fiscal 2016 holiday performance at Intermix stores, the decision to reduce expected future store openings, the approval of additional store closures in fiscal 2017, and the budgeting of additional headcount required to support increased focus on the online business. These factors arising during the fourth quarter of fiscal 2016 had a significant and negative impact on the estimated fair value of the Intermix reporting unit, and we have determined that the Intermix reporting unit’s carrying value exceeded its fair value as of the date of our annual impairment review. As such, we performed the second step of the goodwill impairment test which resulted in an impairment charge of $71 million for goodwill related to Intermix in fiscal 2016. This impairment charge reduced the $81 million of purchase price allocated to goodwill in connection with the acquisition of Intermix in December 2012 to $10 million as of January 28, 2017. We did not recognize any impairment charges for goodwill in fiscal 2015. As of January 28, 2017, the aggregate carrying value of trade names was $95 million, which primarily consisted of $54 million and $38 million related to Athleta and Intermix, respectively. A trade name is considered impaired if the carrying amount exceeds its estimated fair value. If a trade name is considered impaired, we recognize a loss equal to the difference between the carrying amount and the estimated fair value of the trade name. The fair value of the trade names is determined using the relief from royalty method. During the fourth quarter of fiscal 2016, we completed our annual impairment review of the trade names and we did not recognize any impairment charges. We determined that the fair value of the Athleta trade name significantly exceeded its carrying amount as of the date of our annual impairment review. The fair value of the Intermix trade name exceeded its carrying amount by less than 10 percent as of the date of our annual impairment review. These analyses require management to make assumptions and to apply judgment, including forecasting future sales and expenses, and selecting appropriate discount rates and royalty rates, which can be affected by economic conditions and other factors that can be difficult to predict. If actual store and online results and brand performance, real estate market conditions, and economic conditions including interest rates are not consistent with our estimates and assumptions used in our calculations, we may be exposed to additional impairment losses that could be material. Revenue Recognition While revenue recognition for the Company does not involve significant judgment, it represents an important accounting policy. We recognize revenue and the related cost of goods sold at the time the products are received by the customers. For sales transacted at stores, revenue is recognized when the customer receives and pays for the merchandise at the register. For sales where we ship the merchandise to the customer from a distribution center or store, revenue is recognized at the time we estimate the customer receives the merchandise. We sell merchandise to franchisees under multi-year franchise agreements. We recognize revenue from sales to franchisees at the time merchandise ownership is transferred to the franchisee, which generally occurs when the merchandise reaches the franchisee’s predesignated turnover point. We also receive royalties from franchisees primarily based on a percentage of the total merchandise purchased by the franchisee, net of any refunds or credits due them. Royalty revenue is recognized primarily when merchandise ownership is transferred to the franchisee. We record an allowance for estimated returns based on our historical return patterns and various other assumptions that management believes to be reasonable. We do not believe there is a reasonable likelihood that there will be a material change in the future estimates or assumptions we use to calculate our sales return allowance. However, if the actual rate of sales returns increases significantly, our operating results could be adversely affected. We have not made any material changes in the accounting methodology used to estimate future sales returns in the past three fiscal years. See Note 1 of Notes to Consolidated Financial Statements included in Item 8 of this Form 10-K for recent accounting pronouncements related to revenue recognition and expected impact from the adoption of new standards. Unredeemed Gift Cards, Gift Certificates, and Credit Vouchers Upon issuance of a gift card, gift certificate, or credit voucher, a liability is established for its cash value. The liability is relieved and net sales are recorded upon redemption by the customer. Over time, some portion of these instruments is not redeemed (“breakage”). Based on historical redemption patterns, we determine breakage income for gift cards, gift certificates, and credit vouchers when we can determine the portion of the liability where redemption is remote, which is three years after issuance. Breakage income, which has been historically immaterial, is recorded in other income which is a component of operating expenses in the Consolidated Statements of Income. When breakage income is recorded, a liability is recognized for any legal obligation to remit the unredeemed portion to relevant jurisdictions. Substantially all of our gift cards, gift certificates, and credit vouchers have no expiration dates. We do not believe there is a reasonable likelihood that there will be a material change in the future estimates or assumptions we use to calculate our breakage income. However, if the actual pattern of redemption for gift cards, gift certificates, and credit vouchers changes significantly, our operating results could be adversely affected. We have not made any material changes in the accounting methodology used to estimate breakage in the past three fiscal years. See Note 1 of Notes to Consolidated Financial Statements included in Item 8 of this Form 10-K for recent accounting pronouncements related to revenue recognition and expected impact on recognition of breakage income from the adoption of new standards. Income Taxes We record a valuation allowance against our deferred tax assets when it is more likely than not that some portion or all of such deferred tax assets will not be realized. In determining the need for a valuation allowance, management is required to make assumptions and to apply judgment, including forecasting future income, taxable income, and the mix of income or losses in the jurisdictions in which we operate. Our effective tax rate in a given financial statement period may also be materially impacted by changes in the mix and level of income or losses, changes in the expected outcome of audits, or changes in the deferred tax valuation allowance. At any point in time, many tax years are subject to or in the process of being audited by various taxing authorities. To the extent our estimates of settlements change or the final tax outcome of these matters is different from the amounts recorded, such differences will impact the income tax provision in the period in which such determinations are made. Our income tax expense includes changes in our estimated liability for exposures associated with our various tax filing positions. Determining the income tax expense for these potential assessments requires management to make assumptions that are subject to factors such as proposed assessments by tax authorities, changes in facts and circumstances, issuance of new regulations, and resolution of tax audits. We believe the judgments and estimates discussed above are reasonable. However, if actual results are not consistent with our estimates or assumptions, we may be exposed to losses or gains that could be material. Recent Accounting Pronouncements See "Organization and Summary of Significant Accounting Policies" in Note 1 of Notes to Consolidated Financial Statements included in Item 8 of this Form 10-K for recent accounting pronouncements, including the expected dates of adoption and estimated effects on our Consolidated Financial Statements.

<s>[INST] We are a global retailer offering apparel, accessories, and personal care products for men, women, and children under the Gap, Banana Republic, Old Navy, Athleta, and Intermix brands. We have Companyoperated stores in the United States, Canada, the United Kingdom, France, Ireland, Japan, Italy, China, Hong Kong, Taiwan, and beginning in October 2015, Mexico. We have franchise agreements with unaffiliated franchisees to operate Gap, Banana Republic, and Old Navy stores throughout Asia, Australia, Europe, Latin America, the Middle East, and Africa. Under these agreements, third parties operate, or will operate, stores that sell apparel and related products under our brand names. Our products are also available to customers online through Companyowned websites and through the use of third parties that provide logistics and fulfillment services. In addition to operating in the specialty, outlet, online, and franchise channels, we also use our omnichannel capabilities to bridge the digital world and physical stores to further enhance our shopping experience for our customers. Our omnichannel services, including orderinstore, reserveinstore, findinstore, and shipfromstore, as well as enhanced mobile experiences, are tailored uniquely across our portfolio of brands. Most of the products sold under our brand names are designed by us and manufactured by independent sources. We also sell products that are designed and manufactured by branded third parties, primarily at our Intermix brand. We identify our operating segments according to how our business activities are managed and evaluated. As of January 28, 2017, our operating segments included Gap Global, Old Navy Global, Banana Republic Global, Athleta, and Intermix. We have determined that each of our operating segments share similar economic and other qualitative characteristics, and therefore the results of our operating segments are aggregated into one reportable segment. In May 2016, we announced measures to better align talent and financial resources against our most important priorities to position the Company for improved business performance and longterm success. Our aim is to capture additional market share in our home market, North America, where we have our largest structural advantages, and to focus on international regions with the greatest potential. As part of this effort, we closed the entire fleet of 53 Old Navy stores in Japan during fiscal 2016. Japan remains an important market for the Company's portfolio, with a continued strong presence of more than 200 Gap and Banana Republic stores. Including the Old Navy closures in Japan, the Company closed 67 stores in total related to these measures in fiscal 2016. We also created a more efficient operating model, enabling us to more fully leverage our scale. For example, we centralized or consolidated several brand and corporate functions, allowing us to simplify the organization and operate more efficiently. The Company estimates that its actions will result in annualized pretax savings of about $275 million. In connection with the decision to close stores and streamline the Company's operations, the Company incurred $197 million in restructuring costs during fiscal 2016 on a pretax basis. The charges primarily include lease termination fees, employeerelated costs, and store asset impairment. Certain of these costs incurred in foreign subsidiaries did not result in a tax benefit. On August 29, 2016, a fire occurred in one of the buildings at a Companyowned distribution center campus in Fishkill, New York. Following the fire, the Company immediately activated contingency plans to help mitigate the overall impact to the business. In October 2016, the Company completed construction of a temporary fulfillment site at the Fishkill campus, which was in place to process orders by peak holiday season, and plans to rebuild a permanent building are currently underway. For fiscal 2016, the Company incurred firerelated costs which included $86 million in inventory at cost, $12 million in property, plant, and equipment at net book value, and $35 million in other firerelated costs. In January of fiscal 2016, the Company agreed upon a partial settlement of $159 million related to the inventory and recorded a gain of $73 million, representing the excess over the loss on inventory. Based on the provisions of the Company’s insurance policies, the Company has determined that recovery of certain remaining firerelated costs incurred during fiscal 2016 [/INST] Negative. </s>

GAP INC

2018-03-20

2018-02-03

Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations. Overview We are a global retailer offering apparel, accessories, and personal care products for men, women, and children under the Old Navy, Gap, Banana Republic, Athleta, and Intermix brands. We have Company-operated stores in the United States, Canada, the United Kingdom, France, Ireland, Japan, Italy, China, Hong Kong, Taiwan, and Mexico. We have franchise agreements with unaffiliated franchisees to operate Old Navy, Gap, and Banana Republic stores throughout Asia, Europe, Latin America, the Middle East, and Africa. Under these agreements, third parties operate, or will operate, stores that sell apparel and related products under our brand names. Our products are also available to customers online through Company-owned websites and through the use of third parties that provide logistics and fulfillment services. In addition to operating in the specialty, outlet, online, and franchise channels, we also use our omni-channel capabilities to bridge the digital world and physical stores to further enhance our shopping experience for our customers. Our omni-channel services, including order-in-store, reserve-in-store, find-in-store, and ship-from-store, as well as enhanced mobile experiences, are tailored uniquely across our portfolio of brands. Most of the products sold under our brand names are designed by us and manufactured by independent sources. We also sell products that are designed and manufactured by branded third parties, primarily at our Intermix brand. We identify our operating segments according to how our business activities are managed and evaluated. As of February 3, 2018, our operating segments included Gap Global, Old Navy Global, Banana Republic Global, Athleta, and Intermix. We have determined that each of our operating segments share similar economic and other qualitative characteristics, and therefore the results of our operating segments are aggregated into one reportable segment. Fiscal 2017 consisted of 53 weeks versus 52 weeks in fiscal 2016 and 2015. Net sales and operating results, as well as other metrics derived from the Consolidated Statement of Income, include the impact of the additional week; however, the comparable sales calculation excludes the 53rd week. On August 29, 2016, a fire occurred in one of the buildings at a Company-owned distribution center campus in Fishkill, New York ("the Fishkill fire"). In January 2018, the Company agreed upon a final settlement with its insurers and all insurance proceeds were received as of February 3, 2018. In May 2016, we announced measures to better align talent and financial resources against our most important priorities to position the Company for improved business performance and long-term success. Our aim is to capture additional market share in our home market, North America, where we have our largest structural advantages, and to focus on international regions with the greatest potential. As part of this effort, we closed the entire fleet of 53 Old Navy stores in Japan during fiscal 2016. Japan remains an important market for the Company's portfolio, with a continued strong presence of approximately 200 Gap and Banana Republic stores. Including the Old Navy closures in Japan, the Company closed 67 stores in total related to these measures in fiscal 2016. We also took steps toward creating a more efficient operating model, enabling us to more fully leverage our scale. For example, we centralized or consolidated several brand and corporate functions, allowing us to simplify the organization and operate more efficiently. In connection with the decision to close stores and streamline the Company's operations, the Company incurred $197 million in restructuring costs during fiscal 2016 on a pre-tax basis. The charges primarily include lease termination fees, employee-related costs, and store asset impairment. Certain of the costs incurred in foreign subsidiaries did not result in a tax benefit. Fiscal 2015 results were impacted by a series of strategic actions to position Gap brand for improved business performance in the future, including rightsizing the Gap brand store fleet primarily in North America, streamlining the brand's headquarter workforce, and developing a clear, on-brand product aesthetic framework to strengthen the Gap brand to compete more successfully on the global stage. During fiscal 2015, the Company completed the closure of about 150 Gap global specialty stores related to the strategic actions. During fiscal 2015, the Company incurred $132 million of charges in connection with the strategic actions, primarily consisting of impairment of store assets related to underperforming stores, lease termination fees and lease losses, employee-related expenses, and impairment of inventory that did not meet brand standards. Financial results for fiscal 2017 are as follows: • Net sales for fiscal 2017 increased 2 percent to $15.9 billion compared with $15.5 billion for fiscal 2016. • Comparable sales for fiscal 2017 increased 3 percent. • Gross profit for fiscal 2017 was $6.1 billion compared with $5.6 billion for fiscal 2016. Gross margin for fiscal 2017 was 38.3 percent compared with 36.3 percent for fiscal 2016. • Operating margin for fiscal 2017 was 9.3 percent compared with 7.7 percent for fiscal 2016. Operating margin is defined as operating income as a percentage of net sales. • Net income for fiscal 2017 was $848 million compared with $676 million for fiscal 2016, and diluted earnings per share was $2.14 for fiscal 2017 compared with $1.69 for fiscal 2016. Diluted earnings per share for fiscal 2017 included about a $0.10 benefit from the gain from insurance proceeds related to the Fishkill fire and an unfavorable net provisional tax impact of federal tax reform of about $0.09. Diluted earnings per share for fiscal 2016 included about a $0.41 impact of restructuring costs incurred during fiscal 2016, a non-cash goodwill impairment charge of $0.18 related to Intermix, an $0.11 benefit from the gain from insurance proceeds related to the Fishkill fire, and a favorable income tax impact of a legal structure realignment of about $0.15. • During fiscal 2017, we distributed $676 million to shareholders through share repurchases and dividends. Our business priorities in 2018 include: • offering product that is consistently brand-appropriate and on-trend with high customer acceptance, with a focus on expanding our advantage in loyalty categories; • investing in digital and customer capabilities to support growth; • creating a unique and differentiated shopping experience that attracts new customers and builds loyalty, with focus on both the physical and digital expressions of our brands; • increasing productivity by leveraging our scale and streamlining operations and processes throughout the organization; • continuing to integrate social and environmental sustainability into business practices to support long term growth; and • attracting and retaining strong talent in our businesses and functions. In fiscal 2018, we are focused on investing strategically in the business while maintaining operating expense discipline and driving efficiency through our productivity initiative. One of our primary objectives is to continue transforming our product to market process, with the development of a more efficient operating model, allowing us to more fully leverage our scale. To enable this, we have several product, supply chain, and IT initiatives underway. Further, we expect to continue our investment in customer experience to drive higher customer engagement and loyalty across all of our brands and channels, resulting in market share gains. Finally, we will continue to invest in strengthening brand awareness, customer acquisition, and digital capabilities. Underpinning these strategies is a focus on utilizing data, analytics, and technology to respond faster while making decisions that will fuel market share gains and lead to a more nimble organization. Fiscal 2018 will consist of 52 weeks versus 53 weeks in fiscal 2017. Results of Operations Net Sales See Item 8, Financial Statements and Supplementary Data, Note 16 of Notes to Consolidated Financial Statements for net sales by brand and region. Comparable Sales ("Comp Sales") The percentage change in Comp Sales by global brand and for total Company, as compared with the preceding year, is as follows: Comp Sales include the results of Company-operated stores and sales through online channels in those countries where we have existing comparable store sales. The calculation of The Gap, Inc. Comp Sales includes the results of Athleta and Intermix but excludes the results of our franchise business. A store is included in the Comp Sales calculations when it has been open and operated by the Company for at least one year and the selling square footage has not changed by 15 percent or more within the past year. A store is included in the Comp Sales calculations on the first day it has comparable prior year sales. Stores in which the selling square footage has changed by 15 percent or more as a result of a remodel, expansion, or reduction are excluded from the Comp Sales calculations until the first day they have comparable prior year sales. A store is considered non-comparable (“Non-comp”) when it has been open and operated by the Company for less than one year or has changed its selling square footage by 15 percent or more within the past year. A store is considered “Closed” if it is temporarily closed for three or more full consecutive days or it is permanently closed. When a temporarily closed store reopens, the store will be placed in the Comp/Non-comp status it was in prior to its closure. If a store was in Closed status for three or more days in the prior year, the store will be in Non-comp status for the same days the following year. Current year foreign exchange rates are applied to both current year and prior year Comp Sales to achieve a consistent basis for comparison. Store Count and Square Footage Information Net sales per average square foot is as follows: __________ (1) Excludes net sales associated with our online and franchise businesses. Online sales includes both sales through our online channels as well as ship-from-store sales. (2) Fiscal 2017 includes incremental sales attributable to the 53rd week. Store count, openings, closings, and square footage for our stores are as follows: Gap and Banana Republic outlet and factory stores are reflected in each of the respective brands. In fiscal 2018, we expect net openings of about 25 Company-operated store locations, primarily for Old Navy and Athleta, with closures weighted toward Gap brand and Banana Republic. Net Sales Discussion Our net sales for fiscal 2017 increased $339 million, or 2 percent, compared with fiscal 2016, primarily due to an increase in net sales at Old Navy and Athleta, partially offset by a decrease in net sales at Gap and Banana Republic. The translation of net sales in foreign currencies to U.S. dollars had an unfavorable impact of about $11 million for fiscal 2017 and is calculated by translating net sales for fiscal 2016 at exchange rates applicable during fiscal 2017. Fiscal 2017 includes incremental sales attributable to the 53rd week. Our net sales for fiscal 2016 decreased $281 million, or 2 percent, compared with fiscal 2015 primarily due to a decrease in net sales at Gap and Banana Republic, partially offset by an increase in net sales at Old Navy and Athleta. The translation of net sales in foreign currencies to U.S. dollars had an unfavorable impact of about $20 million for fiscal 2016 and is calculated by translating net sales for fiscal 2015 at exchange rates applicable during fiscal 2016. In fiscal 2018, we will return to a 52-week fiscal year which could potentially impact the seasonality of net sales throughout the year as a result of the calendar shift of our fiscal quarters in fiscal 2018 compared with fiscal 2017. Cost of Goods Sold and Occupancy Expenses Cost of goods sold and occupancy expenses decreased 2.0 percentage points as a percentage of net sales in fiscal 2017 compared with fiscal 2016. • Cost of goods sold decreased 1.3 percentage points as a percentage of net sales in fiscal 2017 compared with fiscal 2016, primarily driven by higher margins achieved as a result of improved average selling price per unit at all global brands; partially offset by higher average unit cost at all global brands. This was offset by a negative foreign exchange impact for our foreign subsidiaries as our merchandise purchases are primarily in U.S. dollars. • Occupancy expenses decreased 0.7 percentage points as a percentage of net sales in fiscal 2017 compared with fiscal 2016, primarily driven by an increase in online sales without a corresponding increase in occupancy expenses, international store closures, and higher sales from the impact of the 53rd week; partially offset by real estate expenses for the Times Square New York location for Gap and Old Navy. Cost of goods sold and occupancy expenses decreased 0.1 percentage points as a percentage of net sales in fiscal 2016 compared with fiscal 2015. • Cost of goods sold decreased 0.3 percentage points as a percentage of net sales in fiscal 2016 compared with fiscal 2015, primarily driven by higher selling at regular prices at all global brands and improved product acceptance resulting in improved margins at Old Navy. This was offset by a negative foreign exchange impact for our foreign subsidiaries as our merchandise purchases are primarily in U.S. dollars. • Occupancy expenses increased 0.2 percentage points as a percentage of net sales in fiscal 2016 compared with fiscal 2015, primarily driven by the decrease in net sales without a corresponding decrease in occupancy expenses. In fiscal 2018, we currently expect that gross margins for our foreign subsidiaries, net of the impact from our merchandise hedge program, will be slightly favorable due to the appreciation of certain foreign currencies as our merchandise purchases are primarily in U.S. dollars. Operating Expenses and Operating Margin Operating expenses increased $138 million or 0.2 percentage points as a percentage of net sales in fiscal 2017 compared with fiscal 2016 primarily due to the following: • an increase in variable costs, such as payroll-related costs, due to the growth in Old Navy and Athleta brands, increase in bonus expense, and the 53rd week impact; • an increase in advertising; and • an increase in overhead costs related to productivity work including investments in customer and digital initiatives as well as severance expenses and the impacts of store closures; partially offset by • a gain from insurance proceeds of $64 million related to the Fishkill fire recorded in the second quarter of fiscal year 2017; • a decrease of $197 million of restructuring costs incurred in fiscal year 2016; and • a decrease of $71 million related to a goodwill impairment charges for Intermix in fiscal year 2016. Operating expenses increased $253 million or 2.1 percentage points as a percentage of net sales in fiscal 2016 compared with fiscal 2015 primarily due to the following: • restructuring costs of $197 million in fiscal 2016 compared with the costs related to strategic actions of $98 million in fiscal 2015; • store asset impairment charges of $53 million unrelated to restructuring activities in fiscal 2016 compared with store asset impairment charges of $16 million unrelated to the strategic actions in fiscal 2015; • a goodwill impairment charge related to Intermix in fiscal 2016 of $71 million; and • an increase in bonus and marketing expense; partially offset by • a gain from insurance proceeds of $73 million related to the Fishkill fire, representing the excess over the loss on inventory; and • higher income from revenue sharing payments from Synchrony. Interest Expense Interest expense for fiscal 2017 and 2016 primarily includes interest on overall borrowings and obligations mainly related to our $1.25 billion long-term debt. Interest expense for fiscal 2015 includes $74 million of interest on overall borrowings and obligations mainly related to our $1.25 billion long-term debt, offset by a reversal of $15 million of interest expense primarily resulting from a favorable foreign tax ruling and actions of foreign tax authorities related to transfer pricing matters in fiscal 2015. Income Taxes On December 22, 2017, the Tax Cuts and Jobs Act of 2017 (“TCJA”) was enacted into law, which significantly changes existing U.S. tax law and includes numerous provisions that affect our business, such as imposing a one-time transition tax on deemed repatriation of deferred foreign income, reducing the U.S. federal statutory tax rate, and adopting a territorial tax system. The TCJA resulted in a one-time transition tax, payable over eight years without interest or penalties, on deferred foreign income not previously subject to U.S. income tax at a rate of 15.5% for income held in foreign cash and certain other net current assets, and 8% on the remaining income. The TCJA also reduces the U.S. federal statutory tax rate from 35% to 21% effective January 1, 2018, which resulted in a remeasurement of deferred tax assets and liabilities. We have calculated a reasonable estimate of the impact of the TCJA in our income tax provision in accordance with our understanding of guidance available as of the date of this filing and as a result have recorded $57 million as additional income tax expense in the fourth quarter of fiscal 2017, the period in which the legislation was enacted. The increase in the effective tax rate for fiscal 2017 compared with fiscal 2016 was primarily due to the impact of the TCJA, partially offset by the recognition of certain tax benefits associated with legal structure changes. The increase in the effective tax rate for fiscal 2016 compared with fiscal 2015 was primarily due to the impact of restructuring costs incurred in certain foreign subsidiaries for which the Company was not able to recognize any tax benefit and the impact of a non-deductible goodwill impairment charge related to Intermix. The increase was partially offset by the recognition of certain foreign tax benefits associated with a legal structure realignment. Liquidity and Capital Resources Our largest source of cash flows is cash collections from the sale of our merchandise. Our primary uses of cash include merchandise inventory purchases, occupancy costs, personnel-related expenses, purchases of property and equipment, and payment of taxes. In addition, we may have dividend payments, debt repayments, and share repurchases. We consider the following to be measures of our liquidity and capital resources: As of February 3, 2018, the majority of our cash and cash equivalents was held in the United States and is generally accessible without any limitations. In October 2015, the Company entered into a $400 million unsecured term loan (the "Term Loan"), which was fully repaid in January 2017. In January 2014, the Company entered into a 15 billion Japanese yen, four-year, unsecured term loan ("Japan Term Loan"), which was fully repaid in June 2017. We believe that current cash balances and cash flows from our operations will be sufficient to support our business operations, including growth initiatives, planned capital expenditures, and repayment of debt, for the next 12 months and beyond. We are also able to supplement near-term liquidity, if necessary, with our $500 million revolving credit facility or other available market instruments. Cash Flows from Operating Activities Net cash provided by operating activities during fiscal 2017 decreased $339 million compared with fiscal 2016, primarily due to the following: Net income • an increase of $172 million in net income. Non-cash items • a decrease of $79 million in store asset impairment charges in fiscal 2017 compared with fiscal 2016 in part due to restructuring activities in fiscal 2016; and • a decrease of $71 million due to a goodwill impairment charge related to Intermix during fiscal 2016. Changes in operating assets and liabilities • a decrease of $236 million related to accounts payable primarily due to timing of payments; • a decrease of $188 million related to merchandise inventory primarily due to the volume and timing of receipts; and • a decrease of $71 million related to income taxes payable, net of prepaid and other tax-related items, primarily due to the timing of tax payments, partially offset by an increase in estimated current expense in fiscal 2017 compared with fiscal 2016; partially offset by • an increase of $115 million related to the recognition of deferred tax expense in fiscal 2017 compared with deferred tax benefit in fiscal 2016 primarily due to the deferred tax impact of federal tax reform and favorable current year temporary differences. Net cash provided by operating activities during fiscal 2016 increased $125 million compared with fiscal 2015, primarily due to the following: Net income • a decrease of $244 million in net income. Non-cash items • an increase of $246 million related to non-cash and other items primarily due to the lower gain reclassified into income related to our derivative financial instruments in fiscal 2016 compared with fiscal 2015, a goodwill impairment charge related to Intermix of $71 million during fiscal 2016, and an increase of $53 million related to store asset impairment; partially offset by • a decrease of $155 million related to deferred income taxes driven by fluctuations in book versus tax temporary differences for bonus accruals, depreciation, and share-based compensation. Changes in operating assets and liabilities • an increase of $193 million related to accounts payable primarily due to the timing of merchandise and lease payments; • an increase of $117 million related to accrued expenses and other current liabilities primarily due to bonus accruals; and • an increase of $52 million related to merchandise inventory primarily due to the volume and timing of receipts; partially offset by • a decrease of $79 million related to other current assets and other long-term assets in part due to the insurance claim receivable from the Fishkill fire. We fund inventory expenditures during normal and peak periods through cash flows from operating activities and available cash. Our business follows a seasonal pattern, with sales peaking during the end-of-year holiday period. The seasonality of our operations, combined with the calendar shift of weeks in fiscal 2018 compared with fiscal 2017 as a result of the 53rd week in fiscal 2017, may lead to significant fluctuations in certain asset and liability accounts between fiscal year-end and subsequent interim periods. Cash Flows from Investing Activities Net cash used for investing activities during fiscal 2017 increased $139 million compared with fiscal 2016, primarily due to the following: • $207 million increase for purchases of property and equipment in fiscal 2017 compared with fiscal 2016 primarily related to the rebuilding of the Company's Fishkill, New York distribution center campus; partially offset by • $66 million related to insurance proceeds allocated to loss on property and equipment in fiscal 2017 primarily related to the Fishkill fire compared with no insurance proceeds allocated to loss on property and equipment in fiscal 2016. Net cash used for investing activities during fiscal 2016 decreased $201 million compared with fiscal 2015, primarily due to less property and equipment purchases. In fiscal 2017, cash used for purchases of property and equipment was $731 million primarily related to investments in stores, information technology, and supply chain, including costs associated with the rebuilding of the company's Fishkill, New York distribution center campus. Cash Flows from Financing Activities Net cash used for financing activities during fiscal 2017 decreased $46 million compared with fiscal 2016, primarily due to the following: • $67 million related to the final repayment of the Japan term loan in full in June 2017 compared with a $421 million payment of debt in fiscal 2016; partially offset by • $315 million of cash used for repurchases of common stock in fiscal 2017 compared with no repurchases of common stock in fiscal 2016. Net cash used for financing activities during fiscal 2016 decreased $213 million compared with fiscal 2015, primarily due to the following: • no repurchases of common stock in fiscal 2016 compared with $1 billion cash outflow related to repurchases of common stock in fiscal 2015; partially offset by • no debt issuances in fiscal 2016 compared with the issuance of $400 million in debt in fiscal 2015; and • the repayment of $400 million in debt in fiscal 2016. Free Cash Flow Free cash flow is a non-GAAP financial measure. We believe free cash flow is an important metric because it represents a measure of how much cash a company has available for discretionary and non-discretionary items after the deduction of capital expenditures as we require regular capital expenditures to build and maintain stores and purchase new equipment to improve our business. We use this metric internally, as we believe our sustained ability to generate free cash flow is an important driver of value creation. However, this non-GAAP financial measure is not intended to supersede or replace our GAAP result. Free cash flow for fiscal 2017 is further adjusted for insurance proceeds allocated to loss on property and equipment, as our cash used for purchases of property and equipment for fiscal 2017 includes certain capital expenditures related to the rebuilding of the Company-owned distribution center which was impacted by the Fishkill fire. The following table reconciles free cash flow, a non-GAAP financial measure, from net cash provided by operating activities, a GAAP financial measure. Debt and Credit Facilities Certain financial information about the Company's debt and credit facilities is set forth under the headings "Debt" and "Credit Facilities" in Notes 4 and 5, respectively, of Notes to Consolidated Financial Statements included in Item 8, Financial Statements and Supplementary Data, of this Form 10-K. Dividend Policy In determining whether and at what level to declare a dividend, we consider a number of factors including sustainability, operating performance, liquidity, and market conditions. We paid an annual dividend of $0.92 per share in fiscal 2017 and fiscal 2016. We intend to increase our annual dividend to $0.97 per share in fiscal 2018. Share Repurchases Certain financial information about the Company's share repurchases is set forth under the heading "Share Repurchases" in Note 8 of Notes to Consolidated Financial Statements included in Item 8, Financial Statements and Supplementary Data, of this Form 10-K. Contractual Cash Obligations We are party to many contractual obligations involving commitments to make payments to third parties. The following table provides summary information concerning our future contractual obligations as of February 3, 2018. These obligations impact our short-term and long-term liquidity and capital resource needs. Certain of these contractual obligations are reflected in the Consolidated Balance Sheet as of February 3, 2018, while others are disclosed as future obligations. __________ (1) Represents principal maturities, excluding interest. See Note 4 of Notes to Consolidated Financial Statements for discussion on debt. (2) Excludes maintenance, insurance, taxes, and contingent rent obligations. See Note 11 of Notes to Consolidated Financial Statements for discussion of our operating leases. (3) Represents estimated open purchase orders to purchase inventory as well as commitments for products and services used in the normal course of business. There is $138 million of long-term liabilities recorded in lease incentives and other long-term liabilities in the Consolidated Balance Sheet as of February 3, 2018 that is excluded from the table above as the amount relates to uncertain tax positions and deferred compensation, and we are not able to reasonably estimate the timing of the payments or the amount by which the liability will increase or decrease over time. Commercial Commitments We have commercial commitments, not reflected in the table above, that were incurred in the normal course of business to support our operations, including standby letters of credit of $15 million, surety bonds of $43 million, and bank guarantees of $22 million outstanding (of which $17 million was issued under the unsecured revolving credit facilities for our operations in foreign locations) as of February 3, 2018. Other Cash Obligations Not Reflected in the Consolidated Balance Sheet (Off-Balance Sheet Arrangements) The majority of our contractual obligations relate to operating leases for our stores. Future minimum lease payments represent commitments under non-cancelable operating leases and are disclosed in the table above with additional information provided under the heading "Leases" in Note 11 of Notes to Consolidated Financial Statements included in Item 8, Financial Statements and Supplementary Data, of this Form 10-K. Critical Accounting Policies and Estimates The preparation of financial statements in accordance with accounting principles generally accepted in the United States of America ("U.S. GAAP") requires management to adopt accounting policies and make significant judgments and estimates to develop amounts reflected and disclosed in the financial statements. In many cases, there are alternative policies or estimation techniques that could be used. We maintain a thorough process to review the application of our accounting policies and to evaluate the appropriateness of the many estimates that are required to prepare the financial statements of a large, global corporation. However, even under optimal circumstances, estimates routinely require adjustment based on changing circumstances and the receipt of new or better information. Our significant accounting policies can be found under the heading "Organization and Summary of Significant Accounting Policies" in Note 1 of Notes to Consolidated Financial Statements included in Item 8, Financial Statements and Supplementary Data, of this Form 10-K. The policies and estimates discussed below include the financial statement elements that are either judgmental or involve the selection or application of alternative accounting policies and are material to our financial statements. Management has discussed the development and selection of these critical accounting policies and estimates with the Audit and Finance Committee of our Board of Directors, which has reviewed our disclosure relating to critical accounting policies and estimates in this annual report on Form 10-K. Merchandise Inventory We value inventory at the lower of cost or net realizable value (“LCNRV”), with cost determined using the weighted-average cost method. We review our inventory levels in order to identify slow-moving merchandise and broken assortments (items no longer in stock in a sufficient range of sizes or colors), and we primarily use promotions and markdowns to clear merchandise. We record an adjustment to inventory when future estimated selling price is less than cost. Our LCNRV adjustment calculation requires management to make assumptions to estimate the selling price and amount of slow-moving merchandise and broken assortments subject to markdowns, which is dependent upon factors such as historical trends with similar merchandise, inventory aging, forecasted consumer demand, and the promotional environment. In addition, we estimate and accrue shortage for the period between the last physical count and the balance sheet date. Our shortage estimate can be affected by changes in merchandise mix and changes in actual shortage trends. Historically, actual shortage has not differed materially from our estimates. We do not believe there is a reasonable likelihood that there will be a material change in the future estimates or assumptions we use to calculate our LCNRV or inventory shortage adjustments. However, if estimates regarding consumer demand are inaccurate or actual physical inventory shortage differs significantly from our estimate, our operating results could be affected. We have not made any material changes in the accounting methodology used to calculate our LCNRV or inventory shortage adjustments in the past three fiscal years. Impairment of Long-Lived Assets, Goodwill, and Intangible Assets We review the carrying amount of long-lived assets for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset or asset group may not be recoverable. Events that result in an impairment review include a significant decrease in the operating performance of the long-lived asset, or the decision to close a store, corporate facility, or distribution center. Long-lived assets are considered impaired if the carrying amount exceeds the estimated undiscounted future cash flows of the asset or asset group. For impaired assets, we recognize a loss equal to the difference between the carrying amount of the asset or asset group and its estimated fair value. The estimated fair value of the asset or asset group is based on estimated discounted future cash flows of the asset or asset group using a discount rate commensurate with the related risk. The asset group is defined as the lowest level for which identifiable cash flows are available and largely independent of the cash flows of other groups of assets. The asset group for our retail stores is reviewed for impairment primarily at the store level. Our estimate of future cash flows requires management to make assumptions and to apply judgment, including forecasting future sales and expenses and estimating useful lives of the assets. These estimates can be affected by factors such as future store results, real estate demand, and economic conditions that can be difficult to predict. We have not made any material changes in the methodology to assess and calculate impairment of long-lived assets in the past three fiscal years. We recorded a charge for the impairment of long-lived assets of $28 million, $107 million, and $54 million for fiscal 2017, 2016, and 2015, respectively, related to store assets, which is recorded in operating expenses in the Consolidated Statements of Income. We also review the carrying amount of goodwill and other indefinite-lived intangible assets for impairment annually in the fourth quarter of the fiscal year and whenever events or changes in circumstances indicate that it is more likely than not that the carrying amount may not be recoverable. Events that result in an impairment review include significant changes in the business climate, declines in our operating results, or an expectation that the carrying amount may not be recoverable. We early adopted ASU No. 2017-04, Intangibles - Goodwill and Other: Simplifying the Test for Goodwill Impairment in the first quarter of fiscal 2017. The amendments simplify the subsequent measurement of goodwill impairment by eliminating the requirement to calculate the implied fair value of goodwill to measure a goodwill impairment charge. Under the ASU, the impairment test is simply the comparison of the fair value of a reporting unit with its carrying amount, with the impairment charge being the deficit in fair value but not exceeding the total amount of goodwill allocated to that reporting unit. The simplified one-step impairment test applies to all reporting units (including those with zero or negative carrying amounts). In connection with the acquisitions of Athleta in September 2008 and Intermix in December 2012, we recorded $99 million and $81 million of goodwill. Goodwill is reviewed for impairment using the applicable reporting unit, which is an operating segment or a business unit one level below that operating segment for which discrete financial information is prepared and regularly reviewed by segment management. We have deemed Athleta and Intermix to be the reporting units at which goodwill is tested for Athleta and Intermix, respectively. During the fourth quarter of fiscal 2017, we completed our annual impairment testing of goodwill and we did not recognize any impairment charges. We determined that the respective fair value of goodwill attributed to Athleta and Intermix significantly exceeded their respective carrying amount as of the date of our annual impairment review. In fiscal 2016, the Company performed the goodwill impairment test under the previous FASB Accounting Standards Codification No. 350 Intangibles - Goodwill and Other as the annual impairment test was performed prior to January 1, 2017. At the end of each of the first three quarters of fiscal 2016, given the information available at the time of those assessments, we determined that there were no events or circumstances that indicated any impairment for goodwill related to Intermix. During the fourth quarter of fiscal 2016, management updated the fiscal 2017 budget and financial projections beyond fiscal 2017 for Intermix. There were several factors that caused the financial projections and estimates to significantly decrease from the previous estimates, which included: poor fourth quarter of fiscal 2016 holiday performance at Intermix stores, the decision to reduce expected future store openings, the approval of additional store closures in fiscal 2017, and the budgeting of additional headcount required to support increased focus on the online business. These factors arising during the fourth quarter of fiscal 2016 had a significant and negative impact on the estimated fair value of the Intermix reporting unit, and we determined that the Intermix reporting unit’s carrying value exceeded its fair value as of the date of our annual impairment review. As such, we performed the second step of the goodwill impairment test which resulted in an impairment charge of $71 million for goodwill related to Intermix in fiscal 2016. This impairment charge reduced the $81 million of purchase price allocated to goodwill in connection with the acquisition of Intermix in December 2012 to $10 million as of January 28, 2017. We did not recognize any impairment charges for goodwill in fiscal 2015. As of February 3, 2018, the aggregate carrying value of trade names was $95 million, which primarily consisted of $54 million and $38 million related to Athleta and Intermix, respectively. A trade name is considered impaired if the carrying amount exceeds its estimated fair value. If a trade name is considered impaired, we recognize a loss equal to the difference between the carrying amount and the estimated fair value of the trade name. The fair value of the trade names is determined using the relief from royalty method. During the fourth quarter of fiscal 2017, we completed our annual impairment review of the trade names, and we did not recognize any impairment charges. These analyses require management to make assumptions and to apply judgment, including forecasting future sales and expenses, and selecting appropriate discount rates and royalty rates, which can be affected by economic conditions and other factors that can be difficult to predict. If actual store and online results and brand performance, real estate market conditions, and economic conditions including interest rates are not consistent with our estimates and assumptions used in our calculations, we may be exposed to additional impairment losses that could be material. Revenue Recognition While revenue recognition for the Company does not involve significant judgment, it represents an important accounting policy. We recognize revenue and the related cost of goods sold at the time the products are received by the customers. For sales transacted at stores, revenue is recognized when the customer receives and pays for the merchandise at the register. For sales where we ship the merchandise to the customer from a distribution center or store, revenue is recognized at the time we estimate the customer receives the merchandise. We sell merchandise to franchisees under multi-year franchise agreements. We recognize revenue from sales to franchisees at the time merchandise ownership is transferred to the franchisee, which generally occurs when the merchandise reaches the franchisee’s predesignated turnover point. We also receive royalties from franchisees primarily based on a percentage of the total merchandise purchased by the franchisee, net of any refunds or credits due them. Royalty revenue is recognized primarily when merchandise ownership is transferred to the franchisee. We record an allowance for estimated returns based on our historical return patterns and various other assumptions that management believes to be reasonable. We do not believe there is a reasonable likelihood that there will be a material change in the future estimates or assumptions we use to calculate our sales return allowance. However, if the actual rate of sales returns increases significantly, our operating results could be adversely affected. We have not made any material changes in the accounting methodology used to estimate future sales returns in the past three fiscal years. See Note 1 of Notes to Consolidated Financial Statements included in Item 8, Financial Statements and Supplementary Data, of this Form 10-K for recent accounting pronouncements related to revenue recognition and expected impact from the adoption of new standards. Unredeemed Gift Cards, Gift Certificates, and Credit Vouchers Upon issuance of a gift card, gift certificate, or credit voucher, a liability is established for its cash value. The liability is relieved and net sales are recorded upon redemption by the customer. Over time, some portion of these instruments is not redeemed (“breakage”). Based on historical redemption patterns, we determine breakage income for gift cards, gift certificates, and credit vouchers when we can determine the portion of the liability where redemption is remote, which is three years after issuance. Breakage income, which has been historically immaterial, is recorded in other income which is a component of operating expenses in the Consolidated Statements of Income. When breakage income is recorded, a liability is recognized for any legal obligation to remit the unredeemed portion to relevant jurisdictions. Substantially all of our gift cards, gift certificates, and credit vouchers have no expiration dates. We do not believe there is a reasonable likelihood that there will be a material change in the future estimates or assumptions we use to calculate our breakage income. However, if the actual pattern of redemption for gift cards, gift certificates, and credit vouchers changes significantly, our operating results could be adversely affected. We have not made any material changes in the accounting methodology used to estimate breakage in the past three fiscal years. See Note 1 of Notes to Consolidated Financial Statements included in Item 8, Financial Statements and Supplementary Data, of this Form 10-K for recent accounting pronouncements related to revenue recognition and expected impact on recognition of breakage income from the adoption of new standards. Income Taxes We record a valuation allowance against our deferred tax assets when it is more likely than not that some portion or all of such deferred tax assets will not be realized. In determining the need for a valuation allowance, management is required to make assumptions and to apply judgment, including forecasting future income, taxable income, and the mix of income or losses in the jurisdictions in which we operate. Our effective tax rate in a given financial statement period may also be materially impacted by changes in the mix and level of income or losses, changes in the expected outcome of audits, or changes in the deferred tax valuation allowance. At any point in time, many tax years are subject to or in the process of being audited by various taxing authorities. To the extent our estimates of settlements change or the final tax outcome of these matters is different from the amounts recorded, such differences will impact the income tax provision in the period in which such determinations are made. Our income tax expense includes changes in our estimated liability for exposures associated with our various tax filing positions. Determining the income tax expense for these potential assessments requires management to make assumptions that are subject to factors such as proposed assessments by tax authorities, changes in facts and circumstances, issuance of new regulations, and resolution of tax audits. We believe the judgments and estimates discussed above are reasonable. However, if actual results are not consistent with our estimates or assumptions, we may be exposed to losses or gains that could be material. See Note 12 of Notes to Consolidated Financial Statements included in Item 8, Financial Statements and Supplementary Data, of this Form 10-K for the impact of the U.S. Tax Cuts and Jobs Act enacted on December 22, 2017 on income taxes. Recent Accounting Pronouncements See "Organization and Summary of Significant Accounting Policies" in Note 1 of Notes to Consolidated Financial Statements included in Item 8, Financial Statements and Supplementary Data, of this Form 10-K for recent accounting pronouncements, including the expected dates of adoption and estimated effects on our Consolidated Financial Statements.

<s>[INST] We are a global retailer offering apparel, accessories, and personal care products for men, women, and children under the Old Navy, Gap, Banana Republic, Athleta, and Intermix brands. We have Companyoperated stores in the United States, Canada, the United Kingdom, France, Ireland, Japan, Italy, China, Hong Kong, Taiwan, and Mexico. We have franchise agreements with unaffiliated franchisees to operate Old Navy, Gap, and Banana Republic stores throughout Asia, Europe, Latin America, the Middle East, and Africa. Under these agreements, third parties operate, or will operate, stores that sell apparel and related products under our brand names. Our products are also available to customers online through Companyowned websites and through the use of third parties that provide logistics and fulfillment services. In addition to operating in the specialty, outlet, online, and franchise channels, we also use our omnichannel capabilities to bridge the digital world and physical stores to further enhance our shopping experience for our customers. Our omnichannel services, including orderinstore, reserveinstore, findinstore, and shipfromstore, as well as enhanced mobile experiences, are tailored uniquely across our portfolio of brands. Most of the products sold under our brand names are designed by us and manufactured by independent sources. We also sell products that are designed and manufactured by branded third parties, primarily at our Intermix brand. We identify our operating segments according to how our business activities are managed and evaluated. As of February 3, 2018, our operating segments included Gap Global, Old Navy Global, Banana Republic Global, Athleta, and Intermix. We have determined that each of our operating segments share similar economic and other qualitative characteristics, and therefore the results of our operating segments are aggregated into one reportable segment. Fiscal 2017 consisted of 53 weeks versus 52 weeks in fiscal 2016 and 2015. Net sales and operating results, as well as other metrics derived from the Consolidated Statement of Income, include the impact of the additional week; however, the comparable sales calculation excludes the 53rd week. On August 29, 2016, a fire occurred in one of the buildings at a Companyowned distribution center campus in Fishkill, New York ("the Fishkill fire"). In January 2018, the Company agreed upon a final settlement with its insurers and all insurance proceeds were received as of February 3, 2018. In May 2016, we announced measures to better align talent and financial resources against our most important priorities to position the Company for improved business performance and longterm success. Our aim is to capture additional market share in our home market, North America, where we have our largest structural advantages, and to focus on international regions with the greatest potential. As part of this effort, we closed the entire fleet of 53 Old Navy stores in Japan during fiscal 2016. Japan remains an important market for the Company's portfolio, with a continued strong presence of approximately 200 Gap and Banana Republic stores. Including the Old Navy closures in Japan, the Company closed 67 stores in total related to these measures in fiscal 2016. We also took steps toward creating a more efficient operating model, enabling us to more fully leverage our scale. For example, we centralized or consolidated several brand and corporate functions, allowing us to simplify the organization and operate more efficiently. In connection with the decision to close stores and streamline the Company's operations, the Company incurred $197 million in restructuring costs during fiscal 2016 on a pretax basis. The charges primarily include lease termination fees, employeerelated costs, and store asset impairment. Certain of the costs incurred in foreign subsidiaries did not result in a tax benefit. Fiscal 2015 results were impacted by a series of strategic actions to position Gap brand for improved business performance in the future, including rightsizing the Gap brand store fleet primarily in North America, streamlining the brand's headquarter workforce, and developing a clear, onbrand product aesthetic framework to strengthen the Gap brand to compete more successfully on the global stage. During fiscal 2015, the Company completed the closure of about 150 Gap global specialty stores related to the strategic actions. During fiscal 201 [/INST] Negative. </s>

GAP INC

2019-03-19

2019-02-02

Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations. Overview We are a global retailer offering apparel, accessories, and personal care products for men, women, and children under the Old Navy, Gap, Banana Republic, Athleta, Intermix, and Hill City brands. We have Company-operated stores in the United States, Canada, the United Kingdom, France, Ireland, Japan, Italy, China, Hong Kong, Taiwan, and Mexico. We have franchise agreements with unaffiliated franchisees to operate Old Navy, Gap, and Banana Republic stores throughout Asia, Europe, Latin America, the Middle East, and Africa. Under these agreements, third parties operate, or will operate, stores that sell apparel and related products under our brand names. Our products are also available to customers online through Company-owned websites and through the use of third parties that provide logistics and fulfillment services. In addition to operating in the specialty, outlet, online, and franchise channels, we also use our omni-channel capabilities to bridge the digital world and physical stores to further enhance our shopping experience for our customers. Our omni-channel services, including order-in-store, reserve-in-store, find-in-store, and ship-from-store, as well as enhanced mobile experiences, are tailored uniquely across our portfolio of brands. Most of the products sold under our brand names are designed by us and manufactured by independent sources. We also sell products that are designed and manufactured by branded third parties, primarily at our Intermix brand. We identify our operating segments according to how our business activities are managed and evaluated. As of February 2, 2019, our operating segments included Old Navy Global, Gap Global, Banana Republic Global, Athleta, and Intermix. We have determined that each of our operating segments share similar economic and other qualitative characteristics, and therefore the results of our operating segments are aggregated into one reportable segment. On February 28, 2019, the Company announced plans to restructure the specialty fleet and revitalize the Gap brand, including closing about 230 Gap specialty stores during fiscal 2019 and fiscal 2020. The Company believes these actions will drive a healthier specialty fleet and will serve as a more appropriate foundation for brand revitalization. During the two-year period, the Company estimates pre-tax costs associated with these closure actions to be about $250 million to $300 million, with the majority expected to be cash expenditures for lease-related costs. The remaining charges are expected to primarily include employee-related costs and the net impact of write-offs related to long-term assets and liabilities. The Company estimates an annualized sales loss of approximately $625 million as a result of these store closures, with resulting annualized pre-tax savings of about $90 million. On February 28, 2019, the Company also announced that its Board of Directors approved a plan to separate the Company into two independent publicly-traded companies: Old Navy and a yet-to-be-named company (“NewCo”), which will consist of Gap brand, Athleta, Banana Republic, Intermix, and Hill City. The separation is intended to enable both companies to capitalize on their respective opportunities and act decisively in an evolving retail environment by creating distinct financial profiles, tailored operating priorities and unique capital allocation strategies. Both companies will be positioned to create value for customers, shareholders and employees with enhanced focus and flexibility, aligned investments and incentives to meet the unique strategic goals, and optimized cost structures to deliver growth. The transaction is targeted to be completed in 2020 and is subject to certain conditions, including final approval by the Company’s Board of Directors, receipt of a tax opinion from counsel, and the filing and effectiveness of a registration statement with the U.S. Securities and Exchange Commission. During the first quarter of fiscal 2018, the Company adopted the new revenue recognition standard, Accounting Standards Codification ("ASC") 606, using the modified retrospective transition method and recorded an increase to opening retained earnings of $36 million, net of tax. The comparative information has not been restated and continues to be reported under the accounting standards in effect for those periods. The adoption of this standard had a significant impact on the presentation of certain line items within the Consolidated Statements of Income, but did not have a material impact to operating income, net income or earnings per share for fiscal year 2018. The presentation changes primarily consist of $443 million for the fiscal year ended February 2, 2019 for revenue sharing associated with our credit card programs and breakage revenue for gift cards and credit vouchers, which now is recorded as net sales and previously was recorded as a reduction to operating expenses in our Consolidated Statements of Income; and $176 million for the fiscal year ended February 2, 2019, for reimbursements of loyalty program discounts associated with our credit card programs, which now is recorded as net sales and previously was recorded as a reduction to cost of goods sold and occupancy expenses in our Consolidated Statements of Income. See Note 1 of Notes to Consolidated Financial Statements for additional disclosures about the adoption of the new revenue standard. On August 29, 2016, a fire occurred in one of the buildings at a Company-owned distribution center campus in Fishkill, New York ("the Fishkill fire"). In January 2018, we agreed upon a final settlement with our insurers and all insurance proceeds were received as of February 3, 2018. Fiscal 2018 and 2016 consisted of 52 weeks versus 53 weeks in fiscal 2017. Net sales and operating results, as well as other metrics derived from the Consolidated Statement of Income, include the impact of the additional week; however, the comparable sales calculation excludes the 53rd week. Financial results for fiscal 2018 are as follows: • Net sales for fiscal 2018 increased 5 percent to $16.6 billion compared with $15.9 billion for fiscal 2017. • Comparable sales for fiscal 2018 were flat. • Gross profit for fiscal 2018 was $6.3 billion compared with $6.1 billion for fiscal 2017. Gross margin for fiscal 2018 was 38.1 percent compared with 38.3 percent for fiscal 2017. • Operating margin for fiscal 2018 was 8.2 percent compared with 9.3 percent for fiscal 2017. • Effective tax rate for fiscal 2018 was 24.1 percent compared with 40.4 percent for fiscal 2017. • Net income for fiscal 2018 was $1,003 million compared with $848 million for fiscal 2017, and diluted earnings per share was $2.59 for fiscal 2018 compared with $2.14 for fiscal 2017. Diluted earnings per share for fiscal 2017 included about a $0.10 benefit from the gain from insurance proceeds related to the Fishkill fire and an unfavorable net provisional tax impact of federal tax reform of about $0.09. • During fiscal 2018, we paid dividends of $373 million compared with $361 million during fiscal 2017. • During fiscal 2018, share repurchases were $398 million compared with $315 million for fiscal 2017. Our business priorities in fiscal 2019 are as follows: • offering product that is consistently brand-appropriate and on-trend with high customer acceptance, with a focus on expanding our advantage in core businesses and loyalty categories; and leading customer-focused product innovation; • preparing for successful separation; • restructuring the Gap brand specialty fleet globally to create a healthier, more profitable base from which to grow; • investing in digital and customer capabilities as well as store experience to create a unique and differentiated converged retail experience that attracts new customers, retains existing customers, and builds loyalty; • increasing productivity by leveraging our scale and streamlining operations and processes throughout the organization; • attracting and retaining strong talent in our businesses and functions; and • continuing to integrate social and environmental sustainability into business practices to support long term growth. In fiscal 2019, while we work through the plan for separation, we are focused on investing strategically in the business while maintaining operating expense discipline and driving efficiency through our productivity initiative. One of our primary objectives is to continue transforming our product to market process, with the development of a more efficient operating model. Furthermore, we expect to continue our investment in customer experience, both in stores and online, to drive higher customer engagement and loyalty across all of our brands and channels, resulting in market share gains. Finally, we will continue to invest in strengthening brand awareness, customer acquisition, and digital capabilities. Underpinning these strategies is a focus on utilizing data, analytics, and technology to respond faster while making decisions that will fuel market share gains and lead to a more nimble organization. Results of Operations Net Sales See Item 8, Financial Statements and Supplementary Data, Note 16 of Notes to Consolidated Financial Statements for net sales by brand and region. Comparable Sales ("Comp Sales") Fiscal 2018 consisted of 52 weeks versus 53 weeks in fiscal 2017. Due to the 53rd week in fiscal 2017, in order to maintain consistency, comparable ("Comp") sales for the fifty-two weeks ended February 2, 2019, are compared to the fifty-two weeks ended February 3, 2018. The percentage change in Comp Sales by global brand and for total Company, as compared with the preceding year, is as follows: Comp Sales include merchandise sales in Company-operated stores and merchandise sales through online channels in those countries where we have existing comparable store sales. The calculation of The Gap, Inc. Comp Sales includes the results of Athleta and Intermix but excludes the results of our franchise business. A store is included in the Comp Sales calculations when it has been open and operated by the Company for at least one year and the selling square footage has not changed by 15 percent or more within the past year. A store is included in the Comp Sales calculations on the first day it has comparable prior year sales. Stores in which the selling square footage has changed by 15 percent or more as a result of a remodel, expansion, or reduction are excluded from the Comp Sales calculations until the first day they have comparable prior year sales. A store is considered non-comparable (“Non-comp”) when it has been open and operated by the Company for less than one year or has changed its selling square footage by 15 percent or more within the past year. A store is considered “Closed” if it is temporarily closed for three or more full consecutive days or it is permanently closed. When a temporarily closed store reopens, the store will be placed in the Comp/Non-comp status it was in prior to its closure. If a store was in Closed status for three or more days in the prior year, the store will be in Non-comp status for the same days the following year. Current year foreign exchange rates are applied to both current year and prior year Comp Sales to achieve a consistent basis for comparison. Store Count and Square Footage Information Net sales per average square foot is as follows: __________ (1) Excludes net sales associated with our online and franchise businesses. Online sales includes both sales through our online channels as well as ship-from-store sales. (2) Reflects the adoption of ASC 606. Prior period amounts have not been restated and continue to be reported under accounting standards in effect for those periods. (3) Fiscal 2017 includes incremental sales attributable to the 53rd week. Store count, openings, closings, and square footage for our stores are as follows: Gap and Banana Republic outlet and factory stores are reflected respectively within each brand. In fiscal 2019, we expect to open about 140 and close about 190 Company-operated store locations. Openings will be primarily focused on Old Navy and Athleta. Closures are primarily driven by the specialty fleet restructuring. Net Sales Discussion Our net sales for fiscal 2018 increased $725 million, or 5 percent, compared with fiscal 2017, primarily driven by the impact of significant presentation changes of $619 million resulting from the adoption of the new revenue recognition standard, and an increase in net sales for Old Navy Global and Athleta; partially offset by a decrease in net sales for Gap Global. The translation of net sales in foreign currencies to U.S. dollars had a favorable impact of about $17 million for fiscal 2018 and is calculated by translating net sales for fiscal 2017 at exchange rates applicable during fiscal 2018. Our net sales for fiscal 2017 increased $339 million, or 2 percent, compared with fiscal 2016 primarily due to an increase in net sales at Old Navy Global and Athleta, partially offset by a decrease in net sales at Gap Global and Banana Republic Global. The translation of net sales in foreign currencies to U.S. dollars had an unfavorable impact of about $11 million for fiscal 2017 and is calculated by translating net sales for fiscal 2016 at exchange rates applicable during fiscal 2017. Fiscal 2017 includes incremental sales attributable to the 53rd week. Cost of Goods Sold and Occupancy Expenses Cost of goods sold and occupancy expenses increased 0.2 percentage points as a percentage of net sales in fiscal 2018 compared with fiscal 2017, which includes $176 million of presentation changes resulting from the adoption of the new revenue recognition standard. • Cost of goods sold increased 0.7 percentage points as a percentage of net sales in fiscal 2018 compared with fiscal 2017, primarily driven by lower product margin at Gap Global and higher online shipping costs. This was partially offset by a favorable impact from presentation changes resulting from the adoption of the new revenue recognition standard. • Occupancy expenses decreased 0.5 percentage points as a percentage of net sales in fiscal 2018 compared with fiscal 2017, primarily driven by presentation changes resulting from the adoption of the new revenue recognition standard. Cost of goods sold and occupancy expenses decreased 2.0 percentage points as a percentage of net sales in fiscal 2017 compared with fiscal 2016. • Cost of goods sold decreased 1.3 percentage points as a percentage of net sales in fiscal 2017 compared with fiscal 2016, primarily driven by higher margins achieved as a result of improved average selling price per unit at all global brands; partially offset by higher average unit cost at all global brands. This was offset by a negative foreign exchange impact for our foreign subsidiaries as our merchandise purchases are primarily in U.S. dollars. • Occupancy expenses decreased 0.7 percentage points as a percentage of net sales in fiscal 2017 compared with fiscal 2016, primarily driven by an increase in online sales, international store closures, and higher sales from the impact of the 53rd week; partially offset by real estate expenses for the Times Square New York location for Gap and Old Navy. In fiscal 2019, we do not expect significant year-over-year impacts on gross margins due to fluctuations in foreign currencies. Operating Expenses and Operating Margin Operating expenses increased $373 million or 1.0 percentage points as a percentage of net sales in fiscal 2018 compared with fiscal 2017 primarily due to the following: • an increase of $443 million related to the presentation changes resulting from the adoption of new revenue recognition standard; and • a gain from insurance proceeds of $64 million during fiscal 2017 related to the fire that occurred at the Fishkill, New York Company-owned distribution center; partially offset by • a decrease in expenses related to payroll and benefits, primarily driven by a decrease in bonus expense. Operating expenses increased $138 million or 0.2 percentage points as a percentage of net sales in fiscal 2017 compared with fiscal 2016 primarily due to the following: • an increase in variable costs, such as payroll-related costs, due to the growth in Old Navy Global and Athleta brands, increase in bonus expense, and the 53rd week impact; • an increase in advertising; and • an increase in overhead costs related to productivity work including investments in customer and digital initiatives as well as severance expenses and the impacts of store closures; partially offset by • a gain from insurance proceeds of $64 million related to the Fishkill fire recorded in the second quarter of fiscal year 2017; • a decrease of $197 million of restructuring costs incurred in fiscal year 2016; and • a decrease of $71 million related to a goodwill impairment charges for Intermix in fiscal year 2016. Interest Expense Interest expense for fiscal 2018, 2017 and 2016 is primarily comprised of interest on our $1.25 billion long-term debt. Income Taxes The decrease in the effective tax rate for fiscal 2018 compared with fiscal 2017 was primarily due to the reduction in the U.S. federal statutory tax rate from 35% to 21%, enacted as part of the Tax Cuts and Jobs Act of 2017 (the “TCJA”), and measurement period adjustments to reduce our fiscal 2017 estimated net charge for the effects of the TCJA, offset by increases in unrecognized tax benefits recorded in connection with examinations by taxing authorities. During fiscal 2017, we calculated and recorded a $57 million net charge for our best estimate of the impact of the TCJA one-time transition tax on the deemed repatriation of foreign income and the impact of TCJA on deferred tax assets and liabilities. During fiscal 2018, we recorded a $33 million measurement period adjustment to reduce our fiscal 2017 provisional estimated net charge related to the transition tax and recorded certain other immaterial measurement period adjustments to reduce our fiscal 2017 provisional estimated impact of the remeasurement of our deferred tax assets and liabilities to reflect the TCJA rate reduction. We have evaluated the TCJA and interpreted additional guidance issued by the U.S. Treasury Department and Internal Revenue Service (“IRS”) during fiscal 2018 and our accounting for the impact of the TCJA is complete as of February 2, 2019. The increase in the effective tax rate for fiscal 2017 compared with fiscal 2016 was primarily due to the impact of the TCJA, partially offset by the recognition of certain tax benefits associated with legal structure changes. Liquidity and Capital Resources Our largest source of cash flows is cash collections from the sale of our merchandise. Our primary uses of cash include merchandise inventory purchases, occupancy costs, personnel-related expenses, purchases of property and equipment, and payment of taxes. In addition, we may have dividend payments, debt repayments, and share repurchases. We consider the following to be measures of our liquidity and capital resources: As of February 2, 2019, the majority of our cash, cash equivalents, and short-term investments were held in the United States and is generally accessible without any limitations. In addition, as of February 2, 2019, there was restricted cash of $320 million held by a third party in connection with the purchase of a building recorded in other long-term assets on the Consolidated Balance Sheet. In April 2011, the Company entered into a $1.25 billion aggregate principal amount of 5.95 percent notes (the "Notes"), which are due April 2021. In October 2015, the Company entered into a $400 million unsecured term loan (the "Term Loan"), which was fully repaid in January 2017. In January 2014, the Company entered into a 15 billion Japanese yen, four-year, unsecured term loan ("Japan Term Loan"), which was fully repaid in June 2017. We believe that current cash balances and cash flows from our operations will be sufficient to support our business operations, including the purchase of a building and expansion costs related to the buildout of our Ohio distribution center, for the next 12 months and beyond. We are also able to supplement near-term liquidity, if necessary, with our $500 million revolving credit facility or other available market instruments. Cash Flows from Operating Activities Net cash provided by operating activities during fiscal 2018 was flat compared with fiscal 2017, which was comprised of the following significant changes: Net income • an increase of $155 million in net income. Changes in operating assets and liabilities • an increase of $165 million related to income taxes payable, net of prepaid and other tax-related items, driven primarily by the timing of payments; offset by • a decrease of $230 million related to accrued expenses and other current liabilities, driven primarily by a decrease in bonus accrual for fiscal 2018 compared with an increase for fiscal 2017; and • a decrease of $51 million related to other current assets and long-term assets driven in part by the receipt of insurance claims receivable related to the Fishkill fire during fiscal 2017. Net cash provided by operating activities during fiscal 2017 decreased $339 million compared with fiscal 2016, primarily due to the following: Net income • an increase of $172 million in net income. Non-cash items • a decrease of $79 million in store asset impairment charges in fiscal 2017 compared with fiscal 2016 in part due to restructuring activities in fiscal 2016; and • a decrease of $71 million due to a goodwill impairment charge related to Intermix during fiscal 2016. Changes in operating assets and liabilities • a decrease of $236 million related to accounts payable primarily due to timing of payments; • a decrease of $188 million related to merchandise inventory primarily due to the volume and timing of receipts; and • a decrease of $71 million related to income taxes payable, net of prepaid and other tax-related items, primarily due to the timing of tax payments, partially offset by an increase in estimated current expense in fiscal 2017 compared with fiscal 2016; partially offset by • an increase of $115 million related to the recognition of deferred tax expense in fiscal 2017 compared with deferred tax benefit in fiscal 2016 primarily due to the deferred tax impact of federal tax reform and favorable current year temporary differences. We fund inventory expenditures during normal and peak periods through cash flows from operating activities and available cash. Our business follows a seasonal pattern, with sales peaking during the end-of-year holiday period. The seasonality of our operations may lead to significant fluctuations in certain asset and liability accounts between fiscal year-end and subsequent interim periods. Cash Flows from Investing Activities Net cash used for investing activities during fiscal 2018 increased $335 million compared with fiscal 2017, primarily due to the following: • $287 million of net purchases of available-for-sale securities during fiscal 2018; and • $66 million of insurance proceeds allocated to the loss on property and equipment during fiscal 2017. In fiscal 2018, cash used for purchases of property and equipment was $705 million related to information technology and supply chain to support our omni and digital strategies, and store investments. Net cash used for investing activities during fiscal 2017 increased $139 million compared with fiscal 2016, primarily due to: • $207 million increase for purchases of property and equipment in fiscal 2017 compared with fiscal 2016 primarily related to the rebuilding of the Company's Fishkill, New York distribution center campus; partially offset by • $66 million related to insurance proceeds allocated to loss on property and equipment in fiscal 2017 primarily related to the Fishkill fire compared with no insurance proceeds allocated to loss on property and equipment in fiscal 2016. In fiscal 2017, cash used for purchases of property and equipment was $731 million primarily related to investments in stores, information technology, and supply chain, including costs associated with the rebuilding of the Company's Fishkill, New York distribution center campus. Cash Flows from Financing Activities Net cash used for financing activities during fiscal 2018 increased $18 million compared with fiscal 2017, primarily due to the following: • $83 million higher repurchases of common stock during fiscal 2018; offset by • $67 million cash outflow related to the final repayment of the Japan term loan during fiscal 2017. Net cash used for financing activities during fiscal 2017 decreased $46 million compared with fiscal 2016, primarily due to the following: • $67 million related to the final repayment of the Japan term loan in full in June 2017 compared with a $421 million payment of debt in fiscal 2016; partially offset by • $315 million of cash used for repurchases of common stock in fiscal 2017 compared with no repurchases of common stock in fiscal 2016. Free Cash Flow Free cash flow is a non-GAAP financial measure. We believe free cash flow is an important metric because it represents a measure of how much cash a company has available for discretionary and non-discretionary items after the deduction of capital expenditures, net of insurance proceeds to loss on property and equipment, as we require regular capital expenditures to build and maintain stores and purchase new equipment to improve our business. We use this metric internally, as we believe our sustained ability to generate free cash flow is an important driver of value creation. However, this non-GAAP financial measure is not intended to supersede or replace our GAAP result. Free cash flow for fiscal 2017 is adjusted for insurance proceeds allocated to loss on property and equipment, as our cash used for purchases of property and equipment for fiscal 2017 includes certain capital expenditures related to the rebuilding of the Company-owned distribution center which was impacted by the Fishkill fire. The following table reconciles free cash flow, a non-GAAP financial measure, from net cash provided by operating activities, a GAAP financial measure. Debt and Credit Facilities Certain financial information about the Company's debt and credit facilities is set forth under the headings "Debt" and "Credit Facilities" in Notes 4 and 5, respectively, of Notes to Consolidated Financial Statements included in Item 8, Financial Statements and Supplementary Data, of this Form 10-K. Dividend Policy In determining whether and at what level to declare a dividend, we consider a number of factors including sustainability, operating performance, liquidity, and market conditions. We paid an annual dividend of $0.97 per share in fiscal 2018 and $0.92 per share in fiscal 2017. We plan to pay an annual dividend of $0.97 per share in fiscal 2019. Share Repurchases Certain financial information about the Company's share repurchases is set forth under the heading "Share Repurchases" in Note 8 of Notes to Consolidated Financial Statements included in Item 8, Financial Statements and Supplementary Data, of this Form 10-K. Contractual Cash Obligations We are party to many contractual obligations involving commitments to make payments to third parties. The following table provides summary information concerning our future contractual obligations as of February 2, 2019. These obligations impact our short-term and long-term liquidity and capital resource needs. Certain of these contractual obligations are reflected on the Consolidated Balance Sheet as of February 2, 2019, while others are disclosed as future obligations. __________ (1) Represents principal maturities, excluding interest. See Note 4 of Notes to Consolidated Financial Statements for discussion on debt. (2) Excludes maintenance, insurance, taxes, and contingent rent obligations. See Note 11 of Notes to Consolidated Financial Statements for discussion of our operating leases. (3) Represents estimated open purchase orders to purchase inventory as well as commitments for products and services used in the normal course of business. In addition, includes consideration related to the purchase of a building expected to be completed within one year. There is $156 million of long-term liabilities recorded in lease incentives and other long-term liabilities on the Consolidated Balance Sheet as of February 2, 2019 that is excluded from the table above as the amount relates to uncertain tax positions and deferred compensation, and we are not able to reasonably estimate the timing of the payments or the amount by which the liability will increase or decrease over time. Commercial Commitments We have commercial commitments, not reflected in the table above, that were incurred in the normal course of business to support our operations, including standby letters of credit of $13 million, surety bonds of $45 million, and bank guarantees of $25 million outstanding (of which $16 million was issued under the unsecured revolving credit facilities for our operations in foreign locations) as of February 2, 2019. Other Cash Obligations Not Reflected on the Consolidated Balance Sheet (Off-Balance Sheet Arrangements) The majority of our contractual obligations relate to operating leases for our stores. Future minimum operating lease payments represent commitments under non-cancelable operating leases and are disclosed in the table above with additional information provided under the heading "Leases" in Note 11 of Notes to Consolidated Financial Statements included in Item 8, Financial Statements and Supplementary Data, of this Form 10-K. Critical Accounting Policies and Estimates The preparation of financial statements in accordance with accounting principles generally accepted in the United States of America ("U.S. GAAP") requires management to adopt accounting policies and make significant judgments and estimates to develop amounts reflected and disclosed in the financial statements. In many cases, there are alternative policies or estimation techniques that could be used. We maintain a thorough process to review the application of our accounting policies and to evaluate the appropriateness of the many estimates that are required to prepare the financial statements of a large, global corporation. However, even under optimal circumstances, estimates routinely require adjustment based on changing circumstances and the receipt of new or better information. Our significant accounting policies can be found under the heading "Organization and Summary of Significant Accounting Policies" in Note 1 of Notes to Consolidated Financial Statements included in Item 8, Financial Statements and Supplementary Data, of this Form 10-K. The policies and estimates discussed below include the financial statement elements that are either judgmental or involve the selection or application of alternative accounting policies and are material to our financial statements. Management has discussed the development and selection of these critical accounting policies and estimates with the Audit and Finance Committee of our Board of Directors, which has reviewed our disclosure relating to critical accounting policies and estimates in this annual report on Form 10-K. Merchandise Inventory We value inventory at the lower of cost or net realizable value (“LCNRV”), with cost determined using the weighted-average cost method. We review our inventory levels in order to identify slow-moving merchandise and broken assortments (items no longer in stock in a sufficient range of sizes or colors), and we primarily use promotions and markdowns to clear merchandise. We record an adjustment to inventory when future estimated selling price is less than cost. Our LCNRV adjustment calculation requires management to make assumptions to estimate the selling price and amount of slow-moving merchandise and broken assortments subject to markdowns, which is dependent upon factors such as historical trends with similar merchandise, inventory aging, forecasted consumer demand, and the promotional environment. In addition, we estimate and accrue shortage for the period between the last physical count and the balance sheet date. Our shortage estimate can be affected by changes in merchandise mix and changes in actual shortage trends. Historically, actual shortage has not differed materially from our estimates. We do not believe there is a reasonable likelihood that there will be a material change in the future estimates or assumptions we use to calculate our LCNRV or inventory shortage adjustments. However, if estimates regarding consumer demand are inaccurate or actual physical inventory shortage differs significantly from our estimate, our operating results could be affected. We have not made any material changes in the accounting methodology used to calculate our LCNRV or inventory shortage adjustments in the past three fiscal years. Impairment of Long-Lived Assets, Goodwill, and Intangible Assets We review the carrying amount of long-lived assets for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset or asset group may not be recoverable. Events that result in an impairment review include a significant decrease in the operating performance of the long-lived asset, or the decision to close a store, corporate facility, or distribution center. Long-lived assets are considered impaired if the carrying amount exceeds the estimated undiscounted future cash flows of the asset or asset group. For impaired assets, we recognize a loss equal to the difference between the carrying amount of the asset or asset group and its estimated fair value. The estimated fair value of the asset or asset group is based on estimated discounted future cash flows of the asset or asset group using a discount rate commensurate with the related risk. The asset group is defined as the lowest level for which identifiable cash flows are available and largely independent of the cash flows of other groups of assets. The asset group for our retail stores is reviewed for impairment primarily at the store level. Our estimate of future cash flows requires management to make assumptions and to apply judgment, including forecasting future sales and expenses and estimating useful lives of the assets. These estimates can be affected by factors such as future store results, real estate demand, store closure plans, and economic conditions that can be difficult to predict. We have not made any material changes in the methodology to assess and calculate impairment of long-lived assets in the past three fiscal years. We recorded a charge for the impairment of long-lived assets of $14 million, $28 million, and $107 million for fiscal 2018, 2017, and 2016, respectively, related to store assets, which is recorded in operating expenses on the Consolidated Statements of Income. We also review the carrying amount of goodwill and other indefinite-lived intangible assets for impairment annually in the fourth quarter of the fiscal year and whenever events or changes in circumstances indicate that it is more likely than not that the carrying amount may not be recoverable. Events that result in an impairment review include significant changes in the business climate, declines in our operating results, or an expectation that the carrying amount may not be recoverable. We adopted ASU No. 2017-04, Intangibles-Goodwill and Other: Simplifying the Test for Goodwill Impairment in the first quarter of fiscal 2017. The amendments simplify the subsequent measurement of goodwill impairment by eliminating the requirement to calculate the implied fair value of goodwill to measure a goodwill impairment charge. Under the ASU, the impairment test is simply the comparison of the fair value of a reporting unit with its carrying amount, with the impairment charge being the deficit in fair value but not exceeding the total amount of goodwill allocated to that reporting unit. The simplified one-step impairment test applies to all reporting units (including those with zero or negative carrying amounts). In connection with the acquisitions of Athleta in September 2008 and Intermix in December 2012, we recorded $99 million and $81 million of goodwill, respectively. Goodwill is reviewed for impairment using the applicable reporting unit, which is an operating segment or a business unit one level below that operating segment for which discrete financial information is prepared and regularly reviewed by segment management. We have deemed Athleta and Intermix to be the reporting units at which goodwill is tested for Athleta and Intermix, respectively. We assess whether events or circumstances indicate that goodwill is impaired every quarter, and evaluate goodwill impairment annually in the fourth quarter of the fiscal year. During the fourth quarter of fiscal 2018, we completed our annual impairment test of goodwill, and we did not recognize any impairment charges. We did not recognize any impairment charges for goodwill in fiscal 2017. In fiscal 2016, the Company performed the goodwill impairment test under the previous Accounting Standards Codification No. 350, Intangibles - Goodwill and Other, as the annual impairment test was performed prior to January 1, 2017. At the end of each of the first three quarters of fiscal 2016, given the information available at the time of those assessments, we determined that there were no events or circumstances that indicated any impairment for goodwill related to Intermix. During the fourth quarter of fiscal 2016, management updated the fiscal 2017 budget and financial projections beyond fiscal 2017 for Intermix. There were several factors that caused the financial projections and estimates to significantly decrease from the previous estimates, which included: poor fourth quarter of fiscal 2016 holiday performance at Intermix stores, the decision to reduce expected future store openings, the approval of additional store closures in fiscal 2017, and the budgeting of additional headcount required to support increased focus on the online business. These factors arising during the fourth quarter of fiscal 2016 had a significant and negative impact on the estimated fair value of the Intermix reporting unit, and we determined that the Intermix reporting unit’s carrying value exceeded its fair value as of the date of our annual impairment review. As such, we performed the second step of the goodwill impairment test which resulted in an impairment charge of $71 million for goodwill related to Intermix in fiscal 2016. This impairment charge reduced the $81 million of purchase price allocated to goodwill in connection with the acquisition of Intermix in December 2012 to $10 million as of January 28, 2017. As of February 2, 2019, the aggregate carrying value of trade names was $92 million, which consisted of $54 million and $38 million related to Athleta and Intermix, respectively. A trade name is considered impaired if the carrying amount exceeds its estimated fair value. If a trade name is considered impaired, we recognize a loss equal to the difference between the carrying amount and the estimated fair value of the trade name. The fair value of the trade names is determined using the relief from royalty method. During the fourth quarter of fiscal 2018, we completed our annual impairment review of the trade names, and we did not recognize any impairment charges. These analyses require management to make assumptions and to apply judgment, including forecasting future sales and expenses, and selecting appropriate discount rates and royalty rates, which can be affected by economic conditions and other factors that can be difficult to predict. If actual store and online results and brand performance, real estate market conditions, and economic conditions including interest rates are not consistent with our estimates and assumptions used in our calculations, we may be exposed to additional impairment losses that could be material. Revenue Recognition and Deferred Revenue The Company’s revenues include merchandise sales at stores, online, and through franchise agreements. We also receive revenue sharing from our credit card agreement for private label and co-branded credit cards, and breakage revenue related to our gift cards, credit vouchers, and outstanding loyalty points, which are realized based upon historical redemption patterns. For online sales and catalog sales, the Company has elected to treat shipping and handling as fulfillment activities and not a separate performance obligation. Accordingly, we recognize revenue for our single performance obligation related to online sales and catalog sales at the time control of the merchandise passes to the customer, which is generally at the time of shipment. We also record an allowance for estimated returns based on our historical return patterns and various other assumptions that management believes to be reasonable, which is presented on a gross basis on our Consolidated Balance Sheet. Revenues are presented net of any taxes collected from customers and remitted to governmental authorities. In addition, we defer revenue when cash payments are received in advance of performance for unsatisfied obligations related to our gift cards, credit vouchers, outstanding loyalty points, and reimbursements of loyalty program discounts associated with our credit card agreement. For fiscal 2018, the opening balance of deferred revenue for these obligations was $232 million, of which $200 million was recognized as revenue during the period. The closing balance of deferred revenue related to gift cards, credit vouchers, outstanding loyalty points, and reimbursements of loyalty program discounts was $227 million as of February 2, 2019. See Note 1 of Notes to Consolidated Financial Statements included in Item 8, Financial Statements and Supplementary Data, of this Form 10-K for recent accounting pronouncements related to revenue recognition. Income Taxes We record a valuation allowance against our deferred tax assets when it is more likely than not that some portion or all of such deferred tax assets will not be realized. In determining the need for a valuation allowance, management is required to make assumptions and to apply judgment, including forecasting future income, taxable income, and the geographic mix of income or losses in the jurisdictions in which we operate. Our effective tax rate in a given financial statement period may also be materially impacted by changes in the geographic mix and level of income or losses, changes in the expected outcome of audits, changes in the deferred tax valuation allowance, guidance related to the enactment of U.S. Tax Cuts and Jobs Act of 2017 (“TCJA”) that is issued by the U.S. Treasury Department and Internal Revenue Service (“IRS”) or new tax legislation. At any point in time, many tax years are subject to or in the process of being audited by various taxing authorities. To the extent our estimates of settlements change or the final tax outcome of these matters is different from the amounts recorded, such differences will impact the income tax provision in the period in which such determinations are made. Our income tax expense includes changes in our estimated liability for exposures associated with our various tax filing positions. Determining the income tax expense for these potential assessments requires management to make assumptions that are subject to factors such as proposed assessments by tax authorities, changes in facts and circumstances, issuance of new regulations, and resolution of tax audits. We believe the judgments and estimates discussed above are reasonable. However, if actual results are not consistent with our estimates or assumptions, we may be exposed to losses or gains that could be material. See Note 12 of Notes to Consolidated Financial Statements included in Item 8, Financial Statements and Supplementary Data, of this Form 10-K for additional information on the impact of the U.S. Tax Cuts and Jobs Act enacted on December 22, 2017 on income taxes. Recent Accounting Pronouncements See "Organization and Summary of Significant Accounting Policies" in Note 1 of Notes to Consolidated Financial Statements included in Item 8, Financial Statements and Supplementary Data, of this Form 10-K for recent accounting pronouncements, including the expected dates of adoption and estimated effects on our Consolidated Financial Statements.

<s>[INST] We are a global retailer offering apparel, accessories, and personal care products for men, women, and children under the Old Navy, Gap, Banana Republic, Athleta, Intermix, and Hill City brands. We have Companyoperated stores in the United States, Canada, the United Kingdom, France, Ireland, Japan, Italy, China, Hong Kong, Taiwan, and Mexico. We have franchise agreements with unaffiliated franchisees to operate Old Navy, Gap, and Banana Republic stores throughout Asia, Europe, Latin America, the Middle East, and Africa. Under these agreements, third parties operate, or will operate, stores that sell apparel and related products under our brand names. Our products are also available to customers online through Companyowned websites and through the use of third parties that provide logistics and fulfillment services. In addition to operating in the specialty, outlet, online, and franchise channels, we also use our omnichannel capabilities to bridge the digital world and physical stores to further enhance our shopping experience for our customers. Our omnichannel services, including orderinstore, reserveinstore, findinstore, and shipfromstore, as well as enhanced mobile experiences, are tailored uniquely across our portfolio of brands. Most of the products sold under our brand names are designed by us and manufactured by independent sources. We also sell products that are designed and manufactured by branded third parties, primarily at our Intermix brand. We identify our operating segments according to how our business activities are managed and evaluated. As of February 2, 2019, our operating segments included Old Navy Global, Gap Global, Banana Republic Global, Athleta, and Intermix. We have determined that each of our operating segments share similar economic and other qualitative characteristics, and therefore the results of our operating segments are aggregated into one reportable segment. On February 28, 2019, the Company announced plans to restructure the specialty fleet and revitalize the Gap brand, including closing about 230 Gap specialty stores during fiscal 2019 and fiscal 2020. The Company believes these actions will drive a healthier specialty fleet and will serve as a more appropriate foundation for brand revitalization. During the twoyear period, the Company estimates pretax costs associated with these closure actions to be about $250 million to $300 million, with the majority expected to be cash expenditures for leaserelated costs. The remaining charges are expected to primarily include employeerelated costs and the net impact of writeoffs related to longterm assets and liabilities. The Company estimates an annualized sales loss of approximately $625 million as a result of these store closures, with resulting annualized pretax savings of about $90 million. On February 28, 2019, the Company also announced that its Board of Directors approved a plan to separate the Company into two independent publiclytraded companies: Old Navy and a yettobenamed company (“NewCo”), which will consist of Gap brand, Athleta, Banana Republic, Intermix, and Hill City. The separation is intended to enable both companies to capitalize on their respective opportunities and act decisively in an evolving retail environment by creating distinct financial profiles, tailored operating priorities and unique capital allocation strategies. Both companies will be positioned to create value for customers, shareholders and employees with enhanced focus and flexibility, aligned investments and incentives to meet the unique strategic goals, and optimized cost structures to deliver growth. The transaction is targeted to be completed in 2020 and is subject to certain conditions, including final approval by the Company’s Board of Directors, receipt of a tax opinion from counsel, and the filing and effectiveness of a registration statement with the U.S. Securities and Exchange Commission. During the first quarter of fiscal 2018, the Company adopted the new revenue recognition standard, Accounting Standards Codification ("ASC") 606, using the modified retrospective transition method and recorded an increase to opening retained earnings of $36 million, net of tax. The comparative information has not been restated and continues to be reported under the accounting standards in effect for those periods. The adoption of this standard had a significant impact on the presentation of certain line items within the Consolidated Statements of Income, but did not have a material impact to operating income, net income or earnings per share for fiscal year 2018. The [/INST] Negative. </s>

HALLIBURTON CO

2020-02-11

2019-12-31

Item 7 | Executive Overview Business outlook 2019 closed the decade of the shale revolution that transformed the United States into the world's top hydrocarbon producer. Our company was an early participant in this development and invested and innovated alongside our customers since the beginning. As unconventionals enter the maturation phase and as capital spending by our customers has decreased, we remain committed to the North American market and taking appropriate actions to thrive in the new environment. The cost containment measures we took in the fourth quarter of 2019 should benefit our business as we adapt to this dynamic market environment. In North America, the shale industry is facing its biggest challenge since the 2015 downturn with a strong focus on capital discipline. In the fourth quarter of 2019, the market experienced a long-awaited attrition of equipment. More equipment is expected to exit the market in 2020 driven by lower demand and increasing service intensity. After systematically rationalizing and reducing equipment supply in 2019 to adjust to changing activity levels, in 2020 we plan to provide the capacity that maximizes the returns on our overall fleet. We also expect customer spending behavior to remain similar to 2019 in which some operators spend a higher portion of their budgets earlier in the year. With North America customer spending expected to decline again in 2020, we will continue our strategy to maximize returns with an appropriate level of service capacity while continuing to invest in technologies that improve margins. We plan to continue strategic growth opportunities with our non-hydraulic fracturing businesses. Our Wireline and Perforating, Artificial Lift, and Specialty Chemical product lines all produced strong double-digit revenue growth in 2019, despite the overall market softness in U.S. land, and we intend to build on this momentum and spread it to other services. Internationally, we expect a third consecutive year of customer spending growth. We believe we have the right footprint and an enhanced technology portfolio to compete successfully across the international markets. Our pipeline of projects is strong and we expect continued growth in our Drilling and Evaluation division as our iCruise rotary steerable drilling platform roll-out continues, new offshore drilling activity begins around the world, and we operate a full year of our Norway integrated contracts. Pricing in certain international regions is improving, and we expect this momentum to continue in 2020. We are gaining pricing traction on new work and contract renewals, and we are making strategic choices about the work we pursue to deliver returns-driven growth in the international markets. We intend to be prudent with capital allocation with a strategic reallocation of assets to opportunities with better returns, driving the right pricing discussions with customers. We believe that with increased activity, disciplined capital allocation, pricing improvements, and our ability to compete for a larger share of high-margin services, we will achieve international margin expansion. In 2020, we will continue to focus on delivering margin expansion and strong returns and cash flow while continuing to build the foundation for a longer-term recovery. We intend to dynamically respond to the changing market, invest effectively and remain flexible in our cost structure. We believe in responsible capital stewardship, prioritizing capital efficiency, and investing in the technologies that deliver differentiation and returns. We will continue to collaborate and engineer solutions to maximize asset value for our customers and align our business with customers in the fastest growing market segments with attention to the sustainability of our business, minimizing environmental impacts and acting as a responsible corporate citizen. We intend to continue to strengthen our product service lines through a combination of organic growth, investment and selective acquisitions. We plan to continue executing the following strategies in 2020: - prudently allocating capital into strategic markets around the world; - collaborating with, and engineering solutions to maximize asset value for, our customers; - leveraging our broad technology offerings to provide value to our customers and enable them to more efficiently drill and complete their wells; - investing in technology that will help our customers reduce reservoir uncertainty, increase operational efficiency and improve well productivity - as well as help us reduce our costs and deliver acceptable returns; - improving working capital and managing our balance sheet to maximize our financial flexibility; - seeking additional ways to be one of the most cost-efficient service providers in the industry by optimizing costs, maintaining capital discipline and leveraging our scale and breadth of operations; and - striving to achieve superior returns and cash flow generation for our shareholders. Our operating performance and business outlook are described in more detail in “Business Environment and Results of Operations.” HAL 2019 FORM 10-K | 20 Item 7 | Executive Overview Capital expenditures During 2019, our capital expenditures were approximately $1.5 billion, a decrease of 24% from 2018, which were predominantly made in our Sperry Drilling, Production Enhancement, Artificial Lift, Wireline and Perforating, and Production Solutions product service lines. We intend to reduce our capital expenditures by 20% in 2020 to approximately $1.2 billion. We believe this level of spend, approximately 60% of which we plan to allocate to our Completion and Production division, will allow continued investments in our anticipated international growth while continuing to adjust our business to the current conditions in North America. Within this reduced budget, we will continue investing in and growing certain of our businesses, expanding our Artificial Lift footprint, continuing our global roll-out of our iCruise rotary steerable drilling platform, and focusing on digital efforts and new technologies aimed at improving our efficiency and reducing our operating costs. However, the allocation of capital expenditures across business lines may change depending on market conditions. We believe our capital allocation decisions are consistent with our focus on generating strong cash flow for our investors, regardless of the market environment. Financial markets, liquidity and capital resources We believe we have invested our cash balances conservatively and secured sufficient financing to help mitigate any near-term negative impact on our operations from adverse market conditions. As of December 31, 2019, we had $2.3 billion of cash and equivalents and $3.5 billion of available committed bank credit under our revolving credit facility which expires in 2024. We believe this provides us with sufficient liquidity to address the challenges and opportunities of the current market. For additional information on market conditions, see “Liquidity and Capital Resources” and “Business Environment and Results of Operations.” HAL 2019 FORM 10-K | 21 Item 7 | Liquidity and Capital Resources LIQUIDITY AND CAPITAL RESOURCES As of December 31, 2019, we had $2.3 billion of cash and equivalents, compared to $2.0 billion of cash and equivalents at December 31, 2018. Significant sources and uses of cash in 2019 Sources of cash: - Cash flows from operating activities were $2.4 billion. Included within cash flows from operating activities was a negative impact from the primary components of our working capital (receivables, inventories and accounts payable) of a net $161 million, primarily associated with reduced payables and a build-up of inventory related to our strategic technology deployments, coupled with approximately $144 million of severance payments. Uses of cash: - Capital expenditures were $1.5 billion and were predominantly made in our Sperry Drilling, Production Enhancement, Artificial Lift, Wireline and Perforating and Production Solutions product service lines. - We paid $630 million of dividends to our shareholders. - We repurchased approximately 4.5 million shares of our common stock under our share repurchase program at a total cost of approximately $100 million. Future sources and uses of cash We manufacture most of our own equipment, which provides some flexibility to increase or decrease our capital expenditures based on market conditions. Capital spending for 2020 is currently expected to be approximately $1.2 billion, a reduction of approximately 20% from 2019. For additional information on capital expenditures, see “Executive Overview.” We are actively evaluating our debt maturity profile and other opportunities around uses of cash, which could include paying off portions of near-term debt, funding acquisitions and organic growth projects or shareholder return opportunities. Currently, our quarterly dividend rate is $0.18 per common share, or approximately $158 million. Subject to Board of Directors approval, our intention is to continue paying dividends at our current rate during 2020. Our Board of Directors has authorized a program to repurchase our common stock from time to time. Approximately $5.2 billion remained authorized for repurchases as of December 31, 2019 and may be used for open market and other share purchases. Contractual obligations The following table summarizes our significant contractual obligations and other long-term liabilities as of December 31, 2019: (a) Represents principal amounts of long-term debt, including current maturities of debt, which excludes any unamortized debt issuance costs and discounts. (b) Interest on debt includes 77 years of interest on $300 million of debentures at 7.6% interest that become due in 2096. (c) Amount in 2020 primarily represents certain purchase orders for goods and services utilized in the ordinary course of our business. (d) Represents pension funding obligations associated with international plans for 2020 only and are based on assumptions that are subject to change as we are currently not able to reasonably estimate our contributions for years after 2020. Due to the uncertainty with respect to the timing of potential future cash outflows associated with our uncertain tax positions, we are not able to reasonably estimate the period of cash settlement with the respective taxing authorities. Therefore, gross unrecognized tax benefits have been excluded from the contractual obligations table above. We had $425 million of gross HAL 2019 FORM 10-K | 22 Item 7 | Liquidity and Capital Resources unrecognized tax benefits, excluding penalties and interest, at December 31, 2019, of which we estimate $235 million may require a cash payment by us. We estimate that $205 million of the cash payment will not be settled within the next 12 months. Other factors affecting liquidity Financial position in current market. As of December 31, 2019, we had $2.3 billion of cash and equivalents and $3.5 billion of available committed bank credit under our revolving credit facility which expires in 2024. Furthermore, we have no financial covenants or material adverse change provisions in our bank agreements, and our debt maturities extend over a long period of time. We believe our cash on hand, cash flows generated from operations and our available credit facility will provide sufficient liquidity to address the challenges and opportunities of the current market and our global cash needs in 2020, including capital expenditures, working capital investments, dividends, if any, and contingent liabilities. Guarantee agreements. In the normal course of business, we have agreements with financial institutions under which approximately $2.1 billion of letters of credit, bank guarantees, or surety bonds were outstanding as of December 31, 2019. Some of the outstanding letters of credit have triggering events that would entitle a bank to require cash collateralization. Credit ratings. Our credit ratings with Standard & Poor’s (S&P) remain A- for our long-term debt and A-2 for our short-term debt, with a negative outlook. Our credit ratings with Moody’s Investors Service (Moody's) remain Baa1 for our long-term debt and P-2 for our short-term debt, with a stable outlook. Customer receivables. In line with industry practice, we bill our customers for our services in arrears and are, therefore, subject to our customers delaying or failing to pay our invoices. In weak economic environments, we may experience increased delays and failures to pay our invoices due to, among other reasons, a reduction in our customers’ cash flow from operations and their access to the credit markets, as well as unsettled political conditions. If our customers delay paying or fail to pay us a significant amount of our outstanding receivables, it could have a material adverse effect on our liquidity, consolidated results of operations and consolidated financial condition. See Note 5 to the consolidated financial statements for further discussion. HAL 2019 FORM 10-K | 23 Item 7 | Business Environment and Results of Operations BUSINESS ENVIRONMENT AND RESULTS OF OPERATIONS We operate in more than 80 countries throughout the world to provide a comprehensive range of services and products to the energy industry. Our revenue is generated from the sale of services and products to major, national, and independent oil and natural gas companies worldwide. The industry we serve is highly competitive with many substantial competitors in each segment of our business. In 2019, 2018 and 2017, based on the location of services provided and products sold, 51%, 58% and 53%, respectively, of our consolidated revenue was from the United States. No other country accounted for more than 10% of our revenue. Operations in some countries may be adversely affected by unsettled political conditions, acts of terrorism, civil unrest, force majeure, war or other armed conflict, health or similar issues, sanctions, expropriation or other governmental actions, inflation, changes in foreign currency exchange rates, foreign currency exchange restrictions and highly inflationary currencies, as well as other geopolitical factors. We believe the geographic diversification of our business activities reduces the risk that an interruption of operations in any one country, other than the United States, would be materially adverse to our consolidated results of operations. Activity within our business segments is significantly impacted by spending on upstream exploration, development and production programs by our customers. Also impacting our activity is the status of the global economy, which impacts oil and natural gas consumption. Some of the more significant determinants of current and future spending levels of our customers are oil and natural gas prices and our customers' expectations about future prices, global oil supply and demand, completions intensity, the world economy, the availability of credit, government regulation and global stability, which together drive worldwide drilling and completions activity. Additionally, many of our customers in North America have shifted their strategy from production growth to operating within cash flow and generating returns. Lower oil and natural gas prices usually translate into lower exploration and production budgets and lower rig count, while the opposite is usually true for higher oil and natural gas prices. Our financial performance is therefore significantly affected by oil and natural gas prices and worldwide rig activity, which are summarized in the tables below. The following table shows the average oil and natural gas prices for West Texas Intermediate (WTI), United Kingdom Brent crude oil and Henry Hub natural gas: The historical average rig counts based on the weekly Baker Hughes rig count data were as follows: HAL 2019 FORM 10-K | 24 Item 7 | Business Environment and Results of Operations Crude oil prices have been extremely volatile over the past five years. WTI oil spot prices declined significantly beginning in 2014 from a peak price of $108 per barrel in June 2014 to a low of $26 per barrel in February 2016, a level which had not been experienced since 2003. Since the low point experienced in early 2016, oil prices increased substantially, with WTI oil spot prices reaching a high of $77 per barrel in June 2018. In late 2018, oil prices again declined with WTI oil spot prices reaching a low of $44 per barrel in December, but rising to a high of $66 per barrel in April 2019. The average full year 2019 WTI crude oil spot price of $57 decreased 12% from the average 2018 price. In the United States Energy Information Administration (EIA) January 2020 "Short Term Energy Outlook," the EIA projected Brent prices to average $65 per barrel in 2020 and $68 per barrel in 2021, while WTI prices were projected to average approximately $5.50 less per barrel through 2020 and 2021. The International Energy Agency's (IEA) January 2020 "Oil Market Report" forecasts 2020 global demand to average approximately 101.5 million barrels per day, an increase of 1% from 2019, driven by increases in the Asia Pacific region, while all other regions remain approximately the same. The Henry Hub natural gas spot price in the United States averaged $2.54 per MMBtu in 2019, a decrease of $0.63 per MMBtu, or 20%, from 2018. The EIA January 2020 “Short Term Energy Outlook” projects Henry Hub natural gas prices to average $2.33 per MMBtu in 2020 and some upward price pressures to emerge in 2021 causing the average price to increase to $2.54 per MMBtu. North America operations The average North America rig count decreased 146 rigs, or 12%, for the full year 2019 as compared to 2018. The market for both drilling and completion services softened during the second half of 2019 with a continued reduction in activity as customers were focused on staying within their capital spending budgets. Some of the other factors leading to activity reductions included an oversupplied gas market and concerns about oil demand softness. In 2020, based on current information, we expect customers in U.S. land to reduce capital spending by approximately 10% from 2019 levels. International operations The average international rig count for 2019 increased 110 rigs, or 11% compared to 2018. We continue to see a broad-based recovery across numerous international geographies, and we expect more revenue and margin growth opportunities coming from mature fields and shallow water markets in 2020. Barring a global economic slowdown, broader offshore recovery should add momentum to the international growth. In 2020, we expect the international spend by our customers to slightly increase, making it the third consecutive year of spending growth. Venezuela. The general license issued by the Office of Foreign Assets Control (OFAC) of the U.S. Department of Treasury, which allows us to continue operating in Venezuela despite OFAC sanctions imposed against the Venezuelan energy industry, was set to expire on July 27, 2019, but has been extended several times and is now set to expire on April 22, 2020. Consequently, unless OFAC further extends the term of the general license, we will cease operations in Venezuela on that date in order to comply with the sanctions. In that event, it is unlikely that we will be able to remove our assets that remain in Venezuela and those assets may be expropriated. Since we have previously written down all of our investment in Venezuela and have maintained limited operations in this country during the general license period, we do not expect the expiration of the license to have a material adverse effect on our business, consolidated results of operations and consolidated financial condition. HAL 2019 FORM 10-K | 25 Item 7 | Results of Operations in 2019 Compared to 2018 RESULTS OF OPERATIONS IN 2019 COMPARED TO 2018 Consolidated revenue in 2019 was $22.4 billion, a decrease of $1.6 billion, or 7%, compared to 2018, primarily due to lower activity and pricing in North America land, primarily associated with stimulation services and well construction. Revenue from North America was 53% of consolidated revenue in 2019 and 60% of consolidated revenue in 2018. We reported a consolidated operating loss of $448 million in 2019 driven by $2.5 billion of impairments and other charges. This compares to operating income of $2.5 billion in 2018, which includes $265 million of impairments and other charges related to Venezuela. A significant decline in stimulation activity and pricing in North America land during 2019 negatively impacted operating results, coupled with reduced drilling activity in the Middle East. See Note 2 to the consolidated financial statements for further discussion on impairments and other charges. OPERATING SEGMENTS Completion and Production Completion and Production revenue was $14.0 billion in 2019, a decrease of $1.9 billion, or 12%, compared to 2018. Operating income was $1.7 billion in 2019, a 27% decrease from $2.3 billion in 2018. These results were primarily driven by reduced activity and pricing for stimulation services and lower completion tool sales in North America land. Partially offsetting these results were increased artificial lift activity in North America land, higher completion tool sales in the Gulf of Mexico, increased pressure pumping activity and higher completion tool sales in the Eastern Hemisphere, and higher pressure pumping activity in Latin America. Drilling and Evaluation Drilling and Evaluation revenue was $8.4 billion in 2019, an increase of $355 million, or 4%, from 2018. These results were primarily driven by a global increase in wireline activity, increased activity in multiple product service lines in the North Sea and Mexico, coupled with improved drilling activity in Asia Pacific and higher testing activity in the Eastern Hemisphere. These improvements were partially offset by decreased activity for drilling-related services in North America land and lower project management activity in the Middle East. HAL 2019 FORM 10-K | 26 Item 7 | Results of Operations in 2019 Compared to 2018 Operating income was $642 million in 2019, a decrease of $103 million, or 14%, compared to 2018. These results were primarily driven by a decline in drilling activity in North America land, coupled with lower project management and drilling activity in the Middle East. Partially offsetting these results were global improvements in wireline activity and increased drilling-related services in Europe/Africa/CIS. GEOGRAPHIC REGIONS North America North America revenue was $11.9 billion in 2019, an 18% decrease compared to 2018, resulting from lower activity and pricing in North America land, primarily associated with stimulation and drilling-related activity. This decline was partially offset by increased artificial lift activity in North America land and improved completion tool sales in the Gulf of Mexico. Latin America Latin America revenue was $2.4 billion in 2019, a 14% increase compared to 2018, resulting primarily from increased activity in multiple product service lines in Mexico and Argentina, partially offset by decreased well construction activity in Brazil. Europe/Africa/CIS Europe/Africa/CIS revenue was $3.3 billion in 2019, a 12% increase compared to 2018. The increases were due to higher activity for multiple product service lines throughout the region, primarily in the North Sea, Israel and Russia, partially offset by decreased pipeline services across the region. Middle East/Asia Middle East/Asia revenue was $4.9 billion in 2019, a 7% increase compared to 2018. The increases were due to higher activity throughout the region, primarily related to pressure pumping, completion tool sales and wireline activity, partially offset by decreased drilling activity and project management activity in the Middle East. OTHER OPERATING ITEMS Impairments and other charges were $2.5 billion in 2019, consisting of asset impairments, primarily associated with pressure pumping and drilling equipment, as well as severance and other costs incurred as we adjusted our cost structure during the year. This compares to $265 million of impairments and other charges recorded in 2018, representing a write-down of all of our remaining investment in Venezuela. See Note 2 to the consolidated financial statements for further discussion on these charges. NONOPERATING ITEMS Effective tax rate. During 2019, we recorded a total income tax provision of $7 million on a pre-tax loss of $1.1 billion, resulting in an effective tax rate of -0.6%. During 2018, we recorded a total income tax provision $157 million on pre-tax income of $1.8 billion, resulting in an effective tax rate of 8.7%. See Note 11 to the consolidated financial statements for significant drivers of these effective tax rates. HAL 2019 FORM 10-K | 27 Item 7 | Results of Operations in 2018 Compared to 2017 RESULTS OF OPERATIONS IN 2018 COMPARED TO 2017 Information related to the comparison of our operating results between the years 2018 and 2017 is included in "Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations" of our 2018 Form 10-K filed with the SEC and is incorporated by reference into this annual report on Form 10-K. HAL 2019 FORM 10-K | 28 Item 7 | Critical Accounting Estimates CRITICAL ACCOUNTING ESTIMATES The preparation of financial statements requires the use of judgments and estimates. Our critical accounting policies are described below to provide a better understanding of how we develop our assumptions and judgments about future events and related estimates and how they can impact our financial statements. A critical accounting estimate is one that requires our most difficult, subjective or complex judgments and assessments and is fundamental to our results of operations. We identified our most critical accounting estimates to be: - forecasting our effective income tax rate, including our future ability to utilize foreign tax credits and the realizability of deferred tax assets (including net operating loss carryforwards), and providing for uncertain tax positions; - legal and investigation matters; - valuations of long-lived assets, including intangible assets and goodwill; - purchase price allocation for acquired businesses; and - allowance for bad debts. We base our estimates on historical experience and on various other assumptions we believe to be reasonable according to the current facts and circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. We believe the following are the critical accounting policies used in the preparation of our consolidated financial statements, as well as the significant estimates and judgments affecting the application of these policies. This discussion and analysis should be read in conjunction with our consolidated financial statements and related notes included in this report. Income tax accounting We recognize the amount of taxes payable or refundable for the current year and use an asset and liability approach in recognizing the amount of deferred tax liabilities and assets for the future tax consequences of events that have been recognized in our financial statements or tax returns. We apply the following basic principles in accounting for our income taxes: - a current tax liability or asset is recognized for the estimated taxes payable or refundable on tax returns for the current year; - a deferred tax liability or asset is recognized for the estimated future tax effects attributable to temporary differences and carryforwards; - the measurement of current and deferred tax liabilities and assets is based on provisions of the enacted tax law, and the effects of potential future changes in tax laws or rates are not considered; and - the value of deferred tax assets is reduced, if necessary, by the amount of any tax benefits that, based on available evidence, are not expected to be realized. We determine deferred taxes separately for each tax-paying component (an entity or a group of entities that is consolidated for tax purposes) in each tax jurisdiction. That determination includes the following procedures: - identifying the types and amounts of existing temporary differences; - measuring the total deferred tax liability for taxable temporary differences using the applicable tax rate; - measuring the total deferred tax asset for deductible temporary differences and operating loss carryforwards using the applicable tax rate; - measuring the deferred tax assets for each type of tax credit carryforward; and - reducing the deferred tax assets by a valuation allowance if, based on available evidence, it is more likely than not that some portion or all of the deferred tax assets will not be realized. Our methodology for recording income taxes requires a significant amount of judgment in the use of assumptions and estimates. Additionally, we use forecasts of certain tax elements, such as taxable income and foreign tax credit utilization, as well as evaluate the feasibility of implementing tax planning strategies. Given the inherent uncertainty involved with the use of such variables, there can be significant variation between anticipated and actual results. Unforeseen events may significantly impact these variables, and changes to these variables could have a material impact on our income tax accounts related to both continuing and discontinued operations. HAL 2019 FORM 10-K | 29 Item 7 | Critical Accounting Estimates We have operations in more than 80 countries. Consequently, we are subject to the jurisdiction of a significant number of taxing authorities. The income earned in these various jurisdictions is taxed on differing bases, including net income actually earned, net income deemed earned and revenue-based tax withholding. Our tax filings are routinely examined in the normal course of business by tax authorities. The final determination of our income tax liabilities involves the interpretation of local tax laws, tax treaties and related authorities in each jurisdiction, as well as the significant use of estimates and assumptions regarding the scope of future operations and results achieved and the timing and nature of income earned and expenditures incurred. The final determination of tax audits or changes in the operating environment, including changes in tax law and currency/repatriation controls, could impact the determination of our income tax liabilities for a tax year and have an adverse effect on our financial statements. Tax filings of our subsidiaries, unconsolidated affiliates and related entities are routinely examined in the normal course of business by tax authorities. These examinations may result in assessments of additional taxes, which we work to resolve with the tax authorities and through the judicial process. Predicting the outcome of disputed assessments involves some uncertainty. Factors such as the availability of settlement procedures, willingness of tax authorities to negotiate and the operation and impartiality of judicial systems vary across the different tax jurisdictions and may significantly influence the ultimate outcome. We review the facts for each assessment, and then utilize assumptions and estimates to determine the most likely outcome and provide taxes, interest and penalties as needed based on this outcome. We provide for uncertain tax positions pursuant to current accounting standards, which prescribe a minimum recognition threshold and measurement methodology that a tax position taken or expected to be taken in a tax return is required to meet before being recognized in the financial statements. The standards also provide guidance for derecognition classification, interest and penalties, accounting in interim periods, disclosure and transition. Legal and investigation matters As discussed in Note 10 of our consolidated financial statements, we are subject to various legal and investigation matters arising in the ordinary course of business. As of December 31, 2019, we have accrued an estimate of the probable and estimable costs for the resolution of some of our legal and investigation matters, which is not material to our consolidated financial statements. For other matters for which the liability is not probable and reasonably estimable, we have not accrued any amounts. Attorneys in our legal department monitor and manage all claims filed against us and review all pending investigations. Generally, the estimate of probable costs related to these matters is developed in consultation with internal and outside legal counsel representing us. Our estimates are based upon an analysis of potential results, assuming a combination of litigation and settlement strategies. The accuracy of these estimates is impacted by, among other things, the complexity of the issues and the amount of due diligence we have been able to perform. We attempt to resolve these matters through settlements, mediation and arbitration proceedings when possible. If the actual settlement costs, final judgments or fines, after appeals, differ from our estimates, there may be a material adverse effect on our future financial results. We have in the past recorded significant adjustments to our initial estimates of these types of contingencies. Value of long-lived assets, including intangible assets and goodwill We carry a variety of long-lived assets on our balance sheet including property, plant and equipment, goodwill and other intangibles. Impairment is the condition that exists when the carrying amount of a long-lived asset exceeds its fair value, and any impairment charge that we record reduces our operating income. Goodwill is the excess of the cost of an acquired entity over the net of the amounts assigned to assets acquired and liabilities assumed. We conduct impairment tests on goodwill annually, during the third quarter, or more frequently whenever events or changes in circumstances indicate an impairment may exist. We conduct impairment tests on long-lived assets, other than goodwill, whenever events or changes in circumstances indicate that the carrying value may not be recoverable. When conducting an impairment test on long-lived assets, other than goodwill, we first group individual assets based on a the lowest level for which identifiable cash flows are largely independent of the cash flows from other assets, which requires some judgment. We then compare estimated future undiscounted cash flows expected to result from the use and eventual disposition of the asset group to its carrying amount. If the undiscounted cash flows are less than the asset group’s carrying amount, we then determine the asset group's fair value by using a discounted cash flow analysis. This analysis is based on estimates such as management’s short-term and long-term forecast of operating performance, including revenue growth rates and expected profitability margins, estimates of the remaining useful life and service potential of the assets within the asset group, and a discount rate based on our weighted average cost of capital. An impairment loss is measured and recorded as the amount by which the asset group's carrying amount exceeds its fair value. See Note 2 to the consolidated financial statements for impairments and other charges recorded during the year ended December 31, 2019. HAL 2019 FORM 10-K | 30 Item 7 | Critical Accounting Estimates We perform our goodwill impairment assessment for each reporting unit, which is the same as our reportable segments, the Completion and Production division and the Drilling and Evaluation division, comparing the estimated fair value of each reporting unit to the reporting unit’s carrying value, including goodwill. We estimate the fair value for each reporting unit using a discounted cash flow analysis based on management’s short-term and long-term forecast of operating performance. This analysis includes significant assumptions regarding discount rates, revenue growth rates, expected profitability margins, forecasted capital expenditures and the timing of expected future cash flows based on market conditions. If the estimated fair value of a reporting unit exceeds its carrying amount, goodwill of the reporting unit is not considered impaired. If the carrying amount of a reporting unit exceeds its estimated fair value, an impairment loss is measured and recorded. The impairment assessments discussed above incorporate inherent uncertainties, including projected commodity pricing, supply and demand for our services and future market conditions, which are difficult to predict in volatile economic environments and could result in impairment charges in future periods if actual results materially differ from the estimated assumptions utilized in our forecasts. If market conditions further deteriorate, including crude oil prices significantly declining and remaining at low levels for a sustained period of time, we could be required to record additional impairments of the carrying value of our long-lived assets in the future which could have a material adverse impact on our operating results. See Note 1 to the consolidated financial statements for our accounting policies related to long-lived assets. Acquisitions - purchase price allocation We allocate the purchase price of an acquired business to its identifiable assets and liabilities based on estimated fair values. The excess of the purchase price over the amount allocated to the assets and liabilities, if any, is recorded as goodwill. We use all available information to estimate fair values, including quoted market prices, the carrying value of acquired assets and widely accepted valuation techniques such as discounted cash flows. We engage third-party appraisal firms when appropriate to assist in fair value determination of inventories, identifiable intangible assets and any other significant assets or liabilities. The judgments made in determining the estimated fair value assigned to each class of assets acquired and liabilities assumed, as well as asset lives, can materially impact our results of operations. Our acquisitions may also include contingent consideration, or earn-out provisions, which provide for additional consideration to be paid to the seller if certain future conditions are met. These earn-out provisions are estimated and recognized at fair value at the acquisition date based on projected earnings or other financial metrics over specified periods after the acquisition date. These estimates are reviewed during the specified period and adjusted based on actual results. Allowance for bad debts We evaluate our global accounts receivable through a continuous process of assessing our portfolio on an individual customer and overall basis. This process consists of a thorough review of historical collection experience, current aging status of the customer accounts, financial condition of our customers and whether the receivables involve retainages. We also consider the economic environment of our customers, both from a marketplace and geographic perspective, in evaluating the need for an allowance. Based on our review of these factors, we establish or adjust allowances for specific customers. This process involves a high degree of judgment and estimation, and frequently involves significant dollar amounts. Accordingly, our results of operations can be affected by adjustments to the allowance due to actual write-offs that differ from estimated amounts. At December 31, 2019, our allowance for bad debts totaled $776 million, or 15.4% of notes and accounts receivable before the allowance. At December 31, 2018, our allowance for bad debts totaled $738 million, or 12.8% of notes and accounts receivable before the allowance. The allowance for bad debts in both years is primarily comprised of accounts receivable with our primary customer in Venezuela. A hypothetical 100 basis point change in our estimate of the collectability of our notes and accounts receivable balance as of December 31, 2019 would have resulted in a $51 million adjustment to 2019 total operating costs and expenses. See Note 5 to the consolidated financial statements for further information. OFF BALANCE SHEET ARRANGEMENTS At December 31, 2019, we had no material off balance sheet arrangements. In the normal course of business, we have agreements with financial institutions under which approximately $2.1 billion of letters of credit, bank guarantees or surety bonds were outstanding as of December 31, 2019. Some of the outstanding letters of credit have triggering events that would entitle a bank to require cash collateralization. None of these off balance sheet arrangements either has, or is likely to have, a material effect on our consolidated financial statements. HAL 2019 FORM 10-K | 31 Item 7 | Financial Instrument Market Risk FINANCIAL INSTRUMENT MARKET RISK We are exposed to market risk from changes in foreign currency exchange rates and interest rates. We selectively manage these exposures through the use of derivative instruments, including forward foreign exchange contracts, foreign exchange options and interest rate swaps. The objective of our risk management strategy is to minimize the volatility from fluctuations in foreign currency and interest rates. We do not use derivative instruments for trading purposes. The counterparties to our forward contracts, options and interest rate swaps are global commercial and investment banks. We use a sensitivity analysis model to measure the impact of potential adverse movements in foreign currency exchange rates and interest rates. With respect to foreign exchange sensitivity, after consideration of the impact from our foreign exchange hedges, a hypothetical 10% adverse change in the value of all our foreign currency positions relative to the United States dollar as of December 31, 2019 would result in a $91 million, pre-tax, loss for our net monetary assets denominated in currencies other than United States dollars. With respect to interest rates sensitivity, after consideration of the impact from our interest rate swap, a hypothetical 100 basis point increase in the LIBOR rate would result in approximately an additional $1 million of interest charges for the year ended December 31, 2019. There are certain limitations inherent in the sensitivity analyses presented, primarily due to the assumption that exchange rates and interest rates change instantaneously in an equally adverse fashion. In addition, the analyses are unable to reflect the complex market reactions that normally would arise from the market shifts modeled. While this is our best estimate of the impact of the various scenarios, these estimates should not be viewed as forecasts. For further information regarding foreign currency exchange risk, interest rate risk and credit risk, see Note 15 to the consolidated financial statements. ENVIRONMENTAL MATTERS We are subject to numerous environmental, legal and regulatory requirements related to our operations worldwide. For information related to environmental matters, see Note 10 to the consolidated financial statements and "Part I, Item 1(a). “Risk Factors.” FORWARD-LOOKING INFORMATION The Private Securities Litigation Reform Act of 1995 provides safe harbor provisions for forward-looking information. Forward-looking information is based on projections and estimates, not historical information. Some statements in this Form 10-K are forward-looking and use words like “may,” “may not,” “believe,” “do not believe,” “plan,” “estimate,” “intend,” “expect,” “do not expect,” “anticipate,” “do not anticipate,” “should,” “likely” and other expressions. We may also provide oral or written forward-looking information in other materials we release to the public. Forward-looking information involves risk and uncertainties and reflects our best judgment based on current information. Our results of operations can be affected by inaccurate assumptions we make or by known or unknown risks and uncertainties. In addition, other factors may affect the accuracy of our forward-looking information. As a result, no forward-looking information can be guaranteed. Actual events and the results of our operations may vary materially. We do not assume any responsibility to publicly update any of our forward-looking statements regardless of whether factors change as a result of new information, future events or for any other reason. You should review any additional disclosures we make in our press releases and Forms 10-K, 10-Q and 8-K filed with or furnished to the SEC. We also suggest that you listen to our quarterly earnings release conference calls with financial analysts. HAL 2019 FORM 10-K | 32 Item 7(a) | Quantitative and Qualitative Disclosures About Market Risk Item 7(a). Quantitative and Qualitative Disclosures About Market Risk. Information related to market risk is included in "Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations - Financial Instrument Market Risk” and Note 15 to the consolidated financial statements. HAL 2019 FORM 10-K | 33

<s>[INST] 2019 closed the decade of the shale revolution that transformed the United States into the world's top hydrocarbon producer. Our company was an early participant in this development and invested and innovated alongside our customers since the beginning. As unconventionals enter the maturation phase and as capital spending by our customers has decreased, we remain committed to the North American market and taking appropriate actions to thrive in the new environment. The cost containment measures we took in the fourth quarter of 2019 should benefit our business as we adapt to this dynamic market environment. In North America, the shale industry is facing its biggest challenge since the 2015 downturn with a strong focus on capital discipline. In the fourth quarter of 2019, the market experienced a longawaited attrition of equipment. More equipment is expected to exit the market in 2020 driven by lower demand and increasing service intensity. After systematically rationalizing and reducing equipment supply in 2019 to adjust to changing activity levels, in 2020 we plan to provide the capacity that maximizes the returns on our overall fleet. We also expect customer spending behavior to remain similar to 2019 in which some operators spend a higher portion of their budgets earlier in the year. With North America customer spending expected to decline again in 2020, we will continue our strategy to maximize returns with an appropriate level of service capacity while continuing to invest in technologies that improve margins. We plan to continue strategic growth opportunities with our nonhydraulic fracturing businesses. Our Wireline and Perforating, Artificial Lift, and Specialty Chemical product lines all produced strong doubledigit revenue growth in 2019, despite the overall market softness in U.S. land, and we intend to build on this momentum and spread it to other services. Internationally, we expect a third consecutive year of customer spending growth. We believe we have the right footprint and an enhanced technology portfolio to compete successfully across the international markets. Our pipeline of projects is strong and we expect continued growth in our Drilling and Evaluation division as our iCruise rotary steerable drilling platform rollout continues, new offshore drilling activity begins around the world, and we operate a full year of our Norway integrated contracts. Pricing in certain international regions is improving, and we expect this momentum to continue in 2020. We are gaining pricing traction on new work and contract renewals, and we are making strategic choices about the work we pursue to deliver returnsdriven growth in the international markets. We intend to be prudent with capital allocation with a strategic reallocation of assets to opportunities with better returns, driving the right pricing discussions with customers. We believe that with increased activity, disciplined capital allocation, pricing improvements, and our ability to compete for a larger share of highmargin services, we will achieve international margin expansion. In 2020, we will continue to focus on delivering margin expansion and strong returns and cash flow while continuing to build the foundation for a longerterm recovery. We intend to dynamically respond to the changing market, invest effectively and remain flexible in our cost structure. We believe in responsible capital stewardship, prioritizing capital efficiency, and investing in the technologies that deliver differentiation and returns. We will continue to collaborate and engineer solutions to maximize asset value for our customers and align our business with customers in the fastest growing market segments with attention to the sustainability of our business, minimizing environmental impacts and acting as a responsible corporate citizen. We intend to continue to strengthen our product service lines through a combination of organic growth, investment and selective acquisitions. We plan to continue executing the following strategies in 2020: prudently allocating capital into strategic markets around the world; collaborating with, and engineering solutions to maximize asset value for, our customers; leveraging our broad technology offerings to provide value to our customers and enable them to more efficiently drill and complete their wells; investing in technology that will help our customers reduce reservoir uncertainty, increase operational efficiency and improve well productivity as well as help us reduce our costs and deliver acceptable returns; improving working capital and managing our balance sheet to maximize our financial flexibility; seeking additional ways to be one of the most costefficient service providers in the industry by optimizing costs, maintaining capital discipline and leveraging our scale and breadth of operations [/INST] Positive. </s>

MARTEN TRANSPORT LTD

2015-03-12

2014-12-31

ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The following discussion and analysis of our financial condition and results of operations should be read together with the selected consolidated financial data and our consolidated financial statements and the related notes appearing elsewhere in this report. This discussion and analysis contains forward-looking statements that involve risks, uncertainties and assumptions. Our actual results may differ materially from those anticipated in these forward-looking statements as a result of many factors, including but not limited to those under the heading “Risk Factors” beginning on page 7. We do not assume, and specifically disclaim, any obligation to update any forward-looking statement contained in this report. Overview The primary source of our operating revenue is provided by our Truckload segment through a combination of regional short-haul and medium-to-long-haul full-load transportation services. We transport food and other consumer packaged goods that require a temperature-controlled or insulated environment across the United States and into and out of Mexico and Canada. Our Dedicated segment provides customized transportation solutions tailored to meet individual customers’ requirements, utilizing temperature-controlled trailers, dry vans and other specialized equipment within the United States. Our customer contracts range from three to five years and are subject to annual rate reviews. Generally, we are paid by the mile for our Truckload and Dedicated services. We also derive Truckload and Dedicated revenue from fuel surcharges, loading and unloading activities, equipment detention and other ancillary services. The main factors that affect our Truckload and Dedicated revenue are the rate per mile we receive from our customers, the percentage of miles for which we are compensated, the number of miles we generate with our equipment and changes in fuel prices. We monitor our revenue production primarily through average Truckload and Dedicated revenue, net of fuel surcharges, per tractor per week. We also analyze our average Truckload and Dedicated revenue, net of fuel surcharges, per total mile, non-revenue miles percentage, the miles per tractor we generate, our fuel surcharge revenue, our accessorial revenue and our other sources of operating revenue. Our Intermodal segment transports our customers’ freight within the United States primarily utilizing our temperature-controlled trailers and also our dry containers on railroad flatcars for portions of trips, with the balance of the trips using our tractors or, to a lesser extent, contracted carriers. The main factors that affect our Intermodal revenue are the rate per mile and other charges we receive from our customers. Our Brokerage segment arranges for smaller third-party carriers to transport freight for our customers in temperature-controlled trailers and dry vans within the United States and into and out of Mexico while we retain the billing, collection and customer management responsibilities. The main factors that affect our Brokerage revenue are the rate per mile and other charges we receive from our customers. Our Brokerage segment also included the revenue of MWL, a third-party provider of logistics services to the transportation industry, until we deconsolidated our 45% interest in MWL effective March 28, 2013. In addition to the factors discussed above, our operating revenue is also affected by, among other things, the United States economy, inventory levels, the level of truck and rail capacity in the transportation market, a contracting driver market, severe weather conditions and specific customer demand. Our operating revenue increased $13.7 million, or 2.1%, in 2014. Our operating revenue, net of fuel surcharges and MWL revenue, increased $22.9 million, or 4.4%, compared with 2013. Truckload segment revenue, net of fuel surcharges, decreased 2.3% primarily due to a decrease in our average fleet size of 6.3% from 2013, partially offset by an increase in our average Truckload revenue, net of fuel surcharges, per tractor per week of 4.2%. The increase in our average revenue per tractor was primarily due to an increase in our average rate per mile. Dedicated segment revenue, net of fuel surcharges, increased 68.9% primarily due to an increase in our average fleet size of 73.0%, partially offset by a 2.2% decrease in our average Dedicated revenue, net of fuel surcharges, per tractor per week from 2013. Intermodal segment revenue, net of fuel surcharges, increased 5.1% due to continued volume growth in our Intermodal services. Marten Transport Brokerage revenue increased $4.5 million in 2014 due to an increase in volume. With the March 28, 2013 deconsolidation of MWL, MWL revenue included in our Brokerage segment decreased $6.7 million in 2014. Fuel surcharge revenue decreased to $125.2 million in 2014 from $127.7 million in 2013. Our profitability is impacted by the variable costs of transporting freight for our customers, fixed costs, and expenses containing both fixed and variable components. The variable costs include fuel expense, driver-related expenses, such as wages, benefits, training, and recruitment, and independent contractor costs, which are recorded under purchased transportation. Expenses that have both fixed and variable components include maintenance and tire expense and our cost of insurance and claims. These expenses generally vary with the miles we travel, but also have a controllable component based on safety, fleet age, efficiency and other factors. Our main fixed costs relate to the acquisition of long-term assets, such as revenue equipment and operating terminals. We expect our annual cost of tractor and trailer ownership will increase in future periods as a result of higher prices of new equipment. Although certain factors affecting our expenses are beyond our control, we monitor them closely and attempt to anticipate changes in these factors in managing our business. For example, fuel prices have significantly fluctuated over the past several years. We manage our exposure to changes in fuel prices primarily through fuel surcharge programs with our customers, as well as through volume fuel purchasing arrangements with national fuel centers and bulk purchases of fuel at our terminals. To help further reduce fuel expense, we have installed and tightly manage the use of auxiliary power units in our tractors to provide climate control and electrical power for our drivers without idling the tractor engine, and also have improved the fuel usage in the temperature-control units on our trailers. For our Intermodal and Brokerage segments, our profitability is impacted by the percentage of revenue we pay to providers for the transportation services we arrange, which is included within purchased transportation in our consolidated statements of operations. Our operating expenses as a percentage of operating revenue, or “operating ratio,” increased to 92.4% in 2014 from 92.1% in 2013. Operating expenses as a percentage of operating revenue, with both amounts net of fuel surcharge revenue, increased to 90.7% in 2014 from 90.2% in 2013. Our net income decreased to $29.8 million in 2014 from $30.1 million in 2013. The decrease in profitability in 2014 was primarily caused by the impact of the severe weather conditions in the first quarter of 2014 on both freight volumes and operating costs, costs associated with rail service interruption and delay issues that constrained our Intermodal operations and an intensification of the most severe driver shortage in the history of our industry, partially offset by the increase in our average Truckload revenue per tractor. Our business requires substantial, ongoing capital investments, particularly for new tractors and trailers. At December 31, 2014, we had $24.4 million of long-term debt outstanding and $387.9 million in stockholders’ equity. In 2014, net cash flows provided by operating activities of $82.0 million, borrowings under our credit facility of $24.4 million, and cash and cash equivalents of $13.5 million were primarily used to purchase new revenue equipment, net of proceeds from dispositions, in the amount of $87.7 million, to acquire and partially construct regional operating facilities in the amount of $27.4 million, and to pay cash dividends of $3.3 million. We estimate that capital expenditures, net of proceeds from dispositions, will be approximately $110 million in 2015. We believe our sources of liquidity are adequate to meet our current and anticipated needs for at least the next twelve months. Based upon anticipated cash flows, existing cash and cash equivalents balances, current borrowing availability and other sources of financing we expect to be available to us, we do not anticipate any significant liquidity constraints in the foreseeable future. We have transformed our business strategy to a multifaceted set of transportation service solutions, primarily regional Truckload temperature-controlled operations along with Dedicated, Intermodal and Brokerage services, while developing a diverse customer base that gains value from and expands each of these operating segments. We believe that we are well-positioned regardless of the economic environment with this transformation of our services combined with our competitive position, cost control emphasis, modern fleet and strong balance sheet. This Management’s Discussion and Analysis of Financial Condition and Results of Operations includes discussions of operating revenue, net of fuel surcharge revenue and MWL revenue; Truckload, Dedicated and Intermodal revenue net of fuel surcharge revenue; operating expenses as a percentage of operating revenue, each net of fuel surcharge revenue; and net fuel expense (fuel and fuel taxes net of fuel surcharge revenue and surcharges passed through to independent contractors, outside drayage carriers and railroads). We provide these additional disclosures because management believes these measures provide a more consistent basis for comparing results of operations from period to period. These financial measures in this report have not been determined in accordance with U.S. generally accepted accounting principles (GAAP). Pursuant to Item 10(e) of Regulation S-K, we have included the amounts necessary to reconcile these non-GAAP financial measures to the most directly comparable GAAP financial measures of operating revenue, operating expenses divided by operating revenue, and fuel and fuel taxes. Stock Split On June 14, 2013, we effected a three-for-two stock split of our common stock, $.01 par value, in the form of a 50% stock dividend. Our consolidated financial statements, related notes, and other financial data contained in this report have been adjusted to give retroactive effect to the stock split for all periods presented. Results of Operations The following table sets forth for the years indicated certain operating statistics regarding our revenue and operations: (1) Includes tractors driven by both company-employed drivers and independent contractors. Independent contractors provided 52, 49 and 36 tractors as of December 31, 2014, 2013 and 2012, respectively. Comparison of Year Ended December 31, 2014 to Year Ended December 31, 2013 The following table sets forth for the years indicated our operating revenue, operating income and operating ratio by segment, along with the change for each component: (1) Brokerage revenue is net of $2.1 million of inter-segment revenue in 2013 for loads transported by our tractors and arranged by MWL that have been eliminated in consolidation. The inter-segment revenue in 2013 relates to loads transported prior to the deconsolidation of MWL effective March 28, 2013. (2) Represents operating expenses as a percentage of operating revenue. Our operating revenue increased $13.7 million, or 2.1%, to $672.9 million in 2014 from $659.2 million in 2013. Our operating revenue, net of fuel surcharges and MWL revenue, increased $22.9 million, or 4.4%, to $547.7 million in 2014 from $524.8 million in 2013. This increase was primarily due to a $23.1 million increase in Dedicated revenue, net of fuel surcharges. Fuel surcharge revenue decreased to $125.2 million in 2014 from $127.7 million in 2013. Truckload segment revenue decreased $16.7 million, or 3.6%, to $448.3 million in 2014 from $465.0 million in 2013. Truckload segment revenue, net of fuel surcharges, decreased 2.3% primarily due to a decrease in our average fleet size of 6.3% from 2013, partially offset by an increase in our average revenue, net of fuel surcharges, per tractor per week of 4.2%. The increase in our average revenue per tractor was primarily due to an increase in our average rate per mile. The increase in profitability in 2014 was due to an increase in our average revenue per tractor, partially offset by the impact of severe weather conditions in the first quarter of 2014 on both freight volumes and operating costs. Dedicated segment revenue increased $28.0 million, or 66.2%, to $70.4 million in 2014 from $42.3 million in 2013. Dedicated segment revenue, net of fuel surcharges, increased 68.9% primarily due to an increase in our average fleet size of 73.0% driven by a significant increase in our number of Dedicated contracts with customers, partially offset by a 2.2% decrease in our average revenue, net of fuel surcharges, per tractor per week from 2013. The increase in the operating ratio for our Dedicated segment in 2014 was primarily due to the addition of contracts with higher operating ratios than the average in 2013, along with the impact of severe weather conditions in the first quarter of 2014 on both freight volumes and operating costs. Intermodal segment revenue increased $4.6 million, or 4.9%, to $97.1 million in 2014 from $92.5 million in 2013. Intermodal segment revenue, net of fuel surcharges, increased 5.1% due to continued volume growth in our Intermodal services. The increase in the operating ratio for our Intermodal segment in 2014 was primarily due to costs associated with rail service interruption and delay issues that constrained our Intermodal operations, volume growth in our dry container service, which produces a higher operating ratio than our temperature-controlled trailer service, and the impact of severe weather conditions in the first quarter of 2014 on both freight volumes and operating costs. Brokerage segment revenue decreased $2.2 million, or 3.7%, to $57.2 million in 2014 from $59.4 million in 2013. Marten Transport Brokerage revenue increased $4.5 million in 2014 due to an increase in volume. With the March 28, 2013 deconsolidation of MWL, MWL revenue included in our Brokerage segment decreased $6.7 million in 2014. The increase in the operating ratio for our Brokerage segment in 2014 was primarily due to an increase in the payments to carriers for transportation services which we arranged as a percentage of our Brokerage revenue. The following table sets forth for the years indicated the dollar and percentage increase or decrease of the items in our consolidated statements of operations, and those items as a percentage of operating revenue: Salaries, wages and benefits consist of compensation for our employees, including both driver and non-driver employees, employees’ health insurance, 401(k) plan contributions and other fringe benefits. These expenses vary depending upon the size of our Truckload, Dedicated and Intermodal tractor fleets, the ratio of company drivers to independent contractors, our efficiency, our experience with employees’ health insurance claims, changes in health care premiums and other factors. The increase in salaries, wages and benefits from 2013 resulted primarily from increases to several components of the amount paid to company drivers during 2014 and an increase in employees’ health insurance expense of $3.3 million due to an increase in our self-insured medical claims, which was partially offset by an $800,000 decrease in bonus compensation expense for our non-driver employees. Purchased transportation consists of payments to railroads and carriers for transportation services we arrange in connection with Brokerage and Intermodal operations and to independent contractor providers of revenue equipment. This category will vary depending upon the amount and rates, including fuel surcharges, we pay to third-party railroad and motor carriers, the ratio of company drivers versus independent contractors and the amount of fuel surcharges passed through to independent contractors. Purchased transportation expense decreased $419,000 in total, or 0.3%, in 2014 from 2013. Payments to carriers for transportation services we arranged in our Brokerage segment increased $3.5 million to $49.1 million in 2014 from $45.6 million in 2013. With the March 28, 2013 deconsolidation of MWL, there was no purchased transportation expense related to MWL included in the Brokerage segment in 2014 compared with $5.4 million in 2013. Payments to railroads and drayage carriers for transportation services within our Intermodal segment increased $1.3 million to $66.4 million in 2014 from $65.1 million in 2013. The portion of purchased transportation expense related to our independent contractors within our Truckload and Dedicated segments, including fuel surcharges, increased $266,000 in 2014. We expect that purchased transportation expense will increase as we grow our Intermodal and Brokerage segments. Fuel and fuel taxes decreased by $9.3 million in 2014 from 2013. Net fuel expense (fuel and fuel taxes net of fuel surcharge revenue and surcharges passed through to independent contractors, outside drayage carriers and railroads) decreased $6.8 million, or 12.6%, to $46.7 million in 2014 from $53.4 million in 2013. Fuel surcharges passed through to independent contractors, outside drayage carriers and railroads were $18.0 million in 2014 and $17.9 million in 2013. We have worked diligently to control fuel usage and costs by improving our volume purchasing arrangements and optimizing our drivers’ fuel purchases with national fuel centers, focusing on shorter lengths of haul, installing and tightly managing the use of auxiliary power units in our tractors to minimize engine idling and improving fuel usage in the temperature-control units on our trailers. Auxiliary power units, which we have installed in our company-owned tractors, provide climate control and electrical power for our drivers without idling the tractor engine. The decrease in net fuel expense was primarily due to continued progress with the cost control measures stated above and a decrease in the DOE national average cost of fuel to $3.83 per gallon in 2014 from $3.92 per gallon in 2013. Net fuel expense represented 9.5% of Truckload, Dedicated and Intermodal segment revenue, net of fuel surcharges, in 2014, compared with 11.3% in 2013. Depreciation relates to owned tractors, trailers, auxiliary power units, communication units, terminal facilities and other assets. The increase in depreciation was primarily due to a continued increase in the cost of revenue equipment. We expect our annual cost of tractor and trailer ownership will increase in future periods as a result of higher prices of new equipment, which will result in greater depreciation over the useful life. Insurance and claims consist of the costs of insurance premiums and the accruals we make for claims within our self-insured retention amounts, primarily for personal injury, property damage, physical damage to our equipment, cargo claims and workers’ compensation claims. These expenses will vary primarily based upon the frequency and severity of our accident experience, our self-insured retention levels and the market for insurance. The $3.6 million increase in insurance and claims in 2014 was primarily due to an increase in the cost of our self-insured auto liability, workers’ compensation and cargo claims. Our significant self-insured retention exposes us to the possibility of significant fluctuations in claims expense between periods which could materially impact our financial results depending on the frequency, severity and timing of claims. Gain on disposition of revenue equipment decreased to $4.4 million in 2014 from $6.0 million in 2013 due to a decrease in the market value for used revenue equipment and a decrease in the number of tractors sold. Future gains or losses on dispositions of revenue equipment will be impacted by the market for used revenue equipment, which is beyond our control. As a result of the foregoing factors, our operating expenses as a percentage of operating revenue, or “operating ratio,” increased to 92.4% in 2014 from 92.1% in 2013. The operating ratio for our Truckload segment was 91.2% in 2014 and 91.5% in 2013, for our Dedicated segment was 89.9% in 2014 and 86.8% in 2013, for our Intermodal segment was 98.2% in 2014 and 95.7% in 2013, and for our Brokerage segment was 95.4% in 2014 and 94.8 % in 2013. Operating expenses as a percentage of operating revenue, with both amounts net of fuel surcharge revenue, increased to 90.7% in 2014 from 90.2% in 2013. Our effective income tax rate decreased slightly to 42.3% in 2014 from 42.4% in 2013. As a result of the factors described above, net income decreased to $29.8 million in 2014 from $30.1 million in 2013. Net earnings per diluted share decreased to $0.89 in 2014 from $0.90 in 2013. Comparison of Year Ended December 31, 2013 to Year Ended December 31, 2012 The following table sets forth for the years indicated our operating revenue, operating income and operating ratio by segment, along with the change for each component: (1) Brokerage revenue is net of $2.1 million and $9.7 million of inter-segment revenue in 2013 and 2012, respectively, for loads transported by our tractors and arranged by MWL that have been eliminated in consolidation. The inter-segment revenue in 2013 relates to loads transported prior to the deconsolidation of MWL effective March 28, 2013. (2) Represents operating expenses as a percentage of operating revenue. Our operating revenue increased $20.8 million, or 3.3%, to $659.2 million in 2013 from $638.5 million in 2012. Our operating revenue, net of fuel surcharges and MWL revenue, increased $38.1 million, or 7.8%, to $524.8 million in 2013 from $486.7 million in 2012. This increase was primarily due to an increase in Dedicated revenue, net of fuel surcharges, along with growth in Intermodal revenue. Fuel surcharge revenue increased to $127.7 million in 2013 from $121.1 million in 2012 primarily due to the increase in volume for our Dedicated and Intermodal services. Truckload segment revenue increased $1.2 million, or 0.3%, to $465.0 million in 2013 from $463.7 million in 2012. Truckload segment revenue, net of fuel surcharges, increased 0.9% primarily due to an increase in our average revenue, net of fuel surcharges, per tractor per week of 4.3%, partially offset by a decrease in our average fleet size of 3.0% from 2012. The increase in revenue per tractor per week and the improvement in our overall cost structure primarily caused the increase in profitability in 2013. Dedicated segment revenue increased $22.7 million, or 115.8%, to $42.3 million in 2013 from $19.6 million in 2012. Dedicated segment revenue, net of fuel surcharges, increased 127.5% primarily due to an increase in our average fleet size of 142.3%, partially offset by a 6.3% decrease in our average revenue, net of fuel surcharges, per tractor per week from 2012. The increase in the operating ratio for our Dedicated segment in 2013 was primarily due to an increase in insurance and claims expense. Intermodal segment revenue increased $21.2 million, or 29.7%, to $92.5 million in 2013 from $71.3 million in 2012. Intermodal segment revenue, net of fuel surcharges, increased 30.1% due to continued volume growth in our Intermodal services. The increase in the operating ratio for our Intermodal segment in 2013 was primarily due to an increase in the payments to railroads and drayage carriers as a percentage of our revenue. Brokerage segment revenue decreased $24.4 million, or 29.1%, to $59.4 million in 2013 from $83.8 million in 2012. With the March 28, 2013 deconsolidation of MWL, MWL revenue included in our Brokerage segment decreased $24.0 million in 2013. Marten Transport Brokerage revenue decreased $415,000 in 2013 due to a decrease in margins partially offset by continued volume growth. The operating ratio for our Brokerage segment in 2013 was consistent with 2012. The following table sets forth for the years indicated the dollar and percentage increase or decrease of the items in our consolidated statements of operations, and those items as a percentage of operating revenue: The increase in salaries, wages and benefits resulted primarily from a 4.4% increase in the total miles driven by company drivers and increases to several components of the amount paid to company drivers during 2012, which was partially offset by a decrease in employees’ health insurance expense of $1.3 million due to a decrease in our self-insured medical claims and a $1.2 million decrease in bonus compensation expense for our non-driver employees. Purchased transportation expense decreased $833,000 in total, or 0.7%, in 2013 from 2012. Payments to carriers for transportation services we arranged in our Brokerage segment decreased $145,000 to $45.6 million in 2013 from $45.7 million in 2012. With the March 28, 2013 deconsolidation of MWL, purchased transportation expense related to MWL included in our Brokerage segment in 2013 was $5.4 million compared with $24.5 million in 2012. Payments to railroads and drayage carriers for transportation services within our Intermodal segment increased $17.8 million to $65.1 million in 2013 from $47.3 million in 2012. The portion of purchased transportation expense related to our independent contractors within our Truckload and Dedicated segments, including fuel surcharges, increased $572,000 in 2013. Fuel and fuel taxes decreased by $326,000 in 2013 from 2012. Net fuel expense (fuel and fuel taxes net of fuel surcharge revenue and surcharges passed through to independent contractors, outside drayage carriers and railroads) decreased $2.8 million, or 5.0%, to $53.4 million in 2013 from $56.3 million in 2012. Fuel surcharges passed through to independent contractors, outside drayage carriers and railroads were $17.9 million in 2013 and $13.8 million in 2012. We have worked diligently to control fuel usage and costs by improving our volume purchasing arrangements and optimizing our drivers’ fuel purchases with national fuel centers, focusing on shorter lengths of haul, installing and tightly managing the use of auxiliary power units in our tractors to minimize engine idling and improving fuel usage in the temperature-control units on our trailers. The decrease in net fuel expense was primarily due to continued progress with the cost control measures stated above and extreme heat in 2012 which increased fuel consumption, partially offset by an increase in total miles driven. The DOE national average cost of fuel decreased slightly to $3.92 per gallon in 2013 from $3.97 per gallon in 2012. Net fuel expense represented 11.3% of Truckload, Dedicated and Intermodal segment revenue, net of fuel surcharges, in 2013, compared with 13.0% in 2012. The increase in depreciation was primarily due to a continued increase in the cost of revenue equipment and a 2.3% increase in our average fleet size. The $3.0 million increase in insurance and claims in 2013 was primarily due to increases in the cost of physical damage claims related to our tractors and trailers and in the cost of our self-insured auto liability claims. Gain on disposition of revenue equipment increased to $6.0 million in 2013 from $5.3 million in 2012 due to an increase in the market value for used revenue equipment. As a result of the foregoing factors, our operating expenses as a percentage of operating revenue, or “operating ratio,” improved to 92.1% in 2013 from 92.8% in 2012. The operating ratio for our Truckload segment was 91.5% in 2013 and 92.7% in 2012, for Dedicated segment was 86.8% in 2013 and 84.2% in 2012, for our Intermodal segment was 95.7% in 2013 and 93.4% in 2012 and for our Brokerage segment was 94.8% in each of 2013 and 2012. Our effective income tax rate increased to 42.4% in 2013 from 39.9% in 2012. A decrease to our deferred income tax liability as a result of a change in income apportionment for several states decreased our effective income tax rate in 2012. As a result of the factors described above, net income increased 10.6% to $30.1 million in 2013 from $27.3 million in 2012. Net earnings per diluted share increased to $0.90 in 2013 from $0.82 in 2012. Liquidity and Capital Resources Our business requires substantial, ongoing capital investments, particularly for new tractors and trailers. Our primary sources of liquidity are funds provided by operations and our revolving credit facility. A portion of our tractor fleet is provided by independent contractors who own and operate their own equipment. We have no capital expenditure requirements relating to those drivers who own their tractors or obtain financing through third parties. The table below reflects our net cash flows provided by operating activities, net cash flows used for investing activities and net cash flows provided by (used for) financing activities for the years indicated. In 2014, net cash flows provided by operating activities of $82.0 million, borrowings under our credit facility of $24.4 million, and cash and cash equivalents of $13.5 million were primarily used to purchase new revenue equipment, net of proceeds from dispositions, in the amount of $87.7 million, to acquire and partially construct regional operating facilities in the amount of $27.4 million, and to pay cash dividends of $3.3 million. In 2013, net cash flows provided by operating activities of $89.2 million were primarily used to purchase new revenue equipment, net of proceeds from dispositions, in the amount of $54.8 million, to partially construct and acquire regional operating facilities in the amount of $16.9 million, to pay cash dividends of $2.8 million, to repay $2.7 million of long-term debt, and to increase cash and cash equivalents by $10.2 million. In 2012, net cash flows provided by operating activities of $85.5 million and cash and cash equivalents of $17.3 million were primarily used to purchase new revenue equipment, net of proceeds from dispositions, in the amount of $75.1 million, to partially construct and acquire regional operating facilities in the amount of $10.9 million, and to pay cash dividends of $18.7 million. We estimate that capital expenditures, net of proceeds from dispositions, will be approximately $110 million in 2015. Quarterly cash dividends of $0.025 per share of common stock totaling $3.3 million were declared in each quarter of 2014. Quarterly cash dividends of $0.017 per share were declared in each of the first and second quarters of 2013, and of $0.025 per share were declared in each of the third and fourth quarters of 2013, totaling $2.8 million. Quarterly cash dividends of $0.013 per share were declared in the first quarter of 2012, and of $0.017 per share were declared in each of the second through fourth quarters of 2012, along with a special dividend of $0.50 per share in the fourth quarter of 2012, totaling $18.7 million. We currently expect to continue to pay quarterly cash dividends in the future. The payment of cash dividends in the future, and the amount of any such dividends, will depend upon our financial condition, results of operations, cash requirements, and certain corporate law requirements, as well as other factors deemed relevant by our Board of Directors. As current federal and state bonus depreciation provisions have expired, we expect an increase in our current income tax payments as a portion of our deferred tax liability for property and equipment reverses. We believe our sources of liquidity are adequate to meet our current and anticipated needs for at least the next twelve months. Based upon anticipated cash flows, existing cash and cash equivalents balances, current borrowing availability and other sources of financing we expect to be available to us, we do not anticipate any significant liquidity constraints in the foreseeable future. In December 2014, we entered into an amendment to our unsecured committed credit facility which extends the maturity date of loans made under the facility until December 2019. The aggregate principal amount of the credit facility of $50.0 million may be increased at our option, subject to completion of signed amendments with the lender, up to a maximum aggregate principal amount of $75.0 million. At December 31, 2014, there was an outstanding principal balance of $24.4 million on the credit facility. As of that date, we had outstanding standby letters of credit of $9.2 million and remaining borrowing availability of $16.4 million. This facility bears interest at a variable rate based on the London Interbank Offered Rate or the lender’s Prime Rate, in each case plus/minus applicable margins. Our credit facility prohibits us from paying, in any fiscal year, dividends in excess of 25% of our net income from the prior fiscal year. This facility also contains restrictive covenants which, among other matters, require us to maintain compliance with cash flow leverage and fixed charge coverage ratios. We were in compliance with all of these covenants at December 31, 2014. The following is a summary of our contractual obligations as of December 31, 2014. Due to uncertainty with respect to the timing of future cash flows, the obligation under our nonqualified deferred compensation plan at December 31, 2014 of 70,514 shares of Company common stock with a value of $1.5 million has been excluded from the above table. Related Parties We purchase fuel and obtain tires and related services from Bauer Built, Inc., or BBI. Jerry M. Bauer, one of our directors, is the chairman of the board and chief executive officer and the principal stockholder of BBI. We paid BBI $562,000 in 2014, $585,000 in 2013 and $988,000 in 2012 for fuel and tire services. In addition, we paid $1.4 million in 2014, $1.6 million in 2013 and $1.7 million in 2012 to tire manufacturers for tires that we purchased from the tire manufacturers but were provided by BBI. BBI received commissions from the tire manufacturers related to these purchases. Other than any benefit received from his ownership interest, Mr. Bauer receives no compensation or other benefits from our business with BBI. We paid Durand Builders Service, Inc. $495,000 in 2012 for various construction projects. We did not pay Durand Builders Service, Inc. for any services in 2014 or 2013. Larry B. Hagness, one of our directors, is the president and owner of Durand Builders Service, Inc. Other than any benefit received from his ownership interest, Mr. Hagness receives no compensation or other benefits from these transactions. We own a 45% equity interest in MWL, a third-party provider of logistics services to the transportation industry. We received $8.5 million, $8.2 million and $9.7 million of our revenue for loads transported by our tractors and arranged by MWL in 2014, 2013 and 2012, respectively. Prior to deconsolidation effective March 28, 2013, these inter-segment revenues were eliminated in consolidation. Inter-segment revenue eliminated in consolidation was $2.1 million and $9.7 million in 2013 and 2012, respectively. As of December 31, 2014, we also had a trade receivable in the amount of $920,000 from MWL and an accrued liability of $466,000 to MWL for the excess of payments by MWL’s customers into our lockbox account over the amounts drawn on the account by MWL. We believe that the transactions with related parties noted above are on reasonable terms which, based upon market rates, are comparable to terms available from unaffiliated third parties. Off-balance Sheet Arrangements Other than standby letters of credit maintained in connection with our self-insurance programs in the amount of $9.2 million and operating leases summarized above in our summary of contractual obligations, we did not have any other material off-balance sheet arrangements at December 31, 2014. Inflation and Fuel Costs Most of our operating expenses are inflation-sensitive, with inflation generally producing increased costs of operations. During the past three years, the most significant effects of inflation have been on revenue equipment prices, accident claims, health insurance and employee compensation. We attempt to limit the effects of inflation through increases in freight rates and cost control efforts. In addition to inflation, fluctuations in fuel prices can affect our profitability. We require substantial amounts of fuel to operate our tractors and power the temperature-control units on our trailers. Substantially all of our contracts with customers contain fuel surcharge provisions. Although we historically have been able to pass through a significant portion of long-term increases in fuel prices and related taxes to customers in the form of surcharges and higher rates, such increases usually are not fully recovered. These surcharge provisions are not effective in mitigating the fuel price increases related to non-revenue miles or fuel used while the tractor is idling. Seasonality Our tractor productivity generally decreases during the winter season because inclement weather impedes operations and some shippers reduce their shipments. At the same time, operating expenses generally increase, with harsh weather creating higher accident frequency, increased claims and more equipment repairs. Critical Accounting Policies The preparation of financial statements in conformity with U.S. generally accepted accounting principles requires management to make estimates and assumptions about future events, and apply judgments that affect the reported amounts of assets, liabilities, revenue and expenses in our consolidated financial statements and related notes. We base our estimates, assumptions and judgments on historical experience, current trends and other factors believed to be relevant at the time our consolidated financial statements are prepared. However, because future events and their effects cannot be determined with certainty, actual results could differ from our estimates and assumptions, and such differences could be material. We believe that the following critical accounting policies affect our more significant estimates, assumptions and judgments used in the preparation of our consolidated financial statements. Revenue Recognition. We recognize revenue, including fuel surcharges, at the time shipment of freight is completed. We account for revenue of our Intermodal and Brokerage segments and revenue on freight transported by independent contractors within our Truckload and Dedicated segments on a gross basis because we are the primary obligor in the arrangements, we have the ability to establish prices, we have the risk of loss in the event of cargo claims and we bear credit risk with customer payments. Accordingly, all such revenue billed to customers is classified as operating revenue and all corresponding payments to carriers for transportation services we arrange in connection with brokerage and intermodal activities and to independent contractor providers of revenue equipment are classified as purchased transportation expense. Accounts Receivable. We are dependent upon a limited number of customers, and, as a result, our trade accounts receivable are highly concentrated. Trade accounts receivable are recorded at the invoiced amounts, net of an allowance for doubtful accounts. Our allowance for doubtful accounts was $475,000 as of December 31, 2014 and $450,000 as of December 31, 2013. A considerable amount of judgment is required in assessing the realization of these receivables including the current creditworthiness of each customer and related aging of the past-due balances, including any billing disputes. In order to assess the collectibility of these receivables, we perform ongoing credit evaluations of our customers’ financial condition. Through these evaluations, we may become aware of a situation where a customer may not be able to meet its financial obligations due to deterioration of its financial viability, credit ratings or bankruptcy. The allowance for doubtful accounts is based on the best information available to us and is reevaluated and adjusted as additional information is received. We evaluate the allowance based on historical write-off experience, the size of the individual customer balances, past-due amounts and the overall national economy. We review the adequacy of our allowance for doubtful accounts monthly. Property and Equipment. The transportation industry requires significant capital investments. Our net property and equipment was $465.7 million as of December 31, 2014 and $415.0 million as of December 31, 2013. Our depreciation expense was $68.2 million in 2014, $64.5 million in 2013 and $60.9 million in 2012. We compute depreciation of our property and equipment for financial reporting purposes based on the cost of each asset, reduced by its estimated salvage value, using the straight-line method over its estimated useful life. We determine and periodically evaluate our estimate of the projected salvage values and useful lives primarily by considering the market for used equipment, prior useful lives and changes in technology. We have not changed our policy regarding salvage values as a percentage of initial cost or useful lives of tractors and trailers within the last ten years. We believe that our policies and past estimates have been reasonable. Actual results could differ from these estimates. A 5% decrease in estimated salvage values would have decreased our net property and equipment as of December 31, 2014 by approximately $9.8 million, or 2.1%. Impairment of Assets. Long-lived assets are reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. Recoverability of assets to be held and used is measured by a comparison of the carrying amount of an asset to future net undiscounted cash flows expected to be generated by the asset. If such assets are considered to be impaired, the impairment to be recognized is measured by the amount by which the carrying amount of the assets exceeds the fair value of the assets. Assets to be disposed of are reported at the lower of the carrying amount or fair value less the costs to sell. Insurance and Claims. We self-insure, in part, for losses relating to workers’ compensation, auto liability, general liability, cargo and property damage claims, along with employees’ health insurance with varying risk retention levels. We maintain insurance coverage for per-incident and total losses in excess of these risk retention levels in amounts we consider adequate based upon historical experience and our ongoing review. However, we could suffer a series of losses within our self-insured retention limits or losses over our policy limits, which could negatively affect our financial condition and operating results. We are responsible for the first $1.0 million on each auto liability claim and for the first $750,000 on each workers’ compensation claim. We have $9.2 million in standby letters of credit to guarantee settlement of claims under agreements with our insurance carriers and regulatory authorities. The insurance and claims accruals in our consolidated balance sheets were $14.0 million as of December 31, 2014 and $14.4 million as December 31, 2013. We reserve currently for the estimated cost of the uninsured portion of pending claims. We periodically evaluate and adjust these reserves based on our evaluation of the nature and severity of outstanding individual claims and our estimate of future claims development based on historical claims development factors. We believe that our claims development factors have historically been reasonable, as indicated by the adequacy of our insurance and claims accruals compared to settled claims. Actual results could differ from these current estimates. In addition, to the extent that claims are litigated and not settled, jury awards are difficult to predict. If our claims settlement experience worsened causing our historical claims development factors to increase by 5%, our estimated insurance and claims accruals as of December 31, 2014 would have needed to increase by approximately $3.7 million. Share-based Payment Arrangement Compensation. We have granted stock options to certain employees and non-employee directors. We recognize compensation expense for all stock options net of an estimated forfeiture rate and only record compensation expense for those shares expected to vest on a straight-line basis over the requisite service period (normally the vesting period). Determining the appropriate fair value model and calculating the fair value of stock options require the input of highly subjective assumptions, including the expected life of the stock options and stock price volatility. We use the Black-Scholes model to value our stock option awards. We believe that future volatility will not materially differ from our historical volatility. Thus, we use the historical volatility of our common stock over the expected life of the award. The assumptions used in calculating the fair value of stock options represent our best estimates, but these estimates involve inherent uncertainties and the application of judgment. As a result, if factors change and we use different assumptions, stock option compensation expense could be materially different in the future. We have also granted performance unit awards to certain employees which are subject to vesting requirements over a five-year period, primarily based on our earnings growth. The fair value of each performance unit is based on the closing market price on the date of grant. We recognize compensation expense for these awards based on the estimated number of units probable of achieving the vesting requirements of the awards, net of an estimated forfeiture rate. Recent Accounting Pronouncements In May 2014, the Financial Accounting Standards Board issued Accounting Standards Update No. 2014-09, “Revenue from Contracts with Customers” which requires an entity to recognize the amount of revenue to which it expects to be entitled for the transfer of promised goods or services to customers. The standard, which is effective for the first quarter of 2017, will replace most existing revenue recognition guidance required by U.S. generally accepted accounting principles. Early application is not permitted. The adoption of this standard is not expected to have a significant impact on our consolidated balance sheets, statements of operations or statements of cash flows.

<s>[INST] The following discussion and analysis of our financial condition and results of operations should be read together with the selected consolidated financial data and our consolidated financial statements and the related notes appearing elsewhere in this report. This discussion and analysis contains forwardlooking statements that involve risks, uncertainties and assumptions. Our actual results may differ materially from those anticipated in these forwardlooking statements as a result of many factors, including but not limited to those under the heading “Risk Factors” beginning on page 7. We do not assume, and specifically disclaim, any obligation to update any forwardlooking statement contained in this report. Overview The primary source of our operating revenue is provided by our Truckload segment through a combination of regional shorthaul and mediumtolonghaul fullload transportation services. We transport food and other consumer packaged goods that require a temperaturecontrolled or insulated environment across the United States and into and out of Mexico and Canada. Our Dedicated segment provides customized transportation solutions tailored to meet individual customers’ requirements, utilizing temperaturecontrolled trailers, dry vans and other specialized equipment within the United States. Our customer contracts range from three to five years and are subject to annual rate reviews. Generally, we are paid by the mile for our Truckload and Dedicated services. We also derive Truckload and Dedicated revenue from fuel surcharges, loading and unloading activities, equipment detention and other ancillary services. The main factors that affect our Truckload and Dedicated revenue are the rate per mile we receive from our customers, the percentage of miles for which we are compensated, the number of miles we generate with our equipment and changes in fuel prices. We monitor our revenue production primarily through average Truckload and Dedicated revenue, net of fuel surcharges, per tractor per week. We also analyze our average Truckload and Dedicated revenue, net of fuel surcharges, per total mile, nonrevenue miles percentage, the miles per tractor we generate, our fuel surcharge revenue, our accessorial revenue and our other sources of operating revenue. Our Intermodal segment transports our customers’ freight within the United States primarily utilizing our temperaturecontrolled trailers and also our dry containers on railroad flatcars for portions of trips, with the balance of the trips using our tractors or, to a lesser extent, contracted carriers. The main factors that affect our Intermodal revenue are the rate per mile and other charges we receive from our customers. Our Brokerage segment arranges for smaller thirdparty carriers to transport freight for our customers in temperaturecontrolled trailers and dry vans within the United States and into and out of Mexico while we retain the billing, collection and customer management responsibilities. The main factors that affect our Brokerage revenue are the rate per mile and other charges we receive from our customers. Our Brokerage segment also included the revenue of MWL, a thirdparty provider of logistics services to the transportation industry, until we deconsolidated our 45% interest in MWL effective March 28, 2013. In addition to the factors discussed above, our operating revenue is also affected by, among other things, the United States economy, inventory levels, the level of truck and rail capacity in the transportation market, a contracting driver market, severe weather conditions and specific customer demand. Our operating revenue increased $13.7 million, or 2.1%, in 2014. Our operating revenue, net of fuel surcharges and MWL revenue, increased $22.9 million, or 4.4%, compared with 2013. Truckload segment revenue, net of fuel surcharges, decreased 2.3% primarily due to a decrease in our average fleet size of 6.3% from 2013, partially offset by an increase in our average Truckload revenue, net of fuel surcharges, per tractor per week of 4.2%. The increase in our average revenue per tractor was primarily due to an increase in our average rate per mile. Dedicated segment revenue, net of fuel surcharges, increased 68.9% primarily due to an increase in our average fleet size of 73.0%, partially offset by a 2.2% decrease in our average Dedicated revenue, net of fuel surcharges, per tractor per week from 2013. Intermodal segment revenue, net of fuel surcharges [/INST] Positive. </s>

MARTEN TRANSPORT LTD

2016-03-11

2015-12-31

ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The following discussion and analysis of our financial condition and results of operations should be read together with the selected consolidated financial data and our consolidated financial statements and the related notes appearing elsewhere in this report. This discussion and analysis contains forward-looking statements that involve risks, uncertainties and assumptions. Our actual results may differ materially from those anticipated in these forward-looking statements as a result of many factors, including but not limited to those under the heading “Risk Factors” beginning on page 7. We do not assume, and specifically disclaim, any obligation to update any forward-looking statement contained in this report. Overview The primary source of our operating revenue is provided by our Truckload segment through a combination of regional short-haul and medium-to-long-haul full-load transportation services. We transport food and other consumer packaged goods that require a temperature-controlled or insulated environment across the United States and into and out of Mexico and Canada. Our Dedicated segment provides customized transportation solutions tailored to meet individual customers’ requirements, utilizing temperature-controlled trailers, dry vans and other specialized equipment within the United States. Our customer contracts range from three to five years and are subject to annual rate reviews. Generally, we are paid by the mile for our Truckload and Dedicated services. We also derive Truckload and Dedicated revenue from fuel surcharges, loading and unloading activities, equipment detention and other ancillary services. The main factors that affect our Truckload and Dedicated revenue are the rate per mile we receive from our customers, the percentage of miles for which we are compensated, the number of miles we generate with our equipment and changes in fuel prices. We monitor our revenue production primarily through average Truckload and Dedicated revenue, net of fuel surcharges, per tractor per week. We also analyze our average Truckload and Dedicated revenue, net of fuel surcharges, per total mile, non-revenue miles percentage, the miles per tractor we generate, our fuel surcharge revenue, our accessorial revenue and our other sources of operating revenue. Our Intermodal segment transports our customers’ freight within the United States primarily utilizing our temperature-controlled trailers and also, through March 2015, our dry containers on railroad flatcars for portions of trips, with the balance of the trips using our tractors or, to a lesser extent, contracted carriers. The main factors that affect our Intermodal revenue are the rate per mile and other charges we receive from our customers. Our Brokerage segment arranges for smaller third-party carriers to transport freight for our customers in temperature-controlled trailers and dry vans within the United States and into and out of Mexico while we retain the billing, collection and customer management responsibilities. The main factors that affect our Brokerage revenue are the rate per mile and other charges we receive from our customers. In addition to the factors discussed above, our operating revenue is also affected by, among other things, the United States economy, inventory levels, the level of truck and rail capacity in the transportation market, a contracting driver market, severe weather conditions and specific customer demand. Our operating revenue decreased $7.9 million, or 1.2%, in 2015, reflecting a 42.2% decrease in fuel surcharge revenue to $72.3 million from $125.2 million in 2014 due to lower fuel prices. Our operating revenue, net of fuel surcharges, increased $44.9 million, or 8.2%, compared with 2014. Truckload segment revenue, net of fuel surcharges, decreased 2.9% from 2014. Dedicated segment revenue, net of fuel surcharges, increased 89.5% primarily due to an increase in our average fleet size of 83.2% from 2014. Intermodal segment revenue, net of fuel surcharges, decreased 12.7% due to the disposal in March 2015 of the overhead-intensive dry containers that were used in our intermodal operations, partially offset by increased volume with our temperature-controlled intermodal trailer service. Brokerage revenue increased 24.8% in 2015 due to an increase in volume. Our profitability is impacted by the variable costs of transporting freight for our customers, fixed costs, and expenses containing both fixed and variable components. The variable costs include fuel expense, driver-related expenses, such as wages, benefits, training, and recruitment, and independent contractor costs, which are recorded under purchased transportation. Expenses that have both fixed and variable components include maintenance and tire expense and our cost of insurance and claims. These expenses generally vary with the miles we travel, but also have a controllable component based on safety, fleet age, efficiency and other factors. Our main fixed costs relate to the acquisition and subsequent depreciation of long-term assets, such as revenue equipment and operating terminals. We expect our annual cost of tractor and trailer ownership will increase in future periods as a result of higher prices of new equipment, along with any increases in fleet size. Although certain factors affecting our expenses are beyond our control, we monitor them closely and attempt to anticipate changes in these factors in managing our business. For example, fuel prices have significantly fluctuated over the past several years. We manage our exposure to changes in fuel prices primarily through fuel surcharge programs with our customers, as well as through volume fuel purchasing arrangements with national fuel centers and bulk purchases of fuel at our terminals. To help further reduce fuel expense, we have installed and tightly manage the use of auxiliary power units in our tractors to provide climate control and electrical power for our drivers without idling the tractor engine, and also have improved the fuel usage in the temperature-control units on our trailers. For our Intermodal and Brokerage segments, our profitability is impacted by the percentage of revenue we pay to providers for the transportation services we arrange, which is included within purchased transportation in our consolidated statements of operations. Our operating expenses as a percentage of operating revenue, or “operating ratio,” improved to 90.8% in 2015 from 92.4% in 2014. Operating expenses as a percentage of operating revenue, with both amounts net of fuel surcharges, improved to 89.7% in 2015 from 90.7% in 2014. Our operating ratio for 2015, net of both the gain on the disposition of facilities of $4.1 million and fuel surcharges, improved to 90.4%. Our net income increased by 19.8% to $35.7 million, or $1.06 per diluted share, in 2015 from $29.8 million, or $0.89 per diluted share, in 2014. The increase in profitability in 2015 was primarily driven by the $0.07 per diluted share impact of the facilities disposition gains, the disposal in March 2015 of the overhead-intensive dry containers that were used in a portion of our intermodal operations, an improvement in net fuel expense with the lower fuel prices, the negative impact that the severe weather conditions had on the first quarter of 2014 on both freight volumes and operating costs, and costs associated with rail service interruption and delay issues in 2014 that constrained our intermodal operations, partially offset by a decrease in our Truckload average revenue per tractor within a soft freight market since the second quarter of 2015 and an increase in insurance and claims in 2015. Our business requires substantial, ongoing capital investments, particularly for new tractors and trailers. At December 31, 2015, we had $434,000 of cash and cash equivalents, $37.9 million of long-term debt outstanding and $409.4 million in stockholders’ equity. In 2015, net cash flows provided by operating activities of $128.2 million and net borrowings under our credit facility of $13.5 million were primarily used to purchase new revenue equipment, net of proceeds from dispositions, in the amount of $118.2 million, to partially construct regional operating facilities in the amount of $8.6 million, to repurchase and retire 941,024 shares of our common stock for $16.2 million and to pay cash dividends of $3.3 million. We estimate that capital expenditures, net of proceeds from dispositions, will be approximately $130 million in 2016. We believe our sources of liquidity are adequate to meet our current and anticipated needs for at least the next twelve months. Based upon anticipated cash flows, existing cash and cash equivalents balances, current borrowing availability and other sources of financing we expect to be available to us, we do not anticipate any significant liquidity constraints in the foreseeable future. Our business strategy encompasses a multifaceted set of transportation service solutions, primarily regional Truckload temperature-controlled operations along with Dedicated, Intermodal and Brokerage services, with a diverse customer base that gains value from and expands each of these operating segments. We believe that we are well-positioned regardless of the economic environment with the services we provide combined with our competitive position, cost control emphasis, modern fleet and strong balance sheet. This Management’s Discussion and Analysis of Financial Condition and Results of Operations includes discussions of operating revenue, net of fuel surcharge revenue; Truckload, Dedicated and Intermodal revenue, net of fuel surcharge revenue; operating expenses as a percentage of operating revenue, each net of fuel surcharge revenue and the sum of fuel surcharge revenue and the gain on disposition of facilities; and net fuel expense (fuel and fuel taxes net of fuel surcharge revenue and surcharges passed through to independent contractors, outside drayage carriers and railroads). We provide these additional disclosures because management believes these measures provide a more consistent basis for comparing results of operations from period to period. These financial measures in this report have not been determined in accordance with U.S. generally accepted accounting principles (GAAP). Pursuant to Item 10(e) of Regulation S-K, we have included the amounts necessary to reconcile these non-GAAP financial measures to the most directly comparable GAAP financial measures of operating revenue, operating expenses divided by operating revenue, and fuel and fuel taxes. Stock Split On June 14, 2013, we effected a three-for-two stock split of our common stock, $.01 par value, in the form of a 50% stock dividend. Our consolidated financial statements, related notes, and other financial data contained in this report have been adjusted to give retroactive effect to the stock split for all periods presented. Results of Operations The following table sets forth for the years indicated certain operating statistics regarding our revenue and operations: (1) Includes tractors driven by both company-employed drivers and independent contractors. Independent contractors provided 65, 52 and 49 tractors as of December 31, 2015, 2014 and 2013, respectively. Comparison of Year Ended December 31, 2015 to Year Ended December 31, 2014 The following table sets forth for the years indicated our operating revenue, operating income and operating ratio by segment, along with the change for each component: (1) Represents operating expenses as a percentage of operating revenue. Our operating revenue decreased $7.9 million, or 1.2%, to $665.0 million in 2015 from $672.9 million in 2014, reflecting a 42.2% decrease in fuel surcharge revenue to $72.3 million from $125.2 million in 2014 due to lower fuel prices. Our operating revenue, net of fuel surcharges, increased $44.9 million, or 8.2%, to $592.6 million in 2015 from $547.7 million in 2014. This increase was due to a $50.7 million increase in Dedicated revenue, net of fuel surcharges, and a $14.2 million increase in Brokerage revenue, partially offset by a $10.4 million decrease in Truckload revenue, net of fuel surcharges, and a $9.6 million decrease in Intermodal revenue, net of fuel surcharges. Truckload segment revenue decreased $49.9 million, or 11.1%, to $398.4 million in 2015 from $448.3 million in 2014. Truckload segment revenue, net of fuel surcharges, decreased $10.4 million, or 2.9%, to $348.1 million in 2015 from $358.5 million in 2014. The slight improvement in the operating ratio in 2015 was primarily due to an improvement in our net fuel expense with the lower fuel prices and the negative impact of severe weather conditions in the first quarter of 2014 on both freight volumes and operating costs, partially offset by a decrease in our average revenue per tractor within a soft freight market since the second quarter of 2015. Dedicated segment revenue increased $47.9 million, or 68.1%, to $118.3 million in 2015 from $70.4 million in 2015. Dedicated segment revenue, net of fuel surcharges, increased 89.5% primarily due to an increase in our average fleet size of 83.2% driven by a significant increase in our number of Dedicated contracts with customers. The improvement in the operating ratio in 2015 was primarily due to an increase in our average revenue per tractor. Intermodal segment revenue decreased $20.1 million, or 20.7%, to $77.0 million in 2015 from $97.1 million in 2014. Intermodal segment revenue, net of fuel surcharges, decreased 12.7% due to the disposal in March 2015 of the dry containers that were used in a portion of our intermodal operations, partially offset by increased volume with our temperature-controlled intermodal trailer service. The improvement in the operating ratio in 2015 was primarily due to costs associated with rail service interruption and delay issues in 2014 that constrained our intermodal operations, the disposal of our dry container service, which produced a higher operating ratio than our temperature-controlled trailer service, rate increases beginning in the fourth quarter of 2014, and the negative impact of severe weather conditions in the first quarter of 2014 on both freight volumes and operating costs. Brokerage segment revenue increased $14.2 million, or 24.8%, to $71.4 million in 2015 from $57.2 million in 2014, primarily due to an increase in volume. The improvement in the operating ratio in 2015 was primarily due to a decrease in the payments to carriers for transportation services which we arranged as a percentage of our Brokerage revenue. The following table sets forth for the years indicated the dollar and percentage increase or decrease of the items in our consolidated statements of operations, and those items as a percentage of operating revenue: Salaries, wages and benefits consist of compensation for our employees, including both driver and non-driver employees, employees’ health insurance, 401(k) plan contributions and other fringe benefits. These expenses vary depending upon the size of our Truckload, Dedicated and Intermodal tractor fleets, the ratio of company drivers to independent contractors, our efficiency, our experience with employees’ health insurance claims, changes in health care premiums and other factors. The increase in salaries, wages and benefits from 2014 resulted primarily from a 5.2% increase in the total miles driven by company drivers and increases to several components of the amount paid to company drivers. Employees’ health insurance costs increased $2.1 million due to higher self-insured medical claims and bonus compensation expense for our non-driver employees increased $1.0 million as well. Purchased transportation consists of payments to railroads and carriers for transportation services we arrange in connection with Brokerage and Intermodal operations and to independent contractor providers of revenue equipment. This category will vary depending upon the amount and rates, including fuel surcharges, we pay to third-party railroad and motor carriers, the ratio of company drivers versus independent contractors and the amount of fuel surcharges passed through to independent contractors. Purchased transportation expense decreased $5.0 million in total, or 4.1%, in 2015 from 2014. Payments to carriers for transportation services we arranged in our Brokerage segment increased $11.4 million to $60.5 million in 2015 from $49.1 million in 2014, primarily due to an increase in volume. Payments to railroads and drayage carriers for transportation services within our Intermodal segment decreased $17.1 million to $49.3 million in 2015 from $66.4 million in 2014. This decrease was due to the disposal in March 2015 of the dry containers that were used in a portion of our intermodal operations, partially offset by increased volume with our temperature-controlled intermodal trailer service. The portion of purchased transportation expense related to our independent contractors within our Truckload and Dedicated segments, including fuel surcharges, increased $704,000 in 2015. We expect that purchased transportation expense will increase as we grow our Intermodal and Brokerage segments. Fuel and fuel taxes decreased by $49.3 million in 2015 from 2014. Net fuel expense (fuel and fuel taxes net of fuel surcharge revenue and surcharges passed through to independent contractors, outside drayage carriers and railroads) decreased $5.6 million, or 12.0%, to $41.1 million in 2015 from $46.7 million in 2014. Fuel surcharges passed through to independent contractors, outside drayage carriers and railroads were $8.9 million in 2015 and $18.0 million in 2014. We have worked diligently to control fuel usage and costs by improving our volume purchasing arrangements and optimizing our drivers’ fuel purchases with national fuel centers, focusing on shorter lengths of haul, installing and tightly managing the use of auxiliary power units in our tractors to minimize engine idling and improving fuel usage in the temperature-control units on our trailers. Auxiliary power units, which we have installed in our company-owned tractors, provide climate control and electrical power for our drivers without idling the tractor engine. The decrease in net fuel expense was primarily due to a decrease in the DOE national average cost of fuel to $2.71 per gallon in 2015 from $3.83 per gallon in 2014 and continued progress with the cost control measures stated above. Net fuel expense represented 7.9% of Truckload, Dedicated and Intermodal segment revenue, net of fuel surcharges, in 2015, compared with 9.5% in 2014. Supplies and maintenance consist of repairs, maintenance, tires, parts, oil, and engine fluids, along with load-specific expenses including loading/unloading, tolls, pallets and trailer hostling. Our supplies and maintenance expense increased $1.8 million, or 4.4%, from 2014 primarily due to increased repair costs at external facilities. Depreciation relates to owned tractors, trailers, auxiliary power units, communication units, terminal facilities and other assets. The increase in depreciation was primarily due to a continued increase in the cost of revenue equipment and growth of our fleet. We expect our annual cost of tractor and trailer ownership will increase in future periods as a result of higher prices of new equipment, which will result in greater depreciation over the useful life. Insurance and claims consist of the costs of insurance premiums and accruals we make for claims within our self-insured retention amounts, primarily for personal injury, property damage, physical damage to our equipment, cargo claims and workers’ compensation claims. These expenses will vary primarily based upon the frequency and severity of our accident experience, our self-insured retention levels and the market for insurance. The $2.0 million increase in insurance and claims in 2015 was primarily due to increases in the cost of physical damage claims related to our tractors and trailers, self-insured auto liability claims and workers’ compensation accident claims. Our significant self-insured retention exposes us to the possibility of significant fluctuations in claims expense between periods which could materially impact our financial results depending on the frequency, severity and timing of claims. Gain on disposition of revenue equipment increased to $5.6 million in 2015 from $4.4 million in 2014 primarily due to an increase in the number of trailers sold. Future gains or losses on dispositions of revenue equipment will be impacted by the market for used revenue equipment, which is beyond our control. Gain on disposition of facilities was $4.1 million in 2015. The disposition of the facilities, located in Ontario, CA and Indianapolis, IN, was part of our ongoing program to expand and update the footprint of our facilities throughout the United States, in which we have spent over $83 million since 2009. Any future gains or losses on disposition of facilities will be impacted by the market for real estate, which is beyond our control. As a result of the foregoing factors, our operating expenses as a percentage of operating revenue, or “operating ratio,” improved to 90.8% in 2015 from 92.4% in 2014. The operating ratio for our Truckload segment was 91.1% in 2015 and 91.2% in 2014, for our Dedicated segment was 89.2% in 2015 and 89.9% in 2014, for our Intermodal segment was 93.7% in 2015 and 98.2% in 2014, and for our Brokerage segment was 94.7% in 2015 and 95.4% in 2014. Operating expenses as a percentage of operating revenue, with both amounts net of fuel surcharges, improved to 89.7% in 2015 from 90.7% in 2014. Our operating ratio for 2015, net of both the gain on the disposition of facilities and fuel surcharges, improved to 90.4%. The decrease in other non-operating income was primarily due to decreased earnings in 2015 by MWL, a 45% owned affiliate. Our effective income tax rate decreased to 41.1% in 2015 from 42.3% in 2014, primarily due to per diem and other non-deductible expenses being a lower percentage of the increased taxable income in 2015. As a result of the factors described above, net income increased by 19.8% to $35.7 million in 2015 from $29.8 million in 2014. Net earnings per diluted share increased to $1.06 in 2015 from $0.89 in 2014. Comparison of Year Ended December 31, 2014 to Year Ended December 31, 2013 The following table sets forth for the years indicated our operating revenue, operating income and operating ratio by segment, along with the change for each component: (1) Brokerage revenue is net of $2.1 million of inter-segment revenue in 2013 for loads transported by our tractors and arranged by MWL that have been eliminated in consolidation. The inter-segment revenue in 2013 relates to loads transported prior to the deconsolidation of MWL effective March 28, 2013. (2) Represents operating expenses as a percentage of operating revenue. Our operating revenue increased $13.7 million, or 2.1%, to $672.9 million in 2014 from $659.2 million in 2013. Our operating revenue, net of fuel surcharges and MWL revenue, increased $22.9 million, or 4.4%, to $547.7 million in 2014 from $524.8 million in 2013. This increase was primarily due to a $23.1 million increase in Dedicated revenue, net of fuel surcharges. Fuel surcharge revenue decreased to $125.2 million in 2014 from $127.7 million in 2013. Truckload segment revenue decreased $16.7 million, or 3.6%, to $448.3 million in 2014 from $465.0 million in 2013. Truckload segment revenue, net of fuel surcharges, decreased 2.3% primarily due to a decrease in our average fleet size of 6.3% from 2013, partially offset by an increase in our average revenue, net of fuel surcharges, per tractor per week of 4.2%. The increase in our average revenue per tractor was primarily due to an increase in our average rate per mile. The improvement in the operating ratio in 2014 was due to an increase in our average revenue per tractor, partially offset by the negative impact of severe weather conditions in the first quarter of 2014 on both freight volumes and operating costs. Dedicated segment revenue increased $28.0 million, or 66.2%, to $70.4 million in 2014 from $42.3 million in 2013. Dedicated segment revenue, net of fuel surcharges, increased 68.9% primarily due to an increase in our average fleet size of 73.0% driven by a significant increase in our number of Dedicated contracts with customers, partially offset by a 2.2% decrease in our average revenue, net of fuel surcharges, per tractor per week from 2013. The increase in the operating ratio for our Dedicated segment in 2014 was primarily due to the addition of contracts with higher operating ratios than the average in 2013, along with the negative impact of severe weather conditions in the first quarter of 2014 on both freight volumes and operating costs. Intermodal segment revenue increased $4.6 million, or 4.9%, to $97.1 million in 2014 from $92.5 million in 2013. Intermodal segment revenue, net of fuel surcharges, increased 5.1% due to continued volume growth in our Intermodal services. The increase in the operating ratio for our Intermodal segment in 2014 was primarily due to costs associated with rail service interruption and delay issues that constrained our Intermodal operations, volume growth in our dry container service, which produces a higher operating ratio than our temperature-controlled trailer service, and the negative impact of severe weather conditions in the first quarter of 2014 on both freight volumes and operating costs. Brokerage segment revenue decreased $2.2 million, or 3.7%, to $57.2 million in 2014 from $59.4 million in 2013. Marten Transport Brokerage revenue increased $4.5 million in 2014 due to an increase in volume. With the March 28, 2013 deconsolidation of MWL, MWL revenue included in our Brokerage segment decreased $6.7 million in 2014. The increase in the operating ratio for our Brokerage segment in 2014 was primarily due to an increase in the payments to carriers for transportation services which we arranged as a percentage of our Brokerage revenue. The following table sets forth for the years indicated the dollar and percentage increase or decrease of the items in our consolidated statements of operations, and those items as a percentage of operating revenue: The increase in salaries, wages and benefits from 2013 resulted primarily from increases to several components of the amount paid to company drivers during 2014 and an increase in employees’ health insurance expense of $3.3 million due to an increase in our self-insured medical claims, which was partially offset by an $800,000 decrease in bonus compensation expense for our non-driver employees. Purchased transportation expense decreased $419,000 in total, or 0.3%, in 2014 from 2013. Payments to carriers for transportation services we arranged in our Brokerage segment increased $3.5 million to $49.1 million in 2014 from $45.6 million in 2013. With the March 28, 2013 deconsolidation of MWL, there was no purchased transportation expense related to MWL included in the Brokerage segment in 2014 compared with $5.4 million in 2013. Payments to railroads and drayage carriers for transportation services within our Intermodal segment increased $1.3 million to $66.4 million in 2014 from $65.1 million in 2013. The portion of purchased transportation expense related to our independent contractors within our Truckload and Dedicated segments, including fuel surcharges, increased $266,000 in 2014. Fuel and fuel taxes decreased by $9.3 million in 2014 from 2013. Net fuel expense (fuel and fuel taxes net of fuel surcharge revenue and surcharges passed through to independent contractors, outside drayage carriers and railroads) decreased $6.8 million, or 12.6%, to $46.7 million in 2014 from $53.4 million in 2013. Fuel surcharges passed through to independent contractors, outside drayage carriers and railroads were $18.0 million in 2014 and $17.9 million in 2013. We have worked diligently to control fuel usage and costs by improving our volume purchasing arrangements and optimizing our drivers’ fuel purchases with national fuel centers, focusing on shorter lengths of haul, installing and tightly managing the use of auxiliary power units in our tractors to minimize engine idling and improving fuel usage in the temperature-control units on our trailers. The decrease in net fuel expense was primarily due to continued progress with the cost control measures stated above and a decrease in the DOE national average cost of fuel to $3.83 per gallon in 2014 from $3.92 per gallon in 2013. Net fuel expense represented 9.5% of Truckload, Dedicated and Intermodal segment revenue, net of fuel surcharges, in 2014, compared with 11.3% in 2013. The increase in depreciation was primarily due to a continued increase in the cost of revenue equipment. The $3.6 million increase in insurance and claims in 2014 was primarily due to an increase in the cost of our self-insured auto liability, workers’ compensation and cargo claims. Gain on disposition of revenue equipment decreased to $4.4 million in 2014 from $6.0 million in 2013 due to a decrease in the market value for used revenue equipment and a decrease in the number of tractors sold. As a result of the foregoing factors, our operating expenses as a percentage of operating revenue, or “operating ratio,” increased to 92.4% in 2014 from 92.1% in 2013. The operating ratio for our Truckload segment was 91.2% in 2014 and 91.5% in 2013, for our Dedicated segment was 89.9% in 2014 and 86.8% in 2013, for our Intermodal segment was 98.2% in 2014 and 95.7% in 2013, and for our Brokerage segment was 95.4% in 2014 and 94.8% in 2013. Operating expenses as a percentage of operating revenue, with both amounts net of fuel surcharge revenue, increased to 90.7% in 2014 from 90.2% in 2013. Our effective income tax rate decreased slightly to 42.3% in 2014 from 42.4% in 2013. As a result of the factors described above, net income decreased to $29.8 million in 2014 from $30.1 million in 2013. Net earnings per diluted share decreased to $0.89 in 2014 from $0.90 in 2013. Liquidity and Capital Resources Our business requires substantial, ongoing capital investments, particularly for new tractors and trailers. Our primary sources of liquidity are funds provided by operations and our revolving credit facility. A portion of our tractor fleet is provided by independent contractors who own and operate their own equipment. We have no capital expenditure requirements relating to those drivers who own their tractors or obtain financing through third parties. The table below reflects our net cash flows provided by operating activities, net cash flows used for investing activities and net cash flows (used for) provided by financing activities for the years indicated. In December 2007, our Board of Directors approved and we announced a share repurchase program to repurchase up to one million shares of our common stock either through purchases on the open market or through private transactions and in accordance with Rule 10b-18 of the Exchange Act. On November 4, 2015, our Board of Directors approved and we announced an increase in the share repurchase program, providing for the repurchase of up to $40 million, or approximately 2 million shares, of our common stock. The timing and extent to which we repurchase shares depends on market conditions and other corporate considerations. The repurchase program does not have an expiration date. In the fourth quarter of 2015 we repurchased and retired 941,024 shares of our common stock for $16.2 million. In 2015, net cash flows provided by operating activities of $128.2 million and net borrowings under our credit facility of $13.5 million were primarily used to purchase new revenue equipment, net of proceeds from dispositions, in the amount of $118.2 million, to partially construct regional operating facilities in the amount of $8.6 million, to repurchase and retire 941,024 shares of our common stock for $16.2 million, and to pay cash dividends of $3.3 million. In 2014, net cash flows provided by operating activities of $82.0 million, borrowings under our credit facility of $24.4 million, and cash and cash equivalents of $13.5 million were primarily used to purchase new revenue equipment, net of proceeds from dispositions, in the amount of $87.7 million, to acquire and partially construct regional operating facilities in the amount of $27.4 million, and to pay cash dividends of $3.3 million. In 2013, net cash flows provided by operating activities of $89.2 million were primarily used to purchase new revenue equipment, net of proceeds from dispositions, in the amount of $54.8 million, to partially construct and acquire regional operating facilities in the amount of $16.9 million, to pay cash dividends of $2.8 million, to repay $2.7 million of long-term debt, and to increase cash and cash equivalents by $10.2 million. We estimate that capital expenditures, net of proceeds from dispositions, will be approximately $130 million in 2016. Quarterly cash dividends of $0.025 per share of common stock were declared in each quarter of 2015 and 2014 and totaled $3.3 million in each of 2015 and 2014. Quarterly cash dividends of $0.017 per share were declared in each of the first and second quarters of 2013, and of $0.025 per share were declared in each of the third and fourth quarters of 2013, totaling $2.8 million. We currently expect to continue to pay quarterly cash dividends in the future. The payment of cash dividends in the future, and the amount of any such dividends, will depend upon our financial condition, results of operations, cash requirements, and certain corporate law requirements, as well as other factors deemed relevant by our Board of Directors. We believe our sources of liquidity are adequate to meet our current and anticipated needs for at least the next twelve months. Based upon anticipated cash flows, existing cash and cash equivalents balances, current borrowing availability and other sources of financing we expect to be available to us, we do not anticipate any significant liquidity constraints in the foreseeable future. We maintain a credit agreement that provides for an unsecured committed credit facility which matures in December 2019. In November 2015, we entered into an amendment to the facility which increased the aggregate principal amount of the facility from $50.0 million to $75.0 million. At December 31, 2015, there was an outstanding principal balance of $37.9 million on the facility. As of that date, we had outstanding standby letters of credit of $10.4 million and remaining borrowing availability of $26.7 million. This facility bears interest at a variable rate based on the London Interbank Offered Rate or the lender’s Prime Rate, in each case plus/minus applicable margins. Our credit facility prohibits us from paying, in any fiscal year, stock redemptions and dividends in excess of 25% of our net income from the prior fiscal year. A waiver of the 25% limitation for 2015 and 2016, should it apply, was obtained from the lender. This facility also contains restrictive covenants which, among other matters, require us to maintain compliance with cash flow leverage and fixed charge coverage ratios. We were in compliance with all covenants at December 31, 2015. The following is a summary of our contractual obligations as of December 31, 2015. Due to uncertainty with respect to the timing of future cash flows, the obligation under our nonqualified deferred compensation plan at December 31, 2015 of 90,143 shares of Company common stock with a value of $1.6 million has been excluded from the above table. Related Parties We purchase fuel and tires and obtain related services from Bauer Built, Inc., or BBI. Jerry M. Bauer, one of our directors, is the chairman of the board, chief executive officer and the principal stockholder of BBI. We paid BBI $335,000 in 2015, $562,000 in 2014 and $585,000 in 2013 for fuel, tires and related services. In addition, we paid $1.5 million in 2015, $1.4 million in 2014 and $1.6 million in 2013 to tire manufacturers for tires that were provided by BBI. BBI received commissions from the tire manufacturers related to these purchases. Other than any benefit received from his ownership interest, Mr. Bauer receives no compensation or other benefits from our business with BBI. We own a 45% equity interest in MWL, a third-party provider of logistics services to the transportation industry. We received $5.0 million, $8.5 million and $8.2 million of our revenue for loads transported by our tractors and arranged by MWL in 2015, 2014 and 2013, respectively. Prior to deconsolidation effective March 28, 2013, these inter-segment revenues were eliminated in consolidation. Inter-segment revenue eliminated in consolidation was $2.1 million in 2013. As of December 31, 2015, we also had a trade receivable in the amount of $204,000 from MWL and an accrued liability of $4.3 million to MWL for the excess of payments by MWL’s customers into our lockbox account over the amounts drawn on the account by MWL. We believe that the transactions with related parties noted above are on reasonable terms which, based upon market rates, are comparable to terms available from unaffiliated third parties. Off-balance Sheet Arrangements Other than standby letters of credit maintained in connection with our self-insurance programs in the amount of $10.4 million and operating leases summarized above in our summary of contractual obligations, we did not have any other material off-balance sheet arrangements at December 31, 2015. Inflation and Fuel Costs Most of our operating expenses are inflation-sensitive, with inflation generally producing increased costs of operations. During the past three years, the most significant effects of inflation have been on revenue equipment prices, accident claims, health insurance and employee compensation. We attempt to limit the effects of inflation through increases in freight rates and cost control efforts. In addition to inflation, fluctuations in fuel prices can affect our profitability. We require substantial amounts of fuel to operate our tractors and power the temperature-control units on our trailers. Substantially all of our contracts with customers contain fuel surcharge provisions. Although we historically have been able to pass through a significant portion of long-term increases in fuel prices and related taxes to customers in the form of fuel surcharges and higher rates, such increases usually are not fully recovered. These fuel surcharge provisions are not effective in mitigating the fuel price increases related to non-revenue miles or fuel used while the tractor is idling. Seasonality Our tractor productivity generally decreases during the winter season because inclement weather impedes operations and some shippers reduce their shipments. At the same time, operating expenses generally increase, with harsh weather creating higher accident frequency, increased claims, lower fuel efficiency and more equipment repairs. Critical Accounting Policies The preparation of financial statements in conformity with U.S. generally accepted accounting principles requires management to make estimates and assumptions about future events, and apply judgments that affect the reported amounts of assets, liabilities, revenue and expenses in our consolidated financial statements and related notes. We base our estimates, assumptions and judgments on historical experience, current trends and other factors believed to be relevant at the time our consolidated financial statements are prepared. However, because future events and their effects cannot be determined with certainty, actual results could differ from our estimates and assumptions, and such differences could be material. We believe that the following critical accounting policies affect our more significant estimates, assumptions and judgments used in the preparation of our consolidated financial statements. Revenue Recognition. We recognize revenue, including fuel surcharges, at the time shipment of freight is completed. We account for revenue of our Intermodal and Brokerage segments and revenue on freight transported by independent contractors within our Truckload and Dedicated segments on a gross basis because we are the primary obligor in the arrangements, we have the ability to establish prices, we have the risk of loss in the event of cargo claims and we bear credit risk with customer payments. Accordingly, all such revenue billed to customers is classified as operating revenue and all corresponding payments to carriers for transportation services we arrange in connection with brokerage and intermodal activities and to independent contractor providers of revenue equipment are classified as purchased transportation expense. Accounts Receivable. We are dependent upon a limited number of customers, and, as a result, our trade accounts receivable are highly concentrated. Trade accounts receivable are recorded at the invoiced amounts, net of an allowance for doubtful accounts. Our allowance for doubtful accounts was $305,000 as of December 31, 2015 and $475,000 as of December 31, 2014. A considerable amount of judgment is required in assessing the realization of these receivables including the current creditworthiness of each customer and related aging of the past-due balances, including any billing disputes. In order to assess the collectibility of these receivables, we perform ongoing credit evaluations of our customers’ financial condition. Through these evaluations, we may become aware of a situation where a customer may not be able to meet its financial obligations due to deterioration of its financial viability, credit ratings or bankruptcy. The allowance for doubtful accounts is based on the best information available to us and is reevaluated and adjusted as additional information is received. We evaluate the allowance based on historical write-off experience, the size of the individual customer balances, past-due amounts and the overall national economy. We review the adequacy of our allowance for doubtful accounts monthly. Property and Equipment. The transportation industry requires significant capital investments. Our net property and equipment was $528.0 million as of December 31, 2015 and $465.7 million as of December 31, 2014. Our depreciation expense was $75.3 million in 2015, $68.2 million in 2014 and $64.5 million in 2013. We compute depreciation of our property and equipment for financial reporting purposes based on the cost of each asset, reduced by its estimated salvage value, using the straight-line method over its estimated useful life. We determine and periodically evaluate our estimate of the projected salvage values and useful lives primarily by considering the market for used equipment, prior useful lives and changes in technology. We have not changed our policy regarding salvage values as a percentage of initial cost or useful lives of tractors and trailers within the last ten years. We believe that our policies and past estimates have been reasonable. Actual results could differ from these estimates. A 5% decrease in estimated salvage values would have decreased our net property and equipment as of December 31, 2015 by approximately $10.0 million, or 1.9%. Impairment of Assets. Long-lived assets are reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. Recoverability of assets to be held and used is measured by a comparison of the carrying amount of an asset to future net undiscounted cash flows expected to be generated by the asset. If such assets are considered to be impaired, the impairment to be recognized is measured by the amount by which the carrying amount of the assets exceeds the fair value of the assets. Assets to be disposed of are reported at the lower of the carrying amount or fair value less the costs to sell. Insurance and Claims. We self-insure, in part, for losses relating to workers’ compensation, auto liability, general liability, cargo and property damage claims, along with employees’ health insurance with varying risk retention levels. We maintain insurance coverage for per-incident and total losses in excess of these risk retention levels in amounts we consider adequate based upon historical experience and our ongoing review. However, we could suffer a series of losses within our self-insured retention limits or losses over our policy limits, which could negatively affect our financial condition and operating results. We are responsible for the first $1.0 million on each auto liability claim and for the first $750,000 on each workers’ compensation claim. We have $10.4 million in standby letters of credit to guarantee settlement of claims under agreements with our insurance carriers and regulatory authorities. The insurance and claims accruals in our consolidated balance sheets were $16.2 million as of December 31, 2015 and $14.0 million as of December 31, 2014. We reserve currently for the estimated cost of the uninsured portion of pending claims. We periodically evaluate and adjust these reserves based on our evaluation of the nature and severity of outstanding individual claims and our estimate of future claims development based on historical development. Actual results could differ from these current estimates. In addition, to the extent that claims are litigated and not settled, jury awards are difficult to predict. Share-based Payment Arrangement Compensation. We have granted stock options to certain employees and non-employee directors. We recognize compensation expense for all stock options net of an estimated forfeiture rate and only record compensation expense for those shares expected to vest on a straight-line basis over the requisite service period (normally the vesting period). Determining the appropriate fair value model and calculating the fair value of stock options require the input of highly subjective assumptions, including the expected life of the stock options and stock price volatility. We use the Black-Scholes model to value our stock option awards. We believe that future volatility will not materially differ from our historical volatility. Thus, we use the historical volatility of our common stock over the expected life of the award. The assumptions used in calculating the fair value of stock options represent our best estimates, but these estimates involve inherent uncertainties and the application of judgment. As a result, if factors change and we use different assumptions, stock option compensation expense could be materially different in the future. We have also granted performance unit awards to certain employees which are subject to vesting requirements over a five-year period, primarily based on our earnings growth. The fair value of each performance unit is based on the closing market price on the date of grant. We recognize compensation expense for these awards based on the estimated number of units probable of achieving the performance and service vesting requirements of the awards, net of an estimated forfeiture rate. Recent Accounting Pronouncements In May 2014, the Financial Accounting Standards Board, or FASB, issued Accounting Standards Update No. 2014-09, “Revenue from Contracts with Customers” which requires an entity to recognize the amount of revenue to which it expects to be entitled for the transfer of promised goods or services to customers. The standard, which is effective for the first quarter of 2018, will replace most existing revenue recognition guidance required by U.S. generally accepted accounting principles. The adoption of this standard is not expected to have a significant impact on our consolidated balance sheets, statements of operations or statements of cash flows. In February 2016, the FASB issued Accounting Standards Update No. 2016-02, “Leases” which requires organizations that lease assets to recognize on the balance sheet the assets and liabilities for the rights and obligations created by those leases. The new guidance also requires additional disclosures related to leasing transactions. The standard is effective for the first quarter of 2019. The adoption of this standard is not expected to have a significant impact on our consolidated balance sheets, statements of operations or statements of cash flows.

<s>[INST] Overview The primary source of our operating revenue is provided by our Truckload segment through a combination of regional shorthaul and mediumtolonghaul fullload transportation services. We transport food and other consumer packaged goods that require a temperaturecontrolled or insulated environment across the United States and into and out of Mexico and Canada. Our Dedicated segment provides customized transportation solutions tailored to meet individual customers’ requirements, utilizing temperaturecontrolled trailers, dry vans and other specialized equipment within the United States. Our customer contracts range from three to five years and are subject to annual rate reviews. Generally, we are paid by the mile for our Truckload and Dedicated services. We also derive Truckload and Dedicated revenue from fuel surcharges, loading and unloading activities, equipment detention and other ancillary services. The main factors that affect our Truckload and Dedicated revenue are the rate per mile we receive from our customers, the percentage of miles for which we are compensated, the number of miles we generate with our equipment and changes in fuel prices. We monitor our revenue production primarily through average Truckload and Dedicated revenue, net of fuel surcharges, per tractor per week. We also analyze our average Truckload and Dedicated revenue, net of fuel surcharges, per total mile, nonrevenue miles percentage, the miles per tractor we generate, our fuel surcharge revenue, our accessorial revenue and our other sources of operating revenue. Our Intermodal segment transports our customers’ freight within the United States primarily utilizing our temperaturecontrolled trailers and also, through March 2015, our dry containers on railroad flatcars for portions of trips, with the balance of the trips using our tractors or, to a lesser extent, contracted carriers. The main factors that affect our Intermodal revenue are the rate per mile and other charges we receive from our customers. Our Brokerage segment arranges for smaller thirdparty carriers to transport freight for our customers in temperaturecontrolled trailers and dry vans within the United States and into and out of Mexico while we retain the billing, collection and customer management responsibilities. The main factors that affect our Brokerage revenue are the rate per mile and other charges we receive from our customers. In addition to the factors discussed above, our operating revenue is also affected by, among other things, the United States economy, inventory levels, the level of truck and rail capacity in the transportation market, a contracting driver market, severe weather conditions and specific customer demand. Our operating revenue decreased $7.9 million, or 1.2%, in 2015, reflecting a 42.2% decrease in fuel surcharge revenue to $72.3 million from $125.2 million in 2014 due to lower fuel prices. Our operating revenue, net of fuel surcharges, increased $44.9 million, or 8.2%, compared with 2014. Truckload segment revenue, net of fuel surcharges, decreased 2.9% from 2014. Dedicated segment revenue, net of fuel surcharges, increased 89.5% primarily due to an increase in our average fleet size of 83.2% from 2014. Intermodal segment revenue, net of fuel surcharges, decreased 12.7% due to the disposal in March 2015 of the overheadintensive dry containers that were used in our intermodal operations, partially offset by increased volume with our temperaturecontrolled intermodal trailer service. Brokerage revenue increased 24.8% in 2015 due to an increase in volume. Our profitability is impacted by the variable costs of transporting freight for our customers, fixed costs, and expenses containing both fixed and variable components. The variable costs include fuel expense, driverrelated expenses, such as wages, benefits, training, and recruitment, and independent contractor costs, which are recorded under purchased transportation. Expenses that have both fixed and variable components include maintenance and tire expense and our cost of insurance and claims. These expenses generally vary with the miles we travel, but also have a controllable component based on safety, fleet age, efficiency and other factors. Our main fixed costs relate to the acquisition and subsequent depreciation of longterm assets, such as revenue equipment and operating terminals. We expect our annual cost of tra [/INST] Negative. </s>

MARTEN TRANSPORT LTD

2017-03-15

2016-12-31

ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The following discussion and analysis of our financial condition and results of operations should be read together with the selected consolidated financial data and our consolidated financial statements and the related notes appearing elsewhere in this report. This discussion and analysis contains forward-looking statements that involve risks, uncertainties and assumptions. Our actual results may differ materially from those anticipated in these forward-looking statements as a result of many factors, including but not limited to those under the heading “Risk Factors” beginning on page 7. We do not assume, and specifically disclaim, any obligation to update any forward-looking statement contained in this report. Overview The primary source of our operating revenue is provided by our Truckload segment through a combination of regional short-haul and medium-to-long-haul full-load transportation services. We transport food and other consumer packaged goods that require a temperature-controlled or insulated environment, along with dry freight, across the United States and into and out of Mexico and Canada. Our Dedicated segment provides customized transportation solutions tailored to meet individual customers’ requirements, utilizing temperature-controlled trailers, dry vans and other specialized equipment within the United States. Our customer contracts range from three to five years and are subject to annual rate reviews. Generally, we are paid by the mile for our Truckload and Dedicated services. We also derive Truckload and Dedicated revenue from fuel surcharges, loading and unloading activities, equipment detention and other ancillary services. The main factors that affect our Truckload and Dedicated revenue are the rate per mile we receive from our customers, the percentage of miles for which we are compensated, the number of miles we generate with our equipment and changes in fuel prices. We monitor our revenue production primarily through average Truckload and Dedicated revenue, net of fuel surcharges, per tractor per week. We also analyze our average Truckload and Dedicated revenue, net of fuel surcharges, per total mile, non-revenue miles percentage, the miles per tractor we generate, our fuel surcharge revenue, our accessorial revenue and our other sources of operating revenue. Our Intermodal segment transports our customers’ freight within the United States primarily utilizing our temperature-controlled trailers and also, through March 2015, our dry containers on railroad flatcars for portions of trips, with the balance of the trips using our tractors or, to a lesser extent, contracted carriers. The main factors that affect our Intermodal revenue are the rate per mile and other charges we receive from our customers. Our Brokerage segment develops contractual relationships with and arranges for third-party carriers to transport freight for our customers in temperature-controlled trailers and dry vans within the United States and into and out of Mexico through Marten Transport Logistics, LLC, which was established in 2007 and operates pursuant to brokerage authority granted by the DOT. We retain the billing, collection and customer management responsibilities. The main factors that affect our Brokerage revenue are the rate per mile and other charges that we receive from our customers. In addition to the factors discussed above, our operating revenue is also affected by, among other things, the United States economy, inventory levels, the level of truck and rail capacity in the transportation market, a contracting driver market, severe weather conditions and specific customer demand. Our operating revenue increased $6.2 million, or 0.9%, in 2016, despite a 26.4% decrease in fuel surcharge revenue to $53.2 million from $72.3 million in 2015 due to lower fuel prices. Our operating revenue, net of both fuel surcharges and revenue from our dry container service discontinued in March 2015, increased $26.6 million, or 4.5%, compared with 2015. Truckload segment revenue, net of fuel surcharges, decreased 2.3% from 2015 primarily due to a decrease in our average revenue per tractor. Dedicated segment revenue, net of fuel surcharges, increased 37.1% primarily due to an increase in our average fleet size of 36.7% from 2015. Intermodal segment revenue, net of both fuel surcharges and revenue from our discontinued dry container service, decreased $49,000 from 2015 due to a decrease in volume. Brokerage segment revenue decreased 7.0% in 2016 due to a decrease in revenue per load, primarily caused by lower fuel surcharges. Our profitability is impacted by the variable costs of transporting freight for our customers, fixed costs, and expenses containing both fixed and variable components. The variable costs include fuel expense, driver-related expenses, such as wages, benefits, training, and recruitment, and independent contractor costs, which are recorded under purchased transportation. Expenses that have both fixed and variable components include maintenance and tire expense and our cost of insurance and claims. These expenses generally vary with the miles we travel, but also have a controllable component based on safety, fleet age, efficiency and other factors. Our main fixed costs relate to the acquisition and subsequent depreciation of long-term assets, such as revenue equipment and operating terminals. We expect our annual cost of tractor and trailer ownership will increase in future periods as a result of higher prices of new equipment, along with any increases in fleet size. Although certain factors affecting our expenses are beyond our control, we monitor them closely and attempt to anticipate changes in these factors in managing our business. For example, fuel prices have significantly fluctuated over the past several years. We manage our exposure to changes in fuel prices primarily through fuel surcharge programs with our customers, as well as through volume fuel purchasing arrangements with national fuel centers and bulk purchases of fuel at our terminals. To help further reduce fuel expense, we have installed and tightly manage the use of auxiliary power units in our tractors to provide climate control and electrical power for our drivers without idling the tractor engine, and also have improved the fuel usage in the temperature-control units on our trailers. For our Intermodal and Brokerage segments, our profitability is impacted by the percentage of revenue which is payable to the providers of the transportation services we arrange. This expense is included within purchased transportation in our consolidated statements of operations. Our operating expenses as a percentage of operating revenue, or “operating ratio,” increased to 91.3% in 2016 from 90.8% in 2015. Operating expenses as a percentage of operating revenue, with both amounts net of fuel surcharges, was 90.6% in 2016. Our operating ratio for 2015, net of both the facility disposition gain of $4.1 million and fuel surcharges, was 90.4%. Our net income was $33.5 million, or $1.02 per diluted share, in 2016 and $35.7 million, or $1.06 per diluted share, in 2015. Net income in 2016 improved 0.4% over earnings of $33.3 million, or $0.99 per diluted share, in 2015 excluding the facility disposition gain, due to increased operating income in our Dedicated, Intermodal and Brokerage segments, partially offset by decreased operating income in our Truckload segment. Our business requires substantial, ongoing capital investments, particularly for new tractors and trailers. At December 31, 2016, we had $7.9 million of long-term debt outstanding and $437.3 million in stockholders’ equity. In 2016, net cash flows provided by operating activities of $133.6 million were primarily used to purchase new revenue equipment, net of proceeds from dispositions, in the amount of $89.9 million, to partially construct regional operating facilities in the amount of $5.1 million, to repay, net of borrowings, $30.0 million of long-term debt, to repurchase and retire 455,581 shares of our common stock for $7.5 million, and to pay cash dividends of $3.3 million. We estimate that capital expenditures, net of proceeds from dispositions, will be approximately $88 million in 2017. We believe our sources of liquidity are adequate to meet our current and anticipated needs for at least the next twelve months. Based upon anticipated cash flows, existing cash and cash equivalents balances, current borrowing availability and other sources of financing we expect to be available to us, we do not anticipate any significant liquidity constraints in the foreseeable future. Our business strategy encompasses a multifaceted set of transportation service solutions, primarily regional Truckload temperature-controlled operations along with Dedicated, Intermodal and Brokerage services, with a diverse customer base that gains value from and expands each of these operating segments. We believe that we are well-positioned regardless of the economic environment with the services we provide combined with our competitive position, cost control emphasis, modern fleet and strong balance sheet. This Management’s Discussion and Analysis of Financial Condition and Results of Operations includes discussions of operating revenue, net of fuel surcharge revenue; Truckload, Dedicated and Intermodal revenue, net of fuel surcharge revenue; operating revenue and Intermodal revenue, each net of fuel surcharge revenue and revenue from our dry container service discontinued in March 2015; operating expenses as a percentage of operating revenue, each net of fuel surcharge revenue and the sum of fuel surcharge revenue and the facility disposition gain; and net fuel expense (fuel and fuel taxes net of fuel surcharge revenue and surcharges passed through to independent contractors, outside drayage carriers and railroads). We provide these additional disclosures because management believes these measures provide a more consistent basis for comparing results of operations from period to period. These financial measures in this report have not been determined in accordance with U.S. generally accepted accounting principles (GAAP). Pursuant to Item 10(e) of Regulation S-K, we have included the amounts necessary to reconcile these non-GAAP financial measures to the most directly comparable GAAP financial measures of operating revenue, operating expenses divided by operating revenue, and fuel and fuel taxes. Results of Operations The following table sets forth for the years indicated certain operating statistics regarding our revenue and operations: (1) Includes tractors driven by both company-employed drivers and independent contractors. Independent contractors provided 68, 65 and 52 tractors as of December 31, 2016, 2015 and 2014, respectively. Comparison of Year Ended December 31, 2016 to Year Ended December 31, 2015 The following table sets forth for the years indicated our operating revenue, operating income and operating ratio by segment, along with the change for each component: (1) Represents operating expenses as a percentage of operating revenue. Our operating revenue increased $6.2 million, or 0.9%, to $671.1 million in 2016 from $665.0 million in 2015, despite a 26.4% decrease in fuel surcharge revenue to $53.2 million from $72.3 million in 2015 due to lower fuel prices. Our operating revenue, net of both fuel surcharges and revenue from our dry container service discontinued in March 2015, increased $26.6 million, or 4.5%, to $617.9 million in 2016 from $591.3 million in 2015. This increase was due to a $39.7 million increase in Dedicated revenue, net of fuel surcharges, partially offset by an $8.1 million decrease in Truckload revenue, net of fuel surcharges, a $5.0 million decrease in Brokerage revenue, and a $49,000 decrease in Intermodal revenue, net of both fuel surcharges and the discontinued dry container service. Truckload segment revenue decreased $22.5 million, or 5.7%, to $375.9 million in 2016 from $398.4 million in 2015. Truckload segment revenue, net of fuel surcharges, decreased $8.1 million, or 2.3%, to $340.0 million in 2016 from $348.1 million in 2015, primarily due to a decrease in our average revenue per tractor. The increase in the operating ratio in 2016 was also primarily due to a decrease in our average revenue per tractor within a continued soft freight market. Dedicated segment revenue increased $39.1 million, or 33.1%, to $157.4 million in 2016 from $118.3 million in 2015. Dedicated segment revenue, net of fuel surcharges, increased 37.1% primarily due to an increase in our average fleet size of 36.7% driven by a significant increase in the number of Dedicated contracts we have with customers. The improvement in the operating ratio in 2016 was achieved primarily through multiple cost control measures. Intermodal segment revenue decreased $5.5 million, or 7.1%, to $71.5 million in 2016 from $77.0 million in 2015. Intermodal segment revenue, net of both fuel surcharges and $1.3 million of revenue from our discontinued dry container service, decreased $49,000 from 2015 due to a decrease in volume. The improvement in the operating ratio in 2016 was primarily due to the disposal of our dry container service, which produced a higher operating ratio than our temperature-controlled trailer service, and decreases in salaries, wages and benefits and depreciation expense, as the fleet size was reduced to optimize productivity. Brokerage segment revenue decreased $5.0 million, or 7.0%, to $66.4 million in 2016 from $71.4 million in 2015, due to a decrease in revenue per load, primarily caused by lower fuel surcharges. The improvement in the operating ratio in 2016 was primarily driven by a decrease in the percentage of the amounts payable to carriers for transportation services which we arranged to our Brokerage revenue. The following table sets forth for the years indicated the dollar and percentage increase or decrease of the items in our consolidated statements of operations, and those items as a percentage of operating revenue: Salaries, wages and benefits consist of compensation for our employees, including both driver and non-driver employees, employees’ health insurance, 401(k) plan contributions and other fringe benefits. These expenses vary depending upon the size of our Truckload, Dedicated and Intermodal tractor fleets, the ratio of company drivers to independent contractors, our efficiency, our experience with employees’ health insurance claims, changes in health care premiums and other factors. Salaries, wages and benefits expense increased $15.4 million, or 7.3%, in 2016 from 2015. The increase in salaries, wages and benefits from 2015 resulted primarily from a 6.3% increase in the total miles driven by company drivers and increases to several components of the amount paid to company drivers, along with an increase in employees’ health insurance expense of $1.8 million due to an increase in our self-insured medical claims, partially offset by a decrease of $960,000 in bonus compensation expense for our non-driver employees. Purchased transportation consists of amounts payable to railroads and carriers for transportation services we arrange in connection with Brokerage and Intermodal operations and to independent contractor providers of revenue equipment. This category will vary depending upon the amount and rates, including fuel surcharges, we pay to third-party railroad and motor carriers, the ratio of company drivers versus independent contractors and the amount of fuel surcharges passed through to independent contractors. Purchased transportation expense decreased $7.3 million in total, or 6.2%, in 2016 from 2015. Amounts payable to carriers for transportation services we arranged in our Brokerage segment decreased $5.1 million to $55.4 million in 2016 from $60.5 million in 2015, primarily due to a decrease in brokerage revenue. Amounts payable to railroads and drayage carriers for transportation services within our Intermodal segment decreased $3.4 million to $45.9 million in 2016 from $49.3 million in 2015. This decrease was primarily due to decreased revenue within our temperature-controlled intermodal trailer service, along with the disposal in March 2015 of the dry containers that were used in a portion of our intermodal operations. The portion of purchased transportation expense related to our independent contractors within our Truckload and Dedicated segments, including fuel surcharges, increased $1.2 million in 2016. We expect that purchased transportation expense will increase as we grow our Intermodal and Brokerage segments. Fuel and fuel taxes decreased by $10.5 million, or 10.0%, in 2016 from 2015. Net fuel expense (fuel and fuel taxes net of fuel surcharge revenue and surcharges passed through to independent contractors, outside drayage carriers and railroads) increased $5.9 million, or 14.4%, to $47.0 million in 2016 from $41.1 million in 2015. Fuel surcharges passed through to independent contractors, outside drayage carriers and railroads decreased to $6.2 million from $8.9 million in 2015. Despite a decrease in the DOE national average cost of fuel to $2.30 per gallon from $2.71 per gallon in 2015, net fuel expense increased to 8.5% of Truckload, Dedicated and Intermodal segment revenue, net of fuel surcharges, from 7.9% in 2015. The net fuel expense to revenue increased in 2016 primarily due to our discount from retail being larger in 2015 as the result of a significant decrease in fuel prices during the first quarter, compared with level fuel prices in the first quarter of 2016. The discount from retail typically increases when prices decrease. We have worked diligently to control fuel usage and costs by improving our volume purchasing arrangements and optimizing our drivers’ fuel purchases with national fuel centers, focusing on shorter lengths of haul, installing and tightly managing the use of auxiliary power units in our tractors to minimize engine idling and improving fuel usage in the temperature-control units on our trailers. Auxiliary power units, which we have installed in our company-owned tractors, provide climate control and electrical power for our drivers without idling the tractor engine. Depreciation relates to owned tractors, trailers, auxiliary power units, communication units, terminal facilities and other assets. The increase in depreciation was primarily due to a continued increase in the cost of revenue equipment and growth of our fleet. We expect our annual cost of tractor and trailer ownership will increase in future periods as a result of higher prices of new equipment, which will result in greater depreciation over the useful life. Insurance and claims consist of the costs of insurance premiums and accruals we make for claims within our self-insured retention amounts, primarily for personal injury, property damage, physical damage to our equipment, cargo claims and workers’ compensation claims. These expenses will vary primarily based upon the frequency and severity of our accident experience, our self-insured retention levels and the market for insurance. The $3.0 million increase in insurance and claims in 2016 was primarily due to increases in self-insured auto liability claims and auto liability insurance premiums. Our significant self-insured retention exposes us to the possibility of significant fluctuations in claims expense between periods which could materially impact our financial results depending on the frequency, severity and timing of claims. Gain on disposition of revenue equipment increased to $10.5 million in 2016 from $5.6 million in 2015 primarily due to an increase in both the average gain per tractor and in the number of tractors sold. We expect our gain on disposition of revenue equipment to decrease to approximately $3 million in 2017. Future gains or losses on dispositions of revenue equipment will be impacted by the market for used revenue equipment, which is beyond our control. Gain on disposition of facilities was $4.1 million in 2015. The disposition of the facilities, located in Ontario, CA and Indianapolis, IN, was part of our ongoing program to expand and update the footprint of our facilities throughout the United States, in which we have spent $89 million since 2009. Any future gains or losses on disposition of facilities will be impacted by the market for real estate, which is beyond our control. As a result of the foregoing factors, our operating expenses as a percentage of operating revenue, or “operating ratio,” was 91.3% in 2016 and 90.8% in 2015. The operating ratio for our Truckload segment was 92.7% in 2016 and 91.1% in 2015, for our Dedicated segment was 87.6% in 2016 and 89.2% in 2015, for our Intermodal segment was 90.0% in 2016 and 93.7% in 2015, and for our Brokerage segment was 93.7% in 2016 and 94.7% in 2015. Operating expenses as a percentage of operating revenue, with both amounts net of fuel surcharges, was 90.6% in 2016. Our operating ratio for 2015, net of both the gain on disposition of facilities and fuel surcharges, was 90.4%. The increase in our non-operating expense was primarily due to increased losses in 2016 by MW Logistics, LLC, or MWL, a 45% owned affiliate. Our effective income tax rate increased slightly to 41.4% in 2016 from 41.1% in 2015. As a result of the factors described above, net income was $33.5 million in 2016 and $35.7 million in 2015. Net earnings per diluted share was $1.02 in 2016 and $1.06 in 2015. Net income in 2016 improved 0.4% over earnings of $33.3 million, or $0.99 per diluted share, in 2015 excluding the gain on disposition of facilities. Comparison of Year Ended December 31, 2015 to Year Ended December 31, 2014 The following table sets forth for the years indicated our operating revenue, operating income and operating ratio by segment, along with the change for each component: (1) Represents operating expenses as a percentage of operating revenue. Our operating revenue decreased $7.9 million, or 1.2%, to $665.0 million in 2015 from $672.9 million in 2014, reflecting a 42.2% decrease in fuel surcharge revenue to $72.3 million from $125.2 million in 2014 due to lower fuel prices. Our operating revenue, net of fuel surcharges, increased $44.9 million, or 8.2%, to $592.6 million in 2015 from $547.7 million in 2014. This increase was due to a $50.7 million increase in Dedicated revenue, net of fuel surcharges, and a $14.2 million increase in Brokerage revenue, partially offset by a $10.4 million decrease in Truckload revenue, net of fuel surcharges, and a $9.6 million decrease in Intermodal revenue, net of fuel surcharges. Truckload segment revenue decreased $49.9 million, or 11.1%, to $398.4 million in 2015 from $448.3 million in 2014. Truckload segment revenue, net of fuel surcharges, decreased $10.4 million, or 2.9%, to $348.1 million in 2015 from $358.5 million in 2014. The slight improvement in the operating ratio in 2015 was primarily due to an improvement in our net fuel expense with the lower fuel prices and the negative impact of severe weather conditions in the first quarter of 2014 on both freight volumes and operating costs, partially offset by a decrease in our average revenue per tractor within a soft freight market since the second quarter of 2015. Dedicated segment revenue increased $47.9 million, or 68.1%, to $118.3 million in 2015 from $70.4 million in 2015. Dedicated segment revenue, net of fuel surcharges, increased 89.5% primarily due to an increase in our average fleet size of 83.2% driven by a significant increase in our number of Dedicated contracts with customers. The improvement in the operating ratio in 2015 was primarily due to an increase in our average revenue per tractor. Intermodal segment revenue decreased $20.1 million, or 20.7%, to $77.0 million in 2015 from $97.1 million in 2014. Intermodal segment revenue, net of fuel surcharges, decreased 12.7% due to the disposal in March 2015 of the dry containers that were used in a portion of our intermodal operations, partially offset by increased volume with our temperature-controlled intermodal trailer service. The improvement in the operating ratio in 2015 was primarily due to costs associated with rail service interruption and delay issues in 2014 that constrained our intermodal operations, the disposal of our dry container service, which produced a higher operating ratio than our temperature-controlled trailer service, rate increases beginning in the fourth quarter of 2014, and the negative impact of severe weather conditions in the first quarter of 2014 on both freight volumes and operating costs. Brokerage segment revenue increased $14.2 million, or 24.8%, to $71.4 million in 2015 from $57.2 million in 2014, primarily due to an increase in volume. The improvement in the operating ratio in 2015 was primarily due to a decrease in the payments to carriers for transportation services which we arranged as a percentage of our Brokerage revenue. The following table sets forth for the years indicated the dollar and percentage increase or decrease of the items in our consolidated statements of operations, and those items as a percentage of operating revenue: Salaries, wages and benefits expense increased $26.0 million, or 14.2%, in 2015 from 2014. The increase in salaries, wages and benefits from 2014 resulted primarily from a 5.2% increase in the total miles driven by company drivers and increases to several components of the amount paid to company drivers. Employees’ health insurance costs increased $2.1 million due to higher self-insured medical claims and bonus compensation expense for our non-driver employees increased $1.0 million as well. Purchased transportation expense decreased $5.0 million in total, or 4.1%, in 2015 from 2014. Payments to carriers for transportation services we arranged in our Brokerage segment increased $11.4 million to $60.5 million in 2015 from $49.1 million in 2014, primarily due to an increase in volume. Payments to railroads and drayage carriers for transportation services within our Intermodal segment decreased $17.1 million to $49.3 million in 2015 from $66.4 million in 2014. This decrease was due to the disposal in March 2015 of the dry containers that were used in a portion of our intermodal operations, partially offset by increased volume with our temperature-controlled intermodal trailer service. The portion of purchased transportation expense related to our independent contractors within our Truckload and Dedicated segments, including fuel surcharges, increased $704,000 in 2015. Fuel and fuel taxes decreased by $49.3 million, or 32.1%, in 2015 from 2014. Net fuel expense (fuel and fuel taxes net of fuel surcharge revenue and surcharges passed through to independent contractors, outside drayage carriers and railroads) decreased $5.6 million, or 12.0%, to $41.1 million in 2015 from $46.7 million in 2014. Fuel surcharges passed through to independent contractors, outside drayage carriers and railroads were $8.9 million in 2015 and $18.0 million in 2014. We have worked diligently to control fuel usage and costs by improving our volume purchasing arrangements and optimizing our drivers’ fuel purchases with national fuel centers, focusing on shorter lengths of haul, installing and tightly managing the use of auxiliary power units in our tractors to minimize engine idling and improving fuel usage in the temperature-control units on our trailers. The decrease in net fuel expense was primarily due to a decrease in the DOE national average cost of fuel to $2.71 per gallon in 2015 from $3.83 per gallon in 2014 and continued progress with the cost control measures stated above. Net fuel expense represented 7.9% of Truckload, Dedicated and Intermodal segment revenue, net of fuel surcharges, in 2015, compared with 9.5% in 2014. Supplies and maintenance consist of repairs, maintenance, tires, parts, oil, and engine fluids, along with load-specific expenses including loading/unloading, tolls, pallets and trailer hostling. Our supplies and maintenance expense increased $1.8 million, or 4.4%, from 2014 primarily due to increased repair costs at external facilities. The increase in depreciation was primarily due to a continued increase in the cost of revenue equipment and growth of our fleet. The $2.0 million increase in insurance and claims in 2015 was primarily due to increases in the cost of physical damage claims related to our tractors and trailers, self-insured auto liability claims and workers’ compensation accident claims. Gain on disposition of revenue equipment increased to $5.6 million in 2015 from $4.4 million in 2014 primarily due to an increase in the number of trailers sold. Gain on disposition of facilities was $4.1 million in 2015. The disposition of the facilities, located in Ontario, CA and Indianapolis, IN, was part of our ongoing program to expand and update the footprint of our facilities throughout the United States. As a result of the foregoing factors, our operating expenses as a percentage of operating revenue, or “operating ratio,” improved to 90.8% in 2015 from 92.4% in 2014. The operating ratio for our Truckload segment was 91.1% in 2015 and 91.2% in 2014, for our Dedicated segment was 89.2% in 2015 and 89.9% in 2014, for our Intermodal segment was 93.7% in 2015 and 98.2% in 2014, and for our Brokerage segment was 94.7% in 2015 and 95.4% in 2014. Operating expenses as a percentage of operating revenue, with both amounts net of fuel surcharges, improved to 89.7% in 2015 from 90.7% in 2014. Our operating ratio for 2015, net of both the gain on the disposition of facilities and fuel surcharges, improved to 90.4%. The decrease in other non-operating income was primarily due to decreased earnings in 2015 by MWL, a 45% owned affiliate. Our effective income tax rate decreased to 41.1% in 2015 from 42.3% in 2014, primarily due to per diem and other non-deductible expenses being a lower percentage of the increased taxable income in 2015. As a result of the factors described above, net income increased by 19.8% to $35.7 million in 2015 from $29.8 million in 2014. Net earnings per diluted share increased to $1.06 in 2015 from $0.89 in 2014. Liquidity and Capital Resources Our business requires substantial, ongoing capital investments, particularly for new tractors and trailers. Our primary sources of liquidity are funds provided by operations and our revolving credit facility. A portion of our tractor fleet is provided by independent contractors who own and operate their own equipment. We have no capital expenditure requirements relating to those drivers who own their tractors or obtain financing through third parties. The table below reflects our net cash flows provided by operating activities, net cash flows used for investing activities and net cash flows (used for) provided by financing activities for the years indicated. In December 2007, our Board of Directors approved and we announced a share repurchase program to repurchase up to one million shares of our common stock either through purchases on the open market or through private transactions and in accordance with Rule 10b-18 of the Exchange Act. In November 2015, our Board of Directors approved and we announced an increase in the share repurchase program, providing for the repurchase of up to $40 million, or approximately 2 million shares, of our common stock. The timing and extent to which we repurchase shares depends on market conditions and other corporate considerations. The repurchase program does not have an expiration date. We repurchased and retired 455,581 shares of our common stock for $7.5 million in the first quarter of 2016 and did not repurchase any shares in the last three quarters of 2016. In the fourth quarter of 2015 we repurchased and retired 941,024 shares of our common stock for $16.2 million. In 2016, net cash flows provided by operating activities of $133.6 million were primarily used to purchase new revenue equipment, net of proceeds from dispositions, in the amount of $89.9 million, to partially construct regional operating facilities in the amount of $5.1 million, to repay, net of borrowings, $30.0 million of long-term debt, to repurchase and retire 455,581 shares of our common stock for $7.5 million, and to pay cash dividends of $3.3 million. In 2015, net cash flows provided by operating activities of $128.2 million and net borrowings under our credit facility of $13.5 million were primarily used to purchase new revenue equipment, net of proceeds from dispositions, in the amount of $118.2 million, to partially construct regional operating facilities in the amount of $8.6 million, to repurchase and retire 941,024 shares of our common stock for $16.2 million, and to pay cash dividends of $3.3 million. In 2014, net cash flows provided by operating activities of $82.0 million, net borrowings under our credit facility of $24.4 million, and cash and cash equivalents of $13.5 million were primarily used to purchase new revenue equipment, net of proceeds from dispositions, in the amount of $87.7 million, to acquire and partially construct regional operating facilities in the amount of $27.4 million, and to pay cash dividends of $3.3 million. We estimate that capital expenditures, net of proceeds from dispositions, will be approximately $88 million in 2017. Quarterly cash dividends of $0.025 per share of common stock were declared in each quarter of 2016, 2015 and 2014, and totaled $3.3 million in each of the three years respectively. We currently expect to continue to pay quarterly cash dividends in the future. The payment of cash dividends in the future, and the amount of any such dividends, will depend upon our financial condition, results of operations, cash requirements, and certain corporate law requirements, as well as other factors deemed relevant by our Board of Directors. We believe our sources of liquidity are adequate to meet our current and anticipated needs for at least the next twelve months. Based upon anticipated cash flows, existing cash and cash equivalents balances, current borrowing availability and other sources of financing we expect to be available to us, we do not anticipate any significant liquidity constraints in the foreseeable future. We maintain a credit agreement that provides for an unsecured committed credit facility which matures in December 2019. In November 2015, we entered into an amendment to the facility which increased the aggregate principal amount of the facility from $50.0 million to $75.0 million. In April 2016, we elected to reduce the aggregate principal amount of the facility to $30.0 million. In December 2016, we entered into an amendment to the facility which increased the aggregate principal amount to $40.0 million. At December 31, 2016, there was an outstanding principal balance of $7.9 million on the facility. As of that date, we had outstanding standby letters of credit to guarantee settlement of self-insurance claims of $11.2 million and remaining borrowing availability of $20.9 million. This facility bears interest at a variable rate based on the London Interbank Offered Rate or the lender’s Prime Rate, in each case plus/minus applicable margins. Our credit facility prohibits us from paying, in any fiscal year, stock redemptions and dividends in excess of 25% of our net income from the prior fiscal year. A waiver of the 25% limitation for 2015 and 2016 was obtained from the lender. This facility also contains restrictive covenants which, among other matters, require us to maintain compliance with cash flow leverage and fixed charge coverage ratios. We were in compliance with all covenants at December 31, 2016 and 2015. The following is a summary of our contractual obligations as of December 31, 2016. Due to uncertainty with respect to the timing of future cash flows, the obligation under our nonqualified deferred compensation plan at December 31, 2016 of 96,310 shares of Company common stock with a value of $2.2 million has been excluded from the above table. Related Parties We purchase fuel and tires and obtain related services from Bauer Built, Inc., or BBI. Jerry M. Bauer, one of our directors, is the chairman of the board, chief executive officer and the principal stockholder of BBI. We paid BBI $361,000 in 2016, $335,000 in 2015 and $562,000 in 2014 for fuel, tires and related services. In addition, we paid $2.0 million in 2016, $1.5 million in 2015 and $1.4 million in 2014 to tire manufacturers for tires that were provided by BBI. BBI received commissions from the tire manufacturers related to these purchases. Other than any benefit received from his ownership interest in BBI, Mr. Bauer receives no compensation or other benefits from our business with BBI. We own a 45% equity interest in MWL, a third-party provider of logistics services to the transportation industry. We received $1.2 million, $5.0 million and $8.5 million of our revenue for loads transported by our tractors and arranged by MWL in 2016, 2015 and 2014, respectively. As of December 31, 2016, we also had a trade receivable in the amount of $55,000 from MWL and an accrued liability of $3.0 million to MWL for the excess of payments by MWL’s customers into our lockbox account over the amounts drawn on the account by MWL. We believe that the transactions with related parties noted above are on reasonable terms which, based upon market rates, are comparable to terms available from unaffiliated third parties. Off-balance Sheet Arrangements Other than standby letters of credit maintained in connection with our self-insurance programs in the amount of $11.2 million, purchase obligations and operating leases summarized above in our summary of contractual obligations, we did not have any other material off-balance sheet arrangements at December 31, 2016. Inflation and Fuel Costs Most of our operating expenses are inflation-sensitive, with inflation generally producing increased costs of operations. During the past three years, the most significant effects of inflation have been on revenue equipment prices, accident claims, health insurance and employee compensation. We attempt to limit the effects of inflation through increases in freight rates and cost control efforts. In addition to inflation, fluctuations in fuel prices can affect our profitability. We require substantial amounts of fuel to operate our tractors and power the temperature-control units on our trailers. Substantially all of our contracts with customers contain fuel surcharge provisions. Although we historically have been able to pass through a significant portion of long-term increases in fuel prices and related taxes to customers in the form of fuel surcharges and higher rates, such increases usually are not fully recovered. These fuel surcharge provisions are not effective in mitigating the fuel price increases related to non-revenue miles or fuel used while the tractor is idling. Seasonality Our tractor productivity generally decreases during the winter season because inclement weather impedes operations and some shippers reduce their shipments. At the same time, operating expenses generally increase, with harsh weather creating higher accident frequency, increased claims, lower fuel efficiency and more equipment repairs. Critical Accounting Policies The preparation of financial statements in conformity with U.S. generally accepted accounting principles requires management to make estimates and assumptions about future events, and apply judgments that affect the reported amounts of assets, liabilities, revenue and expenses in our consolidated financial statements and related notes. We base our estimates, assumptions and judgments on historical experience, current trends and other factors believed to be relevant at the time our consolidated financial statements are prepared. However, because future events and their effects cannot be determined with certainty, actual results could differ from our estimates and assumptions, and such differences could be material. We believe that the following critical accounting policies affect our more significant estimates, assumptions and judgments used in the preparation of our consolidated financial statements. Revenue Recognition. We recognize revenue, including fuel surcharges, at the time shipment of freight is completed. We account for revenue of our Intermodal and Brokerage segments and revenue on freight transported by independent contractors within our Truckload and Dedicated segments on a gross basis because we are the primary obligor in the arrangements, we have the ability to establish prices, we have the risk of loss in the event of cargo claims and we bear credit risk with customer payments. Accordingly, all such revenue billed to customers is classified as operating revenue and all corresponding payments to carriers for transportation services we arrange in connection with brokerage and intermodal activities and to independent contractor providers of revenue equipment are classified as purchased transportation expense. Accounts Receivable. We are dependent upon a limited number of customers, and, as a result, our trade accounts receivable are highly concentrated. Trade accounts receivable are recorded at the invoiced amounts, net of an allowance for doubtful accounts. Our allowance for doubtful accounts was $275,000 as of December 31, 2016 and $305,000 as of December 31, 2015. A considerable amount of judgment is required in assessing the realization of these receivables including the current creditworthiness of each customer and related aging of the past-due balances, including any billing disputes. In order to assess the collectibility of these receivables, we perform ongoing credit evaluations of our customers’ financial condition. Through these evaluations, we may become aware of a situation where a customer may not be able to meet its financial obligations due to deterioration of its financial viability, credit ratings or bankruptcy. The allowance for doubtful accounts is based on the best information available to us and is reevaluated and adjusted as additional information is received. We evaluate the allowance based on historical write-off experience, the size of the individual customer balances, past-due amounts and the overall national economy. We review the adequacy of our allowance for doubtful accounts monthly. Property and Equipment. The transportation industry requires significant capital investments. Our net property and equipment was $557.8 million as of December 31, 2016 and $528.0 million as of December 31, 2015. Our depreciation expense was $82.4 million in 2016, $75.3 million in 2015 and $68.2 million in 2014. We compute depreciation of our property and equipment for financial reporting purposes based on the cost of each asset, reduced by its estimated salvage value, using the straight-line method over its estimated useful life. We determine and periodically evaluate our estimate of the projected salvage values and useful lives primarily by considering the market for used equipment, prior useful lives and changes in technology. We have not changed our policy regarding salvage values as a percentage of initial cost or useful lives of tractors and trailers within the last ten years. We believe that our policies and past estimates have been reasonable. Actual results could differ from these estimates. A 5% decrease in estimated salvage values would have decreased our net property and equipment as of December 31, 2016 by approximately $10.6 million, or 1.9%. Impairment of Assets. Long-lived assets are reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. Recoverability of assets to be held and used is measured by a comparison of the carrying amount of an asset to future net undiscounted cash flows expected to be generated by the asset. If such assets are considered to be impaired, the impairment to be recognized is measured by the amount by which the carrying amount of the assets exceeds the fair value of the assets. Assets to be disposed of are reported at the lower of the carrying amount or fair value less the costs to sell. Insurance and Claims. We self-insure, in part, for losses relating to workers’ compensation, auto liability, general liability, cargo and property damage claims, along with employees’ health insurance with varying risk retention levels. We maintain insurance coverage for per-incident and total losses in excess of these risk retention levels in amounts we consider adequate based upon historical experience and our ongoing review. However, we could suffer a series of losses within our self-insured retention limits or losses over our policy limits, which could negatively affect our financial condition and operating results. We are responsible for the first $1.0 million on each auto liability claim and for the first $750,000 on each workers’ compensation claim. We have $11.2 million in standby letters of credit to guarantee settlement of claims under agreements with our insurance carriers and regulatory authorities. The insurance and claims accruals in our consolidated balance sheets were $19.4 million as of December 31, 2016 and $16.2 million as of December 31, 2015. We reserve currently for the estimated cost of the uninsured portion of pending claims. We periodically evaluate and adjust these reserves based on our evaluation of the nature and severity of outstanding individual claims and our estimate of future claims development based on historical development. Actual results could differ from these current estimates. In addition, to the extent that claims are litigated and not settled, jury awards are difficult to predict. Share-based Payment Arrangement Compensation. We have granted stock options to certain employees and non-employee directors. We recognize compensation expense for all stock options net of an estimated forfeiture rate and only record compensation expense for those shares expected to vest on a straight-line basis over the requisite service period (normally the vesting period). Determining the appropriate fair value model and calculating the fair value of stock options require the input of highly subjective assumptions, including the expected life of the stock options and stock price volatility. We use the Black-Scholes model to value our stock option awards. We believe that future volatility will not materially differ from our historical volatility. Thus, we use the historical volatility of our common stock over the expected life of the award. The assumptions used in calculating the fair value of stock options represent our best estimates, but these estimates involve inherent uncertainties and the application of judgment. As a result, if factors change and we use different assumptions, stock option compensation expense could be materially different in the future. We have also granted performance unit awards to certain employees which are subject to vesting requirements over a five-year period, primarily based on our earnings growth. The fair value of each performance unit is based on the closing market price on the date of grant. We recognize compensation expense for these awards based on the estimated number of units probable of achieving the performance and service vesting requirements of the awards, net of an estimated forfeiture rate. Recent Accounting Pronouncements In May 2014, the Financial Accounting Standards Board, or FASB, issued Accounting Standards Update No. 2014-09, “Revenue from Contracts with Customers” which requires an entity to recognize the amount of revenue to which it expects to be entitled for the transfer of promised goods or services to customers. The standard, which is effective for the first quarter of 2018, will replace most existing revenue recognition guidance required by U.S. generally accepted accounting principles and will require additional disclosures. We have completed our evaluation of the requirements of the new guidance and have determined that our current policy in which we record revenue and related expenses on the date shipment of freight is completed, and in which we account for revenue of our Intermodal and Brokerage segments and revenue on freight transported by independent contractors within our Truckload and Dedicated segments on a gross basis, is also appropriate under the new guidance. As a result, the adoption of this standard is not expected to have a significant impact on our consolidated balance sheets, statements of operations or statements of cash flows. In February 2016, the FASB issued Accounting Standards Update No. 2016-02, “Leases” which requires organizations that lease assets to recognize on the balance sheet the assets and liabilities for the rights and obligations created by those leases. The new guidance also requires additional disclosures related to leasing transactions. The standard is effective for the first quarter of 2019. The adoption of this standard is not expected to have a significant impact on our consolidated balance sheets, statements of operations or statements of cash flows. In March 2016, the FASB issued Accounting Standards Update No. 2016-09, “Compensation - Stock Compensation: Improvements to Employee Share-Based Payment Accounting” which simplifies several aspects of the accounting for share-based payment transactions, including the income tax consequences, classification of awards as either equity or liabilities and classification on the statement of cash flows. The standard is effective for the first quarter of 2017. The adoption of this standard will result in an increase or decrease to our provision for income taxes each quarter based on the actual increase in our stock price compared with the grant-date fair value of the quarter’s exercised options and vested performance unit awards. The adoption of the other provisions of this standard is not expected to have a significant impact on our consolidated balance sheets, statements of operations or statements of cash flows.

<s>[INST] The following discussion and analysis of our financial condition and results of operations should be read together with the selected consolidated financial data and our consolidated financial statements and the related notes appearing elsewhere in this report. This discussion and analysis contains forwardlooking statements that involve risks, uncertainties and assumptions. Our actual results may differ materially from those anticipated in these forwardlooking statements as a result of many factors, including but not limited to those under the heading “Risk Factors” beginning on page 7. We do not assume, and specifically disclaim, any obligation to update any forwardlooking statement contained in this report. Overview The primary source of our operating revenue is provided by our Truckload segment through a combination of regional shorthaul and mediumtolonghaul fullload transportation services. We transport food and other consumer packaged goods that require a temperaturecontrolled or insulated environment, along with dry freight, across the United States and into and out of Mexico and Canada. Our Dedicated segment provides customized transportation solutions tailored to meet individual customers’ requirements, utilizing temperaturecontrolled trailers, dry vans and other specialized equipment within the United States. Our customer contracts range from three to five years and are subject to annual rate reviews. Generally, we are paid by the mile for our Truckload and Dedicated services. We also derive Truckload and Dedicated revenue from fuel surcharges, loading and unloading activities, equipment detention and other ancillary services. The main factors that affect our Truckload and Dedicated revenue are the rate per mile we receive from our customers, the percentage of miles for which we are compensated, the number of miles we generate with our equipment and changes in fuel prices. We monitor our revenue production primarily through average Truckload and Dedicated revenue, net of fuel surcharges, per tractor per week. We also analyze our average Truckload and Dedicated revenue, net of fuel surcharges, per total mile, nonrevenue miles percentage, the miles per tractor we generate, our fuel surcharge revenue, our accessorial revenue and our other sources of operating revenue. Our Intermodal segment transports our customers’ freight within the United States primarily utilizing our temperaturecontrolled trailers and also, through March 2015, our dry containers on railroad flatcars for portions of trips, with the balance of the trips using our tractors or, to a lesser extent, contracted carriers. The main factors that affect our Intermodal revenue are the rate per mile and other charges we receive from our customers. Our Brokerage segment develops contractual relationships with and arranges for thirdparty carriers to transport freight for our customers in temperaturecontrolled trailers and dry vans within the United States and into and out of Mexico through Marten Transport Logistics, LLC, which was established in 2007 and operates pursuant to brokerage authority granted by the DOT. We retain the billing, collection and customer management responsibilities. The main factors that affect our Brokerage revenue are the rate per mile and other charges that we receive from our customers. In addition to the factors discussed above, our operating revenue is also affected by, among other things, the United States economy, inventory levels, the level of truck and rail capacity in the transportation market, a contracting driver market, severe weather conditions and specific customer demand. Our operating revenue increased $6.2 million, or 0.9%, in 2016, despite a 26.4% decrease in fuel surcharge revenue to $53.2 million from $72.3 million in 2015 due to lower fuel prices. Our operating revenue, net of both fuel surcharges and revenue from our dry container service discontinued in March 2015, increased $26.6 million, or 4.5%, compared with 2015. Truckload segment revenue, net of fuel surcharges, decreased 2.3% from 2015 primarily due to a decrease in our average revenue per tractor. Dedicated segment revenue, net of fuel surcharges, increased 37.1% primarily due to an increase in our average fleet size of 36.7% from 2015. Intermodal segment revenue, net of both fuel surcharges and revenue from our discontinued dry container service, decreased $49,000 from 2015 due to a decrease in volume [/INST] Positive. </s>

MARTEN TRANSPORT LTD

2018-03-09

2017-12-31

ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The following discussion and analysis of our financial condition and results of operations should be read together with the selected consolidated financial data and our consolidated financial statements and the related notes appearing elsewhere in this report. This discussion and analysis contains forward-looking statements that involve risks, uncertainties and assumptions. Our actual results may differ materially from those anticipated in these forward-looking statements as a result of many factors, including but not limited to those under the heading “Risk Factors” beginning on page 6. We do not assume, and specifically disclaim, any obligation to update any forward-looking statement contained in this report. Overview The primary source of our operating revenue is provided by our Truckload segment through a combination of regional short-haul and medium-to-long-haul full-load transportation services. We transport food and other consumer packaged goods that require a temperature-controlled or insulated environment, along with dry freight, across the United States and into and out of Mexico and Canada. Our Dedicated segment provides customized transportation solutions tailored to meet individual customers’ requirements, utilizing temperature-controlled trailers, dry vans and other specialized equipment within the United States. Our agreements with customers range from three to five years and are subject to annual rate reviews. Generally, we are paid by the mile for our Truckload and Dedicated services. We also derive Truckload and Dedicated revenue from fuel surcharges, loading and unloading activities, equipment detention and other ancillary services. The main factors that affect our Truckload and Dedicated revenue are the rate per mile we receive from our customers, the percentage of miles for which we are compensated, the number of miles we generate with our equipment and changes in fuel prices. We monitor our revenue production primarily through average Truckload and Dedicated revenue, net of fuel surcharges, per tractor per week. We also analyze our average Truckload and Dedicated revenue, net of fuel surcharges, per total mile, non-revenue miles percentage, the miles per tractor we generate, our fuel surcharge revenue, our accessorial revenue and our other sources of operating revenue. Our Intermodal segment transports our customers’ freight within the United States utilizing our temperature-controlled trailers on railroad flatcars for portions of trips, with the balance of the trips using our tractors or, to a lesser extent, contracted carriers. The main factors that affect our Intermodal revenue are the rate per mile and other charges we receive from our customers. Our Brokerage segment develops contractual relationships with and arranges for third-party carriers to transport freight for our customers in temperature-controlled trailers and dry vans within the United States and into and out of Mexico through Marten Transport Logistics, LLC, which was established in 2007 and operates pursuant to brokerage authority granted by the DOT. We retain the billing, collection and customer management responsibilities. The main factors that affect our Brokerage revenue are the rate per mile and other charges that we receive from our customers. In addition to the factors discussed above, our operating revenue is also affected by, among other things, the United States economy, inventory levels, the level of truck and rail capacity in the transportation market, a contracting driver market, severe weather conditions and specific customer demand. Our operating revenue increased $27.0 million, or 4.0%, in 2017. Our operating revenue, net of fuel surcharges, increased $13.1 million, or 2.1%, compared with 2016. Truckload segment revenue, net of fuel surcharges, decreased 1.0% from 2016, primarily due to a reduction in our average number of tractors, partially offset by an increase in our average revenue per tractor. Dedicated segment revenue, net of fuel surcharges, increased 4.5% from 2016, primarily due to fleet growth and an increase in our average revenue per tractor. Intermodal segment revenue, net of fuel surcharges, increased 9.0% due to increased volume and Brokerage segment revenue increased 6.0% due to increased revenue per load in 2017. Fuel surcharge revenue increased to $67.1 million in 2017 from $53.2 million in 2016 due to higher fuel prices. Our profitability is impacted by the variable costs of transporting freight for our customers, fixed costs, and expenses containing both fixed and variable components. The variable costs include fuel expense, driver-related expenses, such as wages, benefits, training, and recruitment, and independent contractor costs, which are recorded under purchased transportation. Expenses that have both fixed and variable components include maintenance and tire expense and our cost of insurance and claims. These expenses generally vary with the miles we travel, but also have a controllable component based on safety, fleet age, efficiency and other factors. Our main fixed costs relate to the acquisition and subsequent depreciation of long-term assets, such as revenue equipment and operating terminals. We expect our annual cost of tractor and trailer ownership will increase in future periods as a result of higher prices of new equipment, along with any increases in fleet size. Although certain factors affecting our expenses are beyond our control, we monitor them closely and attempt to anticipate changes in these factors in managing our business. For example, fuel prices have significantly fluctuated over the past several years. We manage our exposure to changes in fuel prices primarily through fuel surcharge programs with our customers, as well as through volume fuel purchasing arrangements with national fuel centers and bulk purchases of fuel at our terminals. To help further reduce fuel expense, we have installed and tightly manage the use of auxiliary power units in our tractors to provide climate control and electrical power for our drivers without idling the tractor engine, and also have improved the fuel usage in the temperature-control units on our trailers. For our Intermodal and Brokerage segments, our profitability is impacted by the percentage of revenue which is payable to the providers of the transportation services we arrange. This expense is included within purchased transportation in our consolidated statements of operations. Our operating expenses as a percentage of operating revenue, or “operating ratio,” increased to 91.9% in 2017 from 91.3% in 2016. Operating expenses as a percentage of operating revenue, with both amounts net of fuel surcharges, was 91.0% in 2017 and 90.6% in 2016. Our net income increased to $90.3 million, or $1.65 per diluted share, in 2017 from $33.5 million, or $0.61 per diluted share, in 2016. Excluding a deferred income taxes benefit of $56.5 million recorded in 2017 to recognize the impact of the reduction of the federal corporate statutory income tax rate beginning on January 1, 2018 from 35% to 21% related to the Tax Cuts and Jobs Act of 2017, net income improved 1.1% to $33.8 million, or $0.62 per diluted share, from 2016. Our business requires substantial, ongoing capital investments, particularly for new tractors and trailers. At December 31, 2017, we had $15.8 million of cash and cash equivalents, $525.5 million in stockholders’ equity and no long-term debt outstanding. In 2017, net cash flows provided by operating activities of $121.9 million were primarily used to purchase new revenue equipment, net of proceeds from dispositions, in the amount of $87.6 million, to repay, net of borrowings, $7.9 million of long-term debt, to partially construct regional operating facilities in the amount of $5.8 million, and to pay cash dividends of $4.4 million, resulting in a $15.3 million increase in cash and cash equivalents. We estimate that capital expenditures, net of proceeds from dispositions, will be approximately $115 million in 2018. We believe our sources of liquidity are adequate to meet our current and anticipated needs for at least the next twelve months. Based upon anticipated cash flows, existing cash and cash equivalents balances, current borrowing availability and other sources of financing we expect to be available to us, we do not anticipate any significant liquidity constraints in the foreseeable future. Our business strategy encompasses a multifaceted set of transportation service solutions, primarily regional Truckload temperature-controlled operations along with Dedicated, Intermodal and Brokerage services, with a diverse customer base that gains value from and expands each of these operating segments. We believe that we are well-positioned regardless of the economic environment with the services we provide combined with our competitive position, cost control emphasis, modern fleet and strong balance sheet. This Management’s Discussion and Analysis of Financial Condition and Results of Operations includes discussions of net income and diluted earnings per share, net of a deferred income taxes benefit, operating revenue, net of fuel surcharge revenue; Truckload, Dedicated and Intermodal revenue, net of fuel surcharge revenue; operating expenses as a percentage of operating revenue, each net of fuel surcharge revenue; and net fuel expense (fuel and fuel taxes net of fuel surcharge revenue and surcharges passed through to independent contractors, outside drayage carriers and railroads). We provide these additional disclosures because management believes these measures provide a more consistent basis for comparing results of operations from period to period. These financial measures in this report have not been determined in accordance with U.S. generally accepted accounting principles (GAAP). Pursuant to Item 10(e) of Regulation S-K, we have included the amounts necessary to reconcile these non-GAAP financial measures to the most directly comparable GAAP financial measures of net income, diluted earnings per share, operating revenue, operating expenses divided by operating revenue, and fuel and fuel taxes. Stock Split On July 7, 2017, we effected a five-for-three stock split of our common stock, $.01 par value, in the form of a 66 ⅔% stock dividend. Our consolidated financial statements, related notes, and other financial data contained in this report have been adjusted to give retroactive effect to the stock split for all periods presented. Results of Operations The following table sets forth for the years indicated certain operating statistics regarding our revenue and operations: (1) Includes tractors driven by both company-employed drivers and independent contractors. Independent contractors provided 60, 68 and 65 tractors as of December 31, 2017, 2016 and 2015, respectively. Comparison of Year Ended December 31, 2017 to Year Ended December 31, 2016 The following table sets forth for the years indicated our operating revenue, operating income and operating ratio by segment, along with the change for each component: (1) Represents operating expenses as a percentage of operating revenue. Our operating revenue increased $27.0 million, or 4.0%, to $698.1 million in 2017 from $671.1 million in 2016. Our operating revenue, net of fuel surcharges, increased $13.1 million, or 2.1%, to $631.0 million in 2017 from $617.9 million in 2016. This increase was due to a $6.7 million increase in Dedicated revenue, net of fuel surcharges, a $5.8 million increase in Intermodal revenue, net of fuel surcharges, and a $4.0 million increase in Brokerage revenue, partially offset by a $3.4 million decrease in Truckload revenue, net of fuel surcharges. Fuel surcharge revenue increased to $67.1 million in 2017 from $53.2 million in 2016 due to higher fuel prices. Truckload segment revenue increased $4.4 million, or 1.2%, to $380.2 million in 2017 from $375.9 million in 2016. Truckload segment revenue, net of fuel surcharges, decreased $3.4 million, or 1.0%, to $336.6 million in 2017 from $340.0 million in 2016, primarily due to a reduction in our average number of tractors, partially offset by an increase in our average revenue per tractor. The increase in the operating ratio in 2017 was primarily due to an increase in insurance and claims expense, partially offset by the increase in our average revenue per tractor. Dedicated segment revenue increased $9.5 million, or 6.0%, to $166.9 million in 2017 from $157.4 million in 2016. Dedicated segment revenue, net of fuel surcharges, increased 4.5% primarily due to fleet growth and an increase in our average revenue per tractor. The increase in the operating ratio for our Dedicated segment was primarily due to an increase in insurance and claims expense, partially offset by the increase in our average revenue per tractor. Intermodal segment revenue increased $9.1 million, or 12.8%, to $80.6 million in 2017 from $71.5 million in 2016. Intermodal segment revenue, net of fuel surcharges, increased 9.0% from 2016 due to an increase in volume. The operating ratio in 2017 improved slightly from 2016. Brokerage segment revenue increased $4.0 million, or 6.0%, to $70.4 million in 2017 from $66.4 million in 2016 due to an increase in revenue per load. The improvement in the operating ratio in 2017 was achieved primarily through multiple cost control measures. The following table sets forth for the years indicated the dollar and percentage increase or decrease of the items in our consolidated statements of operations, and those items as a percentage of operating revenue: Salaries, wages and benefits consist of compensation for our employees, including both driver and non-driver employees, employees’ health insurance, 401(k) plan contributions and other fringe benefits. These expenses vary depending upon the size of our Truckload, Dedicated and Intermodal tractor fleets, the ratio of company drivers to independent contractors, our efficiency, our experience with employees’ health insurance claims, changes in health care premiums and other factors. Salaries, wages and benefits expense increased $1.3 million, or 0.6%, in 2017 from 2016. The increase in salaries, wages and benefits from 2016 resulted primarily from an increase in non-driver bonus compensation expense of $2.3 million, partially offset by multiple other items. Purchased transportation consists of amounts payable to railroads and carriers for transportation services we arrange in connection with Brokerage and Intermodal operations and to independent contractor providers of revenue equipment. This category will vary depending upon the amount and rates, including fuel surcharges, we pay to third-party railroad and motor carriers, the ratio of company drivers versus independent contractors and the amount of fuel surcharges passed through to independent contractors. Purchased transportation expense increased $7.6 million in total, or 6.9%, in 2017 from 2016. Amounts payable to carriers for transportation services we arranged in our Brokerage segment increased $3.2 million to $58.6 million in 2017 from $55.4 million in 2016, primarily due to an increase in brokerage revenue. Amounts payable to railroads and drayage carriers for transportation services within our Intermodal segment increased $5.6 million to $51.5 million in 2017 from $45.9 million in 2016. This increase was primarily due to increased intermodal revenue. The portion of purchased transportation expense related to our independent contractors within our Truckload and Dedicated segments, including fuel surcharges, decreased $1.2 million in 2017. We expect that purchased transportation expense will increase as we grow our Intermodal and Brokerage segments. Fuel and fuel taxes increased by $11.3 million, or 12.0%, in 2017 from 2016. Net fuel expense (fuel and fuel taxes net of fuel surcharge revenue and surcharges passed through to independent contractors, outside drayage carriers and railroads) decreased $213,000, or 0.5%, to $46.8 million in 2017 from $47.0 million in 2016. Fuel surcharges passed through to independent contractors, outside drayage carriers and railroads increased to $8.6 million from $6.2 million in 2016. Despite an increase in the DOE national average cost of fuel to $2.65 per gallon from $2.30 per gallon in 2016, net fuel expense decreased to 8.4% of Truckload, Dedicated and Intermodal segment revenue, net of fuel surcharges, from 8.5% in 2016. The net fuel expense to revenue improved in 2017 primarily due to increases in our miles per gallon and in our revenue rate per mile. We have worked diligently to control fuel usage and costs by improving our volume purchasing arrangements and optimizing our drivers’ fuel purchases with national fuel centers, focusing on shorter lengths of haul, installing and tightly managing the use of auxiliary power units in our tractors to minimize engine idling and improving fuel usage in the temperature-control units on our trailers. Auxiliary power units, which we have installed in our company-owned tractors, provide climate control and electrical power for our drivers without idling the tractor engine. Supplies and maintenance consist of repairs, maintenance, tires, parts, oil and engine fluids, along with load-specific expenses including loading/unloading, tolls, pallets and trailer hostling. Our supplies and maintenance expense decreased $2.3 million, or 5.2%, from 2016 primarily due to decreased repair costs at external facilities and a reduction in parts costs. Depreciation relates to owned tractors, trailers, auxiliary power units, communication units, terminal facilities and other assets. The increase in depreciation was primarily due to a continued increase in the cost of revenue equipment. We expect our annual cost of tractor and trailer ownership will increase in future periods as a result of higher prices of new equipment, which will result in greater depreciation over the useful life. Insurance and claims consist of the costs of insurance premiums and accruals we make for claims within our self-insured retention amounts, primarily for personal injury, property damage, physical damage to our equipment, cargo claims and workers’ compensation claims. These expenses will vary primarily based upon the frequency and severity of our accident experience, our self-insured retention levels and the market for insurance. The $6.4 million increase in insurance and claims in 2017 was primarily due to increases in the cost of physical damage claims related to our tractors and trailers, in self-insured workers’ compensation claims, and in auto liability insurance premiums. Our significant self-insured retention exposes us to the possibility of significant fluctuations in claims expense between periods which could materially impact our financial results depending on the frequency, severity and timing of claims. Gain on disposition of revenue equipment decreased to $5.5 million in 2017 from $10.5 million in 2016 primarily due to a decrease in the average gain for tractors and trailers within a soft equipment market. Future gains or losses on dispositions of revenue equipment will be impacted by the market for used revenue equipment, which is beyond our control. The $3.2 million decrease in other operating expenses in 2017 was primarily due to proceeds received from the settlement of a lawsuit, net of current period legal expenses, of $1.0 million, along with multiple cost control measures. As a result of the foregoing factors, our operating expenses as a percentage of operating revenue, or “operating ratio,” was 91.9% in 2017 and 91.3% in 2016. The operating ratio for our Truckload segment was 93.1% in 2017 and 92.7% in 2016, for our Dedicated segment was 89.8% in 2017 and 87.6% in 2016, for our Intermodal segment was 89.7% in 2017 and 90.0% in 2016, and for our Brokerage segment was 92.7% in 2017 and 93.7% in 2016. Operating expenses as a percentage of operating revenue, with both amounts net of fuel surcharges, was 91.0% in 2017 and 90.6% in 2016. The decrease in our non-operating expense was primarily due to improved operating results in 2017 by MW Logistics, LLC, or MWL, a 45% owned affiliate. Our effective income tax rate decreased to (59.9%) in 2017 from 41.4% in 2016. We recorded a $56.5 million deferred income taxes benefit in 2017 to recognize the impact of the reduction of the federal corporate statutory income tax rate beginning on January 1, 2018 from 35% to 21% related to the Tax Cuts and Jobs Act of 2017. Excluding that benefit, the effective tax rate was 40.1% in 2017. The decrease to 40.1% was due in part to certain federal employment tax credits realized as a discrete item and an excess tax benefit of $176,000 which was recorded as a decrease to the provision for income taxes in 2017 with the adoption of the provisions of Financial Accounting Standards Board, or FASB, Accounting Standards Update, or ASU, No. 2016-09, “Compensation - Stock Compensation: Improvements to Employee Share-Based Payment Accounting” in 2017. In addition to the reduction of the federal corporate income tax rate, which will lower our effective tax rate by 14 points beginning in 2018, the Tax Cuts and Jobs Act of 2017 establishes new tax laws that will affect us beginning in 2018 including, but not limited to, bonus depreciation that will allow for full expensing of qualified property and the repeal of like-kind exchanges. As a result of the factors described above, net income increased to $90.3 million, or $1.65 per diluted share, in 2017 from $33.5 million, or $0.61 per diluted share, in 2016. Excluding the deferred income taxes benefit, 2017 net income improved 1.1% to $33.8 million, or $0.62 per diluted share, from 2016. Comparison of Year Ended December 31, 2016 to Year Ended December 31, 2015 The following table sets forth for the years indicated our operating revenue, operating income and operating ratio by segment, along with the change for each component: (1) Represents operating expenses as a percentage of operating revenue. Our operating revenue increased $6.2 million, or 0.9%, to $671.1 million in 2016 from $665.0 million in 2015, despite a 26.4% decrease in fuel surcharge revenue to $53.2 million from $72.3 million in 2015 due to lower fuel prices. Our operating revenue, net of both fuel surcharges and revenue from our dry container service discontinued in March 2015, increased $26.6 million, or 4.5%, to $617.9 million in 2016 from $591.3 million in 2015. This increase was due to a $39.7 million increase in Dedicated revenue, net of fuel surcharges, partially offset by an $8.1 million decrease in Truckload revenue, net of fuel surcharges, a $5.0 million decrease in Brokerage revenue, and a $49,000 decrease in Intermodal revenue, net of both fuel surcharges and the discontinued dry container service. Truckload segment revenue decreased $22.5 million, or 5.7%, to $375.9 million in 2016 from $398.4 million in 2015. Truckload segment revenue, net of fuel surcharges, decreased $8.1 million, or 2.3%, to $340.0 million in 2016 from $348.1 million in 2015, primarily due to a decrease in our average revenue per tractor. The increase in the operating ratio in 2016 was also primarily due to a decrease in our average revenue per tractor within a continued soft freight market. Dedicated segment revenue increased $39.1 million, or 33.1%, to $157.4 million in 2016 from $118.3 million in 2015. Dedicated segment revenue, net of fuel surcharges, increased 37.1% primarily due to an increase in our average fleet size of 36.7% driven by a significant increase in the number of Dedicated contracts we have with customers. The improvement in the operating ratio in 2016 was achieved primarily through multiple cost control measures. Intermodal segment revenue decreased $5.5 million, or 7.1%, to $71.5 million in 2016 from $77.0 million in 2015. Intermodal segment revenue, net of both fuel surcharges and $1.3 million of revenue from our discontinued dry container service, decreased $49,000 from 2015 due to a decrease in volume. The improvement in the operating ratio in 2016 was primarily due to the disposal of our dry container service, which produced a higher operating ratio than our temperature-controlled trailer service, and decreases in salaries, wages and benefits and depreciation expense, as the fleet size was reduced to optimize productivity. Brokerage segment revenue decreased $5.0 million, or 7.0%, to $66.4 million in 2016 from $71.4 million in 2015, due to a decrease in revenue per load, primarily caused by lower fuel surcharges. The improvement in the operating ratio in 2016 was primarily driven by a decrease in the percentage of the amounts payable to carriers for transportation services which we arranged to our Brokerage revenue. The following table sets forth for the years indicated the dollar and percentage increase or decrease of the items in our consolidated statements of operations, and those items as a percentage of operating revenue: Salaries, wages and benefits expense increased $15.4 million, or 7.3%, in 2016 from 2015. The increase in salaries, wages and benefits from 2015 resulted primarily from a 6.3% increase in the total miles driven by company drivers and increases to several components of the amount paid to company drivers, along with an increase in employees’ health insurance expense of $1.8 million due to an increase in our self-insured medical claims, partially offset by a decrease of $960,000 in bonus compensation expense for our non-driver employees. Purchased transportation expense decreased $7.3 million in total, or 6.2%, in 2016 from 2015. Amounts payable to carriers for transportation services we arranged in our Brokerage segment decreased $5.1 million to $55.4 million in 2016 from $60.5 million in 2015, primarily due to a decrease in brokerage revenue. Amounts payable to railroads and drayage carriers for transportation services within our Intermodal segment decreased $3.4 million to $45.9 million in 2016 from $49.3 million in 2015. This decrease was primarily due to decreased revenue within our temperature-controlled intermodal trailer service, along with the disposal in March 2015 of the dry containers that were used in a portion of our intermodal operations. The portion of purchased transportation expense related to our independent contractors within our Truckload and Dedicated segments, including fuel surcharges, increased $1.2 million in 2016. Fuel and fuel taxes decreased by $10.5 million, or 10.0%, in 2016 from 2015. Net fuel expense (fuel and fuel taxes net of fuel surcharge revenue and surcharges passed through to independent contractors, outside drayage carriers and railroads) increased $5.9 million, or 14.4%, to $47.0 million in 2016 from $41.1 million in 2015. Fuel surcharges passed through to independent contractors, outside drayage carriers and railroads decreased to $6.2 million from $8.9 million in 2015. Despite a decrease in the DOE national average cost of fuel to $2.30 per gallon from $2.71 per gallon in 2015, net fuel expense increased to 8.5% of Truckload, Dedicated and Intermodal segment revenue, net of fuel surcharges, from 7.9% in 2015. The net fuel expense to revenue increased in 2016 primarily due to our discount from retail being larger in 2015 as the result of a significant decrease in fuel prices during the first quarter, compared with level fuel prices in the first quarter of 2016. The discount from retail typically increases when prices decrease. We have worked diligently to control fuel usage and costs by improving our volume purchasing arrangements and optimizing our drivers’ fuel purchases with national fuel centers, focusing on shorter lengths of haul, installing and tightly managing the use of auxiliary power units in our tractors to minimize engine idling and improving fuel usage in the temperature-control units on our trailers. The increase in depreciation was primarily due to a continued increase in the cost of revenue equipment and growth of our fleet. The $3.0 million increase in insurance and claims in 2016 was primarily due to increases in self-insured auto liability claims and auto liability insurance premiums. Gain on disposition of revenue equipment increased to $10.5 million in 2016 from $5.6 million in 2015 primarily due to an increase in both the average gain per tractor and in the number of tractors sold. Gain on disposition of facilities was $4.1 million in 2015. The disposition of the facilities, located in Ontario, CA and Indianapolis, IN, was part of our ongoing program to expand and update the footprint of our facilities throughout the United States, in which we have spent over $94 million since 2009. Any future gains or losses on disposition of facilities will be impacted by the market for real estate, which is beyond our control. As a result of the foregoing factors, our operating expenses as a percentage of operating revenue, or “operating ratio,” was 91.3% in 2016 and 90.8% in 2015. The operating ratio for our Truckload segment was 92.7% in 2016 and 91.1% in 2015, for our Dedicated segment was 87.6% in 2016 and 89.2% in 2015, for our Intermodal segment was 90.0% in 2016 and 93.7% in 2015, and for our Brokerage segment was 93.7% in 2016 and 94.7% in 2015. Operating expenses as a percentage of operating revenue, with both amounts net of fuel surcharges, was 90.6% in 2016. Our operating ratio for 2015, net of both the gain on disposition of facilities and fuel surcharges, was 90.4%. The increase in our non-operating expense was primarily due to increased losses in 2016 by MW Logistics, LLC, or MWL, a 45% owned affiliate. Our effective income tax rate increased slightly to 41.4% in 2016 from 41.1% in 2015. As a result of the factors described above, net income was $33.5 million in 2016 and $35.7 million in 2015. Net earnings per diluted share was $0.61 in 2016 and $0.64 in 2015. Net income in 2016 improved 0.4% over earnings of $33.3 million, or $0.59 per diluted share, in 2015 excluding the gain on disposition of facilities. Liquidity and Capital Resources Our business requires substantial, ongoing capital investments, particularly for new tractors and trailers. Our primary sources of liquidity are funds provided by operations and our revolving credit facility. A portion of our tractor fleet is provided by independent contractors who own and operate their own equipment. We have no capital expenditure requirements relating to those drivers who own their tractors or obtain financing through third parties. The table below reflects our net cash flows provided by operating activities, net cash flows used for investing activities and net cash flows used for financing activities for the years indicated. In December 2007, our Board of Directors approved and we announced a share repurchase program to repurchase up to one million shares of our common stock either through purchases on the open market or through private transactions and in accordance with Rule 10b-18 of the Exchange Act. In November 2015, our Board of Directors approved and we announced an increase in the share repurchase program, providing for the repurchase of up to $40 million, or approximately 2 million shares, of our common stock, which was increased by our Board of Directors to 3.3 million shares on August 15, 2017 to reflect the five-for-three stock split effected in the form of a stock dividend on July 7, 2017. The timing and extent to which we repurchase shares depends on market conditions and other corporate considerations. The repurchase program does not have an expiration date. We repurchased and retired 759,302 shares of our common stock for $7.5 million in the first quarter of 2016 and did not repurchase any shares in the last three quarters of 2016 or in 2017. In the fourth quarter of 2015 we repurchased and retired 1.6 million shares of our common stock for $16.2 million. In 2017, net cash flows provided by operating activities of $121.9 million were primarily used to purchase new revenue equipment, net of proceeds from dispositions, in the amount of $87.6 million, to repay, net of borrowings, $7.9 million of long-term debt, to partially construct regional operating facilities in the amount of $5.8 million, and to pay cash dividends of $4.4 million, resulting in a $15.3 million increase in cash and cash equivalents. In 2016, net cash flows provided by operating activities of $133.8 million were primarily used to purchase new revenue equipment, net of proceeds from dispositions, in the amount of $89.9 million, to partially construct regional operating facilities in the amount of $5.1 million, to repay, net of borrowings, $30.0 million of long-term debt, to repurchase and retire 759,302 shares of our common stock for $7.5 million, and to pay cash dividends of $3.3 million. In 2015, net cash flows provided by operating activities of $128.7 million and net borrowings under our credit facility of $13.5 million were primarily used to purchase new revenue equipment, net of proceeds from dispositions, in the amount of $118.2 million, to partially construct regional operating facilities in the amount of $8.6 million, to repurchase and retire 1.6 million shares of our common stock for $16.2 million, and to pay cash dividends of $3.3 million. Our net cash flows beginning in 2018 will be increased by the new tax laws established by the Tax Cuts and Jobs Act of 2017 which reduce the federal corporate statutory income tax rate and establish bonus depreciation that will allow for full expensing of qualified assets, partially offset by the repeal of like-kind exchanges. We estimate that capital expenditures, net of proceeds from dispositions, will be approximately $115 million in 2018. Quarterly cash dividends of $0.015 per share of common stock were declared in each of the first two quarters of 2017 along with dividends of $0.025 per share in each of 2017’s last two quarters, which totaled $4.4 million. Quarterly cash dividends of $0.015 per share of common stock were declared in each quarter of 2016 and 2015 and totaled $3.3 million in each of the two years. We currently expect to continue to pay quarterly cash dividends in the future. The payment of cash dividends in the future, and the amount of any such dividends, will depend upon our financial condition, results of operations, cash requirements, and certain corporate law requirements, as well as other factors deemed relevant by our Board of Directors. We believe our sources of liquidity are adequate to meet our current and anticipated needs for at least the next twelve months. Based upon anticipated cash flows, existing cash and cash equivalents balances, current borrowing availability and other sources of financing we expect to be available to us, we do not anticipate any significant liquidity constraints in the foreseeable future. We maintain a credit agreement that provides for an unsecured committed credit facility which matures in December 2019. In April 2016, we elected to reduce the aggregate principal amount of the facility from $75.0 million to $30.0 million. In December 2016, we entered into an amendment to the facility which increased the aggregate principal amount to $40.0 million. At December 31, 2017, there was no outstanding principal balance on the facility. As of that date, we had outstanding standby letters of credit to guarantee settlement of self-insurance claims of $12.9 million and remaining borrowing availability of $27.1 million. This facility bears interest at a variable rate based on the London Interbank Offered Rate or the lender’s Prime Rate, in each case plus/minus applicable margins. Our credit facility prohibits us from paying, in any fiscal year, stock redemptions and dividends in excess of 25% of our net income from the prior fiscal year. A waiver of the 25% limitation for 2016 was obtained from the lender. This facility also contains restrictive covenants which, among other matters, require us to maintain compliance with cash flow leverage and fixed charge coverage ratios. We were in compliance with all covenants at December 31, 2017 and 2016. The following is a summary of our contractual obligations as of December 31, 2017. Due to uncertainty with respect to the timing of future cash flows, the obligation under our nonqualified deferred compensation plan at December 31, 2017 of 175,449 shares of Company common stock with a value of $3.6 million has been excluded from the above table. Off-balance Sheet Arrangements Other than standby letters of credit maintained in connection with our self-insurance programs in the amount of $12.9 million along with purchase obligations and operating leases summarized above in our summary of contractual obligations, we did not have any other material off-balance sheet arrangements at December 31, 2017. Inflation and Fuel Costs Most of our operating expenses are inflation-sensitive, with inflation generally producing increased costs of operations. During the past three years, the most significant effects of inflation have been on revenue equipment prices, accident claims, health insurance and employee compensation. We attempt to limit the effects of inflation through increases in freight rates and cost control efforts. In addition to inflation, fluctuations in fuel prices can affect our profitability. We require substantial amounts of fuel to operate our tractors and power the temperature-control units on our trailers. Substantially all of our contracts with customers contain fuel surcharge provisions. Although we historically have been able to pass through a significant portion of long-term increases in fuel prices and related taxes to customers in the form of fuel surcharges and higher rates, such increases usually are not fully recovered. These fuel surcharge provisions are not effective in mitigating the fuel price increases related to non-revenue miles or fuel used while the tractor is idling. Seasonality Our tractor productivity generally decreases during the winter season because inclement weather impedes operations and some shippers reduce their shipments. At the same time, operating expenses generally increase, with harsh weather creating higher accident frequency, increased claims, lower fuel efficiency and more equipment repairs. Critical Accounting Policies The preparation of financial statements in conformity with U.S. generally accepted accounting principles requires management to make estimates and assumptions about future events, and apply judgments that affect the reported amounts of assets, liabilities, revenue and expenses in our consolidated financial statements and related notes. We base our estimates, assumptions and judgments on historical experience, current trends and other factors believed to be relevant at the time our consolidated financial statements are prepared. However, because future events and their effects cannot be determined with certainty, actual results could differ from our estimates and assumptions, and such differences could be material. We believe that the following critical accounting policies affect our more significant estimates, assumptions and judgments used in the preparation of our consolidated financial statements. Revenue Recognition. We recognize revenue, including fuel surcharges, at the time shipment of freight is completed. We account for revenue of our Intermodal and Brokerage segments and revenue on freight transported by independent contractors within our Truckload and Dedicated segments on a gross basis because we are the primary obligor in the arrangements, we have the ability to establish prices, we have the risk of loss in the event of cargo claims and we bear credit risk with customer payments. Accordingly, all such revenue billed to customers is classified as operating revenue and all corresponding payments to carriers for transportation services we arrange in connection with brokerage and intermodal activities and to independent contractor providers of revenue equipment are classified as purchased transportation expense. In May 2014, the FASB issued ASU No. 2014-09, “Revenue from Contracts with Customers” which requires an entity to recognize the amount of revenue to which it expects to be entitled for the transfer of promised goods or services to customers. The FASB has also issued, along with other additional guidance related to revenue recognition matters, ASU No. 2016-08, “Revenue from Contracts with Customers (Topic 606), Principal versus Agent Considerations (Reporting Revenue Gross versus Net).” The standards, which are effective for the first quarter of 2018, will replace most existing revenue recognition guidance required by U.S. generally accepted accounting principles and will require additional disclosures. The new standards will require us to recognize revenue and related expenses within each of our four segments over time, compared with our current policy in which we record revenue and related expenses on the date shipment of freight is completed. Our current policy in which we account for revenue of our Intermodal and Brokerage segments and revenue on freight transported by independent contractors within our Truckload and Dedicated segments on a gross basis is appropriate under the new standards. Accounts Receivable. We are dependent upon a limited number of customers, and, as a result, our trade accounts receivable are highly concentrated. Trade accounts receivable are recorded at the invoiced amounts, net of an allowance for doubtful accounts. Our allowance for doubtful accounts was $300,000 as of December 31, 2017 and $275,000 as of December 31, 2016. A considerable amount of judgment is required in assessing the realization of these receivables including the current creditworthiness of each customer and related aging of the past-due balances, including any billing disputes. In order to assess the collectibility of these receivables, we perform ongoing credit evaluations of our customers’ financial condition. Through these evaluations, we may become aware of a situation where a customer may not be able to meet its financial obligations due to deterioration of its financial viability, credit ratings or bankruptcy. The allowance for doubtful accounts is based on the best information available to us and is reevaluated and adjusted as additional information is received. We evaluate the allowance based on historical write-off experience, the size of the individual customer balances, past-due amounts and the overall national economy. We review the adequacy of our allowance for doubtful accounts monthly. Property and Equipment. The transportation industry requires significant capital investments. Our net property and equipment was $571.9 million as of December 31, 2017 and $557.8 million as of December 31, 2016. Our depreciation expense was $85.1 million in 2017, $82.4 million in 2016 and $75.3 million in 2015. We compute depreciation of our property and equipment for financial reporting purposes based on the cost of each asset, reduced by its estimated salvage value, using the straight-line method over its estimated useful life. We determine and periodically evaluate our estimate of the projected salvage values and useful lives primarily by considering the market for used equipment, prior useful lives and changes in technology. We have not changed our policy regarding salvage values as a percentage of initial cost or useful lives of tractors and trailers within the last ten years. We believe that our policies and past estimates have been reasonable. Actual results could differ from these estimates. A 5% decrease in estimated salvage values would have decreased our net property and equipment as of December 31, 2017 by approximately $11.1 million, or 1.9%. Impairment of Assets. Long-lived assets are reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. Recoverability of assets to be held and used is measured by a comparison of the carrying amount of an asset to future net undiscounted cash flows expected to be generated by the asset. If such assets are considered to be impaired, the impairment to be recognized is measured by the amount by which the carrying amount of the assets exceeds the fair value of the assets. Assets to be disposed of are reported at the lower of the carrying amount or fair value less the costs to sell. Insurance and Claims. We self-insure, in part, for losses relating to workers’ compensation, auto liability, general liability, cargo and property damage claims, along with employees’ health insurance with varying risk retention levels. We maintain insurance coverage for per-incident and total losses in excess of these risk retention levels in amounts we consider adequate based upon historical experience and our ongoing review. However, we could suffer a series of losses within our self-insured retention limits or losses over our policy limits, which could negatively affect our financial condition and operating results. We are responsible for the first $1.0 million on each auto liability claim and for the first $750,000 on each workers’ compensation claim. We have $12.9 million in standby letters of credit to guarantee settlement of claims under agreements with our insurance carriers and regulatory authorities. The insurance and claims accruals in our consolidated balance sheets were $26.2 million as of December 31, 2017 and $19.4 million as of December 31, 2016. We reserve currently for the estimated cost of the uninsured portion of pending claims. We periodically evaluate and adjust these reserves based on our evaluation of the nature and severity of outstanding individual claims and our estimate of future claims development based on historical development. Actual results could differ from these current estimates. In addition, to the extent that claims are litigated and not settled, jury awards are difficult to predict. Share-based Payment Arrangement Compensation. We have granted stock options to certain employees and non-employee directors. We recognize compensation expense for all stock options net of an estimated forfeiture rate and only record compensation expense for those shares expected to vest on a straight-line basis over the requisite service period (normally the vesting period). Determining the appropriate fair value model and calculating the fair value of stock options require the input of highly subjective assumptions, including the expected life of the stock options and stock price volatility. We use the Black-Scholes model to value our stock option awards. We believe that future volatility will not materially differ from our historical volatility. Thus, we use the historical volatility of our common stock over the expected life of the award. The assumptions used in calculating the fair value of stock options represent our best estimates, but these estimates involve inherent uncertainties and the application of judgment. As a result, if factors change and we use different assumptions, stock option compensation expense could be materially different in the future. We have also granted performance unit awards to certain employees which are subject to vesting requirements over a five-year period, primarily based on our earnings growth. The fair value of each performance unit is based on the closing market price on the date of grant. We recognize compensation expense for these awards based on the estimated number of units probable of achieving the performance and service vesting requirements of the awards, net of an estimated forfeiture rate. Recent Accounting Pronouncements See Note 1 of “Notes to Consolidated Financial Statements” for a full description of recent accounting pronouncements and the respective dates of adoption and effect on our results of operations and financial position.

<s>[INST] The following discussion and analysis of our financial condition and results of operations should be read together with the selected consolidated financial data and our consolidated financial statements and the related notes appearing elsewhere in this report. This discussion and analysis contains forwardlooking statements that involve risks, uncertainties and assumptions. Our actual results may differ materially from those anticipated in these forwardlooking statements as a result of many factors, including but not limited to those under the heading “Risk Factors” beginning on page 6. We do not assume, and specifically disclaim, any obligation to update any forwardlooking statement contained in this report. Overview The primary source of our operating revenue is provided by our Truckload segment through a combination of regional shorthaul and mediumtolonghaul fullload transportation services. We transport food and other consumer packaged goods that require a temperaturecontrolled or insulated environment, along with dry freight, across the United States and into and out of Mexico and Canada. Our Dedicated segment provides customized transportation solutions tailored to meet individual customers’ requirements, utilizing temperaturecontrolled trailers, dry vans and other specialized equipment within the United States. Our agreements with customers range from three to five years and are subject to annual rate reviews. Generally, we are paid by the mile for our Truckload and Dedicated services. We also derive Truckload and Dedicated revenue from fuel surcharges, loading and unloading activities, equipment detention and other ancillary services. The main factors that affect our Truckload and Dedicated revenue are the rate per mile we receive from our customers, the percentage of miles for which we are compensated, the number of miles we generate with our equipment and changes in fuel prices. We monitor our revenue production primarily through average Truckload and Dedicated revenue, net of fuel surcharges, per tractor per week. We also analyze our average Truckload and Dedicated revenue, net of fuel surcharges, per total mile, nonrevenue miles percentage, the miles per tractor we generate, our fuel surcharge revenue, our accessorial revenue and our other sources of operating revenue. Our Intermodal segment transports our customers’ freight within the United States utilizing our temperaturecontrolled trailers on railroad flatcars for portions of trips, with the balance of the trips using our tractors or, to a lesser extent, contracted carriers. The main factors that affect our Intermodal revenue are the rate per mile and other charges we receive from our customers. Our Brokerage segment develops contractual relationships with and arranges for thirdparty carriers to transport freight for our customers in temperaturecontrolled trailers and dry vans within the United States and into and out of Mexico through Marten Transport Logistics, LLC, which was established in 2007 and operates pursuant to brokerage authority granted by the DOT. We retain the billing, collection and customer management responsibilities. The main factors that affect our Brokerage revenue are the rate per mile and other charges that we receive from our customers. In addition to the factors discussed above, our operating revenue is also affected by, among other things, the United States economy, inventory levels, the level of truck and rail capacity in the transportation market, a contracting driver market, severe weather conditions and specific customer demand. Our operating revenue increased $27.0 million, or 4.0%, in 2017. Our operating revenue, net of fuel surcharges, increased $13.1 million, or 2.1%, compared with 2016. Truckload segment revenue, net of fuel surcharges, decreased 1.0% from 2016, primarily due to a reduction in our average number of tractors, partially offset by an increase in our average revenue per tractor. Dedicated segment revenue, net of fuel surcharges, increased 4.5% from 2016, primarily due to fleet growth and an increase in our average revenue per tractor. Intermodal segment revenue, net of fuel surcharges, increased 9.0% due to increased volume and Brokerage segment revenue increased 6.0% due to increased revenue per load in 2017. Fuel surcharge revenue increased to $67.1 million in 2017 from $53.2 million in 2016 due to higher fuel prices. Our profitability is impacted by the variable costs of transporting freight for our [/INST] Positive. </s>

MARTEN TRANSPORT LTD

2019-03-01

2018-12-31

ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The following discussion and analysis of our financial condition and results of operations should be read together with the selected consolidated financial data and our consolidated financial statements and the related notes appearing elsewhere in this report. This discussion and analysis contains forward-looking statements that involve risks, uncertainties and assumptions. Our actual results may differ materially from those anticipated in these forward-looking statements as a result of many factors, including but not limited to those under the heading “Risk Factors” beginning on page 6. We do not assume, and specifically disclaim, any obligation to update any forward-looking statement contained in this report. Overview We have strategically transitioned from a long-haul carrier to a multifaceted business offering a network of truck-based transportation capabilities across our five distinct business platforms - Truckload, Dedicated, Intermodal, Brokerage and MRTN de Mexico. The primary source of our operating revenue is provided by our Truckload segment through a combination of regional short-haul and medium-to-long-haul full-load transportation services. We transport food and other consumer packaged goods that require a temperature-controlled or insulated environment, along with dry freight, across the United States and into and out of Mexico and Canada. Our Dedicated segment provides customized transportation solutions tailored to meet individual customers’ requirements, utilizing temperature-controlled trailers, dry vans and other specialized equipment within the United States. Our agreements with customers range from three to five years and are subject to annual rate reviews. Generally, we are paid by the mile for our Truckload and Dedicated services. We also derive Truckload and Dedicated revenue from fuel surcharges, loading and unloading activities, equipment detention and other accessorial services. The main factors that affect our Truckload and Dedicated revenue are the rate per mile we receive from our customers, the percentage of miles for which we are compensated, the number of miles we generate with our equipment and changes in fuel prices. We monitor our revenue production primarily through average Truckload and Dedicated revenue, net of fuel surcharges, per tractor per week. We also analyze our average Truckload and Dedicated revenue, net of fuel surcharges, per total mile, non-revenue miles percentage, the miles per tractor we generate, our fuel surcharge revenue, our accessorial revenue and our other sources of operating revenue. Our Intermodal segment transports our customers’ freight within the United States utilizing our temperature-controlled trailers on railroad flatcars for portions of trips, with the balance of the trips using our tractors or, to a lesser extent, contracted carriers. The main factors that affect our Intermodal revenue are the rate per mile and other charges we receive from our customers. Our Brokerage segment develops contractual relationships with and arranges for third-party carriers to transport freight for our customers in temperature-controlled trailers and dry vans within the United States and into and out of Mexico through Marten Transport Logistics, LLC, which was established in 2007 and operates pursuant to brokerage authority granted by the DOT. We retain the billing, collection and customer management responsibilities. The main factors that affect our Brokerage revenue are the rate per mile and other charges that we receive from our customers. Operating results of our MRTN de Mexico business which offers our customers door-to-door service between the United States and Mexico with our Mexican partner carriers is reported within our Truckload and Brokerage segments. In addition to the factors discussed above, our operating revenue is also affected by, among other things, the United States economy, inventory levels, the level of truck and rail capacity in the transportation market, a contracting driver market, severe weather conditions and specific customer demand. Our operating revenue increased $89.5 million, or 12.8%, from 2017 to 2018. Our operating revenue, net of fuel surcharges, increased $50.4 million, or 8.0%, compared with 2017. Truckload segment revenue, net of fuel surcharges, decreased 4.2% from 2017, primarily due to a reduction in our average number of tractors, partially offset by an increase in our average revenue per tractor. Dedicated segment revenue, net of fuel surcharges, increased 21.8% from 2017, primarily due to fleet growth driven by an increase in the number of Dedicated contracts we have with our customers. Intermodal segment revenue, net of fuel surcharges, increased 21.8% due to increases in revenue per load and in volume. Brokerage segment revenue increased 22.7% also due to increases in revenue per load and in volume in 2018. Fuel surcharge revenue increased to $106.2 million in 2018 from $67.1 million in 2017 primarily due to higher fuel prices and a shift of a portion of line haul revenue to fuel surcharge revenue which began in the first quarter of 2018 as a result of changes in a number of customer agreements. The change reduced our revenue excluding fuel surcharges by $12.9 million in 2018 and increased our fuel surcharge revenue by the same amount. Our profitability is impacted by the variable costs of transporting freight for our customers, fixed costs, and expenses containing both fixed and variable components. The variable costs include fuel expense, driver-related expenses, such as wages, benefits, training, and recruitment, and independent contractor costs, which are recorded under purchased transportation. Expenses that have both fixed and variable components include maintenance and tire expense and our cost of insurance and claims. These expenses generally vary with the miles we travel, but also have a controllable component based on safety, fleet age, efficiency and other factors. Our main fixed costs relate to the acquisition and subsequent depreciation of long-term assets, such as revenue equipment and operating terminals. We expect our annual cost of tractor and trailer ownership will increase in future periods as a result of higher prices of new equipment, along with any increases in fleet size. Although certain factors affecting our expenses are beyond our control, we monitor them closely and attempt to anticipate changes in these factors in managing our business. For example, fuel prices have significantly fluctuated over the past several years. We manage our exposure to changes in fuel prices primarily through fuel surcharge programs with our customers, as well as through volume fuel purchasing arrangements with national fuel centers and bulk purchases of fuel at our terminals. To help further reduce fuel expense, we have installed and tightly manage the use of auxiliary power units in our tractors to provide climate control and electrical power for our drivers without idling the tractor engine, and also have improved the fuel usage in the temperature-control units on our trailers. For our Intermodal and Brokerage segments, our profitability is impacted by the percentage of revenue which is payable to the providers of the transportation services we arrange. This expense is included within purchased transportation in our consolidated statements of operations. Our operating income improved 23.7% to $70.3 million in 2018 from $56.9 million in 2017. Our operating expenses as a percentage of operating revenue, or “operating ratio,” improved to 91.1% in 2018 from 91.9% in 2017. Operating expenses as a percentage of operating revenue, with both amounts net of fuel surcharges, improved to 89.7% in 2018 from 91.0% in the 2017. Our net income was $55.0 million, or $1.00 per diluted share, in 2018 and $90.3 million, or $1.65 per diluted share, in 2017. Earnings in 2017 include a deferred income taxes benefit of $56.5 million recorded to recognize the impact on our federal net deferred tax liability of the reduction of the federal corporate statutory income tax rate from 35% to 21% related to the Tax Cuts and Jobs Act of 2017. Excluding the deferred income taxes benefit, 2018 net income improved 62.7% from 2017 earnings of $33.8 million, or $0.62 per diluted share. Our business requires substantial, ongoing capital investments, particularly for new tractors and trailers. At December 31, 2018, we had $56.8 million of cash and cash equivalents, $576.0 million in stockholders’ equity and no long-term debt outstanding. In 2018, net cash flows provided by operating activities of $150.6 million were primarily used to purchase new revenue equipment, net of proceeds from dispositions, in the amount of $93.9 million, to acquire and upgrade regional operating facilities in the amount of $5.9 million, to pay cash dividends of $5.5 million, and to repurchase and retire 200,000 shares of our common stock for $3.8 million, resulting in a $41.0 million increase in cash and cash equivalents. We estimate that capital expenditures, net of proceeds from dispositions, will be approximately $125 million in 2019. We believe our sources of liquidity are adequate to meet our current and anticipated needs for at least the next twelve months. Based upon anticipated cash flows, existing cash and cash equivalents balances, current borrowing availability and other sources of financing we expect to be available to us, we do not anticipate any significant liquidity constraints in the foreseeable future. This Management’s Discussion and Analysis of Financial Condition and Results of Operations includes discussions of net income and diluted earnings per share, net of a deferred income taxes benefit; operating revenue, net of fuel surcharge revenue; Truckload, Dedicated and Intermodal revenue, net of fuel surcharge revenue; operating expenses as a percentage of operating revenue, each net of fuel surcharge revenue; and net fuel expense (fuel and fuel taxes net of fuel surcharge revenue and surcharges passed through to independent contractors, outside drayage carriers and railroads). We provide these additional disclosures because management believes these measures provide a more consistent basis for comparing results of operations from period to period. These financial measures in this report have not been determined in accordance with U.S. generally accepted accounting principles (GAAP). Pursuant to Item 10(e) of Regulation S-K, we have included the amounts necessary to reconcile these non-GAAP financial measures to the most directly comparable GAAP financial measures of net income, diluted earnings per share, operating revenue, operating expenses divided by operating revenue, and fuel and fuel taxes. Stock Split On July 7, 2017, we effected a five-for-three stock split of our common stock, $.01 par value, in the form of a 66 ⅔% stock dividend. Our consolidated financial statements, related notes, and other financial data contained in this report have been adjusted to give retroactive effect to the stock split for all periods presented. Adoption of New Revenue Recognition Accounting Standard We account for our revenue in accordance with Financial Accounting Standards Board, or FASB, Accounting Standards Codification, or ASC 606, Revenue from Contracts with Customers, which we adopted on January 1, 2018 using the modified retrospective method. Prior years have not been restated and continue to be reported under the accounting standards in effect for those periods. The new revenue standard requires us to recognize revenue and related expenses within each of our four reporting segments over time, compared with our former policy in which we recorded revenue and related expenses on the date shipment of freight was completed. Results of Operations The following table sets forth for the years indicated certain operating statistics regarding our revenue and operations: (1) Includes tractors driven by both company-employed drivers and independent contractors. Independent contractors provided 46, 60 and 68 tractors as of December 31, 2018, 2017 and 2016, respectively. Comparison of Year Ended December 31, 2018 to Year Ended December 31, 2017 The following table sets forth for the years indicated our operating revenue, operating income and operating ratio by segment, along with the change for each component: (1) Represents operating expenses as a percentage of operating revenue. Our operating revenue increased $89.5 million, or 12.8%, to $787.6 million in 2018 from $698.1 million in 2017. Our operating revenue, net of fuel surcharges, increased $50.4 million, or 8.0%, to $681.4 million in 2018 from $631.0 million in 2017. This increase was due to a $33.4 million increase in Dedicated revenue, net of fuel surcharges, a $16.0 million increase in Brokerage revenue, and a $15.3 million increase in Intermodal revenue, net of fuel surcharges, partially offset by a $14.3 million decrease in Truckload revenue, net of fuel surcharges. Fuel surcharge revenue increased to $106.2 million in 2018 from $67.1 million in 2017 primarily due to higher fuel prices and a shift of a portion of line haul revenue to fuel surcharge revenue which began in the first quarter of 2018 as a result of changes in a number of customer agreements. The change reduced our revenue excluding fuel surcharges by $12.9 million in 2018 and increased our fuel surcharge revenue by the same amount. Truckload segment revenue decreased $4.9 million, or 1.3%, to $375.3 million in 2018 from $380.2 million in 2017. Truckload segment revenue, net of fuel surcharges, decreased $14.3 million, or 4.2%, to $322.3 million in 2018 from $336.6 million in 2017, primarily due to a reduction in our average number of tractors, partially offset by an increase in our average revenue per tractor. The shift from line haul revenue to fuel surcharge revenue as a result of changes in a number of customer agreements decreased our Truckload revenue excluding fuel surcharges by $2.8 million, or $32 per tractor per week, in 2018, and increased our fuel surcharge revenue by the same amount. The improvement in the operating ratio in 2018 was primarily due to the increase in our average revenue per tractor driven by increased rates with our customers. Dedicated segment revenue increased $57.0 million, or 34.1%, to $223.9 million in 2018 from $166.9 million in 2017. Dedicated segment revenue, net of fuel surcharges, increased 21.8% primarily due to fleet growth driven by an increase in the number of Dedicated contracts we have with our customers. The shift from line haul revenue to fuel surcharge revenue as a result of changes in a number of customer agreements decreased our Dedicated revenue excluding fuel surcharges by $10.1 million, or $179 per tractor per week, in 2018, and increased our fuel surcharge revenue by the same amount. The increase in the operating ratio for our Dedicated segment was primarily due to an increase in driver wages, an increase in bonus compensation expense for our non-driver employees and increased depreciation expense. Intermodal segment revenue increased $21.4 million, or 26.5%, to $102.0 million in 2018 from $80.6 million in 2017. Intermodal segment revenue, net of fuel surcharges, increased 21.8% from 2017 due to increases in revenue per load and in volume. The improvement in the operating ratio in 2018 was primarily due to a decrease in the amounts payable to railroads as a percentage of our revenue and increased rates with our customers. Brokerage segment revenue increased $16.0 million, or 22.7%, to $86.4 million in 2018 from $70.4 million in 2017 due to an increase in volume and rates with our customers. The increase in the operating ratio in 2018 was primarily due to an increase in the amounts payable to carriers for transportation services which we arranged as a percentage of our Brokerage revenue. The following table sets forth for the years indicated the dollar and percentage increase or decrease of the items in our consolidated statements of operations, and those items as a percentage of operating revenue: Salaries, wages and benefits consist of compensation for our employees, including both driver and non-driver employees, employees’ health insurance, 401(k) plan contributions and other fringe benefits. These expenses vary depending upon the size of our Truckload, Dedicated and Intermodal tractor fleets, the ratio of company drivers to independent contractors, our efficiency, our experience with employees’ health insurance claims, changes in health care premiums and other factors. Salaries, wages and benefits expense increased $26.0 million, or 11.5%, in 2018 from 2017. The increase in salaries, wages and benefits from 2017 resulted primarily from an increase in company driver compensation expense of $11.1 million, an increase in bonus compensation expense for our non-driver employees of $5.4 million, and an increase in employees’ health insurance expense of $3.3 million due to an increase in our self-insured medical claims. Purchased transportation consists of amounts payable to railroads and carriers for transportation services we arrange in connection with Brokerage and Intermodal operations and to independent contractor providers of revenue equipment. This category will vary depending upon the amount and rates, including fuel surcharges, we pay to third-party railroad and motor carriers, the ratio of company drivers versus independent contractors and the amount of fuel surcharges passed through to independent contractors. Purchased transportation expense increased $26.3 million in total, or 22.2%, in 2018 from 2017. Amounts payable to carriers for transportation services we arranged in our Brokerage segment increased $13.7 million to $72.3 million in 2018 from $58.6 million in 2017, primarily due to an increase in brokerage revenue. Amounts payable to railroads and drayage carriers for transportation services within our Intermodal segment increased $13.6 million to $65.0 million in 2018 from $51.5 million in 2017. This increase was due to increased intermodal revenue along with increased fuel surcharges to the railroads due to higher fuel prices. The portion of purchased transportation expense related to our independent contractors within our Truckload and Dedicated segments, including fuel surcharges, decreased $1.1 million in 2018. We expect that purchased transportation expense will increase as we grow our Intermodal and Brokerage segments. Fuel and fuel taxes increased by $16.2 million, or 15.4%, in 2018 from 2017. Net fuel expense (fuel and fuel taxes net of fuel surcharge revenue and surcharges passed through to independent contractors, outside drayage carriers and railroads) decreased $17.4 million, or 37.2%, to $29.4 million in 2018 from $46.8 million in 2017. Fuel surcharges passed through to independent contractors, outside drayage carriers and railroads increased to $14.0 million from $8.6 million in 2017. Despite an increase in the United States Department of Energy, or DOE, national average cost of fuel to $3.18 per gallon from $2.65 per gallon in 2017, net fuel expense decreased to 4.9% of Truckload, Dedicated and Intermodal segment revenue, net of fuel surcharges, from 8.4% in 2017. The net fuel expense to revenue improved primarily due to a $12.9 million shift during 2018 of a portion of line haul revenue to fuel surcharge revenue as a result of changes in a number of customer agreements. Increases in our miles per gallon and in our revenue rate per mile in 2018 further improved this ratio. We have worked diligently to control fuel usage and costs by improving our volume purchasing arrangements and optimizing our drivers’ fuel purchases with national fuel centers, focusing on shorter lengths of haul, installing and tightly managing the use of auxiliary power units in our tractors to minimize engine idling and improving fuel usage in the temperature-control units on our trailers. Auxiliary power units, which we have installed in our company-owned tractors, provide climate control and electrical power for our drivers without idling the tractor engine. Supplies and maintenance consist of repairs, maintenance, tires, parts, oil and engine fluids, along with load-specific expenses including loading/unloading, tolls, pallets and trailer hostling. Our supplies and maintenance expense decreased $760,000, or 1.8%, from 2017 primarily due to a decrease in our loading/unloading expense. Depreciation relates to owned tractors, trailers, auxiliary power units, communication units, terminal facilities and other assets. The increase in depreciation was primarily due to a continued increase in the cost of revenue equipment. We expect our annual cost of tractor and trailer ownership will increase in future periods as a result of higher prices of new equipment, which will result in greater depreciation over the useful life. Gain on disposition of revenue equipment increased to $7.2 million in 2018 from $5.5 million in 2017 primarily due to an increase in the number of trailers sold, along with an increase in our average gain for each tractor and trailer sold. Future gains or losses on dispositions of revenue equipment will be impacted by the market for used revenue equipment, which is beyond our control. The $5.4 million increase in other operating expenses in 2018 was due in part to proceeds received in 2017 from the settlement of a lawsuit, net of 2017 legal expenses, of $1.0 million, and increased costs associated with recruiting and retaining drivers. As a result of the foregoing factors, our operating income improved 23.7% to $70.3 million in 2018 from $56.9 million in 2017. Our operating expenses as a percentage of operating revenue, or “operating ratio,” improved to 91.1% in 2018 from 91.9% in 2017. The operating ratio for our Truckload segment was 90.7% in 2018 and 93.1% in 2017, for our Dedicated segment was 91.7% in 2018 and 89.8% in 2017, for our Intermodal segment was 89.1% in 2018 and 89.7% in 2017, and for our Brokerage segment was 93.6% in 2018 and 92.7% in 2017. Operating expenses as a percentage of operating revenue, with both amounts net of fuel surcharges, improved to 89.7% in 2018 from 91.0% in 2017. The increase in our non-operating income was primarily due to improved operating results in 2018 by MW Logistics, LLC, or MWL, a 45% owned affiliate. Our effective income tax rate increased to 22.5% in 2018 from (59.9%) in 2017. We recorded a $56.5 million deferred income taxes benefit in 2017 to recognize the impact on our federal net deferred tax liability of the reduction of the federal corporate statutory income tax rate from 35% to 21% related to the Tax Cuts and Jobs Act of 2017, which was enacted prior to December 31, 2017. Excluding that benefit, our effective tax rate was 40.1% in 2017, which exceeds our effective tax rate in 2018 primarily due to the reduction of the federal corporate tax rate in 2018 under the Tax Cuts and Jobs Act of 2017. The Tax Cuts and Jobs Act of 2017 makes broad and complex changes to the U.S. tax code including, but not limited to, reducing the federal corporate income tax rate as noted above and allowing bonus depreciation with full expensing of qualified property placed in service after September 27, 2017. As a result of the factors described above, net income was $55.0 million, or $1.00 per diluted share, in 2018 and $90.3 million, or $1.65 per diluted share, in 2017. Excluding the $56.5 million deferred income taxes benefit recorded in 2017, net income in 2018 improved 62.7% from 2017 earnings of $33.8 million, or $0.62 per diluted share. Comparison of Year Ended December 31, 2017 to Year Ended December 31, 2016 The following table sets forth for the years indicated our operating revenue, operating income and operating ratio by segment, along with the change for each component: (1) Represents operating expenses as a percentage of operating revenue. Our operating revenue increased $27.0 million, or 4.0%, to $698.1 million in 2017 from $671.1 million in 2016. Our operating revenue, net of fuel surcharges, increased $13.1 million, or 2.1%, to $631.0 million in 2017 from $617.9 million in 2016. This increase was due to a $6.7 million increase in Dedicated revenue, net of fuel surcharges, a $5.8 million increase in Intermodal revenue, net of fuel surcharges, and a $4.0 million increase in Brokerage revenue, partially offset by a $3.4 million decrease in Truckload revenue, net of fuel surcharges. Fuel surcharge revenue increased to $67.1 million in 2017 from $53.2 million in 2016 due to higher fuel prices. Truckload segment revenue increased $4.4 million, or 1.2%, to $380.2 million in 2017 from $375.9 million in 2016. Truckload segment revenue, net of fuel surcharges, decreased $3.4 million, or 1.0%, to $336.6 million in 2017 from $340.0 million in 2016, primarily due to a reduction in our average number of tractors, partially offset by an increase in our average revenue per tractor. The increase in the operating ratio in 2017 was primarily due to an increase in insurance and claims expense, partially offset by the increase in our average revenue per tractor. Dedicated segment revenue increased $9.5 million, or 6.0%, to $166.9 million in 2017 from $157.4 million in 2016. Dedicated segment revenue, net of fuel surcharges, increased 4.5% primarily due to fleet growth and an increase in our average revenue per tractor. The increase in the operating ratio for our Dedicated segment was primarily due to an increase in insurance and claims expense, partially offset by the increase in our average revenue per tractor. Intermodal segment revenue increased $9.1 million, or 12.8%, to $80.6 million in 2017 from $71.5 million in 2016. Intermodal segment revenue, net of fuel surcharges, increased 9.0% from 2016 due to an increase in volume. The operating ratio in 2017 improved slightly from 2016. Brokerage segment revenue increased $4.0 million, or 6.0%, to $70.4 million in 2017 from $66.4 million in 2016 due to an increase in revenue per load. The improvement in the operating ratio in 2017 was achieved primarily through multiple cost control measures. The following table sets forth for the years indicated the dollar and percentage increase or decrease of the items in our consolidated statements of operations, and those items as a percentage of operating revenue: Salaries, wages and benefits expense increased $1.3 million, or 0.6%, in 2017 from 2016. The increase in salaries, wages and benefits from 2016 resulted primarily from an increase in non-driver bonus compensation expense of $2.3 million, partially offset by multiple other items. Purchased transportation expense increased $7.6 million in total, or 6.9%, in 2017 from 2016. Amounts payable to carriers for transportation services we arranged in our Brokerage segment increased $3.2 million to $58.6 million in 2017 from $55.4 million in 2016, primarily due to an increase in brokerage revenue. Amounts payable to railroads and drayage carriers for transportation services within our Intermodal segment increased $5.6 million to $51.5 million in 2017 from $45.9 million in 2016. This increase was primarily due to increased intermodal revenue. The portion of purchased transportation expense related to our independent contractors within our Truckload and Dedicated segments, including fuel surcharges, decreased $1.2 million in 2017. Fuel and fuel taxes increased by $11.3 million, or 12.0%, in 2017 from 2016. Net fuel expense (fuel and fuel taxes net of fuel surcharge revenue and surcharges passed through to independent contractors, outside drayage carriers and railroads) decreased $213,000, or 0.5%, to $46.8 million in 2017 from $47.0 million in 2016. Fuel surcharges passed through to independent contractors, outside drayage carriers and railroads increased to $8.6 million from $6.2 million in 2016. Despite an increase in the DOE national average cost of fuel to $2.65 per gallon from $2.30 per gallon in 2016, net fuel expense decreased to 8.4% of Truckload, Dedicated and Intermodal segment revenue, net of fuel surcharges, from 8.5% in 2016. The net fuel expense to revenue improved in 2017 primarily due to increases in our miles per gallon and in our revenue rate per mile. We have worked diligently to control fuel usage and costs by improving our volume purchasing arrangements and optimizing our drivers’ fuel purchases with national fuel centers, focusing on shorter lengths of haul, installing and tightly managing the use of auxiliary power units in our tractors to minimize engine idling and improving fuel usage in the temperature-control units on our trailers. Our supplies and maintenance expense decreased $2.3 million, or 5.2%, from 2016 primarily due to decreased repair costs at external facilities and a reduction in parts costs. The increase in depreciation was primarily due to a continued increase in the cost of revenue equipment. Insurance and claims consist of the costs of insurance premiums and accruals we make for claims within our self-insured retention amounts, primarily for personal injury, property damage, physical damage to our equipment, cargo claims and workers’ compensation claims. These expenses will vary primarily based upon the frequency and severity of our accident experience, our self-insured retention levels and the market for insurance. The $6.4 million increase in insurance and claims in 2017 was primarily due to increases in the cost of physical damage claims related to our tractors and trailers, in self-insured workers’ compensation claims, and in auto liability insurance premiums. Our significant self-insured retention exposes us to the possibility of significant fluctuations in claims expense between periods which could materially impact our financial results depending on the frequency, severity and timing of claims. Gain on disposition of revenue equipment decreased to $5.5 million in 2017 from $10.5 million in 2016 primarily due to a decrease in the average gain for tractors and trailers within a soft equipment market. The $3.2 million decrease in other operating expenses in 2017 was primarily due to proceeds received from the settlement of a lawsuit, net of current period legal expenses, of $1.0 million, along with multiple cost control measures. As a result of the foregoing factors, our operating income decreased to $56.9 million in 2017 from $58.3 million in 2016. Our operating expenses as a percentage of operating revenue, or “operating ratio,” was 91.9% in 2017 and 91.3% in 2016. The operating ratio for our Truckload segment was 93.1% in 2017 and 92.7% in 2016, for our Dedicated segment was 89.8% in 2017 and 87.6% in 2016, for our Intermodal segment was 89.7% in 2017 and 90.0% in 2016, and for our Brokerage segment was 92.7% in 2017 and 93.7% in 2016. Operating expenses as a percentage of operating revenue, with both amounts net of fuel surcharges, was 91.0% in 2017 and 90.6% in 2016. The decrease in our non-operating expense was primarily due to improved operating results in 2017 by MWL, a 45% owned affiliate. Our effective income tax rate decreased to (59.9%) in 2017 from 41.4% in 2016. We recorded a $56.5 million deferred income taxes benefit in 2017 to recognize the impact on our federal net deferred tax liability of the reduction of the federal corporate statutory income tax rate from 35% to 21% related to the Tax Cuts and Jobs Act of 2017. Excluding that benefit, the effective tax rate was 40.1% in 2017. The decrease to 40.1% was due in part to certain federal employment tax credits realized as a discrete item and an excess tax benefit of $176,000 which was recorded as a decrease to the provision for income taxes in 2017 with the adoption of the provisions of FASB Accounting Standards Update, or ASU, No. 2016-09, “Compensation - Stock Compensation: Improvements to Employee Share-Based Payment Accounting” in 2017. As a result of the factors described above, net income increased to $90.3 million, or $1.65 per diluted share, in 2017 from $33.5 million, or $0.61 per diluted share, in 2016. Excluding the deferred income taxes benefit, 2017 net income improved 1.1% to $33.8 million, or $0.62 per diluted share, from 2016. Liquidity and Capital Resources Our business requires substantial, ongoing capital investments, particularly for new tractors and trailers. Our primary sources of liquidity are funds provided by operations and our revolving credit facility. A portion of our tractor fleet is provided by independent contractors who own and operate their own equipment. We have no capital expenditure requirements relating to those drivers who own their tractors or obtain financing through third parties. The table below reflects our net cash flows provided by operating activities, net cash flows used for investing activities and net cash flows used for financing activities for the years indicated. In 2007, our Board of Directors approved and we announced a share repurchase program to repurchase up to one million shares of our common stock either through purchases on the open market or through private transactions and in accordance with Rule 10b-18 of the Exchange Act. In 2015, our Board of Directors approved and we announced an increase in the share repurchase program, providing for the repurchase of up to $40 million, or approximately two million shares, of our common stock, which was increased by our Board of Directors to 3.3 million shares in August 2017 to reflect the five-for-three stock split effected in the form of a stock dividend on July 7, 2017. The timing and extent to which we repurchase shares depends on market conditions and other corporate considerations. The repurchase program does not have an expiration date. We repurchased and retired 200,000 shares of common stock for $3.8 million in the fourth quarter of 2018. We did not repurchase any shares in 2017. We repurchased and retired 759,302 shares of our common stock for $7.5 million in the first quarter of 2016. As of December 31, 2018, future repurchases of up to $12.6 million, or 806,000 shares, were available in the share repurchase program. In 2018, net cash flows provided by operating activities of $150.6 million were primarily used to purchase new revenue equipment, net of proceeds from dispositions, in the amount of $93.9 million, to acquire and upgrade regional operating facilities in the amount of $5.9 million, to pay cash dividends of $5.5 million, and to repurchase and retire 200,000 shares of our common stock for $3.8 million, resulting in a $41.0 million increase in cash and cash equivalents. In 2017, net cash flows provided by operating activities of $121.9 million were primarily used to purchase new revenue equipment, net of proceeds from dispositions, in the amount of $87.6 million, to repay, net of borrowings, $7.9 million of long-term debt, to partially construct regional operating facilities in the amount of $5.8 million, and to pay cash dividends of $4.4 million, resulting in a $15.3 million increase in cash and cash equivalents. In 2016, net cash flows provided by operating activities of $133.8 million were primarily used to purchase new revenue equipment, net of proceeds from dispositions, in the amount of $89.9 million, to partially construct regional operating facilities in the amount of $5.1 million, to repay, net of borrowings, $30.0 million of long-term debt, to repurchase and retire 759,302 shares of our common stock for $7.5 million, and to pay cash dividends of $3.3 million. Beginning in 2018, our net cash flows are increased by the new tax laws established by the Tax Cuts and Jobs Act of 2017, which reduced the federal corporate statutory income tax rate and established bonus depreciation that allows for full expensing of qualified assets. We estimate that capital expenditures, net of proceeds from dispositions, will be approximately $125 million in 2019. Quarterly cash dividends of $0.025 per share of common stock were declared in each quarter of 2018 and totaled $5.5 million. Quarterly cash dividends of $0.015 per share of common stock were declared in each of the first two quarters of 2017 along with dividends of $0.025 per share in each of 2017’s last two quarters, which totaled $4.4 million. Quarterly cash dividends of $0.015 per share of common stock were declared in each quarter of 2016 and totaled $3.3 million. We currently expect to continue to pay quarterly cash dividends in the future. The payment of cash dividends in the future, and the amount of any such dividends, will depend upon our financial condition, results of operations, cash requirements, and certain corporate law requirements, as well as other factors deemed relevant by our Board of Directors. We believe our sources of liquidity are adequate to meet our current and anticipated needs for at least the next twelve months. Based upon anticipated cash flows, existing cash and cash equivalents balances, current borrowing availability and other sources of financing we expect to be available to us, we do not anticipate any significant liquidity constraints in the foreseeable future. In August 2018, we entered into an amendment to our unsecured committed credit facility which reduces the aggregate principal amount of the facility from $40.0 million to $30.0 million and extends the term of the facility to August 2023. At December 31, 2018, there was no outstanding principal balance on the facility. As of that date, we had outstanding standby letters of credit to guarantee settlement of self-insurance claims of $14.6 million and remaining borrowing availability of $15.4 million. This facility bears interest at a variable rate based on the London Interbank Offered Rate or the lender’s Prime Rate, in each case plus/minus applicable margins. Our credit facility prohibits us from paying, in any fiscal year, stock redemptions and dividends in excess of 25% of our net income from the prior fiscal year. A waiver of the 25% limitation for 2016 was obtained from the lender. This facility also contains restrictive covenants which, among other matters, require us to maintain compliance with cash flow leverage and fixed charge coverage ratios. We were in compliance with all covenants at December 31, 2018 and 2017. The following is a summary of our contractual obligations as of December 31, 2018. Due to uncertainty with respect to the timing of future cash flows, the obligation under our nonqualified deferred compensation plan at December 31, 2018 of 241,348 shares of Company common stock with a value of $3.9 million has been excluded from the above table. Off-balance Sheet Arrangements Other than standby letters of credit maintained in connection with our self-insurance programs in the amount of $14.6 million along with purchase obligations and operating leases summarized above in our summary of contractual obligations, we did not have any other material off-balance sheet arrangements at December 31, 2018. Inflation and Fuel Costs Most of our operating expenses are inflation-sensitive, with inflation generally producing increased costs of operations. During the past three years, the most significant effects of inflation have been on revenue equipment prices, accident claims, health insurance and employee compensation. We attempt to limit the effects of inflation through increases in freight rates and cost control efforts. In addition to inflation, fluctuations in fuel prices can affect our profitability. We require substantial amounts of fuel to operate our tractors and power the temperature-control units on our trailers. Substantially all of our contracts with customers contain fuel surcharge provisions. Although we historically have been able to pass through a significant portion of long-term increases in fuel prices and related taxes to customers in the form of fuel surcharges and higher rates, such increases usually are not fully recovered. These fuel surcharge provisions are not effective in mitigating the fuel price increases related to non-revenue miles or fuel used while the tractor is idling. Seasonality Our tractor productivity generally decreases during the winter season because inclement weather impedes operations and some shippers reduce their shipments. At the same time, operating expenses generally increase, with harsh weather creating higher accident frequency, increased claims, lower fuel efficiency and more equipment repairs. Critical Accounting Policies The preparation of financial statements in conformity with U.S. generally accepted accounting principles requires management to make estimates and assumptions about future events, and apply judgments that affect the reported amounts of assets, liabilities, revenue and expenses in our consolidated financial statements and related notes. We base our estimates, assumptions and judgments on historical experience, current trends and other factors believed to be relevant at the time our consolidated financial statements are prepared. However, because future events and their effects cannot be determined with certainty, actual results could differ from our estimates and assumptions, and such differences could be material. We believe that the following critical accounting policies affect our more significant estimates, assumptions and judgments used in the preparation of our consolidated financial statements. Revenue Recognition. We account for our revenue in accordance with FASB ASC 606, Revenue from Contracts with Customers, which we adopted on January 1, 2018 using the modified retrospective method. The new revenue standard requires us to recognize revenue and related expenses within each of our four reporting segments over time, compared with our former policy in which we recorded revenue and related expenses on the date shipment of freight was completed. We account for revenue of our Intermodal and Brokerage segments and revenue on freight transported by independent contractors within our Truckload and Dedicated segments on a gross basis because we are the principal service provider controlling the promised service before it is transferred to each customer. We are primarily responsible for fulfilling the promise to provide each specified service to each customer. We bear the primary risk of loss in the event of cargo claims by our customers. We also have complete control and discretion in establishing the price for each specified service. Accordingly, all such revenue billed to customers is classified as operating revenue and all corresponding payments to carriers for transportation services we arrange in connection with brokerage and intermodal activities and to independent contractor providers of revenue equipment are classified as purchased transportation expense within our consolidated statements of operations. Accounts Receivable. We are dependent upon a limited number of customers, and, as a result, our trade accounts receivable are highly concentrated. Trade accounts receivable are recorded at the invoiced amounts, net of an allowance for doubtful accounts. Our allowance for doubtful accounts was $348,000 as of December 31, 2018 and $300,000 as of December 31, 2017. A considerable amount of judgment is required in assessing the realization of these receivables including the current creditworthiness of each customer and related aging of the past-due balances, including any billing disputes. In order to assess the collectibility of these receivables, we perform ongoing credit evaluations of our customers’ financial condition. Through these evaluations, we may become aware of a situation where a customer may not be able to meet its financial obligations due to deterioration of its financial viability, credit ratings or bankruptcy. The allowance for doubtful accounts is based on the best information available to us and is reevaluated and adjusted as additional information is received. We evaluate the allowance based on historical write-off experience, the size of the individual customer balances, past-due amounts and the overall national economy. We review the adequacy of our allowance for doubtful accounts monthly. Property and Equipment. The transportation industry requires significant capital investments. Our net property and equipment was $588.2 million as of December 31, 2018 and $571.9 million as of December 31, 2017. Our depreciation expense was $88.6 million in 2018, $85.1 million in 2017 and $82.4 million in 2016. We compute depreciation of our property and equipment for financial reporting purposes based on the cost of each asset, reduced by its estimated salvage value, using the straight-line method over its estimated useful life. We determine and periodically evaluate our estimate of the projected salvage values and useful lives primarily by considering the market for used equipment, prior useful lives and changes in technology. We have not changed our policy regarding salvage values as a percentage of initial cost or useful lives of tractors and trailers within the last ten years. We believe that our policies and past estimates have been reasonable. Actual results could differ from these estimates. A 5% decrease in estimated salvage values would have decreased our net property and equipment as of December 31, 2018 by approximately $11.9 million, or 2.0%. Impairment of Assets. Long-lived assets are reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. Recoverability of assets to be held and used is measured by a comparison of the carrying amount of an asset to future net undiscounted cash flows expected to be generated by the asset. If such assets are considered to be impaired, the impairment to be recognized is measured by the amount by which the carrying amount of the assets exceeds the fair value of the assets. Assets to be disposed of are reported at the lower of the carrying amount or fair value less the costs to sell. Insurance and Claims. We self-insure, in part, for losses relating to workers’ compensation, auto liability, general liability, cargo and property damage claims, along with employees’ health insurance with varying risk retention levels. We maintain insurance coverage for per-incident and total losses in excess of these risk retention levels in amounts we consider adequate based upon historical experience and our ongoing review. However, we could suffer a series of losses within our self-insured retention limits or losses over our policy limits, which could negatively affect our financial condition and operating results. We are responsible for the first $1.0 million on each auto liability claim and for the first $750,000 on each workers’ compensation claim. We have $14.6 million in standby letters of credit to guarantee settlement of claims under agreements with our insurance carriers and regulatory authorities. The insurance and claims accruals in our consolidated balance sheets were $28.1 million as of December 31, 2018 and $26.2 million as of December 31, 2017. We reserve currently for the estimated cost of the uninsured portion of pending claims. We periodically evaluate and adjust these reserves based on our evaluation of the nature and severity of outstanding individual claims and our estimate of future claims development based on historical development. Actual results could differ from these current estimates. In addition, to the extent that claims are litigated and not settled, jury awards are difficult to predict. Share-based Payment Arrangement Compensation. We have granted stock options to certain employees and non-employee directors. We recognize compensation expense for all stock options net of an estimated forfeiture rate and only record compensation expense for those shares expected to vest on a straight-line basis over the requisite service period (normally the vesting period). Determining the appropriate fair value model and calculating the fair value of stock options require the input of highly subjective assumptions, including the expected life of the stock options and stock price volatility. We use the Black-Scholes model to value our stock option awards. We believe that future volatility will not materially differ from our historical volatility. Thus, we use the historical volatility of our common stock over the expected life of the award. The assumptions used in calculating the fair value of stock options represent our best estimates, but these estimates involve inherent uncertainties and the application of judgment. As a result, if factors change and we use different assumptions, stock option compensation expense could be materially different in the future. We have also granted performance unit awards to certain employees which are subject to vesting requirements over a five-year period, primarily based on our earnings growth. The fair value of each performance unit is based on the closing market price on the date of grant. We recognize compensation expense for these awards based on the estimated number of units probable of achieving the performance and service vesting requirements of the awards, net of an estimated forfeiture rate. Recent Accounting Pronouncements See Note 1 of “Notes to Consolidated Financial Statements” for a full description of recent accounting pronouncements and the respective dates of adoption and effect on our results of operations and financial position.

<s>[INST] The following discussion and analysis of our financial condition and results of operations should be read together with the selected consolidated financial data and our consolidated financial statements and the related notes appearing elsewhere in this report. This discussion and analysis contains forwardlooking statements that involve risks, uncertainties and assumptions. Our actual results may differ materially from those anticipated in these forwardlooking statements as a result of many factors, including but not limited to those under the heading “Risk Factors” beginning on page 6. We do not assume, and specifically disclaim, any obligation to update any forwardlooking statement contained in this report. Overview We have strategically transitioned from a longhaul carrier to a multifaceted business offering a network of truckbased transportation capabilities across our five distinct business platforms Truckload, Dedicated, Intermodal, Brokerage and MRTN de Mexico. The primary source of our operating revenue is provided by our Truckload segment through a combination of regional shorthaul and mediumtolonghaul fullload transportation services. We transport food and other consumer packaged goods that require a temperaturecontrolled or insulated environment, along with dry freight, across the United States and into and out of Mexico and Canada. Our Dedicated segment provides customized transportation solutions tailored to meet individual customers’ requirements, utilizing temperaturecontrolled trailers, dry vans and other specialized equipment within the United States. Our agreements with customers range from three to five years and are subject to annual rate reviews. Generally, we are paid by the mile for our Truckload and Dedicated services. We also derive Truckload and Dedicated revenue from fuel surcharges, loading and unloading activities, equipment detention and other accessorial services. The main factors that affect our Truckload and Dedicated revenue are the rate per mile we receive from our customers, the percentage of miles for which we are compensated, the number of miles we generate with our equipment and changes in fuel prices. We monitor our revenue production primarily through average Truckload and Dedicated revenue, net of fuel surcharges, per tractor per week. We also analyze our average Truckload and Dedicated revenue, net of fuel surcharges, per total mile, nonrevenue miles percentage, the miles per tractor we generate, our fuel surcharge revenue, our accessorial revenue and our other sources of operating revenue. Our Intermodal segment transports our customers’ freight within the United States utilizing our temperaturecontrolled trailers on railroad flatcars for portions of trips, with the balance of the trips using our tractors or, to a lesser extent, contracted carriers. The main factors that affect our Intermodal revenue are the rate per mile and other charges we receive from our customers. Our Brokerage segment develops contractual relationships with and arranges for thirdparty carriers to transport freight for our customers in temperaturecontrolled trailers and dry vans within the United States and into and out of Mexico through Marten Transport Logistics, LLC, which was established in 2007 and operates pursuant to brokerage authority granted by the DOT. We retain the billing, collection and customer management responsibilities. The main factors that affect our Brokerage revenue are the rate per mile and other charges that we receive from our customers. Operating results of our MRTN de Mexico business which offers our customers doortodoor service between the United States and Mexico with our Mexican partner carriers is reported within our Truckload and Brokerage segments. In addition to the factors discussed above, our operating revenue is also affected by, among other things, the United States economy, inventory levels, the level of truck and rail capacity in the transportation market, a contracting driver market, severe weather conditions and specific customer demand. Our operating revenue increased $89.5 million, or 12.8%, from 2017 to 2018. Our operating revenue, net of fuel surcharges, increased $50.4 million, or 8.0%, compared with 2017. Truckload segment revenue, net of fuel surcharges, decreased 4.2% from 2017, primarily due to a reduction in our average number of tractors, partially offset by an increase in our average revenue per tractor. Dedicated segment revenue, net of fuel surcharges, increased 21.8% from 2017, primarily due to fleet growth driven by an increase in the number [/INST] Negative. </s>

MARTEN TRANSPORT LTD

2020-02-28

2019-12-31

ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The following discussion and analysis of our financial condition and results of operations should be read together with the selected consolidated financial data and our consolidated financial statements and the related notes appearing elsewhere in this report. This discussion and analysis contains forward-looking statements that involve risks, uncertainties and assumptions. Our actual results may differ materially from those anticipated in these forward-looking statements as a result of many factors, including but not limited to those under the heading “Risk Factors” beginning on page 5. We do not assume, and specifically disclaim, any obligation to update any forward-looking statement contained in this report. Overview We have strategically transitioned from a refrigerated long-haul carrier to a multifaceted business offering a network of refrigerated and dry truck-based transportation capabilities across our five distinct business platforms - Truckload, Dedicated, Intermodal, Brokerage and MRTN de Mexico. The primary source of our operating revenue is provided by our Truckload segment through a combination of regional short-haul and medium-to-long-haul full-load transportation services. We transport food and other consumer packaged goods that require a temperature-controlled or insulated environment, along with dry freight, across the United States and into and out of Mexico and Canada. Our agreements with customers are typically for one year. Our Dedicated segment provides customized transportation solutions tailored to meet individual customers’ requirements, utilizing temperature-controlled trailers, dry vans and other specialized equipment within the United States. Our agreements with customers range from three to five years and are subject to annual rate reviews. Generally, we are paid by the mile for our Truckload and Dedicated services. We also derive Truckload and Dedicated revenue from fuel surcharges, loading and unloading activities, equipment detention and other accessorial services. The main factors that affect our Truckload and Dedicated revenue are the rate per mile we receive from our customers, the percentage of miles for which we are compensated, the number of miles we generate with our equipment and changes in fuel prices. We monitor our revenue production primarily through average Truckload and Dedicated revenue, net of fuel surcharges, per tractor per week. We also analyze our average Truckload and Dedicated revenue, net of fuel surcharges, per total mile, non-revenue miles percentage, the miles per tractor we generate, our fuel surcharge revenue, our accessorial revenue and our other sources of operating revenue. Our Intermodal segment transports our customers’ freight within the United States utilizing our temperature-controlled trailers and, beginning in September 2019, our refrigerated containers, each on railroad flatcars for portions of trips, with the balance of the trips using our tractors or, to a lesser extent, contracted carriers. The main factors that affect our Intermodal revenue are the rate per mile and other charges we receive from our customers. Our Brokerage segment develops contractual relationships with and arranges for third-party carriers to transport freight for our customers in temperature-controlled trailers and dry vans within the United States and into and out of Mexico through Marten Transport Logistics, LLC, which was established in 2007 and operates pursuant to brokerage authority granted by the DOT. We retain the billing, collection and customer management responsibilities. The main factors that affect our Brokerage revenue are the rate per mile and other charges that we receive from our customers. Operating results of our MRTN de Mexico business which offers our customers door-to-door service between the United States and Mexico with our Mexican partner carriers is reported within our Truckload and Brokerage segments. In addition to the factors discussed above, our operating revenue is also affected by, among other things, the United States economy, inventory levels, the level of truck and rail capacity in the transportation market, a contracting driver market, severe weather conditions and specific customer demand. Our operating revenue increased $55.7 million, or 7.1%, in 2019 from 2018. Our operating revenue, net of fuel surcharges, increased $58.5 million, or 8.6%, compared with 2018. Truckload segment revenue, net of fuel surcharges, increased 2.2% from 2018 primarily due to an increase in our average number of tractors. Dedicated segment revenue, net of fuel surcharges, increased 19.7% from 2018, primarily due to fleet growth driven by an increase in the number of Dedicated contracts we have with our customers and an increase in our average revenue per tractor. Intermodal segment revenue, net of fuel surcharges, decreased 9.1% due to a reduced load volume. Brokerage segment revenue increased 26.1% due to an increase in load volume in 2019. Fuel surcharge revenue decreased to $103.4 million in 2019 from $106.2 million in 2018. A shift of a portion of line haul revenue to fuel surcharge revenue, which began in mid-first quarter of 2018 as a result of changes in a number of customer agreements, reduced our revenue excluding fuel surcharges by $17.5 million in 2019 and by $12.9 million in 2018, while increasing our fuel surcharge revenue by the same amounts. Our profitability is impacted by the variable costs of transporting freight for our customers, fixed costs, and expenses containing both fixed and variable components. The variable costs include fuel expense, driver-related expenses, such as wages, benefits, training, and recruitment, and independent contractor costs, which are recorded under purchased transportation. Expenses that have both fixed and variable components include maintenance and tire expense and our cost of insurance and claims. These expenses generally vary with the miles we travel, but also have a controllable component based on safety, fleet age, efficiency and other factors. Our main fixed costs relate to the acquisition and subsequent depreciation of long-term assets, such as revenue equipment and operating terminals. We expect our annual cost of tractor and trailer ownership will increase in future periods as a result of higher prices of new equipment, along with any increases in fleet size. Although certain factors affecting our expenses are beyond our control, we monitor them closely and attempt to anticipate changes in these factors in managing our business. For example, fuel prices have significantly fluctuated over the past several years. We manage our exposure to changes in fuel prices primarily through fuel surcharge programs with our customers, as well as through volume fuel purchasing arrangements with national fuel centers and bulk purchases of fuel at our terminals. To help further reduce fuel expense, we have installed and tightly manage the use of auxiliary power units in our tractors to provide climate control and electrical power for our drivers without idling the tractor engine, and also have improved the fuel usage in the temperature-control units on our trailers. For our Intermodal and Brokerage segments, our profitability is impacted by the percentage of revenue which is payable to the providers of the transportation services we arrange. This expense is included within purchased transportation in our consolidated statements of operations. Our operating income improved 8.7% to $76.5 million in 2019 from $70.3 million in 2018. Our operating expenses as a percentage of operating revenue, or “operating ratio,” improved to 90.9% in 2019 from 91.1% in 2018. Operating expenses as a percentage of operating revenue, with both amounts net of fuel surcharges, were 89.7% in both 2019 and 2018. Our net income improved 11.0% to $61.1 million, or $1.11 per diluted share, in 2019 from $55.0 million, or $1.00 per diluted share, in 2018. Our business requires substantial, ongoing capital investments, particularly for new tractors and trailers. At December 31, 2019, we had $31.5 million of cash and cash equivalents, $597.6 million in stockholders’ equity and no long-term debt outstanding. In 2019, net cash flows provided by operating activities of $153.2 million were primarily used to purchase new revenue equipment, net of proceeds from dispositions, in the amount of $133.7 million, to pay cash dividends of $42.1 million, and to upgrade regional operating facilities in the amount of $2.9 million, resulting in a $25.3 million decrease in cash and cash equivalents. We estimate that capital expenditures, net of proceeds from dispositions, will be approximately $153 million in 2020. We paid cash dividends totaling $42.1 million in 2019 which consisted of a special dividend of $0.65 per share of common stock in September, along with quarterly cash dividends of $0.03 per share of common stock in each quarter of 2019. We believe our sources of liquidity are adequate to meet our current and anticipated needs for at least the next twelve months. Based upon anticipated cash flows, existing cash and cash equivalents balances, current borrowing availability and other sources of financing we expect to be available to us, we do not anticipate any significant liquidity constraints in the foreseeable future. We continue to invest considerable time and capital resources to actively implement and promote long-term environmentally sustainable solutions that drive reductions in our fuel and electricity consumption and decrease our carbon footprint. These initiatives include (i) reducing idle time for our tractors by installing and tightly managing the use of auxiliary power units, which are powered by solar panels and provide climate control and electrical power for our drivers without idling the tractor engine, (ii) improving the energy efficiency of our newer, more aerodynamic and well-maintained tractor and trailer fleets by optimizing the equipment’s specifications, weight and tractor speed, equipping our tractors with automatic transmissions, converting the refrigeration units in our refrigerated trailers to the new, more-efficient CARB refrigeration units along with increasing the insulation in the trailer walls and installing trailer skirts, and using ultra-fuel efficient and wide-based tires, and (iii) upgrading all of our facilities to indoor and outdoor LED lighting along with converting all of our facilities to solar power by 2020. Additionally, we are an active participant in the United States EPA SmartWay Transport Partnership, in which freight shippers, carriers, logistics companies and other voluntary stakeholders partner with the EPA to measure, benchmark and improve logistics operations to reduce their environmental footprint. This Management’s Discussion and Analysis of Financial Condition and Results of Operations includes discussions of operating revenue, net of fuel surcharge revenue; Truckload, Dedicated and Intermodal revenue, net of fuel surcharge revenue; operating expenses as a percentage of operating revenue, each net of fuel surcharge revenue; and net fuel expense (fuel and fuel taxes net of fuel surcharge revenue and surcharges passed through to independent contractors, outside drayage carriers and railroads). We provide these additional disclosures because management believes these measures provide a more consistent basis for comparing results of operations from period to period. These financial measures in this report have not been determined in accordance with U.S. generally accepted accounting principles (GAAP). Pursuant to Item 10(e) of Regulation S-K, we have included the amounts necessary to reconcile these non-GAAP financial measures to the most directly comparable GAAP financial measures of operating revenue, operating expenses divided by operating revenue, and fuel and fuel taxes. Stock Split On July 7, 2017, we effected a five-for-three stock split of our common stock, $.01 par value, in the form of a 66 ⅔% stock dividend. Our consolidated financial statements, related notes, and other financial data contained in this report have been adjusted to give retroactive effect to the stock split for all periods presented. Results of Operations The following table sets forth for the years indicated certain operating statistics regarding our revenue and operations: (1) Includes tractors driven by both company-employed drivers and independent contractors. Independent contractors provided 92, 46 and 60 tractors as of December 31, 2019, 2018 and 2017, respectively. Comparison of Year Ended December 31, 2019 to Year Ended December 31, 2018 The following table sets forth for the years indicated our operating revenue, operating income and operating ratio by segment, along with the change for each component: (1) Represents operating expenses as a percentage of operating revenue. Our operating revenue increased $55.7 million, or 7.1%, to $843.3 million in 2019 from $787.6 million in 2018. Our operating revenue, net of fuel surcharges, increased $58.5 million, or 8.6%, to $739.9 million in 2019 from $681.4 million in 2018. This increase was due to a $36.8 million increase in Dedicated revenue, net of fuel surcharges, a $22.5 million increase in Brokerage revenue, and a $7.0 million increase in Truckload revenue, net of fuel surcharges, partially offset by a $7.8 million decrease in Intermodal revenue, net of fuel surcharges. Fuel surcharge revenue decreased to $103.4 million in 2019 from $106.2 million in 2018. A shift of a portion of line haul revenue to fuel surcharge revenue, which began in mid-first quarter of 2018 as a result of changes in a number of customer agreements, reduced our revenue excluding fuel surcharges by $17.5 million in 2019 and by $12.9 million in 2018, while increasing our fuel surcharge revenue by the same amounts. Truckload segment revenue increased $2.7 million, or 0.7%, to $378.0 million in 2019 from $375.3 million in 2018. Truckload segment revenue, net of fuel surcharges, increased $7.0 million, or 2.2%, to $329.3 million in 2019 from $322.3 million in 2018 primarily due to an increase in our average number of tractors. The shift from line haul revenue to fuel surcharge revenue as a result of changes in a number of customer agreements decreased our Truckload revenue excluding fuel surcharges by $3.4 million in 2019 and by $2.8 million in 2018, while increasing our fuel surcharge revenue by the same amounts. The increase in the operating ratio in 2019 was primarily due to an increase in salaries and wages as a percentage of revenue. Dedicated segment revenue increased $42.1 million, or 18.8%, to $266.0 million in 2019 from $223.9 million in 2018. Dedicated segment revenue, net of fuel surcharges, increased 19.7% primarily due to fleet growth driven by an increase in the number of Dedicated contracts we have with our customers and an increase in our average revenue per tractor. The shift from line haul revenue to fuel surcharge revenue as a result of changes in a number of customer agreements decreased our Dedicated revenue excluding fuel surcharges by $14.1 million in 2019 and by $10.1 million in 2018, while increasing our fuel surcharge revenue by the same amounts. The improvement in the operating ratio for our Dedicated segment was primarily due to an increase in our average revenue per tractor, startup costs associated with new business that began in 2018 and multiple cost control measures. Intermodal segment revenue decreased $11.6 million, or 11.4%, to $90.4 million in 2019 from $102.0 million in 2018. Intermodal segment revenue, net of fuel surcharges, decreased 9.1% from 2018 due to a decrease in load volume. The increase in the operating ratio in 2019 was primarily due to increases in salaries and wages, fuel expense and amounts payable to railroads as a percentage of revenue. Brokerage segment revenue increased $22.5 million, or 26.1%, to $108.9 million in 2019 from $86.4 million in 2018 due to an increase in load volume. The improvement in the operating ratio in 2019 was due to multiple cost control measures. The following table sets forth for the years indicated the dollar and percentage increase or decrease of the items in our consolidated statements of operations, and those items as a percentage of operating revenue: Salaries, wages and benefits consist of compensation for our employees, including both driver and non-driver employees, employees’ health insurance, 401(k) plan contributions and other fringe benefits. These expenses vary depending upon the size of our Truckload, Dedicated and Intermodal tractor fleets, the ratio of company drivers to independent contractors, our efficiency, our experience with employees’ health insurance claims, changes in health care premiums and other factors. Salaries, wages and benefits expense increased $22.1 million, or 8.8%, in 2019 from 2018. This increase resulted primarily from additional company driver compensation expense of $20.5 million, partially offset by a $4.7 million decrease in bonus compensation expense for our non-driver employees. Purchased transportation consists of amounts payable to railroads and carriers for transportation services we arrange in connection with Brokerage and Intermodal operations and to independent contractor providers of revenue equipment. This category will vary depending upon the amount and rates, including fuel surcharges, we pay to third-party railroad and motor carriers, the ratio of company drivers versus independent contractors and the amount of fuel surcharges passed through to independent contractors. Purchased transportation expense increased $14.3 million in total, or 9.9%, in 2019 from 2018. Amounts payable to carriers for transportation services we arranged in our Brokerage segment increased $18.3 million to $90.7 million in 2019 from $72.3 million in 2018, primarily due to an increase in brokerage revenue. Amounts payable to railroads and drayage carriers for transportation services within our Intermodal segment decreased $5.8 million to $59.3 million in 2019 from $65.0 million in 2018. This decrease was due to decreased intermodal revenue. The portion of purchased transportation expense related to independent contractors within our Truckload and Dedicated segments, including fuel surcharges, increased $1.8 million in 2019. We expect our purchased transportation expense to increase as we grow our Intermodal and Brokerage segments. Fuel and fuel taxes decreased by $292,000, or 0.2%, in 2019 from 2018. Net fuel expense (fuel and fuel taxes net of fuel surcharge revenue and surcharges passed through to independent contractors, outside drayage carriers and railroads) increased $644,000, or 2.2%, to $30.1 million in 2019 from $29.4 million in 2018. Fuel surcharges passed through to independent contractors, outside drayage carriers and railroads decreased to $12.1 million from $14.0 million in 2018. The United States Department of Energy, or DOE, national average cost of fuel decreased to $3.06 per gallon from $3.18 per gallon in 2018. Net fuel expense also decreased to 4.8% of Truckload, Dedicated and Intermodal segment revenue, net of fuel surcharges, from 4.9% in 2018. We have worked diligently to control fuel usage and costs by improving our volume purchasing arrangements and optimizing our drivers’ fuel purchases with national fuel centers, focusing on shorter lengths of haul, installing and tightly managing the use of auxiliary power units in our tractors to minimize engine idling and improving fuel usage in the temperature-control units on our trailers. Auxiliary power units, which we have installed in our company-owned tractors, provide climate control and electrical power for our drivers without idling the tractor engine. Supplies and maintenance consist of repairs, maintenance, tires, parts, oil and engine fluids, along with load-specific expenses including loading/unloading, tolls, pallets and trailer hostling. Our supplies and maintenance expense increased $5.9 million, or 14.4%, from 2018 primarily due to higher outside repair and parts costs associated, in part, with operating a larger fleet. Depreciation relates to owned tractors, trailers, containers, auxiliary power units, communication units, terminal facilities and other assets. The $6.6 million increase in depreciation was primarily due to an increase in the size of our fleet of tractors and trailers. We expect our annual cost of tractor and trailer ownership will increase in future periods as a result of higher prices of new equipment, which will result in greater depreciation over the useful life. Insurance and claims consist of the costs of insurance premiums and accruals we make for claims within our self-insured retention amounts, primarily for personal injury, property damage, physical damage to our equipment, cargo claims and workers’ compensation claims. These expenses will vary primarily based upon the frequency and severity of our accident experience, our self-insured retention levels and the market for insurance. The $456,000 decrease in insurance and claims in 2019 was primarily due to a decrease in the cost of our self-insured workers’ compensation claims, partially offset by increases in the cost of auto liability and physical damage claims related to our tractors and trailers. Our significant self-insured retention exposes us to the possibility of significant fluctuations in claims expense between periods which could materially impact our financial results depending on the frequency, severity and timing of claims. Gain on disposition of revenue equipment increased to $8.7 million in 2019 from $7.2 million in 2018 primarily due to an increase in our average gain for each tractor and trailer sold. Future gains or losses on dispositions of revenue equipment will be impacted by the market for used revenue equipment, which is beyond our control. As a result of the foregoing factors, our operating income improved 8.7% to $76.5 million in 2019 from $70.3 million in 2018. Our operating expenses as a percentage of operating revenue, or “operating ratio,” was 90.9% in 2019 and 91.1% in 2018. The operating ratio for our Truckload segment was 92.2% in 2019 and 90.7% in 2018, for our Dedicated segment was 88.3% in 2019 and 91.7% in 2018, for our Intermodal segment was 92.7% in 2019 and 89.1% in 2018, and for our Brokerage segment was 91.8% in 2019 and 93.6% in 2018. Operating expenses as a percentage of operating revenue, with both amounts net of fuel surcharges, were 89.7% in both 2019 and 2018. The increase in our other non-operating income was primarily due to additional interest income earned in 2019. Our effective income tax rate decreased to 21.4% in 2019 from 22.5% in 2018 primarily due to a reduction in non-deductible expenses. As a result of the factors described above, net income improved 11.0% to $61.1 million, or $1.11 per diluted share, in 2019 from $55.0 million, or $1.00 per diluted share, in 2018. Comparison of Year Ended December 31, 2018 to Year Ended December 31, 2017 The following table sets forth for the years indicated our operating revenue, operating income and operating ratio by segment, along with the change for each component: (1) Represents operating expenses as a percentage of operating revenue. Our operating revenue increased $89.5 million, or 12.8%, to $787.6 million in 2018 from $698.1 million in 2017. Our operating revenue, net of fuel surcharges, increased $50.4 million, or 8.0%, to $681.4 million in 2018 from $631.0 million in 2017. This increase was due to a $33.4 million increase in Dedicated revenue, net of fuel surcharges, a $16.0 million increase in Brokerage revenue, and a $15.3 million increase in Intermodal revenue, net of fuel surcharges, partially offset by a $14.3 million decrease in Truckload revenue, net of fuel surcharges. Fuel surcharge revenue increased to $106.2 million in 2018 from $67.1 million in 2017 primarily due to higher fuel prices and a shift of a portion of line haul revenue to fuel surcharge revenue which began in the first quarter of 2018 as a result of changes in a number of customer agreements. The change reduced our revenue excluding fuel surcharges by $12.9 million in 2018 and increased our fuel surcharge revenue by the same amount. Truckload segment revenue decreased $4.9 million, or 1.3%, to $375.3 million in 2018 from $380.2 million in 2017. Truckload segment revenue, net of fuel surcharges, decreased $14.3 million, or 4.2%, to $322.3 million in 2018 from $336.6 million in 2017, primarily due to a reduction in our average number of tractors, partially offset by an increase in our average revenue per tractor. The shift from line haul revenue to fuel surcharge revenue as a result of changes in a number of customer agreements decreased our Truckload revenue excluding fuel surcharges by $2.8 million, or $32 per tractor per week, in 2018, and increased our fuel surcharge revenue by the same amount. The improvement in the operating ratio in 2018 was primarily due to the increase in our average revenue per tractor driven by increased rates with our customers. Dedicated segment revenue increased $57.0 million, or 34.1%, to $223.9 million in 2018 from $166.9 million in 2017. Dedicated segment revenue, net of fuel surcharges, increased 21.8% primarily due to fleet growth driven by an increase in the number of Dedicated contracts we have with our customers. The shift from line haul revenue to fuel surcharge revenue as a result of changes in a number of customer agreements decreased our Dedicated revenue excluding fuel surcharges by $10.1 million, or $179 per tractor per week, in 2018, and increased our fuel surcharge revenue by the same amount. The increase in the operating ratio for our Dedicated segment was primarily due to an increase in driver wages, an increase in bonus compensation expense for our non-driver employees and increased depreciation expense. Intermodal segment revenue increased $21.4 million, or 26.5%, to $102.0 million in 2018 from $80.6 million in 2017. Intermodal segment revenue, net of fuel surcharges, increased 21.8% from 2017 due to increases in revenue per load and in volume. The improvement in the operating ratio in 2018 was primarily due to a decrease in the amounts payable to railroads as a percentage of our revenue and increased rates with our customers. Brokerage segment revenue increased $16.0 million, or 22.7%, to $86.4 million in 2018 from $70.4 million in 2017 due to an increase in volume and rates with our customers. The increase in the operating ratio in 2018 was primarily due to an increase in the amounts payable to carriers for transportation services which we arranged as a percentage of our Brokerage revenue. The following table sets forth for the years indicated the dollar and percentage increase or decrease of the items in our consolidated statements of operations, and those items as a percentage of operating revenue: Salaries, wages and benefits expense increased $26.0 million, or 11.5%, in 2018 from 2017. The increase in salaries, wages and benefits from 2017 resulted primarily from an increase in company driver compensation expense of $11.1 million, an increase in bonus compensation expense for our non-driver employees of $5.4 million, and an increase in employees’ health insurance expense of $3.3 million due to an increase in our self-insured medical claims. Purchased transportation expense increased $26.3 million in total, or 22.2%, in 2018 from 2017. Amounts payable to carriers for transportation services we arranged in our Brokerage segment increased $13.7 million to $72.3 million in 2018 from $58.6 million in 2017, primarily due to an increase in brokerage revenue. Amounts payable to railroads and drayage carriers for transportation services within our Intermodal segment increased $13.6 million to $65.0 million in 2018 from $51.5 million in 2017. This increase was due to increased intermodal revenue along with increased fuel surcharges to the railroads due to higher fuel prices. The portion of purchased transportation expense related to our independent contractors within our Truckload and Dedicated segments, including fuel surcharges, decreased $1.1 million in 2018. Fuel and fuel taxes increased by $16.2 million, or 15.4%, in 2018 from 2017. Net fuel expense (fuel and fuel taxes net of fuel surcharge revenue and surcharges passed through to independent contractors, outside drayage carriers and railroads) decreased $17.4 million, or 37.2%, to $29.4 million in 2018 from $46.8 million in 2017. Fuel surcharges passed through to independent contractors, outside drayage carriers and railroads increased to $14.0 million from $8.6 million in 2017. Despite an increase in the DOE national average cost of fuel to $3.18 per gallon from $2.65 per gallon in 2017, net fuel expense decreased to 4.9% of Truckload, Dedicated and Intermodal segment revenue, net of fuel surcharges, from 8.4% in 2017. The net fuel expense to revenue improved primarily due to a $12.9 million shift during 2018 of a portion of line haul revenue to fuel surcharge revenue as a result of changes in a number of customer agreements. Increases in our miles per gallon and in our revenue rate per mile in 2018 further improved this ratio. We have worked diligently to control fuel usage and costs by improving our volume purchasing arrangements and optimizing our drivers’ fuel purchases with national fuel centers, focusing on shorter lengths of haul, installing and tightly managing the use of auxiliary power units in our tractors to minimize engine idling and improving fuel usage in the temperature-control units on our trailers. Our supplies and maintenance expense decreased $760,000, or 1.8%, from 2017 primarily due to a decrease in our loading/unloading expense. The increase in depreciation was primarily due to a continued increase in the cost of revenue equipment. Gain on disposition of revenue equipment increased to $7.2 million in 2018 from $5.5 million in 2017 primarily due to an increase in the number of trailers sold, along with an increase in our average gain for each tractor and trailer sold. The $5.4 million increase in other operating expenses in 2018 was due in part to proceeds received in 2017 from the settlement of a lawsuit, net of 2017 legal expenses, of $1.0 million, and increased costs associated with recruiting and retaining drivers. As a result of the foregoing factors, our operating income improved 23.7% to $70.3 million in 2018 from $56.9 million in 2017. Our operating expenses as a percentage of operating revenue, or “operating ratio,” improved to 91.1% in 2018 from 91.9% in 2017. The operating ratio for our Truckload segment was 90.7% in 2018 and 93.1% in 2017, for our Dedicated segment was 91.7% in 2018 and 89.8% in 2017, for our Intermodal segment was 89.1% in 2018 and 89.7% in 2017, and for our Brokerage segment was 93.6% in 2018 and 92.7% in 2017. Operating expenses as a percentage of operating revenue, with both amounts net of fuel surcharges, improved to 89.7% in 2018 from 91.0% in 2017. The increase in our non-operating income was primarily due to improved operating results in 2018 by MW Logistics, LLC, or MWL, a 45% owned affiliate. We sold our entire membership interest in MWL effective October 31, 2019. Our effective income tax rate increased to 22.5% in 2018 from (59.9)% in 2017. We recorded a $56.5 million deferred income taxes benefit in 2017 to recognize the impact on our federal net deferred tax liability of the reduction of the federal corporate statutory income tax rate from 35% to 21% related to the Tax Cuts and Jobs Act of 2017, which was enacted prior to December 31, 2017. Excluding that benefit, our effective tax rate was 40.1% in 2017, which exceeds our effective tax rate in 2018 primarily due to the reduction of the federal corporate tax rate in 2018 under the Tax Cuts and Jobs Act of 2017. The Tax Cuts and Jobs Act of 2017 makes broad and complex changes to the U.S. tax code including, but not limited to, reducing the federal corporate income tax rate as noted above and allowing bonus depreciation with full expensing of qualified property placed in service after September 27, 2017. As a result of the factors described above, net income was $55.0 million, or $1.00 per diluted share, in 2018 and $90.3 million, or $1.65 per diluted share, in 2017. Excluding the $56.5 million deferred income taxes benefit recorded in 2017, net income in 2018 improved 62.7% from 2017 earnings of $33.8 million, or $0.62 per diluted share. Liquidity and Capital Resources Our business requires substantial, ongoing capital investments, particularly for new tractors and trailers. Our primary sources of liquidity are funds provided by operations and our revolving credit facility. A portion of our tractor fleet is provided by independent contractors who own and operate their own equipment. We have no capital expenditure requirements relating to those drivers who own their tractors or obtain financing through third parties. The table below reflects our net cash flows provided by operating activities, net cash flows used for investing activities and net cash flows used for financing activities for the years indicated. In 2007, our Board of Directors approved, and we announced a share repurchase program to repurchase up to one million shares of our common stock either through purchases on the open market or through private transactions and in accordance with Rule 10b-18 of the Exchange Act. In 2015, our Board of Directors approved and we announced an increase in the share repurchase program, providing for the repurchase of up to $40 million, or approximately two million shares, of our common stock, which was increased by our Board of Directors to 3.3 million shares in August 2017 to reflect the five-for-three stock split effected in the form of a stock dividend on July 7, 2017. In August 2019, our Board of Directors approved and we announced an increase in our existing share repurchase program providing for the repurchase of up to $34 million, or approximately 1.8 million shares, of our common stock. The timing and extent to which we repurchase shares depends on market conditions and other corporate considerations. The repurchase program does not have an expiration date. We repurchased and retired 200,000 shares of common stock for $3.8 million in the fourth quarter of 2018. We did not repurchase any shares in 2019 or 2017. As of December 31, 2019, future repurchases of up to $34 million, or 1.8 million shares, were available in the share repurchase program. In 2019, net cash flows provided by operating activities of $153.2 million were primarily used to purchase new revenue equipment, net of proceeds from dispositions, in the amount of $133.7 million, to pay cash dividends of $42.1 million, and to upgrade regional operating facilities in the amount of $2.9 million, resulting in a $25.3 million decrease in cash and cash equivalents. In 2018, net cash flows provided by operating activities of $150.6 million were primarily used to purchase new revenue equipment, net of proceeds from dispositions, in the amount of $93.9 million, to acquire and upgrade regional operating facilities in the amount of $5.9 million, to pay cash dividends of $5.5 million, and to repurchase and retire 200,000 shares of our common stock for $3.8 million, resulting in a $41.0 million increase in cash and cash equivalents. In 2017, net cash flows provided by operating activities of $121.9 million were primarily used to purchase new revenue equipment, net of proceeds from dispositions, in the amount of $87.6 million, to repay, net of borrowings, $7.9 million of long-term debt, to partially construct regional operating facilities in the amount of $5.8 million, and to pay cash dividends of $4.4 million, resulting in a $15.3 million increase in cash and cash equivalents. Beginning in 2018, our net cash flows have been increased by the new tax laws established by the Tax Cuts and Jobs Act of 2017, which reduces the federal corporate statutory income tax rate and establishes bonus depreciation that allows for full expensing of qualified assets. We estimate that capital expenditures, net of proceeds from dispositions, will be approximately $153 million in 2020. We paid cash dividends totaling $42.1 million in 2019 which consisted of a special dividend of $0.65 per share of common stock in September, along with quarterly cash dividends of $0.03 per share of common stock in each quarter of 2019. Quarterly cash dividends of $0.025 per share of common stock was declared in each quarter of 2018 and totaled $5.5 million. Quarterly cash dividends of $0.015 per share of common stock were declared in each of the first two quarters of 2017 along with dividends of $0.025 per share in each of 2017’s last two quarters, which totaled $4.4 million. We currently expect to continue to pay quarterly cash dividends in the future. The payment of cash dividends in the future, and the amount of any such dividends, will depend upon our financial condition, results of operations, cash requirements, and certain corporate law requirements, as well as other factors deemed relevant by our Board of Directors. We believe our sources of liquidity are adequate to meet our current and anticipated needs for at least the next twelve months. Based upon anticipated cash flows, existing cash and cash equivalents balances, current borrowing availability and other sources of financing we expect to be available to us, we do not anticipate any significant liquidity constraints in the foreseeable future. In August 2018, we entered into an amendment to our unsecured committed credit facility which reduces the aggregate principal amount of the facility from $40.0 million to $30.0 million and extends the term of the facility to August 2023. At December 31, 2019, there was no outstanding principal balance on the facility. As of that date, we had outstanding standby letters of credit to guarantee settlement of self-insurance claims of $15.7 million and remaining borrowing availability of $14.3 million. This facility bears interest at a variable rate based on the London Interbank Offered Rate or the lender’s Prime Rate, in each case plus/minus applicable margins. Our credit facility prohibits us from paying, in any fiscal year, stock redemptions and dividends in excess of 25% of our net income from the prior fiscal year. A waiver allowing stock redemptions and dividends in excess of the 25% limitation in a total amount of up to $65 million in 2019 was obtained from the lender in August 2019. This facility also contains restrictive covenants which, among other matters, require us to maintain compliance with cash flow leverage and fixed charge coverage ratios. We were in compliance with all covenants at December 31, 2019 and 2018. The following is a summary of our contractual obligations as of December 31, 2019. Due to uncertainty with respect to the timing of future cash flows, the obligation under our nonqualified deferred compensation plan at December 31, 2019 of 275,957 shares of Company common stock with a value of $5.9 million has been excluded from the above table. Off-balance Sheet Arrangements Other than standby letters of credit maintained in connection with our self-insurance programs in the amount of $15.7 million along with purchase obligations and operating leases summarized above in our summary of contractual obligations, we did not have any other material off-balance sheet arrangements at December 31, 2019. Inflation and Fuel Costs Most of our operating expenses are inflation-sensitive, with inflation generally producing increased costs of operations. During the past three years, the most significant effects of inflation have been on revenue equipment prices, accident claims, health insurance and employee compensation. We attempt to limit the effects of inflation through increases in freight rates and cost control efforts. In addition to inflation, fluctuations in fuel prices can affect our profitability. We require substantial amounts of fuel to operate our tractors and power the temperature-control units on our trailers. Substantially all of our contracts with customers contain fuel surcharge provisions. Although we historically have been able to pass through a significant portion of long-term increases in fuel prices and related taxes to customers in the form of fuel surcharges and higher rates, such increases usually are not fully recovered. These fuel surcharge provisions are not effective in mitigating the fuel price increases related to non-revenue miles or fuel used while the tractor is idling. Seasonality Our tractor productivity generally decreases during the winter season because inclement weather impedes operations and some shippers reduce their shipments. At the same time, operating expenses generally increase, with harsh weather creating higher accident frequency, increased claims, lower fuel efficiency and more equipment repairs. Critical Accounting Policies The preparation of financial statements in conformity with U.S. generally accepted accounting principles requires management to make estimates and assumptions about future events and apply judgments that affect the reported amounts of assets, liabilities, revenue and expenses in our consolidated financial statements and related notes. We base our estimates, assumptions and judgments on historical experience, current trends and other factors believed to be relevant at the time our consolidated financial statements are prepared. However, because future events and their effects cannot be determined with certainty, actual results could differ from our estimates and assumptions, and such differences could be material. We believe that the following critical accounting policies affect our more significant estimates, assumptions and judgments used in the preparation of our consolidated financial statements. Revenue Recognition. We account for our revenue in accordance with FASB ASC 606, Revenue from Contracts with Customers, which we adopted on January 1, 2018 using the modified retrospective method. The current revenue standard requires us to recognize revenue and related expenses within each of our four reporting segments over time, compared with our former policy in which we recorded revenue and related expenses on the date shipment of freight was completed. We account for revenue of our Intermodal and Brokerage segments and revenue on freight transported by independent contractors within our Truckload and Dedicated segments on a gross basis because we are the principal service provider controlling the promised service before it is transferred to each customer. We are primarily responsible for fulfilling the promise to provide each specified service to each customer. We bear the primary risk of loss in the event of cargo claims by our customers. We also have complete control and discretion in establishing the price for each specified service. Accordingly, all such revenue billed to customers is classified as operating revenue and all corresponding payments to carriers for transportation services we arrange in connection with brokerage and intermodal activities and to independent contractor providers of revenue equipment are classified as purchased transportation expense within our consolidated statements of operations. Accounts Receivable. We are dependent upon a limited number of customers, and, as a result, our trade accounts receivable are highly concentrated. Trade accounts receivable are recorded at the invoiced amounts, net of an allowance for doubtful accounts. Our allowance for doubtful accounts was $382,000 as of December 31, 2019 and $348,000 as of December 31, 2018. A considerable amount of judgment is required in assessing the realization of these receivables including the current creditworthiness of each customer and related aging of the past-due balances, including any billing disputes. In order to assess the collectibility of these receivables, we perform ongoing credit evaluations of our customers’ financial condition. Through these evaluations, we may become aware of a situation where a customer may not be able to meet its financial obligations due to deterioration of its financial viability, credit ratings or bankruptcy. The allowance for doubtful accounts is based on the best information available to us and is reevaluated and adjusted as additional information is received. We evaluate the allowance based on historical write-off experience, the size of the individual customer balances, past-due amounts and the overall national economy. We review the adequacy of our allowance for doubtful accounts monthly. Property and Equipment. The transportation industry requires significant capital investments. Our net property and equipment was $640.4 million as of December 31, 2019 and $588.2 million as of December 31, 2018. Our depreciation expense was $95.1 million in 2019, $88.6 million in 2018 and $85.1 million in 2017. We compute depreciation of our property and equipment for financial reporting purposes based on the cost of each asset, reduced by its estimated salvage value, using the straight-line method over its estimated useful life. We determine and periodically evaluate our estimate of the projected salvage values and useful lives primarily by considering the market for used equipment, prior useful lives and changes in technology. We have not changed our policy regarding salvage values as a percentage of initial cost or useful lives of tractors and trailers within the last ten years. We believe that our policies and past estimates have been reasonable. Actual results could differ from these estimates. A 5% decrease in estimated salvage values would have decreased our net property and equipment as of December 31, 2019 by approximately $12.3 million, or 1.9%. Impairment of Assets. Long-lived assets are reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. Recoverability of assets to be held and used is measured by a comparison of the carrying amount of an asset to future net undiscounted cash flows expected to be generated by the asset. If such assets were considered to be impaired, the impairment to be recognized would be measured by the amount by which the carrying amount of the assets exceeds the fair value of the assets. Assets to be disposed of are reported at the lower of the carrying amount or fair value less the costs to sell. Insurance and Claims. We self-insure, in part, for losses relating to workers’ compensation, auto liability, general liability, cargo and property damage claims, along with employees’ health insurance with varying risk retention levels. We maintain insurance coverage for per-incident and total losses in excess of these risk retention levels in amounts we consider adequate based upon historical experience and our ongoing review. However, we could suffer a series of losses within our self-insured retention limits or losses over our policy limits, which could negatively affect our financial condition and operating results. We are responsible for the first $1.0 million on each auto liability claim and for the first $750,000 on each workers’ compensation claim. We have $15.7 million in standby letters of credit to guarantee settlement of claims under agreements with our insurance carriers and regulatory authorities. The insurance and claims accruals in our consolidated balance sheets were $31.7 million as of December 31, 2019 and $28.1 million as of December 31, 2018. We reserve currently for the estimated cost of the uninsured portion of pending claims. We periodically evaluate and adjust these reserves based on our evaluation of the nature and severity of outstanding individual claims and our estimate of future claims development based on historical development. Actual results could differ from these current estimates. In addition, to the extent that claims are litigated and not settled, jury awards are difficult to predict. Share-based Payment Arrangement Compensation. We have granted stock options to certain employees and non-employee directors. We recognize compensation expense for all stock options net of an estimated forfeiture rate and only record compensation expense for those shares expected to vest on a straight-line basis over the requisite service period (normally the vesting period). Determining the appropriate fair value model and calculating the fair value of stock options require the input of highly subjective assumptions, including the expected life of the stock options and stock price volatility. We use the Black-Scholes model to value our stock option awards. We believe that future volatility will not materially differ from our historical volatility. Thus, we use the historical volatility of our common stock over the expected life of the award. The assumptions used in calculating the fair value of stock options represent our best estimates, but these estimates involve inherent uncertainties and the application of judgment. As a result, if factors change and we use different assumptions, stock option compensation expense could be materially different in the future. We have also granted performance unit awards to certain employees which are subject to vesting requirements over a five-year period, primarily based on our earnings growth. The fair value of each performance unit is based on the closing market price on the date of grant. We recognize compensation expense for these awards based on the estimated number of units probable of achieving the performance and service vesting requirements of the awards, net of an estimated forfeiture rate.

<s>[INST] The following discussion and analysis of our financial condition and results of operations should be read together with the selected consolidated financial data and our consolidated financial statements and the related notes appearing elsewhere in this report. This discussion and analysis contains forwardlooking statements that involve risks, uncertainties and assumptions. Our actual results may differ materially from those anticipated in these forwardlooking statements as a result of many factors, including but not limited to those under the heading “Risk Factors” beginning on page 5. We do not assume, and specifically disclaim, any obligation to update any forwardlooking statement contained in this report. Overview We have strategically transitioned from a refrigerated longhaul carrier to a multifaceted business offering a network of refrigerated and dry truckbased transportation capabilities across our five distinct business platforms Truckload, Dedicated, Intermodal, Brokerage and MRTN de Mexico. The primary source of our operating revenue is provided by our Truckload segment through a combination of regional shorthaul and mediumtolonghaul fullload transportation services. We transport food and other consumer packaged goods that require a temperaturecontrolled or insulated environment, along with dry freight, across the United States and into and out of Mexico and Canada. Our agreements with customers are typically for one year. Our Dedicated segment provides customized transportation solutions tailored to meet individual customers’ requirements, utilizing temperaturecontrolled trailers, dry vans and other specialized equipment within the United States. Our agreements with customers range from three to five years and are subject to annual rate reviews. Generally, we are paid by the mile for our Truckload and Dedicated services. We also derive Truckload and Dedicated revenue from fuel surcharges, loading and unloading activities, equipment detention and other accessorial services. The main factors that affect our Truckload and Dedicated revenue are the rate per mile we receive from our customers, the percentage of miles for which we are compensated, the number of miles we generate with our equipment and changes in fuel prices. We monitor our revenue production primarily through average Truckload and Dedicated revenue, net of fuel surcharges, per tractor per week. We also analyze our average Truckload and Dedicated revenue, net of fuel surcharges, per total mile, nonrevenue miles percentage, the miles per tractor we generate, our fuel surcharge revenue, our accessorial revenue and our other sources of operating revenue. Our Intermodal segment transports our customers’ freight within the United States utilizing our temperaturecontrolled trailers and, beginning in September 2019, our refrigerated containers, each on railroad flatcars for portions of trips, with the balance of the trips using our tractors or, to a lesser extent, contracted carriers. The main factors that affect our Intermodal revenue are the rate per mile and other charges we receive from our customers. Our Brokerage segment develops contractual relationships with and arranges for thirdparty carriers to transport freight for our customers in temperaturecontrolled trailers and dry vans within the United States and into and out of Mexico through Marten Transport Logistics, LLC, which was established in 2007 and operates pursuant to brokerage authority granted by the DOT. We retain the billing, collection and customer management responsibilities. The main factors that affect our Brokerage revenue are the rate per mile and other charges that we receive from our customers. Operating results of our MRTN de Mexico business which offers our customers doortodoor service between the United States and Mexico with our Mexican partner carriers is reported within our Truckload and Brokerage segments. In addition to the factors discussed above, our operating revenue is also affected by, among other things, the United States economy, inventory levels, the level of truck and rail capacity in the transportation market, a contracting driver market, severe weather conditions and specific customer demand. Our operating revenue increased $55.7 million, or 7.1%, in 2019 from 2018. Our operating revenue, net of fuel surcharges, increased $58.5 million, or 8.6%, compared with 2018. Truckload segment revenue, net of fuel surcharges, increased 2.2% from 2018 primarily due to an increase in our average number of tractors. Dedicated segment revenue, net of fuel surcharges, increased 1 [/INST] Negative. </s>

WINNEBAGO INDUSTRIES INC

2015-10-27

2015-08-29

Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations Management's Discussion and Analysis of Financial Condition and Results of Operations (MD&A) is intended to provide a reader of our financial statements with a narrative from the perspective of our management on our financial condition, results of operations, liquidity and certain other factors that may affect our future results. Our MD&A is presented in eight sections: • Executive Overview • Industry Outlook • Company Outlook • Results of Operations • Analysis of Financial Condition, Liquidity and Capital Resources • Contractual Obligations and Commercial Commitments • Critical Accounting Policies • New Accounting Pronouncements Our MD&A should be read in conjunction with the Financial Statements and related Notes included in Item 8, Financial Statements and Supplementary Data, of this Annual Report on Form 10-K. Executive Overview Winnebago Industries, Inc. is a leading US manufacturer of RVs with a proud history of manufacturing RV products for more than 50 years. We produce all of our motorhomes in vertically integrated manufacturing facilities in Iowa and we produce all travel trailer and fifth wheel trailers in Indiana. We distribute our products primarily through independent dealers throughout the US and Canada, who then retail the products to the end consumer. Our retail unit market share, as reported by Stat Surveys based on state records, is illustrated below. Note that this data is subject to adjustment and is continuously updated. Presented in fiscal quarters, certain key metrics are shown below: (1) An additional 343 units were delivered but not included in wholesale deliveries as presented in the table above as the units were subject to repurchase option. These units were included as retail registrations, not in dealer inventory, as the units were immediately placed into rental service once delivered. See Note 4 to the financial statements. Highlights of Fiscal 2015: Consolidated revenues, gross profit, and operating income were comparable for Fiscal 2015 as compared to Fiscal 2014. Quarterly results for the past two fiscal years are illustrated as follows: Operational and financial performance: • Our motorized wholesale deliveries increased by approximately 4% in Fiscal 2015 as compared to Fiscal 2014. In recent years we have sold more units to dealers than our dealer network could sell to the public as dealers restocked their inventories to meet the growing retail demand. Dealer inventory remained relatively flat when comparing Fiscal 2015 to Fiscal 2014 as we believe we have now reached equilibrium where dealers will accept one new wholesale for each unit retailed. • Our Towables operations generated operating income of $2.6 million in Fiscal 2015 compared to operating income of $1.3 million in Fiscal 2014. Towable net revenue experienced growth of approximately 23%, this was a significant driver in the doubling of the operating income. Net revenue growth was enhanced in part by the introduction of our Toy Hauler products along with the increase in our dealer network. The growth in operating income was aided by the operating leverage within the business model and a reduction in our raw materials. • The continued strong financial performance of our business has allowed us to make substantial investments in Fiscal 2015 related to two strategic initiatives to support our operations and strengthen our foundation for success for the future. These initiatives are discussed in more detail in the Company Outlook section. Industry Outlook Key statistics for the motorhome industry are as follows: (1) Class A, B and C wholesale shipments as reported by RVIA. (2) Class A, B and C retail registrations as reported by Stat Surveys for the US and Canada combined. (3) Monthly and quarterly 2015 Class A, B and C wholesale shipments are based upon the forecast prepared by Dr. Richard Curtin of the University of Michigan Consumer Survey Research Center for RVIA and reported in the RV RoadSigns Fall 2015 Industry Forecast Issue. The revised RVIA annual 2015 wholesale shipment forecast is 47,000 and the annual forecast for 2016 is 48,600, an increase of 3.4%. (4) Stat Surveys has not issued a projection for 2015 retail demand for this period. Key statistics for the towable industry are as follows: (1) Towable wholesale shipments as reported by RVIA. (2) Towable retail registrations as reported by Stat Surveys for the US and Canada combined. (3) Monthly and quarterly 2015 towable wholesale shipments are based upon the forecast prepared by Dr. Richard Curtin of the University of Michigan Consumer Survey Research Center for RVIA and reported in the RV RoadSigns Fall 2015 Industry Forecast Issue. The revised annual 2015 wholesale shipment forecast is 314,200 and the annual forecast for 2016 is 322,300, an increase of 2.6%. (4) Stat Surveys has not issued a projection for 2015 retail demand for this period. Company Outlook Based on our profitable operating results in recent years, we believe that we have demonstrated our ability to maintain our liquidity, cover operations costs, recover fixed assets, and maintain physical capacity at present levels. Now that we have entered into the towable market, we are attempting to grow revenues and earnings in a market significantly larger than the motorized market. Our motorized production facilities are located in largely rural areas of northern Iowa. In addition, the unemployment rate in these areas is currently low. These factors limit our ability to increase motorized production volumes at a more rapid pace even if motorized demand justified increased production. To the extent that we have been able to increase the production rate, we have also incurred incremental operating expenses associated with overtime and workers compensation expense. To overcome these labor shortages we recently began expanding within the state of Iowa. In Fiscal 2014 we leased an additional manufacturing facility in Lake Mills which is now in production. In the third quarter of Fiscal 2015 we purchased a separate facility in Waverly, which will be ready for production later this calendar year. These expansions are intended to facilitate the increased production rate and to reach additional labor markets. In addition to finding alternative locations, we are re-evaluating the manner in which we deploy labor in our Forest City facility. We are in the process of exiting our bus and aluminum extrusion operation. Both of these operations provided very low margins while consuming production labor. We have decided it is in our best interest to redeploy these labor hours to the higher margin motorized operations. We expect to have both bus and aluminum extrusion operations exited by the end of the second fiscal quarter of 2016. Fiscal 2016 is a year in which we expect to continue investing and rebuilding for Winnebago’s future. We anticipate flat to modest motorized deliveries growth, which is in line with RVIA’s projection of 3% growth for the industry. We’ve taken steps to improve motorized labor efficiency and expect to see modest improvement in Fiscal 2016. In Towables, we anticipate building on our Fiscal 2015 results, with continued penetration of our new products and further expansion of our distribution base. We believe we can again achieve growth in excess of the overall towables market projections for Fiscal 2016. Our unit order backlog was as follows: (1) We include in our backlog all accepted purchase orders from dealers to be shipped within the next six months. Orders in backlog can be canceled or postponed at the option of the dealer at any time without penalty and, therefore, backlog may not necessarily be an accurate measure of future sales. Our unit dealer inventory was as follows: We believe that the level of our dealer inventory at the end of Fiscal 2015 is reasonable given the improved retail demand and current sales order backlog of our product. A key metric used to evaluate dealer inventory levels is the retail turn rate (12 month retail volume/current deliver inventory). At the end of Fiscal 2015 the retail turn rate was over 2.2 turns which we feel reflects the alignment between retail demand and our dealers' inventory. At the December 2014 Board of Directors meeting, two strategic initiatives were approved and, as a result, commenced in the second quarter of Fiscal 2015. Both of these projects represent significant investments that we believe will contribute to our future success. • The first strategic initiative relates to the execution of an ERP system implementation which will replace our in-house developed financial and operational systems. The new ERP platform will provide better support for our changing business needs and plans for future growth. In addition to supply chain optimization opportunities and lower overall operating costs, the new system will provide more recent and relevant data which will allow us to more quickly react to production and other business changes and in some cases, allow us to be proactive in our response to market trends and opportunities. Our current cost estimate for this project is $12 - $16 million to be completed over a three-year time frame which includes software, external implementation as assistance and increased internal staffing directly related to this initiative. We anticipate that approximately 40% of the cost will be immediately expensed over the life of the project and 60% will be capitalized. As components of the ERP are placed in service, we will amortize over a 10-year life. The following table illustrates the project costs in Fiscal 2015: (1) Of the $2.5 million expensed in Fiscal 2015, $2.2 million was incremental and related to external implementation assistance. We estimate that an additional $6 - $10 million in project costs will be incurred in Fiscal 2016 and Fiscal 2017, most of which will be incurred in the next 12 months. • The second initiative is a strategic sourcing project with the objective of obtaining long-term material cost savings through standardizing our purchasing processes, optimizing our supplier relationships and improving our current sourcing methodologies. We engaged external support with deep domain expertise to help us launch the project and incurred $1.6 million in general and administrative expenses for this assistance in Fiscal 2015, of which $370,000 was incurred in the fourth quarter. We expect to incur approximately $200,000 of incremental general and administrative expense in Fiscal 2016 related to this project, which is less than what was originally planned, as project management will be fully transitioned to internal resources in the first quarter. When all commodities have been through the strategic sourcing process (expected by June 2016), we anticipate this project will provide gross margin expansion of 30 to 50 basis points. Impact of Inflation Materials cost is the primary component in the cost of our products. Historically, the impact of inflation on our operations has not been significantly detrimental, as we have historically been able to adjust our prices to reflect the inflationary impact on the cost of manufacturing our products. While we have historically been able to pass on these increased costs, in the event we are unable to continue to do so due to market conditions, future increases in manufacturing costs could have a material adverse effect on our results of operations. Results of Operations Fiscal 2015 Compared to Fiscal 2014 The following is an analysis of changes in key items included in the statements of operations for the fiscal year ended August 29, 2015 compared to the fiscal year ended August 30, 2014: (1) Percentages may not add due to rounding differences. Motorhome unit deliveries and ASP, net of discounts, consisted of the following: (1) Percentages and dollars may not add due to rounding differences. (2) An additional 343 motorhomes were delivered in Fiscal 2014 but not included in wholesale deliveries as presented in the table above as the units were subject to repurchase option. See Note 4. Towables unit deliveries and ASP, net of discounts, consisted of the following: (1) Percentages and dollars may not add due to rounding differences. Net revenues consisted of the following: (1) Includes motorhome units, parts, and services (2) Includes towable units and parts The increase in motorhome net revenues of $19.4 million or 2.3% was primarily attributed to a 3.9% increase in unit deliveries in Fiscal 2015. • The increase in the incremental revenues was due to the change in our sales agreement with Apollo, a US RV rental company. During Fiscal 2015 we delivered 535 rental units to Apollo. During Fiscal 2014 we delivered 520 rental units to Apollo, of which only 177 were reported as motorhome sales; the remaining 343 were recorded as operating leases due to a repurchase obligation in Fiscal 2014. • Total motorhome ASP decreased 1.7% in Fiscal 2015 due to a mix shift from higher priced Class A products to lower priced Class B and C unit sales in Fiscal 2015 although ASPs increased in every product category during the year. Towables revenues were $71.7 million in Fiscal 2015 compared to revenues of $58.1 million in Fiscal 2014. ASP increased 15.9% and towable unit deliveries increased by 6.4%. Cost of goods sold was $871.6 million, or 89.3% of net revenues for Fiscal 2015 compared to $841.2 million, or 89.0% of net revenues for Fiscal 2014 due to the following: • Total variable costs (materials, direct labor, variable overhead, delivery expense and warranty), as a percent of net revenues, increased to 84.0% from 83.7% primarily due to increased warranty expense and related warranty recall reserve and higher workers compensation expense. • Fixed overhead (manufacturing support labor, depreciation and facility costs) and research and development-related costs decreased to 5.2% of net revenues compared to 5.3%. • All factors considered, gross profit decreased from 11.0% to 10.7% of net revenues. Selling expenses increased to 2.0% from 1.9% of net revenues in Fiscal 2015 and Fiscal 2014, respectively. The increase was due primarily to increased advertising and compensation expenses in Fiscal 2015. General and administrative expenses were 2.6% and 2.4% of net revenues in Fiscal 2015 and Fiscal 2014, respectively. General and administrative expenses increased $3.4 million, or 15.2%, in Fiscal 2015. This increase was due primarily to expenses of $3.9 million in ERP and strategic sourcing projects, $1.6 million in increased legal and product liability expenses, $1.0 million in costs associated with the former CEO retirement agreement and was partially offset by $3.3 million in reduced management compensation expenses. During Fiscal 2015, we recorded an asset impairment on our corporate plane of $462,000. In Fiscal 2014, we sold a warehouse facility in Forest City, Iowa, resulting in a gain of $629,000. See Note 5. Non-operating income decreased $653,000 or 85.0%, in Fiscal 2015, primarily due to lower proceeds from COLI policies than we received in Fiscal 2014. See Note 12. The overall effective income tax rate for Fiscal 2015 was 30.8% compared to 30.3% in Fiscal 2014. With a lower level of pre-tax book income being recorded in Fiscal 2015 compared to Fiscal 2014 the effective tax rate from operations was lower. However, this was offset by the lower level of tax planning initiatives recorded in Fiscal 2015 compared to Fiscal 2014 causing a slight increase in the effective tax rate year over year. Legislation for various applicable tax credits expired on December 31, 2014; therefore, similar to our Fiscal 2014, our projected benefits for these tax credits are limited to four months of our fiscal year. If the applicable credits are extended, this could potentially reduce our annual tax rate by approximately 0.60% to 0.90%. See Note 11. Net income and diluted income per share were $41.2 million and $1.52 per share, respectively, for Fiscal 2015. In Fiscal 2014, the net income was $45.1 million and diluted income was $1.64 per share. Fiscal 2014 Compared to Fiscal 2013 The following is an analysis of changes in key items included in the statements of operations for the fiscal year ended August 30, 2014 compared to the fiscal year ended August 31, 2013: (1) Percentages may not add due to rounding differences. Motorhome unit deliveries and ASP, net of discounts, consisted of the following: (1) An additional 343 motorhomes were delivered in Fiscal 2014 but not included in wholesale deliveries as presented in the table above as the units were subject to repurchase option. See Note 4. (2) Percentages and dollars may not add due to rounding differences. Towables deliveries and ASP, net of discounts, consisted of the following: (1) Percentages and dollars may not add due to rounding differences. Net revenues consisted of the following: (1) Includes motorhome units, parts and service (2) Includes towable units and parts. The increase in motorhome net revenues of $134.9 million or 18.8% was primarily attributed to a 28.4% increase in unit deliveries driven by higher dealer and retail consumer demand when compared to Fiscal 2013. ASP decreased 7.8% in Fiscal 2014 due to new products introduced in all classes at lower price points during the year. Towables revenues were $58.1 million in Fiscal 2014 compared to revenues of $54.7 million in Fiscal 2013. ASP increased 8.6% and towable unit deliveries decreased by 1.0%. One contributing factor to the increase in unit deliveries during Fiscal 2014 relates to revised shipping terms with our dealers. Effective in the first quarter of Fiscal 2014, we entered into revised dealer agreements to change our shipping terms so that title and risk of loss passes to our dealers upon acceptance of the unit by an independent transportation company for delivery which is standard industry practice. As a result of this term change, an additional $40.8 million of revenue was recognized in Fiscal 2014, which represented units in possession of the transportation company in-transit to the dealer. In Fiscal 2013, such revenues would have been recognized in the next fiscal year. Conversely, due to our 52/53 week fiscal year convention, Fiscal 2013 had an extra week in the first quarter as compared to Fiscal 2014 resulting in an additional $13.8 million of revenue recognized in the prior year first quarter. The net effect of these two timing items resulted in a positive impact of $27.0 million when comparing Fiscal 2014 to Fiscal 2013. Cost of goods sold was $841.2 million, or 89.0% of net revenues for Fiscal 2014 compared to $718.5 million, or 89.5% of net revenues for Fiscal 2013 due to the following: • Total variable costs (materials, direct labor, variable overhead, delivery expense and warranty), as a percent of net revenues, were 83.7% in both years. • Fixed overhead (manufacturing support labor, depreciation and facility costs) and research and development-related costs decreased to 5.3% of net revenues compared to 5.7%. The difference was due primarily to increased revenues in Fiscal 2014. • All factors considered, gross profit increased from 10.5% to 11.0% of net revenues. Selling expenses decreased to 1.9% from 2.3% of net revenues in Fiscal 2014 and Fiscal 2013, respectively. The decrease was due primarily to increased revenues in Fiscal 2014, as selling expenses were flat year over year. General and administrative expenses were 2.4% and 2.7% of net revenues in Fiscal 2014 and Fiscal 2013, respectively. The decrease was due primarily to increased revenues in Fiscal 2014. General and administrative expenses increased $537,000, or 2.5%, in Fiscal 2014. This increase was due primarily to a reduction of rental income as a result of the sale of one of our warehouse properties in Fiscal 2014 and was partially offset by approximately $550,000 additional amortization on our Towables intangible assets in Fiscal 2013 (see Note 6). During Fiscal 2014, we sold a warehouse facility in Forest City, Iowa, resulting in a gain of $629,000. See Note 5. Non-operating income increased $72,000 or 10.3%, in Fiscal 2014. We received proceeds from COLI policies in both Fiscal 2014 and Fiscal 2013. See Note 12. The overall effective income tax rate for Fiscal 2014 was 30.3% compared to 29.1% in Fiscal 2013. The overall increase is primarily a result of higher level of pre-tax book income earned in Fiscal 2014 compared to Fiscal 2013, as certain permanent deductions (tax-free income from COLI) recorded during Fiscal 2014 were relatively flat in dollar value compared to the prior year and legislation for various applicable tax credits expired on December 31, 2013; therefore our projected benefits for these tax credits were limited to four months of our fiscal year. See Note 11. Net income and diluted income per share were $45.1 million and $1.64 per share, respectively, for Fiscal 2014. In Fiscal 2013, the net income was $32.0 million and diluted income was $1.13 per share. Analysis of Financial Condition, Liquidity and Resources Cash and cash equivalents increased $12.4 million during Fiscal 2015 and totaled $70.2 million as of August 29, 2015. The significant liquidity events that occurred during Fiscal 2015 were: • Generated net income of $41.2 million • Capital expenditures of $16.6 million • Dividend payments of $9.8 million • Stock repurchases of $6.5 million As noted in Note 7, through our Amended Credit Agreement with GECC, we have the ability to borrow $35.0 million through a revolving credit facility based on our eligible inventory and certain receivables. In addition, the Amended Credit Agreement also includes a framework to expand the size of the facility up to $50.0 million, based on mutually agreeable terms at the time of the expansion. The Credit Agreement's term is through May 28, 2019. As of the date of this report, we are in compliance with all terms of the Credit Agreement, and no borrowings have been made thereunder. We filed a Registration Statement on Form S-3, which was declared effective by the SEC on May 9, 2013. Subject to market conditions, we have the ability to offer and sell up to $35.0 million of our common stock in one or more offerings pursuant to the Registration Statement. The Registration Statement will be available for use for three years from its effective date. We currently have no plans to offer and sell the common stock registered under the Registration Statement; however, it does provide another potential source of liquidity in addition to the alternatives already in place. Working capital at August 29, 2015 and August 30, 2014 was $184.6 million and $172.0 million, respectively, an increase of $12.6 million. We currently expect cash on hand, funds generated from operations and the availability under a credit facility to be sufficient to cover both short-term and long-term operating requirements. We anticipate capital expenditures in Fiscal 2016 of $20-$30 million. In addition to the normal $8 - $10 million of maintenance spend for our current facilities, we will continue to invest in our ERP system and we are also evaluating incremental capacity expansion investments. On October 14, 2015, the Board of Directors approved a quarterly cash dividend of $0.10 per share of common stock, payable on November 25, 2015 to shareholders of record at the close of business on November 11, 2015. We expect this cash outflow to be approximately $2.7 million for each quarter that this dividend is paid. Operating Activities Cash provided by operating activities was $45.2 million for the fiscal year ended August 29, 2015 compared to $23.2 million for the fiscal year ended August 30, 2014, and $10.2 million for the fiscal year ended August 31, 2013. The combination of net income of $41.2 million in Fiscal 2015 and changes in non-cash charges (e.g., depreciation, LIFO, stock-based compensation, deferred income taxes) provided $49.0 million of operating cash compared to $50.6 million in Fiscal 2014 and $39.0 million in Fiscal 2013. In Fiscal 2015, Fiscal 2014, and Fiscal 2013, changes in assets and liabilities (primarily an decrease in receivables in Fiscal 2015, an increase in receivables in Fiscal 2014 and inventory increases in Fiscal 2013) used $3.8 million, $27.4 million, and $28.8 million, respectively, of operating cash. Investing Activities Cash used in investing activities of $16.5 million in Fiscal 2015 was due primarily to capital spending of $16.6 million. In Fiscal 2014, cash used in investing activities of $5.4 million was primarily due to capital spending of $10.5 million and was partially offset by proceeds from the sale of property of $2.4 million and ARS redemptions of $2.4 million. During Fiscal 2013, cash provided by ARS redemptions of $4.1 million was primarily due to proceeds of ARS redemptions of $7.3 million and was partially offset by capital spending of $4.4 million. Financing Activities Cash used in financing activities of $16.2 million in Fiscal 2015 was primarily due to $9.8 million for the payments of dividends and $6.5 million in repurchases of our stock. We borrowed and repaid $22.0 million in our line of credit in the second quarter of Fiscal 2015. Cash used in financing for the fiscal years ended August 30, 2014 and August 31, 2013 was $24.3 million and $12.7 million, respectively, and was primarily for repurchases of our stock. Contractual Obligations and Commercial Commitments Our principal contractual obligations and commercial commitments as of August 29, 2015 were as follows: (1) See Note 9. (2) See Note 10. (3) We are not able to reasonably estimate in which future periods these amounts will ultimately be settled. Critical Accounting Policies Our financial statements are prepared in accordance with GAAP. In connection with the preparation of our financial statements, we are required to make assumptions and estimates about future events and apply judgments that affect the reported amounts of assets, liabilities, revenue, expenses and the related disclosures. We base our assumptions, estimates and judgments on historical experience, current trends and other factors that we believe to be relevant at the time our financial statements are prepared. On a regular basis, we review the accounting policies, assumptions, estimates and judgments to ensure that our financial statements are presented fairly and in accordance with GAAP. However, because future events and their effects cannot be determined with certainty, actual results could differ from our assumptions and estimates and such differences could be material. Our significant accounting policies are discussed in Note 1. We believe that the following accounting estimates and policies are the most critical to aid in fully understanding and evaluating our reported financial results and they require our most difficult, subjective or complex judgments, resulting from the need to make estimates about the effect of matters that are inherently uncertain. We have reviewed these critical accounting estimates and related disclosures with the Audit Committee of our Board of Directors. Revenue Recognition Generally, revenues for our RVs are recorded when the following conditions are met: • an order for a product has been received from a dealer • written or verbal approval for payment has been received from the dealer's floorplan financing institution (if applicable) • an independent transportation company has accepted responsibility for the product as agent for the dealer; and • the product is removed from the Company's property for delivery to the dealer. These conditions are generally met when title passes, which is when RVs are shipped to dealers in accordance with shipping terms, which are primarily FOB shipping point. Products are not sold on consignment except for the rental program described in the next paragraph, dealers do not have the right to return products and dealers are typically responsible for interest costs to floor plan lenders. In Fiscal 2014 we began to sell RVs to a rental company that were subject to our obligation to repurchase at the end of the rental term. These transactions were accounted for as operating leases. At the time of sale, the proceeds were recorded as deferred revenue in other current liabilities. The difference between the proceeds and the repurchase amount was recognized in net revenues over the term which the rental company holds the vehicle, using a straight-line method. The cost of the vehicles was recorded in net investment in operating leases and the difference between the cost of the vehicle and the estimated resale value was depreciated in net revenue over the term of the lease. Net proceeds or losses from the sale of the vehicle at resale were recognized in net revenue at the time of sale. Under the terms of our 2015 sales agreement, this order did not include any repurchase obligation, thus these units were not recorded as operating leases. Revenues of our OEM components and RV related parts are recorded as the products are shipped from our location. The title of ownership transfers on these products as they leave our location due to the freight terms of FOB shipping point. Sales Promotions and Incentives We accrue for sales promotions and incentive expenses, which are recognized as a reduction to revenues, at the time of sale to the dealer or when the sales incentive is offered to the dealer or retail customer. Examples of sales promotions and incentive programs include dealer and consumer rebates, volume discounts, retail financing programs and dealer sales associate incentives. Sales promotion and incentive expenses are estimated based upon current program parameters, such as unit or retail volume, and historical rates. Actual results may differ from these estimates if market conditions dictate the need to enhance or reduce sales promotion and incentive programs or if the retail customer usage rate varies from historical trends. Historically, sales promotion and incentive expenses have been within our expectations and differences have not been material. Repurchase Commitments It is customary practice for manufacturers in the RV industry to enter into repurchase agreements with financing institutions that provide financing to their dealers, upon their request. Our repurchase agreements generally provide that, in the event of a default by a dealer in its obligation to these lenders, we will repurchase vehicles sold to the dealer that have not been resold to retail customers. The terms of these agreements, which can last up to 18 months, provide that our liability will be the lesser of remaining principal owed by the dealer or dealer invoice less periodic reductions based on the time since the date of the original invoice. Our liability cannot exceed 100% of the dealer invoice. In certain instances, we also repurchase inventory from our dealers due to state law or regulatory requirements that govern voluntary or involuntary relationship terminations. Based on these repurchase agreements, we establish an associated loss reserve which is disclosed separately in the balance sheets. Repurchased sales are not recorded as a revenue transaction, but the net difference between the original repurchase price and the resale price are recorded against the loss reserve, which is a deduction from gross revenue. Our loss reserve for repurchase commitments contains uncertainties because the calculation requires management to make assumptions and apply judgment regarding a number of factors. There are two significant assumptions associated with establishing our loss reserve for repurchase commitments: (1) the percentage of dealer inventory that we will be required to repurchase as a result of defaults by the dealer, and (2) the loss that will be incurred, if any, when repurchased inventory is resold. These key assumptions are affected by a number of factors, such as macro-market conditions, current retail demand for our product, age of product in dealer inventory, physical condition of the product, location of the dealer, and the financing source. To the extent that dealers are increasing or decreasing their inventories, our overall exposure under repurchase agreements is likewise impacted. The percentage of dealer inventory we estimate we will repurchase (which has ranged in the past five years from 4 to 8% on a weighted average basis) and the associated estimated loss (which has ranged in the past five years from 5 to 12% on a weighted average basis) is based on historical information, current trends and an analysis of dealer inventory aging for all dealers with inventory subject to this obligation. In periods where there is increasing retail demand for our product at our dealerships, the lower end of our estimated range of assumptions will be more appropriate and in periods of decreasing retail demand, the opposite will be true. While there can be no assurance that dealer and economic conditions will not adversely change, we currently do not believe there is a reasonable likelihood that there will be a material change in the future estimates or assumptions we use to calculate our loss reserve for repurchase commitments. A hypothetical change of a 10% increase or decrease in our significant repurchase commitment assumptions as of August 29, 2015 would have affected net income by approximately $280,000. Warranty We provide, with the purchase of any new motorhome, a comprehensive 12-month/15,000-mile warranty on Class A, B and C motorhomes and a 3-year/36,000-mile warranty on Class A and C sidewalls and floors. We provide a comprehensive 12-month warranty on all towable products. Estimated costs related to product warranty are accrued at the time of sale, based upon past warranty claims and unit sales history. Accruals are adjusted as needed to reflect actual costs incurred, as information becomes available. A significant increase in dealership labor rates, the cost of parts or the frequency of claims could have a material adverse impact on our operating results for the period or periods in which such claims or additional costs materialize. In addition to the costs associated with the contractual warranty coverage provided on our products, we also occasionally incur costs as a result of additional service actions not covered by our warranties, including product recalls and customer satisfaction actions. Although we estimate and reserve for the cost of these service actions, there can be no assurance that expense levels will remain at current levels or such reserves will continue to be adequate. While there can be no assurance that warranty expense will not adversely change, we currently do not believe there is a reasonable likelihood that there will be a material change in the future estimates or assumptions we use to calculate our warranty reserve. A hypothetical change of a 10% increase or decrease in our significant warranty commitment assumptions as of August 29, 2015 would have affected net income by approximately $619,000. Further discussion of our warranty costs and associated accruals is included in Note 8. Income Taxes We account for income taxes in accordance with ASC 740, Income Taxes. In preparing our financial statements, we are required to estimate our income taxes in each of the jurisdictions in which we operate. Significant judgment is required in determining our provision for income taxes, our deferred tax assets and liabilities and any valuation allowance recorded against our deferred tax assets. We will continue to assess the likelihood that our deferred tax assets will be realizable at each reporting period and will be adjusted accordingly, which could materially impact our financial position and results of operations. As of August 29, 2015 , we have determined that our deferred tax assets are realizable, and therefore, no valuation allowance has been recorded. Postretirement Benefits, Obligations and Costs We provide certain health care and other benefits for retired employees hired before April 1, 2001, who have fulfilled eligibility requirements at age 55 with 15 years of continuous service. Postretirement benefit liabilities are determined by actuaries using assumptions about the discount rate and health care cost-trend rates. Assumed health care cost trend rates do not have a significant effect on the amounts reported for retiree health care benefits due to the fact that we have established maximum amounts ("dollar caps") on the amount we will pay for postretirement health care benefits per retiree on an annual basis. However, a significant increase or decrease in interest rates could have a significant impact on our operating results. Further discussion of our postretirement benefit plan and related assumptions is included in Note 9. New Accounting Pronouncements See Note 1 for a summary of new accounting pronouncements which summary is incorporated by reference herein.

<s>[INST] Executive Overview Industry Outlook Company Outlook Results of Operations Analysis of Financial Condition, Liquidity and Capital Resources Contractual Obligations and Commercial Commitments Critical Accounting Policies New Accounting Pronouncements Our MD&A should be read in conjunction with the Financial Statements and related Notes included in Item 8, Financial Statements and Supplementary Data, of this Annual Report on Form 10K. Executive Overview Winnebago Industries, Inc. is a leading US manufacturer of RVs with a proud history of manufacturing RV products for more than 50 years. We produce all of our motorhomes in vertically integrated manufacturing facilities in Iowa and we produce all travel trailer and fifth wheel trailers in Indiana. We distribute our products primarily through independent dealers throughout the US and Canada, who then retail the products to the end consumer. Our retail unit market share, as reported by Stat Surveys based on state records, is illustrated below. Note that this data is subject to adjustment and is continuously updated. Presented in fiscal quarters, certain key metrics are shown below: (1) An additional 343 units were delivered but not included in wholesale deliveries as presented in the table above as the units were subject to repurchase option. These units were included as retail registrations, not in dealer inventory, as the units were immediately placed into rental service once delivered. See Note 4 to the financial statements. Highlights of Fiscal 2015: Consolidated revenues, gross profit, and operating income were comparable for Fiscal 2015 as compared to Fiscal 2014. Quarterly results for the past two fiscal years are illustrated as follows: Operational and financial performance: Our motorized wholesale deliveries increased by approximately 4% in Fiscal 2015 as compared to Fiscal 2014. In recent years we have sold more units to dealers than our dealer network could sell to the public as dealers restocked their inventories to meet the growing retail demand. Dealer inventory remained relatively flat when comparing Fiscal 2015 to Fiscal 2014 as we believe we have now reached equilibrium where dealers will accept one new wholesale for each unit retailed. Our Towables operations generated operating income of $2.6 million in Fiscal 2015 compared to operating income of $1.3 million in Fiscal 2014. Towable net revenue experienced growth of approximately 23%, this was a significant driver in the doubling of the operating income. Net revenue growth was enhanced in part by the introduction of our Toy Hauler products along with the increase in our dealer network. The growth in operating income was aided by the operating leverage within the business model and a reduction in our raw materials. The continued strong financial performance of our business has allowed us to make substantial investments in Fiscal 2015 related to two strategic initiatives to support our operations and strengthen our foundation for success for the future. These initiatives are discussed in more detail in the Company Outlook section. Industry Outlook Key statistics for the motorhome industry are as follows: (1) Class A, B and C wholesale shipments as reported by RVIA. (2) Class A, B and C retail registrations as reported by Stat Surveys for the US and Canada combined. (3) Monthly and quarterly 2015 Class A, B and C wholesale shipments are based upon the forecast prepared by Dr. Richard Curtin of the University of Michigan Consumer Survey Research Center for RVIA and reported in the RV RoadSigns Fall 2015 Industry Forecast Issue. The revised RVIA annual 2015 wholesale shipment forecast is 47,000 and the annual forecast for 2016 is 48,600, an increase of 3.4%. (4) Stat Surveys has not issued a projection for 2015 retail demand for this period. Key statistics for the towable industry are as follows: (1) Towable wholesale shipments as reported by RVIA. (2) T [/INST] Positive. </s>

WINNEBAGO INDUSTRIES INC

2016-10-18

2016-08-27

Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations Management's Discussion and Analysis of Financial Condition and Results of Operations (MD&A) is intended to provide a reader of our financial statements with a narrative from the perspective of our management on our financial condition, results of operations, liquidity and certain other factors that may affect our future results. Our MD&A is presented in eight sections: • Executive Overview • Industry Outlook • Company Outlook • Results of Operations • Analysis of Financial Condition, Liquidity and Capital Resources • Contractual Obligations and Commercial Commitments • Critical Accounting Policies • New Accounting Pronouncements Our MD&A should be read in conjunction with the Financial Statements and related Notes included in Item 8, Financial Statements and Supplementary Data, of this Annual Report on Form 10-K. Executive Overview Winnebago Industries, Inc. is a leading US manufacturer of RVs with a proud history of manufacturing RV products for more than 55 years. We currently produce a large majority of our motorhomes in vertically integrated manufacturing facilities in Iowa and we produce all of our travel trailer and fifth wheel trailers in Indiana. We are in the process of expanding some motorhome manufacturing to Junction City, Oregon. We distribute our products primarily through independent dealers throughout the US and Canada, who then retail the products to the end consumer. We recently announced our entry into a Securities Purchase Agreement pursuant to which we intend to acquire Grand Design, a fast-growing towables manufacturer in Middlebury, Indiana for approximately $500 million. Grand Design manufactures travel trailers and fifth wheel products. With this acquisition, we expect to have a broader and more balanced portfolio of motorized and towable products and intend to capitalize on the opportunities across the RV market and to drive improved profitability and long-term value for shareholders. Our retail unit market share, as reported by Stat Surveys based on state records, is illustrated below. Note that this data is subject to adjustment and is continuously updated. Highlights of Fiscal 2016: Consolidated revenues, gross profit, and operating income were comparable for Fiscal 2016 as compared to Fiscal 2015. Quarterly results for the past two fiscal years are illustrated as follows: Operational and financial performance: • Our motorized wholesale deliveries increased by approximately 2.3% in Fiscal 2016 as compared to Fiscal 2015. Strong demand for our Class B and Class C products was partially offset by weaker demand in Class A products. We anticipate continued strong demand in the Class B and C categories. • Our Towables operation generated operating income of $4.6 million in Fiscal 2016 compared to operating income of $2.6 million in Fiscal 2015. Towable net revenue experienced growth of approximately 25%, this was a significant driver in the 77% increase in operating income. Net revenue growth was enhanced in part by the increase in our dealer network. The growth in operating income was also aided by the operating leverage within the business model and a reduction in our raw material costs. • Total revenue declined modestly in 2016 due mainly to other manufactured products revenues which decreased by $21.1 million. This was primarily due to our exit of the aluminum extrusion and bus businesses. Both of these operations provided very low margins. Although total revenues did decline, gross profit and operating income increased in part due to the exit of these low margin operations as well as operating improvement in motorized and towable operations. • The continued strong financial performance of our business has allowed us to make substantial investments in Fiscal 2016 including the implementation of an ERP system and purchase of our Junction City, Oregon plant. Industry Outlook Key reported statistics for the North American RV industry are as follows: • Wholesale unit shipments: RV product delivered to the dealers, which is reported monthly by RVIA • Retail unit registrations: consumer purchases of RVs from dealers, which is reported by Stat Surveys We track RV Industry conditions using these key statistics to monitor trends and evaluate and understand our performance relative to the overall industry. The rolling twelve months shipment and retail information for 2016 and 2015, as noted below, illustrates that the RV industry continues to grow at the wholesale and retail level. We believe retail demand is the key driver to continued growth in the industry. (1) Towable: Fifth wheel and travel trailer products (2) Motorized: Class A, B and C products The most recent towable and motorized RVIA wholesale shipment forecasts for calendar year 2016 and 2017 as noted in the table below illustrates continued projected growth of the industry. The outlook for future growth in RV sales is based on continued modest gains in job and disposable income prospects as well as low inflation, and takes into account the impact of slowly rising interest rates, a strong U.S. dollar and continued weakness in energy production and prices. (1) Prepared by Dr. Richard Curtin of the University of Michigan Consumer Survey Research Center for RVIA and reported in the Roadsigns RV Fall 2016 Industry Forecast Issue. Company Outlook Based on our profitable operating results in recent years, we believe that we have demonstrated our ability to maintain our liquidity, cover operations costs, recover fixed assets, and maintain physical capacity at present levels. Our entrance into the towable market has been successful and we are seeing high growth rates in revenues and earnings in a market significantly larger than the motorized market. Our motorized production facilities are located in largely rural areas of northern Iowa. In addition, the unemployment rate in these areas is currently low. To the extent that we have been able to increase the production rate, we have also incurred incremental operating expenses associated with overtime and workers compensation expense. To overcome these labor shortages we first expanded within the state of Iowa. In Fiscal 2014, we leased an additional manufacturing facility in Lake Mills, Iowa and in the third quarter of Fiscal 2015 we purchased a separate facility in Waverly, Iowa which is also in production. We also exited our bus and aluminum extrusion operation to better deploy our labor in Forest City, Iowa. In the second quarter of 2016, we purchased a production facility in Junction City, Oregon from a former motorized RV producer. We are expanding some motorhome manufacturing to Junction City in order to diversify our geographical locations. The site also provides a west coast service option for our customers. We expect to continue investing and building for Winnebago’s future. We anticipate modest motorized deliveries growth, which is in line with RVIA’s projection of 3% growth for the industry. We’ve taken steps to improve motorized labor efficiency and expect to see continued improvement in Fiscal 2017. In Towables, we anticipate continued double digit growth, with further penetration of our new products and further expansion of our distribution base. We believe our acquisition of Grand Design, if consummated, will also help fuel this growth. Our order backlog was as follows: (1) We include in our backlog all accepted purchase orders from dealers to be shipped within the next six months. Orders in backlog can be canceled or postponed at the option of the dealer at any time without penalty and, therefore, backlog may not necessarily be an accurate measure of future sales. Our unit dealer inventory was as follows: We believe that the level of our dealer inventory at the end of Fiscal 2016 is reasonable given the improved retail demand and current sales order backlog of our product. A key metric used to evaluate dealer inventory levels is the retail turn rate (12 month retail volume/current deliver inventory). At the end of Fiscal 2016 the retail turn rate was over 2.0 turns for motorized product. Historically, turn rates above 2.0 have been an indication of a balanced dealer inventory and thus we believe motorized dealer inventory levels are in alignment with retail demand. In order to generate sales growth, we have expanded our towables distribution base and thus dealer inventory was higher throughout the year than in previous years. On a year over year basis, towables dealer inventory increased by 29.6% which is reasonable in anticipation of continued sales growth which increased 57.3% in the last year on a unit basis. ERP In the second quarter of Fiscal 2015, the Board of Directors approved the strategic initiative of implementing an ERP system to replace our legacy business applications. The new ERP platform will provide better support for our changing business needs and plans for future growth. Our initial cost estimates have grown for additional needs of the business such as the acquisition of the Junction City, Oregon plant and the opportunity to integrate the ERP system with additional manufacturing systems. The project includes software, external implementation assistance and increased internal staffing directly related to this initiative. We anticipate that approximately 40% of the cost will be immediately expensed over the life of the project and 60% will be capitalized. The following table illustrates the cumulative project costs: (1) During Fiscal 2016, we placed in service $6.3 million of our cumulative investment. These capitalized investments are amortized over a 10-year life. Impact of Inflation Materials cost is the primary component in the cost of our products. Historically, the impact of inflation on our operations has not been significantly detrimental, as we have historically been able to adjust our prices to reflect the inflationary impact on the cost of manufacturing our products. While we have historically been able to pass on these increased costs, in the event we are unable to continue to do so due to market conditions, future increases in manufacturing costs could have a material adverse effect on our results of operations. Results of Operations Fiscal 2016 Compared to Fiscal 2015 The following is an analysis of changes in key items included in the statements of operations for the fiscal year ended August 27, 2016 compared to the fiscal year ended August 29, 2015: (1) Percentages may not add due to rounding differences. Motorhome unit deliveries and ASP, net of discounts, consisted of the following: (1) Percentages and dollars may not add due to rounding differences. Towables unit deliveries and ASP, net of discounts, consisted of the following: (1) Percentages and dollars may not add due to rounding differences. Net revenues consisted of the following: (1) Includes motorhome units, parts, and services (2) Includes towable units and parts The increase in motorhome net revenues of $2.1 million or 0.2% was primarily attributed to a 2.3% increase in unit deliveries in Fiscal 2016. • Unit growth was 25.0% for Class B and and 10.3% for Class C products which was partially offset by a decline in demand for higher priced Class A products. • Total motorhome ASP decreased 1.8% in Fiscal 2016 compared to Fiscal 2015 because Fiscal 2016 saw more deliveries of lower priced Class B and C unit sales. ASPs did increase in every motorhome product category during Fiscal 2016, however, this did not offset the decline due to the lower mix of Class A products in Fiscal 2016. Towables revenues were $89.4 million in Fiscal 2016 compared to revenues of $71.7 million in Fiscal 2015. ASP decreased 21.1% due to the mix of new products while towable unit deliveries increased by 57.3%. Other manufactured products decreased by $21.1 million due to our exit of the aluminum extrusion and bus operations. Both of these operations provided very low margins while consuming production labor in Forest City, Iowa. Labor has been redirected to higher margin motorhome production. Cost of goods sold was $862.6 million, or 88.4% of net revenues for Fiscal 2016 compared to $871.6 million, or 89.3% of net revenues for Fiscal 2015 due to the following: • Total variable costs (materials, direct labor, variable overhead, delivery expense and warranty), as a percent of net revenues, decreased to 83.2% from 84.0% primarily due to improved material sourcing, product shift to a more favorable mix, and cessation of bus and virtually all aluminum extrusion operations which were less profitable than the remainder of our RV products. • Fixed overhead (manufacturing support labor, depreciation and facility costs) and research and development-related costs were comparable at 5.2% of net revenues compared to 5.2% in the prior year. • All factors considered, gross profit increased from 10.7% to 11.6% of net revenues. Selling expenses were 2.0% of net revenues in both Fiscal 2016 and Fiscal 2015, respectively. Selling expenses are largely variable and remained proportional to revenues in Fiscal 2016. General and administrative expenses were 2.8% and 2.6% of net revenues in Fiscal 2016 and Fiscal 2015, respectively. General and administrative expenses increased $1.2 million, or 4.8%, in Fiscal 2016. This increase was due primarily to an increase in ERP related expenses of $3.4 million, bonuses earned of $2.8 million, and $700,000 in compensation, benefits and recruiting costs associated with strengthening the management team, and $355,000 in transaction related costs pertaining to the pending acquisition of Grand Design. These increases were partially offset by favorable legal settlements of $3.4 million in Fiscal 2016, a reduction in professional fees of $1.6 million incurred in Fiscal 2015 related to the strategic sourcing program, and a reduction of $1.0 million in costs associated with the former CEO retirement agreement in Fiscal 2015. During Fiscal 2015, we also recorded an asset impairment on our corporate plane of $462,000. Non-operating income increased $342,000, in Fiscal 2016, primarily due to higher proceeds from COLI policies than we received in Fiscal 2015. The effective tax rate for Fiscal 2016 was 31.3% compared to 30.8% in Fiscal 2015. The increase in the effective tax rate is due to a reduction in the amount of the Domestic Production Activities Deduction applicable in Fiscal 2016 as compared to Fiscal 2015. The reduction in this deduction was partially offset by other tax credits. See Note 10. Net income and diluted income per share were $45.5 million and $1.68 per share, respectively, for Fiscal 2016. In Fiscal 2015, net income was $41.2 million and diluted income per share was $1.52. Fiscal 2015 Compared to Fiscal 2014 The following is an analysis of changes in key items included in the statements of operations for the fiscal year ended August 29, 2015 compared to the fiscal year ended August 30, 2014: (1) Percentages may not add due to rounding differences. Motorhome unit deliveries and ASP, net of discounts, consisted of the following: (1) An additional 343 motorhomes were delivered in Fiscal 2014 but not included in wholesale deliveries as presented in the table above as the units were subject to repurchase option. (2) Percentages and dollars may not add due to rounding differences. Towables deliveries and ASP, net of discounts, consisted of the following: (1) Percentages and dollars may not add due to rounding differences. Net revenues consisted of the following: (1) Includes motorhome units, parts and service (2) Includes towable units and parts The increase in motorhome net revenues of $19.4 million or 2.3% was primarily attributed to a 3.9% increase in unit deliveries in Fiscal 2015. • The increase in incremental revenues was due to the change in our sales agreement with Apollo, a US RV rental company. During Fiscal 2015 we delivered 535 rental units to Apollo. During Fiscal 2014 we delivered 520 rental units to Apollo, of which only 177 were reported as motorhome sales; the remaining 343 were recorded as operating leases due to a repurchase obligation in Fiscal 2014. • Total motorhome ASP decreased 1.7% in Fiscal 2015 compared to Fiscal 2014 due to a mix shift from higher priced Class A products in Fiscal 2014 to lower priced Class B and C unit sales in Fiscal 2015. ASPs increased in every product category during Fiscal 2015. Towables revenues were $71.7 million in Fiscal 2015 compared to revenues of $58.1 million in Fiscal 2014. ASP increased 15.9% and towable unit deliveries increased by 6.4%. Cost of goods sold was $871.6 million, or 89.3% of net revenues for Fiscal 2015 compared to $841.2 million, or 89.0% of net revenues for Fiscal 2014 due to the following: • Total variable costs (materials, direct labor, variable overhead, delivery expense and warranty), as a percent of net revenues, increased to 84.0% from 83.7% primarily due to increased warranty expense and related warranty recall reserve and higher workers compensation expense. • Fixed overhead (manufacturing support labor, depreciation and facility costs) and research and development-related costs decreased to 5.2% of net revenues compared to 5.3%. • All factors considered, gross profit decreased from 11.0% to 10.7% of net revenues. Selling expenses increased to 2.0% from 1.9% of net revenues in Fiscal 2015 and Fiscal 2014, respectively. The increase was due primarily to increased advertising and compensation expenses in Fiscal 2015. General and administrative expenses were 2.6% and 2.4% of net revenues in Fiscal 2015 and Fiscal 2014, respectively. General and administrative expenses increased $3.4 million, or 15.2%, in Fiscal 2015. This increase was due primarily to expenses of $3.9 million in ERP and strategic sourcing projects, $1.6 million in increased legal and product liability expenses, $1.0 million in costs associated with the former CEO retirement agreement and was partially offset by $3.3 million in reduced management compensation expenses. During Fiscal 2015, we recorded an asset impairment on our corporate plane of $462,000. In Fiscal 2014, we sold a warehouse facility in Forest City, Iowa, resulting in a gain of $629,000. Non-operating income decreased $653,000 or 85.0%, in Fiscal 2015, primarily due to lower proceeds from COLI policies than we received in Fiscal 2014. The effective tax rate for Fiscal 2015 was 30.8% compared to 30.3% in Fiscal 2014. With a lower level of pre-tax book income being recorded in Fiscal 2015 compared to Fiscal 2014 the effective tax rate from operations was lower. However, this was offset by the lower level of tax planning initiatives recorded in Fiscal 2015 compared to Fiscal 2014 causing a slight increase in the effective tax rate year over year. Legislation for various applicable tax credits expired on December 31, 2014; therefore, similar to our Fiscal 2014, our projected benefits for these tax credits are limited to four months of our fiscal year. Net income and diluted income per share were $41.2 million and $1.52 per share, respectively, for Fiscal 2015. In Fiscal 2014, net income was $45.1 million and diluted income per share was $1.64. Analysis of Financial Condition, Liquidity and Resources Cash and cash equivalents increased $15.3 million during Fiscal 2016 and totaled $85.6 million as of August 27, 2016. The significant liquidity events that occurred during Fiscal 2016 were: • Generated net income of $45.5 million • Capital expenditures of $24.6 million • Dividend payments of $10.9 million • Stock repurchases of $3.1 million As described in Note 6, through our Amended Credit Agreement with Wells Fargo Capital Finance, we have the ability to borrow $35.0 million through a revolving credit facility based on our eligible inventory and certain receivables. In addition, the Amended Credit Agreement also includes a framework to expand the size of the facility up to $50.0 million, based on mutually agreeable terms at the time of the expansion. The Credit Agreement's term is through May 28, 2019. We are in compliance with all material terms in the Amended Credit Agreement and have no outstanding borrowings as of the date of this report. We filed a Registration Statement on Form S-3, which was declared effective by the SEC on April 25, 2016. Subject to market conditions, we have the ability to offer and sell up to $35.0 million of our common stock in one or more offerings pursuant to the Registration Statement. The Registration Statement will be available for use for three years from its effective date. We currently have no plans to offer and sell the common stock registered under this Registration Statement; however, it does provide another potential source of liquidity to raise capital if we need it, in addition to the alternatives already in place. Working capital at August 27, 2016 and August 29, 2015 was $187.6 million and $184.6 million, respectively, an increase of $3.0 million. We currently expect cash on hand, funds generated from operations and the availability under a credit facility to be sufficient to cover both short-term and long-term operating requirements. We anticipate capital expenditures in Fiscal 2017 of approximately $17 - $20 million. In addition to the normal $8 - $10 million of maintenance spend for our current facilities, we will continue to invest in our ERP system and finalize incremental capacity expansion investments in Oregon. On October 12, 2016, the Board of Directors approved a quarterly cash dividend of $0.10 per share of common stock, payable on November 23, 2016 to shareholders of record at the close of business on November 9, 2016. We expect this cash outflow to be approximately $2.7 million for each quarter that this dividend is paid. Operating Activities Cash provided by operating activities was $52.7 million for the fiscal year ended August 27, 2016 compared to $45.2 million for the fiscal year ended August 29, 2015, and $23.2 million for the fiscal year ended August 30, 2014. The combination of net income of $45.5 million in Fiscal 2016 and changes in non-cash charges (e.g., depreciation, LIFO, stock-based compensation, deferred income taxes) provided $52.7 million of operating cash compared to $49.0 million in Fiscal 2015 and $50.6 million in Fiscal 2014. In Fiscal 2016, Fiscal 2015, and Fiscal 2014, changes in assets and liabilities (primarily a decrease in receivables in Fiscal 2016, an increase in receivables in Fiscal 2015 and inventory increases in Fiscal 2014) used $0.1 million, $3.8 million, and $27.4 million, respectively, of operating cash. Investing Activities Cash used in investing activities of $23.4 million in Fiscal 2016 was due primarily to capital spending of $24.6 million. In Fiscal 2015, cash used in investing activities of $16.5 million was primarily due to capital spending of $16.6 million. During Fiscal 2014, cash used in investing activities of $5.4 million was primarily due to capital spending of $10.5 million partially offset by proceeds from the sale of property of $2.4 million and ARS redemptions of $2.4 million. Financing Activities Cash used in financing activities of $14.0 million in Fiscal 2016 was primarily due to $10.9 million for the payments of dividends and $3.1 million in repurchases of our stock. Cash used in financing for the fiscal year ended August 29, 2015 was primarily due to $9.8 million for the payments of dividends and $6.5 million in repurchases of our stock. In addition, in Fiscal 2015 we borrowed and repaid $22.0 million in our line of credit. Cash used in financing for the fiscal year ended August 30, 2014 was $24.3 million primarily for repurchases of our stock. In connection with our agreement to acquire Grand Design we executed a customary debt commitment letter with JPMorgan Chase Bank, N.A. (“JPMorgan”) pursuant to which, subject to customary exceptions and conditions, JPMorgan has committed to provide a seven-year $300 million secured term loan B facility, and a five-year $125 million asset-based revolving credit facility (collectively the “Credit Facilities”). We intend to use the proceeds from the term loan and a portion of the revolving credit facility together with $60 million in cash and $105 million of common stock to complete the acquisition of Grand Design. The remainder of the revolving credit facility will be used to fund our working capital needs. The Credit Facilities are expected to be secured by all or substantially all of our assets, and will replace our current credit facility with Wells Fargo Bank, N.A. Contractual Obligations and Commercial Commitments Our principal contractual obligations and commercial commitments as of August 27, 2016 were as follows: (1) See Note 8. (2) See Note 9. (3) We are not able to reasonably estimate in which future periods these amounts will ultimately be settled. Critical Accounting Policies Our financial statements are prepared in accordance with GAAP. In connection with the preparation of our financial statements, we are required to make assumptions and estimates about future events and apply judgments that affect the reported amounts of assets, liabilities, revenue, expenses and the related disclosures. We base our assumptions, estimates and judgments on historical experience, current trends and other factors that we believe to be relevant at the time our financial statements are prepared. On a regular basis, we review the accounting policies, assumptions, estimates and judgments to ensure that our financial statements are presented fairly and in accordance with GAAP. However, because future events and their effects cannot be determined with certainty, actual results could differ from our assumptions and estimates and such differences could be material. Our significant accounting policies are discussed in Note 1. We believe that the following accounting estimates and policies are the most critical to aid in fully understanding and evaluating our reported financial results and they require our most difficult, subjective or complex judgments, resulting from the need to make estimates about the effect of matters that are inherently uncertain. We have reviewed these critical accounting estimates and related disclosures with the Audit Committee of our Board of Directors. Revenue Recognition Generally, revenues for our RVs are recorded and title passes when the following conditions are met: • an order for a product has been received from a dealer • written or verbal approval for payment has been received from the dealer's floorplan financing institution (if applicable) • an independent transportation company has accepted responsibility for the product as agent for the dealer; and • the product is removed from the Company's property for delivery to the dealer. Our shipping terms are FOB shipping point. Products are not sold on consignment, dealers do not have the right to return products, and dealers are typically responsible for interest costs to floor plan lenders. Repurchase Commitments It is customary practice for manufacturers in the RV industry to enter into repurchase agreements with financing institutions that provide financing to their dealers. Our repurchase agreements generally provide that, in the event of a default by a dealer in its obligation to these lenders, we will repurchase vehicles sold to the dealer that have not been resold to retail customers. The terms of these agreements, which can last up to 18 months, provide that our liability will be the lesser of remaining principal owed by the dealer or dealer invoice less periodic reductions based on the time since the date of the original invoice. Our liability cannot exceed 100% of the dealer invoice. In certain instances, we also repurchase inventory from our dealers due to state law or regulatory requirements that govern voluntary or involuntary relationship terminations. Based on these repurchase agreements, we establish an associated loss reserve which is disclosed separately in the consolidated balance sheets. Repurchased sales are not recorded as a revenue transaction, but the net difference between the original repurchase price and the resale price are recorded against the loss reserve, which is a deduction from gross revenue. Our loss reserve for repurchase commitments contains uncertainties because the calculation requires management to make assumptions and apply judgment regarding a number of factors. There are two significant assumptions associated with establishing our loss reserve for repurchase commitments: (1) the percentage of dealer inventory that we will be required to repurchase as a result of defaults by the dealer, and (2) the loss that will be incurred, if any, when repurchased inventory is resold. These key assumptions are affected by a number of factors, such as macro-market conditions, current retail demand for our product, age of product in dealer inventory, physical condition of the product, location of the dealer, and the financing source. To the extent that dealers are increasing or decreasing their inventories, our overall exposure under repurchase agreements is likewise impacted. The percentage of dealer inventory we estimate we will repurchase and the associated estimated loss is based on historical information, current trends and an analysis of dealer inventory aging for all dealers with inventory subject to this obligation. In periods where there is increasing retail demand for our product at our dealerships, the lower end of our estimated range of assumptions will be more appropriate and in periods of decreasing retail demand, the opposite will be true. Repurchase risk is affected by the credit worthiness of our dealer network and if we are obligated to repurchase a substantially larger number of RVs in the future, this would increase our costs and could have a material adverse effect on our results of operations, financial condition, and cash flows. Warranty We provide our motorhome customers a comprehensive 12-month/15,000-mile warranty on our Class A, B, and C motorhomes and a 3-year/36,000-mile warranty on Class A and C sidewalls and floors. We provide a comprehensive 12-month warranty on all towable products. Estimated costs related to product warranty are accrued at the time of sale and are based upon past warranty claims and unit sales history. Accruals are adjusted as needed to reflect actual costs incurred as information becomes available. A significant increase in dealership labor rates, the cost of parts or the frequency of claims could have a material adverse impact on our operating results for the period or periods in which such claims or additional costs materialize. In addition to the costs associated with the contractual warranty coverage provided on our products, we also occasionally incur costs as a result of additional service actions not covered by our warranties, including product recalls and customer satisfaction actions. Although we estimate and reserve for the cost of these service actions, there can be no assurance that expense levels will remain at current levels or such reserves will continue to be adequate. A significant increase in dealership labor rates, the cost of parts or the frequency of claims could have a material adverse impact on our operating results for the period or periods in which such claims or additional costs materialize. A hypothetical change of a 10% increase or decrease in our significant warranty commitment assumptions as of August 27, 2016 would have affected net income by approximately $624,000. Further discussion of our warranty costs and associated accruals is included in Note 7. Income Taxes We account for income taxes in accordance with ASC 740, Income Taxes. In preparing our financial statements, we are required to estimate our income taxes in each of the jurisdictions in which we operate. Significant judgment is required in determining our provision for income taxes, our deferred tax assets and liabilities and any valuation allowance recorded against our deferred tax assets. We will continue to assess the likelihood that our deferred tax assets will be realizable at each reporting period and will be adjusted accordingly, which could materially impact our financial position and results of operations. As of August 27, 2016, we have determined that our deferred tax assets are realizable, and therefore, no valuation allowance has been recorded. New Accounting Pronouncements See Note 1 for a summary of new accounting pronouncements which are incorporated by reference herein.

<s>[INST] Executive Overview Industry Outlook Company Outlook Results of Operations Analysis of Financial Condition, Liquidity and Capital Resources Contractual Obligations and Commercial Commitments Critical Accounting Policies New Accounting Pronouncements Our MD&A should be read in conjunction with the Financial Statements and related Notes included in Item 8, Financial Statements and Supplementary Data, of this Annual Report on Form 10K. Executive Overview Winnebago Industries, Inc. is a leading US manufacturer of RVs with a proud history of manufacturing RV products for more than 55 years. We currently produce a large majority of our motorhomes in vertically integrated manufacturing facilities in Iowa and we produce all of our travel trailer and fifth wheel trailers in Indiana. We are in the process of expanding some motorhome manufacturing to Junction City, Oregon. We distribute our products primarily through independent dealers throughout the US and Canada, who then retail the products to the end consumer. We recently announced our entry into a Securities Purchase Agreement pursuant to which we intend to acquire Grand Design, a fastgrowing towables manufacturer in Middlebury, Indiana for approximately $500 million. Grand Design manufactures travel trailers and fifth wheel products. With this acquisition, we expect to have a broader and more balanced portfolio of motorized and towable products and intend to capitalize on the opportunities across the RV market and to drive improved profitability and longterm value for shareholders. Our retail unit market share, as reported by Stat Surveys based on state records, is illustrated below. Note that this data is subject to adjustment and is continuously updated. Highlights of Fiscal 2016: Consolidated revenues, gross profit, and operating income were comparable for Fiscal 2016 as compared to Fiscal 2015. Quarterly results for the past two fiscal years are illustrated as follows: Operational and financial performance: Our motorized wholesale deliveries increased by approximately 2.3% in Fiscal 2016 as compared to Fiscal 2015. Strong demand for our Class B and Class C products was partially offset by weaker demand in Class A products. We anticipate continued strong demand in the Class B and C categories. Our Towables operation generated operating income of $4.6 million in Fiscal 2016 compared to operating income of $2.6 million in Fiscal 2015. Towable net revenue experienced growth of approximately 25%, this was a significant driver in the 77% increase in operating income. Net revenue growth was enhanced in part by the increase in our dealer network. The growth in operating income was also aided by the operating leverage within the business model and a reduction in our raw material costs. Total revenue declined modestly in 2016 due mainly to other manufactured products revenues which decreased by $21.1 million. This was primarily due to our exit of the aluminum extrusion and bus businesses. Both of these operations provided very low margins. Although total revenues did decline, gross profit and operating income increased in part due to the exit of these low margin operations as well as operating improvement in motorized and towable operations. The continued strong financial performance of our business has allowed us to make substantial investments in Fiscal 2016 including the implementation of an ERP system and purchase of our Junction City, Oregon plant. Industry Outlook Key reported statistics for the North American RV industry are as follows: Wholesale unit shipments: RV product delivered to the dealers, which is reported monthly by RVIA Retail unit registrations: consumer purchases of RVs from dealers, which is reported by Stat Surveys We track RV Industry conditions using these key statistics to monitor trends and evaluate and understand our performance relative to the overall industry. The rolling twelve months shipment and retail information for 2016 and 2015, as noted below, illustrates that the RV industry continues to grow at the wholesale and retail level. We believe retail demand is the key driver to continued growth in the industry. (1) Towable: Fifth wheel and travel trailer products ( [/INST] Positive. </s>

WINNEBAGO INDUSTRIES INC

2017-10-20

2017-08-26

Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations Management's Discussion and Analysis of Financial Condition and Results of Operations (MD&A) is intended to provide a reader of our financial statements with a narrative from the perspective of our management on our financial condition, results of operations, liquidity and certain other factors that may affect our future results. Our MD&A is presented in six sections: • Overview • Results of Operations • Analysis of Financial Condition, Liquidity and Capital Resources • Contractual Obligations and Commercial Commitments • Critical Accounting Policies • New Accounting Pronouncements Our MD&A should be read in conjunction with the Financial Statements and related Notes included in Item 8, Financial Statements and Supplementary Data, of this Annual Report on Form 10-K. Overview Winnebago Industries, Inc. is a leading US manufacturer of RVs with a proud history of manufacturing RV products for 59 years. We currently produce a large majority of our motorhomes in vertically integrated manufacturing facilities in Iowa and we produce all of our travel trailer and fifth wheel trailers in Indiana. We are in the process of expanding some motorhome manufacturing to Junction City, Oregon. We distribute our products primarily through independent dealers throughout the US and Canada, who then retail the products to the end consumer. Significant Transaction On November 8, 2016, we closed on the acquisition of all the issued and outstanding capital stock of towable RV manufacturer Grand Design for an aggregate purchase price of $520.5 million. This acquisition was funded from our cash on hand, $353.0 million from asset-based revolving and term loan credit facilities, as well as stock consideration as is more fully described in Note 2 and Note 8 to the Consolidated Financial Statements. We purchased Grand Design to significantly expand our existing towable RV product offerings and dealer base and acquire additional talent in the RV industry. In the first quarter of Fiscal 2017, we revised our reporting segments. Previously, we had one reporting segment which included all RV products and services. With the acquisition of Grand Design in the first quarter, we expanded the number of reporting segments to two: (1) Motorized products and services and (2) Towable products and services. The Motorized segment includes all products that include a motorized chassis as well as other related manufactured products. The Towable segment includes all products which are not motorized and are generally towed by another vehicle. Prior year segment information has been restated to conform to the current reporting segment presentation. Industry Trends Key reported statistics for the North American RV industry are as follows: • Wholesale unit shipments: RV product delivered to the dealers, which is reported monthly by RVIA • Retail unit registrations: consumer purchases of RVs from dealers, which is reported by Stat Surveys We track RV Industry conditions using these key statistics to monitor trends and evaluate and understand our performance relative to the overall industry. The rolling twelve months shipment and retail information for 2017 and 2016, as noted below, illustrates that the RV industry continues to grow at the wholesale and retail level. We believe retail demand is the key driver to continued growth in the industry. (1) Towable: Fifth wheel and travel trailer products (2) Motorized: Class A, B and C products The most recent towable and motorized RVIA wholesale shipment forecasts for calendar year 2017 and 2018 as noted in the table below illustrates continued projected growth of the industry. The outlook for future growth in RV sales is based on continued modest gains in job and disposable income prospects as well as low inflation, and takes into account the impact of slowly rising interest rates, a strong U.S. dollar and continued weakness in energy production and prices. (1) Prepared by Dr. Richard Curtin of the University of Michigan Consumer Survey Research Center for RVIA and reported in the Roadsigns RV Fall 2017 Industry Forecast Issue. Market Share Our retail unit market share, as reported by Stat Surveys based on state records, is illustrated below. Note that this data is subject to adjustment and is continuously updated. (1) Includes retail unit market share for Grand Design since acquisition on November 8, 2016. Towable market share using data for the full rolling 12 month period is 5.7%. Facility Expansion During Fiscal 2017, the Board of Directors approved two large facility expansion projects in the fast growing Towable segment. The Grand Design expansion project began in Fiscal 2017 and is expected to increase units produced midway through Fiscal 2018. The facility expansion in the Winnebago-branded Towable division is expected to increase units produced by the end of Fiscal 2018. ERP System In the second quarter of Fiscal 2015, the Board of Directors approved the strategic initiative of implementing an ERP system to replace our legacy business applications. The new ERP platform will provide better support for our changing business needs and plans for future growth. Our initial cost estimates have grown for additional needs of the business such as the acquisition of the Junction City, Oregon plant and the opportunity to integrate the ERP system with additional manufacturing systems. The project includes software, external implementation assistance and increased internal staffing directly related to this initiative. We anticipate that approximately 40% of the cost will be expensed in the period incurred and 60% will be capitalized and depreciated over its useful life. The following table illustrates the cumulative project costs: In May of 2017, the Board approved continued investment in the ERP system and a change in implementation partner. The project is proceeding and the benefits are expected to be realized over the next several years. Total project costs are expected to be approximately $38 million. Consolidated Results of Operations Fiscal 2017 Compared to Fiscal 2016 The following is an analysis of changes in key items included in the statements of operations for the fiscal year ended August 26, 2017 compared to the fiscal year ended August 27, 2016: (1) Percentages may not add due to rounding differences. Consolidated net revenues increased $571.9 million or 58.6% in Fiscal 2017 over Fiscal 2016. This was primarily due to the acquisition of Grand Design which added revenues of $559.7 million in Fiscal 2017. Winnebago-branded towables products increased $36.1 million in Fiscal 2017. Growth in Towables revenues was partially offset by a $23.9 million decrease in Motorized revenues caused mainly by the consumer trend towards smaller RVs with a lower ASP. In addition, we exited the aluminum extrusion operation in Fiscal 2016 which caused a reduction of $6.1 million in Fiscal 2017 net revenue. Cost of goods sold was $1.3 billion, or 85.6% of net revenues for Fiscal 2017 compared to $862.6 million, or 88.4% of net revenues for Fiscal 2016 due to the following: • Total variable costs (materials, direct labor, variable overhead, delivery expense and warranty), as a percent of net revenues, decreased to 81.2% from 83.2% primarily due to a higher proportion of Towable revenue as the Towable segment operates at a higher gross profit rate. Also, improvement in Towables material efficiency and purchasing synergies reduced costs as a percent of net revenue. Finally, improvement in the Towable segment margin was partially offset by margin pressure in the Motorized segment due in part to the ramp up of the Junction City production facility. • Fixed overhead (manufacturing support labor, depreciation and facility costs) and engineering-related costs were lower at 4.5% of net revenues compared to 5.2% in the prior year due mainly to a higher proportion of Towable revenue which operates at a lower fixed cost per unit. • All factors considered, gross profit increased from 11.6% to 14.4% of net revenues. Selling expenses were 2.3% of net revenues in Fiscal 2017 and 2.0% in Fiscal 2016. Selling expenses are largely variable and proportional to revenues. The increase in the rate of selling expense in Fiscal 2017 is due to the higher mix of Towable volume which operates at a higher commission rate. General and administrative expenses were 3.6% and 3.4% of net revenues in Fiscal 2017 and Fiscal 2016, respectively. General and administrative expenses increased $22.1 million, or 66.7%, in Fiscal 2017. This increase was due to the addition of $13.9 million of general and administrative expenses related to the acquired Grand Design operation, an increase of $6.2 million in transaction related expenses, and the addition of $24.7 million in intangible amortization. In addition, Fiscal 2016 results of operations were impacted by $3.4 million in favorable legal settlements. These increases were partially offset in Fiscal 2017 by the increased benefit of $18.7 million associated with the termination of the postretirement health care plan and reduced ERP implementation expenses. Non-operating income decreased $0.1 million, in Fiscal 2017, primarily due to lower proceeds from COLI policies than we received in Fiscal 2016. The effective tax rate for Fiscal 2017 was 34.3% compared to 31.3% in Fiscal 2016. The increase in the effective tax rate is primarily due to the increased income attributable to the Grand Design acquisition without a proportionate increase in tax credits and other favorable permanent items that provide a benefit to the tax rate. See Note 12. Net income and diluted income per share were $71.3 million and $2.32 per share, respectively, for Fiscal 2017. In Fiscal 2016, net income was $45.5 million and diluted income per share was $1.68. Non-GAAP Reconciliation We have provided the following non-GAAP financial measures, which are not calculated or presented in accordance with GAAP, as information supplemental and in addition to the financial measures presented in accordance with GAAP. Such non-GAAP financial measures should not be considered superior to, as a substitute for, or as an alternative to, and should be considered in conjunction with, the GAAP financial measures presented herein. The non-GAAP financial measures presented below may differ from similar measures used by other companies. The following table reconciles net income to consolidated Adjusted EBITDA for Fiscal 2017 and Fiscal 2016. We have provided non-GAAP performance measures of EBITDA and Adjusted EBITDA as a comparable measure to illustrate items impacting current results which are not expected to impact future performance. EBITDA is defined as net income before interest expense, provision for income taxes, and depreciation and amortization expense. We believe EBITDA and Adjusted EBITDA provide meaningful supplemental information about our operating performance because each measure excludes amounts that we do not consider part of our core operating results when assessing our performance. Examples of items excluded from Adjusted EBITDA include the postretirement health care benefit resulting from plan amendments and termination over the past several years, favorable legal settlements including our Fiscal 2016 Australia trademark settlement, and transaction costs related to our acquisition of Grand Design RV. Management uses these non-GAAP financial measures (a) to evaluate our historical and prospective financial performance and trends as well as our performance relative to competitors and peers that publish similar measures; (b) to measure operational profitability on a consistent basis; (c) in presentations to the members of our board of directors to enable our board of directors to have the same measurement basis of operating performance as is used by management in their assessments of performance and in forecasting and budgeting for our company; and, (d) to evaluate potential acquisitions. We believe these non-GAAP financial measures are frequently used by securities analysts, investors and other interested parties to evaluate companies in our industry. Segment Results of Operations The following is an analysis of key changes in our Motorized segment for Fiscal 2017 compared to Fiscal 2016. (1) Percentages may not add due to rounding differences. (2) We include in our backlog all accepted orders from dealers to be shipped within the next six months. Orders in backlog can be cancelled or postponed at the option of the dealer at any time without penalty and, therefore, backlog may not necessarily be an accurate measure of future sales. Motorized net revenues decreased $23.9 million or 2.7% in Fiscal 2017 as compared to Fiscal 2016. This was primarily due to a decline in Class C sales, a lower ASP on the mix of units sold and the $6.1 million reduction in sales to aluminum extrusion customers as we have ceased those operations. Motorized unit deliveries decreased by 0.5% in Fiscal 2017, most notably in our Class C products. The unit growth we have generated has been in our Class A and Class B products. The shift in product mix has been towards Class B products, which have a lower ASP. Though total Motorized unit deliveries were down for the year, we have seen an increase in the backlog volumes by 13.5% in the fourth quarter of Fiscal 2017. Motorized segment Adjusted EBITDA decreased $13.4 million or 23.4%. This reduction was due to lower revenues as described above, lower pricing, and additional costs associated with the investment in and shift of production to our Junction City, Oregon production facility. Higher personnel expenses were partially offset by a decrease in ERP expenses. The following is an analysis of key changes in our Towable segment for Fiscal 2017 compared to Fiscal 2016. (1) Percentages may not add due to rounding differences. (2) We include in our backlog all accepted orders from dealers to be shipped within the next six months. Orders in backlog can be cancelled or postponed at the option of the dealer at any time without penalty and, therefore, backlog may not necessarily be an accurate measure of future sales. Towable net revenues increased $595.8 million or 666.3% in Fiscal 2017 as compared to Fiscal 2016. This was primarily due to the acquisition of Grand Design which added revenues of $559.7 million in Fiscal 2017. In addition, Winnebago-branded towable revenues rose $36.1 million or 40.4% in Fiscal 2017. Towable unit deliveries grew by 435.2% in Fiscal 2017 primarily due to the acquisition of Grand Design and also due to Towables growth in excess of recent industry trends. With the addition of Grand Design in November, our towables market share increased from 1.1% to 5.1% when comparing shipments during the twelve month trailing periods ended August 2016 and August 2017. The addition of Grand Design has also resulted in a higher ASP due to a greater proportion of higher-priced fifth wheel units sold in Fiscal 2017 compared to Fiscal 2016. Other strong increases in backlog and the dealer inventory turn ratio have been influenced by the acquisition of Grand Design. Towable segment Adjusted EBITDA excludes the costs associated with the acquisition and as such increased $90.0 million. This increase illustrates the favorable impact of Grand Design and the organic growth of Winnebago-branded towables. We achieved strong results in our Towables segment, where shipments grew much faster than the industry as a result of greater penetration of our new products and further expansion of our distribution base and higher gross profit on new products. In addition to the growth in Towables, profitability has increased due to material efficiencies and the leverage of higher volume on the fixed cost components of our business. Fiscal 2016 Compared to Fiscal 2015 The following is an analysis of changes in key items included in the statements of operations for the fiscal year ended August 27, 2016 compared to the fiscal year ended August 29, 2015: (1) Percentages may not add due to rounding differences. Consolidated net revenues decreased $1.3 million or 0.1% in Fiscal 2016 over Fiscal 2015. Other manufactured products decreased by $21.1 million primarily due to our exit of the aluminum extrusion and bus operations. This was partially offset by an increase of motorhome net revenues of $2.1 million and an increase in Towable revenues of $17.7 million due to increases in unit deliveries. Cost of goods sold was $862.6 million, or 88.4% of net revenues for Fiscal 2016 compared to $871.6 million, or 89.3% of net revenues for Fiscal 2015 due to the following: • Total variable costs (materials, direct labor, variable overhead, delivery expense and warranty), as a percent of net revenues, decreased to 83.2% from 84.0% primarily due to improved material sourcing, product shift to a more favorable mix, and cessation of bus and virtually all aluminum extrusion operations which were less profitable than the remainder of our RV products. • Fixed overhead (manufacturing support labor, depreciation and facility costs) and engineering-related costs were comparable at 5.2% of net revenues compared to 5.2% in the prior year. • All factors considered, gross profit increased from 10.7% to 11.6% of net revenues. Selling expenses were 2.0% of net revenues in both Fiscal 2016 and Fiscal 2015, respectively. Selling expenses are largely variable and remained proportional to revenues in Fiscal 2016. General and administrative expenses were 2.8% and 2.6% of net revenues in Fiscal 2016 and Fiscal 2015, respectively. General and administrative expenses increased $1.2 million, or 4.8%, in Fiscal 2016. This increase was due primarily to an increase in ERP related expenses of $3.4 million, bonuses earned of $2.8 million, $0.7 million in compensation, benefits and recruiting costs, and $0.3 million in transaction related costs pertaining to the acquisition of Grand Design. These increases were partially offset by favorable legal settlements of $3.4 million in Fiscal 2016, a reduction in professional fees of $1.6 million incurred in Fiscal 2015 related to the strategic sourcing program, and a reduction of $1.0 million in costs associated with the former CEO retirement agreement in Fiscal 2015. During Fiscal 2015, we recorded an asset impairment on our corporate plane of $0.5 million. Non-operating income increased $0.3 million, in Fiscal 2016, primarily due to higher proceeds from COLI policies than we received in Fiscal 2015. The effective tax rate for Fiscal 2016 was 31.3% compared to 30.8% in Fiscal 2015. The increase in the effective tax rate is due to a reduction in the amount of the Domestic Production Activities Deduction applicable in Fiscal 2016 as compared to Fiscal 2015. The reduction in this deduction was partially offset by other tax credits. See Note 12. Net income and diluted income per share were $45.5 million and $1.68 per share, respectively, for Fiscal 2016. In Fiscal 2015, net income was $41.2 million and diluted income per share was $1.52. Non-GAAP Reconciliation We have provided the following non-GAAP financial measures, which are not calculated or presented in accordance with GAAP, as information supplemental and in addition to the financial measures presented in accordance with GAAP. Such non-GAAP financial measures should not be considered superior to, as a substitute for, or as an alternative to, and should be considered in conjunction with, the GAAP financial measures presented herein. The non-GAAP financial measures presented below may differ from similar measures used by other companies. The following table reconciles net income to consolidated Adjusted EBITDA for Fiscal 2016 and Fiscal 2015 We have provided non-GAAP performance measures of EBITDA and Adjusted EBITDA as a comparable measure to illustrate items impacting current results which are not expected to impact future performance. EBITDA is defined as net income before interest expense, provision for income taxes, and depreciation and amortization expense. We believe EBITDA and Adjusted EBITDA provide meaningful supplemental information about our operating performance because each measure excludes amounts that we do not consider part of our core operating results when assessing our performance. Examples of items excluded from Adjusted EBITDA include the postretirement health care benefit resulting from plan amendments over the past several years, favorable legal settlements including our Fiscal 2016 Australia trademark settlement, and transaction costs related to our acquisition of Grand Design RV. Management uses these non-GAAP financial measures (a) to evaluate our historical and prospective financial performance and trends as well as our performance relative to competitors and peers that publish similar measures; (b) to measure operational profitability on a consistent basis; (c) in presentations to the members of our board of directors to enable our board of directors to have the same measurement basis of operating performance as is used by management in their assessments of performance and in forecasting and budgeting for our company; and, (d) to evaluate potential acquisitions. We believe these non-GAAP financial measures are frequently used by securities analysts, investors and other interested parties to evaluate companies in our industry. Segment Results of Operations The following is an analysis of key changes in our Motorized segment for Fiscal 2016 compared to Fiscal 2015. (1) Percentages may not add due to rounding differences. (2) We include in our backlog all accepted orders from dealers to be shipped within the next six months. Orders in backlog can be cancelled or postponed at the option of the dealer at any time without penalty and, therefore, backlog may not necessarily be an accurate measure of future sales. Motorized net revenues decreased $19.0 million or 2.1% in Fiscal 2016 as compared to Fiscal 2015. This was attributed to a $21.1 million decrease in our other manufactured parts revenue primarily due to our exit of the aluminum extrusion and bus operations. Offsetting this reduction was modest growth in motorhome revenues primarily attributed to a 2.3% increase in unit deliveries in Fiscal 2016. • Unit growth was 25.0% for Class B and 10.3% for Class C products which was partially offset by a decline in demand for higher priced Class A products. • Total motorhome ASP decreased 1.8% in Fiscal 2016 compared to Fiscal 2015 because Fiscal 2016 saw more deliveries of lower priced Class B and C unit sales. ASPs did increase in every motorhome product category during Fiscal 2016, however, this did not offset the decline due to the lower mix of Class A products in Fiscal 2016. Motorized segment Adjusted EBITDA increased $0.3 million or 0.5%. The increase is due to higher gross margin in Fiscal 2016 due to exit of the aluminum extrusion and bus operations. Both of these operations provided very low margins while consuming production labor in Forest City, Iowa. Labor has been redirected to higher margin motorhome production. The margin improvement was offset by an increase in general and administrative expenses of $0.7 million including several offsetting effects. Cost increases due to ERP related expenses of $3.4 million, bonuses earned of $2.6 million, $0.7 million in compensation, and benefits and recruiting costs were partially offset by a reduction in professional fees of $1.6 million related to strategic sourcing program initiated in Fiscal 2015, and a reduction of $1.0 million in costs associated with the former CEO retirement agreement in Fiscal 2015. The following is an analysis of key changes in our Towable segment for Fiscal 2016 compared to Fiscal 2015. (1) Percentages may not add due to rounding differences. (2) We include in our backlog all accepted orders from dealers to be shipped within the next six months. Orders in backlog can be cancelled or postponed at the option of the dealer at any time without penalty and, therefore, backlog may not necessarily be an accurate measure of future sales. Towable net revenues increased $17.7 million or 24.7% in Fiscal 2016 compared to Fiscal 2015. This was primarily due to an increase in unit deliveries by 57.3% offset by a decrease in ASP of 8.5% due to the mix of new products. Towable segment Adjusted EBITDA increased $2.2 million or 79.0%. This increase is due to organic revenue growth and higher gross profit on new products. This is partially offset by increases in general and administrative expenses of $0.5 million, including bonuses earned of $0.2 million. In order to generate sales growth, we have expanded our towables distribution base and thus dealer inventory was higher throughout the year than in previous years. On a year over year basis, towables dealer inventory increased by 29.6% which is reasonable in anticipation of continued sales growth which increased 57.3% in Fiscal 2016 compared to Fiscal 2015 on a unit basis. Analysis of Financial Condition, Liquidity and Resources Cash and cash equivalents decreased $49.6 million during Fiscal 2017 and totaled $35.9 million as of August 26, 2017. The significant liquidity events that occurred during Fiscal 2017 were: • Generated net income of $71.3 million • Capital expenditures of $14.0 million • Dividend payments of $12.7 million • Contribution of $39.5 million in cash toward the $520.5 million acquisition of Grand Design • Established a new Credit Agreement in conjunction with the acquisition of Grand Design as detailed below • Repayment of $82.4 million of debt As described in Note 8, our new Credit Agreement consists of a $300 million term loan and a $125 million asset-based revolving credit (ABL) agreement (collectively, the Credit Agreement) with JPMorgan Chase. We filed a Registration Statement on Form S-3, which was declared effective by the SEC on April 25, 2016. Subject to market conditions, this registration provides for the ability to offer and sell up to $35.0 million of our common stock in one or more offerings pursuant to the Registration Statement. The Registration Statement will be available for use for three years from its effective date. We currently have no plans to offer and sell the common stock registered under this Registration Statement; however, it does provide another potential source of liquidity to raise capital if we need it, in addition to the alternatives already in place. Working capital at August 26, 2017 and August 27, 2016 was $147.0 million and $187.6 million, respectively, a decrease of $40.6 million. We currently expect cash on hand, funds generated from operations and the borrowing available under our Credit Agreement to be sufficient to cover both short-term and long-term operating requirements. We anticipate capital expenditures in Fiscal 2018 of approximately $35.0 - $40.0 million. We will continue to invest in our current motorhome facilities and our ERP system as well as expand our Towable facilities. On October 18, 2017, the Board of Directors approved a quarterly cash dividend of $0.10 per share of common stock, payable on November 29, 2017 to shareholders of record at the close of business on November 15, 2017. We expect this cash outflow to be approximately $3.2 million. Operating Activities Cash provided by operating activities was $97.1 million for the fiscal year ended August 26, 2017 compared to $52.7 million for the fiscal year ended August 27, 2016, and $45.2 million for the fiscal year ended August 29, 2015. The combination of net income of $71.3 million in Fiscal 2017 and changes in non-cash charges (e.g., amortization of debt issuance costs, depreciation, LIFO, stock-based compensation, deferred income taxes, postretirement benefits) provided $93.3 million of operating cash compared to $52.7 million in Fiscal 2016 and $49.0 million in Fiscal 2015. In Fiscal 2017 and Fiscal 2016, changes in assets and liabilities provided $3.8 million and $0.1 million, respectively, and used $3.8 million of operating cash in Fiscal 2015. Investing Activities Cash used in investing activities of $405.4 million in Fiscal 2017 was due primarily to the acquisition of Grand Design for which we paid cash of $392.5 million, net of cash acquired, in addition to issuing Winnebago stock with a value of $124.1 million at closing. Capital expenditures were due primarily to spending on property and equipment of $14.0 million. In Fiscal 2016, cash used in investing activities of $23.4 million was primarily due to capital spending of $24.6 million. In Fiscal 2015, cash used in investing activities of $16.5 million was primarily due to capital spending of $16.6 million. Financing Activities Cash provided by financing activities of $258.6 million in Fiscal 2017 was primarily due to cash proceeds from the new Credit Agreement of $366.4 million, partially offset by payments on the new Credit Agreement of $82.4 million, $12.7 million for the payment of dividends, and $11.0 million for the payment of debt issuance costs. The repayments on the new Credit Agreement included the full repayment of amounts borrowed under the ABL to finance the acquisition of Grand Design in the first quarter. Cash used in financing for the fiscal year ended August 27, 2016 was primarily due to $10.9 million for the payments of dividends and $3.1 million in repurchases of our stock. Cash used in financing for the fiscal year ended August 29, 2015 was $16.2 million primarily due to the payments of dividends and repurchases of our stock. In addition, in Fiscal 2015 we borrowed and repaid $22.0 million on our line of credit. Share Repurchase Authorization On October 18, 2017, the Company's Board of Directors authorized a share repurchase program in the amount of $70 million, which is approximately 5% of the Company's market capitalization as of October 18, 2017. Contractual Obligations and Commercial Commitments Our principal contractual obligations and commercial commitments as of August 26, 2017 were as follows: (1) As of August 26, 2017, we did not have any borrowings under our $125.0 million revolving Credit Agreement other than a $210,000 outstanding letter of credit. Borrowings and repayments are expected to fluctuate over the term. (2) As of August 26, 2017, we had $284.0 million outstanding under our Term Loan agreement that matures on November 8, 2023. The contractual principal payments are included in the previous table. Additional principal payments are potentially due annually on a formula based on excess cash flow and the leverage ratio at that time as defined in the Credit Agreement. No amounts for this contingency are included in the above table. (3) All of the debt under the Term Loan is at a variable rate and the interest in the table assumes the variable rate of 5.7% at August 26, 2017 is constant through the maturity dates of the debt and the principal payments on the term debt are made as scheduled. The variable rate is subject to change. For example, a 1.0% change in Term Loan rates for Fiscal 2018, would change the interest expense by $2.8 million. Additionally, included in interest payments due by period is a 0.4% commitment fee on the ABL for unused borrowings, which are assumed to be at $125.0 million. In addition to interest assumed to be paid, non-cash amortization of debt issuance costs will also be recorded within interest expense on the Consolidated Statements of Income and Comprehensive Income in future periods. (4) We have an interest rate swap agreement with a notional amount of $200.0 million as of August 26, 2017 that decreases to $170.0 million on December 8, 2017, to $120.0 million in December 10, 2018, and $60.0 million on December 9, 2019 and expires on December 8, 2020. We pay a fixed rate at 1.82%, and receive a floating rate that was 1.2% at August 26, 2017. In the previous table, we have assumed the floating rate will be constant through the expiration of the interest rate swap when calculating the net swap payments. The variable rate is subject to change. For example, a 1.0% increase in the floating rate for Fiscal 2018, would decrease the payments noted in footnote(3) by $2.0 million. (5) See Note 9. (6) See Note 10. (7) We are not able to reasonably estimate in which future periods these amounts will ultimately be settled. Critical Accounting Policies Our financial statements are prepared in accordance with GAAP. In connection with the preparation of our financial statements, we are required to make assumptions and estimates about future events and apply judgments that affect the reported amounts of assets, liabilities, revenue, expenses and the related disclosures. We base our assumptions, estimates and judgments on historical experience, current trends and other factors that we believe to be relevant at the time our financial statements are prepared. On a regular basis, we review the accounting policies, assumptions, estimates and judgments to ensure that our financial statements are presented fairly and in accordance with GAAP. However, because future events and their effects cannot be determined with certainty, actual results could differ from our assumptions and estimates and such differences could be material. Our significant accounting policies are discussed in Note 1. We believe that the following accounting estimates and policies are the most critical to aid in fully understanding and evaluating our reported financial results and they require our most difficult, subjective or complex judgments, resulting from the need to make estimates about the effect of matters that are inherently uncertain. We have reviewed these critical accounting estimates and related disclosures with the Audit Committee of our Board of Directors. Accounting for Business Combinations We account for business combinations under the acquisition method of accounting. This method requires the recording of acquired assets, including separately identifiable intangible assets, and assumed liabilities at their acquisition date fair values. The excess of the purchase price over the fair value of assets acquired and liabilities assumed is recorded as goodwill. Determining the fair value of assets acquired and liabilities assumed requires management’s judgment and often involves the use of significant estimates and assumptions, including assumptions with respect to future cash inflows and outflows, discount rates, royalty rates and asset lives, among other items. We used the income approach to value certain intangible assets. Under the income approach, an intangible asset’s fair value is equal to the present value of future economic benefits to be derived from ownership of the asset. We used the income approach known as the relief from royalty method to value the fair value of the trade name. The relief from royalty method is based on the hypothetical royalty stream that would be received if we were to license the trade name and was based on expected revenues. The fair value of the dealer network was estimated using an income approach known as the cost to recreate/cost savings method. This method uses the replacement of the asset as an indicator of the fair value of the asset. The determination of the fair value of other assets acquired and liabilities assumed involves assessing factors such as the expected future cash flows associated with individual assets and liabilities and appropriate discount rates at the date of the acquisition. See Note 2 to the consolidated financial statements for further information. Goodwill and Indefinite-lived Intangible Assets We test goodwill and identifiable intangible assets with indefinite lives for impairment at least annually in the fourth quarter. Impairment testing for goodwill is done at a reporting unit level and all goodwill is assigned to a reporting unit. Our reporting units are the same as our operating segments and one level below the reporting segment level. We test goodwill for impairment by either performing a qualitative evaluation or a quantitative test, whereby a goodwill impairment loss will be measured as the excess of a reporting unit's carrying amount over its fair value. The qualitative evaluation is an assessment of factors, including reporting unit specific operating results and cost factors, as well as industry, market and general economic conditions, to determine whether it is more likely than not that the fair value of a reporting unit is less than its carrying amount, including goodwill. We may elect to bypass this qualitative assessment and perform the quantitative test in accordance with ASC 350, Intangibles - Goodwill and Other. Fair values under the quantitative test are estimated using a combination of discounted projected future earnings or cash flow methods and multiples of earnings in estimating fair value. The estimate of the reporting unit’s fair value is determined by weighting a discounted cash flow model and a market-related model using current industry information that involve significant unobservable inputs (Level 3 inputs). In determining the estimated future cash flow, we consider and apply certain estimates and judgments, including current and projected future levels of income based on management’s plans, business trends, prospects and market and economic conditions and market-participant considerations. These assumptions require significant judgment and actual results may differ from assumed and estimated amounts. If we fail the quantitative assessment of goodwill impairment ("quantitative assessment"), pursuant to our adoption of FASB ASU No. 2017-04 in fiscal 2017, we would be required to recognize an impairment loss equal to the amount that a reporting unit's carrying value exceeded its fair value. Substantially all of the goodwill resulting from the Grand Design acquisition on November 8, 2016 is in the Towable products and services segment and reporting unit. As of August 26, 2017, we had an indefinite-lived intangible asset for trade name of $148.0 million from the Grand Design acquisition. Annually in the fourth quarter, or if conditions indicate an interim review is necessary, we assess qualitative factors to determine if it is more likely than not that the fair value of an indefinite-lived intangible asset is less than its carrying amount. If we perform a quantitative test, projections regarding estimated discounted future cash flows and other factors are made to determine if impairment has occurred. These assumptions require significant judgment and actual results may differ from assumed and estimated amounts. If we conclude that there has been impairment, we will write down the carrying value of the asset to its fair value. During the fourth quarter of Fiscal 2017, we completed our annual impairment tests. We elected not to rely on the qualitative assessment as of the testing date and rather performed the quantitative analysis. We elected to perform this analysis because Grand Design was acquired during Fiscal 2017 and the analysis resulted in setting foundational assumptions to be used to evaluate goodwill and the indefinite-lived trade name asset in the future. The result of the test was that the fair value far exceeded the carrying value of the reporting unit and no impairment was present. Long-Lived Assets Long-lived assets, which include property, plant and equipment, and definite-lived intangible assets, primarily the dealer network, are assessed for impairment whenever events or changes in circumstances indicate the carrying amount of the asset may not be recoverable. The impairment testing involves comparing the carrying amount of the asset to the forecasted undiscounted future cash flows generated by that asset. These assumptions require significant judgment and actual results may differ from assumed and estimated amounts. In the event the carrying amount of the asset exceeds the undiscounted future cash flows generated by that asset and the carrying amount is not considered recoverable, an impairment exists. An impairment loss is measured as the excess of the asset’s carrying amount over its fair value and is recognized in the statement of income in the period that the impairment occurs. The dealer network is amortized over its estimated useful life of 12 years. The reasonableness of the useful lives of this asset and other long-lived assets is regularly evaluated. Revenue Recognition Generally, revenues for our RVs are recorded and title passes when the following conditions are met: • an order for a product has been received from a dealer • written or verbal approval for payment has been received from the dealer's floorplan financing institution (if applicable) • an independent transportation company has accepted responsibility for the product as agent for the dealer; and • the product is removed from the Company's property for delivery to the dealer by the agent. Our shipping terms are FOB shipping point. Products are not sold on consignment, dealers do not have the right to return products, and dealers are typically responsible for interest costs to floor plan lenders. Repurchase Commitments It is customary practice for manufacturers in the RV industry to enter into repurchase agreements with financing institutions that provide financing to their dealers. Our repurchase agreements generally provide that, in the event of a default by a dealer in its obligation to these lenders, we will repurchase vehicles sold to the dealer that have not been resold to retail customers. The terms of these agreements, which can last up to 18 months, provide that our liability will be the lesser of remaining principal owed by the dealer or dealer invoice less periodic reductions based on the time since the date of the original invoice. Our liability cannot exceed 100% of the dealer invoice. In certain instances, we also repurchase inventory from our dealers due to state law or regulatory requirements that govern voluntary or involuntary relationship terminations. Based on these repurchase agreements, we establish an associated loss reserve which is included in "Accrued expenses - Other" on the consolidated balance sheets. Repurchased sales are not recorded as a revenue transaction, but the net difference between the original repurchase price and the resale price are recorded against the loss reserve, which is a deduction from gross revenue. Our loss reserve for repurchase commitments contains uncertainties because the calculation requires management to make assumptions and apply judgment regarding a number of factors. We base our reserve primarily on our historical loss experience rate per dollar of dealer inventory. The historical experience has been affected by a number of factors which are evaluated, such as macro-market conditions, current retail demand for our product, location of the dealer, and the financing source. The percentage of dealer inventory we estimate we will repurchase and the associated estimated loss is based on historical loss experience and current trends and economic conditions. Repurchase risk is affected by the credit worthiness of our dealer network and if we are obligated to repurchase a substantially larger number of RVs in the future, this would increase our costs and could have a material adverse effect on our results of operations, financial condition, and cash flows. Warranty We provide our motorhome customers a comprehensive 12-month/15,000-mile warranty on our Class A, B, and C motorhomes and a 3-year/36,000-mile warranty on Class A and C sidewalls and floors. We provide a comprehensive 12-month warranty on all towable products. Estimated costs related to product warranty are accrued at the time of sale and are based upon past warranty claims and unit sales history. Accruals are adjusted as needed to reflect actual costs incurred as information becomes available. In addition to the costs associated with the contractual warranty coverage provided on our products, we also occasionally incur costs as a result of additional service actions not covered by our warranties, including product recalls and customer satisfaction actions. Although we estimate and reserve for the cost of these service actions, there can be no assurance that expense levels will remain at current levels or such reserves will continue to be adequate. A significant increase in dealership labor rates, the cost of parts or the frequency of claims could have a material adverse impact on our operating results for the period or periods in which such claims or additional costs materialize. A hypothetical change of a 10% increase or decrease in our significant warranty commitment assumptions as of August 26, 2017 would have affected net income by approximately $1.9 million. Further discussion of our warranty costs and associated accruals is included in Note 7. Income Taxes We account for income taxes in accordance with ASC 740, Income Taxes. In preparing our financial statements, we are required to estimate our income taxes in each of the jurisdictions in which we operate. Significant judgment is required in determining our provision for income taxes, our deferred tax assets and liabilities and any valuation allowance recorded against our deferred tax assets. We will continue to assess the likelihood that our deferred tax assets will be realizable at each reporting period. Any adjustment to the deferred tax assets could materially impact our financial position and results of operations. As of August 26, 2017, we have determined that our deferred tax assets are realizable and, therefore, no valuation allowance has been recorded. New Accounting Pronouncements See Note 1 for a summary of new accounting pronouncements which are incorporated by reference herein.

<s>[INST] Overview Results of Operations Analysis of Financial Condition, Liquidity and Capital Resources Contractual Obligations and Commercial Commitments Critical Accounting Policies New Accounting Pronouncements Our MD&A should be read in conjunction with the Financial Statements and related Notes included in Item 8, Financial Statements and Supplementary Data, of this Annual Report on Form 10K. Overview Winnebago Industries, Inc. is a leading US manufacturer of RVs with a proud history of manufacturing RV products for 59 years. We currently produce a large majority of our motorhomes in vertically integrated manufacturing facilities in Iowa and we produce all of our travel trailer and fifth wheel trailers in Indiana. We are in the process of expanding some motorhome manufacturing to Junction City, Oregon. We distribute our products primarily through independent dealers throughout the US and Canada, who then retail the products to the end consumer. Significant Transaction On November 8, 2016, we closed on the acquisition of all the issued and outstanding capital stock of towable RV manufacturer Grand Design for an aggregate purchase price of $520.5 million. This acquisition was funded from our cash on hand, $353.0 million from assetbased revolving and term loan credit facilities, as well as stock consideration as is more fully described in Note 2 and Note 8 to the Consolidated Financial Statements. We purchased Grand Design to significantly expand our existing towable RV product offerings and dealer base and acquire additional talent in the RV industry. In the first quarter of Fiscal 2017, we revised our reporting segments. Previously, we had one reporting segment which included all RV products and services. With the acquisition of Grand Design in the first quarter, we expanded the number of reporting segments to two: (1) Motorized products and services and (2) Towable products and services. The Motorized segment includes all products that include a motorized chassis as well as other related manufactured products. The Towable segment includes all products which are not motorized and are generally towed by another vehicle. Prior year segment information has been restated to conform to the current reporting segment presentation. Industry Trends Key reported statistics for the North American RV industry are as follows: Wholesale unit shipments: RV product delivered to the dealers, which is reported monthly by RVIA Retail unit registrations: consumer purchases of RVs from dealers, which is reported by Stat Surveys We track RV Industry conditions using these key statistics to monitor trends and evaluate and understand our performance relative to the overall industry. The rolling twelve months shipment and retail information for 2017 and 2016, as noted below, illustrates that the RV industry continues to grow at the wholesale and retail level. We believe retail demand is the key driver to continued growth in the industry. (1) Towable: Fifth wheel and travel trailer products (2) Motorized: Class A, B and C products The most recent towable and motorized RVIA wholesale shipment forecasts for calendar year 2017 and 2018 as noted in the table below illustrates continued projected growth of the industry. The outlook for future growth in RV sales is based on continued modest gains in job and disposable income prospects as well as low inflation, and takes into account the impact of slowly rising interest rates, a strong U.S. dollar and continued weakness in energy production and prices. (1) Prepared by Dr. Richard Curtin of the University of Michigan Consumer Survey Research Center for RVIA and reported in the Roadsigns RV Fall 2017 Industry Forecast Issue. Market Share Our retail unit market share, as reported by Stat Surveys based on state records, is illustrated below. Note that this data is subject to adjustment and is continuously updated. (1) Includes retail unit market share for Grand Design since acquisition on November 8, 2016. Towable market share using data for the full rolling 12 month period is 5.7%. Facility Expansion During Fiscal 2017, the Board of Directors approved two large facility expansion projects in the fast [/INST] Positive. </s>

WINNEBAGO INDUSTRIES INC

2018-10-18

2018-08-25

Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations. Management's Discussion and Analysis of Financial Condition and Results of Operations (MD&A) is intended to provide a reader of our financial statements with a narrative from the perspective of our management on our financial condition, results of operations, liquidity, and certain other factors that may affect our future results. Our MD&A is presented in six sections: • Overview • Results of Operations • Analysis of Financial Condition, Liquidity, and Capital Resources • Contractual Obligations and Commercial Commitments • Critical Accounting Estimates • New Accounting Pronouncements Our MD&A should be read in conjunction with the Consolidated Financial Statements and related Notes included in Item 8, Financial Statements and Supplementary Data, of this Annual Report on Form 10-K. Overview Winnebago Industries, Inc. is one of the leading U.S. manufacturers with a diversified portfolio of recreation vehicles ("RV"s) and marine products used primarily in leisure travel and outdoor recreation activities. We produce our motorhomes in manufacturing facilities in Iowa and Oregon; our towable units in Indiana; and our marine products in Florida. We distribute our RV and marine products primarily through independent dealers throughout the U.S. and Canada, who then retail the products to the end consumer. We also distribute our marine products internationally through independent dealers, who then retail the products to the end consumer. Non-GAAP Reconciliation This MD&A includes financial information prepared in accordance with accounting principles generally accepted in the U.S. ("GAAP"), as well as certain adjusted or non-GAAP financial measures such as EBITDA and Adjusted EBITDA. EBITDA is defined as net income before interest expense, provision for income taxes, and depreciation and amortization expense. Adjusted EBITDA is defined as net income before interest expense, provision for income taxes, depreciation and amortization expense, and other adjustments made in order to present comparable results from period to period. These non-GAAP financial measures, which are not calculated or presented in accordance with GAAP, have been provided as information supplemental and in addition to the financial measures presented in accordance with GAAP. Such non-GAAP financial measures should not be considered superior to, as a substitute for, or as an alternative to, and should be considered in conjunction with, the GAAP financial measures presented herein. The non-GAAP financial measures presented may differ from similar measures used by other companies. Refer to the Consolidated Results of Operations-Fiscal 2018 Compared to Fiscal 2017 and the Consolidated Results of Operations-Fiscal 2017 Compared to Fiscal 2016 for a detailed reconciliation of items that impacted EBITDA and Adjusted EBITDA. We have included this non-GAAP performance measure as a comparable measure to illustrate the effect of non-recurring transactions occurring during the year and improve comparability of our results from period to period. We believe Adjusted EBITDA provides meaningful supplemental information about our operating performance because this measure excludes amounts that we do not consider part of our core operating results when assessing our performance. Examples of items excluded from Adjusted EBITDA include the postretirement health care benefit income from terminating the plan and transaction costs related to acquisitions. These types of adjustments are also specified in the definition of certain measures required under the terms of our Credit Agreement. For additional information, see Note 9, Long-Term Debt, of the Notes to Consolidated Financial Statements, included in Item 8, Financial Statements and Supplementary Data, of this Annual Report on Form 10-K. Management uses these non-GAAP financial measures (a) to evaluate our historical and prospective financial performance and trends as well as our performance relative to competitors and peers; (b) to measure operational profitability on a consistent basis; (c) in presentations to the members of our board of directors to enable our board of directors to have the same measurement basis of operating performance as is used by management in its assessments of performance and in forecasting and budgeting for our company; (d) to evaluate potential acquisitions; and (e) to ensure compliance with covenants and restricted activities under the terms of our Credit Agreement. We believe these non-GAAP financial measures are frequently used by securities analysts, investors, and other interested parties to evaluate companies in our industry. Business Combinations On June 4, 2018, we acquired 100% of the ownership interests of Chris-Craft, a privately-owned company based in Sarasota, Florida. Chris-Craft manufactures and sells premium quality boats in the recreational powerboat industry through an established global network of independent authorized dealers. On November 8, 2016, we closed on the acquisition of all the issued and outstanding capital stock of towable RV manufacturer Grand Design RV, LLC ("Grand Design") for an aggregate purchase price of $520.5 million. This acquisition was funded from our cash on hand, $353.0 million from asset-based revolving and term loan credit facilities, as well as stock consideration as is more fully described in Note 2, Business Combinations, of the Notes to Consolidated Financial Statements, included in Item 8, Financial Statements and Supplementary Data, of this Annual Report on Form 10-K. We purchased Grand Design to significantly expand our existing towable RV product offerings and dealer base and acquire additional talent in the RV industry. Reportable Segments Beginning in the fourth quarter of Fiscal 2018, we have five operating segments: 1) Winnebago motorhomes, 2) Winnebago towables, 3) Grand Design towables, 4) Winnebago specialty vehicles, and 5) Chris-Craft marine. We evaluate performance based on each operating segment's Adjusted EBITDA, as defined above, which excludes certain corporate administration expenses and non-operating income and expense. Our two reportable segments include: 1) Motorhome (comprised of products that include a motorized chassis as well as other related manufactured products and services) and 2) Towable (comprised of products which are not motorized and are generally towed by another vehicle as well as other related manufactured products and services), which is an aggregation of the Winnebago towables and Grand Design towables operating segments. The Corporate / All Other category includes the Winnebago specialty vehicles and Chris-Craft marine operating segments as well as expenses related to certain corporate administration expenses for the oversight of the enterprise. These expenses include items such as corporate leadership and administration costs. Previously, these expenses were allocated to each operating segment. Prior year segment information has been reclassified to conform to the current reportable segment presentation. The reclassifications included removing the corporate administration expenses from both the Motorhome and Towable reportable segments and removing Winnebago specialty vehicles from the Motorhome reportable segment, as we begin to dedicate leadership and focus on these operations separately from our Winnebago motorhomes operations. Industry Trends Key reported statistics for the North American RV industry are as follows: • Wholesale unit shipments: RV product delivered to the dealers, which is reported monthly by the Recreation Vehicle Industry Association ("RVIA") • Retail unit registrations: consumer purchases of RVs from dealers, which is reported by Stat Surveys We track RV Industry conditions using these key statistics to monitor trends and evaluate and understand our performance relative to the overall industry. The rolling twelve months shipment and retail information for 2018 and 2017, as noted below, illustrates that the RV industry continues to grow at the wholesale and retail level. We believe retail demand is the key driver to continued growth in the industry. (1) Towable: Fifth wheel and travel trailer products. (2) Motorhome: Class A, B and C products. The most recent RVIA wholesale shipment forecasts for calendar year 2019, as noted in the table below, indicate that industry shipments are most likely expected to decline slightly in 2019. The RV sales outlook is based on anticipated increases in inflation and interest rates and rising costs of production, partially offset by strong job and wage growth. (1) Prepared by Dr. Richard Curtin of the University of Michigan Consumer Survey Research Center for RVIA and reported in the Roadsigns RV Fall 2018 Industry Forecast Issue. Market Share Our retail unit market share, as reported by Stat Surveys based on state records, is illustrated below. Note that this data is subject to adjustment and is continuously updated. (1) Includes retail unit market share for Grand Design since acquisition on November 8, 2016. Facility Expansion During Fiscal 2017, our Board of Directors approved two large facility expansion projects to increase production capacity in the fast growing Towable segment. The Grand Design expansion project consisted of two new production facilities. The first facility was completed in the second quarter of Fiscal 2018, and the second was completed in the third quarter of Fiscal 2018. Both facilities have resulted in an increase in units produced. The facility expansion in the Winnebago towables division is expected to be completed in the first half of Fiscal 2019. Enterprise Resource Planning System In the second quarter of Fiscal 2015, our Board of Directors approved the strategic initiative of implementing an enterprise resource planning ("ERP") system to replace our legacy business applications. The new ERP platform will provide better support for our changing business needs and plans for future growth. Our initial cost estimates have grown for additional needs of the business, such as the opportunity to integrate the ERP system with additional manufacturing systems. The project includes software, external implementation assistance, and increased internal staffing directly related to this initiative. We anticipate that approximately 40% of the cost will be expensed in the period incurred and 60% will be capitalized and depreciated over its useful life. The following table illustrates the cumulative project costs: Consolidated Results of Operations Fiscal 2018 Compared to Fiscal 2017 The following is an analysis of changes in key items included in the statements of operations for the fiscal year ended August 25, 2018 compared to the fiscal year ended August 26, 2017: (1) Percentages may not add due to rounding differences. Consolidated net revenues increased in Fiscal 2018 compared to Fiscal 2017 primarily due to organic volume growth in our Towable segment and acquisition-related growth. Gross profit as a percentage of revenue increased in Fiscal 2018 compared to Fiscal 2017 driven by a favorable mix due to the accelerated growth in the Towable segment. Selling expenses increased in Fiscal 2018 compared to Fiscal 2017 primarily due to volume growth in our Towable segment. Total general and administrative expenses increased in Fiscal 2018 compared to Fiscal 2017 due primarily to the $24.8 million benefit recorded in Fiscal 2017 associated with the termination of the postretirement health care plan, investments in our business, and incentives related to the growth in our business. The increase was partially offset by the reduction of amortization of definite-lived intangible assets, driven by the Grand Design acquisition in Fiscal 2017. Interest expense increased in Fiscal 2018 compared to Fiscal 2017, which was related to our Credit Agreements associated with the acquisition of Grand Design. See Analysis of Financial Condition, Liquidity, and Resources and Note 9, Long-Term Debt, of the Notes to Consolidated Financial Statements, included in Item 8, Financial Statements and Supplementary Data, of this Annual Report on Form 10-K for further information. The overall effective income tax rate for Fiscal 2018 was 28.2% compared to the effective income tax rate of 34.3% for Fiscal 2017. The decrease in the tax rate from Fiscal 2017 to Fiscal 2018 was primarily due to the decrease in the Federal statutory rate as part of the enactment of the Tax Cuts and Jobs Act ("Tax Act") on December 22, 2017. The decrease was partially offset by the required remeasurement of our net deferred tax assets due to the change in the Federal statutory tax rate. Net income and diluted income per share increased in Fiscal 2018 compared to Fiscal 2017 primarily due to the sales increase in the Towable segment, the increased gross profit rate, and the lower effective income tax rate. These increases were partially offset by an increase in the SG&A rate driven primarily by the termination of the postretirement health care plan, which lowered expense in Fiscal 2017. Non-GAAP Reconciliation The following table reconciles net income to consolidated Adjusted EBITDA for Fiscal 2018 and Fiscal 2017. Segment Results of Operations The following is an analysis of key changes in our Motorhome segment for Fiscal 2018 compared to Fiscal 2017. (1) Percentages may not add due to rounding differences. (2) We include in our backlog all accepted orders from dealers to generally be shipped within the next six months. Orders in backlog can be cancelled or postponed at the option of the dealer at any time without penalty and, therefore, backlog may not necessarily be an accurate measure of future sales. Motorhome net revenues increased in Fiscal 2018 as compared to Fiscal 2017 primarily due to an increase in the number of units sold, partially offset by product mix. Motorhome unit deliveries grew slower than recent industry growth in Fiscal 2018 compared to Fiscal 2017. Our overall Motorhome market share moved to 15.7% from 16.4% when comparing shipments during the twelve-month trailing periods ended August 2018 and August 2017 due to a mix change from our Class A-diesel products to our Class B products. Motorhome Adjusted EBITDA decreased in Fiscal 2018 as compared to Fiscal 2017 due to increased material costs and investments in our business, including higher costs and lower productivity associated with a new facility that produces our Class A diesel product line. The following is an analysis of key changes in our Towable segment for Fiscal 2018 compared to Fiscal 2017. (1) Percentages may not add due to rounding differences. (2) We include in our backlog all accepted orders from dealers to generally be shipped within the next six months. Orders in backlog can be cancelled or postponed at the option of the dealer at any time without penalty and, therefore, backlog may not necessarily be an accurate measure of future sales. Towable net revenues increased in Fiscal 2018 as compared to Fiscal 2017 primarily due to organic volume growth as well as the annualization of net revenues related to the Fiscal 2017 acquisition of Grand Design. Towable unit deliveries grew in Fiscal 2018 as compared to Fiscal 2017 primarily due to Towable growth in excess of recent industry trends and due to the acquisition of Grand Design. With the addition of Grand Design in the first quarter of Fiscal 2017, our Towable market share increased to 7.4% from 5.2% when comparing shipments during the twelve-month trailing periods ended August 2018 and August 2017. Towable Adjusted EBITDA increased in Fiscal 2018 as compared to Fiscal 2017 due to the favorable impact of organic growth as well as the annualization of net revenues related to the Fiscal 2017 acquisition of Grand Design. We achieved strong results in our Towable segment, where shipments grew much faster than the industry as a result of greater penetration of our new products and further expansion of our distribution base, as well as higher gross profit from cost savings initiatives and pricing, which more than offset escalating cost inputs. Fiscal 2017 Compared to Fiscal 2016 The following is an analysis of changes in key items included in the statements of operations for the fiscal year ended August 26, 2017 compared to the fiscal year ended August 27, 2016: (1) Percentages may not add due to rounding differences. Consolidated net revenues increased in Fiscal 2017 over Fiscal 2016 primarily due to the acquisition of Grand Design, which added revenues of $559.7 million in Fiscal 2017. Winnebago-branded towables products increased $36.1 million in Fiscal 2017. Growth in Towable revenues was partially offset by a $28.0 million decrease in Motorhome revenues caused mainly by the consumer trend towards smaller RVs with a lower ASP. In addition, we exited the aluminum extrusion operation in Fiscal 2016, which caused a reduction of $6.1 million in Fiscal 2017 net revenue. Cost of goods sold was 85.6% of net revenues for Fiscal 2017 compared to 88.4% of net revenues for Fiscal 2016 due to the following: • Total variable costs (materials, direct labor, variable overhead, delivery expense, and warranty), as a percent of net revenues, decreased to 81.2% from 83.2% primarily due to a higher proportion of Towable revenue as the Towable segment operates at a higher gross profit rate. Also, improvement in Towable segment material efficiency and purchasing synergies reduced costs as a percent of net revenue. Finally, improvement in the Towable segment margin was partially offset by margin pressure in the Motorhome segment due in part to the ramp up of the Junction City, Oregon production facility. • Fixed overhead (manufacturing support labor, depreciation, and facility costs) and engineering-related costs were lower at 4.5% of net revenues compared to 5.2% in the prior year due mainly to a higher proportion of Towable revenue that operates at a lower fixed cost per unit. • All factors considered, gross profit increased from 11.6% to 14.4% of net revenues. Selling expenses were 2.3% and 2.0% of net revenues in Fiscal 2017 and Fiscal 2016, respectively. Selling expenses are largely variable and remained proportional to revenues in Fiscal 2017. General and administrative expenses were 4.0% and 2.8% of net revenues in Fiscal 2017 and Fiscal 2016, respectively. General and administrative expenses increased in Fiscal 2017 due to the addition of $13.9 million of general and administrative expenses related to the acquired Grand Design operation, an increase of $6.6 million in transaction related expenses, and the addition of $24.7 million in intangible amortization. In addition, Fiscal 2016 results of operations were impacted by $3.4 million in favorable legal settlements. These increases were partially offset in Fiscal 2017 by the increased benefit of $18.7 million associated with the termination of the postretirement health care plan and reduced ERP implementation expenses. Non-operating income decreased $0.1 million, in Fiscal 2017, primarily due to lower proceeds from company-owned life insurance ("COLI") policies than we received in Fiscal 2016. The effective tax rate for Fiscal 2017 was 34.3% compared to 31.3% in Fiscal 2016. The increase in the effective tax rate is primarily due to the increased income attributable to the Grand Design acquisition without a proportionate increase in tax credits and other favorable permanent items that provide a benefit to the tax rate. Net income and diluted income per share were $71.3 million and $2.32 per share, respectively, for Fiscal 2017. In Fiscal 2016, net income was $45.5 million and diluted income per share was $1.68. Non-GAAP Reconciliation The following table reconciles net income to consolidated Adjusted EBITDA for Fiscal 2017 and Fiscal 2016 Segment Results of Operations The following is an analysis of key changes in our Motorhome segment for Fiscal 2017 compared to Fiscal 2016. (1) Percentages may not add due to rounding differences. (2) We include in our backlog all accepted orders from dealers to generally be shipped within the next six months. Orders in backlog can be cancelled or postponed at the option of the dealer at any time without penalty and, therefore, backlog may not necessarily be an accurate measure of future sales. Motorhome net revenues decreased 3.2% in Fiscal 2017 as compared to Fiscal 2016. This was primarily due to a decline in Class C sales, a lower ASP on the mix of units sold, and the $6.1 million reduction in sales to aluminum extrusion customers as we have ceased those operations. Motorhome unit deliveries decreased by 0.5% in Fiscal 2017, most notably in our Class C products. The unit growth we have generated has been in our Class A and Class B products. The shift in product mix has been towards Class B products, which have a lower ASP. Though total Motorhome unit deliveries were down for Fiscal 2017, we saw an increase in the backlog volumes by 13.5% as of August 26, 2017 versus the prior period. Motorhome segment Adjusted EBITDA decreased due to lower revenues as described above, lower pricing, and additional costs associated with the investment in and shift of production to our Junction City, Oregon production facility. Higher personnel expenses were partially offset by a decrease in ERP expenses. The following is an analysis of key changes in our Towable segment for Fiscal 2017 compared to Fiscal 2016. (1) Percentages may not add due to rounding differences. (2) We include in our backlog all accepted orders from dealers to generally be shipped within the next six months. Orders in backlog can be cancelled or postponed at the option of the dealer at any time without penalty and, therefore, backlog may not necessarily be an accurate measure of future sales. Towable net revenues increased 666.3% in Fiscal 2017 as compared to Fiscal 2016. This was primarily due to the acquisition of Grand Design, which added revenues of $559.7 million in Fiscal 2017. In addition, Winnebago-branded towable revenues rose $36.1 million or 40.4% in Fiscal 2017. Towable unit deliveries grew by 435.2% in Fiscal 2017 primarily due to the acquisition of Grand Design and also due to Towable segment growth in excess of recent industry trends. With the addition of Grand Design in November 2016, our towables market share increased from 1.1% to 5.1% when comparing shipments during the twelve month trailing periods ended August 2016 and August 2017. The addition of Grand Design has also resulted in a higher ASP due to a greater proportion of higher-priced fifth wheel units sold in Fiscal 2017 compared to Fiscal 2016. Strong increases in backlog and the dealer inventory turn ratio in Fiscal 2017 resulted primarily from the acquisition of Grand Design. Towable segment Adjusted EBITDA excludes the costs associated with the acquisition and as such increased $88.0 million. This increase illustrates the favorable impact of Grand Design and the organic growth of Winnebago-branded towables. We achieved strong results in our Towable segment, where shipments grew much faster than the industry as a result of greater penetration of our new products and further expansion of our distribution base and higher gross profit on new products. In addition to the growth in our Towable segment, profitability has increased due to material efficiencies and the leverage of higher volume on the fixed cost components of our business. Analysis of Financial Condition, Liquidity, and Resources Cash Flows The following table summarizes our cash flows from total operations for Fiscal 2018, 2017, and 2016: Operating Activities Cash provided by operating activities decreased in Fiscal 2018 compared to Fiscal 2017 due to an increase in inventory to support organic growth, partially offset by growth in net income. Cash provided by operating activities increased in Fiscal 2017 compared to Fiscal 2016 due to net income and changes in non-cash charges (e.g., amortization of debt issuance costs, depreciation, LIFO, stock-based compensation, deferred income taxes, postretirement benefits). Investing Activities Cash used in investing activities for Fiscal 2018 consisted primarily of the acquisition of Chris-Craft and capital expenditures related to the capacity expansions taking place in our Towable segment. In Fiscal 2017, cash used in investing activities consisted of the acquisition of Grand Design for which we paid cash of $392.5 million, net of cash acquired, in addition to issuing Winnebago stock with a value of $124.1 million at closing. In Fiscal 2016, cash used in investing activities was primarily due to capital spend. Financing Activities Cash used in financing activities for Fiscal 2018 consisted of payments on the Credit Agreement, dividend payments, and share repurchases; these were partially offset by cash proceeds on the Credit Agreement. Cash provided by financing activities for Fiscal 2017 consisted of cash proceeds from the Credit Agreement, partially offset by payments on the Credit Agreement, payment of debt issuance costs, and dividend payments. Cash used in financing for Fiscal 2016 was primarily due to dividend payments and share repurchases. Debt and Capital As described in Note 9, Long-Term Debt, of the Notes to Consolidated Financial Statements, included in Item 8, Financial Statements and Supplementary Data, of this Annual Report on Form 10-K, effective December 8, 2017, our Credit Agreement consists of a $300.0 million loan agreement ("Term Loan") and a $125.0 million asset-based revolving credit agreement ("ABL") (collectively, the "Credit Agreement") with JPMorgan Chase. The requirement to hedge a portion of the Term Loan floating rate interest exposure was removed from the ABL on December 8, 2017, which provided greater flexibility under the Credit Agreement. The ABL was increased to a $165.0 million revolving credit agreement as of September 21, 2018. We filed a Registration Statement on Form S-3, which was declared effective by the SEC on April 25, 2016. Subject to market conditions, this registration provides for the ability to offer and sell up to $35.0 million of our common stock in one or more offerings pursuant to the Registration Statement. The Registration Statement will be available for use for three years from its effective date. We currently have no plans to offer and sell the common stock registered under this Registration Statement; however, it does provide another potential source of liquidity to raise capital if we need it, in addition to the alternatives already in place. Other Financial Measures Working capital at August 25, 2018 and August 26, 2017 was $167.8 million and $147.0 million, respectively. We currently expect cash on hand, funds generated from operations, and the borrowing available under our Credit Agreement to be sufficient to cover both short-term and long-term operating requirements. Capital Expenditures We anticipate capital expenditures in Fiscal 2019 of approximately $40.0 million to $50.0 million. We will continue to invest in our ERP system as well as expand our towable and marine facilities and make improvements to our motorhome facilities. Share Repurchases and Dividends We repurchase our common stock and pay dividends pursuant to programs approved by our Board of Directors. Our long-term capital allocation strategy is to first fund operations and investments in growth, maintain a debt leverage ratio within our targeted zone, maintain reasonable liquidity, and then return excess cash over time to shareholders through dividends and share repurchases. On December 19, 2007, our Board of Directors authorized the repurchase of outstanding shares of our common stock, depending on market conditions, for an aggregate consideration of up to $60.0 million. On October 18, 2017, our Board of Directors authorized a share repurchase program in the amount of $70.0 million. There is no time restriction on either authorization. During Fiscal 2018, we repurchased 134,803 shares of our common stock at a cost of $5.0 million. An additional 33,560 shares of our common stock at a cost of $1.5 million were repurchased to satisfy tax obligations on employee equity awards as they vested. We continually evaluate if share repurchases reflect a prudent use of our capital and, subject to compliance with our Credit Agreement, we may purchase shares in the future. At August 25, 2018, we have $66.0 million remaining on our board repurchase authorization. On August 15, 2018, our Board of Directors declared a quarterly cash dividend of $0.10 per share, totaling $3.2 million, paid on September 26, 2018 to common stockholders of record at the close of business on September 12, 2018. Contractual Obligations and Commercial Commitments Our principal contractual obligations and commercial commitments as of August 25, 2018 were as follows: (1) As of August 25, 2018, we had $38.5 million in borrowings under our ABL. Borrowings and repayments are expected to fluctuate over the term. (2) As of August 25, 2018, we had $260.0 million outstanding under our Term Loan that matures on November 8, 2023. The contractual principal payments are included in the table. Additional principal payments are potentially due annually on a formula based on excess cash flow and the leverage ratio at that time as defined in the Credit Agreement. No amounts for this contingency are included in the above table. (3) The Term Loan is at a variable rate and the interest in the table assumes the variable rate of 5.8% at August 25, 2018 is constant through the maturity dates of the debt and the principal payments on the term debt are made as scheduled. The variable rate is subject to change. For example, a 1.0% change in Term Loan rates for Fiscal 2018, would change the interest expense by $2.5 million. Additionally, included in interest payments due by period is a 0.25% - 0.375% commitment fee on the ABL for unused borrowings, which are assumed to be at $125.0 million. In addition to interest assumed to be paid, non-cash amortization of debt issuance costs will also be recorded within interest expense on the Consolidated Statements of Income and Comprehensive Income in future periods. (4) We have an interest rate swap agreement with a notional amount of $170.0 million as of August 25, 2018 that decreases to $120.0 million on December 8, 2018, to $60.0 million on December 8, 2019, and expires on December 8, 2020. We pay a fixed rate at 1.82%, and receive a floating rate that was 2.3% at August 25, 2018. In the table, we have assumed the floating rate will be constant through the expiration of the interest rate swap when calculating the net swap payments. The variable rate is subject to change. For example, a 1.0% increase in the floating rate for Fiscal 2018 would decrease the payments noted in footnote 3 by $2.1 million. (5) See Note 10, Employee and Retiree Benefits, of the Notes to Consolidated Financial Statements, included in Item 8, Financial Statements and Supplementary Data, of this Annual Report on Form 10-K. (6) See Note 11, Contingent Liabilities and Commitments, of the Notes to Consolidated Financial Statements, included in Item 8, Financial Statements and Supplementary Data, of this Annual Report on Form 10-K. (7) We are not able to reasonably estimate in which future periods these amounts will ultimately be settled. Critical Accounting Estimates Our consolidated financial statements are prepared in accordance with GAAP. In connection with the preparation of our financial statements, we are required to make assumptions and estimates about future events and apply judgments that affect the reported amounts of assets, liabilities, revenue, expenses, and the related disclosures. We base our assumptions, estimates, and judgments on historical experience, current trends, and other factors believed to be relevant at the time our consolidated financial statements are prepared. Because future events and their effects cannot be determined with certainty, actual results could differ from our assumptions and estimates, and such differences could be material. Our significant accounting policies are discussed in Note 1, Summary of Significant Accounting Policies, of the Notes to Consolidated Financial Statements, included in Item 8, Financial Statements and Supplementary Data, of this Annual Report on Form 10-K. We believe that the following accounting estimates are the most critical to aid in fully understanding and evaluating our reported financial results. These estimates require our most difficult, subjective, or complex judgments because they relate to matters that are inherently uncertain. We have reviewed these critical accounting estimates and related disclosures with the Audit Committee of our Board of Directors. We have not made any material changes during the past three fiscal years, nor do we believe there is a reasonable likelihood of a material future change to the accounting methodologies for the areas described below. Goodwill and Indefinite-lived Intangible Assets We test goodwill and indefinite-lived intangible assets (trade names) for impairment at least annually in the fourth quarter and more frequently if events or circumstances occur that would indicate a reduction in fair value. Our test of impairment begins by either performing a qualitative evaluation or a quantitative test: • Qualitative evaluation - Performed to determine whether it is more likely than not that the carrying value of goodwill or the trade name exceeds the fair value of the asset. During our qualitative assessment, we make significant estimates, assumptions, and judgments, including, but not limited to, the macroeconomic conditions, industry and market conditions, cost factors, overall financial performance of the Company and the reporting units, changes in our share price, and relevant company-specific events. If we determine that it is more likely than not that the carrying value of goodwill exceeds the fair value of goodwill, we perform the quantitative test to determine the amount of the impairment. • Quantitative test - Used to calculate the fair value of goodwill or the trade name. If the carrying value of goodwill or the trade name exceeds the fair value of the asset, the impairment is calculated as the difference between the carrying value and fair value. Our goodwill fair value model uses a blend of the income (discounted future cash flow) and market (guideline public company) approaches, which includes the use of significant unobservable inputs (Level 3 inputs). Our trade name fair value model uses the income (relief-from-royalty) approach, which includes the use of significant unobservable inputs (Level 3 inputs). During these valuations, we make significant estimates, assumptions, and judgments, including, current and projected future levels of income based on management’s plans, business trends, market and economic conditions, and market-participant considerations. Actual results may differ from assumed and estimated amounts. As of August 25, 2018, our goodwill balance includes $244.7 million within our Towable segment and $29.7 million within our Corporate / All Other category, and our indefinite-lived intangible asset balance is $177.3 million. The qualitative test was not performed in the current year. No impairments were recorded in Fiscal 2018, 2017, and 2016. Long-Lived Assets Long-lived assets, which include property, plant, and equipment, and definite-lived intangible assets, primarily the dealer network, are assessed for impairment whenever events or changes in circumstances indicate the carrying amount of the asset may not be recoverable. The impairment testing involves comparing the carrying amount of the asset to the fair value of the asset as determined by calculating the undiscounted future cash flows generated by the asset. During these valuations, we make significant estimates, assumptions, and judgments, including current and projected future levels of income based on management’s plans, business trends, and market and economic conditions. In the event the carrying amount of the asset exceeds the fair value and the carrying amount is not considered recoverable, an impairment exists. An impairment loss is measured as the excess of the asset’s carrying amount over its fair value. In addition, the reasonableness of the useful lives of these assets is regularly evaluated. No impairments were recorded in Fiscal 2018, 2017, and 2016. Repurchase Commitments It is customary practice for manufacturers in our industries to enter into repurchase agreements with financing institutions that provide financing to their dealers. Our repurchase agreements generally provide that, in the event of a default by a dealer in its obligation to these lenders, we will repurchase units sold to the dealer that have not been resold to retail customers. The terms of these agreements, which can last up to 24 months, provide that our liability will be the lesser of remaining principal owed by the dealer or dealer invoice less periodic reductions based on the time since the date of the original invoice. Our liability cannot exceed 100% of the dealer invoice. In certain instances, we also repurchase inventory from our dealers due to state law or regulatory requirements that govern voluntary or involuntary relationship terminations. Based on these repurchase agreements, we establish an associated loss reserve. Our loss reserve for repurchase commitments contains uncertainties because the calculation requires management to make assumptions and apply judgment regarding a number of factors. We base our reserve primarily on our historical loss experience rate per dollar of dealer inventory. The historical experience has been affected by a number of factors which are evaluated, such as macro-market conditions, current retail demand for our product, location of the dealer, and the financing source. The percentage of dealer inventory we estimate we will repurchase and the associated estimated loss is based on historical loss experience and current trends and economic conditions. Repurchase risk is affected by the credit worthiness of our dealer network and if we are obligated to repurchase a substantially larger number of units in the future, this would increase our costs and could have a material adverse effect on our results of operations, financial condition, and cash flows. A hypothetical change of a 10% increase or decrease in our repurchases commitments as of August 25, 2018 would have an immaterial effect on net income. Warranty We provide certain service and warranty on our products. Estimated costs related to product warranty are accrued at the time of sale and are based upon past warranty claims and unit sales history. Estimates are adjusted as needed to reflect actual costs incurred as information becomes available. In addition to the costs associated with the contractual warranty coverage provided on our products, we also occasionally incur costs as a result of additional service actions not covered by our warranties, including product recalls and customer satisfaction actions. Although we estimate and reserve for the cost of these service actions, there can be no assurance that expense levels will remain at current levels or such reserves will continue to be adequate. A significant increase in dealership labor rates, the cost of parts, or the frequency of claims could have a material adverse impact on our operating results for the period or periods in which such claims or additional costs materialize. A hypothetical change of a 10% increase or decrease in our warranty liability as of August 25, 2018 would have affected net income by approximately $2.8 million. Income Taxes We account for income taxes in accordance with Accounting Standards Codification ("ASC") 740, Income Taxes. In preparing our financial statements, we are required to estimate our income taxes in each of the jurisdictions in which we operate. Significant judgment is required in determining our provision for income taxes, our deferred tax assets and liabilities, and any valuation allowance recorded against our deferred tax assets. We will continue to assess the likelihood that our deferred tax assets are properly measured and will be realizable at each reporting period. Any adjustment to the deferred tax assets could materially impact our financial position and results of operations. As of August 25, 2018, we have determined that our deferred tax assets are properly measured and realizable and, therefore, no valuation allowance has been recorded. New Accounting Pronouncements For a summary of new applicable accounting pronouncements, See Note 1, Summary of Significant Accounting Policies, of the Notes to Consolidated Financial Statements, included in Item 8, Financial Statements and Supplementary Data, of this Annual Report on Form 10-K.

<s>[INST] Overview Results of Operations Analysis of Financial Condition, Liquidity, and Capital Resources Contractual Obligations and Commercial Commitments Critical Accounting Estimates New Accounting Pronouncements Our MD&A should be read in conjunction with the Consolidated Financial Statements and related Notes included in Item 8, Financial Statements and Supplementary Data, of this Annual Report on Form 10K. Overview Winnebago Industries, Inc. is one of the leading U.S. manufacturers with a diversified portfolio of recreation vehicles ("RV"s) and marine products used primarily in leisure travel and outdoor recreation activities. We produce our motorhomes in manufacturing facilities in Iowa and Oregon; our towable units in Indiana; and our marine products in Florida. We distribute our RV and marine products primarily through independent dealers throughout the U.S. and Canada, who then retail the products to the end consumer. We also distribute our marine products internationally through independent dealers, who then retail the products to the end consumer. NonGAAP Reconciliation This MD&A includes financial information prepared in accordance with accounting principles generally accepted in the U.S. ("GAAP"), as well as certain adjusted or nonGAAP financial measures such as EBITDA and Adjusted EBITDA. EBITDA is defined as net income before interest expense, provision for income taxes, and depreciation and amortization expense. Adjusted EBITDA is defined as net income before interest expense, provision for income taxes, depreciation and amortization expense, and other adjustments made in order to present comparable results from period to period. These nonGAAP financial measures, which are not calculated or presented in accordance with GAAP, have been provided as information supplemental and in addition to the financial measures presented in accordance with GAAP. Such nonGAAP financial measures should not be considered superior to, as a substitute for, or as an alternative to, and should be considered in conjunction with, the GAAP financial measures presented herein. The nonGAAP financial measures presented may differ from similar measures used by other companies. Refer to the Consolidated Results of OperationsFiscal 2018 Compared to Fiscal 2017 and the Consolidated Results of OperationsFiscal 2017 Compared to Fiscal 2016 for a detailed reconciliation of items that impacted EBITDA and Adjusted EBITDA. We have included this nonGAAP performance measure as a comparable measure to illustrate the effect of nonrecurring transactions occurring during the year and improve comparability of our results from period to period. We believe Adjusted EBITDA provides meaningful supplemental information about our operating performance because this measure excludes amounts that we do not consider part of our core operating results when assessing our performance. Examples of items excluded from Adjusted EBITDA include the postretirement health care benefit income from terminating the plan and transaction costs related to acquisitions. These types of adjustments are also specified in the definition of certain measures required under the terms of our Credit Agreement. For additional information, see Note 9, LongTerm Debt, of the Notes to Consolidated Financial Statements, included in Item 8, Financial Statements and Supplementary Data, of this Annual Report on Form 10K. Management uses these nonGAAP financial measures (a) to evaluate our historical and prospective financial performance and trends as well as our performance relative to competitors and peers; (b) to measure operational profitability on a consistent basis; (c) in presentations to the members of our board of directors to enable our board of directors to have the same measurement basis of operating performance as is used by management in its assessments of performance and in forecasting and budgeting for our company; (d) to evaluate potential acquisitions; and (e) to ensure compliance with covenants and restricted activities under the terms of our Credit Agreement. We believe these nonGAAP financial measures are frequently used by securities analysts, investors, and other interested parties to evaluate companies in our industry. Business Combinations On June 4, 2018, we acquired 100% of the ownership interests of ChrisCraft, a privatelyowned company based in Sarasota [/INST] Negative. </s>

WINNEBAGO INDUSTRIES INC

2019-10-23

2019-08-31

Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations. Management's Discussion and Analysis of Financial Condition and Results of Operations (MD&A) is intended to provide a reader of our financial statements with a narrative from the perspective of our management on our financial condition, results of operations, liquidity, and certain other factors that may affect our future results. Our MD&A is presented in six sections: • Overview • Results of Operations • Analysis of Financial Condition, Liquidity, and Capital Resources • Contractual Obligations and Commercial Commitments • Critical Accounting Estimates • New Accounting Pronouncements Our MD&A should be read in conjunction with the Consolidated Financial Statements and related Notes included in Item 8, Financial Statements and Supplementary Data, of this Annual Report on Form 10-K. Overview Winnebago Industries, Inc. is one of the leading U.S. manufacturers with a diversified portfolio of recreation vehicles ("RV"s) and marine products used primarily in leisure travel and outdoor recreation activities. We produce our Towable units in IN; our Motorhome units in manufacturing facilities in IA; and our marine products in FL. We distribute our RV and marine products primarily through independent dealers throughout the U.S. and Canada, who then retail the products to the end consumer. We also distribute our marine products internationally through independent dealers, who then retail the products to the end consumer. Non-GAAP Reconciliation This MD&A includes financial information prepared in accordance with accounting principles generally accepted in the U.S. ("GAAP"), as well as certain adjusted or non-GAAP financial measures such as EBITDA and Adjusted EBITDA. EBITDA is defined as net income before interest expense, provision for income taxes, and depreciation and amortization expense. Adjusted EBITDA is defined as net income before interest expense, provision for income taxes, depreciation and amortization expense, and other adjustments made in order to present comparable results from period to period. These non-GAAP financial measures, which are not calculated or presented in accordance with GAAP, have been provided as information supplemental and in addition to the financial measures presented in accordance with GAAP. Such non-GAAP financial measures should not be considered superior to, as a substitute for, or as an alternative to, and should be considered in conjunction with, the GAAP financial measures presented herein. The non-GAAP financial measures presented may differ from similar measures used by other companies. Refer to the Results of Operations-Fiscal 2019 Compared to Fiscal 2018 and the Results of Operations-Fiscal 2018 Compared to Fiscal 2017 for a detailed reconciliation of items that impacted EBITDA and Adjusted EBITDA. We have included this non-GAAP performance measure as a comparable measure to illustrate the effect of non-recurring transactions occurring during the year and improve comparability of our results from period to period. We believe Adjusted EBITDA provides meaningful supplemental information about our operating performance because this measure excludes amounts that we do not consider part of our core operating results when assessing our performance. Examples of items excluded from Adjusted EBITDA include acquisition-related costs, restructuring expenses, and non-operating income. Management uses these non-GAAP financial measures (a) to evaluate our historical and prospective financial performance and trends as well as our performance relative to competitors and peers; (b) to measure operational profitability on a consistent basis; (c) in presentations to the members of our board of directors to enable our board of directors to have the same measurement basis of operating performance as is used by management in its assessments of performance and in forecasting and budgeting for our company; (d) to evaluate potential acquisitions; and (e) to ensure compliance with covenants and restricted activities under the terms of our Credit Agreement, as further described in Note 9, Long-Term Debt, of the Notes to Consolidated Financial Statements, included in Item 8, Financial Statements and Supplementary Data, of this Annual Report on Form 10-K. We believe these non-GAAP financial measures are frequently used by securities analysts, investors, and other interested parties to evaluate companies in our industry. Business Combinations On June 4, 2018, we acquired 100% of the ownership interests of Chris-Craft, a privately-owned company based in Sarasota, FL. Chris-Craft manufactures and sells premium quality boats in the recreational powerboat industry through an established global network of independent authorized dealers. On November 8, 2016, we closed on the acquisition of all the issued and outstanding capital stock of towable RV manufacturer Grand Design RV, LLC ("Grand Design") for an aggregate purchase price of $520.5 million. This acquisition was funded from our cash on hand, $353.0 million from asset-based revolving and term loan credit facilities, as well as stock consideration as is more fully described in Note 2, Business Combinations, of the Notes to Consolidated Financial Statements, included in Item 8, Financial Statements and Supplementary Data, of this Annual Report on Form 10-K. We purchased Grand Design to significantly expand our existing towable RV product offerings and dealer base and acquire additional talent in the RV industry. Subsequent to Year-end On September 15, 2019, we entered into a definitive agreement to acquire Newmar Corporation for total consideration of approximately $344 million, based on the closing price of our stock on September 13, 2019. The consideration will consist of approximately $270.0 million in cash and a fixed amount of 2.0 million shares of our stock. Newmar is a leading manufacturer of Class A and Super C motorized recreational vehicles that sells through an established network of independent authorized dealers throughout North America. The Purchase Agreement also provides that we may terminate the Purchase Agreement if our stock price falls below $20.00 per share, in which case we will be subject to a termination fee of $5.0 million. The acquisition is not subject to approval by our shareholders. In connection with the execution of the Purchase Agreement, we executed a commitment letter with Goldman Sachs Bank USA, Bank of Montreal, and BMO Capital Markets Corp. (the “Commitment Letter”). As set forth in the Commitment Letter, (a) we intend to obtain up to $290.0 million in gross cash proceeds from the issuance of senior secured notes (the “Senior Notes”) and (b) if we do not, or are unable to, issue the full amount of the Senior Notes at or prior to the time of the closing of the acquisition, we plan to obtain a senior secured bridge facility in an amount up to $290.0 million minus any gross cash proceeds received by us from the issuance of any Senior Notes or other securities. Reportable Segments We have five operating segments: 1) Grand Design towables, 2) Winnebago towables, 3) Winnebago motorhomes, 4) Chris-Craft marine, and 5) Winnebago specialty vehicles. We evaluate performance based on each operating segment's Adjusted EBITDA, as defined above, which excludes certain corporate administration expenses and non-operating income and expense. Our two reportable segments include: 1) Towable (comprised of products which are not motorized and are generally towed by another vehicle as well as other related manufactured products and services), which is an aggregation of the Winnebago towables and Grand Design towables operating segments, and 2) Motorhome (comprised of products that include a motorized chassis as well as other related manufactured products and services). The Corporate / All Other category includes the Winnebago specialty vehicles and Chris-Craft marine operating segments as well as expenses related to certain corporate administration expenses for the oversight of the enterprise. These expenses include items such as corporate leadership and administration costs. Industry Trends Key reported statistics for the North American RV industry are as follows: • Wholesale unit shipments: RV product delivered to the dealers, which is reported monthly by the Recreation Vehicle Industry Association ("RVIA") • Retail unit registrations: consumer purchases of RVs from dealers, which is reported by Stat Surveys We track RV Industry conditions using these key statistics to monitor trends and evaluate and understand our performance relative to the overall industry. The following is an analysis of changes in these key statistics for the rolling 12 months through August as of 2019 and 2018: (1) Towable: Fifth wheel and travel trailer products. (2) Motorhome: Class A, B and C products. The rolling twelve months shipments for 2019 and 2018 reflect a contraction in shipments as dealers rationalize inventory. The rolling twelve months retail information for 2019 and 2018 illustrates that the RV industry is growing at a slower rate than previous quarters, however ahead of wholesale shipments. We believe retail demand is the key driver to continued growth in the industry. The most recent RVIA wholesale shipment forecasts for calendar year 2020, as noted in the table below, indicate that industry shipments are most likely expected to decline in 2020. The RV sales outlook for 2019 considers the continuation of dealer inventory realignment that has been occurring over the last 9-12 months and gradually increasing interest rates, partially offset by anticipated growth in wages and employment levels. (1) Prepared by Dr. Richard Curtin of the University of Michigan Consumer Survey Research Center for RVIA and reported in the Roadsigns RV Fall 2019 Industry Forecast Issue. Market Share Our retail unit market share, as reported by Stat Surveys based on state records, is illustrated below. Note that this data is subject to adjustment and is continuously updated. (1) Includes retail unit market share for Grand Design since acquisition on November 8, 2016. Facility Expansion Due to the rapid growth in our Towable segment, we have implemented facility expansion projects in our Grand Design towables and Winnebago towables operating segments. The Grand Design towables expansion project consisted of three new production facilities--two were completed in Fiscal 2018 and the remaining is expected to be completed mid-Fiscal 2020. The facility expansion in the Winnebago towables division was completed in the third quarter of Fiscal 2019. Enterprise Resource Planning System In the second quarter of Fiscal 2015, our Board of Directors approved the strategic initiative of implementing an enterprise resource planning ("ERP") system to replace our legacy business applications. The new ERP platform will provide better support for our changing business needs and plans for future growth. Our initial cost estimates have grown for additional needs of the business, such as the opportunity to integrate the ERP system with additional manufacturing systems. The project includes software, external implementation assistance, and increased internal staffing directly related to this initiative. We anticipate that approximately 40% of the cost will be expensed in the period incurred and 60% will be capitalized and depreciated over its useful life. The following table illustrates the cumulative project costs: Restructuring On February 4, 2019, we announced our intent to move our Motorhome diesel production from Junction City, OR to Forest City, IA to enable more effective product development and improve our cost structure. These restructuring activities resulted in pretax charges of $1.9 million in Fiscal 2019. These expenses are included in our Motorhome segment and include employee-related costs and accelerated depreciation for assets that will no longer be used. Employee-related costs were primarily paid in Fiscal 2019. We expect additional expenses of approximately $1.0 million in Fiscal 2020, primarily related to facility closure costs. We expect these expenses to be fully offset by the corresponding savings generated by the project. We currently estimate that upon completion of this restructuring plan in Fiscal 2020, these actions will reduce annual costs by approximately $4.0 million, which is primarily due to lower employee-related costs, lower depreciation expense, and other manufacturing and logistics efficiencies. We achieved a portion of these savings in Fiscal 2019. We expect a portion of these savings will be achieved in Fiscal 2020, and the full annual benefit of these actions is expected in Fiscal 2021. Results of Operations - Fiscal 2019 Compared to Fiscal 2018 Consolidated Performance Summary The following is an analysis of changes in key items included in the statements of operations for the fiscal year ended August 31, 2019 compared to the fiscal year ended August 25, 2018: (1) Percentages may not add due to rounding differences. Net revenues decreased in Fiscal 2019 compared to Fiscal 2018 primarily due to a decrease in our Motorhome segment sales, which is partially offset by an increase in our Towable segment sales and the acquisition of Chris-Craft in the fourth quarter of Fiscal 2018. Gross profit as a percentage of revenue increased in Fiscal 2019 compared to Fiscal 2018 due to a favorable mix and pricing that were partially offset by higher allowances and higher cost inputs. Operating expenses increased in Fiscal 2019 compared to Fiscal 2018 due to the addition of the Chris-Craft business and investments in our business, partially offset by a reduction in variable compensation. Interest expense decreased in Fiscal 2019 compared to Fiscal 2018 due to the unamortized debt issuance costs expensed in Fiscal 2018 related to our voluntary prepayment on our Credit Agreement and our Credit Agreement amendment during the second quarter of Fiscal 2018, which resulted in a decrease to the interest rate spread by 1.0% on the Term Loan and 0.25% on the ABL. Non-operating income increased in Fiscal 2019 compared to Fiscal 2018 due to net proceeds received from company-owned life insurance policies. The effective tax rate decreased to 19.5% in Fiscal 2019 compared to 28.2% in Fiscal 2018 primarily due to the enactment of the Tax Cuts and Jobs Act (the "Tax Act") on December 22, 2017 and $3.6 million in net favorable discrete items, primarily attributable to R&D-related tax credits, realized in the current fiscal year. The reduction related to the enactment of the Tax Act is primarily attributable to the reduction in the Federal statutory tax rate to 21% being applied to the entirety of Fiscal 2019 earnings whereas Fiscal 2018 utilized a blended rate of 25.9%. Net income and diluted income per share increased in Fiscal 2019 compared to Fiscal 2018 primarily due to a lower effective tax rate and increased Towable segment sales, partially offset by a decrease in our Motorhome segment profitability. Non-GAAP Reconciliation The following table reconciles net income to consolidated EBITDA and Adjusted EBITDA for Fiscal 2019 and 2018: (1) Balance excludes depreciation expense classified as restructuring as the balance is already included in the EBITDA calculation. Reportable Segment Performance Summary Towable The following is an analysis of key changes in our Towable segment for Fiscal 2019 and 2018: (1) ASP excludes off-invoice dealer incentives. (2) Percentages may not add due to rounding differences. (3) We include in our backlog all accepted orders from dealers to generally be shipped within the next six months. Orders in backlog can be cancelled or postponed at the option of the dealer at any time without penalty and, therefore, backlog may not necessarily be an accurate measure of future sales. Net revenues increased in Fiscal 2019 compared to Fiscal 2018 due to increased pricing and organic volume growth. ASP increased in Fiscal 2019 compared to Fiscal 2018 due to price increases as well as favorable product mix. Adjusted EBITDA increased in Fiscal 2019 compared to Fiscal 2018 primarily due to sales growth, offset partially by higher incentives to dealers and higher input costs. Unit deliveries increased in Fiscal 2019 to Fiscal 2018 primarily due to volume growth in excess of recent industry trends. Our Towable segment market share increased from 7.4% to 8.8% when comparing retail registrations during the twelve-month trailing periods ended August 2018 and August 2019. Shipments grew faster than the industry as a result of greater penetration of our new products and further expansion of our products on dealer lots. We have seen a decrease in the backlog volumes as of August 31, 2019 compared to August 25, 2018 due to our utilization of additional capacity added during 2018 and a change in our dealer ordering patterns as a result of a more challenging retail environment, partially offset by strong demand for our new products. Motorhome The following is an analysis of key changes in our Motorhome segment for Fiscal 2019 and 2018: (1) ASP excludes off-invoice dealer incentives. (2) Percentages may not add due to rounding differences. (3) We include in our backlog all accepted orders from dealers to generally be shipped within the next six months. Orders in backlog can be cancelled or postponed at the option of the dealer at any time without penalty and, therefore, backlog may not necessarily be an accurate measure of future sales. Net revenues decreased in Fiscal 2019 compared to Fiscal 2018 due to a decrease in the number of units sold, partially offset by increased pricing. ASP increased in Fiscal 2019 compared to Fiscal 2018 due to price increases implemented during the second half of Fiscal 2018. Adjusted EBITDA decreased in Fiscal 2019 compared to Fiscal 2018 due to lower volume and higher input costs, partially offset by increased pricing and favorable mix of business. Unit deliveries decreased in Fiscal 2019 compared to Fiscal 2018 driven by decreases in our Class A and Class C products, partially offset by an increase in our Class B products. We have seen an increase in the volume and dollar value of backlog as of August 31, 2019 compared to August 25, 2018 due to the introduction of new product models. Results of Operations - Fiscal 2018 Compared to Fiscal 2017 Consolidated Performance Summary The following is an analysis of changes in key items included in the statements of operations for the fiscal year ended August 25, 2018 compared to the fiscal year ended August 26, 2017: (1) Percentages may not add due to rounding differences. Consolidated net revenues increased in Fiscal 2018 compared to Fiscal 2017 primarily due to organic volume growth in our Towable segment and acquisition-related growth. Gross profit as a percentage of revenue increased in Fiscal 2018 compared to Fiscal 2017 driven by a favorable mix due to the accelerated growth in the Towable segment. Selling expenses increased in Fiscal 2018 compared to Fiscal 2017 primarily due to volume growth in our Towable segment. Total general and administrative expenses increased in Fiscal 2018 compared to Fiscal 2017 due primarily to the $24.8 million benefit recorded in Fiscal 2017 associated with the termination of the postretirement health care plan, investments in our business, and incentives related to the growth in our business. The increase was partially offset by the reduction of amortization of definite-lived intangible assets, driven by the Grand Design acquisition in Fiscal 2017. Interest expense increased in Fiscal 2018 compared to Fiscal 2017, which was related to our Credit Agreements associated with the acquisition of Grand Design. See Analysis of Financial Condition, Liquidity, and Resources and Note 9, Long-Term Debt, of the Notes to Consolidated Financial Statements, included in Item 8, Financial Statements and Supplementary Data, of this Annual Report on Form 10-K for further information. The overall effective income tax rate for Fiscal 2018 was 28.2% compared to the effective income tax rate of 34.3% for Fiscal 2017. The decrease in the tax rate from Fiscal 2017 to Fiscal 2018 was primarily due to the decrease in the Federal statutory rate as part of the enactment of the Tax Act on December 22, 2017. The decrease was partially offset by the required remeasurement of our net deferred tax assets due to the change in the Federal statutory tax rate. Net income and diluted income per share increased in Fiscal 2018 compared to Fiscal 2017 primarily due to the sales increase in the Towable segment, the increased gross profit rate, and the lower effective income tax rate. These increases were partially offset by an increase in the SG&A rate driven primarily by the termination of the postretirement health care plan, which lowered expense in Fiscal 2017. Non-GAAP Reconciliation The following table reconciles net income to consolidated EBITDA and Adjusted EBITDA for Fiscal 2018 and 2017: Reportable Segment Performance Summary Towable The following is an analysis of key changes in our Towable segment for Fiscal 2018 and 2017: (1) ASP excludes off-invoice dealer incentives. (2) Percentages may not add due to rounding differences. (3) We include in our backlog all accepted orders from dealers to generally be shipped within the next six months. Orders in backlog can be cancelled or postponed at the option of the dealer at any time without penalty and, therefore, backlog may not necessarily be an accurate measure of future sales. Towable net revenues increased in Fiscal 2018 as compared to Fiscal 2017 primarily due to organic volume growth as well as the annualization of net revenues related to the Fiscal 2017 acquisition of Grand Design. Towable unit deliveries grew in Fiscal 2018 as compared to Fiscal 2017 primarily due to Towable growth in excess of recent industry trends and due to the acquisition of Grand Design. With the addition of Grand Design in the first quarter of Fiscal 2017, our Towable market share increased to 7.4% from 5.2% when comparing shipments during the twelve-month trailing periods ended August 2018 and August 2017. Towable Adjusted EBITDA increased in Fiscal 2018 as compared to Fiscal 2017 due to the favorable impact of organic growth as well as the annualization of net revenues related to the Fiscal 2017 acquisition of Grand Design. We achieved strong results in our Towable segment, where shipments grew much faster than the industry as a result of greater penetration of our new products and further expansion of our distribution base, as well as higher gross profit from cost savings initiatives and pricing, which more than offset escalating cost inputs. Motorhome The following is an analysis of key changes in our Motorhome segment for Fiscal 2018 and 2017: (1) ASP excludes off-invoice dealer incentives. (2) Percentages may not add due to rounding differences. (3) We include in our backlog all accepted orders from dealers to generally be shipped within the next six months. Orders in backlog can be cancelled or postponed at the option of the dealer at any time without penalty and, therefore, backlog may not necessarily be an accurate measure of future sales. Motorhome net revenues increased in Fiscal 2018 as compared to Fiscal 2017 primarily due to an increase in the number of units sold, partially offset by product mix. Motorhome unit deliveries grew slower than recent industry growth in Fiscal 2018 compared to Fiscal 2017. Our overall Motorhome market share moved to 15.7% from 16.4% when comparing shipments during the twelve-month trailing periods ended August 2018 and August 2017 due to a mix change from our Class A-diesel products to our Class B products. Motorhome Adjusted EBITDA decreased in Fiscal 2018 as compared to Fiscal 2017 due to increased material costs and investments in our business, including higher costs and lower productivity associated with a new facility that produces our Class A diesel product line. Analysis of Financial Condition, Liquidity, and Capital Resources Cash Flows The following table summarizes our cash flows from total operations for Fiscal 2019, 2018, and 2017: Operating Activities Cash provided by operating activities increased in Fiscal 2019 compared to Fiscal 2018 primarily due to steady profitability and working capital as a percent of sales. Cash provided by operating activities decreased in Fiscal 2018 compared to Fiscal 2017 due to an increase in inventory to support organic growth, partially offset by growth in net income. Investing Activities Cash used in investing activities decreased in Fiscal 2019 compared to Fiscal 2018 primarily due to a decrease in cash used for the Chris-Craft acquisition in Fiscal 2018 partially offset by increased capital expenditures related to the capacity expansions within our Towable segment. Cash used in investing activities for Fiscal 2018 consisted primarily of the acquisition of Chris-Craft and capital expenditures related to the capacity expansions taking place in our Towable segment. In Fiscal 2017, cash used in investing activities consisted of the acquisition of Grand Design for which we paid cash of $392.5 million, net of cash acquired, in addition to issuing Winnebago stock with a value of $124.1 million at closing. Financing Activities Cash used in financing activities increased in Fiscal 2019 compared to Fiscal 2018 primarily due to increased net payments on our Credit Agreement and increased share repurchases. Cash used in financing activities for Fiscal 2018 consisted of payments on the Credit Agreement, dividend payments, and share repurchases; these were partially offset by cash proceeds on the Credit Agreement. Cash provided by financing activities for Fiscal 2017 consisted of cash proceeds from the Credit Agreement, partially offset by payments on the Credit Agreement, payment of debt issuance costs, and dividend payments. Debt and Capital As described in Note 9, Long-Term Debt, of the Notes to Consolidated Financial Statements, included in Item 8, Financial Statements and Supplementary Data, of this Annual Report on Form 10-K, our Credit Agreement consisted of a term loan B loan agreement ("Term Loan") and an asset-based revolving credit agreement ("ABL") (collectively, the "Credit Agreement") with JPMorgan Chase. The commitment under the ABL was increased to $192.5 million revolving credit agreement as of October 22, 2019. Other Financial Measures Working capital at August 31, 2019 and August 25, 2018 was $212.9 million and $167.8 million, respectively. We currently expect cash on hand, funds generated from operations, and the borrowing available under our Credit Agreement to be sufficient to cover both short-term and long-term operating requirements. Capital Expenditures We anticipate capital expenditures in Fiscal 2020 of approximately $35.0 million to $45.0 million. We will continue to invest in our ERP system as well as expand our Towable and marine facilities and make improvements to our Motorhome facilities. Share Repurchases and Dividends We repurchase our common stock and pay dividends pursuant to programs approved by our Board of Directors. Our long-term capital allocation strategy is to first fund operations and investments in growth, maintain a debt leverage ratio within our targeted zone, maintain reasonable liquidity, and then return excess cash over time to shareholders through dividends and share repurchases. On October 18, 2017, our Board of Directors authorized a share repurchase program in the amount of $70.0 million. There is no time restriction on the authorization. During Fiscal 2019, we repurchased 0.2 million shares of our common stock at a cost of $6.1 million. An additional 0.1 million shares of our common stock at a cost of $2.1 million were repurchased to satisfy tax obligations on employee equity awards as they vested. We continually evaluate if share repurchases reflect a prudent use of our capital and, subject to compliance with our Credit Agreement, we may purchase shares in the future. At August 31, 2019, we have $58.9 million remaining on our board repurchase authorization. On August 14, 2019, our Board of Directors declared a quarterly cash dividend of $0.11 per share, totaling $3.5 million, paid on September 25, 2019 to common stockholders of record at the close of business on September 11, 2019. Contractual Obligations and Commercial Commitments Our principal contractual obligations and commercial commitments as of August 31, 2019 were as follows: Note: For additional information refer to Note 4, Derivatives, Investments, and Fair Value Measurements; Note 9, Long-Term Debt; Note 10, Employee and Retiree Benefits; and Note 11, Contingent Liabilities and Commitments, of the Notes to Consolidated Financial Statements, included in Item 8, Financial Statements and Supplementary Data, of this Annual Report on Form 10-K. (1) Borrowings and repayments are expected to fluctuate over the term; therefore, we are not able to reasonably estimate in which future periods this amount will ultimately be settled. (2) Our Term Loan matures on November 8, 2023. The contractual principal payments are included in the table. Additional principal payments are potentially due annually on a formula based on excess cash flow and the leverage ratio at that time as defined in the Credit Agreement. No amounts for this contingency are included in the above table. (3) The Term Loan is at a variable rate and the interest in the table assumes the variable rate of 5.95% at August 31, 2019 is constant through the maturity dates of the debt and the principal payments on the term debt are made as scheduled. The variable rate is subject to change. Additionally, included in interest payments due by period is a 0.25% commitment fee on the ABL for unused borrowings, which are assumed to be at $165.0 million. (4) We have an interest rate swap agreement with a notional amount of $120.0 million as of August 31, 2019 that decreases to $60.0 million on December 9, 2019 and expires on December 8, 2020. We pay a fixed rate at 1.82%, and receive a floating rate that was 2.45% at August 31, 2019. In the table, we have assumed the floating rate will be constant through the expiration of the interest rate swap when calculating the net swap payments. The variable rate is subject to change. (5) Certain renewal options have been included in our future lease commitments as disclosed in Note 11, Contingent Liabilities and Commitments, of the Notes to Consolidated Financial Statements, included in Item 8, Financial Statements and Supplementary Data, of this Annual Report on Form 10-K. However, because these renewals have not been signed and are not contractually obligated, balances within the table exclude the payments related to these options. (6) Unrecognized tax benefits relate to uncertain tax positions. As we are not able to reasonably estimate the timing of the payments or the amount by which the liability will increase or decrease over time, the related balances have not been reflected in the "Payments Due by Period" section of the table. Critical Accounting Estimates Our consolidated financial statements are prepared in accordance with GAAP. In connection with the preparation of our financial statements, we are required to make assumptions and estimates about future events and apply judgments that affect the reported amounts of assets, liabilities, revenue, expenses, and the related disclosures. We base our assumptions, estimates, and judgments on historical experience, current trends, and other factors believed to be relevant at the time our consolidated financial statements are prepared. Because future events and their effects cannot be determined with certainty, actual results could differ from our assumptions and estimates, and such differences could be material. Our significant accounting policies are discussed in Note 1, Summary of Significant Accounting Policies, of the Notes to Consolidated Financial Statements, included in Item 8, Financial Statements and Supplementary Data, of this Annual Report on Form 10-K. We believe that the following accounting estimates are the most critical to aid in fully understanding and evaluating our reported financial results. These estimates require our most difficult, subjective, or complex judgments because they relate to matters that are inherently uncertain. We have reviewed these critical accounting estimates and related disclosures with the Audit Committee of our Board of Directors. We have not made any material changes during the past three fiscal years, nor do we believe there is a reasonable likelihood of a material future change to the accounting methodologies for the areas described below. Goodwill and Indefinite-lived Intangible Assets We test goodwill and indefinite-lived intangible assets (trade names) for impairment at least annually in the fourth quarter and more frequently if events or circumstances occur that would indicate a reduction in fair value. Our test of impairment begins by either performing a qualitative evaluation or a quantitative test: • Qualitative evaluation - Performed to determine whether it is more likely than not that the carrying value of goodwill or the trade name exceeds the fair value of the asset. During our qualitative assessment, we make significant estimates, assumptions, and judgments, including, but not limited to, the macroeconomic conditions, industry and market conditions, cost factors, overall financial performance of the Company and the reporting units, changes in our share price, and relevant company-specific events. If we determine that it is more likely than not that the carrying value of goodwill exceeds the fair value of goodwill, we perform the quantitative test to determine the amount of the impairment. • Quantitative test - Used to calculate the fair value of goodwill or the trade name. If the carrying value of goodwill or the trade name exceeds the fair value of the asset, the impairment is calculated as the difference between the carrying value and fair value. Our goodwill fair value model uses a blend of the income (discounted future cash flow) and market (guideline public company) approaches, which includes the use of significant unobservable inputs (Level 3 inputs). Our trade name fair value model uses the income (relief-from-royalty) approach, which includes the use of significant unobservable inputs (Level 3 inputs). During these valuations, we make significant estimates, assumptions, and judgments, including, current and projected future levels of income based on management’s plans, business trends, market and economic conditions, and market-participant considerations. Actual results may differ from assumed and estimated amounts. As of August 31, 2019, our goodwill balance includes $244.7 million related to our Towable segment and $30.2 million related to our Chris-Craft operating segment, and our indefinite-lived intangible asset balance is $177.3 million. The qualitative test was not performed in the current year. No impairments were recorded in Fiscal 2019, 2018, and 2017. Repurchase Commitments It is customary practice for manufacturers in our industries to enter into repurchase agreements with financing institutions that provide financing to their dealers. Our repurchase agreements generally provide that, in the event of a default by a dealer in its obligation to these lenders, we will repurchase units sold to the dealer that have not been resold to retail customers. The terms of these agreements, which can last up to 24 months, provide that our liability will be the lesser of remaining principal owed by the dealer or dealer invoice less periodic reductions based on the time since the date of the original invoice. Our liability cannot exceed 100% of the dealer invoice. In certain instances, we also repurchase inventory from our dealers due to state law or regulatory requirements that govern voluntary or involuntary relationship terminations. Based on these repurchase agreements, we establish an associated loss reserve. Our loss reserve for repurchase commitments contains uncertainties because the calculation requires management to make assumptions and apply judgment regarding a number of factors. We base our reserve primarily on our historical loss experience rate per dollar of dealer inventory. The historical experience has been affected by a number of factors which are evaluated, such as macro-market conditions, current retail demand for our product, location of the dealer, and the financing source. The percentage of dealer inventory we estimate we will repurchase and the associated estimated loss is based on historical loss experience and current trends and economic conditions. Repurchase risk is affected by the credit worthiness of our dealer network and if we are obligated to repurchase a substantially larger number of units in the future, this would increase our costs and could have a material adverse effect on our results of operations, financial condition, and cash flows. A hypothetical change of a 10% increase or decrease in our repurchases commitments as of August 31, 2019 would have not have a material effect on our net income. Warranty We provide certain service and warranty on our products. Estimated costs related to product warranty are accrued at the time of sale and are based upon past warranty claims and unit sales history. Estimates are adjusted as needed to reflect actual costs incurred as information becomes available. In addition to the costs associated with the contractual warranty coverage provided on our products, we also occasionally incur costs as a result of additional service actions not covered by our warranties, including product recalls and customer satisfaction actions. Although we estimate and reserve for the cost of these service actions, there can be no assurance that expense levels will remain at current levels or such reserves will continue to be adequate. A significant increase in dealership labor rates, the cost of parts, or the frequency of claims could have a material adverse impact on our operating results for the period or periods in which such claims or additional costs materialize. A hypothetical change of a 10% increase or decrease in our warranty liability as of August 31, 2019 would have affected net income by approximately $3.7 million. Income Taxes We account for income taxes in accordance with Accounting Standards Codification ("ASC") 740, Income Taxes. In preparing our financial statements, we are required to estimate our income taxes in each of the jurisdictions in which we operate. Significant judgment is required in determining our provision for income taxes, our deferred tax assets and liabilities, and any valuation allowance recorded against our deferred tax assets. We will continue to assess the likelihood that our deferred tax assets are properly measured and will be realizable at each reporting period. Any adjustment to the deferred tax assets could materially impact our financial position and results of operations. As of August 31, 2019, we have determined that our deferred tax assets are properly measured and realizable and, therefore, no valuation allowance has been recorded. New Accounting Pronouncements For a summary of new applicable accounting pronouncements, see Note 1, Summary of Significant Accounting Policies, of the Notes to Consolidated Financial Statements, included in Item 8, Financial Statements and Supplementary Data, of this Annual Report on Form 10-K.

<s>[INST] Overview Results of Operations Analysis of Financial Condition, Liquidity, and Capital Resources Contractual Obligations and Commercial Commitments Critical Accounting Estimates New Accounting Pronouncements Our MD&A should be read in conjunction with the Consolidated Financial Statements and related Notes included in Item 8, Financial Statements and Supplementary Data, of this Annual Report on Form 10K. Overview Winnebago Industries, Inc. is one of the leading U.S. manufacturers with a diversified portfolio of recreation vehicles ("RV"s) and marine products used primarily in leisure travel and outdoor recreation activities. We produce our Towable units in IN; our Motorhome units in manufacturing facilities in IA; and our marine products in FL. We distribute our RV and marine products primarily through independent dealers throughout the U.S. and Canada, who then retail the products to the end consumer. We also distribute our marine products internationally through independent dealers, who then retail the products to the end consumer. NonGAAP Reconciliation This MD&A includes financial information prepared in accordance with accounting principles generally accepted in the U.S. ("GAAP"), as well as certain adjusted or nonGAAP financial measures such as EBITDA and Adjusted EBITDA. EBITDA is defined as net income before interest expense, provision for income taxes, and depreciation and amortization expense. Adjusted EBITDA is defined as net income before interest expense, provision for income taxes, depreciation and amortization expense, and other adjustments made in order to present comparable results from period to period. These nonGAAP financial measures, which are not calculated or presented in accordance with GAAP, have been provided as information supplemental and in addition to the financial measures presented in accordance with GAAP. Such nonGAAP financial measures should not be considered superior to, as a substitute for, or as an alternative to, and should be considered in conjunction with, the GAAP financial measures presented herein. The nonGAAP financial measures presented may differ from similar measures used by other companies. Refer to the Results of OperationsFiscal 2019 Compared to Fiscal 2018 and the Results of OperationsFiscal 2018 Compared to Fiscal 2017 for a detailed reconciliation of items that impacted EBITDA and Adjusted EBITDA. We have included this nonGAAP performance measure as a comparable measure to illustrate the effect of nonrecurring transactions occurring during the year and improve comparability of our results from period to period. We believe Adjusted EBITDA provides meaningful supplemental information about our operating performance because this measure excludes amounts that we do not consider part of our core operating results when assessing our performance. Examples of items excluded from Adjusted EBITDA include acquisitionrelated costs, restructuring expenses, and nonoperating income. Management uses these nonGAAP financial measures (a) to evaluate our historical and prospective financial performance and trends as well as our performance relative to competitors and peers; (b) to measure operational profitability on a consistent basis; (c) in presentations to the members of our board of directors to enable our board of directors to have the same measurement basis of operating performance as is used by management in its assessments of performance and in forecasting and budgeting for our company; (d) to evaluate potential acquisitions; and (e) to ensure compliance with covenants and restricted activities under the terms of our Credit Agreement, as further described in Note 9, LongTerm Debt, of the Notes to Consolidated Financial Statements, included in Item 8, Financial Statements and Supplementary Data, of this Annual Report on Form 10K. We believe these nonGAAP financial measures are frequently used by securities analysts, investors, and other interested parties to evaluate companies in our industry. Business Combinations On June 4, 2018, we acquired 100% of the ownership interests of ChrisCraft, a privatelyowned company based in Sarasota, FL. ChrisCraft manufactures and sells premium quality boats in the recreational powerboat industry through an established global network of independent authorized dealers. On [/INST] Positive. </s>

EMPIRE DISTRICT ELECTRIC CO

2015-02-20

2014-12-31

ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS EXECUTIVE SUMMARY Electric Segment As a vertically integrated regulated utility, the primary drivers of our electric operating margins (defined as electric revenues less fuel and purchased power costs) in any period are: (1) rates we can charge our customers, including timing of new rates, (2) weather, (3) customer growth and usage and (4) general economic conditions. The utility commissions in the states in which we operate, as well as the Federal Energy Regulatory Commission (FERC), set the rates which we can charge our customers. In order to offset expenses, we depend on our ability to receive adequate and timely recovery of our costs (primarily fuel and purchased power and construction costs) and/or rate relief. We assess the need for rate relief in all of the jurisdictions we serve and file for such relief when necessary. The effects of timing of rate relief are discussed in detail in Note 3 of "Notes to the Consolidated Financial Statements" under Item 8. Of the factors driving margins, weather has the greatest short-term effect on the demand for electricity for our regulated business. Very hot summers and very cold winters increase electric demand, while mild weather reduces demand. Residential and commercial sales are impacted more by weather than industrial sales, which are mostly affected by business needs for electricity and by general economic conditions. Customer growth, which is the growth in the number of customers, contributes to the demand for electricity. We expect our electric customer and sales growth to be less than 1.0% annually over the next several years. Our electric customer growth for the year ended December 31, 2014 was 0.3%. We define electric sales growth to be growth in kWh sales period over period excluding the estimated impact of weather. The primary drivers of electric sales growth are customer growth, customer usage and general economic conditions. The primary drivers of our electric operating expenses in any period are: (1) fuel and purchased power expense, (2) operating maintenance and repairs expense, including repairs following severe weather and plant outages, (3) taxes and (4) non-cash items such as depreciation and amortization expense. We have a fuel cost recovery mechanism in all of our jurisdictions, which significantly reduces the impact of fluctuating fuel and purchased power costs on our net income. Gas Segment The primary drivers of our gas operating revenues in any period are: (1) rates we can charge our customers, (2) weather, (3) customer growth and usage, (4) the cost of natural gas and interstate pipeline transportation charges and (5) general economic conditions. The MPSC sets the rates which we can charge our customers. In order to offset expenses, we depend on our ability to receive adequate and timely recovery of our costs (primarily commodity natural gas) and/or rate relief. We assess the need for rate relief and file for such relief when necessary. A Purchased Gas Adjustment (PGA) clause is included in our gas rates, which allows us to recover our actual cost of natural gas from customers through rate changes, which are made periodically (up to four times) throughout the year in response to weather conditions, natural gas costs and supply demands. Weather affects the demand for natural gas. Very cold winters increase demand for gas, while mild weather reduces demand. Due to the seasonal nature of the gas business, revenues and earnings are typically concentrated in the November through March period, which generally corresponds with the heating season. Customer growth, which is the growth in the number of customers, contributes to the demand for gas. Our annual customer growth is calculated by comparing the number of customers at the end of a year to the number of customers at the end of the prior year. Our gas segment customer count decreased 0.2% for the year ended December 31, 2014, which we believe was due to population losses in the rural communities we serve. We expect gas customer growth to be flat during the next several years. We define gas sales growth to be growth in mcf sales excluding the impact of weather. The primary drivers of gas sales growth are customer growth and general economic conditions. The primary driver of our gas operating expense in any period is the price of natural gas. However, because gas purchase costs for our gas utility operations are normally recovered from our customers, any change in gas prices does not have a corresponding impact on income unless such costs are deemed imprudent or cause customers to reduce usage. Earnings For the year ended December 31, 2014, basic and diluted earnings per weighted average share of common stock were $1.55 on $67.1 million of net income compared to $1.48 on $63.4 million of net income for the year ended December 31, 2013. Increased electric gross margins positively impacted net income for 2014 as compared to 2013 mainly due to increased electric rates for our Missouri customers effective April 1, 2013 and for our wholesale on-system customers in June 2014. Favorable weather and increased AFUDC due to higher levels of construction activity during 2014 also positively impacted results. Increased regulatory operating and maintenance expense, property taxes, and depreciation and amortization expense negatively impacted 2014 results. The table below sets forth a reconciliation of basic and diluted earnings per share between 2013 and 2014, which is a non-GAAP presentation. The economic substance behind our non-GAAP earnings per share (EPS) measure is to present the after tax impact of significant items and components of the statement of income on a per share basis before the impact of additional stock issuances. The dilutive effect of additional shares issued included in the table reflects the estimated impact of all shares issued during the period. We believe this presentation is useful to investors because the statement of income does not readily show the EPS impact of the various components, including the effect of new stock issuances. This could limit the readers' understanding of the reasons for the EPS change from the previous year's EPS. This information is useful to management, and we believe this information is useful to investors, to better understand the reasons for the fluctuation in EPS between the prior and current years on a per share basis. In addition, although a non-GAAP presentation, we believe the presentation of gross margin (in the table below and elsewhere in this report) is useful to investors and others in understanding and analyzing changes in our electric operating performance from one period to the next, and have included the analysis as a complement to the financial information we provide in accordance with GAAP. This reconciliation and margin information may not be comparable to other companies' presentations or more useful than the GAAP presentation included in the statements of income or elsewhere in this report. We also note that this presentation does not purport to be an alternative to earnings per share determined in accordance with GAAP as a measure of operating performance or any other measure of financial performance presented in accordance with GAAP. Management compensates for the limitations of using non-GAAP financial measures by using them to supplement GAAP results to provide a more complete understanding of the factors and trends affecting the business than GAAP results alone. Fourth Quarter Results Earnings for the fourth quarter of 2014 were $11.1 million, or $0.26 per share, as compared to $15.2 million, or $0.35 per share, in the fourth quarter of 2013. Electric segment gross margins decreased during the quarter ending December 31, 2014 compared to the 2013 quarter, reflecting decreased demand in the fourth quarter of 2014 due to milder weather as compared to the fourth quarter of 2013 and increased operating and maintenance expenses. 2014 Activities Regulatory Matters On August 29, 2014, we filed a request with the MPSC for changes in rates for our Missouri electric customers. We are seeking an annual increase in total revenue of approximately $24.3 million, or approximately 5.5%. The main cost drivers in the rate increase are the costs associated with the environmental retrofit project at our Asbury power plant (See Note 11 - New Construction of "Notes to Consolidated Financial Statements" under Item 8) that were incurred to comply with the Environmental Protection Agency's (EPA) rules governing the continued operation of the plant, increases in property taxes, increases in ongoing maintenance expenses and increases in Regional Transmission Organization transmission fees. On May 20, 2014, we filed a settlement agreement with the Arkansas Public Service Commission (APSC) for an increase of $1.375 million, or approximately 11%. A hearing was held on the settlement agreement on July 22, 2014. On September 16, 2014, the APSC issued an order approving the settlement with a modification that reduced the overall revenue increase to $1.367 million. The new rates were effective September 26, 2014. We had filed a request on December 3, 2013 with the APSC seeking an annual increase in total revenue of approximately $2.2 million, or approximately 18%. The rate increase was requested to recover costs incurred to ensure continued reliable service for our customers, including capital investments, operating systems replacement costs and ongoing increases in other operation and maintenance expenses and capital costs. On December 5, 2014, we filed a request with the Kansas Corporation Commission (KCC) to implement an Environmental Cost Recovery Rider for costs associated with the new environmental facilities installed at our Asbury generating unit. We have requested an effective date of March 1, 2015 for the recovery rider. For additional information on all these cases, see Note 3 of "Notes to Consolidated Financial Statements" under Item 8 for information regarding regulatory matters. Asbury In-service Criteria As part of our environmental Compliance Plan, discussed in Note 11 of "Notes to Consolidated Financial Statements" under Item 8, we installed a scrubber, fabric filter and powder activated carbon injection system at our Asbury plant. The addition of this air quality control system (AQCS) equipment was completed in December 2014. Testing began in early November and all in-service testing was completed and results verified for the Asbury AQCS by December 15, 2014. The MPSC staff determined that as of December 15, 2014, the Asbury AQCS had met the in-service criteria. Financing Activities On October 15, 2014, we entered into a Bond Purchase Agreement for a private placement of $60.0 million of 4.27% First Mortgage Bonds due December 1, 2044. The delayed settlement occurred on December 1, 2014. The bonds were issued under the EDE Mortgage. We utilized the proceeds from the sale of the bonds to refinance existing short-term indebtedness and for general corporate purposes. On October 20, 2014, we entered into a new $200 million 5-year Credit Agreement replacing the former $150 million Third Amended and Restated Unsecured Credit Agreement dated January 17, 2012. This new agreement may be used for working capital, commercial paper back-up and general corporate purposes. The credit facility includes a $20 million swingline loan sublimit, a $20 million sublimit for letters of credit issuance and, subject to bank approval, a $75 million accordion feature and two one-year extensions of the credit facility's maturity date. For additional information, see Notes 5 and 6 of "Notes to Consolidated Financial Statements" under Item 8. Day-Ahead Market The Southwest Power Pool (SPP) regional transmission organization (RTO) implemented a Day-Ahead Market, or Integrated Marketplace, on March 1, 2014 in which market participants buy and sell wholesale energy and reserves in both day-ahead and real-time markets through the operation of a single, consolidated SPP balancing authority. Through the IM, the SPP is able to coordinate next-day generation across the region and provide participants, including Empire, with greater access to economical energy. For additional information, see Note 3 "- Markets and Transmission" of "Notes to Consolidated Financial Statements" under Item 8. Integrated Resource Plan We filed our Integrated Resource Plan (IRP) with the MPSC on July 1, 2013. The IRP analysis of future loads and resources is normally conducted once every three years. Our IRP supports our Compliance Plan discussed in Note 11 of "Notes to Consolidated Financial Statements" under Item 8. On March 12, 2014, the MPSC issued an order approving our IRP, effective March 12, 2014. Subsequent Events On November 4, 2008, Missouri voters approved the Clean Energy Initiative (Proposition C) which currently requires Empire and other investor-owned utilities in Missouri to generate or purchase electricity from renewable energy sources, such as solar, wind, biomass and hydro power, or purchase Renewable Energy Credits (RECs), in amounts equal to at least 5% of retail sales in 2014, increasing to at least 15% by 2021. We are currently in compliance with this regulatory requirement as a result of generation from our Ozark Beach Hydroelectric Project and purchased power agreements with Cloud County Windfarm, LLC, located in Cloud County, Kansas, and Elk River Windfarm, LLC, located in Butler County, Kansas. Proposition C also requires that 2% of the energy from renewable energy sources must be solar; however, we believed that we were exempted by statute from the solar requirement. On January 20, 2013 the Earth Island Institute, d/b/a Renew Missouri, and others challenged our solar exemption by filing a complaint with the MPSC. The MPSC dismissed the complaint and Renew Missouri filed a notice of appeal seeking review by the Missouri Supreme Court. On February 10, 2015 the Missouri Supreme Court issued an opinion holding that the legislature had the authority to adopt the statute providing the exemption but reversed the MPSC's holding that the two laws could be harmonized. The statute providing the exemption (which was enacted in August 2008) was impliedly repealed by the adoption of Proposition C because it conflicted with the latter law. We believe the matter will return to the MPSC for further action. While we are not in a position to accurately estimate the impact of this requirement, we expect any future costs to be recoverable in rates. RESULTS OF OPERATIONS The following discussion analyzes significant changes in the results of operations for the years 2014, 2013 and 2012. The following table represents our results of operations by operating segment for the applicable years ended December 31 (in millions): Electric Segment Overview Our electric segment income for 2014 was $61.5 million as compared to $58.6 million and $52.6 million for 2013 and 2012, respectively. Electric on-system operating revenues for 2014, 2013, and 2012 were comprised of the following customer classes: *Primarily other public authorities Gross Margin As shown in the Electric Segment Operating Revenues and Gross Margin table below, electric segment gross margin, defined as electric revenues less fuel and purchased power costs, increased approximately $16.4 million during 2014 as compared to 2013 due to a full twelve months of increased Missouri electric rates that were effective April 1, 2013, increased demand resulting from weather impacts, higher commercial demand and an increase in average electric customer counts. The electric gross margin increased approximately $29.2 million during 2013 as compared to 2012. Increased electric rates for our Missouri customers, an increase in average electric customer counts and colder weather in the first and fourth quarters of 2013 positively impacted revenues and gross margin during 2013. These increases were partially offset by a change in our unbilled revenue estimate in the third quarter of 2012. KWh Sales The amounts and percentage changes from the prior periods in kilowatt-hour ("kWh") sales by major customer class for on-system sales were as follows (in millions): (1)Percentage changes are based on actual kWh sales and may not agree to the rounded amounts shown above. (2)Other kWh sales include street lighting, other public authorities and interdepartmental usage. KWh sales for our on-system customers increased during 2014 as compared to 2013 primarily due to increased demand due to weather impacts, increased commercial demand and increased customer counts. Residential and commercial kWh sales increased 0.7% and 2.7%, respectively, primarily due to these weather impacts and increased customer counts. Industrial sales increased 1.6% during 2014 as compared to 2013 due to increased usage. On-system wholesale kWh sales decreased during 2014 as compared to 2013 reflecting the closure of a large dairy facility in Monett, Missouri during the second half of 2013. Total heating degree days (the sum of the number of degrees that the daily average temperature for each day during that period was below 65° F) for 2014 were 1.2% more than 2013 and 6.3% more than the 30-year average. Total cooling degree days (the cumulative number of degrees that the average temperature for each day during that period was above 65° F) for 2014 were 3.7% more than 2013 and 5.8% more than the 30-year average. KWh sales for our on-system customers increased slightly during 2013 as compared to 2012 primarily due to increased demand due to colder temperatures in the first and fourth quarters of 2013 as compared to the same periods in 2012. Residential kWh sales, the most weather sensitive class, increased 4.6% primarily due to these weather impacts and an increase in the average residential customer count. Commercial sales decreased 1.1% primarily due to a net unbilled sales adjustment recorded in 2012. Industrial sales decreased 1.3% during 2013 as compared to 2012 due to operating reductions by several large industrial customers. On-system wholesale kWh sales decreased during 2013 as compared to 2012 reflecting the closure of a large dairy facility in Monett, Missouri during the second half of 2013. Total heating degree days for 2013 were 31.7% more than 2012 and 5.0% more than the 30-year average. Total cooling degree days for 2013 were 19.7% less than 2012 although they were 2.1% more than the 30-year average. The weather was unseasonably hot in June and July of 2012. Revenues and Gross Margin The amounts and percentage changes from the prior period's electric segment operating revenues by major customer class for on-system and off-system sales, and the associated fuel and purchased power expense (including a reconciliation of our actual fuel and purchased power expenditures to the fuel and purchased power expense shown on our statements of income) were as follows (dollars in millions): (1)Percentage changes are based on actual revenues and may not agree to the rounded amounts shown above. (2)Other operating revenues include street lighting, other public authorities and interdepartmental usage. (3)The SPP IM was implemented on March 1, 2014. As of December 31, 2014, off-system revenues were effectively replaced by SPP IM activity. See "- Markets and Transmission" below for more information. (4)Miscellaneous revenues include transmission service revenues, late payment fees, renewable energy credit sales, rent, etc. (5)Missouri ten year amortization of the $26.6 million payment received from the SWPA in September, 2010, of which $12.9 million of the Missouri portion remains to be amortized as of December 31, 2014. Revenues for our on-system customers increased approximately $25.5 million (5.0%) during 2014 as compared to 2013. Rate changes, primarily the April 2013 Missouri rate increase, contributed an estimated $12.5 million to revenues. Weather and other volumetric related factors increased revenues an estimated $4.6 million in 2014 as compared to 2013. Improved customer counts increased revenues an estimated $1.6 million. A $6.8 million increase in fuel recovery revenue (offset by a corresponding change included in fuel expenses, resulting in no net effect on gross margin) from Missouri customers during 2014 as compared to 2013, positively impacted revenues. Revenues for our on-system customers increased approximately $20.9 million (4.3%) during 2013 as compared to 2012. Rate changes, primarily the April 2013 Missouri rate increase, contributed an estimated $24.6 million to revenues. Weather and other volumetric related factors increased revenues an estimated $3.1 million in 2013 as compared to 2012. Improved customer counts increased revenues an estimated $2.7 million. These revenue increases were partially offset by a $6.1 million decrease in fuel recovery revenue (and corresponding reduction included in fuel expenses, resulting in no net effect on gross margin) from Missouri customers during 2013 as compared to 2012. The change in our unbilled revenue estimate recorded in the third quarter of 2012, as mentioned below, negatively impacted revenues as compared to 2012, making up the remainder of the change. On-system revenues increased in all classes during 2013 primarily due to the April 2013 Missouri rate increase. SPP Integrated Marketplace (IM) and Off-System Electric Transactions. In the past, in addition to sales to our own customers, we also sold power to other utilities as available, including (since 2007) through the SPP Energy Imbalance Services (EIS) market. However, on March 1, 2014, the SPP RTO implemented a Day-Ahead Market, or Integrated Marketplace, which replaces the real-time EIS market. SPP IM activity is settled for each market participant in various time increments. When we sell more generation to the market than we purchase, based on the prescribed time increments, the net sale and corresponding net revenue is included as part of electric revenues. When we purchase more generation from the market than we sell, based on the prescribed time increments, the net purchase cost is recorded as a component of fuel and purchased power on the financial statements. See the Electric Segment Operating Revenues and Gross Margin table above and "- Markets and Transmission" below. The majority of our market activity sales margin is included as a component of the fuel adjustment clause in our Missouri, Kansas and Oklahoma jurisdictions and our transmission rider in our Arkansas jurisdiction. As a result, nearly all of the market activity sales margin flows back to the customer and has little effect on gross margin or net income. Operating Revenue Deductions - Other Than Fuel and Purchased Power The table below shows regulated operating expense increases/(decreases) during 2014 as compared to 2013 and during 2013 as compared to 2012. (1)Mainly due to increased SPP transmission charges. (2)Regulatory reversal of a prior period gain in 2013 on the sale of our Asbury unit train as part of our 2013 rate case Agreement with the MPSC. The table below shows maintenance and repairs expense increases/(decreases) during 2014 as compared to 2013 and during 2013 as compared to 2012. Depreciation and amortization expense increased approximately $3.9 million (6.1%) during 2014 as compared to 2013 and approximately $8.3 million (15.1%) during 2013 as compared to 2012, primarily due to increased depreciation rates resulting from our 2013 Missouri electric rate case settlement and increased plant in service. Other taxes increased approximately $1.8 million in 2014 and $3.3 million in 2013 due to increased property tax (reflecting our additions to plant in service) and increased municipal franchise taxes. Gas Segment Gas Operating Revenues and Sales The following table details our natural gas sales for the years ended December 31: (1)Several commercial customers transferred to transportation customers during 2014, reflecting the decrease in commercial sales and the increase in transportation sales. (2)Other includes other public authorities and interdepartmental usage. The following table details our natural gas revenues for the years ended December 31: (1)Several commercial customers transferred to transportation customers during 2014, reflecting the decrease in commercial revenues and the increase in transportation revenues. (2)Other includes other public authorities and interdepartmental usage. Gas retail sales decreased 1.6% during 2014 as compared to 2013 due to commercial and industrial customers transferring to transportation service. Gas retail revenues increased 2.9% reflecting increased usage by the weather sensitive residential class due to colder weather in 2014 as compared to 2013 and higher gas costs recovered in revenues. Heating degree days were 1.7% higher in 2014 than 2013 and 10.2% higher than the 30-year average. Our gas segment gross margin (defined as gas operating revenues less cost of gas in rates) for 2014 increased $0.6 million compared to 2013. Gas retail sales and revenues increased during 2013 as compared to 2012 reflecting colder weather in 2013 as compared to 2012. Heating degree days were 38.1% higher in 2013 than 2012 and 8.3% higher than the 30-year average. Sales increased in all classes during 2013, reflecting the colder weather. As a result, our margin for 2013 increased $3.0 million compared to 2012. We have a PGA clause in place that allows us to recover from our customers, subject to routine regulatory review, the cost of purchased gas supplies, transportation and storage, including costs associated with the use of financial instruments to hedge the purchase price of natural gas. Pursuant to the provisions of the PGA clause, the difference between actual costs incurred and costs recovered through the application of the PGA are reflected as a regulatory asset or regulatory liability until the balance is recovered from or credited to customers. As of December 31, 2014, we had unrecovered purchased gas costs of $0.6 million recorded as a non-current regulatory asset and $0.5 million recorded as a current regulatory liability as compared to unrecovered purchased gas costs of $1.0 million recorded as a current regulatory asset and $1.2 million recorded as a non-current regulatory liability as of December 31, 2013. Operating Revenue Deductions The table below shows regulated operating expense increases/(decreases) for the years ended December 31: Depreciation and amortization expense increased approximately $0.1 million (1.4%) during 2014 and increased approximately $0.1 million (3.1%) during 2013. Our gas segment had net income of $2.9 million in 2014 as compared to $2.3 million in 2013 and $1.3 million in 2012. Consolidated Company Income Taxes The following table shows our consolidated provision for income taxes (in millions) and our consolidated effective federal and state income tax rates for the applicable years ended December 31: The effective tax rate for 2014 is lower than 2013 and 2012 primarily due to higher equity AFUDC income in 2014 compared with 2013 and 2012. See Note 9 of "Notes to Consolidated Financial Statements" under Item 8 for information and discussion concerning our income tax provision and effective tax rates. Nonoperating Items The following table shows the total allowance for funds used during construction (AFUDC) for the applicable periods ended December 31. AFUDC increased in 2014 as compared to 2013 and 2012 reflecting construction for the environmental retrofit project at our Asbury plant and the Riverton 12 combined cycle project. See Note 1 of "Notes to Consolidated Financial Statements" under Item 8. Total interest charges on long-term and short-term debt for 2014, 2013 and 2012 are shown below. The changes in long-term debt interest for 2014 compared to 2013 and 2013 compared to 2012 reflect the issuance, on May 30, 2013, of $30.0 million of 3.73% First Mortgage Bonds due May 30, 2033 and $120.0 million of 4.32% First Mortgage Bonds due May 30, 2043. We used a portion of the proceeds from the sale of these bonds to redeem all $98.0 million aggregate principal amount of our Senior Notes, 4.50% Series due June 15, 2013. Also, on October 15, 2014, we entered into a Bond Purchase Agreement for a private placement of $60.0 million of 4.27% First Mortgage Bonds due December 1, 2044. The delayed settlement occurred on December 1, 2014. RATE MATTERS We routinely assess the need for rate relief in all of the jurisdictions we serve and file for such relief when necessary. Our rates for retail electric and natural gas services (other than specially negotiated retail rates for industrial or large commercial customers, which are subject to regulatory review and approval) are determined on a "cost of service" basis. Rates are designed to provide, after recovery of allowable operating expenses, an opportunity for us to earn a reasonable return on "rate base." "Rate base" is generally determined by reference to the original cost (net of accumulated depreciation and amortization) of utility plant in service, subject to various adjustments for deferred taxes and other items. Over time, rate base is increased by additions to utility plant in service and reduced by depreciation, amortization and retirement of utility plant or write-off's as ordered by the utility commissions. In general, a request of new rates is made on the basis of a "rate base" as of a date prior to the date of the request and allowable operating expenses for a 12-month test period ended prior to the date of the request. Although the current rate making process provides recovery of some future changes in rate base and operating costs, it does not reflect all changes in costs for the period in which new retail rates will be in place. This results in a lag (commonly referred to as "regulatory lag") between the time we incur costs and the time when we can start recovering the costs through rates. The following table sets forth information regarding electric and water rate increases since January 1, 2012: See Note 3 of "Notes to Consolidated Financial Statements" under Item 8 for additional information regarding rate matters. MARKETS AND TRANSMISSION Electric Segment Day Ahead Market: On March 1, 2014, the SPP RTO implemented its Integrated Marketplace (IM) (or Day-Ahead Market), which replaced the Energy Imbalance Services (EIS) market. The SPP RTO created a single NERC-approved balancing authority (BA) that took over balancing authority responsibilities for its members, including Empire. As part of the IM, we and other SPP members submit generation offers to sell our power and bids to purchase power into the SPP market, with the SPP serving as a centralized dispatch of SPP members' generation resources. The SPP matches offers and bids based upon operating and reliability considerations. It is expected that 90% - 95% of all next day generation needed throughout the SPP territory will be cleared through this IM. We also acquire Transmission Congestion Rights (TCR) in an attempt to mitigate congestion costs associated with the power we will purchase from the IM. The activity for each market participant is settled in various time increments. When we sell more generation to the market than we purchase, based on the prescribed time increments, the net sale is included as part of electric revenues. When we purchase more generation from the market than we sell, based on the prescribed time increments, the net purchase is recorded as a component of fuel and purchased power on our financial statements. The net financial effect of these IM transactions is included in our fuel adjustment mechanisms and therefore has little impact on gross margin. Information concerning recent and pending SPP RTO and other FERC activities can be found under Note 3 of "Notes to Consolidated Financial Statements" under Item 8. LIQUIDITY AND CAPITAL RESOURCES Overview. Our primary sources of liquidity are cash provided by operating activities, short-term borrowings under our commercial paper program (which is supported by our unsecured revolving credit facility) and borrowings from our unsecured revolving credit facility. Historically, we have also successfully raised funds, as needed, from the debt and equity capital markets to fund our liquidity and capital resource needs. Our issuance of various securities, including equity, long-term and short-term debt, is subject to customary approval or authorization by state and federal regulatory bodies including state public service commissions and the SEC. We believe the cash provided by operating activities, together with the amounts available to us under our credit facilities and the issuance of debt and equity securities, will allow us to meet our needs for working capital, pension contributions, our continuing construction expenditures, anticipated debt redemptions, interest payments on debt obligations, dividend payments and other cash needs through the next several years. See "- Capital Requirements and Investing Activities" below for further information. We will continue to evaluate our need to increase available liquidity based on our view of working capital requirements, including the timing of our construction programs and other factors. See Item 1A, "Risk Factors" for additional information on items that could impact our liquidity and capital resource requirements. The following table provides a summary of our operating, investing and financing activities for the last three years. Summary of Cash Flows Cash flow from Operating Activities We prepare our statement of cash flows using the indirect method. Under this method, we reconcile net income to cash flows from operating activities by adjusting net income for those items that impact net income but may not result in actual cash receipts or payments during the period. These reconciling items include depreciation and amortization, pension costs, deferred income taxes, equity AFUDC, changes in commodity risk management assets and liabilities and changes in the consolidated balance sheet for working capital from the beginning to the end of the period. Year-over-year changes in our operating cash flows are attributable primarily to working capital changes resulting from the impact of weather, the timing of customer collections, payments for natural gas and coal purchases, the effects of deferred fuel recoveries and the size and timing of pension contributions. The increase or decrease in natural gas prices directly impacts the cost of gas stored in inventory. 2014 compared to 2013. In 2014, our net cash flows provided from operating activities was $151.2 million, a decrease of $6.2 million, or 4.0%, from 2013. This change was primarily a result of: • Increase in net income - $3.7 million. • Increased plant depreciation - $3.4 million due to additions. • Changes in fuel adjustments and other regulatory amortizations - $8.4 million. • Changes in pension amortizations - $3.9 million. • Tax timing differences as a result of bonus depreciation being reinstated and tangible property regulation changes - $13.4 million. • Working capital changes for accounts receivable, accounts payable and other current assets and liabilities - $(33.6) million. • Increase in equity AFUDC mostly attributable to higher construction work in progress balances - $(2.6) million. 2013 compared to 2012. In 2013, our net cash flows provided from operating activities remained relatively the same, decreasing only $1.6 million, or 1.0%, from 2012. This change was primarily a result of: • Increase in net income - $7.8 million. • Non-cash loss on regulatory plant disallowance as a result of our 2013 Missouri electric rate case - $2.4 million. • Regulatory reversal of a prior period gain on the sale of assets as a result of our 2013 Missouri electric rate case - $1.2 million. • Working capital changes for accounts receivable, accounts payable and other current assets and liabilities - $7.2 million. • Pension contributions increased $5.1 million, partially offset by changes in pension expense accruals of $1.5 million - $(3.6) million net. • Tax timing differences mostly related to depreciation and amortizations - $(3.6) million. • Increase in equity AFUDC mostly attributable to higher construction work in progress balances - $(2.7) million. • Changes in non-cash loss on derivatives - $(4.2) million. • Long-term regulatory fuel adjustment deferrals - $(5.9) million. • Deferred revenues - $(1.4) million. Capital Requirements and Investing Activities Our net cash flows used in investing activities increased $62.0 million from 2013 to 2014. The increase was primarily the result of an increase in new generation capital expenditures related to the Riverton 12 combined cycle construction. Our net cash flows used in investing activities increased $16.4 million from 2012 to 2013, primarily due to an increase in electric plant additions and replacements resulting from the environmental retrofit at our Asbury plant. Our capital expenditures totaled approximately $222.8 million, $160.2 million, and $146.3 million in 2014, 2013 and 2012, respectively. A breakdown of these capital expenditures for 2014, 2013 and 2012 is as follows: (1)Other includes equity AFUDC of $(6.4) million, $(3.9) million and $(1.1) million for 2014, 2013 and 2012, respectively. Also included are insurance proceeds of $(7.8) million for 2013. (2)Expenditures incurred represent the total cost for work completed for the projects during the year. Discussion of capital expenditures throughout this 10-K is presented on this basis. These capital expenditures include AFUDC, capital expenditures to retire assets and benefits from salvage. (3)The amount of expenditures unpaid at the end of the year to adjust to actual cash outlay reflected in the Investing Activities section of the Statement of Cash Flows. Approximately 50%, 74% and 85% of our cash requirements for capital expenditures for 2014, 2013 and 2012, respectively, were satisfied from internally generated funds (funds provided by operating activities less dividends paid). The remaining amounts of such requirements were satisfied from short-term borrowings and proceeds from our sales of common stock and debt securities discussed below. Our estimated capital expenditures (excluding AFUDC) for 2015, 2016 and 2017 are detailed below. See Item 1, "Business - Construction Program." We anticipate that we will spend the following amounts over the next three years for the following projects: Our estimated total capital expenditures (excluding AFUDC) for 2018 and 2019 are $157.5 million and $157.4 million, respectively. We estimate that internally generated funds will provide approximately 78% of the funds required in 2015 for our budgeted capital expenditures. We intend to utilize short-term debt to finance any additional amounts needed beyond those provided by operating activities for such capital expenditures. If additional financing is needed, we intend to utilize a combination of debt and equity securities. The estimates herein may be changed because of changes we make in our construction program, unforeseen construction costs, our ability to obtain financing, regulation and for other reasons. See further discussion under "Financing Activities" below. Financing Activities 2014 compared to 2013. Our net cash flows provided by financing activities was $62.7 million in 2014 as compared to $4.1 million used in financing activities in 2013, an increase of $66.7 million, primarily due to the following: • Issuance of $40.0 million in short-term debt in 2014 as compared to repayment of $20.0 million in short-term debt in 2013. • Issuance of $60.0 million of first mortgage bonds in 2014 compared to $150.0 million issued in 2013. • No repayment of senior notes in 2014 compared to $98.0 million of senior notes repaid in 2013. 2013 compared to 2012. Our net cash flows used in financing activities was $4.1 million in 2013, a decrease of $20.1 million as compared to 2012, primarily due to the following: • Issuance of $150.0 million of first mortgage bonds offset by repayment of $98.0 million of senior notes in 2013 compared to no cash impact from $88.0 million in bond refinancing in 2012. • Repayment of $20.0 million in short-term debt in 2013 as compared to borrowing $12.0 million in 2012, which resulted in an $8.0 million net use of cash when comparing 2013 to 2012. Shelf Registration. We have a $200.0 million shelf registration statement with the SEC, effective December 13, 2013, covering our common stock, unsecured debt securities, preference stock, and first mortgage bonds. As of December 31, 2014, $200.0 million remains available for issuance under this shelf registration statement. However, as a result of our regulatory approvals, of the original $200.0 million, $150.0 million was available for first mortgage bonds with $90.0 million remaining available after the issuance of $60 million in first mortgage bonds on December 1, 2014. We plan to use proceeds from offerings made pursuant to this shelf to fund capital expenditures, refinance existing debt or general corporate needs during the three-year effective period. Credit Agreements. On October 20, 2014, we entered into a new $200 million 5-year Credit Agreement replacing the former $150 million Third Amended and Restated Unsecured Credit Agreement dated January 17, 2012. This new agreement may be used for working capital, commercial paper back-up and general corporate purposes. The credit facility includes a $20 million swingline loan sublimit, a $20 million sublimit for letters of credit issuance and, subject to bank approval, a $75 million accordion feature and two one-year extensions of the credit facility's maturity date. There were no outstanding borrowings under this agreement at December 31, 2014. However $44.0 million was used as of December 31, 2014 to back up our outstanding commercial paper. See Note 6 of "Notes to Consolidated Financial Statements" under Item 8 for additional information regarding this agreement and our unsecured line of credit. EDE Mortgage Indenture. Substantially all of the property, plant and equipment of The Empire District Electric Company (but not its subsidiaries) is subject to the lien of the EDE Mortgage. Restrictions in the EDE mortgage bond indenture could affect our liquidity. The principal amount of all series of first mortgage bonds outstanding at any one time under the Indenture of Mortgage and Deed of Trust of The Empire District Electric Company (EDE Mortgage) is limited by terms of the mortgage to $1.0 billion. Based on the $1.0 billion limit, and our current level of outstanding first mortgage bonds, we are limited to the issuance of $357.0 million of new first mortgage bonds. The EDE Mortgage contains a requirement that for new first mortgage bonds to be issued, our net earnings (as defined in the EDE Mortgage) for any twelve consecutive months within the fifteen months preceding issuance must be two times the annual interest requirements (as defined in the EDE Mortgage) on all first mortgage bonds then outstanding and on the prospective issue of new first mortgage bonds. Our earnings for the year ended December 31, 2014 would permit us to issue approximately $615.9 million of new first mortgage bonds based on this test with an assumed interest rate of 5.5%. In addition to the interest coverage requirement, the EDE Mortgage provides that new bonds must be issued against, among other things, retired bonds or 60% of net property additions. At December 31, 2014, we had retired bonds and net property additions which would enable the issuance of at least $952.5 million principal amount of bonds if the annual interest requirements are met. As of December 31, 2014, we are in compliance with all restrictive covenants of the EDE Mortgage. EDG Mortgage Indenture. The principal amount of all series of first mortgage bonds outstanding at any one time under the Indenture of Mortgage and Deed of Trust of The Empire District Gas Company (EDG Mortgage) is limited by terms of the mortgage to $300.0 million. Substantially all of the property, plant and equipment of The Empire District Gas Company is subject to the lien of the EDG Mortgage. The EDG Mortgage contains a requirement that for new first mortgage bonds to be issued, the amount of such new first mortgage bonds shall not exceed 75% of the cost of property additions acquired after the date of the Missouri Gas acquisition. The mortgage also contains a limitation on the issuance by EDG of debt (including first mortgage bonds, but excluding short-term debt incurred in the ordinary course under working capital facilities) unless, after giving effect to such issuance, EDG's ratio of EBITDA (defined as net income plus interest, taxes, depreciation, amortization and certain other non-cash charges) to interest charges for the most recent four fiscal quarters is at least 2.0 to 1.0. As of December 31, 2014, this test would allow us to issue approximately $19.7 million principal amount of new first mortgage bonds at an assumed interest rate of 5.5%. Credit Ratings Corporate credit ratings and the ratings for our securities are as follows: *Not rated. On January 30, 2014, Moody's upgraded our corporate credit rating to Baa1 from Baa2, senior secured debt to A2 from A3, senior unsecured debt to Baa1 from Baa2 and affirmed our commercial paper rating at P-2. Standard & Poor's and Fitch reaffirmed our ratings on March 20, 2014 and September 30, 2014, respectively. A security rating is not a recommendation to buy, sell or hold securities. Each rating is subject to revision or withdrawal at any time by the assigning rating organization. Each security rating agency has its own methodology for assigning ratings, and, accordingly, each rating should be considered independently of all other ratings. CONTRACTUAL OBLIGATIONS Set forth below is information summarizing our contractual obligations as of December 31, 2014. Other pension and postretirement benefit plans are funded on an ongoing basis to match their corresponding costs, per regulatory requirements, and have been estimated for 2015 - 2019 as noted below. (1)Some of our contractual obligations have price escalations based on economic indices, but we do not anticipate these escalations to be significant. (2)Excludes payments under our Elk River Wind Farm, LLC and Cloud County Wind Farm, LLC agreements, as payments are contingent upon output of the facilities. Payments under the Elk River Wind Farm, LLC agreement can run from zero up to a maximum of approximately $16.9 million per year based on a 20 year average cost and an annual output of 550,000 megawatt hours. Payments under the Meridian Way Wind Farm agreement can range from zero to a maximum of approximately $14.6 million per year based on a 20-year average cost. (3)Includes a water usage contract for our SLCC facility, fuel and purchased power contracts and associated transportation costs, as well as purchased power for 2014 through 2039 for Plum Point. (4)Represents fuel contracts and associated transportation costs of our gas segment. (5)Other long-term liabilities primarily represent electric facilities charges paid to City Utilities of Springfield, Missouri of $11,000 per month over 30 years. DIVIDENDS Holders of our common stock are entitled to dividends if, as, and when declared by the Board of Directors, out of funds legally available therefore, subject to the prior rights of holders of any outstanding cumulative preferred stock and preference stock. Payment of dividends is determined by our Board of Directors after considering all relevant factors, including the amount of our retained earnings (which is essentially our accumulated net income less dividend payouts). A reduction of our dividend per share, partially or in whole, could have an adverse effect on our common stock price. The following table shows our diluted earnings per share, dividends paid per share, total dividends paid and retained earnings balance for the years ended December 31, 2014, 2013 and 2012: Under Kansas corporate law, our Board of Directors may only declare and pay dividends out of our surplus or, if there is no surplus, out of our net profits for the fiscal year in which the dividend is declared or the preceding fiscal year, or both. Our surplus, under Kansas law, is equal to our retained earnings plus accumulated other comprehensive income/(loss), net of income tax. However, Kansas law does permit, under certain circumstances, our Board of Directors to transfer amounts from capital in excess of par value to surplus. In addition, Section 305(a) of the Federal Power Act (FPA) prohibits the payment by a utility of dividends from any funds "properly included in capital account". There are no additional rules or regulations issued by the FERC under the FPA clarifying the meaning of this limitation. However, several decisions by the FERC on specific dividend proposals suggest that any determination would be based on a fact-intensive analysis of the specific facts and circumstances surrounding the utility and the dividend in question, with particular focus on the impact of the proposed dividend on the liquidity and financial condition of the utility. In addition, the EDE Mortgage and our Restated Articles contain certain dividend restrictions. The most restrictive of these is contained in the EDE Mortgage, which provides that we may not declare or pay any dividends (other than dividends payable in shares of our common stock) or make any other distribution on, or purchase (other than with the proceeds of additional common stock financing) any shares of, our common stock if the cumulative aggregate amount thereof after August 31, 1944 (exclusive of the first quarterly dividend of $98,000 paid after said date) would exceed the sum of $10.75 million and the earned surplus (as defined in the EDE Mortgage) accumulated subsequent to August 31, 1944, or the date of succession in the event that another corporation succeeds to our rights and liabilities by a merger or consolidation. The EDE Mortgage permits the payment of any dividend or distribution on, or purchase of, shares of our common stock within 60 days after the related date of declaration or notice of such dividend, distribution or purchase if (i) on the date of declaration or notice, such dividend, distribution or purchase would have complied with the provisions of the EDE Mortgage and (ii) as of the last day of the calendar month ended immediately preceding the date of such payment, our ratio of total indebtedness to total capitalization (after giving pro forma effect to the payment of such dividend, distribution, or purchase) was not more than 0.625 to 1. OFF-BALANCE SHEET ARRANGEMENTS We have no off-balance sheet arrangements that have or are reasonably likely to have a current or future effect on our financial condition, changes in financial condition, revenues or expenses, results of operations, liquidity, capital expenditures or capital resources, other than operating leases entered into in the normal course of business. CRITICAL ACCOUNTING POLICIES Set forth below are certain accounting policies that are considered by management to be critical and that typically require difficult, subjective or complex judgments, often as a result of the need to make estimates about the effect of matters that are inherently uncertain (other accounting policies may also require assumptions that could cause actual results to be different than anticipated results). A change in assumptions or judgments applied in determining the following matters, among others, could have a material impact on future financial results. Pensions and Other Postretirement Benefits (OPEB). We recognize expense related to pension and other postretirement benefits as earned during the employee's period of service. Related assets and liabilities are established based upon the funded status of the plan compared to the accumulated benefit obligation. Our pension and OPEB expense or benefit includes amortization of previously unrecognized net gains or losses. Additional income or expense may be recognized when our unrecognized gains or losses as of the most recent measurement date exceed 10% of our postretirement benefit obligation or fair value of plan assets, whichever is greater. For pension benefits and OPEB benefits, unrecognized net gains or losses as of the measurement date are amortized into actuarial expense over ten years. See Note 1 and Note 7 of "Notes to Consolidated Financial Statements" under Item 8 for further information. Based on the regulatory treatment of pension and OPEB recovery afforded in our jurisdictions, we record the amount of unfunded defined benefit pension and postretirement plan obligations as regulatory assets on our balance sheet rather than as reductions of equity through comprehensive income. Our funding policy is to contribute annually an amount at least equal to the actuarial cost of postretirement benefits. The actual minimum pension funding requirements will be determined based on the results of the actuarial valuations and the performance of our pension assets during the current year. See Note 7 of "Notes to Consolidated Financial Statements" under Item 8. Risks and uncertainties affecting the application of our pension accounting policy include: future rate of return on plan assets, interest rates used in valuing benefit obligations (i.e. discount rates), demographic assumptions (i.e. mortality and retirement rates) and employee compensation trend rates. Factors that could result in additional pension expense and/or funding include: a lower discount rate than estimated, higher compensation rate increases, lower return on plan assets, and longer retirement periods. Risks and uncertainties affecting the application of our OPEB accounting policy and related funding include: future rate of return on plan assets, interest rates used in valuing benefit obligations (i.e. discount rates), healthcare cost trend rates, Medicare prescription drug costs and demographic assumptions (i.e. mortality and retirement rates). See Note 1 and Note 7 of "Notes to Consolidated Financial Statements" under Item 8 for further information. We expect future pension and OPEB expense or benefits are probable of full recovery in our rates, thus lowering our sensitivity to accounting risks and uncertainties. Regulatory Assets and Liabilities. In accordance with the ASC accounting guidance for regulated activities, our financial statements reflect ratemaking policies prescribed by the regulatory commissions having jurisdiction over us (Missouri, Kansas, Arkansas, Oklahoma and the FERC). In accordance with accounting guidance for regulated activities, we record a regulatory asset for all or part of an incurred cost that would otherwise be charged to expense in accordance with the accounting guidance, which requires that an asset be recorded if it is probable that future revenue in an amount at least equal to the capitalized cost will be allowable for costs for rate making purposes and the current available evidence indicates that future revenue will be provided to permit recovery of the cost. Additionally, we follow the accounting guidance for regulated activities which says that a liability should be recorded when a regulator has provided current recovery for a cost that is expected to be incurred in the future. We follow this guidance for incurred costs or credits that are subject to future recovery from or refund to our customers in accordance with the orders of our regulators. Historically, all costs of this nature, which are determined by our regulators to have been prudently incurred, have been recoverable through rates in the course of normal ratemaking procedures. Regulatory assets and liabilities are ratably eliminated through a charge or credit, respectively, to earnings while being recovered in revenues and fully recognized if and when it is no longer probable that such amounts will be recovered through future revenues. We continually assess the recoverability of our regulatory assets. Although we believe it unlikely, should retail electric competition legislation be passed in the states we serve, we may determine that we no longer meet the criteria set forth in the ASC accounting guidance for regulated activities with respect to continued recognition of some or all of the regulatory assets and liabilities. Any regulatory changes that would require us to discontinue application of ASC accounting guidance for regulated activities based upon competitive or other events may also impact the valuation of certain utility plant investments. Impairment of regulatory assets or utility plant investments could have a material adverse effect on our financial condition and results of operations. As of December 31, 2014, we have recorded $220.5 million in regulatory assets and $136.4 million as regulatory liabilities. See Note 3 of "Notes to Consolidated Financial Statements" under Item 8 for detailed information regarding our regulatory assets and liabilities. Risks and uncertainties affecting the application of this accounting policy include: regulatory environment, external regulatory decisions and requirements, anticipated future regulatory decisions and their impact of deregulation and competition on ratemaking process, unexpected disallowances, possible changes in accounting standards (including as a result of adoption of IFRS) and the ability to recover costs. Fuel Adjustment Clause. Typical fuel adjustment clauses permit the distribution to customers of changes in fuel costs, subject to routine regulatory review, without the need for a general rate proceeding. Fuel adjustment clauses are presently applicable to our retail electric sales in Missouri, Oklahoma and Kansas and system wholesale kilowatt-hour sales under FERC jurisdiction. We have an Energy Cost Recovery Rider in Arkansas that adjusts for changing fuel and purchased power costs on an annual basis. The MPSC established a base cost in rates for the recovery of fuel and purchased power expenses used to supply energy. The fuel adjustment clause permits the distribution to our Missouri customers of 95% of the changes in fuel and purchased power costs prudently incurred above or below the base cost. Off-system sales margins are also part of the recovery of fuel and purchased power costs. As a result, nearly all of the off-system sales margin flows back to the customer. Unbilled Revenue. At the end of each period we estimate, based on expected usage, the amount of revenue to record for energy and natural gas that has been provided to customers but not billed. Risks and uncertainties affecting the application of this accounting policy include: projecting customer energy usage, estimating the impact of weather and other factors that affect usage (such as line losses) for the unbilled period and estimating loss of energy during transmission and delivery. Assumptions such as electrical load requirements, customer billing rates, and line loss factors are used in the estimation process and are evaluated periodically. Changes to certain assumptions during the evaluation process can lead to a change in the estimate. Contingent Liabilities. We are a party to various claims and legal proceedings arising in the ordinary course of our business, which are primarily related to workers' compensation and public liability. We regularly assess our insurance deductibles, analyze litigation information with our attorneys and evaluate our loss experience. Based on our evaluation as of the end of 2013, we believe that we have accrued liabilities in accordance with ASC accounting guidance sufficient to meet potential liabilities that could result from these claims. This liability at December 31, 2014 and 2013 was 3.6 million and $4.0 million, respectively. Risks and uncertainties affecting these assumptions include: changes in estimates on potential outcomes of litigation and potential litigation yet unidentified in which we might be named as a defendant. Goodwill. As of December 31, 2014, the consolidated balance sheet included $39.5 million of goodwill. All of this goodwill was derived from our gas acquisition and recorded in our gas segment, which is also the reporting unit for goodwill testing purposes. Accounting guidance requires us to test goodwill for impairment on an annual basis or whenever events or circumstances indicate possible impairment. Absent an indication of fair value from a potential buyer or a similar specific transaction, a combination of the market and income approaches is used to estimate the fair value of goodwill. We use the market approach which estimates fair value of the gas reporting unit by comparing certain financial metrics to comparable companies. Comparable companies whose securities are actively traded in the public market are judgmentally selected by management based on operational and economic similarities. We utilize EBITDA (earnings before interest, taxes, depreciation, and amortization) multiples of the comparable companies in relation to the EBITDA results of the gas reporting unit to determine an estimate of fair value. We also utilize a valuation technique under the income approach which estimates the discounted future cash flows of operations. Our procedures include developing a baseline test and performing sensitivity analysis to calculate a reasonable valuation range. The sensitivities are derived from altering those assumptions which are subjective in nature and inherent to a discounted cash flows calculation. Other qualitative factors and comparisons to industry peers are also used to further support the assumptions and ultimately the overall evaluation. A key qualitative assumption considered in our evaluation is the impact of regulation, including rate regulation and cost recovery for the gas reporting unit. Some of the key quantitative assumptions included in our tests involve: regulatory rate design and results; the discount rate; the growth rate; capital spending rates and terminal value calculations. If negative changes occurred to one or more key assumptions, an impairment charge could result. With the exception of the capital spending rate, the key assumptions noted are significantly determined by market factors and significant changes in market factors that impact the gas reporting unit would somewhat be mitigated by our current and future regulatory rate design to some extent. Other risks and uncertainties affecting these assumptions include: changes in business, industry, laws, technology and economic conditions. Actual results for the gas reporting unit indicate a slight decline in gas customer count and demand. A continued decline in customer count or demand coupled with an increase in the discount rate would have adverse impacts on the valuation and could result in an impairment charge in the future. Our forecasts anticipate relatively flat customer counts over the next several years. We weight the results of the two approaches discussed above in order to estimate the fair value of the gas reporting unit. Our annual test performed as of October 2014 indicated the estimated fair market value of the gas reporting unit to be $10 - 14 million higher than its carrying value at that time. While we believe the assumptions utilized in our analysis were reasonable, adverse developments in future periods could negatively impact goodwill impairment considerations, which could adversely impact earnings. Specifically, the quantitative assumptions noted previously, such as an increase to the discount rate or decline in the terminal value calculation could lead to an impairment charge in the future. Use of Management's Estimates. The preparation of our consolidated financial statements in conformity with generally accepted accounting principles (GAAP) requires management to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenues and expenses, and related disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. We evaluate our estimates on an on-going basis, including those related to unbilled utility revenues, collectibility of accounts receivable, depreciable lives, asset impairment and goodwill evaluations, employee benefit obligations, contingent liabilities, asset retirement obligations, the fair value of stock based compensation and tax provisions. Actual amounts could differ from those estimates. RECENTLY ISSUED ACCOUNTING STANDARDS See Note 1 of "Notes to Consolidated Financial Statements" under Item 8 for further information regarding Recently Issued and Proposed Accounting Standards.

<s>[INST] Electric Segment As a vertically integrated regulated utility, the primary drivers of our electric operating margins (defined as electric revenues less fuel and purchased power costs) in any period are: (1) rates we can charge our customers, including timing of new rates, (2) weather, (3) customer growth and usage and (4) general economic conditions. The utility commissions in the states in which we operate, as well as the Federal Energy Regulatory Commission (FERC), set the rates which we can charge our customers. In order to offset expenses, we depend on our ability to receive adequate and timely recovery of our costs (primarily fuel and purchased power and construction costs) and/or rate relief. We assess the need for rate relief in all of the jurisdictions we serve and file for such relief when necessary. The effects of timing of rate relief are discussed in detail in Note 3 of "Notes to the Consolidated Financial Statements" under Item 8. Of the factors driving margins, weather has the greatest shortterm effect on the demand for electricity for our regulated business. Very hot summers and very cold winters increase electric demand, while mild weather reduces demand. Residential and commercial sales are impacted more by weather than industrial sales, which are mostly affected by business needs for electricity and by general economic conditions. Customer growth, which is the growth in the number of customers, contributes to the demand for electricity. We expect our electric customer and sales growth to be less than 1.0% annually over the next several years. Our electric customer growth for the year ended December 31, 2014 was 0.3%. We define electric sales growth to be growth in kWh sales period over period excluding the estimated impact of weather. The primary drivers of electric sales growth are customer growth, customer usage and general economic conditions. The primary drivers of our electric operating expenses in any period are: (1) fuel and purchased power expense, (2) operating maintenance and repairs expense, including repairs following severe weather and plant outages, (3) taxes and (4) noncash items such as depreciation and amortization expense. We have a fuel cost recovery mechanism in all of our jurisdictions, which significantly reduces the impact of fluctuating fuel and purchased power costs on our net income. Gas Segment The primary drivers of our gas operating revenues in any period are: (1) rates we can charge our customers, (2) weather, (3) customer growth and usage, (4) the cost of natural gas and interstate pipeline transportation charges and (5) general economic conditions. The MPSC sets the rates which we can charge our customers. In order to offset expenses, we depend on our ability to receive adequate and timely recovery of our costs (primarily commodity natural gas) and/or rate relief. We assess the need for rate relief and file for such relief when necessary. A Purchased Gas Adjustment (PGA) clause is included in our gas rates, which allows us to recover our actual cost of natural gas from customers through rate changes, which are made periodically (up to four times) throughout the year in response to weather conditions, natural gas costs and supply demands. Weather affects the demand for natural gas. Very cold winters increase demand for gas, while mild weather reduces demand. Due to the seasonal nature of the gas business, revenues and earnings are typically concentrated in the November through March period, which generally corresponds with the heating season. Customer growth, which is the growth in the number of customers, contributes to the demand for gas. Our annual customer growth is calculated by comparing the number of customers at the end of a year to the number of customers at the end of the prior year. Our gas segment customer count decreased 0.2% for the year ended December 31, 2014, which we believe was due to population losses in the rural communities we serve. We expect gas customer growth to be flat during the next several years. We define gas sales growth to be growth in mcf sales excluding the impact of weather. The primary drivers of gas sales growth are customer growth and general economic conditions. The primary driver of our gas operating expense in any period is the price of natural gas. However, because gas purchase costs for our gas utility operations are normally recovered from our customers, any change in gas prices does not have a corresponding impact on income unless such costs are deemed imprudent or cause customers to reduce usage. Earnings For the year ended December 31, 2014, basic and diluted earnings [/INST] Negative. </s>

EMPIRE DISTRICT ELECTRIC CO

2016-02-26

2015-12-31

ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS EXECUTIVE SUMMARY Electric Segment As a vertically integrated regulated utility, the primary drivers of our electric operating margin (defined as electric revenues less fuel and purchased power costs) in any period are: (1) rates we can charge our customers, including timing of new rates, (2) weather, (3) customer growth and usage and (4) general economic conditions. The utility commissions in the states in which we operate, as well as the Federal Energy Regulatory Commission (FERC), set the rates which we can charge our customers. In order to offset expenses, we depend on our ability to receive adequate and timely recovery of our costs (primarily fuel and purchased power and construction costs) and/or rate relief. We assess the need for rate relief in all of the jurisdictions we serve and file for such relief when necessary. The regulatory lag that occurs between the time we incur costs and the time when we can start recovering the costs through rates has a negative impact on earnings. The effects of timing of rate relief are discussed in detail in Note 3 of "Notes to the Consolidated Financial Statements" under Item 8. Of the factors driving electric operating margin, weather has the greatest short-term effect on the demand for electricity for our regulated business. Very hot summers and very cold winters increase electric demand, while mild weather reduces demand. Residential and commercial sales are impacted more by weather than industrial sales, which are mostly affected by business needs for electricity and by general economic conditions. Customer growth, which is the growth in the number of customers, contributes to the demand for electricity. We expect our electric customer and sales growth to be less than 1.0% annually over the next several years. Our electric customer growth for the year ended December 31, 2015 was 0.5%. We define electric sales growth to be growth in kWh sales period over period excluding the estimated impact of weather. The primary drivers of electric sales growth are customer growth, customer usage and general economic conditions. The primary drivers of our electric operating expenses in any period are: (1) fuel and purchased power expense, (2) operating maintenance and repairs expense, including repairs following severe weather and plant outages, (3) taxes and (4) non-cash items such as depreciation and amortization expense. We have a fuel cost recovery mechanism in all of our jurisdictions, which significantly reduces the impact of fluctuating fuel and purchased power costs on our net income. Gas Segment The primary drivers of our gas operating revenues in any period are: (1) rates we can charge our customers, (2) weather, (3) customer growth and usage, (4) the cost of natural gas and interstate pipeline transportation charges and (5) general economic conditions. The MPSC sets the rates which we can charge our customers. In order to offset expenses, we depend on our ability to receive adequate and timely recovery of our costs (primarily commodity natural gas) and/or rate relief. We assess the need for rate relief and file for such relief when necessary. A Purchased Gas Adjustment (PGA) clause is included in our gas rates, which allows us to recover our actual cost of natural gas from customers through rate changes, which are made periodically (up to four times) throughout the year in response to weather conditions, natural gas costs and supply demands. Weather affects the demand for natural gas. Very cold winters increase demand for gas, while mild weather reduces demand. Due to the seasonal nature of the gas business, revenues and earnings are typically concentrated in the November through March period, which generally corresponds with the heating season. Customer growth, which is the growth in the number of customers, contributes to the demand for gas. Our annual customer growth is calculated by comparing the number of customers at the end of a year to the number of customers at the end of the prior year. Our gas segment customer count decreased 0.5% for the year ended December 31, 2015, which we believe was due to population losses in the rural communities we serve. We expect gas customer growth to be flat during the next several years. We define gas sales growth to be growth in mcf sales excluding the impact of weather. The primary drivers of gas sales growth are customer growth and general economic conditions. The primary driver of our gas operating expense in any period is the price of natural gas. However, because gas purchase costs for our gas utility operations are normally recovered from our customers, any change in gas prices does not have a corresponding impact on income unless such costs are deemed imprudent or cause customers to reduce usage. Earnings For the year ended December 31, 2015, basic earnings per weighted average share of common stock were $1.30 and diluted earnings per weighted average share of common stock were $1.29 on $56.6 million of net income. For the year ended December 31, 2014, basic and diluted earnings per weighted average share of common stock were $1.55 on $67.1 million of net income. Increased electric gross margin positively impacted net income for 2015 as compared to 2014 mainly due to increased electric rates for our Missouri customers effective July 26, 2015 and improved customer counts. The impact of mild weather during the 2015 heating season, as well as increased regulatory operating and maintenance expense, property taxes, and depreciation and amortization expense negatively impacted 2015 results. These increased expenses were driven in large part by the completion of the Asbury Air Quality Control System (AQCS) environmental upgrade that went into service December 14, 2014. Due to regulatory lag, however, these higher costs did not begin to be recovered in electric rates until new Missouri rates took effect on July 26, 2015. The table below sets forth a reconciliation of basic and diluted earnings per share (EPS) between 2014 and 2015, which is a non-GAAP presentation. The economic substance behind our non-GAAP earnings per share measure is to present the after tax impact of significant items and components of the statement of income on a per share basis before the impact of additional stock issuances. The dilutive effect of additional shares issued included in the table reflects the estimated impact of all shares issued during the period. We believe this presentation is useful to investors because the statement of income does not readily show the EPS impact of the various components, including the effect of new stock issuances. This could limit the readers' understanding of the reasons for the EPS change from the previous year's EPS. This information is useful to management, and we believe this information is useful to investors, to better understand the reasons for the fluctuation in EPS between the prior and current years on a per share basis. In addition, although a non-GAAP presentation, we believe the presentation of gross margin (in the table below and elsewhere in this report) is useful to investors and others in understanding and analyzing changes in our electric operating performance from one period to the next, and have included the analysis as a complement to the financial information we provide in accordance with GAAP. This reconciliation and margin information may not be comparable to other companies' presentations or more useful than the GAAP presentation included in the statements of income or elsewhere in this report. We also note that this presentation does not purport to be an alternative to EPS determined in accordance with GAAP as a measure of operating performance or any other measure of financial performance presented in accordance with GAAP. Management compensates for the limitations of using non-GAAP financial measures by using them to supplement GAAP results to provide a more complete understanding of the factors and trends affecting the business than GAAP results alone. Fourth Quarter Results Earnings for the fourth quarter of 2015 were $9.9 million, or $0.23 per share, as compared to $11.1 million, or $0.26 per share, in the fourth quarter of 2014. Electric segment gross margin increased during the quarter ending December 31, 2015 compared to the 2014 quarter, reflecting increased electric rates for our Missouri customers effective July 26, 2015 and improved customer counts. The impact of mild weather, as well as increased regulatory operating expense, property taxes, and depreciation and amortization expense and reduced AFUDC, negatively impacted 2015 fourth quarter results. 2015 Activities Riverton Unit 12 Combined Cycle Project As part of our environmental Compliance Plan, discussed in Note 11 of "Notes to Consolidated Financial Statements" under Item 8, we are currently completing the conversion of Riverton Unit 12 from a simple cycle combustion turbine to a combined cycle unit. The tie-in outage for the Riverton Unit 12 Combined Cycle Project was completed in October 2015 and mechanical completion was achieved on December 15, 2015. Start-up and commissioning of the unit is currently in progress with contractual substantial completion by June 1, 2016. Regulatory Matters On October 16, 2015, we filed a request with the Missouri Public Service Commission (MPSC) for changes in rates for our Missouri electric customers. We are seeking an annual increase in total revenue of approximately $33.4 million, or approximately 7.3%. The most significant factor driving the rate request is the cost associated with the conversion of the Riverton Unit 12 natural gas combustion turbine to combined cycle operation. (See Note 11 - New Construction of "Notes to Consolidated Financial Statements" under Item 8). On June 24, 2015, the MPSC granted new rates for Missouri customers for our rate case filed on August 29, 2014. Rates were effective July 26, 2015. The order approved an annual increase in base revenues of about $17.1 million or 3.90%, which included a net reduction in base fuel and purchased power of $1.60 per MWh, and other items consistent with the non-unanimous stipulation and agreement filed April 8, 2015. On January 22, 2015, we filed an Application with the Kansas Corporation Commission (KCC) requesting approval of our Ad Valorem Tax Surcharge (AVTS). The request sought approval for an annual increase of $0.27 million related to increases in Ad Valorem taxes which exceed amounts currently included in base rates. On February 19, 2015, the KCC approved the request. The new rate was effective on and after February 23, 2015. On January 21, 2016, we filed an Application with the KCC requesting approval for a revision to the AVTS. The request sought approval for an annual increase of an additional $0.20 million related to increases in Ad Valorem taxes which exceed amounts currently included in our AVTS rider currently in effect. On June 8, 2015, the governor of the state of Oklahoma approved an administrative ruling that provides customer rate reciprocity to electric companies who serve less than 10% of total customers within the state of Oklahoma. As a result, future increases in Missouri customer rates approved by the MPSC will be effective for our Oklahoma customers, subject to Oklahoma Corporation Commission (OCC) approval. On October 26, 2015, we filed a request with the OCC to adopt the Missouri customer electric rates requested in our October 16, 2015 Missouri rate filing discussed above for our Oklahoma customers once approval is granted by the MPSC. On October 29, 2013, we filed an application with the MPSC seeking approval, pursuant to the Missouri Energy Efficiency Investment Act (MEEIA), of a new Missouri demand-side management (DSM) portfolio, including four new DSM programs, and for the authority to establish a Demand Side Management Investment Mechanism (DSIM). On July 24, 2015, we filed a motion to withdraw our MEEIA filing. We will continue our current portfolio of Energy Efficiency programs, with recovery through base rates. We will review the need for a future MEEIA filing in conjunction with our 2016 Integrated Resource Plan (IRP). On July 31, 2015, we filed a notice updating our most recent IRP, with the MPSC. In the notice we indicated that Riverton Units 8 and 9 were retired on June 30, 2015. The notice also provides additional information on our MEEIA application withdrawal mentioned above. On May 6, 2015, the MPSC approved tariffs we filed on May 5, 2015 to establish solar rebate payment procedures and revise our net metering tariffs to accommodate the payment of solar rebates mandated by the Missouri Clean Energy Initiative. The law provides a number of methods that may be utilized to recover the associated expenses. We expect these costs to be recoverable in rates. See Note 11 - Renewable Energy of "Notes to Consolidated Financial Statements" under Item 8 for information regarding the Clean Energy Initiative. On February 23, 2015, we filed a notice with the Arkansas Public Service Commission (APSC) to implement the Alternative Generation Environmental Recovery Rider (GER) pursuant to the provision of Act 310 of 1981. The GER recovers reasonably incurred costs and expenditures as a direct result of legislative or regulatory requirements relating to the protection of the public health, safety, or the environment. Our implemented GER recovers our Arkansas jurisdictional share of investment associated with the Asbury AQCS. The new GER was effective upon notice (February 23, 2015) subject to refund. On August 5, 2015, the APSC approved the GER. For additional information on all these cases, see Note 3 of "Notes to Consolidated Financial Statements" under Item 8 for information regarding regulatory matters. Financing Activities On June 11, 2015, we entered into a Bond Purchase Agreement for a private placement of $60.0 million of 3.59% First Mortgage Bonds due 2030. A delayed settlement occurred on August 20, 2015. Interest is payable semi-annually on the bonds on each February 20 and August 20, commencing February 20, 2016. We utilized the proceeds from the sale of the bonds for the Riverton combined cycle project and for general corporate purposes. For additional information, see Note 6 of "Notes to Consolidated Financial Statements" under Item 8. Subsequent Events Pending Acquisition of Empire by Liberty Utilities (Central) Co. On February 9, 2016, Empire entered into an Agreement and Plan of Merger (the Merger Agreement) with Liberty Utilities (Central) Co., a Delaware corporation (Liberty), and Liberty Sub Corp., a Kansas corporation (Merger Sub), providing for the merger of Merger Sub with and into Empire, with Empire surviving the Merger as a wholly-owned subsidiary of Liberty (the Merger). Pursuant to the Merger Agreement, at the effective time of the Merger, each issued and outstanding share of Empire common stock (other than any shares owned by Empire or Algonquin Power & Utilities Corp. (APUC)) or any of their respective subsidiaries or any shares for which appraisal rights have been perfected) will be cancelled and converted automatically into the right to receive $34.00 in cash, without interest. The closing of the Merger is subject to certain conditions, including, among others, approval of Empire shareholders, expiration or termination of the applicable Hart-Scott-Rodino Act waiting period and receipt of all required regulatory approvals and consents, including from the Federal Energy Regulatory Commission, the Federal Communications Commission, the Arkansas Public Service Commission, the Kansas Corporation Commission, the Missouri Public Service Commission, the Oklahoma Corporation Commission and the Committee on Foreign Investment in the United States, which approvals and consents shall not, individually or in the aggregate, have or be reasonably likely to have a material adverse effect on the business, properties, financial condition or results of operations of Liberty Utilities Co. and its subsidiaries (including Empire and its subsidiaries), taken as a whole. If Empire shareholders do not approve the Merger, or the Merger is not consummated by February 9, 2017, the Merger Agreement may terminate, although it may be extended six months in order to obtain certain required regulatory approvals. The Merger Agreement also provides for certain other termination rights for both Empire and Liberty. If either party terminates the Merger Agreement because Empire's board of directors changes its recommendation, or, if within nine months after the termination of the Merger Agreement under certain circumstances, Empire shall have entered into a definitive agreement with respect to, or consummated, an alternative transaction, Empire must pay Liberty a termination fee of $53.0 million. If the Merger Agreement is terminated under certain other circumstances, including the failure to obtain required regulatory approvals, failure to consummate the Merger after all closing conditions have been satisfied and a financing failure has occurred or a breach by Liberty of its regulatory cooperation covenants, Liberty must pay Empire a termination fee of $65.0 million. Simultaneously with the execution of the Merger Agreement, Liberty delivered to Empire a guarantee agreement (the Guarantee Agreement) executed by APUC, the parent of Liberty Utilities Co. The Guarantee Agreement provides for an unconditional and irrevocable guarantee by APUC of the full and prompt payment and performance, when due, of all obligations of Liberty and Merger Sub under the Merger Agreement. In connection with entering into the Merger Agreement, Empire has incurred approximately $0.2 million of transaction costs as of December 31, 2015. We expect that the total transaction costs will be approximately $15 to $17 million, with approximately 50% payable in 2016 (assuming a 2017 closing date), of which approximately $4.5 million will be incurred in the first quarter of 2016. The foregoing description of the Merger, the Merger Agreement and the Guarantee is not a complete description thereof and is qualified in its entirety by reference to the full text of the Merger Agreement and the Guarantee. For more information regarding the terms of the Merger, including copies of the Merger Agreement and the Guarantee, see Empire's Current Report on Form 8-K filed with the SEC on February 9, 2016. RESULTS OF OPERATIONS The following discussion analyzes significant changes in the results of operations for the years 2015, 2014 and 2013. The following table represents our results of operations by operating segment for the applicable years ended December 31 (in millions): Electric Segment Overview Our electric segment income for 2015 was $52.2 million as compared to $61.5 million and $58.6 million for 2014 and 2013, respectively. Electric on-system operating revenues for 2015, 2014, and 2013 were comprised of the following customer classes: *Primarily other public authorities Sales, Revenues and Gross Margin KWh Sales The amounts and percentage changes from the prior periods in kilowatt-hour ("kWh") sales by major customer class for on-system (native load) sales were as follows (in millions): (1)Percentage changes are based on actual kWh sales and may not agree to the rounded amounts shown above. (2)Other kWh sales include street lighting, other public authorities and interdepartmental usage. KWh sales for our on-system customers decreased during 2015 as compared to 2014 primarily due to decreased demand due to weather impacts. Residential kWh sales, the more weather sensitive class, decreased 5.9% primarily due to the impacts of milder weather during the 2015 heating season as compared to 2014. Commercial kWh sales decreased only 0.4% due to increased customer growth offsetting the impact of mild weather. Industrial sales increased 3.2% during 2015 as compared to 2014 mainly due to increased usage. Total heating degree days (the sum of the number of degrees that the daily average temperature for each day during that period was below 65° F) for 2015 were 16.6% less than 2014 and 11.3% less than the 30-year average. Total cooling degree days (the cumulative number of degrees that the average temperature for each day during that period was above 65° F) for 2015 were 5.8% more than 2014 and 12.0% more than the 30-year average. KWh sales for our on-system customers increased during 2014 as compared to 2013 primarily due to increased demand due to weather impacts, increased commercial demand and increased customer counts. Residential and commercial kWh sales increased 0.7% and 2.7%, respectively, primarily due to these weather impacts and increased customer counts. Industrial sales increased 1.6% during 2014 as compared to 2013 due to increased usage. On-system wholesale kWh sales decreased during 2014 as compared to 2013 reflecting the closure of a large dairy facility in Monett, Missouri during the second half of 2013. Total heating degree days for 2014 were 1.2% more than 2013 and 6.3% more than the 30-year average. Total cooling degree days for 2014 were 3.7% more than 2013 and 5.8% more than the 30-year average. Revenues and Gross Margin As shown in the Electric Segment Operating Revenues and Gross Margin table below, electric segment gross margin, defined as electric revenues less fuel and purchased power costs, increased approximately $7.8 million during 2015 as compared to 2014. Electric segment gross margin was positively impacted by the new Missouri retail on-system rate increase effective July 26, 2015 and an increase in average electric customer counts. Electric segment gross margin increased approximately $16.4 million during 2014 as compared to 2013 due to a full twelve months of increased Missouri electric rates that were effective April 1, 2013, increased demand resulting from weather impacts, higher commercial demand and an increase in average electric customer counts. The amounts and percentage changes from the prior period's electric segment operating revenues by major customer class for on-system and off-system sales, and the associated fuel and purchased power expense (including a reconciliation of our actual fuel and purchased power expenditures to the fuel and purchased power expense shown on our statements of income) were as follows (dollars in millions): (1)Slight differences from actual results, including percentage changes, may occur which may not agree to the rounded amounts shown above due to rounding to millions and percentage change based on actual, not rounded amounts shown. (2)Other operating revenues include street lighting, other public authorities and interdepartmental usage. (3)The SPP IM was implemented on March 1, 2014. As of December 31, 2014, off-system revenues were effectively replaced by SPP IM activity. See "- Markets and Transmission" below for more information. (4)Miscellaneous revenues include transmission service revenues, late payment fees, renewable energy credit sales, rent, etc. (5)Missouri ten year amortization of the $26.6 million payment received from the SWPA in September, 2010, of which $10.6 million of the Missouri portion remains to be amortized as of December 31, 2015. Revenues for our on-system customers decreased approximately $6.8 million (1.3%) during 2015 as compared to 2014. Increased revenues of $10.4 million, primarily due to the July 2015 increase in Missouri electric rates mentioned above, net of a $3.3 million decrease resulting from a lowering of Missouri base fuel recovery, contributed an estimated $7.1 million to revenues. Improved customer counts increased revenues an estimated $2.3 million. Weather and other volumetric related factors decreased revenues an estimated $10.3 million in 2015 as compared to 2014. Also negatively impacting revenues was a $1.3 million decrease in Missouri non-base fuel recovery revenue and a $3.2 million decrease in non-Missouri fuel recovery revenue (both of which were offset by a corresponding change in fuel expenses, resulting in no net effect on gross margin). Also decreasing revenues was a $1.4 million January 2015 refund to FERC wholesale customers, reflecting lower fuel costs from the SPP IM. Revenues for our on-system customers increased approximately $25.5 million (5.0%) during 2014 as compared to 2013. Rate changes, primarily the April 2013 Missouri rate increase, contributed an estimated $12.5 million to revenues. Weather and other volumetric related factors increased revenues an estimated $4.6 million in 2014 as compared to 2013. Improved customer counts increased revenues an estimated $1.6 million. A $6.8 million increase in fuel recovery revenue (offset by a corresponding change included in fuel expenses, resulting in no net effect on gross margin) from Missouri customers during 2014 as compared to 2013, positively impacted revenues. SPP Integrated Marketplace (IM) and Off-System Electric Transactions. In the past, in addition to sales to our own customers, we also sold power to other utilities as available, including (since 2007) through the SPP Energy Imbalance Services (EIS) market. However, on March 1, 2014, the SPP RTO implemented a Day-Ahead Market, or Integrated Marketplace (IM), which replaces the real-time EIS market. SPP IM activity is settled for each market participant in various time increments. When we sell more generation to the market than we purchase, based on the prescribed time increments, the net sale and corresponding net revenue is included as part of electric revenues. When we purchase more generation from the market than we sell, based on the prescribed time increments, the net purchase cost is recorded as a component of fuel and purchased power on the financial statements. See the Electric Segment Operating Revenues and Gross Margin table (SPP IM net purchases) above and "- Markets and Transmission" below. The majority of our market activity sales margin is included as a component of the fuel adjustment clause in our Missouri, Kansas and Oklahoma jurisdictions and our transmission rider in our Arkansas jurisdiction. As a result, nearly all of the market activity sales margin flows back to the customer and has little effect on gross margin or net income. Operating Expenses - Other Than Fuel and Purchased Power The table below shows regulated operating expense increases/(decreases) during 2015 as compared to 2014 and during 2014 as compared to 2013 (in millions): (1)Mainly due to increased SPP transmission charges. (2)Mainly due to a $1.0 million increase in power operation expense for the Asbury plant. The table below shows maintenance and repairs expense increases/(decreases) during 2015 as compared to 2014 and during 2014 as compared to 2013(in millions): (1)Mainly due to a planned maintenance outage. (2)Mainly due to a new maintenance contract for the Riverton facility. Depreciation and amortization expense increased approximately $7.2 million (10.7%) during 2015 as compared to 2014 primarily due to increased plant in service reflecting the completion of the Asbury AQCS project and other additions to plant in service. Depreciation and amortization expense increased approximately $3.9 million (6.1%) during 2014 as compared to 2013, primarily due to increased depreciation rates resulting from our 2013 Missouri electric rate case settlement and increased plant in service. Other taxes increased approximately $2.3 million in 2015 and $1.8 million in 2014 due to increased property tax (reflecting our additions to plant in service) and increased municipal franchise taxes. Gas Segment Gas Operating Revenues and Sales The following table details our natural gas sales for the years ended December 31: (1)Several commercial customers transferred to transportation customers during 2014, reflecting the decrease in commercial sales and the increase in transportation sales during 2014 compared to 2013. (2)Other includes other public authorities and interdepartmental usage. The following table details our natural gas revenues for the years ended December 31: (1)Several commercial customers transferred to transportation customers during 2014, reflecting the decrease in commercial revenues and the increase in transportation revenues during 2014 compared to 2013. (2)Other includes other public authorities and interdepartmental usage. Gas retail sales decreased 19.4% and gas retail revenues decreased 20.7% during 2015 as compared to 2014 primarily due to decreased demand from the impacts of milder weather during the 2015 heating season as compared to 2014. Weather in our gas territory in the fourth quarter of 2015 was the mildest in 34 years. Heating degree days were 19.1% lower in 2015 than 2014 and 10.8% lower than the 30-year average. Our gas segment gross margin (defined as gas operating revenues less cost of gas in rates) for 2015 decreased $2.6 million compared to 2014. Gas retail sales decreased 1.6% during 2014 as compared to 2013 due to commercial and industrial customers transferring to transportation service. Gas retail revenues increased 2.9% reflecting increased usage by the weather sensitive residential class due to colder weather in 2014 as compared to 2013 and higher gas costs recovered in revenues. Heating degree days were 1.7% higher in 2014 than 2013 and 10.2% higher than the 30-year average. Our gas segment gross margin (defined as gas operating revenues less cost of gas in rates) for 2014 increased $0.6 million compared to 2013. We have a PGA clause in place that allows us to recover from our customers, subject to routine regulatory review, the cost of purchased gas supplies, transportation and storage, including costs associated with the use of financial instruments to hedge the purchase price of natural gas. Pursuant to the provisions of the PGA clause, the difference between actual costs incurred and costs recovered through the application of the PGA are reflected as a regulatory asset or regulatory liability until the balance is recovered from or credited to customers. Operating Revenue Deductions The table below shows regulated operating expense increases/(decreases) for the years ended December 31: Our gas segment had net income of $1.3 million in 2015 as compared to $2.9 million in 2014 and $2.3 million in 2013. Consolidated Company Income Taxes The following table shows our consolidated provision for income taxes (in millions) and our consolidated effective federal and state income tax rates for the applicable years ended December 31: The effective tax rate for 2015 is higher than 2014 primarily due to lower equity AFUDC income in 2015 compared with 2014. The effective tax rate for 2014 is lower than 2013 primarily due to higher equity AFUDC income in 2014 compared with 2013. See Note 9 of "Notes to Consolidated Financial Statements" under Item 8 for information and discussion concerning our income tax provision and effective tax rates. Nonoperating Items The following table shows the total allowance for funds used during construction (AFUDC) for the applicable periods ended December 31. AFUDC decreased in 2015 as compared to 2014 reflecting the completion of the environmental retrofit project at our Asbury plant in December 2014. AFUDC increased in 2014 as compared to 2013 reflecting construction for the environmental retrofit project at our Asbury plant and the Riverton 12 combined cycle project. See Note 1 of "Notes to Consolidated Financial Statements" under Item 8. Total interest charges on long-term and short-term debt for 2015, 2014 and 2013 are shown below. The change in long-term debt interest for 2015 compared to 2014 reflects the issuance on December 1, 2014, of $60.0 million of 4.27% First Mortgage Bonds due 2044 and the issuance of $60.0 million of 3.59% First Mortgage Bonds due 2030 on August 20, 2015. The proceeds from both bond issuances were used to refinance existing short-term indebtedness and for general corporate purposes. The change in long-term debt interest for 2014 compared to 2013 reflects the issuance, on May 30, 2013, of $30.0 million of 3.73% First Mortgage Bonds due May 30, 2033 and $120.0 million of 4.32% First Mortgage Bonds due May 30, 2043. We used a portion of the proceeds from the sale of these bonds to redeem all $98.0 million aggregate principal amount of our Senior Notes, 4.50% Series due June 15, 2013. RATE MATTERS We routinely assess the need for rate relief in all of the jurisdictions we serve and file for such relief when necessary. Our rates for retail electric and natural gas services (other than specially negotiated retail rates for industrial or large commercial customers, which are subject to regulatory review and approval) are determined on a "cost of service" basis. Rates are designed to provide, after recovery of allowable operating expenses, an opportunity for us to earn a reasonable return on "rate base." "Rate base" is generally determined by reference to the original cost (net of accumulated depreciation and amortization) of utility plant in service, subject to various adjustments for deferred taxes and other items. Over time, rate base is increased by additions to utility plant in service and reduced by depreciation, amortization and retirement of utility plant or write-off's as ordered by the utility commissions. In general, a request of new rates is made on the basis of a "rate base" as of a date prior to the date of the request and allowable operating expenses for a 12-month test period ended prior to the date of the request. Although the current rate making process provides recovery of some future changes in rate base and operating costs, it does not reflect all changes in costs for the period in which new retail rates will be in place. This results in a lag (commonly referred to as "regulatory lag") between the time we incur costs and the time when we can start recovering the costs through rates. The following table sets forth information regarding electric and water rate increases since January 1, 2013: See Note 3 of "Notes to Consolidated Financial Statements" under Item 8 for additional information regarding rate matters. MARKETS AND TRANSMISSION Electric Segment Day Ahead Market: On March 1, 2014, the SPP RTO implemented its Integrated Marketplace (IM) (or Day-Ahead Market), which replaced the Energy Imbalance Services (EIS) market. The SPP RTO created a single NERC-approved balancing authority (BA) that took over balancing authority responsibilities for its members, including Empire. As part of the IM, we and other SPP members submit generation offers to sell our power and bids to purchase power into the SPP market, with the SPP serving as a centralized commitment and dispatch of SPP members' generation resources. The SPP matches offers and bids based upon operating and reliability considerations. The SPP reports that approximately 90% - 95% of all next day generation needed throughout the SPP territory is being cleared through the IM. We also acquire Transmission Congestion Rights (TCR) through annual and monthly processes in an attempt to mitigate congestion costs associated with the power we purchase from the IM. When we sell more generation to the market than we purchase for a given settlement period, the net sale is included as part of electric revenues. When we purchase more generation from the market than we sell, the net purchase is recorded as a component of fuel and purchased power on our financial statements. The net financial effect of these IM transactions is included in our fuel adjustment mechanisms and therefore has little impact on gross margin. SPP/Midcontinent Independent System Operator (MISO) Joint Operating Agreement and Plum Point Delivery: Due to Plum Point's physical location and interconnection, transmission service from Entergy/MISO is required for delivery. On December 19, 2013, Entergy voluntarily integrated its generation, transmission, and load into the MISO regional transmission organization. Based on the current terms and conditions of MISO membership, Entergy's participation in MISO has increased transmission delivery costs for our Plum Point power station as well as utilizes our transmission system without compensation. As a result, we have participated with the SPP members and other impacted utilities in two separate FERC settlement proceedings in an effort to reduce the costs to our customers. On October 13, 2015, SPP members, SPP, MISO and MISO members filed a settlement at the FERC regarding MISO's unreserved and uncompensated use of the SPP members' systems. If approved by the FERC, the agreement will provide compensation and governance for the continued shared use of the transmission system among MISO, SPP and others impacted. However, the regional through and out transmission delivery rate (RTOR) dispute regarding Plum Point will go to hearing at the FERC. On May 20, 2015, we along with KCPL-GMO, AECI, and Southern Company filed a formal 206 complaint at the FERC that the ROTR rate was unjust and unreasonable. A procedural schedule was issued by the FERC on October 8, 2015 with hearings to commence on April 25, 2016 and an initial decision scheduled for August 10, 2016. Information concerning recent and pending SPP RTO and other FERC activities can be found under Note 3 of "Notes to Consolidated Financial Statements" under Item 8. LIQUIDITY AND CAPITAL RESOURCES Overview. Our primary sources of liquidity are cash provided by operating activities, short-term borrowings under our commercial paper program (which is supported by our unsecured revolving credit facility) and borrowings from our unsecured revolving credit facility. Historically, we have also successfully raised funds, as needed, from the debt and equity capital markets to fund our liquidity and capital resource needs. Our issuance of various securities, including equity, long-term and short-term debt, is subject to customary approval or authorization by state and federal regulatory bodies including state public service commissions and the SEC. We believe the cash provided by operating activities, together with the amounts available to us under our credit facilities and the issuance of debt and equity securities, will allow us to meet our needs for working capital, pension contributions, our continuing construction expenditures, anticipated debt redemptions, interest payments on debt obligations, dividend payments and other cash needs through the next several years. See "- Capital Requirements and Investing Activities" below for further information. We will continue to evaluate our need to increase available liquidity based on our view of working capital requirements, including the timing of our construction programs and other factors. See Item 1A, "Risk Factors" for additional information on items that could impact our liquidity and capital resource requirements. The following table provides a summary of our operating, investing and financing activities for the last three years. Summary of Cash Flows Cash flow from Operating Activities We prepare our statement of cash flows using the indirect method. Under this method, we reconcile net income to cash flows from operating activities by adjusting net income for those items that impact net income but may not result in actual cash receipts or payments during the period. These reconciling items include depreciation and amortization, pension costs, deferred income taxes, equity AFUDC, changes in commodity risk management assets and liabilities and changes in the consolidated balance sheet for working capital from the beginning to the end of the period. Year-over-year changes in our operating cash flows are attributable primarily to working capital changes resulting from the impact of weather, the timing of customer collections, payments for natural gas and coal purchases, the effects of deferred fuel recoveries and the size and timing of pension contributions. The increase or decrease in natural gas prices directly impacts the cost of gas stored in inventory. 2015 compared to 2014. In 2015, our net cash flows provided from operating activities was $184.8 million, an increase of $33.6 million, or 22.2%, from 2014. This change was primarily a result of: • Increased plant depreciation based on additions - $7.7 million. • Working capital changes for collections of accounts receivable and estimated unbilled revenues - $40.6 million. • Regulatory fuel adjustment mechanism liabilities increased - $7.9 million. • Adjustments to recognize non-cash losses for derivatives increased - $5.7 million. • Lower refunds of customer advances in 2015 increased cash - $2.5 million. • Decrease in net income - $(10.5) million. • Changes in fuel related and other regulatory amortizations - $(2.3) million. • Additional pension funding over last year - $(8.7) million. • Tax timing differences lower during 2015 mostly related to bonus depreciation partially offset by expected utilization of 2014 tax net operating losses - $(5.1) million. • Changes related to inventories, prepaid assets and accounts payable, net - $(3.0) million. 2014 compared to 2013. In 2014, our net cash flows provided from operating activities was $151.2 million, a decrease of $6.2 million, or 4.0%, from 2013. This change was primarily a result of: • Increase in net income - $3.7 million. • Increased plant depreciation - $3.4 million due to additions. • Changes in fuel adjustments and other regulatory amortizations - $8.4 million. • Changes in pension amortizations - $3.9 million. • Tax timing differences as a result of bonus depreciation being reinstated and tangible property regulation changes - $13.4 million. • Working capital changes for accounts receivable, accounts payable and other current assets and liabilities - $(33.6) million. • Increase in equity AFUDC mostly attributable to higher construction work in progress balances - $(2.6) million. Capital Requirements and Investing Activities Our net cash flows used in investing activities decreased $29.8 million from 2014 to 2015. The decrease was due to a $28.0 million decrease in total cash outlay for capital expenditures and a $1.8 million decrease in restricted cash. Our net cash flows used in investing activities increased $62.0 million from 2013 to 2014. The increase was primarily the result of an increase in new generation capital expenditures related to the Riverton 12 combined cycle construction. Our capital expenditures totaled approximately $176.0 million, $222.8 million, and $160.2 million in 2015, 2014 and 2013, respectively. A breakdown of these capital expenditures for 2015, 2014 and 2013 is as follows: (1)Other includes equity AFUDC of $(4.9) million, $(6.4) million and $(3.9) million for 2015, 2014 and 2013, respectively. Also included are insurance proceeds of $(7.8) million for 2013. (2)Expenditures incurred represent the total cost for work completed for the projects during the year. Discussion of capital expenditures throughout this 10-K is presented on this basis. These capital expenditures include AFUDC, capital expenditures to retire assets and benefits from salvage. (3)The amount of expenditures unpaid at the end of the year to adjust to actual cash outlay reflected in the Investing Activities section of the Statement of Cash Flows. Approximately 75%, 50% and 74% of our cash requirements for capital expenditures for 2015, 2014 and 2013, respectively, were satisfied from internally generated funds (funds provided by operating activities less dividends paid). The remaining amounts of such requirements were satisfied from short-term borrowings and proceeds from our sales of common stock and debt securities discussed below. Our estimated capital expenditures (excluding AFUDC) for 2016, 2017 and 2018 are detailed below. See Item 1, "Business - Construction Program." We anticipate that we will spend the following amounts over the next three years for the following projects: Customer reliability, communication and efficiency projects comprise $15 million of the 2018 other estimate above. Our estimated total capital expenditures (excluding AFUDC) for 2019 and 2020 are $150.9 million and $114.1 million, respectively. We estimate that internally generated funds will provide approximately 100% of the funds required in 2016 for our budgeted capital expenditures. We intend to utilize short-term debt to finance any additional amounts needed beyond those provided by operating activities for such capital expenditures. If additional financing is needed, we intend to utilize a combination of debt and equity securities. The estimates herein may be changed because of changes we make in our construction program, unforeseen construction costs, our ability to obtain financing, regulation and for other reasons. See further discussion under "Financing Activities" below. Financing Activities 2015 compared to 2014. Our net cash flows provided by financing activities was $0.3 million in 2015 as compared to $62.7 million in 2014, a decrease of $62.4 million, primarily due to the following: • Net short-term repayments of $19.0 million in 2015 as compared to net short-term borrowings of $40.0 million in 2014. • Proceeds from issuance of common stock of $5.5 million in 2015 as compared to $8.0 million in 2014. • Dividends paid of $45.4 million in 2015 as compared to $44.4 million in 2014. 2014 compared to 2013. Our net cash flows provided by financing activities was $62.7 million in 2014 as compared to $4.1 million used in financing activities in 2013, an increase of $66.7 million, primarily due to the following: • Issuance of $40.0 million in short-term debt in 2014 as compared to repayment of $20.0 million in short-term debt in 2013. • Issuance of $60.0 million of first mortgage bonds in 2014 compared to $150.0 million issued in 2013. • No repayment of senior notes in 2014 compared to $98.0 million of senior notes repaid in 2013. Shelf Registration. We have a $200.0 million shelf registration statement with the SEC, effective December 13, 2013, covering our common stock, unsecured debt securities, preference stock, and first mortgage bonds. As of December 31, 2015, $200.0 million remains available for issuance under this shelf registration statement. However, as a result of our regulatory approvals, we may only issue up to $150.0 million of such securities in the form of first mortgage bonds, of which $30.0 million remains available after the issuance of $60.0 million in first mortgage bonds on August 20, 2015 and $60 million on December 1, 2014. Any proceeds from offerings made pursuant to this shelf would be used to fund capital expenditures, refinance existing debt or general corporate needs during the effective period through December 2016. Credit Agreements. We have in place a $200 million 5-year Credit Agreement which expires in October 2019. This agreement replaced the former $150 million Third Amended and Restated Unsecured Credit Agreement that had a January 2017 expiration date. This agreement may be used for working capital, commercial paper back-up and general corporate purposes. The credit facility includes a $20 million swingline loan sublimit, a $20 million sublimit for letters of credit issuance and, subject to bank approval, a $75 million accordion feature and two one-year extensions of the credit facility's maturity date. See Note 6 of "Notes to Consolidated Financial Statements" under Item 8 for additional information regarding this agreement and our unsecured line of credit. EDE Mortgage Indenture. Substantially all of the property, plant and equipment of The Empire District Electric Company (but not its subsidiaries) are subject to the lien of the EDE Mortgage. Restrictions in the EDE mortgage bond indenture could affect our liquidity. The principal amount of all series of first mortgage bonds outstanding at any one time under the Indenture of Mortgage and Deed of Trust of The Empire District Electric Company (EDE Mortgage) is limited by terms of the mortgage to $1.0 billion. Based on the $1.0 billion limit, and our current level of outstanding first mortgage bonds, we are limited to the issuance of $297.0 million of new first mortgage bonds. The EDE Mortgage contains a requirement that for new first mortgage bonds to be issued, our net earnings (as defined in the EDE Mortgage) for any twelve consecutive months within the fifteen months preceding issuance must be two times the annual interest requirements (as defined in the EDE Mortgage) on all first mortgage bonds then outstanding and on the prospective issue of new first mortgage bonds. In addition to the interest coverage requirement, the EDE Mortgage provides that new bonds must be issued against, among other things, retired bonds or 60% of net property additions. The annual interest coverage requirement and retired bonds or 60% of net property additions tests would permit the issuance of more than $297.0 million of new first mortgage bonds; however, as discussed above, we are otherwise limited to the issuance of no more than $297.0 million of new first mortgage bonds. As of December 31, 2015, we are in compliance with all restrictive covenants of the EDE Mortgage. EDG Mortgage Indenture. The principal amount of all series of first mortgage bonds outstanding at any one time under the Indenture of Mortgage and Deed of Trust of The Empire District Gas Company (EDG Mortgage) is limited by terms of the mortgage to $300.0 million. Substantially all of the property, plant and equipment of The Empire District Gas Company is subject to the lien of the EDG Mortgage. The EDG Mortgage contains a requirement that for new first mortgage bonds to be issued, the amount of such new first mortgage bonds shall not exceed 75% of the cost of property additions acquired after the date of the Missouri Gas acquisition. The mortgage also contains a limitation on the issuance by EDG of debt (including first mortgage bonds, but excluding short-term debt incurred in the ordinary course under working capital facilities) unless, after giving effect to such issuance, EDG's ratio of EBITDA (defined as net income plus interest, taxes, depreciation, amortization and certain other non-cash charges) to interest charges for the most recent four fiscal quarters is at least 2.0 to 1.0. As of December 31, 2015, this test would allow us to issue approximately $19.5 million principal amount of new first mortgage bonds at an assumed interest rate of 5.5%. As of December 31, 2015, we are in compliance with all restrictive covenants of the EDG Mortgage. Credit Ratings Corporate credit ratings and the ratings for our securities are as follows: On March 6, 2015, Moody's reaffirmed our credit ratings and outlook. On December 15, 2015, Standard & Poor's reaffirmed our credit ratings and revised our outlook to developing from stable in light of the December 13, 2015 announcement regarding our exploration of strategic alternatives. On February 10, 2016, Standard & Poor's reaffirmed our credit ratings and revised our outlook to negative from developing in light of the February 9, 2016 announcement regarding the proposed merger. On December 1, 2015, we cancelled our relationship with Fitch Ratings. At that time, Fitch's ratings for our securities were as follows: First Mortgage Bonds, BBB+; Senior Notes, BBB; Commercial Paper,; Outlook, Stable. Fitch did not provide a Corporate Credit Rating. They last affirmed the ratings described above on June 12, 2015. A security rating is not a recommendation to buy, sell or hold securities. Each rating is subject to revision or withdrawal at any time by the assigning rating organization. Each security rating agency has its own methodology for assigning ratings, and, accordingly, each rating should be considered independently of all other ratings. CONTRACTUAL OBLIGATIONS Set forth below is information summarizing our contractual obligations as of December 31, 2015. Other pension and postretirement benefit plans are funded on an ongoing basis to match their corresponding costs, per regulatory requirements, and have been estimated for 2016 - 2020 as noted below. (1)Some of our contractual obligations have price escalations based on economic indices, but we do not anticipate these escalations to be significant. (2)Excludes payments under our Elk River Wind Farm, LLC and Cloud County Wind Farm, LLC agreements, as payments are contingent upon output of the facilities. For additional information, see Note 11 of "Notes to Consolidated Financial Statements" under Item 8. Payments under the Elk River Wind Farm, LLC agreement can run from zero up to a maximum of approximately $16.9 million per year based on a 20 year average cost and an annual output of 550,000 megawatt hours. Payments under the Meridian Way Wind Farm agreement can range from zero to a maximum of approximately $14.6 million per year based on a 20-year average cost. (3)Includes a water usage contract for our SLCC facility, fuel and purchased power contracts and associated transportation costs, as well as purchased power for 2016 through 2039 for Plum Point. (4)Represents fuel contracts and associated transportation costs of our gas segment. (5)Other long-term liabilities primarily represent electric facilities charges paid to City Utilities of Springfield, Missouri of $11,000 per month over 30 years. DIVIDENDS Holders of our common stock are entitled to dividends if, as, and when declared by the Board of Directors, out of funds legally available therefore, subject to the prior rights of holders of any outstanding cumulative preferred stock and preference stock. Payment of dividends is determined by our Board of Directors after considering all relevant factors, including the amount of our retained earnings (which is essentially our accumulated net income less dividend payouts). A reduction of our dividend per share, partially or in whole, could have an adverse effect on our common stock price. The following table shows our diluted earnings per share, dividends paid per share, total dividends paid and retained earnings balance for the years ended December 31, 2015, 2014 and 2013: Under Kansas corporate law, our Board of Directors may only declare and pay dividends out of our surplus or, if there is no surplus, out of our net profits for the fiscal year in which the dividend is declared or the preceding fiscal year, or both. Our surplus, under Kansas law, is equal to our retained earnings plus accumulated other comprehensive income/(loss), net of income tax. However, Kansas law does permit, under certain circumstances, our Board of Directors to transfer amounts from capital in excess of par value to surplus. In addition, Section 305(a) of the Federal Power Act (FPA) prohibits the payment by a utility of dividends from any funds "properly included in capital account". There are no additional rules or regulations issued by the FERC under the FPA clarifying the meaning of this limitation. However, several decisions by the FERC on specific dividend proposals suggest that any determination would be based on a fact-intensive analysis of the specific facts and circumstances surrounding the utility and the dividend in question, with particular focus on the impact of the proposed dividend on the liquidity and financial condition of the utility. In addition, the EDE Mortgage and our Restated Articles contain certain dividend restrictions. The most restrictive of these is contained in the EDE Mortgage, which provides that we may not declare or pay any dividends (other than dividends payable in shares of our common stock) or make any other distribution on, or purchase (other than with the proceeds of additional common stock financing) any shares of, our common stock if the cumulative aggregate amount thereof after August 31, 1944 (exclusive of the first quarterly dividend of $98,000 paid after said date) would exceed the sum of $10.75 million and the earned surplus (as defined in the EDE Mortgage) accumulated subsequent to August 31, 1944, or the date of succession in the event that another corporation succeeds to our rights and liabilities by a merger or consolidation. The EDE Mortgage permits the payment of any dividend or distribution on, or purchase of, shares of our common stock within 60 days after the related date of declaration or notice of such dividend, distribution or purchase if (i) on the date of declaration or notice, such dividend, distribution or purchase would have complied with the provisions of the EDE Mortgage and (ii) as of the last day of the calendar month ended immediately preceding the date of such payment, our ratio of total indebtedness to total capitalization (after giving pro forma effect to the payment of such dividend, distribution, or purchase) was not more than 0.625 to 1. OFF-BALANCE SHEET ARRANGEMENTS We have no off-balance sheet arrangements that have or are reasonably likely to have a current or future effect on our financial condition, changes in financial condition, revenues or expenses, results of operations, liquidity, capital expenditures or capital resources, other than operating leases entered into in the normal course of business. CRITICAL ACCOUNTING POLICIES Set forth below are certain accounting policies that are considered by management to be critical and that typically require difficult, subjective or complex judgments, often as a result of the need to make estimates about the effect of matters that are inherently uncertain (other accounting policies may also require assumptions that could cause actual results to be different than anticipated results). A change in assumptions or judgments applied in determining the following matters, among others, could have a material impact on future financial results. Pensions and Other Postretirement Benefits (OPEB). We recognize expense related to pension and other postretirement benefits as earned during the employee's period of service. Related assets and liabilities are established based upon the funded status of the plan compared to the accumulated benefit obligation. Our pension and OPEB expense or benefit includes amortization of previously unrecognized net gains or losses. Additional income or expense may be recognized when our unrecognized gains or losses as of the most recent measurement date exceed 10% of our postretirement benefit obligation or fair value of plan assets, whichever is greater. For pension benefits and OPEB benefits, unrecognized net gains or losses as of the measurement date are amortized into actuarial expense over ten years. See Note 1 and Note 7 of "Notes to Consolidated Financial Statements" under Item 8 for further information. Based on the regulatory treatment of pension and OPEB recovery afforded in our jurisdictions, we record the amount of unfunded defined benefit pension and postretirement plan obligations as regulatory assets on our balance sheet rather than as reductions of equity through comprehensive income. Our funding policy is to contribute annually an amount at least equal to the actuarial cost of postretirement benefits. The actual minimum pension funding requirements will be determined based on the results of the actuarial valuations and the performance of our pension assets during the current year. See Note 7 of "Notes to Consolidated Financial Statements" under Item 8. Risks and uncertainties affecting the application of our pension accounting policy include: future rate of return on plan assets, interest rates used in valuing benefit obligations (i.e. discount rates), demographic assumptions (i.e. mortality and retirement rates) and employee compensation trend rates. Factors that could result in additional pension expense and/or funding include: a lower discount rate than estimated, higher compensation rate increases, lower return on plan assets, and longer retirement periods. Risks and uncertainties affecting the application of our OPEB accounting policy and related funding include: future rate of return on plan assets, interest rates used in valuing benefit obligations (i.e. discount rates), healthcare cost trend rates, Medicare prescription drug costs and demographic assumptions (i.e. mortality and retirement rates). See Note 1 and Note 7 of "Notes to Consolidated Financial Statements" under Item 8 for further information. We expect future pension and OPEB expense or benefits are probable of full recovery in our rates, thus lowering our sensitivity to accounting risks and uncertainties. Regulatory Assets and Liabilities. In accordance with the ASC accounting guidance for regulated activities, our financial statements reflect ratemaking policies prescribed by the regulatory commissions having jurisdiction over us (Missouri, Kansas, Arkansas, Oklahoma and the FERC). In accordance with accounting guidance for regulated activities, we record a regulatory asset for all or part of an incurred cost that would otherwise be charged to expense in accordance with the accounting guidance, which requires that an asset be recorded if it is probable that future revenue in an amount at least equal to the capitalized cost will be allowable for costs for rate making purposes and the current available evidence indicates that future revenue will be provided to permit recovery of the cost. Additionally, we follow the accounting guidance for regulated activities which says that a liability should be recorded when a regulator has provided current recovery for a cost that is expected to be incurred in the future. We follow this guidance for incurred costs or credits that are subject to future recovery from or refund to our customers in accordance with the orders of our regulators. Historically, all costs of this nature, which are determined by our regulators to have been prudently incurred, have been recoverable through rates in the course of normal ratemaking procedures. Regulatory assets and liabilities are ratably eliminated through a charge or credit, respectively, to earnings while being recovered in revenues and fully recognized if and when it is no longer probable that such amounts will be recovered through future revenues. We continually assess the recoverability of our regulatory assets. Although we believe it unlikely, should retail electric competition legislation be passed in the states we serve, we may determine that we no longer meet the criteria set forth in the ASC accounting guidance for regulated activities with respect to continued recognition of some or all of the regulatory assets and liabilities. Any regulatory changes that would require us to discontinue application of ASC accounting guidance for regulated activities based upon competitive or other events may also impact the valuation of certain utility plant investments. Impairment of regulatory assets or utility plant investments could have a material adverse effect on our financial condition and results of operations. As of December 31, 2015, we have recorded $216.8 million in regulatory assets and $141.1 million as regulatory liabilities. See Note 3 of "Notes to Consolidated Financial Statements" under Item 8 for detailed information regarding our regulatory assets and liabilities. Risks and uncertainties affecting the application of this accounting policy include: regulatory environment, external regulatory decisions and requirements, anticipated future regulatory decisions and their impact of deregulation and competition on ratemaking process, unexpected disallowances, possible changes in accounting standards (including as a result of adoption of IFRS) and the ability to recover costs. Fuel Adjustment Clause. Typical fuel adjustment clauses permit the distribution to customers of changes in fuel costs, subject to routine regulatory review, without the need for a general rate proceeding. Fuel adjustment clauses are presently applicable to our retail electric sales in Missouri, Oklahoma and Kansas and system wholesale kilowatt-hour sales under FERC jurisdiction. We have an Energy Cost Recovery Rider in Arkansas that adjusts for changing fuel and purchased power costs on an annual basis. The MPSC established a base cost in rates for the recovery of fuel and purchased power expenses used to supply energy. The fuel adjustment clause permits the distribution to our Missouri customers of 95% of the changes in fuel and purchased power costs prudently incurred above or below the base cost. Off-system sales margins are also part of the recovery of fuel and purchased power costs. As a result, nearly all of the off-system sales margin flows back to the customer. Unbilled Revenue. At the end of each period we estimate, based on expected usage, the amount of revenue to record for energy and natural gas that has been provided to customers but not billed. Risks and uncertainties affecting the application of this accounting policy include: projecting customer energy usage, estimating the impact of weather and other factors that affect usage (such as line losses) for the unbilled period and estimating loss of energy during transmission and delivery. Assumptions such as electrical load requirements, customer billing rates, and line loss factors are used in the estimation process and are evaluated periodically. Changes to certain assumptions during the evaluation process can lead to a change in the estimate. Contingent Liabilities. We are a party to various claims and legal proceedings arising in the ordinary course of our business, which are primarily related to workers' compensation and public liability. We regularly assess our insurance deductibles, analyze litigation information with our attorneys and evaluate our loss experience. Based on our evaluation as of the end of 2015, we believe that we have accrued liabilities in accordance with ASC accounting guidance sufficient to meet potential liabilities that could result from these claims. This liability at December 31, 2015 and 2014 was 3.7 million and $3.6 million, respectively. Risks and uncertainties affecting these assumptions include: changes in estimates on potential outcomes of litigation and potential litigation yet unidentified in which we might be named as a defendant. Goodwill. As of December 31, 2015, the consolidated balance sheet included $39.5 million of goodwill. All of this goodwill was derived from our gas business acquisition and recorded in our gas segment, which is also the reporting unit for goodwill testing purposes. Accounting guidance requires us to test goodwill for impairment on an annual basis or whenever events or circumstances indicate possible impairment. Absent an indication of fair value from a potential buyer or a similar specific transaction, a combination of the market and income approaches is used to estimate the fair value of goodwill. Our annual test performed as of October 2015 indicated the estimated fair market value of the gas reporting unit to be $18 - $22 million higher than its carrying value at that time. While we believe the assumptions utilized in our analysis were reasonable, adverse developments in future periods could negatively impact goodwill impairment considerations, which could adversely impact earnings. Specifically, the quantitative assumptions, such as an increase to the discount rate or decline in the terminal value calculation could lead to an impairment charge in the future. See Note 1 of "Notes to Consolidated Financial Statements" under Item 8 for further information. Use of Management's Estimates. The preparation of our consolidated financial statements in conformity with generally accepted accounting principles (GAAP) requires management to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenues and expenses, and related disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. We evaluate our estimates on an on-going basis, including those related to unbilled utility revenues, collectibility of accounts receivable, depreciable lives, asset impairment and goodwill evaluations, employee benefit obligations, contingent liabilities, asset retirement obligations, the fair value of stock based compensation and tax provisions. Actual amounts could differ from those estimates. RECENTLY ISSUED ACCOUNTING STANDARDS See Note 1 of "Notes to Consolidated Financial Statements" under Item 8 for further information regarding Recently Issued and Proposed Accounting Standards.

<s>[INST] Electric Segment As a vertically integrated regulated utility, the primary drivers of our electric operating margin (defined as electric revenues less fuel and purchased power costs) in any period are: (1) rates we can charge our customers, including timing of new rates, (2) weather, (3) customer growth and usage and (4) general economic conditions. The utility commissions in the states in which we operate, as well as the Federal Energy Regulatory Commission (FERC), set the rates which we can charge our customers. In order to offset expenses, we depend on our ability to receive adequate and timely recovery of our costs (primarily fuel and purchased power and construction costs) and/or rate relief. We assess the need for rate relief in all of the jurisdictions we serve and file for such relief when necessary. The regulatory lag that occurs between the time we incur costs and the time when we can start recovering the costs through rates has a negative impact on earnings. The effects of timing of rate relief are discussed in detail in Note 3 of "Notes to the Consolidated Financial Statements" under Item 8. Of the factors driving electric operating margin, weather has the greatest shortterm effect on the demand for electricity for our regulated business. Very hot summers and very cold winters increase electric demand, while mild weather reduces demand. Residential and commercial sales are impacted more by weather than industrial sales, which are mostly affected by business needs for electricity and by general economic conditions. Customer growth, which is the growth in the number of customers, contributes to the demand for electricity. We expect our electric customer and sales growth to be less than 1.0% annually over the next several years. Our electric customer growth for the year ended December 31, 2015 was 0.5%. We define electric sales growth to be growth in kWh sales period over period excluding the estimated impact of weather. The primary drivers of electric sales growth are customer growth, customer usage and general economic conditions. The primary drivers of our electric operating expenses in any period are: (1) fuel and purchased power expense, (2) operating maintenance and repairs expense, including repairs following severe weather and plant outages, (3) taxes and (4) noncash items such as depreciation and amortization expense. We have a fuel cost recovery mechanism in all of our jurisdictions, which significantly reduces the impact of fluctuating fuel and purchased power costs on our net income. Gas Segment The primary drivers of our gas operating revenues in any period are: (1) rates we can charge our customers, (2) weather, (3) customer growth and usage, (4) the cost of natural gas and interstate pipeline transportation charges and (5) general economic conditions. The MPSC sets the rates which we can charge our customers. In order to offset expenses, we depend on our ability to receive adequate and timely recovery of our costs (primarily commodity natural gas) and/or rate relief. We assess the need for rate relief and file for such relief when necessary. A Purchased Gas Adjustment (PGA) clause is included in our gas rates, which allows us to recover our actual cost of natural gas from customers through rate changes, which are made periodically (up to four times) throughout the year in response to weather conditions, natural gas costs and supply demands. Weather affects the demand for natural gas. Very cold winters increase demand for gas, while mild weather reduces demand. Due to the seasonal nature of the gas business, revenues and earnings are typically concentrated in the November through March period, which generally corresponds with the heating season. Customer growth, which is the growth in the number of customers, contributes to the demand for gas. Our annual customer growth is calculated by comparing the number of customers at the end of a year to the number of customers at the end of the prior year. Our gas segment customer count decreased 0.5% for the year ended December 31, 2015, which we believe was due to population losses in the rural communities we serve. We expect gas customer growth to be flat during the next several years. We define gas sales growth to be growth in mcf sales excluding the impact of weather. The primary drivers of gas sales growth are customer growth and general economic conditions. The primary driver of our gas operating expense in any period is the price of natural gas. However, because gas purchase costs for our gas utility operations are normally recovered from our customers, any change in gas prices does not have a corresponding impact on income unless such costs are deemed impr [/INST] Negative. </s>

HUNT J B TRANSPORT SERVICES INC

2015-02-24

2014-12-31

ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The following discussion of our results of operations and financial condition should be read in conjunction with our financial statements and related notes in Item 8. This discussion contains forward-looking statements. Please see “Forward-looking Statements” and “Risk Factors” for a discussion of items, uncertainties, assumptions and risks associated with these statements. Critical Accounting Policies and Estimates The preparation of our financial statements in accordance with U.S. generally accepted accounting principles requires us to make estimates and assumptions that impact the amounts reported in our Consolidated Financial Statements and accompanying notes. Therefore, the reported amounts of assets, liabilities, revenues, expenses and associated disclosures of contingent liabilities are affected by these estimates. We evaluate these estimates on an ongoing basis, utilizing historical experience, consultation with third parties and other methods considered reasonable in the particular circumstances. Nevertheless, actual results may differ significantly from our estimates. Any effects on our business, financial position or results of operations resulting from revisions to these estimates are recognized in the accounting period in which the facts that give rise to the revision become known. We consider our critical accounting policies and estimates to be those that require us to make more significant judgments and estimates when we prepare our financial statements and include the following: Workers’ Compensation and Accident Costs We purchase insurance coverage for a portion of expenses related to employee injuries, vehicular collisions, accidents, and cargo damage. Certain insurance arrangements include a level of self-insurance (deductible) coverage applicable to each claim. We have umbrella policies to limit our exposure to catastrophic claim costs. We are substantially self-insured for loss of and damage to our owned and leased revenue equipment. The amounts of self-insurance change from time to time based on measurement dates, policy expiration dates, and claim type. We have policies in place for 2015 with substantially the same terms as our 2014 policies for personal injury, property damage, workers’ compensation, and cargo loss or damage. Our claims accrual policy for all self-insured claims is to recognize a liability at the time of the incident based on our analysis of the nature and severity of the claims and analyses provided by third-party claims administrators, as well as legal, economic, and regulatory factors. Our safety and claims personnel work directly with representatives from the insurance companies to continually update the estimated cost of each claim. The ultimate cost of a claim develops over time as additional information regarding the nature, timing, and extent of damages claimed becomes available. Accordingly, we use an actuarial method to develop current claim information to derive an estimate of our ultimate claim liability. This process involves the use of loss-development factors based on our historical claims experience and includes a contractual premium adjustment factor, if applicable. In doing so, the recorded liability considers future claims growth and, if applicable, conversion to fully insured status and provides a reserve for incurred-but-not-reported claims. We do not discount our estimated losses. At December 31, 2014, we had an accrual of approximately $88 million for estimated claims. In addition, we are required to pay certain advanced deposits and monthly premiums. At December 31, 2014, we had an aggregate prepaid insurance asset of approximately $68 million, which represented prefunded premiums and deposits. Revenue Equipment We operate a significant number of tractors, trucks, containers, chassis, and trailers in connection with our business. This equipment may be purchased or acquired under lease agreements. In addition, we may rent revenue equipment from various third parties under short-term rental arrangements. Purchased revenue equipment is depreciated on the straight-line method over the estimated useful life to an estimated salvage or trade-in value. We periodically review the useful lives and salvage values of our revenue equipment and evaluate our long-lived assets for impairment. We have not identified any impairment to our assets at December 31, 2014. We have agreements with our primary tractor suppliers for residual or trade-in values for certain new equipment. We have utilized these trade-in values, as well as other operational information such as anticipated annual miles, in accounting for depreciation expense. If our suppliers were unable to perform under the terms of our agreements for trade-in values, it could have a material adverse effect on our financial results. Revenue Recognition We recognize revenue based on the relative transit time of the freight transported and as other services are provided. Accordingly, a portion of the total revenue that will be billed to the customer once a load is delivered is recognized in each reporting period based on the percentage of the freight pickup and delivery service that has been completed at the end of the reporting period. We record revenues on the gross basis at amounts charged to our customers because we are the primary obligor, we are a principal in the transaction, we invoice our customers and retain all credit risks, and we maintain discretion over pricing. Additionally, we are responsible for the selection of third-party transportation providers. Our trade accounts receivable includes amounts due from customers that have been reduced by an allowance for uncollectible accounts and revenue adjustments. The allowance for uncollectible accounts and revenue adjustments is based on historical experience, as well as any known trends or uncertainties related to customer billing and account collectability. The adequacy of our allowance is reviewed quarterly. Income Taxes We account for income taxes under the liability method. Our deferred tax assets and liabilities represent items that will result in a tax deduction or taxable income in future years for which we have already recorded the related tax expense or benefit in our statement of earnings. Deferred tax accounts arise as a result of timing differences between when items are recognized in our Consolidated Financial Statements and when they are recognized in our tax returns. We assess the likelihood that deferred tax assets will be recovered from future taxable income or the reversal of temporary timing differences. To the extent we believe recovery does not meet the more-likely-than-not threshold, a valuation allowance is established. To the extent we establish a valuation allowance, we include an expense as part of our income tax provision. Significant judgment is required in determining and assessing the impact of complex tax laws and certain tax-related contingencies on our provision for income taxes. As part of our calculation of the provision for income taxes, we assess whether the benefits of our tax positions are at least more likely than not of being sustained upon audit based on the technical merits of the tax position. For tax positions that are not more likely than not of being sustained upon audit, we accrue the largest amount of the benefit that is not more likely than not of being sustained in our Consolidated Financial Statements. Such accruals require us to make estimates and judgments, whereby actual results could vary materially from these estimates. Further, a number of years may elapse before a particular matter for which we have established an accrual is audited and resolved. See Note 7, Income Taxes, in our Consolidated Financial Statements for a discussion of our current tax contingencies. RESULTS OF OPERATIONS The following table sets forth items in our Consolidated Statements of Earnings as a percentage of operating revenues and the percentage increase or decrease of those items as compared with the prior year. 2014 Compared With 2013 Consolidated Operating Revenues Our total consolidated operating revenues were $6.2 billion in 2014, a 10.4% increase over 2013, primarily due to increased load volume and rate increases. Fuel surcharge (FSC) revenues remained flat at $1.1 billion in 2014 when compared to 2013, due to decreases in the price of fuel during the second half of 2014. If FSC revenues were excluded from both years, our 2014 revenue increased 12.3% over 2013. Consolidated Operating Expenses Our 2014 consolidated operating expenses increased 10.5% from 2013, compared to the 10.4% increase in revenue year over year, resulting in a 2014 operating ratio of 89.8% compared to 89.7% in 2013. Rents and purchased transportation costs increased 10.0% in 2014, primarily due to the increase in load volume that increased services from third-party rail and truck carriers within our JBI, DCS and ICS segments. Salaries, wages and employee benefit costs increased 13.4% in 2014 from 2013. This increase was primarily related to increases in driver pay and office personnel compensation due to an increase in the number of employees and a tighter supply of qualified drivers. In addition, workers’ compensation claims expense increased due to increases in both incident volume and severity, as well as increased insurance premium costs. Fuel and fuel taxes expense decreased 0.4% in 2014 compared with 2013, due to decreases in the price of fuel and improved fuel efficiency during 2014, partially offset by increased road miles. We have fuel surcharge programs in place with the majority of our customers. These programs typically involve a specified computation based on the change in national, regional or local fuel prices. While these programs may address fuel cost changes as frequently as weekly, most also reflect a specified miles-per-gallon factor and require a certain minimum change in fuel costs to trigger a change in fuel surcharge revenue. As a result, some of these programs have a time lag between when fuel costs change and when this change is reflected in revenues. Due to these programs, this lag negatively impacts operating income in times of rapidly increasing fuel costs and positively impacts operating income when fuel costs decrease rapidly. It is not meaningful to compare the amount of fuel surcharge revenue or the change in fuel surcharge revenue between reporting periods to fuel and fuel taxes expense, or the change of fuel expense between periods, as a significant portion of fuel cost is included in our payments to railroads, dray carriers and other third parties. These payments are classified as purchased transportation expense. Depreciation and amortization expense increased 16.2% in 2014, primarily due to additions to our JBI segment tractor, container and chassis fleets to support additional business demand, equipment purchased related to new DCS long-term customer contracts, and new replacement tractors and trailers in JBT. Operating supplies and expenses increased 7.8%, driven primarily by increased general maintenance costs resulting from growth in equipment fleets and increased toll activity. Insurance and claims expense increased 47.0% for 2014, primarily due to higher incident volume and increased accident severity. General and administrative expenses increased 11.3%, due primarily to an increase in driver advertising, higher building and facility rental expenses, and increased professional fees, partially offset by an increase in net gains from asset sales and disposals. Net gains from the disposal of assets were $6 million in 2014, compared with $5 million in 2013. Net interest expense for 2014 increased by 16.4% compared with 2013, primarily due to increased average debt levels. Our effective income tax rate was 38.01% in 2014 and 38.15% in 2013. The decrease in 2014 was primarily related to a decrease in the provision for uncertain tax positions taken in prior years. Segments We operated four business segments during calendar year 2014. The operation of each of these businesses is described in our Notes to Consolidated Financial Statements. The following tables summarize financial and operating data by segment: Operating Data by Segment (1) Includes company-owned and independent contractor tractors (2) Using weighted workdays (3) Includes company-owned, independent contractor, and customer-owned trucks JBI Segment JBI segment experienced an environment of challenging rail service and limited dray fleet capacity throughout 2014. JBI segment revenue increased 6.7% to $3.69 billion in 2014, from $3.46 billion in 2013, primarily due to a 6.7% increase in overall load volume, with both our eastern and transcontinental networks reporting increased volumes. Excluding fuel surcharge, revenues increased 8.0% in 2014 over the prior year. The combination of traffic mix, customer rate increases, and FSC revenue resulted in revenue per load remaining unchanged compared to a year ago. Average length of haul decreased 2.3% in 2014 when compared to 2013. Operating income in our JBI segment increased to $461 million in 2014, from $447 million in 2013. This increase was primarily due to increased revenue, partially offset by slow train speeds and reductions in dray fleet capacity throughout 2014, which negatively impacted the network fluidity, resulting in a reduction in box turns and dray power utilization. In addition, JBI experienced higher driver procurement and retention expenses, increased rail and dray purchased transportation costs, higher insurance and claims costs, and increased equipment costs during 2014 when compared to 2013. DCS Segment DCS segment revenue increased 13.2% to $1.39 billion in 2014, from $1.23 billion in 2013. Revenue, excluding fuel surcharges, increased 14.1% in 2014 compared to 2013, primarily attributable to large existing accounts becoming fully implemented in the current year, new customer contracts, and rate increases established in the latter half of 2014. DCS ended 2014 with a net additional 473 revenue-producing trucks when compared to 2013. Productivity for 2014, defined as revenue per truck per week, was virtually flat when compared to 2013, due to the large number of customer accounts affected by severe winter weather conditions during the first quarter of 2014 and continued driver shortages throughout the current year. Operating income increased to $117 million in 2014, compared with $110 million in 2013. The increase in operating income was primarily due to increased revenue, partially offset by higher driver recruiting and retention costs, increased insurance and workers’ compensation costs, higher purchased transportation costs, increased equipment and maintenance expenses, and fewer gains on the sale of equipment compared to 2013. ICS Segment ICS segment revenue grew 33.8% to $718 million in 2014, from $537 million in 2013. This increase in revenue was primarily due to a 16.6% increase in load volume and a 14.8% increase in revenue per load in 2014 when compared to 2013. Both transactional and contractual business experienced increased load volumes. Contractual business was approximately 63% of the total load volume but only 55% of the total revenue in the 2014, compared to 64% of the total load volume and 61% of the total revenue in 2013. Operating income increased to $30 million in 2014, compared to $16 million in 2013. ICS gross profit margin increased to 13.0% for 2014 from 11.8% for 2013, primarily due to customer rate increases in contractual business and maintaining margin discipline in transactional business. ICS incurred increased personnel and branch network expansion costs during 2014 resulting from the continued expansion of the segment’s branch location network. JBT Segment JBT segment revenue decreased 1.4% to $386 million in 2014, from $391 million in 2013, primarily due to operating a reduced fleet size for the majority of 2014, partially offset by increased pricing. Excluding fuel surcharges, revenue for 2014 increased 0.9% compared to 2013. JBT segment had operating income of $24 million in 2014 compared with $4 million in 2013. This increase in operating income was primarily due to increased rate per loaded mile, lower personnel costs, a smaller trailer fleet and gains on equipment sales, offset by increased driver hiring costs, increases in driver and independent contractor costs per mile, higher maintenance and equipment costs per unit, and increased insurance and safety costs. 2013 Compared With 2012 Consolidated Operating Revenues Our total consolidated operating revenues were $5.6 billion in 2013, a 10.5% increase over 2012, primarily due to increased load volume. Fuel surcharge (FSC) revenues increased to $1.1 billion in 2013, compared with $997 million in 2012, due to overall increased load volumes. If FSC revenues were excluded from both years, our 2013 revenue increased 11.6% over 2012. Consolidated Operating Expenses Our 2013 consolidated operating expenses increased 10.7% from 2012, compared to the 10.5% increase in revenue year over year. This combination resulted in our 2013 operating ratio of 89.7% compared to 89.5% in 2012. Rents and purchased transportation costs increased 12.9% in 2013, primarily due to the increase in load volume that increased services from third-party rail and truck carriers. In addition, our JBI segment increased the use of outsourced dray carriers resulting from a challenging driver market, while our ICS segment incurred higher rates paid to third-party carriers in 2013, due to a tighter third-party carrier environment. The total cost of salaries, wages and employee benefits increased 9.7% in 2013 from 2012. This increase was primarily related to increases in driver and other labor pay due to increased business demand, a tighter supply of qualified drivers, and new long-term customer contracts, partially offset by lower overall office personnel compensation and a reduction in driver pay within our JBT segment due to fleet reduction. Fuel and fuel taxes expense decreased 2.1% in 2013 compared with 2012, due to decreases in the price of fuel. Depreciation and amortization expense increased 10.6% in 2013, primarily due to additions to our JBI segment tractor, container, and chassis fleets to support additional business demand, as well as additional equipment purchased related to new DCS long-term customer contracts. These increases were partially offset by the reduction in the JBT tractor fleet. Operating supplies and expenses increased 13.5%, driven primarily by increased general maintenance costs resulting from growth in equipment fleets and a higher cost per unit, increased toll activity and implementation related costs incurred for new DCS long-term customers in 2013. Insurance and claims expense increased 2.5% for 2013, primarily due to an increase in incident volume, offset by a reduction in accident severity. The 67.0% increase in general and administrative expenses was primarily the result of a decrease in net gains from asset sales, higher building and facility rental expense related to new DCS long-term customer contracts, and increased bad debt expense due to two customer bankruptcies. Net gains from the disposal of assets were $5 million in 2013, compared with $17 million in 2012. Net interest expense for 2013 decreased by 9.5% compared with 2012, due to both reduced average debt levels and lower interest rates. Our effective income tax rate was 38.15% in 2013 and 38.50% in 2012. The decrease in 2013 was primarily related to the realization of a deferred tax benefit on the sale of property during the second quarter of 2013. JBI Segment JBI segment revenue increased 12.5% to $3.46 billion in 2013, from $3.07 billion in 2012, primarily due to a 12.6% increase in load volume. Excluding fuel surcharge, revenues increased 13.4% in 2013 over the prior year. Revenue per load was unchanged in 2013 when compared to 2012, and average length of haul remained virtually flat. Operating income in our JBI segment increased to $447 million in 2013, from $375 million in 2012, primarily due to volume growth, improved container utilization and lower office personnel compensation costs, partially offset by increased outsourced drayage and rail purchased transportation costs and by higher driver procurement and retention expenses. DCS Segment DCS segment revenue increased 14.1% to $1.23 billion in 2013, from $1.08 billion in 2012. Revenue, excluding fuel surcharges, increased 16.2% in 2013 compared to 2012, primarily from new long-term contracts related to the conversion of customers’ private fleets. DCS ended 2013 with a net additional 1,154 revenue-producing trucks when compared to 2012. Operating income decreased to $110 million in 2013, compared with $116 million in 2012. The decrease in operating income was primarily due to higher driver and other personnel pay, increased equipment and maintenance costs, increased purchased transportation expenses, lower gains on equipment sales, increased insurance and claims costs, and increased bad debt expense. In addition, DCS incurred significant implementation costs for new long-term customers during 2013. These implementation costs include, but are not limited to, driver and management hiring and relocation costs, personnel travel costs, equipment repositioning costs, technology design and integration, and telecommunication and operational system infrastructure. ICS Segment ICS segment revenue grew 17.6% to $537 million in 2013, from $456 million in 2012. This increase in revenue was primarily due to a 19.1% increase in load volume in 2013 when compared to 2012, partially offset by a slight reduction in revenue per load. Both transactional and contractual business experienced increased load volumes. Operating income remained flat at $16 million in 2013 when compared to 2012. ICS gross profit margin declined to 11.8% for 2013 from 13.0% for 2012, due to higher purchased transportation costs resulting from a tightening third-party carrier environment. Cost increases for additional headcount and branch network expansion also offset increases in revenues. JBT Segment JBT segment revenue decreased 19.2% to $391 million in 2013, from $484 million in 2012, primarily due to lower equipment utilization, shorter length of haul, and an 11.3% reduction in tractors year-over-year, primarily from a reduction in independent contractor capacity. Excluding fuel surcharges, revenue for 2013 decreased 19.5% compared to 2012. JBT segment had operating income of $4 million in 2013 compared with $23 million in 2012. This decrease in operating income was primarily due to lower revenue, increased driver and independent contractor pay, higher maintenance and equipment cost per unit, and fewer gains on equipment sales, partially offset by reductions in office personnel. LIQUIDITY AND CAPITAL RESOURCES Net cash provided by operating activities was $647 million in 2014 and $574 million in 2013. This increase in 2014 was primarily due to increased earnings and the timing of general working capital activities, offset by an increase in cash paid for income taxes during the current year. The increase in taxes paid in 2014 was due to the effect of timing differences caused by the expiration of federal tax bonus depreciation in December 2013. In December 2014, federal tax bonus depreciation was enacted for 2014, but this law change occurred after all estimated tax payments had been made for the current year. Net cash used in investing activities totaled $660 million in 2014, compared with $443 million in 2013. The increase resulted primarily from an increase in equipment purchases in 2014, partially offset by an increase in proceeds from the sale of equipment during the same period. Net cash provided by financing activities was $13 million in 2014, compared to net cash used of $132 million in 2013. This change resulted primarily from the proceeds from long-term debt issuances in 2014, partially offset by long-term debt repayments and an increase in dividends paid and treasury stock purchased. Our dividend policy is subject to review and revision by the Board of Directors, and payments are dependent upon our financial condition, liquidity, earnings, capital requirements, and other factors the Board of Directors may deem relevant. We paid a $0.14 per share quarterly dividend in 2012, a $0.15 per share quarterly dividend in 2013, with the first quarter dividend being pulled forward and paid in fourth quarter 2012, and a $0.20 per share quarterly dividend in 2014. On January 29, 2015, we announced an increase in our quarterly cash dividend from $0.20 to $0.21 per share, which will be paid February 26, 2015, to stockholders of record on February 12, 2015. We currently intend to continue paying cash dividends on a quarterly basis. However, no assurance can be given that future dividends will be paid. Liquidity Our need for capital has typically resulted from the acquisition of containers, chassis, trucks, tractors, and trailers required to support our growth and the replacement of older equipment. We are frequently able to accelerate or postpone a portion of equipment replacements depending on market conditions. We obtain capital through cash generated from operations, revolving lines of credit, and long-term debt issuances. We have also periodically utilized capital and operating leases for revenue equipment. At December 31, 2014, we were authorized to borrow up to $500 million under a senior revolving line of credit, which is supported by a credit agreement with a group of banks and expires in August 2016. This senior credit facility allows us to request an increase in the total commitment by up to $250 million and to request a one-year extension of the maturity date. The applicable interest rate under this agreement is based on the Prime Rate, the Federal Funds Rate, or LIBOR, depending upon the specific type of borrowing, plus an applicable margin based on our credit rating and other fees. At December 31, 2014, we had $183 million outstanding at an average interest rate of 1.12% under this agreement. Our senior notes consist of three separate issuances. The first issuance is $250 million of 3.375% senior notes, which mature in September 2015, with interest payments due semiannually in March and September of each year. The second and third issuances are $250 million of 2.40% senior notes due March 2019 and $250 million of 3.85% senior notes due March 2024, respectively, both of which were issued in March 2014. Interest payments under both notes are due semiannually in March and September of each year, beginning September 2014. We may redeem for cash some or all of the notes based on a redemption price set forth in the note indenture. We currently have an interest rate swap agreement which effectively converts our $250 million of 2.40% fixed-rate senior notes due March 2019 to a variable rate. The applicable interest rate under this agreement is based on LIBOR plus an established margin, resulting in an interest rate of 1.09% at December 31, 2014. Our financing arrangements require us to maintain certain covenants and financial ratios. We were in compliance with all covenants and financial ratios at December 31, 2014. For all debt facilities maturing in 2015, it is our intent to pay the entire outstanding balances in full, on or before the maturity dates, using our existing senior revolving line of credit or other sources of long-term financing. We believe our liquid assets, cash generated from operations, and various financing arrangements will provide sufficient funds for our operating and capital requirements for the foreseeable future. We are currently committed to spend approximately $555 million, net of proceeds from sales or trade-ins during 2015, which is primarily related to the acquisition of containers, chassis, and tractors. Off-Balance Sheet Arrangements Our only off-balance sheet arrangements are related to operating leases. As of December 31, 2014, we had approximately $27.0 million of obligations, primarily related to facility leases. Contractual Obligations and Commitments The following table summarizes our expected obligations and commitments (in millions) as of December 31, 2014: (1) Interest payments on debt are based on the debt balance and applicable rate at December 31, 2014. We had standby letters of credit outstanding of approximately $4.4 million at December 31, 2014, that expire at various dates in fiscal year 2015, which are related to certain operating agreements and our self-insured retention levels for casualty and workers’ compensation claims. We plan to renew these letters of credit in accordance with our third-party agreements. The table above excludes $35.1 million of liabilities related to uncertain tax positions, including interest and penalties, as we are unable to reasonably estimate the ultimate timing of settlement. See Note 7, Income Taxes, in the Notes to Consolidated Financial Statements for further discussion.

<s>[INST] Critical Accounting Policies and Estimates The preparation of our financial statements in accordance with U.S. generally accepted accounting principles requires us to make estimates and assumptions that impact the amounts reported in our Consolidated Financial Statements and accompanying notes. Therefore, the reported amounts of assets, liabilities, revenues, expenses and associated disclosures of contingent liabilities are affected by these estimates. We evaluate these estimates on an ongoing basis, utilizing historical experience, consultation with third parties and other methods considered reasonable in the particular circumstances. Nevertheless, actual results may differ significantly from our estimates. Any effects on our business, financial position or results of operations resulting from revisions to these estimates are recognized in the accounting period in which the facts that give rise to the revision become known. We consider our critical accounting policies and estimates to be those that require us to make more significant judgments and estimates when we prepare our financial statements and include the following: Workers’ Compensation and Accident Costs We purchase insurance coverage for a portion of expenses related to employee injuries, vehicular collisions, accidents, and cargo damage. Certain insurance arrangements include a level of selfinsurance (deductible) coverage applicable to each claim. We have umbrella policies to limit our exposure to catastrophic claim costs. We are substantially selfinsured for loss of and damage to our owned and leased revenue equipment. The amounts of selfinsurance change from time to time based on measurement dates, policy expiration dates, and claim type. We have policies in place for 2015 with substantially the same terms as our 2014 policies for personal injury, property damage, workers’ compensation, and cargo loss or damage. Our claims accrual policy for all selfinsured claims is to recognize a liability at the time of the incident based on our analysis of the nature and severity of the claims and analyses provided by thirdparty claims administrators, as well as legal, economic, and regulatory factors. Our safety and claims personnel work directly with representatives from the insurance companies to continually update the estimated cost of each claim. The ultimate cost of a claim develops over time as additional information regarding the nature, timing, and extent of damages claimed becomes available. Accordingly, we use an actuarial method to develop current claim information to derive an estimate of our ultimate claim liability. This process involves the use of lossdevelopment factors based on our historical claims experience and includes a contractual premium adjustment factor, if applicable. In doing so, the recorded liability considers future claims growth and, if applicable, conversion to fully insured status and provides a reserve for incurredbutnotreported claims. We do not discount our estimated losses. At December 31, 2014, we had an accrual of approximately $88 million for estimated claims. In addition, we are required to pay certain advanced deposits and monthly premiums. At December 31, 2014, we had an aggregate prepaid insurance asset of approximately $68 million, which represented prefunded premiums and deposits. Revenue Equipment We operate a significant number of tractors, trucks, containers, chassis, and trailers in connection with our business. This equipment may be purchased or acquired under lease agreements. In addition, we may rent revenue equipment from various third parties under shortterm rental arrangements. Purchased revenue equipment is depreciated on the straightline method over the estimated useful life to an estimated salvage or tradein value. We periodically review the useful lives and salvage values of our revenue equipment and evaluate our longlived assets for impairment. We have not identified any impairment to our assets at December 31, 2014. We have agreements with our primary tractor suppliers for residual or tradein values for certain new equipment. We have utilized these tradein values, as well as other operational information such as anticipated annual miles, in accounting for depreciation expense. If our suppliers were unable to perform under the terms of our agreements for tradein values, it could have a material adverse effect on our financial results. Revenue Recognition We recognize revenue based on the relative transit time of the freight transported and as other services are provided. Accordingly, a portion of the total revenue that will be billed to the customer once a load is delivered is recognized in each reporting period based on the percentage of the freight pickup and delivery service that has been completed at the [/INST] Negative. </s>

HUNT J B TRANSPORT SERVICES INC

2016-02-23

2015-12-31

ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The following discussion of our results of operations and financial condition should be read in conjunction with our financial statements and related notes in Item 8. This discussion contains forward-looking statements. Please see “Forward-looking Statements” and “Risk Factors” for a discussion of items, uncertainties, assumptions and risks associated with these statements. Critical Accounting Policies and Estimates The preparation of our financial statements in accordance with U.S. generally accepted accounting principles requires us to make estimates and assumptions that impact the amounts reported in our Consolidated Financial Statements and accompanying notes. Therefore, the reported amounts of assets, liabilities, revenues, expenses and associated disclosures of contingent liabilities are affected by these estimates. We evaluate these estimates on an ongoing basis, utilizing historical experience, consultation with third parties and other methods considered reasonable in the particular circumstances. Nevertheless, actual results may differ significantly from our estimates. Any effects on our business, financial position or results of operations resulting from revisions to these estimates are recognized in the accounting period in which the facts that give rise to the revision become known. We consider our critical accounting policies and estimates to be those that require us to make more significant judgments and estimates when we prepare our financial statements and include the following: Workers’ Compensation and Accident Costs We purchase insurance coverage for a portion of expenses related to employee injuries, vehicular collisions, accidents, and cargo damage. Certain insurance arrangements include a level of self-insurance (deductible) coverage applicable to each claim. We have umbrella policies to limit our exposure to catastrophic claim costs. We are substantially self-insured for loss of and damage to our owned and leased revenue equipment. The amounts of self-insurance change from time to time based on measurement dates, policy expiration dates, and claim type. We have policies in place for 2016 with substantially the same terms as our 2015 policies for personal injury, property damage, workers’ compensation, and cargo loss or damage. Our claims accrual policy for all self-insured claims is to recognize a liability at the time of the incident based on our analysis of the nature and severity of the claims and analyses provided by third-party claims administrators, as well as legal, economic, and regulatory factors. Our safety and claims personnel work directly with representatives from the insurance companies to continually update the estimated cost of each claim. The ultimate cost of a claim develops over time as additional information regarding the nature, timing, and extent of damages claimed becomes available. Accordingly, we use an actuarial method to develop current claim information to derive an estimate of our ultimate claim liability. This process involves the use of loss-development factors based on our historical claims experience and includes a contractual premium adjustment factor, if applicable. In doing so, the recorded liability considers future claims growth and, if applicable, conversion to fully insured status and provides a reserve for incurred-but-not-reported claims. We do not discount our estimated losses. At December 31, 2015, we had an accrual of approximately $95 million for estimated claims. In addition, we are required to pay certain advanced deposits and monthly premiums. At December 31, 2015, we had an aggregate prepaid insurance asset of approximately $87 million, which represented prefunded premiums and deposits. Revenue Equipment We operate a significant number of tractors, trucks, containers, chassis, and trailers in connection with our business. This equipment may be purchased or acquired under lease agreements. In addition, we may rent revenue equipment from various third parties under short-term rental arrangements. Purchased revenue equipment is depreciated on the straight-line method over the estimated useful life to an estimated salvage or trade-in value. We periodically review the useful lives and salvage values of our revenue equipment and evaluate our long-lived assets for impairment. We have not identified any impairment to our assets at December 31, 2015. We have agreements with our primary tractor suppliers for residual or trade-in values for certain new equipment. We have utilized these trade-in values, as well as other operational information such as anticipated annual miles, in accounting for depreciation expense. If our suppliers were unable to perform under the terms of our agreements for trade-in values, it could have a material adverse effect on our financial results. Revenue Recognition We recognize revenue based on the relative transit time of the freight transported and as other services are provided. Accordingly, a portion of the total revenue that will be billed to the customer once a load is delivered is recognized in each reporting period based on the percentage of the freight pickup and delivery service that has been completed at the end of the reporting period. We record revenues on the gross basis at amounts charged to our customers because we are the primary obligor, we are a principal in the transaction, we invoice our customers and retain all credit risks, and we maintain discretion over pricing. Additionally, we are responsible for the selection of third-party transportation providers. Our trade accounts receivable includes amounts due from customers that have been reduced by an allowance for uncollectible accounts and revenue adjustments. The allowance for uncollectible accounts and revenue adjustments is based on historical experience, as well as any known trends or uncertainties related to customer billing and account collectability. The adequacy of our allowance is reviewed quarterly. Income Taxes We account for income taxes under the liability method. Our deferred tax assets and liabilities represent items that will result in a tax deduction or taxable income in future years for which we have already recorded the related tax expense or benefit in our statement of earnings. Deferred tax accounts arise as a result of timing differences between when items are recognized in our Consolidated Financial Statements and when they are recognized in our tax returns. We assess the likelihood that deferred tax assets will be recovered from future taxable income or the reversal of temporary timing differences. To the extent we believe recovery does not meet the more-likely-than-not threshold, a valuation allowance is established. To the extent we establish a valuation allowance, we include an expense as part of our income tax provision. Significant judgment is required in determining and assessing the impact of complex tax laws and certain tax-related contingencies on our provision for income taxes. As part of our calculation of the provision for income taxes, we assess whether the benefits of our tax positions are at least more likely than not of being sustained upon audit based on the technical merits of the tax position. For tax positions that are not more likely than not of being sustained upon audit, we accrue the largest amount of the benefit that is not more likely than not of being sustained in our Consolidated Financial Statements. Such accruals require us to make estimates and judgments, whereby actual results could vary materially from these estimates. Further, a number of years may elapse before a particular matter for which we have established an accrual is audited and resolved. See Note 7, Income Taxes, in our Consolidated Financial Statements for a discussion of our current tax contingencies. RESULTS OF OPERATIONS The following table sets forth items in our Consolidated Statements of Earnings as a percentage of operating revenues and the percentage increase or decrease of those items compared with the prior year. 2015 Compared With 2014 Consolidated Operating Revenues Our total consolidated operating revenues were $6.19 billion in 2015, remaining relatively flat when compared to $6.17 billion in 2014. Overall customer rate increases and load growth, and increased fleet counts in our JBI, DCS, and JBT segments, were offset by a 38.0% decrease in fuel surcharge revenue to $671 million in 2015 when compared to $1.08 billion in 2014, due to decreases in the price of fuel during the year. If fuel surcharge revenues were excluded from both years, our 2015 revenue increased 8.5% over 2014. Consolidated Operating Expenses Our 2015 consolidated operating expenses decreased 1.1% from 2014, while year-over-year revenue remained flat, resulting in a 2015 operating ratio of 88.4% compared to 89.8% in 2014. Rents and purchased transportation costs decreased 2.9% in 2015, primarily the result of the lower fuel component in the cost of services provided by third-party rail and truck carriers within JBI, DCS, and ICS segments. Salaries, wages and employee benefit costs increased 8.1% in 2015 from 2014. This increase was primarily related to increases in driver pay and office personnel compensation due to an increase in the number of employees and a tighter supply of qualified drivers. Fuel and fuel taxes expense decreased 31.0% in 2015 compared with 2014, due to decreases in the price of fuel during 2015, partially offset by increased road miles. We have fuel surcharge programs in place with the majority of our customers. These programs typically involve a specified computation based on the change in national, regional or local fuel prices. While these programs may address fuel cost changes as frequently as weekly, most also reflect a specified miles-per-gallon factor and require a certain minimum change in fuel costs to trigger a change in fuel surcharge revenue. As a result, some of these programs have a time lag between when fuel costs change and when this change is reflected in revenues. Due to these programs, this lag negatively impacts operating income in times of rapidly increasing fuel costs and positively impacts operating income when fuel costs decrease rapidly. It is not meaningful to compare the amount of fuel surcharge revenue or the change in fuel surcharge revenue between reporting periods to fuel and fuel taxes expense, or the change of fuel expense between periods, as a significant portion of fuel cost is included in our payments to railroads, dray carriers and other third parties. These payments are classified as purchased transportation expense. Depreciation and amortization expense increased 15.3% in 2015, primarily due to additions to our JBI segment tractor, container and chassis fleets to support additional business demand, equipment purchased related to new DCS long-term customer contracts, and new replacement equipment in JBT. Operating supplies and expenses increased 0.9%, driven primarily by increased toll rates and activity, partially offset by decreased general equipment maintenance and repair costs. Insurance and claims expense decreased 9.1% in 2015, primarily due to decreased accident severity and fewer incidents. General and administrative expenses increased 43.3% from 2014, due primarily to costs related to corporate wide streamlining and technology redevelopment efforts. Net gains from sale or disposal of assets were $1 million in 2015, compared with $6 million in 2014. Net interest expense for 2015 decreased by 5.4% compared with 2014, primarily due to lower effective interest rates. Our effective income tax rate was 38.10% in 2015 and 38.01% in 2014. The increase in 2015 was primarily related to an increase in state income tax expense. We expect our effective income tax rate to be in the range of 38.00% to 38.10% for calendar year 2016. Segments We operated four business segments during calendar year 2015. The operation of each of these businesses is described in our Notes to Consolidated Financial Statements. The following tables summarize financial and operating data by segment: Operating Data by Segment (1) Includes company-owned and independent contractor tractors (2) Using weighted workdays (3) Includes company-owned, independent contractor, and customer-owned trucks JBI Segment JBI segment revenue decreased 0.6% to $3.66 billion in 2015, from $3.69 billion in 2014, resulting from a decrease in revenue per load, which is attributable to customer rate increases offset by lower fuel surcharges and freight mix. This decrease was partially offset by increases in load volume in both our eastern and transcontinental networks. Excluding fuel surcharge, revenues increased 8.7% and revenue per load increased 4.4% in 2015 over the prior year. Average length of haul remained relatively flat in 2015 when compared to 2014. Operating income in our JBI segment increased to $477 million in 2015, from $461 million in 2014. This increase was primarily due to customer rate increases, increased load volume, reduced reliance on outsourced dray carriers, lower insurance and cargo claim costs, and lower maintenance costs, partially offset by increases in rail purchased transportation rates, higher equipment depreciation expense, higher driver procurement and retention expenses, and $6.4 million in corporate-wide streamlining and technology redevelopment costs. DCS Segment DCS segment revenue increased 4.1% to $1.45 billion in 2015, from $1.39 billion in 2014. Productivity, defined as revenue per truck per week, decreased 1.7% when compared to 2014, primarily from lower fuel surcharge revenue. Revenue, excluding fuel surcharges, increased 10.0% in 2015 compared to 2014, and productivity excluding fuel surcharge revenue increased 3.9% from 2014, primarily from customer rate increases and additional activity at customer accounts. DCS ended 2015 with a net additional 328 revenue-producing trucks when compared to 2014. Operating income increased to $163 million in 2015, compared with $117 million in 2014. The increase in operating income was primarily due to increased revenue, improved asset utilization, less reliance on third-party carriers and lower maintenance costs, partially offset by increased equipment depreciation expense, higher driver wage and recruiting costs, and $2.6 million in corporate-wide streamlining and technology redevelopment costs. ICS Segment ICS segment revenue decreased 2.6% to $699 million in 2015, from $718 million in 2014. This decrease in revenue was primarily due to decreased revenue per load resulting from lower fuel prices, changes in freight mix, and less transactional customer demand, partially offset by an increase in overall load volume. Contractual business was approximately 71% of the total load volume and 63% of the total revenue in the 2015, compared to 63% of the total load volume and 55% of the total revenue in 2014. Operating income increased to $36 million in 2015, compared to $30 million in 2014, primarily due to improved gross profit margin. ICS gross profit margin increased to 15.3% for 2015 from 13.0% for 2014. Improvements in gross profit margin were offset by approximately $4.4 million in corporate-wide streamlining and technology redevelopment costs and higher personnel costs as the total branch count increased to 34 from 29 at the end of 2014. ICS’s carrier base increased 17%, and the employee count increased 15% when compared to 2014. JBT Segment JBT segment revenue remained flat at $386 million in 2015 when compared to 2014. Excluding fuel surcharges, revenue for 2015 increased 7.5% compared to 2014, primarily due to increased truck count and core rate increases. JBT segment had operating income of $40 million in 2015 compared with $24 million in 2014. Benefits from an increased truck count, core rate increases, and improvements in equipment maintenance costs, insurance and claims costs, and fuel economy were partially offset by lower asset utilization, higher driver wage and hiring costs, lower gains on equipment sales, increased equipment depreciation expense, increased driver and independent contractor costs per mile, and corporate-wide streamlining and technology redevelopment costs. 2014 Compared With 2013 Consolidated Operating Revenues Our total consolidated operating revenues were $6.2 billion in 2014, a 10.4% increase over 2013, primarily due to increased load volume and rate increases. Fuel surcharge revenues remained flat at $1.1 billion in 2014 when compared to 2013, due to decreases in the price of fuel during the second half of 2014. If fuel surcharge revenues were excluded from both years, our 2014 revenue increased 12.3% over 2013. Consolidated Operating Expenses Our 2014 consolidated operating expenses increased 10.5% from 2013, compared to the 10.4% increase in revenue year over year, resulting in a 2014 operating ratio of 89.8% compared to 89.7% in 2013. Rents and purchased transportation costs increased 10.0% in 2014, primarily due to the increase in load volume that increased services from third-party rail and truck carriers within our JBI, DCS, and ICS segments. Salaries, wages and employee benefit costs increased 13.4% in 2014 from 2013. This increase was primarily related to increases in driver pay and office personnel compensation due to an increase in the number of employees and a tighter supply of qualified drivers. In addition, workers’ compensation claims expense increased due to increases in both incident volume and severity, as well as increased insurance premium costs. Fuel and fuel taxes expense decreased 0.4% in 2014 compared with 2013, due to decreases in the price of fuel and improved fuel efficiency during 2014, partially offset by increased road miles. We have fuel surcharge programs in place with the majority of our customers. These programs typically involve a specified computation based on the change in national, regional or local fuel prices. While these programs may address fuel cost changes as frequently as weekly, most also reflect a specified miles-per-gallon factor and require a certain minimum change in fuel costs to trigger a change in fuel surcharge revenue. As a result, some of these programs have a time lag between when fuel costs change and when this change is reflected in revenues. Due to these programs, this lag negatively impacts operating income in times of rapidly increasing fuel costs and positively impacts operating income when fuel costs decrease rapidly. It is not meaningful to compare the amount of fuel surcharge revenue or the change in fuel surcharge revenue between reporting periods to fuel and fuel taxes expense, or the change of fuel expense between periods, as a significant portion of fuel cost is included in our payments to railroads, dray carriers and other third parties. These payments are classified as purchased transportation expense. Depreciation and amortization expense increased 16.2% in 2014, primarily due to additions to our JBI segment tractor, container and chassis fleets to support additional business demand, equipment purchased related to new DCS long-term customer contracts, and new replacement tractors and trailers in JBT. Operating supplies and expenses increased 7.8%, driven primarily by increased general maintenance costs resulting from growth in equipment fleets and increased toll activity. Insurance and claims expense increased 47.0% for 2014, primarily due to higher incidents and increased accident severity. General and administrative expenses increased 11.3%, due primarily to an increase in driver advertising, higher building and facility rental expenses, and increased professional fees, partially offset by an increase in net gains from asset sales and disposals. Net gains from the disposal of assets were $6 million in 2014, compared with $5 million in 2013. Net interest expense for 2014 increased by 16.4% compared with 2013, primarily due to increased average debt levels. Our effective income tax rate was 38.01% in 2014 and 38.15% in 2013. The decrease in 2014 was primarily related to a decrease in the provision for uncertain tax positions taken in prior years. JBI Segment JBI segment experienced an environment of challenging rail service and limited dray fleet capacity throughout 2014. JBI segment revenue increased 6.7% to $3.69 billion in 2014, from $3.46 billion in 2013, primarily due to a 6.7% increase in overall load volume, with both our eastern and transcontinental networks reporting increased volumes. Excluding fuel surcharge, revenues increased 8.0% in 2014 over the prior year. The combination of traffic mix, customer rate increases, and fuel surcharge revenue resulted in revenue per load remaining unchanged compared to a year ago. Average length of haul decreased 2.3% in 2014 when compared to 2013. Operating income in our JBI segment increased to $461 million in 2014, from $447 million in 2013. This increase was primarily due to increased revenue, partially offset by slow train speeds and reductions in dray fleet capacity throughout 2014, which negatively impacted the network fluidity, resulting in a reduction in box turns and dray power utilization. In addition, JBI experienced higher driver procurement and retention expenses, increased rail and dray purchased transportation costs, higher insurance and claims costs, and increased equipment costs during 2014 when compared to 2013. DCS Segment DCS segment revenue increased 13.2% to $1.39 billion in 2014, from $1.23 billion in 2013. Revenue, excluding fuel surcharges, increased 14.1% in 2014 compared to 2013, primarily attributable to large existing accounts becoming fully implemented in the current year, new customer contracts, and rate increases established in the latter half of 2014. DCS ended 2014 with a net additional 473 revenue-producing trucks when compared to 2013. Productivity for 2014, defined as revenue per truck per week, was virtually flat when compared to 2013, due to the large number of customer accounts affected by severe winter weather conditions during the first quarter of 2014 and continued driver shortages throughout the current year. Operating income increased to $117 million in 2014, compared with $110 million in 2013. The increase in operating income was primarily due to increased revenue, partially offset by higher driver recruiting and retention costs, increased insurance and workers’ compensation costs, higher purchased transportation costs, increased equipment and maintenance expenses, and fewer gains on the sale of equipment compared to 2013. ICS Segment ICS segment revenue grew 33.8% to $718 million in 2014, from $537 million in 2013. This increase in revenue was primarily due to a 16.6% increase in load volume and a 14.8% increase in revenue per load in 2014 when compared to 2013. Both transactional and contractual business experienced increased load volumes. Contractual business was approximately 63% of the total load volume but only 55% of the total revenue in the 2014, compared to 64% of the total load volume and 61% of the total revenue in 2013. Operating income increased to $30 million in 2014, compared to $16 million in 2013. ICS gross profit margin increased to 13.0% for 2014 from 11.8% for 2013, primarily due to customer rate increases in contractual business and maintaining margin discipline in transactional business. ICS incurred increased personnel and branch network expansion costs during 2014 resulting from the continued expansion of the segment’s branch location network. JBT Segment JBT segment revenue decreased 1.4% to $386 million in 2014, from $391 million in 2013, primarily due to operating a reduced fleet size for the majority of 2014, partially offset by increased pricing. Excluding fuel surcharges, revenue for 2014 increased 0.9% compared to 2013. JBT segment had operating income of $24 million in 2014 compared with $4 million in 2013. This increase in operating income was primarily due to increased rate per loaded mile, lower personnel costs, a smaller trailer fleet and gains on equipment sales, offset by increased driver hiring costs, increases in driver and independent contractor costs per mile, higher maintenance and equipment costs per unit, and increased insurance and safety costs. LIQUIDITY AND CAPITAL RESOURCES Net cash provided by operating activities was $873 million in 2015 and $647 million in 2014. This increase in 2015 was primarily due to increased earnings and the collection of trade and income taxes receivable, partially offset by the timing of the payments of trade payables and accrued expenses. Net cash used in investing activities totaled $577 million in 2015, compared with $660 million in 2014. The decrease resulted primarily from a reduction in equipment purchases, combined with an increase in proceeds from the sale of equipment in 2015, compared to 2014. Net cash used in financing activities was $297 million in 2015, compared to net cash provided by financing activities of $13 million in 2014. This change resulted primarily from an increase in treasury stock purchases and lower long-term debt issuances, net of long-term debt repayments, in 2015. Our dividend policy is subject to review and revision by the Board of Directors, and payments are dependent upon our financial condition, liquidity, earnings, capital requirements, and other factors the Board of Directors may deem relevant. We paid a $0.15 per share quarterly dividend in 2013, with the first quarter dividend being pulled forward and paid in fourth quarter 2012, a $0.20 per share quarterly dividend in 2014, and a $0.21 per share quarterly dividend in 2015. On January 28, 2016, we announced an increase in our quarterly cash dividend from $0.21 to $0.22 per share, which will be paid February 26, 2016, to stockholders of record on February 12, 2016. We currently intend to continue paying cash dividends on a quarterly basis. However, no assurance can be given that future dividends will be paid. Liquidity Our need for capital has typically resulted from the acquisition of containers, chassis, trucks, tractors, and trailers required to support our growth and the replacement of older equipment. We are frequently able to accelerate or postpone a portion of equipment replacements depending on market conditions. We obtain capital through cash generated from operations, revolving lines of credit, and long-term debt issuances. We have also periodically utilized capital and operating leases for revenue equipment. At December 31, 2015, we were authorized to borrow up to $500 million under a senior revolving line of credit, which is supported by a credit agreement with a group of banks and expires in September 2020. This senior credit facility allows us to request an increase in the total commitment by up to $250 million and to request a one-year extension of the maturity date. The applicable interest rate under this agreement is based on the Prime Rate, the Federal Funds Rate, or LIBOR, depending upon the specific type of borrowing, plus an applicable margin based on our credit rating and other fees. At December 31, 2015, we had $150 million outstanding at an average interest rate of 1.39% under this agreement. Our senior notes consist of three separate issuances. The first and second issuances are $250 million of 2.40% senior notes due March 2019 and $250 million of 3.85% senior notes due March 2024, respectively, both of which were issued in March 2014. Interest payments under both notes are due semiannually in March and September of each year. The third issuance is $350 million of 3.30% senior notes due August 2022, issued in August 2015. Interest payments under this note are due semiannually in February and August of each year, beginning February 2016. We may redeem for cash some or all of these notes based on a redemption price set forth in the note indenture. We currently have interest rate swap agreements which effectively convert our $250 million of 2.40% fixed-rate senior notes due March 2019 and our $350 million of 3.30% fixed-rate senior notes due August 2022 to variable rates, resulting in interest rates of 1.36% and 1.72%, respectively, at December 31, 2015. The applicable interest rates under these swap agreements are based on LIBOR plus an established margin. Our financing arrangements require us to maintain certain covenants and financial ratios. We were in compliance with all covenants and financial ratios at December 31, 2015. We believe our liquid assets, cash generated from operations, and various financing arrangements will provide sufficient funds for our operating and capital requirements for the foreseeable future. We are currently committed to spend approximately $463 million, net of proceeds from sales or trade-ins, during 2016 and 2017, which is primarily related to the acquisition of containers, chassis, and tractors. Off-Balance Sheet Arrangements Our only off-balance sheet arrangements are related to operating leases. As of December 31, 2015, we had approximately $28.1 million of obligations, primarily related to facility leases. Contractual Obligations and Commitments The following table summarizes our expected obligations and commitments (in millions) as of December 31, 2015: (1) Interest payments on debt are based on the debt balance and applicable rate at December 31, 2015. We had standby letters of credit outstanding of approximately $4.4 million at December 31, 2015, that expire at various dates in 2016, which are related to certain operating agreements and our self-insured retention levels for casualty and workers’ compensation claims. We plan to renew these letters of credit in accordance with our third-party agreements. The table above excludes $36.0 million of liabilities related to uncertain tax positions, including interest and penalties, as we are unable to reasonably estimate the ultimate timing of settlement. See Note 7, Income Taxes, in the Notes to Consolidated Financial Statements for further discussion.

<s>[INST] Critical Accounting Policies and Estimates The preparation of our financial statements in accordance with U.S. generally accepted accounting principles requires us to make estimates and assumptions that impact the amounts reported in our Consolidated Financial Statements and accompanying notes. Therefore, the reported amounts of assets, liabilities, revenues, expenses and associated disclosures of contingent liabilities are affected by these estimates. We evaluate these estimates on an ongoing basis, utilizing historical experience, consultation with third parties and other methods considered reasonable in the particular circumstances. Nevertheless, actual results may differ significantly from our estimates. Any effects on our business, financial position or results of operations resulting from revisions to these estimates are recognized in the accounting period in which the facts that give rise to the revision become known. We consider our critical accounting policies and estimates to be those that require us to make more significant judgments and estimates when we prepare our financial statements and include the following: Workers’ Compensation and Accident Costs We purchase insurance coverage for a portion of expenses related to employee injuries, vehicular collisions, accidents, and cargo damage. Certain insurance arrangements include a level of selfinsurance (deductible) coverage applicable to each claim. We have umbrella policies to limit our exposure to catastrophic claim costs. We are substantially selfinsured for loss of and damage to our owned and leased revenue equipment. The amounts of selfinsurance change from time to time based on measurement dates, policy expiration dates, and claim type. We have policies in place for 2016 with substantially the same terms as our 2015 policies for personal injury, property damage, workers’ compensation, and cargo loss or damage. Our claims accrual policy for all selfinsured claims is to recognize a liability at the time of the incident based on our analysis of the nature and severity of the claims and analyses provided by thirdparty claims administrators, as well as legal, economic, and regulatory factors. Our safety and claims personnel work directly with representatives from the insurance companies to continually update the estimated cost of each claim. The ultimate cost of a claim develops over time as additional information regarding the nature, timing, and extent of damages claimed becomes available. Accordingly, we use an actuarial method to develop current claim information to derive an estimate of our ultimate claim liability. This process involves the use of lossdevelopment factors based on our historical claims experience and includes a contractual premium adjustment factor, if applicable. In doing so, the recorded liability considers future claims growth and, if applicable, conversion to fully insured status and provides a reserve for incurredbutnotreported claims. We do not discount our estimated losses. At December 31, 2015, we had an accrual of approximately $95 million for estimated claims. In addition, we are required to pay certain advanced deposits and monthly premiums. At December 31, 2015, we had an aggregate prepaid insurance asset of approximately $87 million, which represented prefunded premiums and deposits. Revenue Equipment We operate a significant number of tractors, trucks, containers, chassis, and trailers in connection with our business. This equipment may be purchased or acquired under lease agreements. In addition, we may rent revenue equipment from various third parties under shortterm rental arrangements. Purchased revenue equipment is depreciated on the straightline method over the estimated useful life to an estimated salvage or tradein value. We periodically review the useful lives and salvage values of our revenue equipment and evaluate our longlived assets for impairment. We have not identified any impairment to our assets at December 31, 2015. We have agreements with our primary tractor suppliers for residual or tradein values for certain new equipment. We have utilized these tradein values, as well as other operational information such as anticipated annual miles, in accounting for depreciation expense. If our suppliers were unable to perform under the terms of our agreements for tradein values, it could have a material adverse effect on our financial results. Revenue Recognition We recognize revenue based on the relative transit time of the freight transported and as other services are provided. Accordingly, a portion of the total revenue that will be billed to the customer once a load is delivered is recognized in each reporting period based on the percentage of the freight pickup and delivery service that has been completed at the [/INST] Negative. </s>

HUNT J B TRANSPORT SERVICES INC

2017-02-23

2016-12-31

ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The following discussion of our results of operations and financial condition should be read in conjunction with our financial statements and related notes in Item 8. This discussion contains forward-looking statements. Please see “Forward-looking Statements” and “Risk Factors” for a discussion of items, uncertainties, assumptions and risks associated with these statements. Critical Accounting Policies and Estimates The preparation of our financial statements in accordance with U.S. generally accepted accounting principles requires us to make estimates and assumptions that impact the amounts reported in our Consolidated Financial Statements and accompanying notes. Therefore, the reported amounts of assets, liabilities, revenues, expenses and associated disclosures of contingent liabilities are affected by these estimates. We evaluate these estimates on an ongoing basis, utilizing historical experience, consultation with third parties and other methods considered reasonable in the particular circumstances. Nevertheless, actual results may differ significantly from our estimates. Any effects on our business, financial position or results of operations resulting from revisions to these estimates are recognized in the accounting period in which the facts that give rise to the revision become known. We consider our critical accounting policies and estimates to be those that require us to make more significant judgments and estimates when we prepare our financial statements and include the following: Workers’ Compensation and Accident Costs We purchase insurance coverage for a portion of expenses related to employee injuries, vehicular collisions, accidents, and cargo damage. Certain insurance arrangements include a level of self-insurance (deductible) coverage applicable to each claim. We have umbrella policies to limit our exposure to catastrophic claim costs. We are substantially self-insured for loss of and damage to our owned and leased revenue equipment. The amounts of self-insurance change from time to time based on measurement dates, policy expiration dates, and claim type. We have policies in place for 2017 with substantially the same terms as our 2016 policies for personal injury, property damage, workers’ compensation, and cargo loss or damage. Our claims accrual policy for all self-insured claims is to recognize a liability at the time of the incident based on our analysis of the nature and severity of the claims and analyses provided by third-party claims administrators, as well as legal, economic, and regulatory factors. Our safety and claims personnel work directly with representatives from the insurance companies to continually update the estimated cost of each claim. The ultimate cost of a claim develops over time as additional information regarding the nature, timing, and extent of damages claimed becomes available. Accordingly, we use an actuarial method to develop current claim information to derive an estimate of our ultimate claim liability. This process involves the use of loss-development factors based on our historical claims experience and includes a contractual premium adjustment factor, if applicable. In doing so, the recorded liability considers future claims growth and, if applicable, conversion to fully insured status and provides a reserve for incurred-but-not-reported claims. We do not discount our estimated losses. At December 31, 2016, we had an accrual of approximately $98 million for estimated claims. In addition, we are required to pay certain advanced deposits and monthly premiums. At December 31, 2016, we had an aggregate prepaid insurance asset of approximately $93 million, which represented prefunded premiums and deposits. Revenue Equipment We operate a significant number of tractors, trucks, containers, chassis, and trailers in connection with our business. This equipment may be purchased or acquired under lease agreements. In addition, we may rent revenue equipment from various third parties under short-term rental arrangements. Purchased revenue equipment is depreciated on the straight-line method over the estimated useful life to an estimated salvage or trade-in value. We periodically review the useful lives and salvage values of our revenue equipment and evaluate our long-lived assets for impairment. We have not identified any impairment to our assets at December 31, 2016. We have agreements with our primary tractor suppliers for residual or trade-in values for certain new equipment. We have utilized these trade-in values, as well as other operational information such as anticipated annual miles, in accounting for depreciation expense. If our suppliers were unable to perform under the terms of our agreements for trade-in values, it could have a material adverse effect on our financial results. Revenue Recognition We recognize revenue based on the relative transit time of the freight transported and as other services are provided. Accordingly, a portion of the total revenue that will be billed to the customer once a load is delivered is recognized in each reporting period based on the percentage of the freight pickup and delivery service that has been completed at the end of the reporting period. We record revenues on the gross basis at amounts charged to our customers because we are the primary obligor, we are a principal in the transaction, we invoice our customers and retain all credit risks, and we maintain discretion over pricing. Additionally, we are responsible for the selection of third-party transportation providers. Our trade accounts receivable includes amounts due from customers that have been reduced by an allowance for uncollectible accounts and revenue adjustments. The allowance for uncollectible accounts and revenue adjustments is based on historical experience, as well as any known trends or uncertainties related to customer billing and account collectability. The adequacy of our allowance is reviewed quarterly. Income Taxes We account for income taxes under the liability method. Our deferred tax assets and liabilities represent items that will result in a tax deduction or taxable income in future years for which we have already recorded the related tax expense or benefit in our statement of earnings. Deferred tax accounts arise as a result of timing differences between when items are recognized in our Consolidated Financial Statements and when they are recognized in our tax returns. We assess the likelihood that deferred tax assets will be recovered from future taxable income or the reversal of temporary timing differences. To the extent we believe recovery does not meet the more-likely-than-not threshold, a valuation allowance is established. To the extent we establish a valuation allowance, we include an expense as part of our income tax provision. Significant judgment is required in determining and assessing the impact of complex tax laws and certain tax-related contingencies on our provision for income taxes. As part of our calculation of the provision for income taxes, we assess whether the benefits of our tax positions are at least more likely than not to be sustained upon audit based on the technical merits of the tax position. For tax positions that are not more likely than not to be sustained upon audit, we accrue the largest amount of the benefit that is not more likely than not to be sustained in our Consolidated Financial Statements. Such accruals require us to make estimates and judgments, whereby actual results could vary materially from these estimates. Further, a number of years may elapse before a particular matter for which we have established an accrual is audited and resolved. See Note 7, Income Taxes, in our Consolidated Financial Statements for a discussion of our current tax contingencies. RESULTS OF OPERATIONS The following table sets forth items in our Consolidated Statements of Earnings as a percentage of operating revenues and the percentage increase or decrease of those items compared with the prior year. 2016 Compared With 2015 Consolidated Operating Revenues Our total consolidated operating revenues increased 5.9% to $6.56 billion in 2016, compared to $6.19 billion in 2015, primarily due to overall increased load volume, partially offset by lower revenue per load in our JBI, ICS, and JBT segments. Fuel surcharge revenues decreased 18.4% to $548 million in 2016, compared to $671 million in 2015. If fuel surcharge revenues were excluded from both years, our 2016 revenue increased 8.9% over 2015. Consolidated Operating Expenses Our 2016 consolidated operating expenses increased 6.6% from 2015, while year-over-year revenue increased 5.9%, resulting in a 2016 operating ratio of 89.0% compared to 88.4% in 2015. Rents and purchased transportation costs increased 8.7% in 2016, primarily the result of increased rail purchased transportation rates and the increase in load volume, which increased services provided by third-party rail and truck carriers within JBI and ICS segments. Salaries, wages and employee benefit costs increased 5.4% in 2016 from 2015. This increase was primarily related to increases in driver pay and office personnel compensation due to an increase in the number of employees and a tighter supply of qualified drivers, partially offset by a $15.2 million, one-time benefit recorded to reflect a change in our employee paid time off policy. Depreciation and amortization expense increased 6.4% in 2016, primarily due to additions to our JBI segment tractor, container and chassis fleets to support additional business demand, equipment purchased related to new DCS long-term customer contracts, and new replacement equipment in JBT. Fuel and fuel taxes expense decreased 9.5% in 2016 compared with 2015, due to decreases in the price of fuel during 2016, partially offset by increased road miles. We have fuel surcharge programs in place with the majority of our customers. These programs typically involve a specified computation based on the change in national, regional, or local fuel prices. While these programs may address fuel cost changes as frequently as weekly, most also reflect a specified miles-per-gallon factor and require a certain minimum change in fuel costs to trigger a change in fuel surcharge revenue. As a result, some of these programs have a time lag between when fuel costs change and when this change is reflected in revenues. Due to these programs, this lag negatively impacts operating income in times of rapidly increasing fuel costs and positively impacts operating income when fuel costs decrease rapidly. It is not meaningful to compare the amount of fuel surcharge revenue or the change in fuel surcharge revenue between reporting periods to fuel and fuel taxes expense, or the change of fuel expense between periods, as a significant portion of fuel cost is included in our payments to railroads, dray carriers and other third parties. These payments are classified as purchased transportation expense. Operating supplies and expenses increased 5.7%, driven primarily by increased toll activity and tire expense. General and administrative expenses increased 20.0% from 2015, primarily due to increased charitable contributions and the absence of net gains from asset sales and disposals in 2016. Net losses from sale or disposal of assets were $5 million in 2016, compared to net gains of $1 million in 2015. Insurance and claims expense increased 6.4% in 2016, primarily due to higher incident volume. Net interest expense for 2016 decreased by 1.1% compared with 2015, due primarily to lower effective interest rates. Our effective income tax rate was 37.90% in 2016 and 38.10% in 2015. The decrease in 2016 was primarily due to a reduction in permanent differences related to executive compensation and lower state tax rates. Segments We operated four business segments during calendar year 2016. The operation of each of these businesses is described in our Notes to Consolidated Financial Statements. The following tables summarize financial and operating data by segment: Operating Data by Segment (1) Includes company-owned and independent contractor tractors (2) Using weighted workdays (3) Includes company-owned, independent contractor, and customer-owned trucks JBI Segment JBI segment revenue increased 3.6% to $3.80 billion in 2016, from $3.66 billion in 2015. This increase in revenue was primarily a result of an 8.1% increase in load volume, offset by a 4.2% decrease in revenue per load, which is the combination of changes in freight mix, customer rates, and fuel surcharge revenue. Load volume in our eastern network increased 6.7%, and transcontinental loads grew 9.0% compared to 2015. Excluding fuel surcharge, revenues increased 7.1% and revenue per load decreased 1.0% in 2016 over the prior year. Average length of haul remained relatively flat in 2016 when compared to 2015. Operating income of the JBI segment decreased to $450 million in 2016, from $477 million in 2015. Benefits from volume growth, improved network efficiency, improved rail service, and approximately $5.7 million from the change in paid time off policy were offset by increased rail purchased transportation costs, higher equipment ownership costs, increased insurance and cargo claim expense and higher driver wage and retention costs. DCS Segment DCS segment revenue increased 5.6% to $1.53 billion in 2016, from $1.45 billion in 2015. Productivity, defined as revenue per truck per week, increased 1.2% when compared to 2015. Revenue, excluding fuel surcharges, increased 7.3% in 2016 compared to 2015, and productivity excluding fuel surcharge revenue increased 2.8% from 2015, primarily from improved overall operational efficiencies, including better integration of assets between customer accounts, fewer unseated trucks, increased customer supply-chain fluidity, load counts and customer rate increases. DCS ended 2016 with a net additional 193 revenue-producing trucks when compared to 2015. Operating income of our DCS segment increased to $205 million in 2016, from $163 million in 2015. The increase is primarily due to increased revenue, improved asset utilization, and approximately $7.3 million from the change in paid time off policy, partially offset by higher driver wage and recruiting costs, increased salaries and benefits expenses, and higher equipment ownership costs. ICS Segment ICS segment revenue increased 21.7% to $852 million in 2016, from $699 million in 2015. Overall volumes increased 57.0%. Revenue per load decreased 22.5% primarily due to freight mix changes driven by customer demand. Contractual business was approximately 74% of the total load volume and 64% of the total revenue in the 2016, compared to 71% of the total load volume and 63% of the total revenue in 2015. Operating income remained flat at $36 million for both 2016 and 2015, primarily due to increased revenue and approximately $1.0 million from the change in paid time off policy, being offset by a 6.3% decrease in gross profit margin, increased claim costs, higher technology costs and increased personnel costs, as the total branch count increased to 42 from 34 at the end of 2015. ICS gross profit margin decreased to 14.3% for 2016 from 15.3% for 2015. ICS’s carrier base increased 11.4%, and the employee count increased 23.0% when compared to 2015. JBT Segment JBT segment revenue increased 0.6% to $388 million in 2016, from $386 million in 2015. Excluding fuel surcharges, revenue for 2016 increased 3.8% compared to 2015, primarily due to increased average truck count, partially offset by core customer rate decreases and freight mix changes. JBT segment had operating income of $30 million in 2016 compared with $40 million in 2015. Benefits from an increased average truck count, higher load volume, and approximately $1.2 million from the change in paid time off policy, were more than offset by increased driver recruiting costs, higher independent contractor cost per mile, higher safety and insurance costs, and increased tractor maintenance costs. 2015 Compared With 2014 Consolidated Operating Revenues Our total consolidated operating revenues were $6.19 billion in 2015, remaining relatively flat when compared to $6.17 billion in 2014. Overall customer rate increases and load growth, and increased fleet counts in our JBI, DCS, and JBT segments, were offset by a 38.0% decrease in fuel surcharge revenue to $671 million in 2015 when compared to $1.08 billion in 2014, due to decreases in the price of fuel during the year. If fuel surcharge revenues were excluded from both years, our 2015 revenue increased 8.5% over 2014. Consolidated Operating Expenses Our 2015 consolidated operating expenses decreased 1.1% from 2014, while year-over-year revenue remained flat, resulting in a 2015 operating ratio of 88.4% compared to 89.8% in 2014. Rents and purchased transportation costs decreased 2.9% in 2015, primarily the result of the lower fuel component in the cost of services provided by third-party rail and truck carriers within JBI, DCS, and ICS segments. Salaries, wages and employee benefit costs increased 8.1% in 2015 from 2014. This increase was primarily related to increases in driver pay and office personnel compensation due to an increase in the number of employees and a tighter supply of qualified drivers. Depreciation and amortization expense increased 15.3% in 2015, primarily due to additions to our JBI segment tractor, container and chassis fleets to support additional business demand, equipment purchased related to new DCS long-term customer contracts, and new replacement equipment in JBT. Fuel and fuel taxes expense decreased 31.0% in 2015 compared with 2014, due to decreases in the price of fuel during 2015, partially offset by increased road miles. We have fuel surcharge programs in place with the majority of our customers. These programs typically involve a specified computation based on the change in national, regional or local fuel prices. While these programs may address fuel cost changes as frequently as weekly, most also reflect a specified miles-per-gallon factor and require a certain minimum change in fuel costs to trigger a change in fuel surcharge revenue. As a result, some of these programs have a time lag between when fuel costs change and when this change is reflected in revenues. Due to these programs, this lag negatively impacts operating income in times of rapidly increasing fuel costs and positively impacts operating income when fuel costs decrease rapidly. It is not meaningful to compare the amount of fuel surcharge revenue or the change in fuel surcharge revenue between reporting periods to fuel and fuel taxes expense, or the change of fuel expense between periods, as a significant portion of fuel cost is included in our payments to railroads, dray carriers and other third parties. These payments are classified as purchased transportation expense. Operating supplies and expenses increased 0.9%, driven primarily by increased toll rates and activity, partially offset by decreased general equipment maintenance and repair costs. General and administrative expenses increased 43.3% from 2014, due primarily to costs related to corporate wide streamlining and technology redevelopment efforts. Net gains from sale or disposal of assets were $1 million in 2015, compared with $6 million in 2014. Insurance and claims expense decreased 9.1% in 2015, primarily due to decreased accident severity and fewer incidents. Net interest expense for 2015 decreased by 5.4% compared with 2014, primarily due to lower effective interest rates. Our effective income tax rate was 38.10% in 2015 and 38.01% in 2014. The increase in 2015 was primarily related to an increase in state income tax expense. JBI Segment JBI segment revenue decreased 0.6% to $3.66 billion in 2015, from $3.69 billion in 2014, resulting from a decrease in revenue per load, which is attributable to customer rate increases offset by lower fuel surcharges and freight mix. This decrease was partially offset by increases in load volume in both our eastern and transcontinental networks. Excluding fuel surcharge, revenues increased 8.7% and revenue per load increased 4.4% in 2015 over the prior year. Average length of haul remained relatively flat in 2015 when compared to 2014. Operating income in our JBI segment increased to $477 million in 2015, from $461 million in 2014. This increase was primarily due to customer rate increases, increased load volume, reduced reliance on outsourced dray carriers, lower insurance and cargo claim costs, and lower maintenance costs, partially offset by increases in rail purchased transportation rates, higher equipment depreciation expense, higher driver procurement and retention expenses, and $6.4 million in corporate-wide streamlining and technology redevelopment costs. DCS Segment DCS segment revenue increased 4.1% to $1.45 billion in 2015, from $1.39 billion in 2014. Productivity, defined as revenue per truck per week, decreased 1.7% when compared to 2014, primarily from lower fuel surcharge revenue. Revenue, excluding fuel surcharges, increased 10.0% in 2015 compared to 2014, and productivity excluding fuel surcharge revenue increased 3.9% from 2014, primarily from customer rate increases and additional activity at customer accounts. DCS ended 2015 with a net additional 328 revenue-producing trucks when compared to 2014. Operating income increased to $163 million in 2015, compared with $117 million in 2014. The increase in operating income was primarily due to increased revenue, improved asset utilization, less reliance on third-party carriers and lower maintenance costs, partially offset by increased equipment depreciation expense, higher driver wage and recruiting costs, and $2.6 million in corporate-wide streamlining and technology redevelopment costs. ICS Segment ICS segment revenue decreased 2.6% to $699 million in 2015, from $718 million in 2014. This decrease in revenue was primarily due to decreased revenue per load resulting from lower fuel prices, changes in freight mix, and less transactional customer demand, partially offset by an increase in overall load volume. Contractual business was approximately 71% of the total load volume and 63% of the total revenue in the 2015, compared to 63% of the total load volume and 55% of the total revenue in 2014. Operating income increased to $36 million in 2015, compared to $30 million in 2014, primarily due to improved gross profit margin. ICS gross profit margin increased to 15.3% for 2015 from 13.0% for 2014. Improvements in gross profit margin were offset by approximately $4.4 million in corporate-wide streamlining and technology redevelopment costs and higher personnel costs as the total branch count increased to 34 from 29 at the end of 2014. ICS’s carrier base increased 17%, and the employee count increased 15% when compared to 2014. JBT Segment JBT segment revenue remained flat at $386 million in 2015 when compared to 2014. Excluding fuel surcharges, revenue for 2015 increased 7.5% compared to 2014, primarily due to increased truck count and core rate increases. JBT segment had operating income of $40 million in 2015 compared with $24 million in 2014. Benefits from an increased truck count, core rate increases, and improvements in equipment maintenance costs, insurance and claims costs, and fuel economy were partially offset by lower asset utilization, higher driver wage and hiring costs, lower gains on equipment sales, increased equipment depreciation expense, increased driver and independent contractor costs per mile, and corporate-wide streamlining and technology redevelopment costs. LIQUIDITY AND CAPITAL RESOURCES Net cash provided by operating activities was $854 million in 2016 and $873 million in 2015. This decrease in 2016 was primarily due to the timing of collections of trade and other receivables, partially offset by increased earnings, collection of income taxes receivable and the timing of the payments of trade payables. Net cash used in investing activities totaled $485 million in 2016, compared with $577 million in 2015. The decrease resulted primarily from a reduction in equipment purchases, partially offset by a decrease in proceeds from the sale of equipment in 2016, compared to 2015. Net cash used in financing activities was $368 million in 2016, compared with $297 million in 2015. This change resulted primarily from higher long-term debt repayments, net of proceeds from long-term debt, in 2016, partially offset by a reduction in treasury stock purchases. Our dividend policy is subject to review and revision by the Board of Directors, and payments are dependent upon our financial condition, liquidity, earnings, capital requirements, and other factors the Board of Directors may deem relevant. We paid a $0.20 per share quarterly dividend in 2014, a $0.21 per share quarterly dividend in 2015, and a $0.22 per share quarterly dividend in 2016. On January 25, 2017, we announced an increase in our quarterly cash dividend from $0.22 to $0.23 per share, which will be paid February 24, 2017, to stockholders of record on February 10, 2017. We currently intend to continue paying cash dividends on a quarterly basis. However, no assurance can be given that future dividends will be paid. Liquidity Our need for capital has typically resulted from the acquisition of containers, chassis, trucks, tractors, and trailers required to support our growth and the replacement of older equipment. We are frequently able to accelerate or postpone a portion of equipment replacements depending on market conditions. We obtain capital through cash generated from operations, revolving lines of credit, and long-term debt issuances. We have also periodically utilized capital and operating leases for revenue equipment. At December 31, 2016, we were authorized to borrow up to $500 million under a senior revolving line of credit, which is supported by a credit agreement with a group of banks and expires in September 2020. This senior credit facility allows us to request an increase in the total commitment by up to $250 million and to request a one-year extension of the maturity date. The applicable interest rate under this agreement is based on the Prime Rate, the Federal Funds Rate, or LIBOR, depending upon the specific type of borrowing, plus an applicable margin based on our credit rating and other fees. At December 31, 2016, we had $140 million outstanding at an average interest rate of 1.76% under this agreement. Our senior notes consist of three separate issuances. The first and second issuances are $250 million of 2.40% senior notes due March 2019 and $250 million of 3.85% senior notes due March 2024, respectively, both of which were issued in March 2014. Interest payments under both notes are due semiannually in March and September of each year. The third issuance is $350 million of 3.30% senior notes due August 2022, issued in August 2015. Interest payments under this note are due semiannually in February and August of each year. We may redeem for cash some or all of these notes based on a redemption price set forth in the note indenture. We currently have interest rate swap agreements which effectively convert our $250 million of 2.40% fixed-rate senior notes due March 2019 and our $350 million of 3.30% fixed-rate senior notes due August 2022 to variable rates, resulting in interest rates of 1.81% and 2.26%, respectively, at December 31, 2016. The applicable interest rates under these swap agreements are based on LIBOR plus an established margin. Our financing arrangements require us to maintain certain covenants and financial ratios. We were in compliance with all covenants and financial ratios at December 31, 2016. We believe our liquid assets, cash generated from operations, and various financing arrangements will provide sufficient funds for our operating and capital requirements for the foreseeable future. We are currently committed to spend approximately $967 million, net of proceeds from sales or trade-ins, during 2017 and 2018, which is primarily related to the acquisition of containers, chassis, and tractors. Off-Balance Sheet Arrangements Our only off-balance sheet arrangements are related to operating leases. As of December 31, 2016, we had approximately $36.7 million of obligations, primarily related to facility leases. Contractual Obligations and Commitments The following table summarizes our expected obligations and commitments (in millions) as of December 31, 2016: (1) Interest payments on debt are based on the debt balance and applicable rate at December 31, 2016. We had standby letters of credit outstanding of approximately $4.4 million at December 31, 2016, that expire at various dates in 2017, which are related to certain operating agreements and our self-insured retention levels for casualty and workers’ compensation claims. We plan to renew these letters of credit in accordance with our third-party agreements. The table above excludes $39.8 million of liabilities related to uncertain tax positions, including interest and penalties, as we are unable to reasonably estimate the ultimate timing of settlement. See Note 7, Income Taxes, in the Notes to Consolidated Financial Statements for further discussion.

<s>[INST] Critical Accounting Policies and Estimates The preparation of our financial statements in accordance with U.S. generally accepted accounting principles requires us to make estimates and assumptions that impact the amounts reported in our Consolidated Financial Statements and accompanying notes. Therefore, the reported amounts of assets, liabilities, revenues, expenses and associated disclosures of contingent liabilities are affected by these estimates. We evaluate these estimates on an ongoing basis, utilizing historical experience, consultation with third parties and other methods considered reasonable in the particular circumstances. Nevertheless, actual results may differ significantly from our estimates. Any effects on our business, financial position or results of operations resulting from revisions to these estimates are recognized in the accounting period in which the facts that give rise to the revision become known. We consider our critical accounting policies and estimates to be those that require us to make more significant judgments and estimates when we prepare our financial statements and include the following: Workers’ Compensation and Accident Costs We purchase insurance coverage for a portion of expenses related to employee injuries, vehicular collisions, accidents, and cargo damage. Certain insurance arrangements include a level of selfinsurance (deductible) coverage applicable to each claim. We have umbrella policies to limit our exposure to catastrophic claim costs. We are substantially selfinsured for loss of and damage to our owned and leased revenue equipment. The amounts of selfinsurance change from time to time based on measurement dates, policy expiration dates, and claim type. We have policies in place for 2017 with substantially the same terms as our 2016 policies for personal injury, property damage, workers’ compensation, and cargo loss or damage. Our claims accrual policy for all selfinsured claims is to recognize a liability at the time of the incident based on our analysis of the nature and severity of the claims and analyses provided by thirdparty claims administrators, as well as legal, economic, and regulatory factors. Our safety and claims personnel work directly with representatives from the insurance companies to continually update the estimated cost of each claim. The ultimate cost of a claim develops over time as additional information regarding the nature, timing, and extent of damages claimed becomes available. Accordingly, we use an actuarial method to develop current claim information to derive an estimate of our ultimate claim liability. This process involves the use of lossdevelopment factors based on our historical claims experience and includes a contractual premium adjustment factor, if applicable. In doing so, the recorded liability considers future claims growth and, if applicable, conversion to fully insured status and provides a reserve for incurredbutnotreported claims. We do not discount our estimated losses. At December 31, 2016, we had an accrual of approximately $98 million for estimated claims. In addition, we are required to pay certain advanced deposits and monthly premiums. At December 31, 2016, we had an aggregate prepaid insurance asset of approximately $93 million, which represented prefunded premiums and deposits. Revenue Equipment We operate a significant number of tractors, trucks, containers, chassis, and trailers in connection with our business. This equipment may be purchased or acquired under lease agreements. In addition, we may rent revenue equipment from various third parties under shortterm rental arrangements. Purchased revenue equipment is depreciated on the straightline method over the estimated useful life to an estimated salvage or tradein value. We periodically review the useful lives and salvage values of our revenue equipment and evaluate our longlived assets for impairment. We have not identified any impairment to our assets at December 31, 2016. We have agreements with our primary tractor suppliers for residual or tradein values for certain new equipment. We have utilized these tradein values, as well as other operational information such as anticipated annual miles, in accounting for depreciation expense. If our suppliers were unable to perform under the terms of our agreements for tradein values, it could have a material adverse effect on our financial results. Revenue Recognition We recognize revenue based on the relative transit time of the freight transported and as other services are provided. Accordingly, a portion of the total revenue that will be billed to the customer once a load is delivered is recognized in each reporting period based on the percentage of the freight pickup and delivery service that has been completed at the [/INST] Positive. </s>

HUNT J B TRANSPORT SERVICES INC

2018-02-23

2017-12-31

ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The following discussion of our results of operations and financial condition should be read in conjunction with our financial statements and related notes in Item 8. This discussion contains forward-looking statements. Please see “Forward-looking Statements” and “Risk Factors” for a discussion of items, uncertainties, assumptions and risks associated with these statements. Critical Accounting Policies and Estimates The preparation of our financial statements in accordance with U.S. generally accepted accounting principles requires us to make estimates and assumptions that impact the amounts reported in our Consolidated Financial Statements and accompanying notes. Therefore, the reported amounts of assets, liabilities, revenues, expenses and associated disclosures of contingent liabilities are affected by these estimates. We evaluate these estimates on an ongoing basis, utilizing historical experience, consultation with third parties and other methods considered reasonable in the particular circumstances. Nevertheless, actual results may differ significantly from our estimates. Any effects on our business, financial position or results of operations resulting from revisions to these estimates are recognized in the accounting period in which the facts that give rise to the revision become known. We consider our critical accounting policies and estimates to be those that require us to make more significant judgments and estimates when we prepare our financial statements and include the following: Workers’ Compensation and Accident Costs We purchase insurance coverage for a portion of expenses related to employee injuries, vehicular collisions, accidents, and cargo damage. Certain insurance arrangements include a level of self-insurance (deductible) coverage applicable to each claim. We have umbrella policies to limit our exposure to catastrophic claim costs. We are substantially self-insured for loss of and damage to our owned and leased revenue equipment. The amounts of self-insurance change from time to time based on measurement dates, policy expiration dates, and claim type. We have policies in place for 2018 with substantially the same terms as our 2017 policies for personal injury, property damage, workers’ compensation, and cargo loss or damage. Our claims accrual policy for all self-insured claims is to recognize a liability at the time of the incident based on our analysis of the nature and severity of the claims and analyses provided by third-party claims administrators, as well as legal, economic, and regulatory factors. Our safety and claims personnel work directly with representatives from the insurance companies to continually update the estimated cost of each claim. The ultimate cost of a claim develops over time as additional information regarding the nature, timing, and extent of damages claimed becomes available. Accordingly, we use an actuarial method to develop current claim information to derive an estimate of our ultimate claim liability. This process involves the use of loss-development factors based on our historical claims experience and includes a contractual premium adjustment factor, if applicable. In doing so, the recorded liability considers future claims growth and provides a reserve for incurred-but-not-reported claims. We do not discount our estimated losses. At December 31, 2017, we had an accrual of approximately $238 million for estimated claims. In addition, we record receivables for amounts expected to be reimbursed for payments made in excess of self-insurance levels on covered claims. At December 31, 2017, we have recorded $256 million, of expected reimbursement for covered excess claims, insurance premiums and other insurance deposits. Revenue Equipment We operate a significant number of tractors, trucks, containers, chassis, and trailers in connection with our business. This equipment may be purchased or acquired under lease agreements. In addition, we may rent revenue equipment from various third parties under short-term rental arrangements. Purchased revenue equipment is depreciated on the straight-line method over the estimated useful life to an estimated salvage or trade-in value. We periodically review the useful lives and salvage values of our revenue equipment and evaluate our long-lived assets for impairment. We have not identified any impairment to our assets at December 31, 2017. We have agreements with our primary tractor suppliers for residual or trade-in values for certain new equipment. We have utilized these trade-in values, as well as other operational information such as anticipated annual miles, in accounting for depreciation expense. If our suppliers were unable to perform under the terms of our agreements for trade-in values, it could have a material adverse effect on our financial results. Revenue Recognition We recognize revenue based on the relative transit time of the freight transported and as other services are provided. Accordingly, a portion of the total revenue that will be billed to the customer once a load is delivered is recognized in each reporting period based on the percentage of the freight pickup and delivery service that has been completed at the end of the reporting period. We record revenues on the gross basis at amounts charged to our customers because we are the primary obligor, we are a principal in the transaction, we invoice our customers and retain all credit risks, and we maintain discretion over pricing. Additionally, we are responsible for the selection of third-party transportation providers. Our trade accounts receivable includes amounts due from customers that have been reduced by an allowance for uncollectible accounts and revenue adjustments. The allowance for uncollectible accounts and revenue adjustments is based on historical experience, as well as any known trends or uncertainties related to customer billing and account collectability. The adequacy of our allowance is reviewed quarterly. Income Taxes We account for income taxes under the liability method. Our deferred tax assets and liabilities represent items that will result in a tax deduction or taxable income in future years for which we have already recorded the related tax expense or benefit in our statement of earnings. Deferred tax accounts arise as a result of timing differences between when items are recognized in our Consolidated Financial Statements and when they are recognized in our tax returns. We assess the likelihood that deferred tax assets will be recovered from future taxable income or the reversal of temporary timing differences. To the extent we believe recovery does not meet the more-likely-than-not threshold, a valuation allowance is established. To the extent we establish a valuation allowance, we include an expense as part of our income tax provision. The Tax Cuts and Jobs Act (the Act) was enacted in December 2017. Beginning in 2018, the Act reduces the U.S. federal corporate tax rate from 35% to 21%. At December 31, 2017, we had not completed our accounting for the tax effects of enactment of the Act. However, we have made a reasonable estimate of the effects on our existing deferred tax assets and liabilities based on the rates at which they are expected to reverse in the future, which is generally 21%. The provisional amount recorded resulting from the remeasurement of our deferred tax balance was $309.2 million, which is included as a component of income tax from continuing operations. We are still refining our calculations for our 2017 federal income tax return, which will be filed based on the law prior to the Act, and could potentially affect the measurement of these balances. Remaining aspects of the Act are not relevant to our operations. Significant judgment is required in determining and assessing the impact of complex tax laws and certain tax-related contingencies on our provision for income taxes. As part of our calculation of the provision for income taxes, we assess whether the benefits of our tax positions are at least more likely than not to be sustained upon audit based on the technical merits of the tax position. For tax positions that are not more likely than not to be sustained upon audit, we accrue the largest amount of the benefit that is not more likely than not to be sustained in our Consolidated Financial Statements. Such accruals require us to make estimates and judgments, whereby actual results could vary materially from these estimates. Further, a number of years may elapse before a particular matter for which we have established an accrual is audited and resolved. See Note 7, Income Taxes, in our Consolidated Financial Statements for a discussion of our current tax contingencies. RESULTS OF OPERATIONS The following table sets forth items in our Consolidated Statements of Earnings as a percentage of operating revenues and the percentage increase or decrease of those items compared with the prior year. 2017 Compared With 2016 Consolidated Operating Revenues Our total consolidated operating revenues increased 9.7% to $7.19 billion in 2017, compared to $6.56 billion in 2016, primarily due to overall increased load volume and higher revenue per load in our JBI, DCS, and ICS segments. Fuel surcharge revenues increased 37.5% to $754 million in 2017, compared to $548 million in 2016. If fuel surcharge revenues were excluded from both years, our 2017 revenue increased 7.1% over 2016. Consolidated Operating Expenses Our 2017 consolidated operating expenses increased 12.5% from 2016, while year-over-year revenue increased 9.7%, resulting in a 2017 operating ratio of 91.3% compared to 89.0% in 2016. Rents and purchased transportation costs increased 12.1% in 2017, primarily due to increased rail and truck purchased transportation rates and the increase in load volume, which increased services provided by third-party rail and truck carriers within JBI and ICS segments. Salaries, wages and employee benefit costs increase 9.5% in 2017 from 2016. This increase was primarily related to increases in driver pay and office personnel compensation due to an increase in the number of employees and a tighter supply of qualified drivers. In addition, 2016 included a $15.2 million benefit recorded to reflect a change in our employee paid time off policy. Depreciation and amortization expense increased 6.1% in 2017, primarily due to additions to our JBI segment tractor, container and chassis fleets to support additional business demand and equipment purchased related to new DCS long-term customer contracts. Fuel and fuel taxes expense increased 22.6% in 2017 compared with 2016, due primarily to increases in the price of fuel during 2017. We have fuel surcharge programs in place with the majority of our customers. These programs typically involve a specified computation based on the change in national, regional, or local fuel prices. While these programs may address fuel cost changes as frequently as weekly, most also reflect a specified miles-per-gallon factor and require a certain minimum change in fuel costs to trigger a change in fuel surcharge revenue. As a result, some of these programs have a time lag between when fuel costs change and when this change is reflected in revenues. Due to these programs, this lag negatively impacts operating income in times of rapidly increasing fuel costs and positively impacts operating income when fuel costs decrease rapidly. It is not meaningful to compare the amount of fuel surcharge revenue or the change in fuel surcharge revenue between reporting periods to fuel and fuel taxes expense, or the change of fuel expense between periods, as a significant portion of fuel cost is included in our payments to railroads, dray carriers and other third parties. These payments are classified as purchased transportation expense. Operating supplies and expenses increased 10.3%, driven primarily by increased mileage activity and tire expense. General and administrative expenses increased 44.6% from 2016, primarily due to a $20.2 million expense for the reserve of a cash advance for the purchases of new trailing equipment from a manufacturer that will not meet delivery, but also due to increased building rental expense, higher professional fee expenses, higher computer software subscription costs, and increased net losses from asset sales and disposals in 2017. Net losses from sale or disposal of assets were $7.4 million in 2017, compared to net losses of $5.5 million in 2016. Insurance and claims expense increased 57.6% in 2017, primarily due to higher incident volume and accident severity and an $18.6 million increase in reserves for certain claims not covered by insurance. Net interest expense for 2017 increased by 13.2% compared with 2016, due to an increase in average debt levels and higher effective interest rates on our debt during 2017. Our effective income tax rate was (15.29)% in 2017 and 37.90% in 2016. The decrease in 2017 was primarily due to a $309.2 million decrease in income tax expense resulting from adjustments to our deferred tax balances at December 31, 2017, for the change in future tax rates prescribed by the Tax Cuts and Jobs Act. Segments We operated four business segments during calendar year 2017. The operation of each of these businesses is described in our Notes to Consolidated Financial Statements. The following tables summarize financial and operating data by segment: Operating Data by Segment (1) Includes company-owned and independent contractor tractors (2) Using weighted workdays (3) Includes company-owned, independent contractor, and customer-owned trucks JBI Segment JBI segment revenue increased 7.6% to $4.08 billion in 2017, from $3.80 billion in 2016. This increase in revenue was primarily a result of an 4.4% increase in load volume and a 3.1% increase in revenue per load, which is the combination of changes in freight mix, customer rates, and fuel surcharge revenue. Load volume in our transcontinental loads grew 7.2% while our eastern network was relatively flat compared to 2016. Average length of haul increased 1.4% in 2017 when compared to 2016. Revenue per load excluding fuel surcharge was flat in 2017 when compared to 2016. Operating income of the JBI segment decreased to $407 million in 2017, from $450 million in 2016. Benefits from volume growth and increased revenue per load were offset by increases in rail purchased transportation costs, rail inefficiencies, higher driver wages and recruiting costs, higher equipment ownership costs, increased insurance and claims costs, which included an $8.5 million increase in reserves for certain insurance and claims, and the $20.2 million expense for the reserve of a cash advance for the purchases of new trailing equipment from a manufacturer that will not meet delivery. In addition, 2016 included a $5.7 million, one-time benefit from the change in paid time off policy. DCS Segment DCS segment revenue increased 12.1% to $1.72 billion in 2017, from $1.53 billion in 2016. Productivity, defined as revenue per truck per week, increased 3.7% when compared to 2016. Revenue, excluding fuel surcharges, increased 10.0% in 2017 compared to 2016, and productivity excluding fuel surcharge revenue increased 1.6% from 2016. The increase in revenue in 2017 was primarily a result of better integration of assets among customer accounts and customer rate increases, partially offset by lower productivity under new customer contracts, compared to 2016. DCS ended 2017 with a net additional 1,326 revenue-producing trucks when compared to 2016. Operating income of our DCS segment decreased to $171 million in 2017, from $205 million in 2016. The increase in revenue and improved asset utilization were offset by higher driver wages and recruiting costs, increased insurance and claims cost, which included a $7.6 million increase in reserves for certain insurance and claims, increased start up expenditures for new customer contracts, higher equipment ownership costs, and the addition of acquisition costs and intangible asset amortization associated with the purchase of Special Logistics Dedicated, LLC (SLD) when compared to 2016. In addition, 2016 included a $7.3 million, one-time benefit from the change in paid time off policy. ICS Segment ICS segment revenue increased 20.3% to $1.02 billion in 2017, from $852 million in 2016. Overall volumes increased 16.5%. Revenue per load increased 3.3% primarily due to freight mix changes driven by customer demand. Contractual business was approximately 70% of the total load volume and 53% of the total revenue in the 2017, compared to 74% of the total load volume and 64% of the total revenue in 2016. Operating income decreased to $23 million in 2017, from $36 million in 2016, primarily due to lower gross profit margins, increased insurance and claims cost, which included a $1.8 million increase in reserves for certain insurance and claims, increased number of branches less than two years old, and higher technology development costs. ICS gross profit margin decreased to 13.3% for 2017 from 14.3% for 2016. ICS’s carrier base increased 11.4%, and the employee count increased 15.8% when compared to 2016. In addition, 2016 included a $1.0 million, one-time benefit from the change in paid time off policy. JBT Segment JBT segment revenue decreased 2.4% to $378 million in 2017, from $388 million in 2016, primarily from a 3.8% decrease in load count partially offset by a 1.4% increase in revenue per load. Excluding fuel surcharges, revenue for 2017 decreased 4.5% compared to 2016, primarily due to the reduction in load volume and a 4.4% decrease in length of haul. JBT segment had operating income of $23 million in 2017 compared with $30 million in 2016. The decrease in operating income was driven primarily by lower revenue, increased driver wages and recruiting costs, higher independent contractor cost per mile, increased insurance and claims cost, which included an $0.7 million increase in reserves for certain insurance and claims, and increased tractor maintenance costs compared to 2016. In addition, 2016 included a $1.2 million, one-time benefit from the change in paid time off policy. 2016 Compared With 2015 Consolidated Operating Revenues Our total consolidated operating revenues increased 5.9% to $6.56 billion in 2016, compared to $6.19 billion in 2015, primarily due to overall increased load volume, partially offset by lower revenue per load in our JBI, ICS, and JBT segments. Fuel surcharge revenues decreased 18.4% to $548 million in 2016, compared to $671 million in 2015. If fuel surcharge revenues were excluded from both years, our 2016 revenue increased 8.9% over 2015. Consolidated Operating Expenses Our 2016 consolidated operating expenses increased 6.6% from 2015, while year-over-year revenue increased 5.9%, resulting in a 2016 operating ratio of 89.0% compared to 88.4% in 2015. Rents and purchased transportation costs increased 8.7% in 2016, primarily the result of increased rail purchased transportation rates and the increase in load volume, which increased services provided by third-party rail and truck carriers within JBI and ICS segments. Salaries, wages and employee benefit costs increased 5.4% in 2016 from 2015. This increase was primarily related to increases in driver pay and office personnel compensation due to an increase in the number of employees and a tighter supply of qualified drivers, partially offset by a $15.2 million, one-time benefit recorded to reflect a change in our employee paid time off policy. Depreciation and amortization expense increased 6.4% in 2016, primarily due to additions to our JBI segment tractor, container and chassis fleets to support additional business demand, equipment purchased related to new DCS long-term customer contracts, and new replacement equipment in JBT. Fuel and fuel taxes expense decreased 9.5% in 2016 compared with 2015, due to decreases in the price of fuel during 2016, partially offset by increased road miles. We have fuel surcharge programs in place with the majority of our customers. These programs typically involve a specified computation based on the change in national, regional, or local fuel prices. While these programs may address fuel cost changes as frequently as weekly, most also reflect a specified miles-per-gallon factor and require a certain minimum change in fuel costs to trigger a change in fuel surcharge revenue. As a result, some of these programs have a time lag between when fuel costs change and when this change is reflected in revenues. Due to these programs, this lag negatively impacts operating income in times of rapidly increasing fuel costs and positively impacts operating income when fuel costs decrease rapidly. It is not meaningful to compare the amount of fuel surcharge revenue or the change in fuel surcharge revenue between reporting periods to fuel and fuel taxes expense, or the change of fuel expense between periods, as a significant portion of fuel cost is included in our payments to railroads, dray carriers and other third parties. These payments are classified as purchased transportation expense. Operating supplies and expenses increased 5.7%, driven primarily by increased toll activity and tire expense. General and administrative expenses increased 20.0% from 2015, primarily due to increased charitable contributions and the absence of net gains from asset sales and disposals in 2016. Net losses from sale or disposal of assets were $5 million in 2016, compared to net gains of $1 million in 2015. Insurance and claims expense increased 6.4% in 2016, primarily due to higher incident volume. Net interest expense for 2016 decreased by 1.1% compared with 2015, due primarily to lower effective interest rates. Our effective income tax rate was 37.90% in 2016 and 38.10% in 2015. The decrease in 2016 was primarily due to a reduction in permanent differences related to executive compensation and lower state tax rates. JBI Segment JBI segment revenue increased 3.6% to $3.80 billion in 2016, from $3.66 billion in 2015. This increase in revenue was primarily a result of an 8.1% increase in load volume, offset by a 4.2% decrease in revenue per load, which is the combination of changes in freight mix, customer rates, and fuel surcharge revenue. Load volume in our eastern network increased 6.7%, and transcontinental loads grew 9.0% compared to 2015. Excluding fuel surcharge, revenues increased 7.1% and revenue per load decreased 1.0% in 2016 over the prior year. Average length of haul remained relatively flat in 2016 when compared to 2015. Operating income of the JBI segment decreased to $450 million in 2016, from $477 million in 2015. Benefits from volume growth, improved network efficiency, improved rail service, and approximately $5.7 million from the change in paid time off policy were offset by increased rail purchased transportation costs, higher equipment ownership costs, increased insurance and cargo claim expense and higher driver wage and retention costs. DCS Segment DCS segment revenue increased 5.6% to $1.53 billion in 2016, from $1.45 billion in 2015. Productivity, defined as revenue per truck per week, increased 1.2% when compared to 2015. Revenue, excluding fuel surcharges, increased 7.3% in 2016 compared to 2015, and productivity excluding fuel surcharge revenue increased 2.8% from 2015, primarily from improved overall operational efficiencies, including better integration of assets between customer accounts, fewer unseated trucks, increased customer supply-chain fluidity, load counts and customer rate increases. DCS ended 2016 with a net additional 193 revenue-producing trucks when compared to 2015. Operating income of our DCS segment increased to $205 million in 2016, from $163 million in 2015. The increase is primarily due to increased revenue, improved asset utilization, and approximately $7.3 million from the change in paid time off policy, partially offset by higher driver wage and recruiting costs, increased salaries and benefits expenses, and higher equipment ownership costs. ICS Segment ICS segment revenue increased 21.7% to $852 million in 2016, from $699 million in 2015. Overall volumes increased 57.0%. Revenue per load decreased 22.5% primarily due to freight mix changes driven by customer demand. Contractual business was approximately 74% of the total load volume and 64% of the total revenue in the 2016, compared to 71% of the total load volume and 63% of the total revenue in 2015. Operating income remained flat at $36 million for both 2016 and 2015, primarily due to increased revenue and approximately $1.0 million from the change in paid time off policy, being offset by a 6.3% decrease in gross profit margin, increased claim costs, higher technology costs and increased personnel costs, as the total branch count increased to 42 from 34 at the end of 2015. ICS gross profit margin decreased to 14.3% for 2016 from 15.3% for 2015. ICS’s carrier base increased 11.4%, and the employee count increased 23.0% when compared to 2015. JBT Segment JBT segment revenue increased 0.6% to $388 million in 2016, from $386 million in 2015. Excluding fuel surcharges, revenue for 2016 increased 3.8% compared to 2015, primarily due to increased average truck count, partially offset by core customer rate decreases and freight mix changes. JBT segment had operating income of $30 million in 2016 compared with $40 million in 2015. Benefits from an increased average truck count, higher load volume, and approximately $1.2 million from the change in paid time off policy, were more than offset by increased driver recruiting costs, higher independent contractor cost per mile, higher safety and insurance costs, and increased tractor maintenance costs. LIQUIDITY AND CAPITAL RESOURCES Net cash provided by operating activities remained relatively flat at $855 million in 2017 compared to $854 million in 2016, primarily due to the reduction in pre-tax earnings and an increase in cash paid for income taxes, net of refunds, partially offset by the timing of general working capital activities. Net cash used in investing activities totaled $651 million in 2017, compared with $485 million in 2016. The increase resulted primarily from the purchase of SLD and an increase in equipment purchases, net of proceeds from the sale of equipment, in 2017. Net cash used in financing activities was $196 million in 2017, compared with $368 million in 2016. This decrease resulted primarily from a decrease in treasury stock purchased and higher proceeds from long-term debt issuances, net of long-term debt repayments, in 2017. These net proceeds from long-term debt were used primarily for the purchase of SLD. Our dividend policy is subject to review and revision by the Board of Directors, and payments are dependent upon our financial condition, liquidity, earnings, capital requirements, and other factors the Board of Directors may deem relevant. We paid a $0.21 per share quarterly dividend in 2015, a $0.22 per share quarterly dividend in 2016, and a $0.23 per share quarterly dividend in 2017. On January 24, 2018, we announced an increase in our quarterly cash dividend from $0.23 to $0.24 per share, which will be paid February 23, 2018, to stockholders of record on February 9, 2018. We currently intend to continue paying cash dividends on a quarterly basis. However, no assurance can be given that future dividends will be paid. Liquidity Our need for capital has typically resulted from the acquisition of containers, chassis, trucks, tractors, and trailers required to support our growth and the replacement of older equipment. We are frequently able to accelerate or postpone a portion of equipment replacements depending on market conditions. We obtain capital through cash generated from operations, revolving lines of credit, and long-term debt issuances. We have also periodically utilized capital and operating leases for revenue equipment. During the third quarter of 2017, we completed our acquisition of SLD and its affiliated entities. See Note 11, Acquisition, in the Notes to Consolidated Financial Statements for further discussion. We used our existing revolving credit facility to finance this transaction and to provide any necessary liquidity for current and future operations. This acquisition did not have a material impact on our interest expense. At December 31, 2017, we were authorized to borrow up to $500 million under a senior revolving line of credit, which is supported by a credit agreement with a group of banks and expires in September 2020. This senior credit facility allows us to request an increase in the total commitment by up to $250 million and to request a one-year extension of the maturity date. The applicable interest rate under this agreement is based on the Prime Rate, the Federal Funds Rate, or LIBOR, depending upon the specific type of borrowing, plus an applicable margin based on our credit rating and other fees. At December 31, 2017, we had $242 million outstanding at an average interest rate of 2.52% under this agreement. Our senior notes consist of three separate issuances. The first and second issuances are $250 million of 2.40% senior notes due March 2019 and $250 million of 3.85% senior notes due March 2024, respectively, both of which were issued in March 2014. Interest payments under both notes are due semiannually in March and September of each year. The third issuance is $350 million of 3.30% senior notes due August 2022, issued in August 2015. Interest payments under this note are due semiannually in February and August of each year. We may redeem for cash some or all of these notes based on a redemption price set forth in the note indenture. We currently have interest rate swap agreements which effectively convert our $250 million of 2.40% fixed-rate senior notes due March 2019 and our $350 million of 3.30% fixed-rate senior notes due August 2022 to variable rates, resulting in interest rates of 2.43% and 2.77%, respectively, at December 31, 2017. The applicable interest rates under these swap agreements are based on LIBOR plus an established margin. Our financing arrangements require us to maintain certain covenants and financial ratios. We were in compliance with all covenants and financial ratios at December 31, 2017. As previously mentioned above, the Tax Cuts and Jobs Act was enacted in December 2017. Beginning in 2018, the Act reduces the U.S. federal corporate tax rate from 35% to 21%, which will have a positive effect on our overall liquidity. We believe our liquid assets, cash generated from operations, and various financing arrangements will provide sufficient funds for our operating and capital requirements for the foreseeable future. We are currently committed to spend approximately $797.6 million, net of proceeds from sales or trade-ins, during 2018 and 2019, which is primarily related to the acquisition of containers, chassis, and tractors. Off-Balance Sheet Arrangements In addition to our net purchase commitments of $797.6 million, our only other off-balance sheet arrangements are related to operating leases. As of December 31, 2017, we had approximately $74.2 million of obligations, primarily related to facility leases. Contractual Obligations and Commitments The following table summarizes our expected obligations and commitments (in millions) as of December 31, 2017: (1) Interest payments on debt are based on the debt balance and applicable rate at December 31, 2017. We had standby letters of credit outstanding of approximately $4.4 million at December 31, 2017, that expire at various dates in 2018, which are related to certain operating agreements and our self-insured retention levels for casualty and workers’ compensation claims. We plan to renew these letters of credit in accordance with our third-party agreements. The table above excludes $48.9 million of liabilities related to uncertain tax positions, including interest and penalties, as we are unable to reasonably estimate the ultimate timing of settlement. See Note 7, Income Taxes, in the Notes to Consolidated Financial Statements for further discussion.

<s>[INST] Critical Accounting Policies and Estimates The preparation of our financial statements in accordance with U.S. generally accepted accounting principles requires us to make estimates and assumptions that impact the amounts reported in our Consolidated Financial Statements and accompanying notes. Therefore, the reported amounts of assets, liabilities, revenues, expenses and associated disclosures of contingent liabilities are affected by these estimates. We evaluate these estimates on an ongoing basis, utilizing historical experience, consultation with third parties and other methods considered reasonable in the particular circumstances. Nevertheless, actual results may differ significantly from our estimates. Any effects on our business, financial position or results of operations resulting from revisions to these estimates are recognized in the accounting period in which the facts that give rise to the revision become known. We consider our critical accounting policies and estimates to be those that require us to make more significant judgments and estimates when we prepare our financial statements and include the following: Workers’ Compensation and Accident Costs We purchase insurance coverage for a portion of expenses related to employee injuries, vehicular collisions, accidents, and cargo damage. Certain insurance arrangements include a level of selfinsurance (deductible) coverage applicable to each claim. We have umbrella policies to limit our exposure to catastrophic claim costs. We are substantially selfinsured for loss of and damage to our owned and leased revenue equipment. The amounts of selfinsurance change from time to time based on measurement dates, policy expiration dates, and claim type. We have policies in place for 2018 with substantially the same terms as our 2017 policies for personal injury, property damage, workers’ compensation, and cargo loss or damage. Our claims accrual policy for all selfinsured claims is to recognize a liability at the time of the incident based on our analysis of the nature and severity of the claims and analyses provided by thirdparty claims administrators, as well as legal, economic, and regulatory factors. Our safety and claims personnel work directly with representatives from the insurance companies to continually update the estimated cost of each claim. The ultimate cost of a claim develops over time as additional information regarding the nature, timing, and extent of damages claimed becomes available. Accordingly, we use an actuarial method to develop current claim information to derive an estimate of our ultimate claim liability. This process involves the use of lossdevelopment factors based on our historical claims experience and includes a contractual premium adjustment factor, if applicable. In doing so, the recorded liability considers future claims growth and provides a reserve for incurredbutnotreported claims. We do not discount our estimated losses. At December 31, 2017, we had an accrual of approximately $238 million for estimated claims. In addition, we record receivables for amounts expected to be reimbursed for payments made in excess of selfinsurance levels on covered claims. At December 31, 2017, we have recorded $256 million, of expected reimbursement for covered excess claims, insurance premiums and other insurance deposits. Revenue Equipment We operate a significant number of tractors, trucks, containers, chassis, and trailers in connection with our business. This equipment may be purchased or acquired under lease agreements. In addition, we may rent revenue equipment from various third parties under shortterm rental arrangements. Purchased revenue equipment is depreciated on the straightline method over the estimated useful life to an estimated salvage or tradein value. We periodically review the useful lives and salvage values of our revenue equipment and evaluate our longlived assets for impairment. We have not identified any impairment to our assets at December 31, 2017. We have agreements with our primary tractor suppliers for residual or tradein values for certain new equipment. We have utilized these tradein values, as well as other operational information such as anticipated annual miles, in accounting for depreciation expense. If our suppliers were unable to perform under the terms of our agreements for tradein values, it could have a material adverse effect on our financial results. Revenue Recognition We recognize revenue based on the relative transit time of the freight transported and as other services are provided. Accordingly, a portion of the total revenue that will be billed to the customer once a load is delivered is recognized in each reporting period based on the percentage of the freight pickup and delivery [/INST] Positive. </s>

HUNT J B TRANSPORT SERVICES INC

2019-02-22

2018-12-31

ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The following discussion of our results of operations and financial condition should be read in conjunction with our financial statements and related notes in Item 8. This discussion contains forward-looking statements. Please see “Forward-looking Statements” and “Risk Factors” for a discussion of items, uncertainties, assumptions and risks associated with these statements. Critical Accounting Policies and Estimates The preparation of our financial statements in accordance with U.S. generally accepted accounting principles requires us to make estimates and assumptions that impact the amounts reported in our Consolidated Financial Statements and accompanying notes. Therefore, the reported amounts of assets, liabilities, revenues, expenses and associated disclosures of contingent liabilities are affected by these estimates. We evaluate these estimates on an ongoing basis, utilizing historical experience, consultation with third parties and other methods considered reasonable in the particular circumstances. Nevertheless, actual results may differ significantly from our estimates. Any effects on our business, financial position or results of operations resulting from revisions to these estimates are recognized in the accounting period in which the facts that give rise to the revision become known. We consider our critical accounting policies and estimates to be those that require us to make more significant judgments and estimates when we prepare our financial statements and include the following: Workers’ Compensation and Accident Costs We purchase insurance coverage for a portion of expenses related to employee injuries, vehicular collisions, accidents, and cargo damage. Certain insurance arrangements include a level of self-insurance (deductible) coverage applicable to each claim. We have umbrella policies to limit our exposure to catastrophic claim costs. We are substantially self-insured for loss of and damage to our owned and leased revenue equipment. The amounts of self-insurance change from time to time based on measurement dates, policy expiration dates, and claim type. We have policies in place for 2019 with substantially the same terms as our 2018 policies for personal injury, property damage, workers’ compensation, and cargo loss or damage, with the exception of decreasing our self-insured portion of workers’ compensation claims to zero for nearly all states. Our claims accrual policy for all self-insured claims is to recognize a liability at the time of the incident based on our analysis of the nature and severity of the claims and analyses provided by third-party claims administrators, as well as legal, economic, and regulatory factors. Our safety and claims personnel work directly with representatives from the insurance companies to continually update the estimated cost of each claim. The ultimate cost of a claim develops over time as additional information regarding the nature, timing, and extent of damages claimed becomes available. Accordingly, we use an actuarial method to develop current claim information to derive an estimate of our ultimate claim liability. This process involves the use of loss-development factors based on our historical claims experience and includes a contractual premium adjustment factor, if applicable. In doing so, the recorded liability considers future claims growth and provides a reserve for incurred-but-not-reported claims. We do not discount our estimated losses. At December 31, 2018, we had an accrual of approximately $260 million for estimated claims. In addition, we record receivables for amounts expected to be reimbursed for payments made in excess of self-insurance levels on covered claims. At December 31, 2018, we have recorded $261 million of expected reimbursement for covered excess claims, other insurance deposits, and prepaid insurance premiums. Revenue Equipment We operate a significant number of tractors, trucks, containers, chassis, and trailers in connection with our business. This equipment may be purchased or acquired under lease agreements. In addition, we may rent revenue equipment from various third parties under short-term rental arrangements. Purchased revenue equipment is depreciated on the straight-line method over the estimated useful life to an estimated salvage or trade-in value. We periodically review the useful lives and salvage values of our revenue equipment and evaluate our long-lived assets for impairment. We have not identified any impairment to our assets at December 31, 2018. We have agreements with our primary tractor suppliers for residual or trade-in values for certain new equipment. We have utilized these trade-in values, as well as other operational information such as anticipated annual miles, in accounting for depreciation expense. If our suppliers were unable to perform under the terms of our agreements for trade-in values, it could have a material adverse effect on our financial results. Revenue Recognition We record revenues on the gross basis at amounts charged to our customers because we control and are primarily responsible for the fulfillment of promised services. Accordingly, we serve as a principal in the transaction. We invoice our customers, and we maintain discretion over pricing. Additionally, we are responsible for selection of third-party transportation providers to the extent used to satisfy customer freight requirements. We recognize revenue from customer contracts based on relative transit time in each reporting period and as other performance obligations are provided, with related expenses recognized as incurred. Accordingly, a portion of the total revenue that will be billed to the customer is recognized in each reporting period based on the percentage of the freight pickup and delivery performance obligation that has been completed at the end of the reporting period. Our trade accounts receivable includes amounts due from customers that have been reduced by an allowance for uncollectible accounts and revenue adjustments. The allowance for uncollectible accounts and revenue adjustments is based on historical experience, as well as any known trends or uncertainties related to customer billing and account collectability. The adequacy of our allowance is reviewed quarterly. Income Taxes We account for income taxes under the liability method. Our deferred tax assets and liabilities represent items that will result in a tax deduction or taxable income in future years for which we have already recorded the related tax expense or benefit in our statement of earnings. Deferred tax accounts arise as a result of timing differences between when items are recognized in our Consolidated Financial Statements and when they are recognized in our tax returns. We assess the likelihood that deferred tax assets will be recovered from future taxable income or the reversal of temporary timing differences. To the extent we believe recovery does not meet the more-likely-than-not threshold, a valuation allowance is established. To the extent we establish a valuation allowance, we include an expense as part of our income tax provision. The Tax Cuts and Jobs Act (the Act) was enacted in December 2017. Beginning in 2018, the Act reduced the U.S. federal corporate tax rate from 35% to 21%. At December 31, 2017, we made a reasonable estimate of the effects on our existing deferred tax assets and liabilities based on the rates at which they were expected to reverse in the future, which was generally 21%. The provisional amount recorded resulting from the remeasurement of our deferred tax balance was $309.2 million, which was included as a component of 2017 income tax from continuing operations. During 2018, we finalized our calculations for our 2017 federal income tax return, which was filed based on the law prior to the Act, resulting in no significant change to the initial measurement of these balances. Remaining aspects of the Act were not relevant to our operations. Significant judgment is required in determining and assessing the impact of complex tax laws and certain tax-related contingencies on our provision for income taxes. As part of our calculation of the provision for income taxes, we assess whether the benefits of our tax positions are at least more likely than not to be sustained upon audit based on the technical merits of the tax position. For tax positions that are not more likely than not to be sustained upon audit, we accrue the largest amount of the benefit that is not more likely than not to be sustained in our Consolidated Financial Statements. Such accruals require us to make estimates and judgments, whereby actual results could vary materially from these estimates. Further, a number of years may elapse before a particular matter for which we have established an accrual is audited and resolved. See Note 7, Income Taxes, in our Consolidated Financial Statements for a discussion of our current tax contingencies. RESULTS OF OPERATIONS The following table sets forth items in our Consolidated Statements of Earnings as a percentage of operating revenues and the percentage increase or decrease of those items compared with the prior year. 2018 Compared With 2017 Consolidated Operating Revenues Our total consolidated operating revenues increased 19.8% to $8.61 billion in 2018, compared to $7.19 billion in 2017, primarily due to overall increased load volume and higher revenue per load in all four of our segments. Fuel surcharge revenues increased 40.2% to $1.1 billion in 2018, compared to $754 million in 2017. If fuel surcharge revenues were excluded from both years, our 2018 revenue increased 17.4% over 2017. Consolidated Operating Expenses Our 2018 consolidated operating expenses increased 20.8% from 2017, while year-over-year revenue increased 19.8%, resulting in a 2018 operating ratio of 92.1% compared to 91.3% in 2017. Rents and purchased transportation costs increased 21.5% in 2018, primarily due to increased rail and truck purchased transportation rates and the increase in load volume, which increased services provided by third-party rail and truck carriers within JBI and ICS segments. In addition, our JBI segment incurred charges of $152.3 million to rail purchase transportation expense related to the ongoing arbitration with BNSF. Salaries, wages and employee benefit costs increased 19.8% in 2018 from 2017. This increase was primarily related to increases in driver pay and office personnel compensation due to an increase in the number of employees and a tighter supply of qualified drivers. Fuel and fuel taxes expense increased 32.1% in 2018 compared with 2017, due primarily to an increase in road miles and increases in the price of fuel during 2018. We have fuel surcharge programs in place with the majority of our customers. These programs typically involve a specified computation based on the change in national, regional, or local fuel prices. While these programs may address fuel cost changes as frequently as weekly, most also reflect a specified miles-per-gallon factor and require a certain minimum change in fuel costs to trigger a change in fuel surcharge revenue. As a result, some of these programs have a time lag between when fuel costs change and when this change is reflected in revenues. Due to these programs, this lag negatively impacts operating income in times of rapidly increasing fuel costs and positively impacts operating income when fuel costs decrease rapidly. It is not meaningful to compare the amount of fuel surcharge revenue or the change in fuel surcharge revenue between reporting periods to fuel and fuel taxes expense, or the change of fuel expense between periods, as a significant portion of fuel cost is included in our payments to railroads, dray carriers and other third parties. These payments are classified as purchased transportation expense. Depreciation and amortization expense increased 13.7% in 2018, primarily due to additions to our JBI segment tractor, container and chassis fleets to support additional business demand and equipment purchased related to new DCS long-term customer contracts. Operating supplies and expenses increased 18.0%, driven primarily by higher equipment maintenance and tire expenses due to increased equipment counts, higher travel costs, increased toll costs, and higher building maintenance expenses. General and administrative expenses increased 29.7% from 2017, primarily due to increased building and computer rentals, higher professional fees, higher advertising costs, higher bad debt expense driven by a customer bankruptcy, and increased net losses from asset sales and disposals, partially offset by the 2017 inclusion of a $20.2 million reserve of a cash advance for the purchases of new trailing equipment from a manufacturer that did not meet delivery. Additionally, net losses from sale or disposal of assets were $12.1 million in 2018, compared to net losses of $7.4 million in 2017. Insurance and claims expense increased 4.7% in 2018, primarily due to higher incident volume. Net interest expense for 2018 increased by 40.8% compared with 2017, due to an increase in average debt levels, higher effective interest rates on our debt, and expenses incurred to refinance our revolving line of credit compared to 2017. Our effective income tax rate was 23.6% in 2018 and (15.29%) in 2017. The increase in 2018 was primarily due to a $309.2 million decrease in income tax expense in 2017 resulting from adjustments to our deferred tax balances at December 31, 2017, for the change in future tax rates prescribed by the Tax Cuts and Jobs Act. Segments We operated four business segments during calendar year 2018. The operation of each of these businesses is described in our Notes to Consolidated Financial Statements. The following tables summarize financial and operating data by segment: Operating Data by Segment (1) Includes company-owned and independent contractor tractors (2) Using weighted workdays (3) Includes company-owned, independent contractor, and customer-owned trucks JBI Segment JBI segment revenue increased 15% to $4.72 billion in 2018, from $4.08 billion in 2017. This increase in revenue was primarily a result of a 2% increase in load volume and a 13% increase in revenue per load, which is the combination of changes in freight mix, customer rates, and fuel surcharge revenue. Eastern network loads grew at 10% and transcontinental loads decreased 2% compared to 2017. Average length of haul decreased 2% in 2018 when compared to 2017. Revenue per load excluding fuel surcharges increased approximately 10% compared to 2017. Operating income of the JBI segment decreased to $401 million in 2018, from $407 million in 2017. Benefits from volume growth and increased revenue per load were offset by increases in rail purchased transportation costs, which included $152.3 million of additional expense related to the ongoing arbitration with BNSF. Benefits where further offset by higher driver wage and retention costs, higher driver recruiting expenses, higher outsourced dray costs, increased costs for onboarding and integration of container tracking technologies, higher equipment ownership costs, and costs of reduced efficiency and disruptions within the rail network. In addition, 2017 included a $20.2 million expense for the reserve of a cash advance for the purchases of new trailing equipment from a manufacturer that did not meet delivery. DCS Segment DCS segment revenue increased 26% to $2.16 billion in 2018, from $1.72 billion in 2017. Productivity, defined as revenue per truck per week, increased 7% when compared to 2017. Productivity excluding fuel surcharge revenue increased 5% from 2017. The increase in productivity was primarily a result of better integration of assets between customer accounts, customer rate increases, and increased customer supply chain fluidity during 2018 compared to 2017. In addition, the growth in DCS revenue includes an increase of $113 million in Final Mile Services (FMS) revenue, approximately $66 million of which was derived from the 2017 acquisition of Special Logistics Dedicated, LLC (SLD). DCS ended 2018 with a net additional 1,388 revenue-producing trucks when compared to 2017. Operating income of our DCS segment increased to $193 million in 2018, from $171 million in 2017. Increased revenue and improved asset integration was offset by higher costs from the expanded FMS network, increased driver wages and recruiting costs, higher non-driver salaries, wages and benefits, increased maintenance costs on equipment scheduled to be traded in the current year, higher overall insurance and claims costs, implementation costs for new customer contracts and approximately $4.4 million in additional non-cash amortization expense compared to 2017. ICS Segment ICS segment revenue increased 30% to $1.33 billion in 2018, from $1.02 billion in 2017. Overall volumes increased 24%. Revenue per load increased 5% primarily due to increased contractual and spot rates. Contractual business was approximately 70% of the total load volume and 48% of the total revenue in the 2018, compared to 70% of the total load volume and 53% of the total revenue in 2017. Operating income increased to $50 million in 2018, from $23 million in 2017. Gross profit margin improved to 15.4% in the current year compared to 13.3% in 2017 primarily due to improved contractual margins and increased spot market activity. This increase in gross profit margin was partially offset by higher personnel costs, higher technology development costs, and increase bad debt expense due to a customer bankruptcy. Approximately $558 million of ICS revenue for 2018 was executed through the marketplace for JBHunt360. ICS’s carrier base increased 29%, and the employee count increased 20% when compared to 2017. JBT Segment JBT segment revenue increased 10% to $417 million in 2018, from $378 million in 2017. Excluding fuel surcharges, revenue for 2018 increased 9% compared to 2017, primarily from a 16% increase in rates per loaded mile, partially offset by an 4% decrease in load count. JBT segment had operating income of $37 million in 2018 compared with $23 million in 2017. The increase in operating income was driven primarily by higher rates per loaded mile and lower equipment ownership costs, partially offset by increased driver wage and retention costs, higher driver and independent contractor recruiting expenses, and higher independent contractor costs per mile. 2017 Compared With 2016 Consolidated Operating Revenues Our total consolidated operating revenues increased 9.7% to $7.19 billion in 2017, compared to $6.56 billion in 2016, primarily due to overall increased load volume and higher revenue per load in our JBI, DCS, and ICS segments. Fuel surcharge revenues increased 37.5% to $754 million in 2017, compared to $548 million in 2016. If fuel surcharge revenues were excluded from both years, our 2017 revenue increased 7.1% over 2016. Consolidated Operating Expenses Our 2017 consolidated operating expenses increased 12.5% from 2016, while year-over-year revenue increased 9.7%, resulting in a 2017 operating ratio of 91.3% compared to 89.0% in 2016. Rents and purchased transportation costs increased 12.1% in 2017, primarily due to increased rail and truck purchased transportation rates and the increase in load volume, which increased services provided by third-party rail and truck carriers within JBI and ICS segments. Salaries, wages and employee benefit costs increase 9.5% in 2017 from 2016. This increase was primarily related to increases in driver pay and office personnel compensation due to an increase in the number of employees and a tighter supply of qualified drivers. In addition, 2016 included a $15.2 million benefit recorded to reflect a change in our employee paid time off policy. Fuel and fuel taxes expense increased 22.6% in 2017 compared with 2016, due primarily to increases in the price of fuel during 2017. Depreciation and amortization expense increased 6.1% in 2017, primarily due to additions to our JBI segment tractor, container and chassis fleets to support additional business demand and equipment purchased related to new DCS long-term customer contracts. Operating supplies and expenses increased 10.3%, driven primarily by increased mileage activity and tire expense. General and administrative expenses increased 44.6% from 2016, primarily due to a $20.2 million reserve of a cash advance for the purchases of new trailing equipment from a manufacturer that did not meet delivery, increased building rental expense, higher professional fee expenses, higher computer software subscription costs, and increased net losses from asset sales and disposals in 2017. Net losses from sale or disposal of assets were $7.4 million in 2017, compared to net losses of $5.5 million in 2016. Insurance and claims expense increased 57.6% in 2017, primarily due to higher incident volume and accident severity and an $18.6 million increase in reserves for certain claims not covered by insurance. Net interest expense for 2017 increased by 13.2% compared with 2016, due to an increase in average debt levels and higher effective interest rates on our debt during 2017. Our effective income tax rate was (15.29)% in 2017 and 37.90% in 2016. The decrease in 2017 was primarily due to a $309.2 million decrease in income tax expense resulting from adjustments to our deferred tax balances at December 31, 2017, for the change in future tax rates prescribed by the Tax Cuts and Jobs Act. JBI Segment JBI segment revenue increased 7.6% to $4.08 billion in 2017, from $3.80 billion in 2016. This increase in revenue was primarily a result of an 4.4% increase in load volume and a 3.1% increase in revenue per load, which is the combination of changes in freight mix, customer rates, and fuel surcharge revenue. Load volume in our transcontinental loads grew 7.2% while our eastern network was relatively flat compared to 2016. Average length of haul increased 1.4% in 2017 when compared to 2016. Revenue per load excluding fuel surcharge was flat in 2017 when compared to 2016. Operating income of the JBI segment decreased to $407 million in 2017, from $450 million in 2016. Benefits from volume growth and increased revenue per load were offset by increases in rail purchased transportation costs, rail inefficiencies, higher driver wages and recruiting costs, higher equipment ownership costs, increased insurance and claims costs, which included an $8.5 million increase in reserves for certain insurance and claims, and the $20.2 million expense for the reserve of a cash advance for the purchases of new trailing equipment from a manufacturer that did not meet delivery. In addition, 2016 included a $5.7 million, one-time benefit from the change in paid time off policy. DCS Segment DCS segment revenue increased 12.1% to $1.72 billion in 2017, from $1.53 billion in 2016. Productivity, defined as revenue per truck per week, increased 3.7% when compared to 2016. Revenue, excluding fuel surcharges, increased 10.0% in 2017 compared to 2016, and productivity excluding fuel surcharge revenue increased 1.6% from 2016. The increase in revenue in 2017 was primarily a result of better integration of assets among customer accounts and customer rate increases, partially offset by lower productivity under new customer contracts, compared to 2016. DCS ended 2017 with a net additional 1,326 revenue-producing trucks when compared to 2016. Operating income of our DCS segment decreased to $171 million in 2017, from $205 million in 2016. The increase in revenue and improved asset utilization were offset by higher driver wages and recruiting costs, increased insurance and claims cost, which included a $7.6 million increase in reserves for certain insurance and claims, increased start up expenditures for new customer contracts, higher equipment ownership costs, and the addition of acquisition costs and intangible asset amortization associated with the purchase of SLD when compared to 2016. In addition, 2016 included a $7.3 million, one-time benefit from the change in paid time off policy. ICS Segment ICS segment revenue increased 20.3% to $1.02 billion in 2017, from $852 million in 2016. Overall volumes increased 16.5%. Revenue per load increased 3.3% primarily due to freight mix changes driven by customer demand. Contractual business was approximately 70% of the total load volume and 53% of the total revenue in the 2017, compared to 74% of the total load volume and 64% of the total revenue in 2016. Operating income decreased to $23 million in 2017, from $36 million in 2016, primarily due to lower gross profit margins, increased insurance and claims cost, which included a $1.8 million increase in reserves for certain insurance and claims, increased number of branches less than two years old, and higher technology development costs. ICS gross profit margin decreased to 13.3% for 2017 from 14.3% for 2016. ICS’s carrier base increased 11.4%, and the employee count increased 15.8% when compared to 2016. In addition, 2016 included a $1.0 million, one-time benefit from the change in paid time off policy. JBT Segment JBT segment revenue decreased 2.4% to $378 million in 2017, from $388 million in 2016, primarily from a 3.8% decrease in load count partially offset by a 1.4% increase in revenue per load. Excluding fuel surcharges, revenue for 2017 decreased 4.5% compared to 2016, primarily due to the reduction in load volume and a 4.4% decrease in length of haul. JBT segment had operating income of $23 million in 2017 compared with $30 million in 2016. The decrease in operating income was driven primarily by lower revenue, increased driver wages and recruiting costs, higher independent contractor cost per mile, increased insurance and claims cost, which included an $0.7 million increase in reserves for certain insurance and claims, and increased tractor maintenance costs compared to 2016. In addition, 2016 included a $1.2 million, one-time benefit from the change in paid time off policy. LIQUIDITY AND CAPITAL RESOURCES Net cash provided by operating activities totaled $1.09 billion in 2018, compared to $855 million in 2017. This increase was primarily due to the increase in pre-tax earnings and the reduction in the U.S. federal corporate tax rate as a result of the Tax Cuts and Jobs Act, in 2018. Net cash used in investing activities totaled $887 million in 2018, compared with $651 million in 2017. The increase resulted primarily from an increase in equipment purchases, net of proceeds from the sale of equipment, in 2018, partially offset by the 2017 purchase of SLD. Net cash used in financing activities was $208 million in 2018, compared with $196 million in 2017. This increase resulted primarily from lower proceeds from long-term debt issuances, net of long-term debt repayments, partially offset by a decrease in treasury stock purchased in 2018. Our dividend policy is subject to review and revision by the Board of Directors, and payments are dependent upon our financial condition, liquidity, earnings, capital requirements, and other factors the Board of Directors may deem relevant. We paid a $0.22 per share quarterly dividend in 2016, a $0.23 per share quarterly dividend in 2017, and a $0.24 per share quarterly dividend in 2018. On January 23, 2019, we announced an increase in our quarterly cash dividend from $0.24 to $0.26 per share, which will be paid February 22, 2019, to stockholders of record on February 8, 2019. We currently intend to continue paying cash dividends on a quarterly basis. However, no assurance can be given that future dividends will be paid. Liquidity Our need for capital has typically resulted from the acquisition of containers, chassis, trucks, tractors, and trailers required to support our growth and the replacement of older equipment. We are frequently able to accelerate or postpone a portion of equipment replacements depending on market conditions. We obtain capital through cash generated from operations, revolving lines of credit, and long-term debt issuances. We have also periodically utilized capital and operating leases for revenue equipment. In September 2018, we replaced our $500 million senior revolving credit facility dated September 2015 with a new credit facility authorizing us to borrow up to $750 million under a senior revolving line of credit, which is supported by a credit agreement with a group of banks and expires September 2023. This senior credit facility allows us to request an increase in the total commitment by up to $250 million and to request a one-year extension of the maturity date. The applicable interest rate under this agreement is based on the Prime Rate, the Federal Funds Rate, or LIBOR, depending upon the specific type of borrowing, plus an applicable margin based on our credit rating and other fees. At December 31, 2018, we had $309 million outstanding at an average interest rate of 3.47% under this agreement. Our senior notes consist of three separate issuances. The first and second issuances are $250 million of 2.40% senior notes due March 2019 and $250 million of 3.85% senior notes due March 2024, respectively, both of which were issued in March 2014. Interest payments under both notes are due semiannually in March and September of each year. The third issuance is $350 million of 3.30% senior notes due August 2022, issued in August 2015. Interest payments under this note are due semiannually in February and August of each year. We may redeem for cash some or all of these notes based on a redemption price set forth in the note indenture. We currently have interest rate swap agreements which effectively convert our $250 million of 2.40% fixed-rate senior notes due March 2019 and our $350 million of 3.30% fixed-rate senior notes due August 2022 to variable rates, resulting in interest rates of 3.63% and 3.97%, respectively, at December 31, 2018. The applicable interest rates under these swap agreements are based on LIBOR plus an established margin. For our senior notes maturing in 2019, it is our intent to pay the entire outstanding balances in full, on or before the maturity dates, using our existing senior revolving line of credit or other sources of long-term financing. In addition, we have a shelf registration filed with the SEC and may draw upon it as warranted. Our financing arrangements require us to maintain certain covenants and financial ratios. We were in compliance with all covenants and financial ratios at December 31, 2018. As previously mentioned above, the Tax Cuts and Jobs Act was enacted in December 2017. Beginning in 2018, the Act reduced the U.S. federal corporate tax rate from 35% to 21%, which had a positive effect on our overall liquidity. We believe our liquid assets, cash generated from operations, and various financing arrangements will provide sufficient funds for our operating and capital requirements for the foreseeable future. We are currently committed to spend approximately $381.6 million, net of proceeds from sales or trade-ins, during 2019 and 2020, which is primarily related to the acquisition of containers, chassis, and tractors. Off-Balance Sheet Arrangements In addition to our net purchase commitments of $381.6 million, our only other off-balance sheet arrangements are related to operating leases. As of December 31, 2018, we had approximately $117.8 million of obligations, primarily related to facility leases. Contractual Obligations and Commitments The following table summarizes our expected obligations and commitments (in millions) as of December 31, 2018: (1) Interest payments on debt are based on the debt balance and applicable rate at December 31, 2018. We had standby letters of credit outstanding of approximately $1.3 million at December 31, 2018, that expire at various dates in 2019, which are related to certain operating agreements and our self-insured retention levels for casualty and workers’ compensation claims. We plan to renew these letters of credit in accordance with our third-party agreements. The table above excludes $56.8 million of liabilities related to uncertain tax positions, including interest and penalties, as we are unable to reasonably estimate the ultimate timing of settlement. See Note 7, Income Taxes, in the Notes to Consolidated Financial Statements for further discussion.

<s>[INST] Critical Accounting Policies and Estimates The preparation of our financial statements in accordance with U.S. generally accepted accounting principles requires us to make estimates and assumptions that impact the amounts reported in our Consolidated Financial Statements and accompanying notes. Therefore, the reported amounts of assets, liabilities, revenues, expenses and associated disclosures of contingent liabilities are affected by these estimates. We evaluate these estimates on an ongoing basis, utilizing historical experience, consultation with third parties and other methods considered reasonable in the particular circumstances. Nevertheless, actual results may differ significantly from our estimates. Any effects on our business, financial position or results of operations resulting from revisions to these estimates are recognized in the accounting period in which the facts that give rise to the revision become known. We consider our critical accounting policies and estimates to be those that require us to make more significant judgments and estimates when we prepare our financial statements and include the following: Workers’ Compensation and Accident Costs We purchase insurance coverage for a portion of expenses related to employee injuries, vehicular collisions, accidents, and cargo damage. Certain insurance arrangements include a level of selfinsurance (deductible) coverage applicable to each claim. We have umbrella policies to limit our exposure to catastrophic claim costs. We are substantially selfinsured for loss of and damage to our owned and leased revenue equipment. The amounts of selfinsurance change from time to time based on measurement dates, policy expiration dates, and claim type. We have policies in place for 2019 with substantially the same terms as our 2018 policies for personal injury, property damage, workers’ compensation, and cargo loss or damage, with the exception of decreasing our selfinsured portion of workers’ compensation claims to zero for nearly all states. Our claims accrual policy for all selfinsured claims is to recognize a liability at the time of the incident based on our analysis of the nature and severity of the claims and analyses provided by thirdparty claims administrators, as well as legal, economic, and regulatory factors. Our safety and claims personnel work directly with representatives from the insurance companies to continually update the estimated cost of each claim. The ultimate cost of a claim develops over time as additional information regarding the nature, timing, and extent of damages claimed becomes available. Accordingly, we use an actuarial method to develop current claim information to derive an estimate of our ultimate claim liability. This process involves the use of lossdevelopment factors based on our historical claims experience and includes a contractual premium adjustment factor, if applicable. In doing so, the recorded liability considers future claims growth and provides a reserve for incurredbutnotreported claims. We do not discount our estimated losses. At December 31, 2018, we had an accrual of approximately $260 million for estimated claims. In addition, we record receivables for amounts expected to be reimbursed for payments made in excess of selfinsurance levels on covered claims. At December 31, 2018, we have recorded $261 million of expected reimbursement for covered excess claims, other insurance deposits, and prepaid insurance premiums. Revenue Equipment We operate a significant number of tractors, trucks, containers, chassis, and trailers in connection with our business. This equipment may be purchased or acquired under lease agreements. In addition, we may rent revenue equipment from various third parties under shortterm rental arrangements. Purchased revenue equipment is depreciated on the straightline method over the estimated useful life to an estimated salvage or tradein value. We periodically review the useful lives and salvage values of our revenue equipment and evaluate our longlived assets for impairment. We have not identified any impairment to our assets at December 31, 2018. We have agreements with our primary tractor suppliers for residual or tradein values for certain new equipment. We have utilized these tradein values, as well as other operational information such as anticipated annual miles, in accounting for depreciation expense. If our suppliers were unable to perform under the terms of our agreements for tradein values, it could have a material adverse effect on our financial results. Revenue Recognition We record revenues on the gross basis at amounts charged to our customers because we control and are primarily responsible for the fulfillment of promised services. Accordingly, we serve as a principal [/INST] Negative. </s>

HUNT J B TRANSPORT SERVICES INC

2020-03-02

2019-12-31

ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The following discussion of our results of operations and financial condition should be read in conjunction with our financial statements and related notes in Item 8. This discussion contains forward-looking statements. Please see “Forward-looking Statements” and “Risk Factors” for a discussion of items, uncertainties, assumptions and risks associated with these statements. Critical Accounting Policies and Estimates The preparation of our financial statements in accordance with U.S. generally accepted accounting principles requires us to make estimates and assumptions that impact the amounts reported in our Consolidated Financial Statements and accompanying notes. Therefore, the reported amounts of assets, liabilities, revenues, expenses and associated disclosures of contingent liabilities are affected by these estimates. We evaluate these estimates on an ongoing basis, utilizing historical experience, consultation with third parties and other methods considered reasonable in the particular circumstances. Nevertheless, actual results may differ significantly from our estimates. Any effects on our business, financial position or results of operations resulting from revisions to these estimates are recognized in the accounting period in which the facts that give rise to the revision become known. We consider our critical accounting policies and estimates to be those that require us to make more significant judgments and estimates when we prepare our financial statements and include the following: Workers’ Compensation and Accident Costs We purchase insurance coverage for a portion of expenses related to employee injuries, vehicular collisions, accidents, and cargo damage. Certain insurance arrangements include a level of self-insurance (deductible) coverage applicable to each claim. We have umbrella policies to limit our exposure to catastrophic claim costs. We are substantially self-insured for loss of and damage to our owned and leased revenue equipment. The amounts of self-insurance change from time to time based on measurement dates, policy expiration dates, and claim type. For 2017 and 2018, we were self-insured for $500,000 per occurrence for personal injury and property damage and self-insured for $100,000 per workers’ compensation claim. For 2019, we were self-insured for $500,000 per occurrence for personal injury and property damage and fully insured for workers’ compensation claims for nearly all states. We have policies in place for 2020 with substantially the same terms as our 2019 policies for personal injury, property damage, workers’ compensation, and cargo loss or damage. Our claims accrual policy for all self-insured claims is to recognize a liability at the time of the incident based on our analysis of the nature and severity of the claims and analyses provided by third-party claims administrators, as well as legal, economic, and regulatory factors. Our safety and claims personnel work directly with representatives from the insurance companies to continually update the estimated cost of each claim. The ultimate cost of a claim develops over time as additional information regarding the nature, timing, and extent of damages claimed becomes available. Accordingly, we use an actuarial method to develop current claim information to derive an estimate of our ultimate claim liability. This process involves the use of loss-development factors based on our historical claims experience and includes a contractual premium adjustment factor, if applicable. In doing so, the recorded liability considers future claims growth and provides a reserve for incurred-but-not-reported claims. We do not discount our estimated losses. At December 31, 2019, we had an accrual of approximately $263 million for estimated claims. In addition, we record receivables for amounts expected to be reimbursed for payments made in excess of self-insurance levels on covered claims. At December 31, 2019, we have recorded $281 million of expected reimbursement for covered excess claims, other insurance deposits, and prepaid insurance premiums. Revenue Equipment We operate a significant number of tractors, trucks, containers, chassis, and trailers in connection with our business. This equipment may be purchased or acquired under lease agreements. In addition, we may rent revenue equipment from various third parties under short-term rental arrangements. Purchased revenue equipment is depreciated on the straight-line method over the estimated useful life to an estimated salvage or trade-in value. We periodically review the useful lives and salvage values of our revenue equipment and evaluate our long-lived assets for impairment. We have not identified any impairment to our assets at December 31, 2019. We have agreements with our primary tractor suppliers for residual or trade-in values for certain new equipment. We have utilized these trade-in values, as well as other operational information such as anticipated annual miles, in accounting for depreciation expense. Revenue Recognition We record revenues on the gross basis at amounts charged to our customers because we control and are primarily responsible for the fulfillment of promised services. Accordingly, we serve as a principal in the transaction. We invoice our customers, and we maintain discretion over pricing. Additionally, we are responsible for selection of third-party transportation providers to the extent used to satisfy customer freight requirements. We recognize revenue from customer contracts based on relative transit time in each reporting period and as other performance obligations are provided, with related expenses recognized as incurred. Accordingly, a portion of the total revenue that will be billed to the customer is recognized in each reporting period based on the percentage of the freight pickup and delivery performance obligation that has been completed at the end of the reporting period. Our trade accounts receivable includes amounts due from customers that have been reduced by an allowance for uncollectible accounts and revenue adjustments. The allowance for uncollectible accounts and revenue adjustments is based on historical experience, as well as any known trends or uncertainties related to customer billing and account collectability. The adequacy of our allowance is reviewed quarterly. Income Taxes We account for income taxes under the liability method. Our deferred tax assets and liabilities represent items that will result in a tax deduction or taxable income in future years for which we have already recorded the related tax expense or benefit in our statement of earnings. Deferred tax accounts arise as a result of timing differences between when items are recognized in our Consolidated Financial Statements and when they are recognized in our tax returns. We assess the likelihood that deferred tax assets will be recovered from future taxable income or the reversal of temporary timing differences. To the extent we believe recovery does not meet the more-likely-than-not threshold, a valuation allowance is established. To the extent we establish a valuation allowance, we include an expense as part of our income tax provision. The Tax Cuts and Jobs Act (the Act) was enacted in December 2017. Beginning in 2018, the Act reduced the U.S. federal corporate tax rate from 35% to 21%. At December 31, 2017, we made a reasonable estimate of the effects on our existing deferred tax assets and liabilities based on the rates at which they were expected to reverse in the future, which was generally 21%. The provisional amount recorded resulting from the remeasurement of our deferred tax balance was $309.2 million, which was included as a component of 2017 income tax from continuing operations. During 2018, we finalized our calculations for our 2017 federal income tax return, which was filed based on the law prior to the Act, resulting in no significant change to the initial measurement of these balances. Remaining aspects of the Act were not relevant to our operations. Significant judgment is required in determining and assessing the impact of complex tax laws and certain tax-related contingencies on our provision for income taxes. As part of our calculation of the provision for income taxes, we assess whether the benefits of our tax positions are at least more likely than not to be sustained upon audit based on the technical merits of the tax position. For tax positions that are not more likely than not to be sustained upon audit, we accrue the largest amount of the benefit that is not more likely than not to be sustained in our Consolidated Financial Statements. Such accruals require us to make estimates and judgments, whereby actual results could vary materially from these estimates. Further, a number of years may elapse before a particular matter for which we have established an accrual is audited and resolved. See Note 7, Income Taxes, in our Consolidated Financial Statements for a discussion of our current tax contingencies. RESULTS OF OPERATIONS The following table sets forth items in our Consolidated Statements of Earnings as a percentage of operating revenues and the percentage increase or decrease of those items compared with the prior year. 2019 Compared With 2018 Consolidated Operating Revenues Our total consolidated operating revenues increased 6.4% to $9.17 billion in 2019, compared to $8.61 billion in 2018, primarily due to increased revenue in DCS related to an increase in revenue producing trucks, higher truck productivity, defined as revenue per truck per week, and an acquisition in the first quarter 2019. The increase in revenue was further attributable to increased load volumes in ICS and higher revenue per load in JBI, partially offset by a decrease in JBI load volumes and a reduction in rates per loaded mile and the number of operating tractors in JBT. Fuel surcharge revenues decreased 1.4% to $1.04 billion in 2019, compared to $1.06 billion in 2018. If fuel surcharge revenues were excluded from both years, our 2019 revenue increased 7.5% over 2018. Consolidated Operating Expenses Our 2019 consolidated operating expenses increased 6.3% from 2018, while year-over-year revenue increased 6.4%, resulting in a 2019 operating ratio of 92.0% compared to 92.1% in 2018. Rents and purchased transportation costs increased 2.1% in 2019, primarily due to increased rail and truck purchased transportation rates within JBI and ICS segments and JBI rail purchased transportation costs, including a $26.8 million charge in 2019, resulting from the issuance of an award regarding our arbitration with BNSF. The current year increase in rents and purchased transportation costs was partially offset by a $152.3 million BNSF arbitration related charge recorded by JBI in 2018. Salaries, wages and employee benefit costs increased 12.5% in 2019 from 2018. This increase was primarily related to increases in driver pay and office personnel compensation due to an increase in the number of employees and a tighter supply of qualified drivers. Depreciation and amortization expense increased 14.5% in 2019, primarily due to equipment purchased related to new DCS long-term customer contracts. Fuel and fuel taxes expense increased 0.9% in 2019 compared with 2018, due primarily to an increase in road miles, partially offset by a decrease in the price of fuel during 2019. We have fuel surcharge programs in place with the majority of our customers. These programs typically involve a specified computation based on the change in national, regional, or local fuel prices. While these programs may address fuel cost changes as frequently as weekly, most also reflect a specified miles-per-gallon factor and require a certain minimum change in fuel costs to trigger a change in fuel surcharge revenue. As a result, some of these programs have a time lag between when fuel costs change and when this change is reflected in revenues. Due to these programs, this lag negatively impacts operating income in times of rapidly increasing fuel costs and positively impacts operating income when fuel costs decrease rapidly. It is not meaningful to compare the amount of fuel surcharge revenue or the change in fuel surcharge revenue between reporting periods to fuel and fuel taxes expense, or the change of fuel expense between periods, as a significant portion of fuel cost is included in our payments to railroads, dray carriers and other third parties. These payments are classified as purchased transportation expense. Operating supplies and expenses increased 9.7%, driven primarily by higher equipment maintenance and tire expenses due to increased equipment counts, increased toll costs, higher travel costs, and higher facility maintenance expenses. General and administrative expenses increased 17.6% from 2018, primarily due to increased technology spend on the J.B. Hunt 360 platform and legacy system upgrades, higher Final Mile Services® (FMS) network facility costs, and increased advertising expenses. Additionally, net losses from sale or disposal of assets were $13.1 million in 2019, compared to net losses of $12.1 million in 2018. Insurance and claims expense increased 21.5% in 2019, primarily due to 2019 including a $17.4 million reserve charge for arbitration related legal fees, costs and interest claimed by BNSF and the inclusion of a $20.0 million FMS claim charge within DCS, partially offset by 2018 including specific reserve charges for the settlement of lawsuits with current and former drivers. Net interest expense for 2019 increased by 31.7% compared with 2018, due to an increase in average debt levels and higher effective interest rates on our debt. Our effective income tax rate was 24.2% in 2019 and 23.6% in 2018. The increase in 2019 was primarily due to a reduction in discreet tax benefits recognized related to share-based compensation vesting, partially offset by favorable settlements of state income tax audits during 2019. Segments We operated four business segments during calendar year 2019. The operation of each of these businesses is described in our Notes to Consolidated Financial Statements. The following tables summarize financial and operating data by segment: Operating Data by Segment (1) Includes company-owned and independent contractor tractors (2) Using weighted workdays (3) Includes company-owned, independent contractor, and customer-owned trucks JBI Segment JBI segment revenue increased 1% to $4.74 billion in 2019, from $4.72 billion in 2018. This increase in revenue was primarily a result of a 4% increase in revenue per load, which is the combination of changes in freight mix, customer rates, and fuel surcharge revenue, partially offset by a 3% decrease in load volume. Eastern network load volumes decreased 9% and transcontinental loads increased 1% compared to 2018. Average length of haul increased 2% in 2019 when compared to 2018. Revenue per load excluding fuel surcharges increased approximately 6% compared to 2018. Operating income of the JBI segment increased to $447 million in 2019, from $401 million in 2018. Benefits from customer rate increases and freight mix were partially offset by decreased volumes, which includes volume lost to rail rationalization, increased rail purchased transportation costs, higher equipment ownership and maintenance costs, increased technology modernization expenses, lower box turns, higher box repositioning costs and increased driver wages and recruiting costs. Current year operating income was further impacted by a $26.8 million charge to rail purchase transportation expense resulting from the issuance of an award regarding our arbitration with BNSF and a $17.4 million charge to insurance and claims expense, for arbitration related legal fees, costs and interest claimed by BNSF. JBI recorded $152.3 million of additional BNSF arbitration related charges in 2018. Excluding these 2018 charges and the 2019 arbitration related charges of $44.2 million, operating income for 2019, decreased 11% when compared to 2018. DCS Segment DCS segment revenue increased 25% to $2.69 billion in 2019, from $2.16 billion in 2018. Productivity, defined as revenue per truck per week, increased 8% when compared to 2018. Productivity excluding fuel surcharge revenue increased 9% from 2018. The increase in productivity was primarily a result of the acquisition of Cory 1st Choice Home Delivery (Cory), better integration of assets between customer accounts, customer rate increases, and increased customer supply chain fluidity during 2019 compared to 2018. In addition, the growth in DCS revenue includes an increase of $187 million in FMS revenue, the majority of which was derived from the first quarter 2019 Cory acquisition. DCS ended 2019 with a net additional 972 revenue-producing trucks when compared to 2018. Approximately 58% of these additions represent private fleet conversions and 15% represent FMS versus traditional dedicated capacity fleets. Customer retention rates remain above 98%. Operating income of our DCS segment increased to $269 million in 2019, from $193 million in 2018. The increase is primarily due to increased productivity and additional trucks under contract, partially offset by higher insurance and claims costs, which included a $20.0 million FMS claim charge in the second quarter 2019, higher costs from the expanded FMS network, increased driver wages and recruiting costs, and additional non-cash amortization expense of $3.8 million compared to 2018. ICS Segment ICS segment revenue increased 1% to $1.35 billion in 2019, from $1.33 billion in 2018. Overall volumes increased 1%. Revenue per load remained flat when compared to 2018 primarily due to customer mix changes, a lower spot pricing market and a competitive pricing environment for contractual truckload business, when compared to 2018. Contractual business was approximately 71% of the total load volume and 59% of the total revenue in the 2019, compared to 70% of the total load volume and 48% of the total revenue in 2018. ICS segment incurred an operating loss of $11 million in 2019, compared to operating income of $50 million in 2018. The decrease in operating income was primarily due to lower gross profit margins, increased expenses to expand capacity and functionality of the Marketplace for J.B. Hunt 360, higher personnel costs, and increased digital marketing expenses. Gross profit margin decreased to 13.1% in the current year versus 15.4% last year primarily due to weaker spot market activity and lower contractual rates on committed business compared to 2018. Approximately $840 million of ICS revenue for 2019 was executed through the Marketplace for J.B. Hunt 360 compared to $558 million in 2018. ICS’s carrier base increased 15%, and the employee count increased 6% when compared to 2018. JBT Segment JBT segment revenue decreased 7% to $389 million in 2019, from $417 million in 2018. Excluding fuel surcharges, revenue for 2019 decreased 6% compared to 2018, primarily due to a 1% decrease in rates per loaded mile, a 3% decrease in length of haul and a 2% decrease in load volumes, compared to 2018. At the end of 2019, JBT operated 1,831 tractors compared to 2,112 at the end of 2018. JBT segment had operating income of $29 million in 2019 compared with $37 million in 2018. The decrease in operating income was driven primarily by lower spot market activity, higher empty miles per load, increased driver wages and recruiting costs, and the reduction in overall load volumes. 2018 Compared With 2017 Consolidated Operating Revenues Our total consolidated operating revenues increased 19.8% to $8.61 billion in 2018, compared to $7.19 billion in 2017, primarily due to overall increased load volume and higher revenue per load in all four of our segments. Fuel surcharge revenues increased 40.2% to $1.1 billion in 2018, compared to $754 million in 2017. If fuel surcharge revenues were excluded from both years, our 2018 revenue increased 17.4% over 2017. Consolidated Operating Expenses Our 2018 consolidated operating expenses increased 20.8% from 2017, while year-over-year revenue increased 19.8%, resulting in a 2018 operating ratio of 92.1% compared to 91.3% in 2017. Rents and purchased transportation costs increased 21.5% in 2018, primarily due to increased rail and truck purchased transportation rates and the increase in load volume, which increased services provided by third-party rail and truck carriers within JBI and ICS segments. In addition, our JBI segment incurred charges of $152.3 million to rail purchase transportation expense related to the arbitration with BNSF. Salaries, wages and employee benefit costs increased 19.8% in 2018 from 2017. This increase was primarily related to increases in driver pay and office personnel compensation due to an increase in the number of employees and a tighter supply of qualified drivers. Depreciation and amortization expense increased 13.7% in 2018, primarily due to additions to our JBI segment tractor, container and chassis fleets to support additional business demand and equipment purchased related to new DCS long-term customer contracts. Fuel and fuel taxes expense increased 32.1% in 2018 compared with 2017, due primarily to an increase in road miles and increases in the price of fuel during 2018. Operating supplies and expenses increased 18.0%, driven primarily by higher equipment maintenance and tire expenses due to increased equipment counts, higher travel costs, increased toll costs, and higher building maintenance expenses. General and administrative expenses increased 29.7% from 2017, primarily due to increased building and computer rentals, higher professional fees, higher advertising costs, higher bad debt expense driven by a customer bankruptcy, and increased net losses from asset sales and disposals, partially offset by the 2017 inclusion of a $20.2 million reserve of a cash advance for the purchases of new trailing equipment from a manufacturer that did not meet delivery. Additionally, net losses from sale or disposal of assets were $12.1 million in 2018, compared to net losses of $7.4 million in 2017. Insurance and claims expense increased 4.7% in 2018, primarily due to higher incident volume. Net interest expense for 2018 increased by 40.8% compared with 2017, due to an increase in average debt levels, higher effective interest rates on our debt, and expenses incurred to refinance our revolving line of credit compared to 2017. Our effective income tax rate was 23.6% in 2018 and (15.29%) in 2017. The increase in 2018 was primarily due to a $309.2 million decrease in income tax expense in 2017 resulting from adjustments to our deferred tax balances at December 31, 2017, for the change in future tax rates prescribed by the Tax Cuts and Jobs Act. JBI Segment JBI segment revenue increased 15% to $4.72 billion in 2018, from $4.08 billion in 2017. This increase in revenue was primarily a result of a 2% increase in load volume and a 13% increase in revenue per load, which is the combination of changes in freight mix, customer rates, and fuel surcharge revenue. Eastern network loads grew at 10% and transcontinental loads decreased 2% compared to 2017. Average length of haul decreased 2% in 2018 when compared to 2017. Revenue per load excluding fuel surcharges increased approximately 10% compared to 2017. Operating income of the JBI segment decreased to $401 million in 2018, from $407 million in 2017. Benefits from volume growth and increased revenue per load were offset by increases in rail purchased transportation costs, which included $152.3 million of additional expense related to the arbitration with BNSF. Benefits were further offset by higher driver wage and retention costs, higher driver recruiting expenses, higher outsourced dray costs, increased costs for onboarding and integration of container tracking technologies, higher equipment ownership costs, and costs of reduced efficiency and disruptions within the rail network. In addition, 2017 included a $20.2 million expense for the reserve of a cash advance for the purchases of new trailing equipment from a manufacturer that did not meet delivery. DCS Segment DCS segment revenue increased 26% to $2.16 billion in 2018, from $1.72 billion in 2017. Productivity, defined as revenue per truck per week, increased 7% when compared to 2017. Productivity excluding fuel surcharge revenue increased 5% from 2017. The increase in productivity was primarily a result of better integration of assets between customer accounts, customer rate increases, and increased customer supply chain fluidity during 2018 compared to 2017. In addition, the growth in DCS revenue includes an increase of $113 million in FMS revenue, approximately $66 million of which was derived from the 2017 acquisition of Special Logistics Dedicated, LLC. DCS ended 2018 with a net additional 1,388 revenue-producing trucks when compared to 2017. Operating income of our DCS segment increased to $193 million in 2018, from $171 million in 2017. Increased revenue and improved asset integration was offset by higher costs from the expanded FMS network, increased driver wages and recruiting costs, higher non-driver salaries, wages and benefits, increased maintenance costs on equipment scheduled to be traded in the current year, higher overall insurance and claims costs, implementation costs for new customer contracts and approximately $4.4 million in additional non-cash amortization expense compared to 2017. ICS Segment ICS segment revenue increased 30% to $1.33 billion in 2018, from $1.02 billion in 2017. Overall volumes increased 24%. Revenue per load increased 5% primarily due to increased contractual and spot rates. Contractual business was approximately 70% of the total load volume and 48% of the total revenue in 2018, compared to 70% of the total load volume and 53% of the total revenue in 2017. Operating income increased to $50 million in 2018, from $23 million in 2017. Gross profit margin improved to 15.4% in the current year compared to 13.3% in 2017 primarily due to improved contractual margins and increased spot market activity. This increase in gross profit margin was partially offset by higher personnel costs, higher technology development costs, and increase bad debt expense due to a customer bankruptcy. Approximately $558 million of ICS revenue for 2018 was executed through the Marketplace for J.B. Hunt 360. ICS’s carrier base increased 29%, and the employee count increased 20% when compared to 2017. JBT Segment JBT segment revenue increased 10% to $417 million in 2018, from $378 million in 2017. Excluding fuel surcharges, revenue for 2018 increased 9% compared to 2017, primarily from a 16% increase in rates per loaded mile, partially offset by an 4% decrease in load count. JBT segment had operating income of $37 million in 2018 compared with $23 million in 2017. The increase in operating income was driven primarily by higher rates per loaded mile and lower equipment ownership costs, partially offset by increased driver wage and retention costs, higher driver and independent contractor recruiting expenses, and higher independent contractor costs per mile. LIQUIDITY AND CAPITAL RESOURCES Net cash provided by operating activities totaled $1.10 billion in 2019, compared to $1.09 billion in 2018. This increase was primarily due to the increase in earnings, partially offset by the timing of general working capital activities. Net cash used in investing activities totaled $804 million in 2019, compared with $887 million in 2018. The decrease resulted primarily from a decrease in equipment purchases, net of proceeds from the sale of equipment in 2019, partially offset by the purchases of Cory and RDI Last Mile Co. (RDI), which closed during the first and fourth quarters of 2019, respectively. Net cash used in financing activities was $267 million in 2019, compared with $208 million in 2018. This increase resulted primarily from an increase in treasury stock purchased in 2019, partially offset by higher proceeds from long-term debt issuances, net of long-term debt repayments. Our dividend policy is subject to review and revision by the Board of Directors, and payments are dependent upon our financial condition, liquidity, earnings, capital requirements, and other factors the Board of Directors may deem relevant. We paid a $0.23 per share quarterly dividend in 2017, a $0.24 per share quarterly dividend in 2018, and a $0.26 per share quarterly dividend in 2019. On January 22, 2020, we announced an increase in our quarterly cash dividend from $0.26 to $0.27 per share, which will be paid February 21, 2020, to stockholders of record on February 7, 2020. We currently intend to continue paying cash dividends on a quarterly basis. However, no assurance can be given that future dividends will be paid. Liquidity Our need for capital has typically resulted from the acquisition of containers, chassis, trucks, tractors, and trailers required to support our growth and the replacement of older equipment. We are frequently able to accelerate or postpone a portion of equipment replacements depending on market conditions. We obtain capital through cash generated from operations, revolving lines of credit, and long-term debt issuances. We have also periodically utilized capital and operating leases for revenue equipment. During the first and fourth quarters of 2019, we completed two separate business acquisitions. See Note 12, Acquisition, in the Notes to Consolidated Financial Statements for further discussion. We used our existing revolving credit facility and cash to finance these transactions and to provide any necessary liquidity for current and future operations. These acquisitions did not have a material impact on our interest expense. At December 31, 2019, we were authorized to borrow up to $750 million under a senior revolving line of credit, which is supported by a credit agreement with a group of banks and expires in September 2023. This senior credit facility allows us to request an increase in the total commitment by up to $250 million and to request a one-year extension of the maturity date. The applicable interest rate under this agreement is based on either the Prime Rate, the Federal Funds Rate or LIBOR, depending upon the specific type of borrowing, plus an applicable margin based on our credit rating and other fees. At December 31, 2019, we had no outstanding borrowings under this agreement. Our senior notes consist of three separate issuances. The first is $250 million of 3.85% senior notes due March 2024, which was issued in March 2014. Interest payments under this note are due semiannually in March and September of each year, beginning September 2014. The second is $350 million of 3.30% senior notes due August 2022, issued in August 2015. Interest payments under this note are due semiannually in February and August of each year, beginning February 2016. The third is $700 million of 3.875% senior notes due March 2026, issued in March 2019. Interest payments under this note are due semiannually in March and September of each year, beginning September 2019. We may redeem for cash some or all of the notes based on a redemption price set forth in the note indenture. We currently have an interest rate swap agreement which effectively convert our $350 million of 3.30% fixed-rate senior notes due August 2022 to a variable rate, resulting in an interest rates of 3.27% at December 31, 2019. The applicable interest rate under this swap agreement is based on LIBOR plus an established margin. In addition, we previously had $250 million of 2.40% senior notes which matured in March 2019. The entire outstanding balance was paid in full at maturity. Our financing arrangements require us to maintain certain covenants and financial ratios. We were in compliance with all covenants and financial ratios at December 31, 2019. We believe our liquid assets, cash generated from operations, and various financing arrangements will provide sufficient funds for our operating and capital requirements for the foreseeable future. We are currently committed to spend approximately $938 million, net of proceeds from sales or trade-ins, during 2020 through 2021, which is primarily related to the acquisition of tractors, containers, chassis, and other trailing equipment. Off-Balance Sheet Arrangements We had no off-balance sheet arrangements, other than our net purchase commitments of $938 million, as of December 31, 2019. Contractual Obligations and Commitments The following table summarizes our expected obligations and commitments (in millions) as of December 31, 2019: (1) Interest payments on debt are based on the debt balance and applicable rate at December 31, 2019. We had standby letters of credit outstanding of approximately $2.7 million at December 31, 2019, that expire at various dates in 2020, which are related to certain operating agreements and our self-insured retention levels for casualty and workers’ compensation claims. We plan to renew these letters of credit in accordance with our third-party agreements. The table above excludes $55.4 million of liabilities related to uncertain tax positions, including interest and penalties, as we are unable to reasonably estimate the ultimate timing of settlement. See Note 7, Income Taxes, in the Notes to Consolidated Financial Statements for further discussion.

<s>[INST] Critical Accounting Policies and Estimates The preparation of our financial statements in accordance with U.S. generally accepted accounting principles requires us to make estimates and assumptions that impact the amounts reported in our Consolidated Financial Statements and accompanying notes. Therefore, the reported amounts of assets, liabilities, revenues, expenses and associated disclosures of contingent liabilities are affected by these estimates. We evaluate these estimates on an ongoing basis, utilizing historical experience, consultation with third parties and other methods considered reasonable in the particular circumstances. Nevertheless, actual results may differ significantly from our estimates. Any effects on our business, financial position or results of operations resulting from revisions to these estimates are recognized in the accounting period in which the facts that give rise to the revision become known. We consider our critical accounting policies and estimates to be those that require us to make more significant judgments and estimates when we prepare our financial statements and include the following: Workers’ Compensation and Accident Costs We purchase insurance coverage for a portion of expenses related to employee injuries, vehicular collisions, accidents, and cargo damage. Certain insurance arrangements include a level of selfinsurance (deductible) coverage applicable to each claim. We have umbrella policies to limit our exposure to catastrophic claim costs. We are substantially selfinsured for loss of and damage to our owned and leased revenue equipment. The amounts of selfinsurance change from time to time based on measurement dates, policy expiration dates, and claim type. For 2017 and 2018, we were selfinsured for $500,000 per occurrence for personal injury and property damage and selfinsured for $100,000 per workers’ compensation claim. For 2019, we were selfinsured for $500,000 per occurrence for personal injury and property damage and fully insured for workers’ compensation claims for nearly all states. We have policies in place for 2020 with substantially the same terms as our 2019 policies for personal injury, property damage, workers’ compensation, and cargo loss or damage. Our claims accrual policy for all selfinsured claims is to recognize a liability at the time of the incident based on our analysis of the nature and severity of the claims and analyses provided by thirdparty claims administrators, as well as legal, economic, and regulatory factors. Our safety and claims personnel work directly with representatives from the insurance companies to continually update the estimated cost of each claim. The ultimate cost of a claim develops over time as additional information regarding the nature, timing, and extent of damages claimed becomes available. Accordingly, we use an actuarial method to develop current claim information to derive an estimate of our ultimate claim liability. This process involves the use of lossdevelopment factors based on our historical claims experience and includes a contractual premium adjustment factor, if applicable. In doing so, the recorded liability considers future claims growth and provides a reserve for incurredbutnotreported claims. We do not discount our estimated losses. At December 31, 2019, we had an accrual of approximately $263 million for estimated claims. In addition, we record receivables for amounts expected to be reimbursed for payments made in excess of selfinsurance levels on covered claims. At December 31, 2019, we have recorded $281 million of expected reimbursement for covered excess claims, other insurance deposits, and prepaid insurance premiums. Revenue Equipment We operate a significant number of tractors, trucks, containers, chassis, and trailers in connection with our business. This equipment may be purchased or acquired under lease agreements. In addition, we may rent revenue equipment from various third parties under shortterm rental arrangements. Purchased revenue equipment is depreciated on the straightline method over the estimated useful life to an estimated salvage or tradein value. We periodically review the useful lives and salvage values of our revenue equipment and evaluate our longlived assets for impairment. We have not identified any impairment to our assets at December 31, 2019. We have agreements with our primary tractor suppliers for residual or tradein values for certain new equipment. We have utilized these tradein values, as well as other operational information such as anticipated annual miles, in accounting for depreciation expense. Revenue [/INST] Negative. </s>

CITY HOLDING CO

2018-02-28

2017-12-31

Item 7.Management's Discussion and Analysis of Financial Condition and Results of Operations CITY HOLDING COMPANY City Holding Company (the “Company”), a West Virginia corporation headquartered in Charleston, West Virginia, is a registered financial holding company under the Bank Holding Company Act and conducts its principal activities through its wholly owned subsidiary, City National Bank of West Virginia ("City National"). City National is a retail and consumer-oriented community bank with 86 bank branches in West Virginia (57), Virginia (14), Kentucky (12) and Ohio (3). City National provides credit, deposit, and trust and investment management services to its customers in a broad geographical area that includes many rural and small community markets in addition to larger cities including Charleston (WV), Huntington (WV), Martinsburg (WV), Winchester (VA), Staunton (VA), Virginia Beach (VA), Ashland (KY) and Lexington (KY). In the Company's key markets, the Company's primary subsidiary, City National, generally ranks in the top three relative to deposit market share and the top two relative to branch share (Charleston/Huntington MSA, Beckley/Lewisburg counties, Staunton MSA and Winchester, VA/WV Eastern Panhandle counties). In addition to its branch network, City National's delivery channels include automated-teller-machines ("ATMs"), interactive-teller-machines ("ITMs"), mobile banking, debit cards, interactive voice response systems, and Internet technology. The Company’s business activities are currently limited to one reportable business segment, which is community banking. In January 2015, the Company sold its insurance operations, CityInsurance, to The Hilb Group effective January 1, 2015. As a result of this sale, the Company recognized a one-time after tax gain of $5.8 million in the first quarter of 2015. On November 6, 2015, the Company purchased three branch locations from American Founders Bank, Inc. (“AFB”) located in Lexington, Kentucky. The Company acquired approximately $119 million in performing loans and assumed deposit liabilities of approximately $145 million. The Company paid AFB a deposit premium of 5.5% on non-time deposits and 1.0% on premium loan balances acquired. CRITICAL ACCOUNTING POLICIES The accounting policies of the Company conform to U.S. generally accepted accounting principles and require management to make estimates and develop assumptions that affect the amounts reported in the financial statements and related footnotes. These estimates and assumptions are based on information available to management as of the date of the financial statements. Actual results could differ significantly from management’s estimates. As this information changes, management’s estimates and assumptions used to prepare the Company’s financial statements and related disclosures may also change. The most significant accounting policies followed by the Company are presented in Note One of the Notes to Consolidated Financial Statements included herein. Based on the valuation techniques used and the sensitivity of financial statement amounts to the methods, assumptions, and estimates underlying those amounts, management has identified: (i) the determination of the allowance for loan losses and (ii) income taxes to be the accounting areas that require the most subjective or complex judgments and, as such, could be most subject to revision as new information becomes available. The Allowance and Provision for Loan Losses section of this Annual Report on Form 10-K provides management’s analysis of the Company’s allowance for loan losses and related provision. The allowance for loan losses is maintained at a level that represents management’s best estimate of probable losses in the loan portfolio. Management’s determination of the appropriateness of the allowance for loan losses is based upon an evaluation of individual credits in the loan portfolio, historical loan loss experience, current economic conditions, and other relevant factors. This determination is inherently subjective, as it requires material estimates including the amounts and timing of future cash flows expected to be received on impaired loans that may be susceptible to significant change. The allowance for loan losses related to loans considered to be impaired is generally evaluated based on the discounted cash flows using the impaired loan’s initial effective interest rate or the fair value of the collateral for certain collateral dependent loans. The allowance not specifically allocated to individual credits is generally determined by analyzing potential exposure and other qualitative factors that could negatively impact the overall credit risk of the loan portfolio. Loans not individually evaluated for impairment are grouped by pools with similar risk characteristics and the related historical loss rates are adjusted to reflect current inherent risk factors, such as unemployment, overall economic conditions, concentrations of credit, loan growth, classified and impaired loan trends, staffing, adherence to lending policies, and loss trends. The Income Taxes section of this Annual Report on Form 10-K provides management’s analysis of the Company’s income taxes. The Company is subject to federal and state income taxes in the jurisdictions in which it conducts business. In computing the provision for income taxes, management must make judgments regarding interpretation of laws in those jurisdictions. Because the application of tax laws and regulations for many types of transactions is susceptible to varying interpretations, amounts reported in the financial statements could be changed at a later date upon final determinations by taxing authorities. On a quarterly basis, the Company estimates its annual effective tax rate for the year and uses that rate to provide for income taxes on a year-to-date basis. The Company's unrecognized tax benefits could change over the next twelve months as a result of various factors. The Company is currently open to audit under the statute of limitations by the Internal Revenue Service and various state taxing authorities for the years ended December 31, 2014 through 2016. FINANCIAL SUMMARY The Company’s financial performance over the previous three years is summarized in the following table: *ROA (Return on Average Assets) is a measure of the effectiveness of asset utilization. ROE (Return on Average Equity) is a measure of the return on shareholders’ investment. ROATCE (Return on Average Tangible Common Equity) is a measure of the return on shareholders’ equity less intangible assets. The Company’s tax equivalent net interest income increased $7.8 million, or 6.5%, from $119.8 million in 2016 to $127.6 million in 2017 (see Net Interest Income). The Company’s provision for loan losses decreased $1.4 million from $4.4 million in 2016 to $3.0 million in 2017 (see Allowance and Provision for Loan Losses). Non-interest income increased $4.8 million and non-interest expense decreased $0.2 million (see Non-Interest Income and Expense). As a result of a reduction in the corporate income tax rate effective January 1, 2018, the Company reassessed its deferred tax assets and liabilities, which resulted in additional deferred income taxes of $7.1 million (see Income Taxes). As a result, the Company's net income increased $2.2 million from $52.1 million in 2016 to $54.3 million in 2017 and the Company achieved a return on assets of 1.33%, a return on tangible equity of 13.1% and an efficiency ratio of 51.5%. BALANCE SHEET ANALYSIS Selected balance sheet fluctuations are summarized in the following table (in millions): Investment securities increased $89 million, or 16.6%, from $540 million at December 31, 2016, to $629 million at December 31, 2017. During 2017, in conjunction with its interest rate risk management strategy, the Company elected to grow investment balances and maintain cash balances to enhance net interest income. Gross loans increased $81 million, or 2.7%, from $3.05 billion at December 31, 2016 to $3.13 billion at December 31, 2017. Commercial loans increased $70.9 million (5.0%) and residential real estate loans increased $16.8 million (1.2%) from December 31, 2016 to December 31, 2017. Deferred tax assets decreased $16 million, or (57.4)%, from $28 million at December 31, 2016 to $12 million at December 31, 2017. This is primarily due to the remeasurement of the Company's net deferred tax assets associated with the enactment of the Tax Cuts and Jobs Act ("TCJA"). This remeasurement decreased the Company's net deferred tax assets by $7.1 million. In addition, the deferred tax asset associated with other-than-temporarily impaired investment securities decreased by $3.4 million due to the sales of those securities during the year (see Income taxes). Total deposits increased $84 million, or 2.6%, from $3.23 billion at December 31, 2016 to $3.32 billion at December 31, 2017. The increase is due to growth in interest bearing demand deposits of $73.4 million and growth in time deposits of $42.1 million. These increases were partially offset by decreases in savings deposit accounts ($25.8 million) and noninterest-bearing deposits ($5.6 million). Shareholders' equity increased $60.1 million from December 31, 2016 to December 31, 2017 (see Capital Resources). TABLE TWO AVERAGE BALANCE SHEETS AND NET INTEREST INCOME (In thousands) 1. For purposes of this table, non-accruing loans have been included in average balances and loan fees, which are immaterial, have been included in interest income. 2.Includes the Company's residential real estate and home equity loan categories. 3. Included in the above table are the following amounts (in thousands) for the accretion of the fair value adjustments related to the Company's recent acquisitions: 4.Includes the Company’s commercial and industrial and commercial real estate loan categories. 5.Includes the Company’s consumer and DDA overdrafts loan categories. 6.Effective January 1, 2012, the carrying value of the Company's previously securitized loans was reduced to $0. 7.Computed on a fully federal tax-equivalent basis assuming a tax rate of approximately 35%. NET INTEREST INCOME 2017 vs. 2016 The Company's net interest income increased from $118.9 million for the year ended December 31, 2016 to $126.1 million for the year ended December 31, 2017. The Company’s tax equivalent net interest income increased $7.8 million, or 6.5%, from $119.8 million in 2016 to $127.6 million in 2017. This increase was due primarily to higher average balances on commercial loans ($132.0 million) which increased interest income by $5.1 million, and residential real estate loans ($33.5 million) which increased interest income by $1.3 million as compared to the year ended December 31, 2016. Increased interest yields on residential real estate loans also increased net interest income by $1.8 million compared to the year ended December 31, 2016. In addition, higher average investment balances ($86.9 million) increased investment income by $3.2 million. These increases were partially offset by increased interest expense on interest bearing deposits ($3.0 million), primarily due to an increase in the cost of funds, and lower accretion from fair value adjustments on recent acquisitions ($1.0 million). The Company’s reported net interest margin decreased from 3.50% for the year ended December 31, 2016 to 3.46% for the year ended December 31, 2017. Excluding the favorable impact of the accretion from fair value adjustments, the net interest margin would have been 3.40% for the year ended December 31, 2017 and 3.41% for the year ended December 31, 2016. Average interest-earning assets increased $266 million from 2016 to 2017, due to increases in commercial, financial, and agriculture loans ($132 million), investment securities ($87 million) and residential real estate loans ($34 million). Average interest-bearing liabilities increased $173 million from 2016 due to increases in savings deposits ($60 million), short-term borrowings ($54 million), time deposits ($38 million) and interest-bearing demand deposits ($20 million). 2016 vs. 2015 The Company's net interest income increased from $115.2 million for the year ended December 31, 2015 to $118.9 million for the year ended December 31, 2016. The Company’s tax equivalent net interest income increased $4.0 million, or 3.4%, from $115.9 million in 2015 to $119.8 million in 2016. This increase was due primarily to an increase in average loan balances from organic growth ($127 million) and from loans associated with the acquisition of three branches in the Lexington, Kentucky market in November 2015 (approximately $102 million in loans) contributing additional net interest income of $9.0 million in 2016. In addition, higher average investment balances ($111.5 million) increased net interest income by $3.9 million. During 2016, in conjunction with its interest rate risk management strategy, the Company elected to grow investment balances and reduce cash balances to enhance net interest income. As part of this strategy, the Company purchased tax-exempt municipal securities to improve its earnings by lowering its effective income tax rate. As a result of this strategy, the Company's overnight borrowings increased during 2016 . These increases in net interest income were partially offset by lower accretion from fair value adjustments on recent acquisitions that decreased net interest income $3.8 million ($6.7 million in 2015 compared to $2.9 million in 2016) and margin compression, which lowered net interest income $3.9 million. The Company’s reported net interest margin decreased from 3.76% for the year ended December 31, 2015 to 3.50% for the year ended December 31, 2016. Excluding the favorable impact of the accretion from fair value adjustments on recent acquisitions, the net interest margin would have been 3.41% for the year ended December 31, 2016 and 3.54% for the year ended December 31, 2015. This decrease was primarily caused by loan yields (excluding accretion) compressing from 4.05% for the year ended December 31, 2015 to 3.96% for the year ended December 31, 2016 and by the yield on investment securities decreasing from 3.28% to 3.01% for the same period. Average interest-earning assets increased $341 million from 2015 to 2016, due to increases in commercial, financial, and agriculture loans ($142 million), investment securities ($112 million) and residential real estate loans ($90 million). Average interest-bearing liabilities increased $161 million from 2015 due to increases in savings deposits ($65 million), interest-bearing demand deposits ($40 million), short-term borrowings ($31 million) and time deposits ($24 million). TABLE THREE RATE/VOLUME ANALYSIS OF CHANGES IN INTEREST INCOME AND INTEREST EXPENSE (In thousands) 1. Fully federal taxable equivalent using a tax rate of approximately 35%. Non-GAAP Financial Measures Management of the Company uses measures in its analysis of the Company's performance other than those in accordance with generally accepted accounting principals in the United States of America ("GAAP"). These measures are useful when evaluating the underlying performance of the Company's operations. The Company's management believes that these non-GAAP measures enhance comparability of results with prior periods and demonstrate the effects of significant gains and charges in the current period. The Company's management believes that investors may use these non-GAAP financial measures to evaluate the Company's financial performance without the impact of those items that may obscure trends in the Company's performance. These disclosures should not be viewed as a substitute for financial measures determined in accordance with GAAP, nor are they comparable to non-GAAP financial measures that may be presented by other companies. The following table reconciles fully taxable equivalent net interest income and fully taxable equivalent net interest income excluding accretion with net interest income as derived from the Company's financial statements (in thousands): TABLE FOUR NON-GAAP FINANCIAL MEASURES (In thousands) NON-INTEREST INCOME AND NON-INTEREST EXPENSE 2017 vs. 2016 Selected income statement fluctuations are summarized in the following table (dollars in millions): During the years ended December 31, 2017 and 2016, the Company realized investment gains of $4.5 million and $3.5 million, respectively, from the sale of pools of trust preferred securities, which represented a partial recovery of impairment charges previously recognized. Exclusive of these gains, non-interest income increased $3.8 million to $59.1 million for the year ended December 31, 2017 as compared to $55.3 million for the year ended December 31, 2016. This is primarily due to increases in service charges of $1.9 million, or 7.0%, bank owned life insurance of $0.9 million, or 26.6% (primarily due to death benefit proceeds), trust revenues of $0.7 million, or 12.5%, and bankcard revenue of $0.6 million, or 3.7%. Non-interest expenses decreased $0.2 million from $96.2 million for the year ended December 31, 2016 to $96.0 million for the year ended December 31, 2017. This is primarily due to decreases in occupancy related expenses of $0.6 million, or 5.6%, bankcard expenses of $0.5 million, or 12.0%, and FDIC insurance of $0.3 million, or 16.9%. These decreases were partially offset by increases in equipment and software related expenses of $0.5 million, or 7.2%, advertising of $0.3 million, or 11.8%, salaries and employee benefits of $0.2 million, or 0.3%, telecommunciation expenses of $0.2 million, or 9.7%, and repossessed asset losses, net of expenses, of $0.2 million or 17.4%. 2016 vs. 2015 Selected income statement fluctuations are summarized in the following table (dollars in millions): During the years ended December 31, 2016 and 2015, the Company realized investment gains of $3.5 million and $2.1 million, respectively, from the call or sale of trust preferred securities, which represented a partial recovery of impairment charges previously recognized. During the year ended December 31, 2015, the Company sold its insurance operations, CityInsurance, which resulted in the recognition of a pre-tax gain of $11.1 million. Exclusive of these gains, non-interest income increased $1.3 million to $55.3 million for the year ended December 31, 2016 as compared to $54.0 million for the year ended December 31, 2015. This is primarily due to increases in bankcard revenue of $0.6 million, or 3.9%, trust revenues of $0.4 million, or 8.8%, and service charges of $0.4 million, or 1.5%. Non-interest expenses increased $3.2 million from the year ended December 31, 2015 to the year ended December 31, 2016. During 2015, the Company recognized $0.6 million of acquisition and integration expenses associated with the acquisition of three branches in Lexington, Kentucky. Excluding acquisition related expenses, non-interest expenses increased $3.8 million from $92.4 million for the year ended December 31, 2015 to $96.2 million for the year ended December 31, 2016. This increase was largely due to an increase in salaries and employee benefits ($2.1 million) due to salary adjustments and increased health insurance costs. In addition, non-interest expenses increased $1.7 million due to the annual operating costs of the three branches acquired in November 2015 and from an increase of $0.5 million in bankcard expenses due to increased transaction volumes. INCOME TAXES The Company recorded income tax expense of $36.4 million, $25.1 million and $28.4 million in 2017, 2016 and 2015, respectively. The Company’s effective tax rates for 2017, 2016 and 2015 were 40.2%, 32.5% and 34.4%, respectively. A reconciliation of the effective tax rate to the statutory rate is included in Note Twelve of the Notes to Consolidated Financial Statements. On December 22, 2017, the President signed the Tax Cut and Jobs Act ("TCJA") into law. Among other things, the TCJA reduced the corporate income tax rate from 35% to 21%, effective January 1, 2018. This change required management to remeasure its deferred tax assets and liabilities at the new income tax rate. The provisional amount recorded as a result of the remeasurement was $7.1 million. Management continues to evaluate the TCJA and refine calculations which could potentially impact the measurement of these balances. In addition, during the years ended December 31, 2017, 2016 and 2015, the Company reduced income tax expense by $0.3 million, $0.5 million and $0.6 million, respectively due to the recognition of previously unrecognized tax positions resulting from the close of the statute of limitations for previous tax years. Also, as a result of differences between the book and tax basis of the assets that were sold in conjunction with the sale of CityInsurance, the Company’s income tax expense increased by $1.1 million during the year ended December 31, 2015. Exclusive of these items, the Company’s tax rate from operations was 32.7%, 33.2% and 33.6% for the years ended December 31, 2017, 2016 and 2015, respectively. Deferred income taxes reflect the net tax effects of temporary differences between the carrying amount of assets and liabilities for financial reporting purposes and the amounts used for income tax purposes. The Company’s net deferred tax assets decreased from $28.0 million at December 31, 2016 to $11.9 million at December 31, 2017. The decrease is primarily driven by the income tax rate decrease as a result of the enactment of the TCJA. The components of the Company’s net deferred tax assets are disclosed in Note Twelve of the Notes to Consolidated Financial Statements. Realization of the most significant net deferred tax assets is primarily dependent on future events taking place that will reverse the current deferred tax assets. The deferred tax asset and/or liability associated with unrealized securities losses is the tax impact of the unrealized gains and/or losses on the Company’s available-for-sale security portfolio. At December 31, 2017 and 2016, the Company had a deferred tax asset of $0.2 million and $1.3 million, respectively, associated with unrealized securities losses. The impact of the Company’s unrealized losses is noted in the Company’s Consolidated Statements of Changes in Shareholders’ Equity as an adjustment to Accumulated Other Comprehensive Income (Loss). This deferred tax asset would be realized if the unrealized securities losses on the Company's securities were realized from either the sales or maturities of the related securities. At December 31, 2017 and 2016, the Company had a deferred tax asset of $0.4 million and $3.8 million, respectively, associated with other-than-temporarily impaired securities. The decrease of $3.4 million is primarily due to sales of other-than-temporarily impaired securities. The deferred tax asset associated with the allowance for loan losses decreased from $7.3 million at December 31, 2016 to $4.4 million at December 31, 2017. The decrease of $2.9 million is primarily due to the income tax rate decrease associated with the TCJA. The deferred tax asset associated with the allowance for loan losses is expected to be realized as additional loan charge-offs, which have already been provided for within the Company’s financial statements, are recognized for tax purposes. The Company believes that it is more likely than not that each of the deferred tax assets will be realized and that no valuation allowance was necessary as of December 31, 2017 or 2016. LIQUIDITY The Company evaluates the adequacy of liquidity at both the Parent Company level and at the banking subsidiary level. At the Parent Company level, the principal source of cash is dividends from its banking subsidiary, City National. Dividends paid by City National to the Parent Company are subject to certain legal and regulatory limitations. Generally, any dividends in amounts that exceed the earnings retained by City National in the current year plus retained net profits for the preceding two years must be approved by regulatory authorities. At December 31, 2017, City National could pay dividends up to $75.0 million without prior regulatory permission. During 2017, the Parent Company used cash obtained from the dividends received primarily to: (1) pay common dividends to shareholders, (2) remit interest payments on the Company’s junior subordinated debentures and (3) fund repurchases of the Company's common shares. Additional information concerning sources and uses of cash by the Parent Company is reflected in Note Nineteen of the Notes to Consolidated Financial Statements. On December 19, 2016, the Company announced that it had filed a prospectus supplement to its existing shelf registration statement on Form S-3 for the sale of its common stock having an aggregate value of up to $55 million through an “at-the-market” equity offering program. Through the year ended December 31, 2017, the Company has sold approximately 548,000 common shares at a weighted average price of $64.82, net of broker fees. The Company has sold no shares since the first quarter of 2017. To date, the Company has received $36.4 million in gross proceeds. Under the program, the Company has the ability to receive an additional $18.6 million in gross proceeds from the sale of common shares. Over the next 12 months, the Parent Company has an obligation to remit interest payments approximating $0.8 million on the junior subordinated debentures held by City Holding Capital Trust III. Additionally, the Parent Company anticipates continuing the payment of dividends, which are expected to approximate $28.6 million on an annualized basis for 2018 based on common shareholders of record at December 31, 2017 at a dividend rate of $1.84 for 2018. However, interest payments on the debentures can be deferred for up to five years under certain circumstances and dividends to shareholders can, if necessary, be suspended. In addition to these anticipated cash needs, the Parent Company has operating expenses and other contractual obligations, which are estimated to require $1.4 million of additional cash over the next 12 months. As of December 31, 2017, the Parent Company reported a cash balance of $59.0 million and management believes that the Parent Company’s available cash balance, together with cash dividends from City National, will be adequate to satisfy its funding and cash needs over the next twelve months. Excluding the interest and dividend payments discussed above, the Parent Company has no significant commitments or obligations in years after 2018 other than the repayment of its $16.5 million obligation under the debentures held by City Holding Capital Trust III. However, this obligation does not mature until June 2038, or earlier at the option of the Parent Company. It is expected that the Parent Company will be able to obtain the necessary cash, either through dividends obtained from City National or the issuance of other debt, to fully repay the debentures at their maturity. City National manages its liquidity position in an effort to effectively and economically satisfy the funding needs of its customers and to accommodate the scheduled repayment of borrowings. Funds are available to City National from a number of sources, including depository relationships, sales and maturities within the investment securities portfolio, and borrowings from the Federal Home Loan Bank ("FHLB") and other financial institutions. As of December 31, 2017, City National’s assets are significantly funded by deposits and capital. City National maintains borrowing facilities with the FHLB and other financial institutions that can be accessed as necessary to fund operations and to provide contingency funding mechanisms. As of December 31, 2017, City National had the capacity to borrow an additional $1.6 billion from the FHLB and other financial institutions under existing borrowing facilities. City National maintains a contingency funding plan, incorporating these borrowing facilities, to address liquidity needs in the event of an institution-specific or systemic financial industry crisis. Also, although it has no current intention to do so, City National could liquidate its unpledged securities, if necessary, to provide an additional funding source. City National also segregates certain mortgage loans, mortgage-backed securities, and other investment securities in a separate subsidiary so that it can separately monitor the asset quality of these primarily mortgage-related assets, which could be used to raise cash through securitization transactions or obtain additional equity or debt financing if necessary. The Company manages its asset and liability mix to balance its desire to maximize net interest income against its desire to minimize risks associated with capitalization, interest rate volatility, and liquidity. With respect to liquidity, the Company has chosen a conservative posture and believes that its liquidity position is strong. As illustrated in the Consolidated Statements of Cash Flows, the Company generated $77.8 million of cash from operating activities during 2017, primarily from interest income received on loans and investments, net of interest expense paid on deposits and borrowings. The Company has obligations to extend credit, but these obligations are primarily associated with existing home equity loans that have predictable borrowing patterns across the portfolio. The Company has investment security balances with carrying values that totaled $629.0 million at December 31, 2017, and that greatly exceeded the Company’s non-deposit sources of borrowing, which totaled $268.7 million. The Company’s net loan to asset ratio is 75.2% as of December 31, 2017 and deposit balances fund 80.2% of total assets as compared to 69.9% for its peers (Bank Holding Company Peer Group with assets ranging from $3 billion to $10 billion). Further, the Company’s deposit mix has a very high proportion of transaction and savings accounts that fund 54.0% of the Company’s total assets and the Company uses time deposits over $250,000 to fund 2.8% of total assets compared to its peers, which fund 13.1% of total assets with such deposits. INVESTMENTS The Company’s investment portfolio increased $89 million, or 16.5%, from $540 million at December 31, 2016, to $629 million at December 31, 2017. During 2017, in conjunction with its interest rate risk management strategy, the Company elected to grow investment balances (primarily mortgage-backed and municipal securities) and maintain cash balances to enhance net interest income. As part of this strategy, the Company increased its tax-exempt municipal securities to improve its earnings by lowering its effective income tax rate. The investment portfolio is structured to provide flexibility in managing liquidity needs and interest rate risk, while providing acceptable rates of return. The majority of the Company’s investment securities continue to be mortgage-backed securities. The mortgage-backed securities in which the Company has invested are predominantly underwritten to the standards of, and guaranteed by government-sponsored agencies such as Fannie Mae ("FNMA") and Freddie Mac ("FHLMC"). The Company's municipal bond portfolio of $96.2 million as of December 31, 2017 has an average tax equivalent yield of 4.43% with an average maturity of 12.2 years. The average dollar amount invested in each security is $0.5 million. The portfolio has 66% rated "A" or better and the remaining portfolio is unrated, as the issuances represented small issuances of revenue bonds. Additional credit support was been purchased by the issuer for 35% of the portfolio, while 65% has no additional credit support. Management does underwrite 100% of the portfolio on an annual basis, using the same guidelines that are used to underwrite its commercial loans. Revenue bonds were 71% of the portfolio, while the remaining 29% were general obligation bonds. Geographically, the portfolio supports the Company's footprint, with 70% of the portfolio being from municipalities throughout West Virginia, and the remainder from communities in Ohio, Indiana, and various other states. TABLE FIVE INVESTMENT PORTFOLIO The carrying value of the Company's securities are presented in the following table (in thousands): Included in non-marketable equity securities in the table above at December 31, 2017 are $5.9 million of Federal Home Loan Bank stock and $8.2 million of Federal Reserve Bank stock. At December 31, 2017, there were no securities of any non-governmental issuers whose aggregate carrying or estimated fair value exceeded 10% of shareholders’ equity. The weighted average yield of the Company's investment portfolio is presented in the following table (dollars in thousands): Weighted-average yields on tax-exempt obligations of states and political subdivisions have been computed on a taxable-equivalent basis using the federal statutory tax rate of 35%. Average yields on investments available-for-sale are computed based on amortized cost. Mortgage-backed securities have been allocated to their respective maturity groupings based on their contractual maturity. TABLE SIX LOAN PORTFOLIO The composition of the Company’s loan portfolio as of the dates indicated follows (in thousands): Residential real estate loans increased $17 million from December 31, 2016 to $1.47 billion at December 31, 2017. Residential real estate loans represent loans to consumers that are secured by a first lien on residential property. Residential real estate loans provide for the purchase or refinance of a residence and first-lien home equity loans allow consumers to borrow against the equity in their home. These loans primarily consist of single family 3 and 5 year adjustable rate mortgages with terms that amortize up to 30 years. City National also offers fixed-rate residential real estate loans that are sold in the secondary market that are not included on the Company's balance sheet once sold and City National does not retain the servicing rights to these loans. Residential mortgage loans are generally underwritten to comply with Fannie Mae guidelines, while the home equity loans are underwritten with typically less documentation, but with lower loan-to-value ratios and shorter maturities. At December 31, 2017, $25 million of the residential real estate loans were for properties under construction. Home equity loans decreased $2 million from December 31, 2016 to $139 million at December 31, 2017. City National's home equity loans represent loans to consumers that are secured by a second (or junior) lien on a residential property. Home equity loans allow consumers to borrow against the equity in their home without paying off an existing first lien. These loans consist of home equity lines of credit ("HELOC") and amortized home equity loans that require monthly installment payments. Home equity loans are underwritten with less documentation, lower loan-to-value ratios and for shorter terms than residential real estate loans. The amount of credit extended is directly related to the value of the real estate at the time the loan is made. The commercial and industrial ("C&I") loan portfolio consists of loans to corporate borrowers primarily in small to mid-size industrial and commercial companies. Collateral securing these loans includes equipment, machinery, inventory, receivables and vehicles. C&I loans are considered to contain a higher level of risk than other loan types, although care is taken to minimize these risks. Numerous risk factors impact this portfolio, including industry specific risks such as economy, new technology, labor rates and cyclicality, as well as customer specific factors, such as cash flow, financial structure, operating controls and asset quality. C&I loans increased $23 million to $208.5 million at December 31, 2017. Commercial real estate loans consist of commercial mortgages, which generally are secured by nonresidential and multi-family residential properties, including hotel/motel and apartment lending. Commercial real estate loans are to many of the same customers and carry similar industry risks as C&I loans, but have different collateral risk. Commercial real estate loans increased $48 million to $1.28 billion at December 31, 2017. At December 31, 2017, $29 million of the commercial real estate loans were for commercial properties under construction. The Company categorizes commercial loans by industry according to the North American Industry Classification System (NAICS) to monitor the portfolio for possible concentrations in one or more industries. Management monitors industry concentrations against internally designated percents of risk-based capital. As of December 31, 2017, City National was within its internally designated concentration limits. As of December 31, 2017, City National's loans to borrowers within the Lessors of Nonresidential Buildings categories exceeded 10% of total loans (13%). No other industry classification exceeded 10% of total loans as of December 31, 2017. Management also monitors non-owner occupied commercial real estate as a percent of risk based capital (based upon regulatory guidance). At December 31, 2017, the Company had $967.5 million of commercial loans classified as non-owner occupied and was within its designated concentration threshold. Consumer loans may be secured by automobiles, boats, recreational vehicles and other personal property. City National monitors the risk associated with these types of loans by monitoring such factors as portfolio growth, lending policies and economic conditions. Underwriting standards are continually evaluated and modified based upon these factors. Consumer loans decreased $3 million from 2016 to $29.2 million at December 31, 2017. The following table shows the scheduled maturity of loans outstanding as of December 31, 2017 (in thousands): ALLOWANCE AND PROVISION FOR LOAN LOSSES Management systematically monitors the loan portfolio and the appropriateness of the allowance for loan losses (“ALLL”) on a quarterly basis to provide for probable losses incurred in the portfolio. Management assesses the risk in each loan type based on historical delinquency and loss trends, the general economic environment of its local markets, individual loan performance, and other relevant factors. Individual credits in excess of $1 million are selected at least annually for detailed loan reviews, which are utilized by management to assess the risk in the portfolio and the appropriateness of the allowance. Due to the nature of commercial lending, evaluation of the appropriateness of the allowance as it relates to these loan types is often based more upon specific credit review, with consideration given to the potential impairment of certain credits and historical loss rates, adjusted for general economic conditions and other inherent risk factors. Conversely, due to the homogeneous nature of the real estate and installment portfolios, the portions of the allowance allocated to those portfolios are primarily based on prior loss history of each portfolio, adjusted for general economic conditions and other inherent risk factors. Risk factors considered by the Company in completing this analysis include: (1) unemployment and economic trends in the Company’s markets, (2) concentrations of credit, if any, among any industries, (3) trends in loan growth, loan mix, delinquencies, losses or credit impairment, (4) adherence to lending policies and others. Each risk factor is designated as low, moderate/increasing, or high based on the Company’s assessment of the risk to loss associated with each factor. Each risk factor is then weighted to consider probability of occurrence. The allowance not specifically allocated to individual credits is generally determined by analyzing potential exposure and other qualitative factors that could negatively impact the overall credit risk of the loan portfolio. Loans not individually evaluated for impairment are grouped by pools with similar risk characteristics and the related historical loss rates are adjusted to reflect current inherent risk factors, such as unemployment, overall economic conditions, concentrations of credit, loan growth, classified and impaired loan trends, staffing, adherence to lending policies, and loss trends. Determination of the allowance for loan losses is subjective in nature and requires management to periodically reassess the validity of its assumptions. Differences between actual losses and estimated losses are assessed such that management can timely modify its evaluation model to ensure that adequate provision has been made for risk in the total loan portfolio. As a result of the Company’s analysis of the appropriateness of the ALLL, the Company recorded a provision for loan losses of $3.0 million, $4.4 million and $7.0 million for the years ended December 31, 2017, 2016 and 2015, respectively. The provision for loan losses recorded in 2017 reflects the revisions to the regulatory rating of a shared national credit ("SNC") in which the Company is a participant, changes in the quality of the portfolio and general improvement in the Company's historical loss rates used to compute the allowance not specifically allocated to individual credits. SNCs are credit facilities greater than $20 million that are shared by three or more federally supervised financial institutions and are reviewed annually by regulatory authorities at the agent bank level. The SNC that the Company is a participant is for a local customer that outgrew the lending limit of the Company and involves three local banks. The reserve recorded in 2017 of $1.1 million related to this SNC reflects the loss factors associated with the rating assigned to this SNC as a result of the current year review by the Office of the Comptroller of the Currency ("OCC"). The Company's balance outstanding at December 31, 2017 associated with this SNIC was $27.7 million, with an additional commitment of $6.2 million related to a line of credit to the borrower. As of December 31, 2017, the SNC was performing in accordance with terms and its debt service coverage ratios were acceptable. Changes in the amount of the allowance and related provision are based on the Company's detailed systematic methodology and are directionally consistent with changes in the composition and quality of the Company's loan portfolio. The Company believes its methodology for determining the adequacy of its ALLL adequately provides for probable losses inherent in the loan portfolio and produces a provision and allowance for loan losses that is directionally consistent with changes in asset quality and loss experience. The Company had net charge-offs of $3.9 million in each of the years ended December 31, 2017 and 2016. Net charge-offs in 2017 consisted primarily of net charge-offs on residential real estate loans of $1.3 million, DDA overdraft loans of $1.3 million, and commercial real estate loans of $0.6 million. Based on the Company’s analysis of the appropriateness of the allowance for loan losses and in consideration of the known factors utilized in computing the allowance, management believes that the allowance for loan losses as of December 31, 2017 is adequate to provide for probable losses inherent in the Company’s loan portfolio. Future provisions for loan losses will be dependent upon trends in loan balances including the composition of the loan portfolio, changes in loan quality and loss experience trends, and recoveries of previously charged-off loans, among other factors. TABLE SEVEN ANALYSIS OF THE ALLOWANCE FOR LOAN LOSSES An analysis of changes in the Company's allowance for loan losses follows (dollars in thousands): TABLE EIGHT NON-ACCRUAL AND PAST-DUE LOANS The Company's nonperforming assets and past-due loans were as follows (dollars in thousands): The Company’s ratio of non-performing assets to total loans and other real estate owned decreased from 0.61% at December 31, 2016 to 0.45% at December 31, 2017. Total past due loans increased from $8.6 million, or 0.28% of total loans outstanding, at December 31, 2016 to $11.0 million, or 0.35% of total loans outstanding, at December 31, 2017. Interest on loans is accrued and credited to operations based upon the principal amount outstanding. The accrual of interest income is generally discontinued when a loan becomes 90 days past due as to principal or interest unless the loan is well collateralized and in the process of collection. When interest accruals are discontinued, interest credited to income in the current year that is unpaid and deemed uncollectible is charged to operations. Prior-year interest accruals that are unpaid and deemed uncollectible are charged to the allowance for loan losses, provided that such amounts were specifically reserved. TABLE NINE IMPAIRED LOANS Information pertaining to the Company's impaired loans is included in the following table (in thousands): Impaired loans with a valuation allowance at the end of 2017 and 2016 were comprised of one commercial borrowing relationship that was evaluated during that year and determined that an allowance was necessary, as the present value of expected cash flows was less than the outstanding amount of the loan. There were no commitments to provide additional funds on non-accrual, impaired, or other potential problem loans at December 31, 2017 and 2016. TABLE TEN RESTRUCTURED LOANS The following table sets forth the Company’s troubled debt restructurings ("TDRs") (in thousands): Regulatory guidance requires loans to be accounted for as collateral-dependent loans when borrowers have filed Chapter 7 bankruptcy, the debt has been discharged by the bankruptcy court and the borrower has not reaffirmed the debt. The filing of bankruptcy is deemed to be evidence that the borrower is in financial difficulty and the discharge of the debt by the bankruptcy court is deemed to be a concession granted to the borrower. The Company's troubled debt restructurings ("TDRs") related to its borrowers who had filed for Chapter 7 bankruptcy protection make up 74% of the Company's total TDRs as of December 31, 2017. The average age of these TDRs was 12.1 years; the average current balance as a percentage of the original balance was 68.2%; and the average loan-to-value ratio was 65.4% as of December 31, 2017. Of the total 461 Chapter 7 related TDRs, 31 had an estimated loss exposure based on the current balance and appraised value at December 31, 2017. TABLE ELEVEN ALLOCATION OF THE ALLOWANCE FOR LOAN LOSSES The allocation of the allowance for loan losses by portfolio segment and the percent of loans in each category to total loans is shown in the table below (dollars in thousands). The allocation of a portion of the allowance in one portfolio segment does not preclude its availability to absorb losses in other portfolio segments. The allowance attributed to the commercial and industrial loan portfolio increased $0.4 million from $4.2 million at December 31, 2016 to $4.6 million at December 31, 2017. The increase is primarily attributable to an increase in the amount of loans classified as special mention and substandard as well as loan growth in this portfolio. The allowance attributed to the commercial real estate loan portfolio decreased $0.4 million from $6.6 million at December 31, 2016 to $6.2 million at December 31, 2017. This decrease is primarily attributable to improvements in the historical loss rates in the portfolio. The allowance attributed to the residential real estate portfolio decreased $1.5 million from $6.7 million at December 31, 2016 to $5.2 million at December 31, 2017. The decrease is primarily attributable to improvements in the historical loss rates in the portfolio. The allowance attributed to the home equity portfolio decreased $0.3 million from $1.4 million at December 31, 2016 to $1.1 million at December 31, 2017. The allowance attributed to the consumer portfolio decreased $0.02 million from $0.08 million at December 31, 2016 to $0.06 million at December 31, 2017. The allowance attributed to DDA overdrafts increased $0.9 million from $0.8 million at December 31, 2016 to $1.7 million at December 31, 2017. This increase is primarily attributable to an increase in the historical loss rate in the portfolio. GOODWILL The Company evaluates the recoverability of goodwill and indefinite lived intangible assets annually as of November 30th, or more frequently if events or changes in circumstances warrant, such as a material adverse change in the business. Goodwill is considered to be impaired when the carrying value of a reporting unit exceeds its estimated fair value. Indefinite-lived intangible assets are considered impaired if their carrying value exceeds their estimated fair value. As described in Note One of the Notes to Consolidated Financial Statements, the Company conducts its business activities through one reportable business segment - community banking. Fair values are estimated by reviewing the Company’s stock price as it compares to book value and the Company’s reported earnings. In addition, the impact of future earnings and activities are considered in the Company’s analysis. The Company had approximately $76 million of goodwill at December 31, 2017 and 2016, respectively, and no impairment was required to be recognized in 2017 or 2016, as the estimated fair value of the Company has continued to exceed its book value. CERTIFICATES OF DEPOSIT Scheduled maturities of time certificates of deposit of $100,000 or more at December 31, 2017 are summarized in the table below (in thousands). The Company has time certificates of deposit that meet or exceed the FDIC insurance limit of $250,000 totaling $122.4 million (approximately 11% of total time deposits). TABLE TWELVE MATURITY DISTRIBUTION OF CERTIFICATES OF DEPOSIT OF $100,000 OR MORE FAIR VALUE MEASUREMENTS The Company determines the fair value of its financial instruments based on the fair value hierarchy established in ASC Topic 820, whereby the fair value of certain assets and liabilities is an exit price, representing the amount that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants. ASC Topic 820 establishes a three-level hierarchy for disclosure of assets and liabilities recorded at fair value. The hierarchy classification is based on whether the inputs in the methodology for determining fair value are observable or unobservable. Observable inputs reflect market-based information obtained from independent sources (Level 1 or Level 2), while unobservable inputs reflect management’s estimate of market data (Level 3). Assets and liabilities that are actively traded and have quoted prices or observable market data require a minimal amount of subjectivity concerning fair value. Management’s judgment is necessary to estimate fair value when quoted prices or observable market data are not available. At December 31, 2017, approximately 14% of total assets, or $565 million, consisted of financial instruments recorded at fair value. Most of these financial instruments used valuation methodologies involving observable market data, collectively Level 1 and Level 2 measurements, to determine fair value. At December 31, 2017, approximately $14 million of derivative liabilities were recorded at fair value using methodologies involving observable market data. The Company does not believe that any changes in the unobservable inputs used to value the financial instruments mentioned above would have a material impact on the Company’s results of operations, liquidity, or capital resources. See Note Eighteen of the Notes to Consolidated Financial Statements for additional information regarding ASC Topic 820 and its impact on the Company’s financial statements. CONTRACTUAL OBLIGATIONS The Company has various financial obligations that may require future cash payments according to the terms of the obligations. Demand, both noninterest- and interest-bearing, and savings deposits are, generally, payable immediately upon demand at the request of the customer. Therefore, the contractual maturity of these obligations is presented in the following table as “less than one year.” Time deposits, typically certificates of deposit, are customer deposits that are evidenced by an agreement between the Company and the customer that specify stated maturity dates and early withdrawals by the customer are subject to penalties assessed by the Company. Short-term borrowings and long-term debt represent borrowings of the Company and have stated maturity dates. Capital and operating leases between the Company and the lessor have stated expiration dates and renewal terms. TABLE THIRTEEN CONTRACTUAL OBLIGATIONS The composition of the Company's contractual obligations as of December 31, 2017 is presented in the following table (in thousands): (1) Includes interest on both fixed- and variable-rate obligations. The interest associated with variable-rate obligations is based upon interest rates in effect at December 31, 2017. The contractual amounts to be paid on variable-rate obligations are affected by market interest rates that could materially affect the contractual amounts to be paid. The Company’s liability for uncertain tax positions at December 31, 2017 was $1.9 million pursuant to ASC Topic 740. This liability represents an estimate of tax positions that the Company has taken in its tax returns that may ultimately not be sustained upon examination by tax authorities. As the ultimate amount and timing of any future cash settlements cannot be predicted with reasonable reliability, this estimated liability has been excluded from the contractual obligations table. OFF-BALANCE SHEET ARRANGEMENTS As disclosed in Note Fifteen of the Notes to Consolidated Financial Statements, the Company has also entered into agreements with its customers to extend credit or to provide conditional commitments to provide payment on drafts presented in accordance with the terms of the underlying credit documents (including standby and commercial letters of credit). The Company also provides overdraft protection to certain demand deposit customers that represent an unfunded commitment. As a result of the Company’s off-balance sheet arrangements for 2017 and 2016, no material revenue, expenses, or cash flows were recognized. In addition, the Company had no other indebtedness or retained interests nor entered into agreements to extend credit or provide conditional payments pursuant to standby and commercial letters of credit. CAPITAL RESOURCES During 2017, Shareholders’ Equity increased $60 million, or 13.6%, from $442 million at December 31, 2016 to $503 million at December 31, 2017. This increase was primarily due to net income of $54 million and the issuance of common shares of $28 million, partially offset by cash dividends declared of $28 million. On September 24, 2014, the Company announced that the Board of Directors authorized the Company to buy back up to 1,000,000 shares of its common shares (approximately 7% of outstanding shares) in open market transactions at prices that are accretive to the earnings per share of continuing shareholders. No time limit was placed on the duration of the share repurchase program. During the year ended December 31, 2016, the Company repurchased approximately 231,000 common shares at a weighted average price of $43.34. During the year ended December 31, 2017, the Company did not repurchase any common shares. At December 31, 2017, the Company could repurchase approximately 279,000 shares under the current plan. On December 19, 2016, the Company announced that it had filed a prospectus supplement to its existing shelf registration statement on Form S-3 for the sale of its common stock having an aggregate value of up to $55 million through an "at-the-market" equity offering program. Through the year ended December 31, 2017, the Company has sold approximately 548,000 common shares at a weighted average price of $64.82, net of broker fees. The Company has sold no shares since the first quarter of 2017. To date, the Company has received $36.4 million in gross proceeds. Under the program, the Company has the ability to receive an additional $18.6 million in gross proceeds from the sale of common shares. In July 2013, the Federal Reserve published the final rules that established a new comprehensive capital framework for banking organizations, commonly referred to as Basel III. These final rules substantially revised the risk-based capital requirements applicable to bank holding companies and depository institutions. The final rule became effective January 1, 2015 for smaller, non-complex banking organizations with full implementation by January 1, 2019. Regulatory guidelines require the Company to maintain a minimum common equity tier I ("CET 1") capital ratio of 5.75% and a total capital to risk-adjusted assets ratio of 9.25%, with at least one-half of capital consisting of tangible common stockholders’ equity, and a minimum Tier I leverage ratio of 7.25%. Similarly, City National is also required to maintain minimum capital levels as set forth by various regulatory agencies. Under capital adequacy guidelines, City National is required to maintain minimum CET 1, total capital, Tier I capital, and leverage ratios of 5.75%, 9.25%, 7.25%, and 4.0%, respectively. To be classified as “well capitalized,” City National must maintain CET 1, total capital, Tier I capital, and leverage ratios of 6.5%, 10.0%, 8.0%, and 5.0%, respectively. When fully phased in on January 1, 2019, the Basel III Capital Rules will require City Holding and City National to maintain (i) a minimum ratio of CET 1 to risk-weighted assets of at least 4.5%, plus a 2.5% "capital conservation buffer" (which is added to the 4.5% CET 1 ratio as that buffer is phased in, effectively resulting in a minimum ratio of CET 1 to risk-weighted assets of at least 7.0% upon full implementation), (ii) a minimum ratio of Tier 1 capital to risk-weighted assets of at least 6.0%, plus the capital conservation buffer (which is added to the 6.0% Tier 1 capital ratio as that buffer is phased in, effectively resulting in a minimum Tier 1 capital ratio of 8.5% upon full implementation), (iii) a minimum ratio of total capital (that is, Tier 1 plus Tier 2) to risk-weighted assets of at least 8.0%, plus the capital conservation buffer (which is added to the 8.0% total capital ratio as that buffer is phased in, effectively resulting in a minimum total capital ratio of 10.5% upon full implementation) and (iv) a minimum leverage ratio of 4.0%, calculated as the ratio of Tier 1 capital to average assets (as compared to the previous minimum leverage ratio of 3.0% for banking organizations that either have the highest supervisory rating or have implemented the appropriate federal regulatory authority's risk-adjusted measure for market risk). The implementation of the capital conservation buffer began on January 1, 2016 at the 0.625% level and will be phased in over a four-year period (increasing by that amount on each subsequent January 1, until it reaches 2.5% on January 1, 2019). The Basel III Capital Rules also provide for a “countercyclical capital buffer” that is applicable to only certain covered institutions and does not have any current applicability to City Holding Company or City National Bank. The aforementioned capital conservation buffer is designed to absorb losses during periods of economic stress. Banking institutions with a ratio of CET 1 capital to risk-weighted assets above the minimum but below the conservation buffer (or below the combined capital conservation buffer and countercyclical capital buffer, when the latter is applied) will face constraints on dividends, equity repurchases and compensation based on the amount of the shortfall. The Company’s regulatory capital ratios for both City Holding and City National are illustrated in the following table: As of December 31, 2017, management believes that City Holding Company, and its banking subsidiary, City National, were “well capitalized.” City Holding is subject to regulatory capital requirements administered by the Federal Reserve, while City National is subject to regulatory capital requirements administered by the OCC and the FDIC. Regulatory agencies can initiate certain mandatory actions if either City Holding or City National fails to meet the minimum capital requirements, as shown above. As of December 31, 2017, management believes that City Holding and City National meet all capital adequacy requirements. LEGAL ISSUES The Company is engaged in various legal actions that it deems to be in the ordinary course of business. As these legal actions are resolved, the Company could realize impacts to its financial performance in the period in which these legal actions are determined to be probable and reasonably estimated. There can be no assurance that current actions will have immaterial results, or that no material actions may be presented in the future. RECENT ACCOUNTING PROCOUNCEMENTS AND DEVELOPMENTS Note One, “Recent Accounting Pronouncements,” of the Notes to Consolidated Financial Statements discusses recently issued new accounting pronouncements and their expected impact on the Company’s consolidated financial statements.

<s>[INST] City Holding Company (the “Company”), a West Virginia corporation headquartered in Charleston, West Virginia, is a registered financial holding company under the Bank Holding Company Act and conducts its principal activities through its wholly owned subsidiary, City National Bank of West Virginia ("City National"). City National is a retail and consumeroriented community bank with 86 bank branches in West Virginia (57), Virginia (14), Kentucky (12) and Ohio (3). City National provides credit, deposit, and trust and investment management services to its customers in a broad geographical area that includes many rural and small community markets in addition to larger cities including Charleston (WV), Huntington (WV), Martinsburg (WV), Winchester (VA), Staunton (VA), Virginia Beach (VA), Ashland (KY) and Lexington (KY). In the Company's key markets, the Company's primary subsidiary, City National, generally ranks in the top three relative to deposit market share and the top two relative to branch share (Charleston/Huntington MSA, Beckley/Lewisburg counties, Staunton MSA and Winchester, VA/WV Eastern Panhandle counties). In addition to its branch network, City National's delivery channels include automatedtellermachines ("ATMs"), interactivetellermachines ("ITMs"), mobile banking, debit cards, interactive voice response systems, and Internet technology. The Company’s business activities are currently limited to one reportable business segment, which is community banking. In January 2015, the Company sold its insurance operations, CityInsurance, to The Hilb Group effective January 1, 2015. As a result of this sale, the Company recognized a onetime after tax gain of $5.8 million in the first quarter of 2015. On November 6, 2015, the Company purchased three branch locations from American Founders Bank, Inc. (“AFB”) located in Lexington, Kentucky. The Company acquired approximately $119 million in performing loans and assumed deposit liabilities of approximately $145 million. The Company paid AFB a deposit premium of 5.5% on nontime deposits and 1.0% on premium loan balances acquired. CRITICAL ACCOUNTING POLICIES The accounting policies of the Company conform to U.S. generally accepted accounting principles and require management to make estimates and develop assumptions that affect the amounts reported in the financial statements and related footnotes. These estimates and assumptions are based on information available to management as of the date of the financial statements. Actual results could differ significantly from management’s estimates. As this information changes, management’s estimates and assumptions used to prepare the Company’s financial statements and related disclosures may also change. The most significant accounting policies followed by the Company are presented in Note One of the Notes to Consolidated Financial Statements included herein. Based on the valuation techniques used and the sensitivity of financial statement amounts to the methods, assumptions, and estimates underlying those amounts, management has identified: (i) the determination of the allowance for loan losses and (ii) income taxes to be the accounting areas that require the most subjective or complex judgments and, as such, could be most subject to revision as new information becomes available. The Allowance and Provision for Loan Losses section of this Annual Report on Form 10K provides management’s analysis of the Company’s allowance for loan losses and related provision. The allowance for loan losses is maintained at a level that represents management’s best estimate of probable losses in the loan portfolio. Management’s determination of the appropriateness of the allowance for loan losses is based upon an evaluation of individual credits in the loan portfolio, historical loan loss experience, current economic conditions, and other relevant factors. This determination is inherently subjective, as it requires material estimates including the amounts and timing of future cash flows expected to be received on impaired loans that may be susceptible to significant change. The allowance for loan losses related to loans considered to be impaired is generally evaluated based on the discounted cash flows using the impaired loan’s initial effective interest rate or the fair value of the collateral for certain collateral dependent loans. The allowance not specifically allocated to individual credits is generally determined by analyzing potential exposure and other qualitative factors that could negatively impact the overall credit [/INST] Negative. </s>

CITY HOLDING CO

2019-03-11

2018-12-31

Item 7.Management's Discussion and Analysis of Financial Condition and Results of Operations Statistical Information The information noted below is provided pursuant to Guide 3 -- Statistical Disclosure by Bank Holding Companies. Description of Information Page Reference 1. Distribution of Assets, Liabilities and Stockholders' Equity; Interest Rates and Interest Differential a. Average Balance Sheets b. Analysis of Net Interest Earnings c. Rate Volume Analysis of Changes in Interest Income and Expense 2. Investment Portfolio a. Book Value of Investments b. Maturity Schedule of Investments c. Securities of Issuers Exceeding 10% of Stockholders’ Equity 3. Loan Portfolio a. Types of Loans b. Maturities and Sensitivity to Changes in Interest Rates c. Risk Elements d. Other Interest Bearing Assets None 4. Summary of Loan Loss Experience 5. Deposits a. Breakdown of Deposits by Categories, Average Balance and Average Rate Paid b. Maturity Schedule of Time Certificates of Deposit and Other Time Deposits of $100,000 or More 6. Return on Equity and Assets 7. Short-term Borrowings CITY HOLDING COMPANY City Holding Company (the “Company”), a West Virginia corporation headquartered in Charleston, West Virginia, is a registered financial holding company under the Bank Holding Company Act and conducts its principal activities through its wholly owned subsidiary, City National Bank of West Virginia ("City National"). City National is a retail and consumer-oriented community bank with 100 bank branches in West Virginia (58), Kentucky (24), Virginia (14) and Ohio (4). City National provides credit, deposit, and trust and investment management services to its customers in a broad geographical area that includes many rural and small community markets in addition to larger cities including Charleston (WV), Huntington (WV), Martinsburg (WV), Ashland (KY), Lexington (KY), Winchester (VA) and Staunton (VA). In the Company's key markets, the Company's primary subsidiary, City National, generally ranks in the top three relative to deposit market share and the top two relative to branch share (Charleston/Huntington MSA, Beckley/Lewisburg counties, Staunton MSA and Winchester, VA/WV Eastern Panhandle counties). In addition to its branch network, City National's delivery channels include automated-teller-machines ("ATMs"), interactive-teller-machines ("ITMs"), mobile banking, debit cards, interactive voice response systems, and Internet technology. The Company’s business activities are currently limited to one reportable business segment, which is community banking. In July 2018, the Company announced that it had concurrently executed two separate definitive agreements to acquire Poage Bankshares, Inc., of Ashland, Kentucky and its principal banking subsidiary, Town Square Bank (collectively, "Poage") and Farmers Deposit Bancorp, Inc., of Cynthiana, Kentucky and its principal banking subsidiary, Farmers Deposit Bank (collectively, "Farmers Deposit"). The acquisitions were finalized in December 2018. Poage operated nine branches across northeastern Kentucky, along with a loan production office in Cincinnati, Ohio. Farmers Deposit operated three branches around the Lexington, Kentucky region. As a result of overlapping service areas, the Company plans to merge three of the Poage branches into existing City branches and two existing City branches into former Poage branches. In January 2019, the Company announced the signing of a definitive agreement to sell its Virginia Beach, Virginia, branch to Select Bancorp, Inc., the holding company for Select Bank & Trust Company. The transaction is expected to close during the second quarter of 2019. After the Poage-City branch mergers and the Virginia Beach branch divestiture, the Company expects to have 94 bank branches in its network. CRITICAL ACCOUNTING POLICIES The accounting policies of the Company conform to U.S. generally accepted accounting principles and require management to make estimates and develop assumptions that affect the amounts reported in the financial statements and related footnotes. These estimates and assumptions are based on information available to management as of the date of the financial statements. Actual results could differ significantly from management’s estimates. As this information changes, management’s estimates and assumptions used to prepare the Company’s financial statements and related disclosures may also change. The most significant accounting policies followed by the Company are presented in Note One of the Notes to Consolidated Financial Statements included herein. Based on the valuation techniques used and the sensitivity of financial statement amounts to the methods, assumptions, and estimates underlying those amounts, management has identified: (i) the determination of the allowance for loan losses and (ii) income taxes to be the accounting areas that require the most subjective or complex judgments and, as such, could be most subject to revision as new information becomes available. The Allowance and Provision for Loan Losses section of this Annual Report on Form 10-K provides management’s analysis of the Company’s allowance for loan losses and related provision. The allowance for loan losses is maintained at a level that represents management’s best estimate of probable losses in the loan portfolio. Management’s determination of the appropriateness of the allowance for loan losses is based upon an evaluation of individual credits in the loan portfolio, historical loan loss experience, current economic conditions, and other relevant factors. This determination is inherently subjective, as it requires material estimates including the amounts and timing of future cash flows expected to be received on impaired loans that may be susceptible to significant change. The allowance for loan losses related to loans considered to be impaired is generally evaluated based on the discounted cash flows using the impaired loan’s initial effective interest rate or the fair value of the collateral for certain collateral dependent loans. The allowance not specifically allocated to individual credits is generally determined by analyzing potential exposure and other qualitative factors that could negatively impact the overall credit risk of the loan portfolio. Loans not individually evaluated for impairment are grouped by pools with similar risk characteristics and the related historical loss rates are adjusted to reflect current inherent risk factors, such as unemployment, overall economic conditions, concentrations of credit, loan growth, classified and impaired loan trends, staffing, adherence to lending policies, and loss trends. The Income Taxes section of this Annual Report on Form 10-K provides management’s analysis of the Company’s income taxes. The Company is subject to federal and state income taxes in the jurisdictions in which it conducts business. In computing the provision for income taxes, management must make judgments regarding interpretation of laws in those jurisdictions. Because the application of tax laws and regulations for many types of transactions is susceptible to varying interpretations, amounts reported in the financial statements could be changed at a later date upon final determinations by taxing authorities. On a quarterly basis, the Company estimates its annual effective tax rate for the year and uses that rate to provide for income taxes on a year-to-date basis. The Company's unrecognized tax benefits could change over the next twelve months as a result of various factors. The Company is currently open to audit under the statute of limitations by the Internal Revenue Service and various state taxing authorities for the years ended December 31, 2015 through 2017. FINANCIAL SUMMARY The Company’s financial performance over the previous three years is summarized in the following table: *ROA (Return on Average Assets) is a measure of the effectiveness of asset utilization. ROE (Return on Average Equity) is a measure of the return on shareholders’ investment. ROATCE (Return on Average Tangible Common Equity) is a measure of the return on shareholders’ equity less intangible assets. BALANCE SHEET ANALYSIS Selected balance sheet fluctuations are summarized in the following table (in millions): Cash and cash equivalents increased $41 million, from $83 million at December 31, 2017 to $123 million at December 31, 2018, as the Company elected to improve its on-balance sheet liquidity during 2018. Investment securities increased $184 million, from $629 million at December 31, 2017, to $813 million at December 31, 2018. The acquisitions of Poage and Farmers Deposit contributed approximately $119 million to this increase. In addition, in conjunction with its interest rate risk management strategy, the Company elected to grow investment balances to enhance net interest income. Gross loans increased $460 million, from $3.13 billion at December 31, 2017 to $3.59 billion at December 31, 2018. The acquisitions of Poage and Farmers Deposit contributed approximately $362 million to this increase. Excluding the impact of the two acquisitions, commercial loans increased $57 million and residential real estate loans increased $33 million from December 31, 2017 to December 31, 2018. Goodwill and other intangible assets, net increased $44 million, from $79 million at December 31, 2017 to $123 million at December 31, 2018. The acquisitions of Poage and Farmers Deposit contributed approximately $33 million in goodwill and $11 million in core deposit intangibles in 2018. Total deposits increased $660 million, from $3.32 billion at December 31, 2017 to $3.98 billion at December 31, 2018. The acquisitions of Poage and Farmers Deposit contributed approximately $472 million to this increase. Excluding the impact of the two acquisitions, the Company grew time deposits ($90 million), interest-bearing demand deposits ($46 million), noninterest-bearing deposits ($32 million) and savings deposits ($20 million). Long-term debt decreased $12.4 million as the Company repaid its $16.5 million of Junior Subordinated Deferrable Interest Debentures issued by the Company and held by City Holding Company Trust III at a price of 100% of principal. As part of its Poage acquisition, the Company assumed Poage's subordinated debentures of $4.1 million. Shareholders' equity increased $98 million from December 31, 2017 to December 31, 2018, as the Company issued approximately $83 million of common shares in conjunction with the Poage acquisition. The issuance of these shares, along with net income of $70 million, were partially offset by cash dividends declared of $31 million and common share repurchases of $20 million. TABLE TWO AVERAGE BALANCE SHEETS AND NET INTEREST INCOME (In thousands) 1. For purposes of this table, non-accruing loans have been included in average balances and the following loan fees (in thousands) have been included in interest income. 2.Includes the Company's residential real estate and home equity loan categories. 3. Included in the above table are the following amounts (in thousands) for the accretion of the fair value adjustments related to the Company's recent acquisitions: 4.Includes the Company’s commercial and industrial and commercial real estate loan categories. 5.Includes the Company’s consumer and DDA overdrafts loan categories. 6.Effective January 1, 2012, the carrying value of the Company's previously securitized loans was reduced to $0. 7. Computed on a fully federal tax-equivalent basis assuming a tax rate of approximately 21% for the year ended December 31, 2018 and 35% for the years ended December 31, 2017 and 2016. NET INTEREST INCOME 2018 vs. 2017 The Company's net interest income increased from $126.1 million for the year ended December 31, 2017 to $138.2 million for the year ended December 31, 2018. The Company’s tax equivalent net interest income increased $11.4 million or 8.9%, from $127.6 million in 2017 to $139.0 million in 2018. Exclusive of the impact of the acquisitions of Poage and Farmers Deposit, increased yields on commercial and residential real estate loans increased net interest income $7.8 million and $4.8 million, respectively, while higher average balances on commercial loans ($40.0 million) and residential real estate loans ($20.4 million) increased interest income by $1.6 million and $0.8 million, respectively, as compared to the year ended December 31, 2017. In addition, higher average investment balances ($68.6 million) increased investment income by $2.0 million, while interest income from deposits in depository institutions also increased $1.6 million as the Company elected to improve its on-balance sheet liquidity during the year ended December 31, 2018. These increases were partially offset by increased interest expense on interest bearing liabilities ($7.7 million), primarily due to an increase in the cost of funds. The Company’s reported net interest margin increased from 3.46% for the year ended December 31, 2017 to 3.52% for the year ended December 31, 2018. Excluding the favorable impact of the accretion from the fair value adjustments, the net interest margin would have been 3.49% for the year ended December 31, 2018 and 3.40% for the year ended December 31, 2017. Excluding the impact of the Poage and Farmers Deposit acquisitions, average interest-earning assets increased $219 million from 2017 to 2018, due to increases in deposits with depository institutions ($96 million), investment securities ($61 million), commercial, financial, and agriculture loans ($40 million) and residential real estate loans ($20 million). Average interest-bearing liabilities increased $159 million from 2017 as increases in interest bearing deposits ($82 million), time deposits ($64 million) and short-term borrowings ($34 million) were partially offset by a decrease in savings deposits ($20 million). 2017 vs. 2016 The Company's net interest income increased from $118.9 million for the year ended December 31, 2016 to $126.1 million for the year ended December 31, 2017. The Company’s tax equivalent net interest income increased $7.8 million, or 6.5%, from $119.8 million in 2016 to $127.6 million in 2017. This increase was due primarily to higher average balances on commercial loans ($132.0 million) which increased interest income by $5.1 million, and residential real estate loans ($33.5 million) which increased interest income by $1.3 million as compared to the year ended December 31, 2016. Increased interest yields on residential real estate loans also increased net interest income by $1.8 million compared to the year ended December 31, 2016. In addition, higher average investment balances ($86.9 million) increased investment income by $3.2 million. These increases were partially offset by increased interest expense on interest bearing deposits ($3.0 million), primarily due to an increase in the cost of funds, and lower accretion from fair value adjustments ($1.0 million). The Company's reported net interest margin decreased from 3.50% for the year ended December 31, 2016 to 3.46% for the year ended December 31, 2017. Excluding the favorable impact of the accretion from fair value adjustments, the net interest margin would have been 3.40% for the year ended December 31, 2017 and 3.41% for the year ended December 31, 2016. Average interest-earning assets increased $266 million from 2016 to 2017, due to increases in commercial, financial, and agriculture loans ($132 million), investment securities ($87 million) and residential real estate loans ($34 million). Average interest-bearing liabilities increased $173 million from 2016 due to increases in savings deposits ($60 million), short-term borrowings ($54 million), time deposits ($38 million) and interest-bearing demand deposits ($20 million). TABLE THREE RATE/VOLUME ANALYSIS OF CHANGES IN INTEREST INCOME AND INTEREST EXPENSE (In thousands) 1. Fully federal taxable equivalent using a tax rate of approximately 21% for 2018 and 35% for 2017 and 2016. Non-GAAP Financial Measures Management of the Company uses measures in its analysis of the Company's performance other than those in accordance with generally accepted accounting principals in the United States of America ("GAAP"). These measures are useful when evaluating the underlying performance of the Company's operations. The Company's management believes that these non-GAAP measures enhance comparability of results with prior periods and demonstrate the effects of significant gains and charges in the current period. The Company's management believes that investors may use these non-GAAP financial measures to evaluate the Company's financial performance without the impact of those items that may obscure trends in the Company's performance. These disclosures should not be viewed as a substitute for financial measures determined in accordance with GAAP, nor are they comparable to non-GAAP financial measures that may be presented by other companies. TABLE FOUR NON-GAAP FINANCIAL MEASURES (In thousands) NON-INTEREST INCOME AND NON-INTEREST EXPENSE 2018 vs. 2017 Selected income statement fluctuations are summarized in the following table (dollars in millions): During 2017, the Company realized investment gains of $4.5 million that represented partial recoveries of impairment charges previously recognized on pools of trust preferred securities. During 2018, the Company recognized $0.1 million of unrealized investment losses related to its equity and perpetual preferred securities. As a result of the adoption of ASU No. 2016-02, effective January 1, 2018, unrealized gains and losses on equity and equity-like securities are now required to be recognized in the Company's Consolidated Statements of Income. Exclusive of these gains and losses, non-interest income increased from $59.1 million for the year ended December 31, 2017 to $60.7 million for the year ended December 31, 2018. This increase was primarily attributable to an increase of $1.2 million, or 7.3%, in bankcard revenues and an increase of $1.1 million, or 4.0%, in service charges. These increases were partially offset by a decrease of $1.1 million in bank owned life insurance revenues due to lower death benefit proceeds received during 2018 as compared to 2017. During 2018, the Company recognized $13.3 million of merger related expenses associated with the completed acquisitions of Poage and Farmers Deposit. Excluding these expenses, non-interest expenses increased from $96.0 million for 2017 to $99.8 million for 2018. This increase was primarily due to an increase in salaries and employee benefits of $3.3 million that was largely attributable to annual salary adjustments, including an adjustment to wages for approximately 50% of the Company's employees late in the first quarter of 2018 to make salaries more competitive in the current employment environment. Additionally, the Company experienced increases in bankcard expenses of $0.6 million and other expenses of $0.5 million. 2017 vs. 2016 Selected income statement fluctuations are summarized in the following table (dollars in millions): During the years ended December 31, 2017 and 2016, the Company realized investment gains of $4.5 million and $3.5 million, respectively, from the sale of pools of trust preferred securities, which represented a partial recovery of impairment charges previously recognized. Exclusive of these gains, non-interest income increased $3.8 million to $59.1 million for the year ended December 31, 2017, as compared to $55.3 million for the year ended December 31, 2016. This is primarily due to increases in service charges of $1.9 million, or 7.0%, bank owned life insurance of $0.9 million, or 26.6% (primarily due to death benefit proceeds), trust revenues of $0.7 million, or 12.5%, and bankcard revenues of $0.6 million, or 3.7%. Non-interest expenses decreased $0.2 million from $96.2 million for the year ended December 31, 2016 to $96.0 million for the year ended December 31, 2017. This is primarily due to decreases in occupancy related expenses of $0.6 million, or 5.6%, bankcard expenses of $0.5 million, or 12.0%, FDIC insurance of $0.3 million and repossessed asset losses, net of expenses of $0.2 million. These decreases were partially offset by increases in equipment and software related expenses of $0.5 million, or 7.2%, advertising of $0.3 million, or 11.8%, salaries and employee benefits of $0.2 million and telecommunication expenses of $0.2 million, or 9.7%. INCOME TAXES Selected information regarding the Company's income taxes is presented in the table below (dollars in millions): A reconciliation of the effective tax rate to the statutory rate is included in Note Fourteen of the Notes to Consolidated Financial Statements. On December 22, 2017, the President signed the Tax Cut and Jobs Act ("TCJA") into law. Among other things, the TCJA reduced the corporate income tax rate from 35% to 21%, effective January 1, 2018. The Company recorded a provisional amount of $7.1 million at December 31, 2017 related to the re-measurement of net deferred tax balances. Upon final analysis of available information and refinement of the Company's calculations during 2018, the Company increased its provisional amount by $0.1 million, which is included as a component of income tax expense. The Company considers the TCJA re-measurement of its deferred taxes and its accounting for the income tax effects of TCJA to be complete. Deferred income taxes reflect the net tax effects of temporary differences between the carrying amount of assets and liabilities for financial reporting purposes and the amounts used for income tax purposes. The Company’s net deferred tax assets increased from $11.9 million at December 31, 2017 to $17.3 million at December 31, 2018. The increase in the Company's net deferred tax assets was primarily the result of accounting for the acquisitions that were completed during the year, along with realized and unrealized security losses that are not includable in current taxable income. The components of the Company’s net deferred tax assets are disclosed in Note Fourteen of the Notes to Consolidated Financial Statements. Realization of the most significant net deferred tax assets is primarily dependent on future events taking place that will reverse the current deferred tax assets. The deferred tax asset and/or liability associated with unrealized securities losses and/or gains is the tax impact of the unrealized gains and/or losses on the Company’s available-for-sale security portfolio. The impact of the Company’s unrealized losses is noted in the Company’s Consolidated Statements of Changes in Shareholders’ Equity as an adjustment to Accumulated Other Comprehensive Income (Loss). This deferred tax asset would be realized if the unrealized securities losses on the Company's securities were realized from either the sales or maturities of the related securities. The deferred tax asset associated with the allowance for loan losses is expected to be realized as additional loan charge-offs, which have already been provided for within the Company’s financial statements, are recognized for tax purposes. The Company believes that it is more likely than not that each of the deferred tax assets will be realized and that no valuation allowance was necessary as of December 31, 2018 or 2017. LIQUIDITY The Company evaluates the adequacy of liquidity at both the Parent Company level and at the banking subsidiary level. At the Parent Company level, the principal source of cash is dividends from its banking subsidiary, City National. Dividends paid by City National to the Parent Company are subject to certain legal and regulatory limitations. Generally, any dividends in amounts that exceed the earnings retained by City National in the current year plus retained net profits for the preceding two years must be approved by regulatory authorities. At December 31, 2018, City National could pay dividends up to $88.8 million without prior regulatory permission. During 2018, the Parent Company used cash obtained from the dividends received primarily to: (1) acquire Farmers Deposit, (2) pay common dividends to shareholders, (3) repay the Company's Junior Subordinated Deferrable Interest Debentures, (4) remit interest payments on those debentures prior to payoff and (5) fund repurchases of the Company's common shares. Additional information concerning sources and uses of cash by the Parent Company is discussed in Note Twenty-One of the Notes to Consolidated Financial Statements. On December 19, 2016, the Company announced that it had filed a prospectus supplement to its existing shelf registration statement on Form S-3 for the sale of its common stock having an aggregate value of up to $55 million through an “at-the-market” equity offering program. Through the year ended December 31, 2018, the Company has sold approximately 548,000 common shares at a weighted average price of $64.82, net of broker fees. The Company has sold no shares since the first quarter of 2017. To date, the Company has received $36.4 million in gross proceeds. Under the program, the Company has the ability to receive an additional $18.6 million in gross proceeds from the sale of common shares. Over the next 12 months, the Parent Company has an obligation to remit interest payments approximating $0.2 million on the Junior Subordinated Deferrable Interest Debentures held by Town Square Statutory Trust I. However, interest payments on the debentures can be deferred for up to five years under certain circumstances. During 2018, the Parent Company repaid $16.5 million of Junior Subordinated Deferrable Interest Debentures issued by the Company and held by City Holding Capital Trust III at a price of 100% of principal. Additionally, the Parent Company anticipates continuing the payment of dividends, which are expected to approximate $35.1 million on an annualized basis for 2019 based on common shareholders of record at December 31, 2018 at a dividend rate of $2.12 per share for 2019. However, dividends to shareholders can, if necessary, be suspended. In addition to these anticipated cash needs, the Parent Company has operating expenses and other contractual obligations, which are estimated to require $1.3 million of additional cash over the next 12 months. As of December 31, 2018, the Parent Company reported a cash balance of $20.6 million and management believes that the Parent Company’s available cash balance, together with cash dividends from City National, will be adequate to satisfy its funding and cash needs over the next twelve months. Excluding the interest and dividend payments discussed above, the Parent Company has no significant commitments or obligations in years after 2019 other than the repayment of its $4.1 million obligation under the debentures held by Town Square Statutory Trust I. However, this obligation does not mature until June 2036, or earlier at the option of the Parent Company. It is expected that the Parent Company will be able to obtain the necessary cash, either through dividends obtained from City National or the issuance of other debt, to fully repay the debentures at their maturity. City National manages its liquidity position in an effort to effectively and economically satisfy the funding needs of its customers and to accommodate the scheduled repayment of borrowings. Funds are available to City National from a number of sources, including depository relationships, sales and maturities within the investment securities portfolio, and borrowings from the Federal Home Loan Bank ("FHLB") and other financial institutions. As of December 31, 2018, City National’s assets are significantly funded by deposits and capital. City National maintains borrowing facilities with the FHLB and other financial institutions that can be accessed as necessary to fund operations and to provide contingency funding mechanisms. As of December 31, 2018, City National had the capacity to borrow an additional $1.9 billion from the FHLB and other financial institutions under existing borrowing facilities. City National maintains a contingency funding plan, incorporating these borrowing facilities, to address liquidity needs in the event of an institution-specific or systemic financial industry crisis. Also, although it has no current intention to do so, City National could liquidate its unpledged securities, if necessary, to provide an additional funding source. City National also segregates certain mortgage loans, mortgage-backed securities, and other investment securities in a separate subsidiary so that it can separately monitor the asset quality of these primarily mortgage-related assets, which could be used to raise cash through securitization transactions or obtain additional equity or debt financing if necessary. The Company manages its asset and liability mix to balance its desire to maximize net interest income against its desire to minimize risks associated with capitalization, interest rate volatility, and liquidity. With respect to liquidity, the Company has chosen a conservative posture and believes that its liquidity position is strong. As illustrated in the Consolidated Statements of Cash Flows, the Company generated $73 million of cash from operating activities during 2018, primarily from interest income received on loans and investments, net of interest expense paid on deposits and borrowings. The Company has obligations to extend credit, but these obligations are primarily associated with existing home equity loans that have predictable borrowing patterns across the portfolio. The Company has investment security balances with carrying values that totaled $813 million at December 31, 2018, and that greatly exceeded the Company’s non-deposit sources of borrowing, which totaled $266 million. The Company’s net loan to asset ratio is 72.9% as of December 31, 2018 and deposit balances fund 81.2% of total assets as compared to 70.2% for its peers (Bank Holding Company Peer Group, as of the most recent data available of September 30, 2018, which includes commercial banks with assets ranging from $3 billion to $10 billion). Further, the Company’s deposit mix has a very high proportion of transaction and savings accounts that fund 53.5% of the Company’s total assets and the Company uses time deposits over $250,000 to fund 3.3% of total assets compared to its peers, which fund 13.1% of total assets with such deposits. INVESTMENTS The Company’s investment portfolio increased $184 million from $629 million at December 31, 2017, to $813 million at December 31, 2018. The acquisitions of Poage and Farmers Deposit contributed approximately $119 million to this increase. In addition, in conjunction with its interest rate risk management strategy, the Company elected to grow investment balances to enhance net interest income. The investment portfolio is structured to provide flexibility in managing liquidity needs and interest rate risk, while providing acceptable rates of return. The majority of the Company’s investment securities continue to be mortgage-backed securities. The mortgage-backed securities in which the Company has invested are predominantly underwritten to the standards of, and guaranteed by government-sponsored agencies such as Fannie Mae ("FNMA"), Freddie Mac ("FHLMC") and Ginnie Mae ("GNMA"). The Company's municipal bond portfolio of $128 million as of December 31, 2018 has an average tax equivalent yield of 3.70% with an average maturity of 11.5 years. The average dollar amount invested in each security is $0.5 million. The portfolio has 74% rated "A" or better and the remaining portfolio is unrated, as the issuances represented small issuances of revenue bonds. Additional credit support has been purchased by the issuer for 40% of the portfolio, while 60% has no additional credit support. Management re-underwrites 100% of the portfolio on an annual basis, using the same guidelines that are used to underwrite its commercial loans. Revenue bonds were 68% of the portfolio, while the remaining 32% were general obligation bonds. Geographically, the portfolio supports the Company's footprint, with 47% of the portfolio being from municipalities throughout West Virginia, and the remainder from communities in Kentucky, Texas, Ohio and various other states. TABLE FIVE INVESTMENT PORTFOLIO The carrying value of the Company's securities are presented in the following table (in thousands): The Company's mortgage-backed U.S. government agency securities consist of both residential and commercial securities, all of which are guaranteed by Fannie Mae ("FNMA"), Freddie Mac ("FHLMC"), or Ginnie Mae ("GNMA"). Marketable equity securities consist of investments made by the Company in equity positions of various community banks. Non-marketable equity securities consist of Federal Home Loan Bank ("FHLB") stock and Federal Reserve Bank ("FRB") stock. The Company's certificates of deposit consist of domestically issued certificates of deposits in denominations of less than the FDIC insurance limit of $250,000. At December 31, 2018, there were no securities of any non-governmental issuers whose aggregate carrying or estimated fair value exceeded 10% of shareholders’ equity. The weighted average yield of the Company's investment portfolio is presented in the following table (dollars in thousands): Weighted-average yields on tax-exempt obligations of states and political subdivisions have been computed on a taxable-equivalent basis using the federal statutory tax rate of 21%. Average yields on investments available-for-sale are computed based on amortized cost. Mortgage-backed securities have been allocated to their respective maturity groupings based on their contractual maturity. TABLE SIX LOAN PORTFOLIO The composition of the Company’s loan portfolio as of the dates indicated follows (in thousands): Residential real estate loans increased $189 million from December 31, 2017 to $1.66 billion at December 31, 2018. The acquisitions of Poage and Farmers Deposit accounted for $156 million of the increase. Residential real estate loans include loans for the purchase or refinance of consumers' residence and first-priority home equity loans allow consumers to borrow against the equity in their home. These loans primarily consist of single family three- and five-year adjustable rate mortgages with terms that amortize up to 30 years. City National also offers fixed-rate residential real estate loans that are sold in the secondary market; once sold these loans are not included on the Company's balance sheet and City National does not retain the servicing rights to these loans. Residential purchase real estate loans are generally underwritten to comply with Fannie Mae guidelines, while first priority home equity loans are underwritten with typically less documentation, lower loan-to-value ratios and shorter maturities. At December 31, 2018, $22 million of the residential real estate loans were for properties under construction. Home equity loans increased $14 million from December 31, 2017 to $153 million at December 31, 2018. The acquisitions of Poage and Farmers Deposit accounted for $10 million of the increase. City National's home equity loans represent loans to consumers that are secured by a second (or junior) priority lien on a residential property. Home equity loans allow consumers to borrow against the equity in their home without paying off an existing first priority lien. These loans include home equity lines of credit ("HELOC") and amortized home equity loans that require monthly installment payments. Second priority lien home equity loans are underwritten with less documentation than first priority lien residential real estate loans but typically have similar loan-to-value ratios and other terms as first priority lien residential real estate loans. The amount of credit extended is directly related to the value of the real estate securing the loan at the time the loan is made. All mortgage loans, whether fixed rate or adjustable rate, are originated in accordance with acceptable industry standards and comply with regulatory requirements. Fixed rate mortgage loans are processed and underwritten in accordance with Fannie Mae and Freddie Mac guidelines, while adjustable rate mortgage loans are underwritten in accordance with City National's internal loan policy. The commercial and industrial ("C&I") loan portfolio consists of loans to corporate and other legal entity borrowers, primarily small to mid-size industrial and commercial companies. C&I loans typically involve a higher level of risk than other loan types, including industry specific risks such as the pertinent economy, new technology, labor rates and cyclicality, as well as customer specific factors, such as cash flow, financial structure, operating controls and asset quality. Collateral securing these loans includes equipment, machinery, inventory, receivables and vehicles. C&I loans increased $78 million to $286 million at December 31, 2018, with the acquisitions of Poage and Farmers Deposit accounting for $37 million of the increase. Commercial real estate loans consist of commercial mortgages, which generally are secured by nonresidential and multi-family residential properties, including hotel/motel and apartment lending. Commercial real estate loans are to many of the same customers and carry similar industry risks as C&I loans, but have different collateral risk. Commercial real estate loans increased $156 million to $1.43 billion at December 31, 2018, with the acquisitions of Poage and Farmers Deposit accounting for $139 million of the increase. At December 31, 2018, $38 million of the commercial real estate loans were for commercial properties under construction. The Company categorizes commercial loans by industry according to the North American Industry Classification System ("NAICS") to monitor the portfolio for possible concentrations in one or more industries. Management monitors industry concentrations against internally established risk-based capital thresholds. As of December 31, 2018, City National was within its internally designated concentration limits. As of December 31, 2018, City National's loans to borrowers within the Lessors of Nonresidential Buildings categories exceeded 10% of total loans (12%). No other NAICS industry classification exceeded 10% of total loans as of December 31, 2018. Management also monitors non-owner occupied commercial real estate as a percent of risk based capital (based upon regulatory guidance). At December 31, 2018, the Company had $1.30 billion of commercial loans classified as non-owner occupied and was within its designated concentration threshold. Consumer loans may be secured by automobiles, boats, recreational vehicles, certificates of deposit and other personal property or they may be unsecured. The Company manages the risk associated with consumer loans by monitoring such factors as portfolio size and growth, internal lending policies and pertinent economic conditions. City National's underwriting standards are continually evaluated and modified based upon these factors. Consumer loans increased $22 million from 2017 to $51 million at December 31, 2018, with the acquisitions of Poage and Farmers Deposit accounting for $19 million of the increase. The following table shows the scheduled maturity of loans outstanding as of December 31, 2018 (in thousands): ALLOWANCE AND PROVISION FOR LOAN LOSSES Management systematically monitors the loan portfolio and the appropriateness of the allowance for loan losses (“ALLL”) on a quarterly basis to provide for probable losses incurred in the portfolio. Management assesses the risk in each loan type based on historical delinquency and loss trends, the general economic environment of its local markets, individual loan performance, and other relevant factors. Individual credits in excess of $1 million are selected at least annually for detailed loan reviews, which are utilized by management to assess the risk in the portfolio and the appropriateness of the allowance. Due to the nature of commercial lending, evaluation of the appropriateness of the allowance as it relates to these loan types is often based more upon specific credit review, with consideration given to the potential impairment of certain credits and historical loss rates, adjusted for general economic conditions and other inherent risk factors. Conversely, due to the homogeneous nature of the real estate and installment portfolios, the portions of the allowance allocated to those portfolios are primarily based on prior loss history of each portfolio, adjusted for general economic conditions and other inherent risk factors. Risk factors considered by the Company in completing this analysis include: (1) unemployment and economic trends in the Company’s markets, (2) concentrations of credit, if any, among any industries, (3) trends in loan growth, loan mix, delinquencies, losses or credit impairment, (4) adherence to lending policies and others. Each risk factor is designated as low, moderate/increasing, or high based on the Company’s assessment of the risk to loss associated with each factor. Each risk factor is then weighted to consider probability of occurrence. The allowance not specifically allocated to individual credits is generally determined by analyzing potential exposure and other qualitative factors that could negatively impact the overall credit risk of the loan portfolio. Loans not individually evaluated for impairment are grouped by pools with similar risk characteristics and the related historical loss rates are adjusted to reflect current inherent risk factors, such as unemployment, overall economic conditions, concentrations of credit, loan growth, classified and impaired loan trends, staffing, adherence to lending policies, and loss trends. Determination of the allowance for loan losses is subjective in nature and requires management to periodically reassess the validity of its assumptions. Differences between actual losses and estimated losses are assessed such that management can timely modify its assumptions model to ensure that adequate provision has been made for risk in the total loan portfolio. The Company's (recovery of) provision for loan losses for the past three years are shown in the table below (in thousands): During the year ended December 31, 2018, the Company liquidated repossessed assets associated with the Kentucky Fuels Corporate credit. As a result of the proceeds from this liquidation, the Company recovered $1.3 million related to this credit. Additionally, as a result of this recovery, the historical loss rate used to compute the allowance not specifically allocated to individual credits in the Company's commercial and industrial mining and energy sector (per the North American Industry Classification system ("NAICS")) improved and an additional release of reserve of $1.7 million was recognized during the year ended December 31, 2018. The company also received a $0.4 million recovery through a settlement from a commercial customer during the quarter ended December 31, 2018. The provision for loan losses recorded in 2017 reflected the revisions to the regulatory rating of a previously classified shared national credit ("SNC") in which the Company is a participant, changes in the quality of the portfolio and general improvement in the Company's historical loss rates used to compute the allowance not specifically allocated to individual credits. This credit was for a local customer that outgrew the lending limit of the Company and involves three local banks. The reserve recorded in 2017 of $1.1 million related to this credit reflects the loss factors associated with the rating assigned to this credit as a result of the current year review by the Office of the Comptroller of the Currency ("OCC"). The provision for loan losses recorded in 2016 reflected the impact of several factors, including the growth in the loan portfolio and changes in the quality of the portfolio. Additionally, during the fourth quarter of 2016, a commercial customer of the Company with a hotel and motel related credit whose business is located in North Central West Virginia experienced a downfall in occupancy rates as a result of a slowdown in the oil and gas industry. As a result, the Company increased the allowance for loan losses in the fourth quarter in relation to this loan. Beyond this particular loan, the Company has very limited exposure to the oil and gas industry and does not have any direct loans to any oil and gas operations. Changes in the amount of the allowance and related provision are based on the Company's detailed systematic methodology and are directionally consistent with changes in the composition and quality of the Company's loan portfolio. The Company believes its methodology for determining the adequacy of its ALLL adequately provides for probable losses inherent in the loan portfolio and produces a provision and allowance for loan losses that is directionally consistent with changes in asset quality and loss experience. The Company's net charge-offs for the past three years are shown in the table below (in thousands): Net charge-offs in 2018 consisted primarily of net charge-offs on DDA overdraft loans of $1.2 million and consumer loans of $0.6 million that were partially offset by net recoveries on commercial and industrial loans of $1.4 million and commercial real estate loans of $0.4 million. Net charge-offs in 2017 consisted primarily of net charge-offs on residential real estate loans of $1.3 million, DDA overdraft loans of $1.3 million and commercial real estate loans of $0.6 million. Net charge-offs in 2016 consisted primarily of net charge-offs on residential real estate loans of $1.5 million, commercial real estate loans of $1.2 million and DDA overdraft loans of $0.6 million. Based on the Company’s analysis of the appropriateness of the allowance for loan losses and in consideration of the known factors utilized in computing the allowance, management believes that the allowance for loan losses as of December 31, 2018 is adequate to provide for probable losses inherent in the Company’s loan portfolio. Future provisions for loan losses will be dependent upon trends in loan balances including the composition of the loan portfolio, changes in loan quality and loss experience trends, and recoveries of previously charged-off loans, among other factors. TABLE SEVEN ANALYSIS OF THE ALLOWANCE FOR LOAN LOSSES An analysis of changes in the Company's allowance for loan losses follows (dollars in thousands): TABLE EIGHT NON-ACCRUAL AND PAST-DUE LOANS The Company's nonperforming assets and past-due loans were as follows (dollars in thousands): The Company’s ratio of non-performing assets to total loans and other real estate owned increased from 0.45% at December 31, 2017 to 0.54% at December 31, 2018. Excluded from this ratio are purchased credit-impaired ("PCI") loans in which the Company estimated cash flows and estimated a credit mark. Such loans would be considered nonperforming loans if the loan's performance deteriorates below the Company's initial expectation. Total past due loans increased from $11.0 million, or 0.35% of total loans outstanding, at December 31, 2017 to $13.1 million, or 0.37% of total loans outstanding, at December 31, 2018. Acquired past due loans from Poage and Farmers Deposit represent approximately 37% of the total past due loans at December 31, 2018. Interest on loans is accrued and credited to operations based upon the principal amount outstanding. The accrual of interest income is generally discontinued when a loan becomes 90 days past due as to principal or interest unless the loan is well collateralized and in the process of collection. When interest accruals are discontinued, interest credited to income that is unpaid and deemed uncollectible is reversed and charged to operations. TABLE NINE IMPAIRED LOANS Information pertaining to the Company's impaired loans is included in the following table (in thousands): Impaired loans with a valuation allowance at the end of 2018 were comprised of one commercial borrowing relationship that was evaluated during 2017 and determined that an allowance was necessary, as the present value of expected cash flows was less than the outstanding amount of the loan. There were no commitments to provide additional funds on non-accrual, impaired, or other potential problem loans at December 31, 2018 and 2017. TABLE TEN RESTRUCTURED LOANS The following table sets forth the Company’s troubled debt restructurings ("TDRs") (in thousands): Regulatory guidance requires loans to be accounted for as collateral-dependent loans when borrowers have filed Chapter 7 bankruptcy, the debt has been discharged by the bankruptcy court and the borrower has not reaffirmed the debt. The filing of bankruptcy is deemed to be evidence that the borrower is in financial difficulty and the discharge of the debt by the bankruptcy court is deemed to be a concession granted to the borrower. The Company's troubled debt restructurings ("TDRs") related to its borrowers who had filed for Chapter 7 bankruptcy protection make up 76% of the Company's total TDRs as of December 31, 2018. The average age of these TDRs was 12.1 years; the average current balance as a percentage of the original balance was 68.2%; and the average loan-to-value ratio was 65.8% as of December 31, 2018. Of the total 498 Chapter 7 related TDRs, 34 had an estimated loss exposure based on the current balance and appraised value at December 31, 2018. TABLE ELEVEN ALLOCATION OF THE ALLOWANCE FOR LOAN LOSSES The allocation of the allowance for loan losses by portfolio segment and the percent of loans in each category to total loans is shown in the table below (dollars in thousands). The allocation of a portion of the allowance in one portfolio segment does not preclude its availability to absorb losses in other portfolio segments. The allowance attributed to the commercial and industrial loan portfolio decreased $0.5 million from $4.6 million at December 31, 2017 to $4.1 million at December 31, 2018. This decrease is primarily due to proceeds resulting from the liquidation of repossessed assets and the resulting improvement in the historical loss rate used to compute the allowance in the Company's commercial and industrial mining and energy sector. The allowance attributed to the commercial real estate loan portfolio decreased $1.7 million from $6.2 million at December 31, 2017 to $4.5 million at December 31, 2018. This decrease is primarily attributable to improvements in the historical loss rates in the portfolio and a decrease in risk-rated commercial real estate loans. The allowance attributed to the residential real estate portfolio decreased $1.1 million from $5.2 million at December 31, 2017 to $4.1 million at December 31, 2018. The decrease is primarily attributable to improvements in the historical loss rates in the portfolio. GOODWILL The Company evaluates the recoverability of goodwill and indefinite lived intangible assets annually as of November 30th, or more frequently if events or changes in circumstances warrant, such as a material adverse change in the Company's business. Goodwill is considered to be impaired when the carrying value of a reporting unit exceeds its estimated fair value. Indefinite-lived intangible assets are considered impaired if their carrying value exceeds their estimated fair value. As described in Note One of the Notes to Consolidated Financial Statements, the Company conducts its business activities through one reportable business segment - community banking. Fair values are estimated by reviewing the Company’s stock price as it compares to book value and the Company’s reported earnings. In addition, the impact of future earnings and activities are considered in the Company’s analysis. The Company had approximately $110 million and $76 million of goodwill at December 31, 2018 and 2017, respectively, and no impairment was required to be recognized in 2018 or 2017, as the estimated fair value of the Company has continued to exceed its book value. CERTIFICATES OF DEPOSIT Scheduled maturities of time certificates of deposit of $100,000 or more at December 31, 2018 are summarized in the table below (in thousands). The Company has time certificates of deposit that meet or exceed the FDIC insurance limit of $250,000 totaling $172.2 million (approximately 13% of total time deposits). TABLE TWELVE MATURITY DISTRIBUTION OF CERTIFICATES OF DEPOSIT OF $100,000 OR MORE FAIR VALUE MEASUREMENTS The Company determines the fair value of its financial instruments based on the fair value hierarchy established in ASC Topic 820, whereby the fair value of certain assets and liabilities is an exit price, representing the amount that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants. ASC Topic 820 establishes a three-level hierarchy for disclosure of assets and liabilities recorded at fair value. The hierarchy classification is based on whether the inputs in the methodology for determining fair value are observable or unobservable. Observable inputs reflect market-based information obtained from independent sources (Level 1 or Level 2), while unobservable inputs reflect management’s estimate of market data (Level 3). Assets and liabilities that are actively traded and have quoted prices or observable market data require a minimal amount of subjectivity concerning fair value. Management’s judgment is necessary to estimate fair value when quoted prices or observable market data are not available. At December 31, 2018, approximately 15% of total assets, or $751 million, consisted of financial instruments recorded at fair value. Most of these financial instruments used valuation methodologies involving observable market data, collectively Level 1 and Level 2 measurements, to determine fair value. At December 31, 2018, approximately $17 million of derivative liabilities were recorded at fair value using methodologies involving observable market data. The Company does not believe that any changes in the unobservable inputs used to value the financial instruments mentioned above would have a material impact on the Company’s results of operations, liquidity, or capital resources. See Note Twenty of the Notes to Consolidated Financial Statements for additional information regarding ASC Topic 820 and its impact on the Company’s financial statements. CONTRACTUAL OBLIGATIONS The Company has various financial obligations that may require future cash payments according to the terms of the obligations. Demand, both noninterest- and interest-bearing, and savings deposits are, generally, payable immediately upon demand at the request of the customer. Therefore, the contractual maturity of these obligations is presented in the following table as “less than one year.” Time deposits, typically certificates of deposit, are customer deposits that are evidenced by an agreement between the Company and the customer that specify stated maturity dates; early withdrawals by the customer are subject to penalties assessed by the Company. Short-term borrowings and long-term debt represent borrowings of the Company and have stated maturity dates. Capital and operating leases between the Company and the lessor have stated expiration dates and renewal terms. TABLE THIRTEEN CONTRACTUAL OBLIGATIONS The composition of the Company's contractual obligations as of December 31, 2018 is presented in the following table (in thousands): (1) Includes interest on both fixed- and variable-rate obligations. The interest associated with variable-rate obligations is based upon interest rates in effect at December 31, 2018. The contractual amounts to be paid on variable-rate obligations are affected by market interest rates that could materially affect the contractual amounts to be paid. The Company’s liability for uncertain tax positions at December 31, 2018 was $1.8 million pursuant to ASC Topic 740. This liability represents an estimate of tax positions that the Company has taken in its tax returns that may ultimately not be sustained upon examination by tax authorities. As the ultimate amount and timing of any future cash settlements cannot be predicted with reasonable reliability, this estimated liability has been excluded from the contractual obligations table. OFF-BALANCE SHEET ARRANGEMENTS As disclosed in Note Seventeen of the Notes to Consolidated Financial Statements, the Company has also entered into agreements with its customers to extend credit or to provide conditional commitments to provide payment on drafts presented in accordance with the terms of the underlying credit documents (including standby and commercial letters of credit). The Company also provides overdraft protection to certain demand deposit customers that represent an unfunded commitment. As a result of the Company’s off-balance sheet arrangements for 2018 and 2017, no material revenue, expenses, or cash flows were recognized. In addition, the Company had no other indebtedness or retained interests nor entered into agreements to extend credit or provide conditional payments pursuant to standby and commercial letters of credit. CAPITAL RESOURCES During 2018, Shareholders’ Equity increased $98 million, or 19.6%, from $503 million at December 31, 2017 to $601 million at December 31, 2018. This increase was primarily due to the acquisition of Poage of $83 million and net income of $70 million, partially offset by cash dividends declared of $31 million and common share repurchases of $20 million. On September 24, 2014, the Company announced that the Board of Directors authorized the Company to buy back up to 1,000,000 shares of its common shares (approximately 7% of outstanding shares at the time) in open market transactions at prices that are accretive to the earnings per share of continuing shareholders. During the year ended December 31, 2017, the Company did not repurchase any common shares. During the year ended December 31, 2018, the Company repurchased approximately 290,000 common shares at a weighted average price of $69.78. On February 27, 2019, the Company announced that the Board of Directors rescinded the 2014 plan and authorized the Company to buy back up to 1,000,000 shares of its common stock (approximately 6% of the outstanding shares), in open market transactions, at prices that are accretive to continuing shareholders. No timetable was placed on the duration of this share repurchase program. On December 19, 2016, the Company announced that it had filed a prospectus supplement to its existing shelf registration statement on Form S-3 for the sale of its common stock having an aggregate value of up to $55 million through an "at-the-market" equity offering program. Through the year ended December 31, 2018, the Company has sold approximately 548,000 common shares at a weighted average price of $64.82, net of broker fees. The Company has sold no shares since the first quarter of 2017. To date, the Company has received $36.4 million in gross proceeds. Under the program, the Company has the ability to receive an additional $18.6 million in gross proceeds from the sale of common shares. In July 2013, the Federal Reserve published the final rules that established a new comprehensive capital framework for banking organizations, commonly referred to as Basel III. These final rules substantially revised the risk-based capital requirements applicable to bank holding companies and depository institutions. The final rule became effective January 1, 2015 for smaller, non-complex banking organizations with full implementation by January 1, 2019. On January 1, 2019, the Basel III Capital Rules will require City Holding and City National to maintain minimum CET 1, Tier 1 and Total Capital ratios, along with a capital conservation buffer that will become fully phased in on that date, effectively resulting in new minimum capital ratios (which are shown in the table below). The implementation of the capital conservation buffer began on January 1, 2016 at the 0.625% level and was phased in over a four-year period (increasing by that amount on each subsequent January 1, until it reached 2.5% on January 1, 2019). The capital conservation buffer is designed to absorb losses during periods of economic stress. Banking institutions with a ratio of CET 1 capital to risk-weighted assets above the minimum but below the conservation buffer (or below the combined capital conservation buffer and countercyclical capital buffer, when the latter is applied) will face constraints on dividends, equity repurchases and compensation based on the amount of the shortfall. The Basel III Capital Rules also provide for a “countercyclical capital buffer” that is applicable to only certain covered institutions and does not have any current applicability to City Holding Company or City National Bank. The Company’s regulatory capital ratios for both City Holding and City National are illustrated in the following tables (in thousands): As of December 31, 2018, management believes that City Holding Company, and its banking subsidiary, City National, were “well capitalized.” City Holding is subject to regulatory capital requirements administered by the Federal Reserve, while City National is subject to regulatory capital requirements administered by the OCC and the FDIC. Regulatory agencies can initiate certain mandatory actions if either City Holding or City National fails to meet the minimum capital requirements, as shown above. As of December 31, 2018, management believes that City Holding and City National meet all capital adequacy requirements. On May 24, 2018, the Economic Growth, Regulatory Relief, and Consumer Protection Act (the "Regulatory Relief Act") went into effect. The Regulatory Relief Act provides for a simplification of the minimum capital level requirements applicable to the Company. The federal bank regulatory agencies have not yet issued final rules regarding this change, but it is expected that a to-be-developed community bank leverage ratio requirement of tangible equity to average consolidated assets between eight to ten percent will replace the Basel III Capital Rules applicable to the Company. There can be no assurances, however, as to the substance of the final rule or its effect on the Company. LEGAL ISSUES The Company is engaged in various legal actions that it deems to be in the ordinary course of business. As these legal actions are resolved, the Company could realize impacts to its financial performance in the period in which these legal actions are ultimately decided. There can be no assurance that current actions will have immaterial results, or that no material actions may be presented in the future. RECENT ACCOUNTING PROCOUNCEMENTS AND DEVELOPMENTS Note Two, “Recent Accounting Pronouncements,” of the Notes to Consolidated Financial Statements discusses recently issued new accounting pronouncements and their expected impact on the Company’s consolidated financial statements.

<s>[INST] The information noted below is provided pursuant to Guide 3 Statistical Disclosure by Bank Holding Companies. Description of Information Page Reference 1. Distribution of Assets, Liabilities and Stockholders' Equity; Interest Rates and Interest Differential a. Average Balance Sheets b. Analysis of Net Interest Earnings c. Rate Volume Analysis of Changes in Interest Income and Expense 2. Investment Portfolio a. Book Value of Investments b. Maturity Schedule of Investments c. Securities of Issuers Exceeding 10% of Stockholders’ Equity 3. Loan Portfolio a. Types of Loans b. Maturities and Sensitivity to Changes in Interest Rates c. Risk Elements d. Other Interest Bearing Assets None 4. Summary of Loan Loss Experience 5. Deposits a. Breakdown of Deposits by Categories, Average Balance and Average Rate Paid b. Maturity Schedule of Time Certificates of Deposit and Other Time Deposits of $100,000 or More 6. Return on Equity and Assets 7. Shortterm Borrowings CITY HOLDING COMPANY City Holding Company (the “Company”), a West Virginia corporation headquartered in Charleston, West Virginia, is a registered financial holding company under the Bank Holding Company Act and conducts its principal activities through its wholly owned subsidiary, City National Bank of West Virginia ("City National"). City National is a retail and consumeroriented community bank with 100 bank branches in West Virginia (58), Kentucky (24), Virginia (14) and Ohio (4). City National provides credit, deposit, and trust and investment management services to its customers in a broad geographical area that includes many rural and small community markets in addition to larger cities including Charleston (WV), Huntington (WV), Martinsburg (WV), Ashland (KY), Lexington (KY), Winchester (VA) and Staunton (VA). In the Company's key markets, the Company's primary subsidiary, City National, generally ranks in the top three relative to deposit market share and the top two relative to branch share (Charleston/Huntington MSA, Beckley/Lewisburg counties, Staunton MSA and Winchester, VA/WV Eastern Panhandle counties). In addition to its branch network, City National's delivery channels include automatedtellermachines ("ATMs"), interactivetellermachines ("ITMs"), mobile banking, debit cards, interactive voice response systems, and Internet technology. The Company’s business activities are currently limited to one reportable business segment, which is community banking. In July 2018, the Company announced that it had concurrently executed two separate definitive agreements to acquire Poage Bankshares, Inc., of Ashland, Kentucky and its principal banking subsidiary, Town Square Bank (collectively, "Poage") and Farmers Deposit Bancorp, Inc., of Cynthiana, Kentucky and its principal banking subsidiary, Farmers Deposit Bank (collectively, "Farmers Deposit"). The acquisitions were finalized in December 2018. Poage operated nine branches across northeastern Kentucky, along with a loan production office in Cincinnati, Ohio. Farmers Deposit operated three branches around the Lexington, Kentucky region. As a result of overlapping service areas, the Company plans to merge three of the Poage branches into existing City branches and two existing City branches into former Poage branches. In January 2019, the Company announced the signing of a definitive agreement to sell its Virginia Beach, Virginia, branch to Select Bancorp, Inc., the holding company for Select Bank & Trust Company. The transaction is expected to close during the second quarter of 2019. After the PoageCity branch mergers and the Virginia Beach branch divestiture, the Company expects to have 94 bank branches in its network. CRITICAL ACCOUNTING POLICIES The accounting policies of the Company conform to U.S. generally accepted accounting principles and require management to make estimates and develop assumptions [/INST] Negative. </s>

CITY HOLDING CO

2020-02-27

2019-12-31

Item 7.Management's Discussion and Analysis of Financial Condition and Results of Operations Statistical Information The information noted below is provided pursuant to Guide 3 -- Statistical Disclosure by Bank Holding Companies. Description of Information Page Reference 1. Distribution of Assets, Liabilities and Stockholders' Equity; Interest Rates and Interest Differential a. Average Balance Sheets b. Analysis of Net Interest Earnings c. Rate Volume Analysis of Changes in Interest Income and Expense 2. Investment Portfolio a. Book Value of Investments b. Maturity Schedule of Investments c. Securities of Issuers Exceeding 10% of Stockholders’ Equity 3. Loan Portfolio a. Types of Loans b. Maturities and Sensitivity to Changes in Interest Rates c. Risk Elements d. Other Interest Bearing Assets None 4. Summary of Loan Loss Experience 5. Deposits a. Breakdown of Deposits by Categories, Average Balance and Average Rate Paid b. Maturity Schedule of Time Certificates of Deposit and Other Time Deposits of $100,000 or More 6. Return on Equity and Assets 7. Short-term Borrowings CITY HOLDING COMPANY City Holding Company (the “Company”), a West Virginia corporation headquartered in Charleston, West Virginia, is a registered financial holding company under the Bank Holding Company Act and conducts its principal activities through its wholly owned subsidiary, City National Bank of West Virginia ("City National"). City National is a retail and consumer-oriented community bank with 95 bank branches in West Virginia (58), Kentucky (20), Virginia (13) and Ohio (4). City National provides credit, deposit, and trust and investment management services to its customers in a broad geographical area that includes many rural and small community markets in addition to larger cities including Charleston (WV), Huntington (WV), Martinsburg (WV), Ashland (KY), Lexington (KY), Winchester (VA) and Staunton (VA). In the Company's key markets, the Company's primary subsidiary, City National, generally ranks in the top three relative to deposit market share and the top two relative to branch share (Charleston/Huntington MSA, Beckley/Lewisburg counties, Staunton MSA and Winchester, VA/WV Eastern Panhandle counties). In addition to its branch network, City National's delivery channels include automated-teller-machines ("ATMs"), interactive-teller-machines ("ITMs"), mobile banking, debit cards, interactive voice response systems, and Internet technology. The Company’s business activities are currently limited to one reportable business segment, which is community banking. In December 2018, the Company acquired Poage Bankshares, Inc., of Ashland, Kentucky and its principal banking subsidiary, Town Square Bank (collectively, "Poage") and Farmers Deposit Bancorp, Inc., of Cynthiana, Kentucky and its principal banking subsidiary, Farmers Deposit Bank (collectively, "Farmers Deposit"). In July 2019, the Company sold its Virginia Beach, Virginia, branch to Select Bank & Trust Company. CRITICAL ACCOUNTING POLICIES The accounting policies of the Company conform to U.S. generally accepted accounting principles and require management to make estimates and develop assumptions that affect the amounts reported in the financial statements and related footnotes. These estimates and assumptions are based on information available to management as of the date of the financial statements. Actual results could differ significantly from management’s estimates. As this information changes, management’s estimates and assumptions used to prepare the Company’s financial statements and related disclosures may also change. The most significant accounting policies followed by the Company are presented in Note One of the Notes to Consolidated Financial Statements included herein. Based on the valuation techniques used and the sensitivity of financial statement amounts to the methods, assumptions, and estimates underlying those amounts, management has identified: (i) the determination of the allowance for loan losses and (ii) income taxes to be the accounting areas that require the most subjective or complex judgments and, as such, could be most subject to revision as new information becomes available. The Allowance and Provision for Loan Losses section of this Annual Report on Form 10-K provides management’s analysis of the Company’s allowance for loan losses and related provision. The allowance for loan losses is maintained at a level that represents management’s best estimate of probable incurred losses in the loan portfolio. Management’s determination of the appropriateness of the allowance for loan losses is based upon an evaluation of individual credits in the loan portfolio, historical loan loss experience, current economic conditions, and other relevant factors. This determination is inherently subjective, as it requires material estimates including the amounts and timing of future cash flows expected to be received on impaired loans that may be susceptible to significant change. The allowance for loan losses related to loans considered to be impaired is generally evaluated based on the discounted cash flows using the impaired loan’s initial effective interest rate or the fair value of the collateral for certain collateral dependent loans. The allowance not specifically allocated to individual credits is generally determined by analyzing potential exposure and other qualitative factors that could negatively impact the overall credit risk of the loan portfolio. Loans not individually evaluated for impairment are grouped by pools with similar risk characteristics and the related historical loss rates are adjusted to reflect current inherent risk factors, such as unemployment, overall economic conditions, concentrations of credit, loan growth, classified and impaired loan trends, staffing, adherence to lending policies, and loss trends. The Income Taxes section of this Annual Report on Form 10-K provides management’s analysis of the Company’s income taxes. The Company is subject to federal and state income taxes in the jurisdictions in which it conducts business. In computing the provision for income taxes, management must make judgments regarding interpretation of laws in those jurisdictions. Because the application of tax laws and regulations for many types of transactions is susceptible to varying interpretations, amounts reported in the financial statements could be changed at a later date upon final determinations by taxing authorities. On a quarterly basis, the Company estimates its annual effective tax rate for the year and uses that rate to provide for income taxes on a year-to-date basis. The Company's unrecognized tax benefits could change over the next twelve months as a result of various factors. The Company is currently open to audit under the statute of limitations by the Internal Revenue Service and various state taxing authorities for the years ended December 31, 2016 through 2018. FINANCIAL SUMMARY The Company’s financial performance over the previous three years is summarized in the following table: *ROA (Return on Average Assets) is a measure of the effectiveness of asset utilization. ROE (Return on Average Equity) is a measure of the return on shareholders’ investment. ROATCE (Return on Average Tangible Common Equity) is a measure of the return on shareholders’ equity less intangible assets. BALANCE SHEET ANALYSIS Selected balance sheet fluctuations are summarized in the following table (in millions): Investment securities increased $75 million, from $813 million at December 31, 2018, to $888 million at December 31, 2019 as the Company elected to grow investment balances to enhance net interest income, in conjunction with its interest rate risk management strategy. Gross loans increased $29 million, from $3.59 billion at December 31, 2018 to $3.62 billion at December 31, 2019, primarily due to increases in commercial loans of $26.5 million (1.5%) and residential real estate loans of $5.1 million (0.3%). Total deposits increased $100 million, from $3.98 billion at December 31, 2018 to $4.08 billion at December 31, 2019. The Company experienced increases in savings deposits ($75.6 million), noninterest bearing deposits ($16.0 million), and time deposits ($11.9 million). Shareholders' equity increased $57 million from December 31, 2018 to December 31, 2019, primarily due to net income of $89 million and other comprehensive income of $20 million, which were partially offset by cash dividends declared of $36 million and treasury stock purchases of $19 million. TABLE TWO AVERAGE BALANCE SHEETS AND NET INTEREST INCOME (In thousands) 1. For purposes of this table, non-accruing loans have been included in average balances and the following loan fees (in thousands) have been included in interest income: 2.Includes the Company's residential real estate and home equity loan categories. 3. Included in the above table are the following amounts (in thousands) for the accretion of the fair value adjustments related to the Company's acquisitions: 4.Includes the Company’s consumer and DDA overdrafts loan categories. 5.Effective January 1, 2012, the carrying value of the Company's previously securitized loans was reduced to $0. 6. Computed on a fully federal tax-equivalent basis assuming a tax rate of approximately 21% for the years ended December 31, 2019 and 2018, and 35% for the year ended December 31, 2017. NET INTEREST INCOME 2019 vs. 2018 The Company’s net interest income increased from $138.2 million for the year ended December 31, 2018 to $161.4 million for the year ended December 31, 2019. The Company’s tax equivalent net interest income increased $23.2 million, or 16.7%, from $139.0 million for the year ended December 31, 2018 to $162.2 million for the year ended December 31, 2019. The acquisitions of Poage and Farmers Deposit accounted for $18.3 million of this increase, while higher loan yields on residential real estate and commercial loans increased net interest income $5.7 million and $1.5 million, respectively, and higher average balances on commercial loans ($51.7 million) increased interest income by $2.3 million as compared to the year ended December 31, 2018. In addition, higher average investment balances ($98.1 million) increased investment income by $3.1 million and an increase in accretion from fair value adjustments increased interest income by $2.2 million during the year ended December 31, 2019. These increases were partially offset by increased interest expense on interest bearing liabilities ($8.5 million), primarily due to an increase in the cost of funds. The Company’s reported net interest margin increased from 3.52% for the year ended December 31, 2018 to 3.59% for the year ended December 31, 2019. Excluding the favorable impact of the accretion from the fair value adjustments, the net interest margin would have been 3.51% for the year ended December 31, 2019 and 3.49% for the year ended December 31, 2018. 2018 vs. 2017 The Company's net interest income increased from $126.1 million for the year ended December 31, 2017 to $138.2 million for the year ended December 31, 2018. The Company’s tax equivalent net interest income increased $11.4 million or 8.9%, from $127.6 million in 2017 to $139.0 million in 2018. Exclusive of the impact of the acquisitions of Poage and Farmers Deposit, increased yields on commercial and residential real estate loans increased net interest income $7.8 million and $4.8 million, respectively, while higher average balances on commercial loans ($40.0 million) and residential real estate loans ($20.4 million) increased interest income by $1.6 million and $0.8 million, respectively, as compared to the year ended December 31, 2017. In addition, higher average investment balances ($68.6 million) increased investment income by $2.0 million, while interest income from deposits in depository institutions also increased $1.6 million as the Company elected to improve its on-balance sheet liquidity during the year ended December 31, 2018. These increases were partially offset by increased interest expense on interest bearing liabilities ($7.7 million), primarily due to an increase in the cost of funds. The Company’s reported net interest margin increased from 3.46% for the year ended December 31, 2017 to 3.52% for the year ended December 31, 2018. Excluding the favorable impact of the accretion from the fair value adjustments, the net interest margin would have been 3.49% for the year ended December 31, 2018 and 3.40% for the year ended December 31, 2017. Excluding the impact of the Poage and Farmers Deposit acquisitions, average interest-earning assets increased $219 million from 2017 to 2018, due to increases in deposits with depository institutions ($96 million), investment securities ($61 million), commercial, financial, and agriculture loans ($40 million) and residential real estate loans ($20 million). Average interest-bearing liabilities increased $159 million from 2017 as increases in interest bearing deposits ($82 million), time deposits ($64 million) and short-term borrowings ($34 million) were partially offset by a decrease in savings deposits ($20 million). TABLE THREE RATE/VOLUME ANALYSIS OF CHANGES IN INTEREST INCOME AND INTEREST EXPENSE (In thousands) 1. Fully federal taxable equivalent using a tax rate of approximately 21% for 2019 and 2018 and 35% for 2017. Non-GAAP Financial Measures Management of the Company uses measures in its analysis of the Company's performance other than those in accordance with generally accepted accounting principals in the United States of America ("GAAP"). These measures are useful when evaluating the underlying performance of the Company's operations. The Company's management believes that these non-GAAP measures enhance comparability of results with prior periods and demonstrate the effects of significant gains and charges in the current period. The Company's management believes that investors may use these non-GAAP financial measures to evaluate the Company's financial performance without the impact of those items that may obscure trends in the Company's performance. These disclosures should not be viewed as a substitute for financial measures determined in accordance with GAAP, nor are they comparable to non-GAAP financial measures that may be presented by other companies. TABLE FOUR NON-GAAP FINANCIAL MEASURES (In thousands) NON-INTEREST INCOME AND NON-INTEREST EXPENSE 2019 vs. 2018 Selected income statement fluctuations are summarized in the following table (dollars in millions): Non-interest income was $68.5 million for 2019 as compared to $60.6 million for 2018. During 2019, the Company reported $0.9 million of unrealized fair value gains on the Company’s equity securities compared to $0.1 million of unrealized fair value losses on the Company’s equity securities during 2018. Exclusive of these unrealized fair value gains and losses, non-interest income increased from $60.7 million for the year ended December 31, 2018 to $67.5 million for the year ended December 31, 2019. This increase was primarily attributable to an increase of $2.7 million, or 14.8%, in bankcard revenues, and an increase of $1.8 million, or 6.1%, in service charges, with $1.4 million and $1.6 million, respectively, attributable to the late 2018 acquisitions of Poage and Farmers Deposit. Additionally, other income increased by $1.0 million (due largely to the $0.7 million gain from the sale of our Virginia Beach, VA branch to Select Bank & Trust Company during the second quarter of 2019), bank owned life insurance revenues increased $0.7 million due to higher death benefit proceeds received during 2019 compared to 2018, and trust and investment management fee income increased $0.6 million. During 2019 and 2018, the Company recognized $0.8 million and $13.3 million, respectively, of acquisition and integration expenses associated with the completed acquisitions of Poage and Farmers Deposit. Excluding these expenses, non-interest expenses increased from $99.8 million for 2018 to $116.8 million for 2019. This increase was primarily due to an increase in salaries and employee benefits of $7.7 million that was largely attributable to the acquisitions of Poage and Farmers Deposit ($4.3 million), annual salary adjustments, and increased incentive compensation. Primarily due to the acquisitions of Poage and Farmers Deposit, other expenses increased $4.5 million, occupancy related expenses increased $1.3 million, equipment and software related expenses increased $1.2 million and bankcard expenses increased $1.1 million, from 2018 to 2019. Partially offsetting these increases was a decrease of $0.6 million in FDIC insurance expense. As the Deposit Insurance Fund (“DIF”) reserve ratio exceeded 1.38% at June 30, 2019, the Company received a Small Bank Assessment Credit for the full amount of its Federal Deposit Insurance Corporation (“FDIC”) assessment for the third and fourth quarters of 2019. 2018 vs. 2017 Selected income statement fluctuations are summarized in the following table (dollars in millions): During 2017, the Company realized investment gains of $4.5 million that represented partial recoveries of impairment charges previously recognized on pools of trust preferred securities. During 2018, the Company recognized $0.1 million of unrealized investment losses related to its equity and perpetual preferred securities. As a result of the adoption of ASU No. 2016-02, effective January 1, 2018, unrealized gains and losses on equity and equity-like securities are now required to be recognized in the Company's Consolidated Statements of Income. Exclusive of these gains and losses, non-interest income increased from $59.1 million for the year ended December 31, 2017 to $60.7 million for the year ended December 31, 2018. This increase was primarily attributable to an increase of $1.2 million, or 7.3%, in bankcard revenues and an increase of $1.1 million, or 4.0%, in service charges. These increases were partially offset by a decrease of $1.1 million in bank owned life insurance revenues due to lower death benefit proceeds received during 2018 as compared to 2017. During 2018, the Company recognized $13.3 million of merger related expenses associated with the completed acquisitions of Poage and Farmers Deposit. Excluding these expenses, non-interest expenses increased from $96.0 million for 2017 to $99.8 million for 2018. This increase was primarily due to an increase in salaries and employee benefits of $3.3 million that was largely attributable to annual salary adjustments, including an adjustment to wages for approximately 50% of the Company's employees late in the first quarter of 2018 to make salaries more competitive in the current employment environment. Additionally, the Company experienced increases in bankcard expenses of $0.6 million and other expenses of $0.5 million. INCOME TAXES Selected information regarding the Company's income taxes is presented in the table below (dollars in millions): A reconciliation of the effective tax rate to the statutory rate is included in Note Fourteen of the Notes to Consolidated Financial Statements. The Company's effective income tax rate for the year ended December 31, 2019 was 21.3%, compared to 20.5% and 40.2% for the years ended December 31, 2018 and 2017, respectively. Deferred income taxes reflect the net tax effects of temporary differences between the carrying amount of assets and liabilities for financial reporting purposes and the amounts used for income tax purposes. The Company’s net deferred tax assets decreased from $17.3 million at December 31, 2018 to $6.7 million at December 31, 2019. The components of the Company’s net deferred tax assets are disclosed in Note Fourteen of the Notes to Consolidated Financial Statements. Realization of the most significant net deferred tax assets is primarily dependent on future events taking place that will reverse the current deferred tax assets. The deferred tax asset and/or liability associated with unrealized securities losses and/or gains is the tax impact of the unrealized gains and/or losses on the Company’s available-for-sale security portfolio. The impact of the Company’s unrealized losses is noted in the Company’s Consolidated Statements of Changes in Shareholders’ Equity as an adjustment to Accumulated Other Comprehensive Income (Loss). This deferred tax asset would be realized if the unrealized securities losses on the Company's securities were realized from either the sales or maturities of the related securities. The deferred tax asset associated with the allowance for loan losses is expected to be realized as additional loan charge-offs, which have already been provided for within the Company’s financial statements, are recognized for tax purposes. The Company believes that it is more likely than not that each of the deferred tax assets will be realized and that no significant valuation allowances were necessary as of December 31, 2019 or 2018. LIQUIDITY The Company evaluates the adequacy of liquidity at both the Parent Company level and at the banking subsidiary level. At the Parent Company level, the principal source of cash is dividends from its banking subsidiary, City National. Dividends paid by City National to the Parent Company are subject to certain legal and regulatory limitations. Generally, any dividends in amounts that exceed the earnings retained by City National in the current year plus retained net profits for the preceding two years must be approved by regulatory authorities. At December 31, 2019, City National could pay dividends up to $76.8 million without prior regulatory permission. During 2019, the Parent Company used cash obtained from the dividends received primarily to: (1) pay common dividends to shareholders and (2) fund repurchases of the Company's common shares. Additional information concerning sources and uses of cash by the Parent Company is discussed in Note Twenty-One of the Notes to Consolidated Financial Statements. On January 29, 2020, the Board of Directors of the Company authorized repayment of its Subordinated Debentures assumed by the Company as part of its acquisition of Poage at a price of 100% of the principal amount. Town Square Statutory Trust I will repay its Capital Securities on March 16, 2020 at a price of 100%. These securities were issued in December 2006 and were callable in whole or in part any time after December 22, 2012. All regulatory approvals have been received by the Company to redeem these securities. The Parent Company anticipates continuing the payment of dividends, which are expected to approximate $37.2 million on an annualized basis for 2020 based on common shareholders of record at December 31, 2019 at a dividend rate of $2.28 per share for 2020. However, dividends to shareholders can, if necessary, be suspended. In addition to these anticipated cash needs, the Parent Company has operating expenses and other contractual obligations, which are estimated to require $1.4 million of additional cash over the next 12 months. As of December 31, 2019, the Parent Company reported a cash balance of $26.2 million and management believes that the Parent Company’s available cash balance, together with cash dividends from City National, will be adequate to satisfy its funding and cash needs over the next twelve months. Excluding the dividend payments discussed above, the Parent Company has no significant commitments or obligations in years after 2020. City National manages its liquidity position in an effort to effectively and economically satisfy the funding needs of its customers and to accommodate the scheduled repayment of borrowings. Funds are available to City National from a number of sources, including depository relationships, sales and maturities within the investment securities portfolio, and borrowings from the Federal Home Loan Bank ("FHLB") and other financial institutions. As of December 31, 2019, City National’s assets are significantly funded by deposits and capital. City National maintains borrowing facilities with the FHLB and other financial institutions that can be accessed as necessary to fund operations and to provide contingency funding mechanisms. As of December 31, 2019, City National had the capacity to borrow an additional $1.9 billion from the FHLB and other financial institutions under existing borrowing facilities. City National maintains a contingency funding plan, incorporating these borrowing facilities, to address liquidity needs in the event of an institution-specific or systemic financial industry crisis. Also, although it has no current intention to do so, City National could liquidate its unpledged securities, if necessary, to provide an additional funding source. City National also segregates certain mortgage loans, mortgage-backed securities, and other investment securities in a separate subsidiary so that it can separately monitor the asset quality of these primarily mortgage-related assets, which could be used to raise cash through securitization transactions or obtain additional equity or debt financing if necessary. The Company manages its asset and liability mix to balance its desire to maximize net interest income against its desire to minimize risks associated with capitalization, interest rate volatility, and liquidity. With respect to liquidity, the Company has chosen a conservative posture and believes that its liquidity position is strong. As illustrated in the Consolidated Statements of Cash Flows, the Company generated $98.6 million of cash from operating activities during 2019, primarily from interest income received on loans and investments, net of interest expense paid on deposits and borrowings. The Company has obligations to extend credit, but these obligations are primarily associated with existing home equity loans that have predictable borrowing patterns across the portfolio. The Company has investment security balances with carrying values that totaled $888 million at December 31, 2019, and that greatly exceeded the Company’s non-deposit sources of borrowing, which totaled $215 million. The Company’s net loan to asset ratio is 71.8% as of December 31, 2019 and deposit balances fund 81.2% of total assets as compared to 70.8% for its peers (Bank Holding Company Peer Group, as of the most recent data available of September 30, 2019, which includes commercial banks with assets ranging from $3 billion to $10 billion). Further, the Company’s deposit mix has a very high proportion of transaction and savings accounts that fund 54.0% of the Company’s total assets and the Company uses time deposits over $250,000 to fund just 3.4% of total assets compared to its peers, which fund 12.0% of total assets with such deposits. INVESTMENTS The Company’s investment portfolio increased $75 million from $813 million at December 31, 2018, to $888 million at December 31, 2019. The investment portfolio is structured to provide flexibility in managing liquidity needs and interest rate risk, while providing acceptable rates of return. The majority of the Company’s investment securities continue to be mortgage-backed securities. The mortgage-backed securities in which the Company has invested are predominantly underwritten to the standards of, and guaranteed by government-sponsored agencies such as Fannie Mae ("FNMA"), Freddie Mac ("FHLMC") and Ginnie Mae ("GNMA"). The Company's municipal bond portfolio of $117 million as of December 31, 2019 has an average tax equivalent yield of 3.83% with an average maturity of 11.1 years. The average dollar amount invested in each security is $0.6 million. The portfolio has 76% rated "A" or better and the remaining portfolio is unrated, as the issuances represented small issuances of revenue bonds. Additional credit support has been purchased by the issuer for 37% of the portfolio, while 62% has no additional credit support. Management re-underwrites 100% of the portfolio on an annual basis, using the same guidelines that are used to underwrite its commercial loans. Revenue bonds were 54% of the portfolio, while the remaining 46% were general obligation bonds. Geographically, the portfolio supports the Company's footprint, with 42% of the portfolio being from municipalities throughout West Virginia, and the remainder from communities in Colorado, Washington, Ohio and various other states. TABLE FIVE INVESTMENT PORTFOLIO The carrying value of the Company's securities are presented in the following table (in thousands): The Company's mortgage-backed U.S. government agency securities consist of both residential and commercial securities, all of which are guaranteed by Fannie Mae ("FNMA"), Freddie Mac ("FHLMC"), or Ginnie Mae ("GNMA"). Marketable equity securities consist of investments made by the Company in equity positions of various community banks. Non-marketable equity securities consist of Federal Home Loan Bank ("FHLB") stock and Federal Reserve Bank ("FRB") stock. At December 31, 2019, there were no securities of any non-governmental issuers whose aggregate carrying or estimated fair value exceeded 10% of shareholders’ equity. The weighted average yield of the Company's investment portfolio is presented in the following table (dollars in thousands): Weighted-average yields on tax-exempt obligations of states and political subdivisions have been computed on a taxable-equivalent basis using the federal statutory tax rate of 21%. Average yields on investments available-for-sale are computed based on amortized cost. Mortgage-backed securities have been allocated to their respective maturity groupings based on their contractual maturity. TABLE SIX LOAN PORTFOLIO The composition of the Company’s loan portfolio as of the dates indicated follows (in thousands): Residential real estate loans increased $5 million from December 31, 2018 to $1.64 billion at December 31, 2019. Residential real estate loans include loans for the purchase or refinance of consumers' residence and first-priority home equity loans allow consumers to borrow against the equity in their home. These loans primarily consist of single family three- and five-year adjustable rate mortgages with terms that amortize up to 30 years. City National also offers fixed-rate residential real estate loans that are sold in the secondary market; once sold these loans are not included on the Company's balance sheet and City National does not retain the servicing rights to these loans. Residential purchase real estate loans are generally underwritten to comply with Fannie Mae and Freddie Mac guidelines, while first priority home equity loans are underwritten with typically less documentation, lower loan-to-value ratios and shorter maturities. At December 31, 2019, $29 million of the residential real estate loans were for properties under construction. Home equity loans decreased $5 million from December 31, 2018 to $149 million at December 31, 2019. City National's home equity loans represent loans to consumers that are secured by a second (or junior) priority lien on a residential property. Home equity loans allow consumers to borrow against the equity in their home without paying off an existing first priority lien. These loans include home equity lines of credit ("HELOC") and amortized home equity loans that require monthly installment payments. Second priority lien home equity loans are underwritten with less documentation than first priority lien residential real estate loans but typically have similar loan-to-value ratios and other terms as first priority lien residential real estate loans. The amount of credit extended is directly related to the value of the real estate securing the loan at the time the loan is made. All mortgage loans, whether fixed rate or adjustable rate, are originated in accordance with acceptable industry standards and comply with regulatory requirements. Fixed rate mortgage loans are processed and underwritten in accordance with Fannie Mae and Freddie Mac guidelines, while adjustable rate mortgage loans are underwritten in accordance with City National's internal loan policy. The commercial and industrial ("C&I") loan portfolio consists of loans to corporate and other legal entity borrowers, primarily small to mid-size industrial and commercial companies. C&I loans typically involve a higher level of risk than other loan types, including industry specific risks such as the pertinent economy, new technology, labor rates and cyclicality, as well as customer specific factors, such as cash flow, financial structure, operating controls and asset quality. Collateral securing these loans includes equipment, machinery, inventory, receivables and vehicles. C&I loans increased $22 million to $308 million at December 31, 2019. Commercial real estate loans consist of commercial mortgages, which generally are secured by nonresidential and multi-family residential properties, including hotel/motel and apartment lending. Commercial real estate loans are to many of the same customers and carry similar industry risks as C&I loans, but have different collateral risk. Commercial real estate loans increased $5 million to $1.46 billion at December 31, 2019. At December 31, 2019, $64 million of the commercial real estate loans were for commercial properties under construction. The Company categorizes commercial loans by industry according to the North American Industry Classification System ("NAICS") to monitor the portfolio for possible concentrations in one or more industries. Management monitors industry concentrations against internally established risk-based capital thresholds. As of December 31, 2019, City National was within its internally designated concentration limits. As of December 31, 2019, City National's loans to borrowers within the Lessors of Nonresidential Buildings categories exceeded 10% of total loans (12%). No other NAICS industry classification exceeded 10% of total loans as of December 31, 2019. Management also monitors non-owner occupied commercial real estate as a percent of risk based capital (based upon regulatory guidance). At December 31, 2019, the Company had $1.35 billion of commercial loans classified as non-owner occupied and was within its designated concentration threshold. Consumer loans may be secured by automobiles, boats, recreational vehicles, certificates of deposit and other personal property or they may be unsecured. The Company manages the risk associated with consumer loans by monitoring such factors as portfolio size and growth, internal lending policies and pertinent economic conditions. City National's underwriting standards are continually evaluated and modified based upon these factors. Consumer loans increased $3 million from 2018 to $54 million at December 31, 2019. The following table shows the scheduled maturity of loans outstanding as of December 31, 2019 (in thousands): ALLOWANCE AND PROVISION FOR LOAN LOSSES Management systematically monitors the loan portfolio and the appropriateness of the allowance for loan losses (“ALLL”) on a quarterly basis to provide for probable losses incurred in the portfolio. Management assesses the risk in each loan type based on historical delinquency and loss trends, the general economic environment of its local markets, individual loan performance, and other relevant factors. Individual credits in excess of $1 million are selected at least annually for detailed loan reviews, which are utilized by management to assess the risk in the portfolio and the appropriateness of the allowance. Due to the nature of commercial lending, evaluation of the appropriateness of the allowance as it relates to these loan types is often based more upon specific credit review, with consideration given to the potential impairment of certain credits and historical loss rates, adjusted for general economic conditions and other inherent risk factors. Conversely, due to the homogeneous nature of the real estate and installment portfolios, the portions of the allowance allocated to those portfolios are primarily based on prior loss history of each portfolio, adjusted for general economic conditions and other inherent risk factors. Risk factors considered by the Company in completing this analysis include: (1) unemployment and economic trends in the Company’s markets, (2) concentrations of credit, if any, among any industries, (3) trends in loan growth, loan mix, delinquencies, losses or credit impairment, and (4) adherence to lending policies and others. Each risk factor is designated as low, moderate/increasing, or high based on the Company’s assessment of the risk to loss associated with each factor. Each risk factor is then weighted to consider probability of occurrence. The allowance not specifically allocated to individual credits is generally determined by analyzing potential exposure and other qualitative factors that could negatively impact the overall credit risk of the loan portfolio. Loans not individually evaluated for impairment are grouped by pools with similar risk characteristics and the related historical loss rates are adjusted to reflect current inherent risk factors, such as unemployment, overall economic conditions, concentrations of credit, loan growth, classified and impaired loan trends, staffing, adherence to lending policies, and loss trends. Determination of the allowance for loan losses is subjective in nature and requires management to periodically reassess the validity of its assumptions. Differences between actual losses and estimated losses are assessed such that management can timely modify its assumptions model to ensure that adequate provision has been made for risk in the total loan portfolio. The Company's (recovery of) provision for loan losses for the past three years are shown in the table below (in thousands): The recovery of loan loss provision during 2019 reflects a general improvement in the Company’s historical loss rates used to compute the allowance not specifically allocated to individual credits as charge offs have declined over the periods encompassed in the Company’s historical loss review. In addition, the Company recovered significant amounts on loans previously charged off, including a $0.5 million recovery from a loan that had previously been charged off during 2014. During the year ended December 31, 2018, the Company liquidated repossessed assets associated with the Kentucky Fuels Corporate credit. As a result of the proceeds from this liquidation, the Company recovered $1.3 million related to this credit. Additionally, as a result of this recovery, the historical loss rate used to compute the allowance not specifically allocated to individual credits in the Company's commercial and industrial mining and energy sector (per the North American Industry Classification system ("NAICS")) improved and an additional release of reserve of $1.7 million was recognized during the year ended December 31, 2018. The company also received a $0.4 million recovery through a settlement from a commercial customer during the quarter ended December 31, 2018. The provision for loan losses recorded in 2017 reflected the revisions to the regulatory rating of a previously classified shared national credit ("SNC") in which the Company is a participant, changes in the quality of the portfolio and general improvement in the Company's historical loss rates used to compute the allowance not specifically allocated to individual credits. This credit was for a local customer that outgrew the lending limit of the Company and involves three local banks. The reserve recorded in 2017 of $1.1 million related to this credit reflects the loss factors associated with the rating assigned to this credit as a result of the current year review by the Office of the Comptroller of the Currency ("OCC"). Changes in the amount of the allowance and related provision are based on the Company's detailed systematic methodology and are directionally consistent with changes in the composition and quality of the Company's loan portfolio. The Company believes its methodology for determining the adequacy of its ALLL adequately provides for probable losses inherent in the loan portfolio and produces a provision and allowance for loan losses that is directionally consistent with changes in asset quality and loss experience. The Company's net charge-offs for the past three years are shown in the table below (in thousands): Net charge-offs in 2019 consisted primarily of net charge-offs on DDA overdraft loans of $1.3 million, consumer loans of $0.9 million, commercial real estate loans of $0.7 million, and residential real estate loans of $0.4 million, that were partially offset by net recoveries on commercial and industrial loans of $0.5 million. Net charge-offs in 2018 consisted primarily of net charge-offs on DDA overdraft loans of $1.2 million and consumer loans of $0.6 million that were partially offset by net recoveries on commercial and industrial loans of $1.4 million and commercial real estate loans of $0.4 million. Net charge-offs in 2017 consisted primarily of net charge-offs on residential real estate loans of $1.3 million, DDA overdraft loans of $1.3 million and commercial real estate loans of $0.6 million. Based on the Company’s analysis of the appropriateness of the allowance for loan losses and in consideration of the known factors utilized in computing the allowance, management believes that the allowance for loan losses as of December 31, 2019 is adequate to provide for probable incurred losses inherent in the Company’s loan portfolio. Future provisions for loan losses will be dependent upon trends in loan balances including the composition of the loan portfolio, changes in loan quality and loss experience trends, and recoveries of previously charged-off loans, among other factors. TABLE SEVEN ANALYSIS OF THE ALLOWANCE FOR LOAN LOSSES An analysis of changes in the Company's allowance for loan losses follows (dollars in thousands): Credit Losses As a result of adopting ASU No. 2016-13, "Financial Instruments-Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments," the Company expects the increase in its allowance effective January 1, 2020, to be in the range of $2.3 million to $4.1 million. In addition, the adoption of ASU No. 2016-13 will require the Company to gross up its previously purchased credit impaired loans through the allowance at January 1, 2020. As a result, the Company expects an increase in its allowance and loan balances as of January 1, 2020, to be in the range of $2.2 million to $3.2 million. These estimates are subject to further refinements based on ongoing evaluations of our model, methodologies, and judgments, as well as prevailing economic conditions and forecasts as of the adoption date. TABLE EIGHT NON-ACCRUAL AND PAST-DUE LOANS The Company's nonperforming assets and past-due loans were as follows (dollars in thousands): The Company’s ratio of non-performing assets to total loans and other real estate owned decreased from 0.54% at December 31, 2018 to 0.45% at December 31, 2019. Excluded from this ratio are purchased credit-impaired ("PCI") loans in which the Company estimated cash flows and estimated a credit mark. Such loans would be considered nonperforming loans if the loan's performance deteriorates below the Company's initial expectation. Total past due loans decreased from $13.1 million, or 0.37% of total loans outstanding, at December 31, 2018 to $11.4 million, or 0.32% of total loans outstanding, at December 31, 2019. TABLE NINE IMPAIRED LOANS Information pertaining to the Company's impaired loans is included in the following table (in thousands): Impaired loans with a valuation allowance at the end of 2019 were comprised of one commercial borrowing relationship that was evaluated during 2017 and determined that an allowance was necessary, as the present value of expected cash flows was less than the outstanding amount of the loan. There were no commitments to provide additional funds on non-accrual, impaired, or other potential problem loans at December 31, 2019 and 2018. TABLE TEN RESTRUCTURED LOANS The Company’s policy on loan modifications typically does not allow for modifications that would be considered a concession from the Company. However, when there is a modification, the Company evaluates each modification to determine if the modification constitutes a troubled debt restructuring (“TDR”) in accordance with ASU 2011-02, whereby a modification of a loan would be considered a TDR when both of the following conditions are met: (1) a borrower is experiencing financial difficulty and (2) the modification constitutes a concession. When determining whether the borrower is experiencing financial difficulties, the Company reviews whether the debtor is currently in payment default on any of its debt or whether it is probable that the debtor would be in payment default in the foreseeable future without the modification. Other indicators of financial difficulty include whether the debtor has declared or is in the process of declaring bankruptcy, the debtor’s ability to continue as a going concern, or the debtor’s projected cash flow to service its debt (including principal and interest) in accordance with the contractual terms for the foreseeable future, without a modification. Regulatory guidance requires loans to be accounted for as collateral-dependent loans when borrowers have filed Chapter 7 bankruptcy, the debt has been discharged by the bankruptcy court and the borrower has not reaffirmed the debt. The filing of bankruptcy is deemed to be evidence that the borrower is in financial difficulty and the discharge of the debt by the bankruptcy court is deemed to be a concession granted to the borrower. The following table sets forth the Company’s TDRs (in thousands): The Company's troubled debt restructurings ("TDRs") related to its borrowers who had filed for Chapter 7 bankruptcy protection made up 81% of the Company's total TDRs as of December 31, 2019. The average age of these TDRs was 12.6 years; the average current balance as a percentage of the original balance was 68.5%; and the average loan-to-value ratio was 64.2% as of December 31, 2019. Of the total 452 Chapter 7 related TDRs, 29 had an estimated loss exposure based on the current balance and appraised value at December 31, 2019. TABLE ELEVEN ALLOCATION OF THE ALLOWANCE FOR LOAN LOSSES The allocation of the allowance for loan losses by portfolio segment and the percent of loans in each category to total loans is shown in the table below (dollars in thousands). The allocation of a portion of the allowance in one portfolio segment does not preclude its availability to absorb losses in other portfolio segments. The allowance attributed to the commercial and industrial loan portfolio decreased $2.0 million from $4.1 million at December 31, 2018 to $2.1 million at December 31, 2019. This decrease is primarily attributable to an improvement in the overall average historical loss rate. The allowance attributed to the commercial real estate loan portfolio decreased $1.9 million from $4.5 million at December 31, 2018 to $2.6 million at December 31, 2019. This decrease is primarily attributable to improvements in the historical loss rates in the portfolio. The allowance attributed to the residential real estate portfolio decreased $0.7 million from $4.1 million at December 31, 2018 to $3.4 million at December 31, 2019. The decrease is primarily attributable to improvements in the historical loss rates in the portfolio. The allowance attributed to the consumer loan portfolio increased $0.7 million from $0.3 million at December 31, 2018 to $1.0 million at December 31, 2019. The increase is primarily attributable to an increase in historical loss rates, as well as an increase in loan balances. GOODWILL The Company evaluates the recoverability of goodwill and indefinite lived intangible assets annually as of November 30th, or more frequently if events or changes in circumstances warrant, such as a material adverse change in the Company's business. Goodwill is considered to be impaired when the carrying value of a reporting unit exceeds its estimated fair value. Indefinite-lived intangible assets are considered impaired if their carrying value exceeds their estimated fair value. As described in Note One of the Notes to Consolidated Financial Statements, the Company conducts its business activities through one reportable business segment - community banking. Fair values are estimated by reviewing the Company’s stock price as it compares to book value and the Company’s reported earnings. In addition, the impact of future earnings and activities are considered in the Company’s analysis. The Company had approximately $109 million and $110 million of goodwill at December 31, 2019 and 2018, respectively, and no impairment was required to be recognized in 2019 or 2018, as the estimated fair value of the Company has continued to exceed its book value. CERTIFICATES OF DEPOSIT Scheduled maturities of time certificates of deposit of $100,000 or more at December 31, 2019 are summarized in the table below (in thousands). The Company has time certificates of deposit that meet or exceed the FDIC insurance limit of $250,000 totaling $184.4 million (approximately 14% of total time deposits). TABLE TWELVE MATURITY DISTRIBUTION OF CERTIFICATES OF DEPOSIT OF $100,000 OR MORE FAIR VALUE MEASUREMENTS The Company determines the fair value of its financial instruments based on the fair value hierarchy established in ASC Topic 820, whereby the fair value of certain assets and liabilities is an exit price, representing the amount that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants. ASC Topic 820 establishes a three-level hierarchy for disclosure of assets and liabilities recorded at fair value. The hierarchy classification is based on whether the inputs in the methodology for determining fair value are observable or unobservable. Observable inputs reflect market-based information obtained from independent sources (Level 1 or Level 2), while unobservable inputs reflect management’s estimate of market data (Level 3). Assets and liabilities that are actively traded and have quoted prices or observable market data require a minimal amount of subjectivity concerning fair value. Management’s judgment is necessary to estimate fair value when quoted prices or observable market data are not available. At December 31, 2019, approximately 17% of total assets, or $842 million, consisted of financial instruments recorded at fair value. Most of these financial instruments used valuation methodologies involving observable market data, collectively Level 1 and Level 2 measurements, to determine fair value. At December 31, 2019, approximately $19 million of derivative liabilities were recorded at fair value using methodologies involving observable market data. The Company does not believe that any changes in the unobservable inputs used to value the financial instruments mentioned above would have a material impact on the Company’s results of operations, liquidity, or capital resources. See Note Twenty of the Notes to Consolidated Financial Statements for additional information regarding ASC Topic 820 and its impact on the Company’s financial statements. CONTRACTUAL OBLIGATIONS The Company has various financial obligations that may require future cash payments according to the terms of the obligations. Demand, both noninterest- and interest-bearing, and savings deposits are, generally, payable immediately upon demand at the request of the customer. Therefore, the contractual maturity of these obligations is presented in the following table as “less than one year.” Time deposits, typically certificates of deposit, are customer deposits that are evidenced by an agreement between the Company and the customer that specify stated maturity dates; early withdrawals by the customer are subject to penalties assessed by the Company. Short-term borrowings and long-term debt represent borrowings of the Company and have stated maturity dates. Operating leases between the Company and the lessor have stated expiration dates and renewal terms. TABLE THIRTEEN CONTRACTUAL OBLIGATIONS The composition of the Company's contractual obligations as of December 31, 2019 is presented in the following table (in thousands): (1) Includes interest on both fixed- and variable-rate obligations. The interest associated with variable-rate obligations is based upon interest rates in effect at December 31, 2019. The contractual amounts to be paid on variable-rate obligations are affected by market interest rates that could materially affect the contractual amounts to be paid. (2) On January 29, 2020, the Board of Directors of the Company authorized repayment of its Subordinated Debentures. All regulatory approvals have been received by the Company and the Company anticipates the repayment to be completed during the first quarter of 2020. The Company’s liability for uncertain tax positions at December 31, 2019 was $1.8 million pursuant to ASC Topic 740. This liability represents an estimate of tax positions that the Company has taken in its tax returns that may ultimately not be sustained upon examination by tax authorities. As the ultimate amount and timing of any future cash settlements cannot be predicted with reasonable reliability, this estimated liability has been excluded from the contractual obligations table. OFF-BALANCE SHEET ARRANGEMENTS As disclosed in Note Seventeen of the Notes to Consolidated Financial Statements, the Company has also entered into agreements with its customers to extend credit or to provide conditional commitments to provide payment on drafts presented in accordance with the terms of the underlying credit documents (including standby and commercial letters of credit). The Company also provides overdraft protection to certain demand deposit customers that represent an unfunded commitment. As a result of the Company’s off-balance sheet arrangements for 2019 and 2018, no material revenue, expenses, or cash flows were recognized. In addition, the Company had no other indebtedness or retained interests nor entered into agreements to extend credit or provide conditional payments pursuant to standby and commercial letters of credit. CAPITAL RESOURCES During 2019, Shareholders’ Equity increased $57 million, or 9.5%, from $601 million at December 31, 2018 to $658 million at December 31, 2019. This increase was primarily due to net income of $89 million and other comprehensive income of $20 million, partially offset by cash dividends declared of $36 million and common share repurchases of $19 million. On September 24, 2014, the Company announced that the Board of Directors authorized the Company to buy back up to 1,000,000 shares of its common shares (approximately 7% of outstanding shares at the time) in open market transactions at prices that are accretive to the earnings per share of continuing shareholders. On February 27, 2019, the Company announced that the Board of Directors rescinded the 2014 plan and authorized the Company to buy back up to 1,000,000 shares of its common stock (approximately 6% of the outstanding shares), in open market transactions, at prices that are accretive to continuing shareholders. No timetable was placed on the duration of this share repurchase program. During the year ended December 31, 2019, the Company repurchased approximately 261,000 common shares at a weighted average price of $74.54. At December 31, 2019, the Company could repurchase approximately 739,000 shares under the current plan. As of January 1, 2019, the Basel III Capital Rules require City Holding and City National to maintain minimum CET 1, Tier 1 and Total Capital ratios, along with a capital conservation buffer, effectively resulting in new minimum capital ratios (which are shown in the table below). The capital conservation buffer is designed to absorb losses during periods of economic stress. Banking institutions with a ratio of CET 1 capital to risk-weighted assets above the minimum but below the conservation buffer (or below the combined capital conservation buffer and countercyclical capital buffer, when the latter is applied) will face constraints on dividends, equity repurchases and compensation based on the amount of the shortfall. The Basel III Capital Rules also provide for a “countercyclical capital buffer” that is applicable to only certain covered institutions and does not have any current applicability to City Holding Company or City National Bank. The Company’s regulatory capital ratios for both City Holding and City National are illustrated in the following tables (in thousands): As of December 31, 2019, management believes that City Holding Company, and its banking subsidiary, City National, were “well capitalized.” City Holding is subject to regulatory capital requirements administered by the Federal Reserve, while City National is subject to regulatory capital requirements administered by the OCC and the FDIC. Regulatory agencies can initiate certain mandatory actions if either City Holding or City National fails to meet the minimum capital requirements, as shown above. As of December 31, 2019, management believes that City Holding and City National meet all capital adequacy requirements. On May 24, 2018, the Economic Growth, Regulatory Relief, and Consumer Protection Act (the “Regulatory Relief Act”) went into effect. The Regulatory Relief Act provides for a simplification of the minimum capital level requirements applicable to the Company. The FDIC issued its final rules regarding this change on September 17, 2019. Beginning on March 31, 2020, the Company will have the option of using a single community bank leverage ratio (Tier 1 capital to average consolidated assets) requirement of over nine percent to qualify as “well-capitalized.” This new framework will replace the Basel III Capital Rules applicable to the Company. As of December 31, 2019, the Company would have satisfied the community bank leverage ratio requirement had it been in effect. LEGAL ISSUES The Company is engaged in various legal actions that it deems to be in the ordinary course of business. As these legal actions are resolved, the Company could realize impacts to its financial performance in the period in which these legal actions are ultimately decided. There can be no assurance that current actions will have immaterial results, or that no material actions may be presented in the future. RECENT ACCOUNTING PRONOUNCEMENTS AND DEVELOPMENTS Note Two, “Recent Accounting Pronouncements,” of the Notes to Consolidated Financial Statements discusses recently issued new accounting pronouncements and their expected impact on the Company’s consolidated financial statements.

<s>[INST] The information noted below is provided pursuant to Guide 3 Statistical Disclosure by Bank Holding Companies. Description of Information Page Reference 1. Distribution of Assets, Liabilities and Stockholders' Equity; Interest Rates and Interest Differential a. Average Balance Sheets b. Analysis of Net Interest Earnings c. Rate Volume Analysis of Changes in Interest Income and Expense 2. Investment Portfolio a. Book Value of Investments b. Maturity Schedule of Investments c. Securities of Issuers Exceeding 10% of Stockholders’ Equity 3. Loan Portfolio a. Types of Loans b. Maturities and Sensitivity to Changes in Interest Rates c. Risk Elements d. Other Interest Bearing Assets None 4. Summary of Loan Loss Experience 5. Deposits a. Breakdown of Deposits by Categories, Average Balance and Average Rate Paid b. Maturity Schedule of Time Certificates of Deposit and Other Time Deposits of $100,000 or More 6. Return on Equity and Assets 7. Shortterm Borrowings CITY HOLDING COMPANY City Holding Company (the “Company”), a West Virginia corporation headquartered in Charleston, West Virginia, is a registered financial holding company under the Bank Holding Company Act and conducts its principal activities through its wholly owned subsidiary, City National Bank of West Virginia ("City National"). City National is a retail and consumeroriented community bank with 95 bank branches in West Virginia (58), Kentucky (20), Virginia (13) and Ohio (4). City National provides credit, deposit, and trust and investment management services to its customers in a broad geographical area that includes many rural and small community markets in addition to larger cities including Charleston (WV), Huntington (WV), Martinsburg (WV), Ashland (KY), Lexington (KY), Winchester (VA) and Staunton (VA). In the Company's key markets, the Company's primary subsidiary, City National, generally ranks in the top three relative to deposit market share and the top two relative to branch share (Charleston/Huntington MSA, Beckley/Lewisburg counties, Staunton MSA and Winchester, VA/WV Eastern Panhandle counties). In addition to its branch network, City National's delivery channels include automatedtellermachines ("ATMs"), interactivetellermachines ("ITMs"), mobile banking, debit cards, interactive voice response systems, and Internet technology. The Company’s business activities are currently limited to one reportable business segment, which is community banking. In December 2018, the Company acquired Poage Bankshares, Inc., of Ashland, Kentucky and its principal banking subsidiary, Town Square Bank (collectively, "Poage") and Farmers Deposit Bancorp, Inc., of Cynthiana, Kentucky and its principal banking subsidiary, Farmers Deposit Bank (collectively, "Farmers Deposit"). In July 2019, the Company sold its Virginia Beach, Virginia, branch to Select Bank & Trust Company. CRITICAL ACCOUNTING POLICIES The accounting policies of the Company conform to U.S. generally accepted accounting principles and require management to make estimates and develop assumptions that affect the amounts reported in the financial statements and related footnotes. These estimates and assumptions are based on information available to management as of the date of the financial statements. Actual results could differ significantly from management’s estimates. As this information changes, management’s estimates and assumptions used to prepare the Company’s financial statements and related disclosures may also change. The most significant accounting policies followed by the Company are presented in Note One of the Notes to Consolidated Financial Statements included herein. Based on the valuation techniques used and the sensitivity of financial statement amounts to the methods, assumptions, and estimates underlying those amounts, management has identified: (i) the determination of the allowance for loan losses and (ii) income taxes to be the accounting areas that require the most subjective or complex judgments and, as such [/INST] Negative. </s>

DIXIE GROUP INC

2015-03-12

2014-12-27

Item 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The following discussion and analysis should be read in conjunction with our consolidated financial statements and related notes appearing elsewhere in this report. OVERVIEW After the downturn of 2008 - 2009, we put together a growth plan to take advantage of the unique opportunities that, we believe, has driven our sales success over the last 5 years. Since 2009, our carpet product sales have grown 96%, while the industry, we estimate, grew only around 12%. While we had planned on 10% growth per year, we became capacity constrained in 2013 as our sales grew over 30%. As a result, we accelerated our plan to grow our capacity from $350 million to a range of $550 to $600 million, depending upon product mix. In addition, we made the decision to merge our two west coast dye houses as a result of the purchase of Atlas Carpet Mills (“Atlas”) in the first quarter of 2014. Further, in the fourth quarter, we decided to discontinue the Carousel brand, a small non-core line of products that was part of the 2013 Robertex acquisition (See Note 21 in Consolidated Financial Statements). Therefore, 2014 was a year of expansion and facility re-alignment which impacted virtually all of our facilities. The investments we made have included both capital expenditures and temporary increases in operating costs due to implementation of the capacity expansion plan. We began the year by expanding capacity at Colormaster, our continuous dyeline. We completed the training and fully commissioning of our expanded Roanoke yarn facility designed to support our growth with internal supply and lessen our dependence on externally supplied yarn. We acquired and began the integration process of Atlas. We expanded our Eton residential tufting operations, doubling the number of machines in service. We realigned our Calhoun wool operations, a change designed to increase capacity and lower costs. Further, we moved the finished goods for our residential east coast business to our newly opened Adairsville facility, consolidating four warehousing operations into one facility. We added continuous yarn dyeing capability to our Colormaster facility and expanded our yarn skein dye operations in Calhoun. Similarly, we shut down our Atmore carpet and yarn dye operations, converting that mill to a dry mill dedicated to serving our Masland Contract brand. As part of this process, we de-commissioned our Atmore wastewater treatment plant. Further, on the west coast, we merged our newly acquired Atlas dye house into our Susan Street dye facility. We upgraded our machine tufted rug capability during the year with added capacity as well as installing skein dye yarn capability to support our custom wool rug programs. We purchased Burtco Enterprises, LLC (“Burtco”) and its excellence in computerized yarn placement tufting technology, using this as the foundation for our newly formed Masland Hospitality sales force. A prime focus in 2015 is on training our workforce which has increased 45% since the beginning of 2013. Further, in 2015 we are focused on improving waste, yields and efficiencies in our operations. We are seeing the positive impact of our expanded sales force, the result of our efforts in 2013 and 2014 to significantly increase our field coverage. Several of the initiatives above were undertaken as a warehousing/distribution/manufacturing restructuring plan approved by our Board of Directors on January 20, 2014. This plan was developed to align our warehousing, distribution and manufacturing to support our growth and manufacturing strategy and to create a better cost structure and to improve distribution capabilities and customer service. The key element and first major step of this plan was securing a 292,000 square foot facility that serves as a finished goods warehouse and a cut-order and distribution center in Adairsville, Georgia on May 1, 2014. In June of 2014, the Board of Directors approved a modification of this plan to include the elimination of both carpet dyeing and yarn dyeing in our Atmore, Alabama facility designed to more fully accommodate our distribution and manufacturing realignment. As a result, the dyeing operations in Atmore were moved to our Colormaster continuous dyeing facility, our Calhoun Wool skein dyeing operation and other outside dyeing processors. Expenses of this plan were $4.0 million in 2014 with remaining estimated expenses of $1.4 million anticipated through early 2016. These expenses primarily consist of moving and relocation expenses of inventory and equipment, facility restoration, information technology expenses and expenses relating to conversion and realignment of equipment. In addition, we incurred non-cash asset impairment charges of $1.1 million related to manufacturing and equipment taken out of service in our facilities. On March 19, 2014, we acquired Atlas Carpet Mills. Total consideration for the acquisition was approximately $18.7 million. Atlas is a California based manufacturer and marketer of high-end commercial broadloom and tile carpeting serving soft floorcovering markets. Atlas has a strong reputation for exceptional design, quality and service. This brand will be sold through the existing Atlas sales force and will serve to broaden our product offerings for commercial applications along with our Masland Contract and Masland Hospitality brands. The existing management of Atlas will continue with the Company. Prior to the acquisition, we were a long-time supplier of yarn to Atlas through our Candlewick Yarn operation and provided certain tile manufacturing services for their tile product line. We recognized a pre-tax gain of $10.9 million on the acquisition of Atlas. We believe several factors were significant in the recognition of a gain from the acquisition of Atlas. Atlas had higher cost of dyeing due to the lack of capacity utilization and therefore needed to lower costs by combining dye facilities with another operation. In addition, Atlas had a higher cost of modular carpet tile manufacturing due to outsourcing the tile manufacturing operations. Therefore, Atlas would have had to make significant investments in product and manufacturing equipment to be competitive in the modular carpet manufacturing business. Finally, the Seller had the desire to see Atlas operated as an independent brand and organization in the future. All of these objectives were achieved in our mutually advantageous relationship (See Note 6 in the Consolidated Financial Statements). Table of Contents 16 As a part of the Atlas acquisition, we discontinued operations at the Atlas dyeing facility in Los Angeles and moved the carpet dyeing of their products to our Susan Street dyeing operation located in Santa Ana, California. As part of the acquisition, we initiated a restructuring plan to accommodate the dyeing move and address the modification of computer systems. The costs of these initiatives are expected to be approximately $1.8 million. $1.4 million of costs were incurred under this plan in 2014 and the remaining initiatives for $400 thousand are expected to be completed in 2015. On September 22, 2014, we purchased certain assets, including specialized tufting equipment, and assumed certain liabilities from Burtco Enterprises. We believe the unique capabilities of this tufting equipment will enable us to develop products that complement our high-end, specialized commercial markets. The total consideration for the equipment, inventories and certain receivables, net of liabilities assumed was approximately $2.4 million. This transaction resulted in a pre-tax bargain purchase of $173 thousand (See Note 6 in the Consolidated Financial Statements). We continue to see opportunities for our modular tile offerings in both the Masland Contract and Atlas markets. Further, the future opportunities in hospitality, we believe, can be capitalized upon with the creation of Masland Hospitality and leveraging our investment in Burtco and its unique position in custom computerized yarn placement tufting technology. Also, we remain optimistic about conditions that affect the higher-end residential markets we serve. We believe the actions discussed above have been, and are, necessary to position us to more fully take advantage of the markets we serve and have helped to facilitate the growth we have experienced and that we anticipate in the future. RESULTS OF OPERATIONS As a result of the discontinuance of the non-core Carousel brand in the fourth quarter of 2014, the operating results of Carousel have been reclassified to discontinued operations for all periods presented. Carousel was acquired as a portion of the Robertex acquisition at the beginning of the third quarter of 2013. The following table sets forth certain elements of our continuing operations as a percentage of net sales for the periods indicated: Fiscal Year Ended December 27, 2014 Compared with Fiscal Year Ended December 28, 2013 Net Sales. Net sales for the year ended December 27, 2014 were $406.6 million compared with $344.4 million in the year-earlier period, an increase of 18.1%, or 7.1% excluding Atlas, for the year-over-year comparison. Sales for the carpet industry were flat for annual 2014 compared with the prior year. Our 2014 year-over-year carpet sales comparison reflected an increase of 18.1% in net sales, or 7.5% excluding Atlas. Sales of residential carpet were up 8.2% and sales of commercial carpet increased 45.5%, or 5.5% excluding Atlas. Revenue from carpet yarn processing and carpet dyeing and finishing services increased $1.9 million in 2014 compared with 2013 primarily as a result of processing services performed by Atlas under an equity investment relationship. We believe our growth in both the residential and commercial sales were positively affected by the introduction of new and innovative products and the expansion of our wool product offerings. Cost of Sales. Cost of sales, as a percentage of net sales, increased 1.3 percentage points, as a percentage of net sales in 2014 compared with 2013. The expansion and restructuring initiatives undertaken along with the expansion of our workforce negatively affected our operating results in the form of training costs, production inefficiencies, increased levels of waste and scrap and generally higher operating costs associated with the breadth and scope of activity. Gross Profit. Gross profit increased $9.9 million in 2014 compared with 2013. The increase in gross profit was primarily attributable to higher sales. However, the gross profit dollars in 2014 were negatively impacted by our actions taken to address our capacity constraints. Selling and Administrative Expenses. Selling and administrative expenses were $93.2 million in 2014 compared with $76.2 million in 2013, or an increase of 0.7% as a percentage of sales. Our selling expense increase as a percentage of sales was Table of Contents 17 primarily driven by the higher relative selling expense of Atlas and higher levels of investment in new products and marketing in our Masland Contract business compared with the prior year. Other Operating (Income) Expense, Net. Net other operating (income) expense was an expense of $904 thousand in 2014 compared with expense of $494 thousand in 2013. The change in 2014 was primarily a result of an increase in losses on currency valuations and the amortization of an intangible asset associated with the 2014 Atlas acquisition. Operating Income (Loss). Operations reflected an operating loss of $5.2 million in 2014 compared with operating income of $8.9 million in 2013. Facility consolidation expenses of $5.5 million and related asset impairment expenses of $1.1 million were included in the 2014 operating results. Interest Expense. Interest expense increased $546 thousand in 2014 principally due to higher levels of debt to support our growth and the acquisition of capital assets under various debt arrangements. Other (Income) Expense, Net. Other (income) expense, net was income of $154 thousand in 2014 compared with expense of $26 thousand in 2013. $209 thousand of earnings from equity investments were included in 2014. Gain on Purchase of Businesses. During 2014, we recognized gains of $11.1 million on business acquisitions. The acquisition of Atlas resulted in a gain of $10.9 million and the acquisition of Burtco resulted in a gain of $173 thousand. Income Tax Provision (Benefit). Our effective income tax rate was 61.0% in 2014 and included an increase of $569 thousand in increased valuation allowances related to state income tax carryforwards and state income tax credit carryforwards. Our income tax provision was a benefit of $643 thousand in 2013 on positive earnings primarily as a result of the reversal of $1.2 million of previously established reserves for state income tax loss and tax credit carryforwards. The recognition or reversal of such reserves established by taxing jurisdiction is based on a number of factors including current and forecasted earnings. Additionally, 2013 included certain tax credits of approximately $520 thousand related to the years 2009 - 2011 determined to be available for utilization and $304 thousand of 2012 research and development tax credits that could not be recognized until the extension of the credit was approved by Congress in 2013. Loss from Discontinued Operations and Loss on Disposal of Discontinued Operations, net of tax. In the fourth quarter of 2014, we discontinued the Carousel specialty tufting and weaving operation that was part of the 2013 Robertex, Inc. acquisition. As a result, we recognized a loss on the disposal of the discontinued operation of $1.5 million, net of tax, which included the impairment of certain intangibles associated with Carousel and the related machinery and equipment. Additionally, 2014 included a loss from the discontinued Carousel operations of $598 thousand, net of tax, compared with a loss of $198 thousand, net of tax in 2013. Net Income (Loss). Continuing operations reflected income of $673 thousand, or $0.03 per diluted share in 2014, compared with income from continuing operations of $5.6 million, or $0.42 per diluted share in 2013. Our discontinued operations reflected a loss of $608 thousand, or $0.04 per diluted share, and a loss on disposal of discontinued operations of $1.5 million, or $0.10 per diluted share in 2014 compared with a loss from discontinued operations of $266 thousand, or $0.02 per diluted share in 2013. Including discontinued operations, we had a net loss of $1.4 million, or $0.11 per diluted share, in 2014 compared with net income of $5.3 million, or $0.40 per diluted share, in 2013. Fiscal Year Ended December 28, 2013 Compared with Fiscal Year Ended December 29, 2012 Net Sales. Net sales for the year ended December 28, 2013 were $344.4 million compared with $266.4 million in the year-earlier period, an increase of 29.3% for the year-over-year comparison. The carpet industry reported a percentage increase in the mid- single digits in net sales in 2013 compared with 2012. Our 2013 year-over-year carpet sales comparison reflected an increase of 28.6% in net sales. Sales of residential carpet were up 26.7% and sales of commercial carpet increased 34.3%. Revenue from carpet yarn processing and carpet dyeing and finishing services increased $4.1 million in 2013 compared with 2012. We believe our residential and commercial sales were positively affected primarily as a result of the introduction of new products and the expansion of our wool products. Cost of Sales. Cost of sales, as a percentage of net sales, was basically unchanged in 2013 compared with 2012. Cost of sales in 2013 included approximately $5.1 million of costs associated with acquisitions in late 2012 and 2013 as well as certain process realignment and expansion initiatives undertaken during 2013. Cost of sales in 2012 included incremental costs of approximately $1.4 million related to tufting equipment relocations and costs related to the transition of products from our beck dyeing operations to our continuous dyeing operations acquired in the fourth quarter of 2012. Gross Profit. Gross profit increased $20.2 million in 2013 compared with 2012. The increase in gross profit was primarily attributable to higher sales. Gross profit in 2013 and 2012 was negatively affected by the incremental costs discussed above related to costs of sales. Selling and Administrative Expenses. Selling and administrative expenses were $76.2 million in 2013 compared with $63.5 million in 2012, a decline of 1.7 percentage points as a percentage of sales in 2013 compared with 2012. Selling and Table of Contents 18 administrative costs in 2013 included approximately $1.8 million of sampling costs incurred to incorporate the new wool products associated with the Robertex acquisition and our launch of a new tile product line. 2012 included $1.7 million related to investment in the development and sampling of new product initiatives, $409 thousand for incremental costs related to the two acquisitions and $600 thousand of costs related to management changes. Other Operating (Income) Expense, Net. Net other operating (income) expense was $494 thousand in 2013 compared with $68 thousand in 2012. The change in 2013 was due to the disposal of certain manufacturing assets taken out of service, losses on currency valuations and settlement of a claim against a supplier. Operating Income. Operating income was $8.9 million in 2013 compared with operating income of $1.8 million in 2012. The increase in 2013 was primarily a result of the increased level of sales in 2013, less the variable selling expenses associated with the sales increase. Interest Expense. Interest expense increased $610 thousand in 2013 principally due to higher levels of debt to support our growth, including an increase in debt related to business acquisitions in late 2012 and during mid-2013. Other (Income) Expense, Net. Other (income) expense, net was an expense of $26 thousand in 2013 compared to income of $277 thousand in 2012. The change was primarily the result of a $187 thousand gain recognized on the sale of a non-operating asset in 2012. Income Tax Provision (Benefit). Our income tax provision was a benefit of $577 thousand in 2013 on positive earnings primarily as a result of the reversal of $1.2 million of previously established reserves for state income tax loss and tax credit carryforwards. The reversal of the reserves was based on a number of factors including current and future earnings assumptions by taxing jurisdiction. Additionally, 2013 included certain tax credits of approximately $520 thousand related to the years 2009 - 2011 determined to be available for utilization and $304 thousand of 2012 research and development tax credits that could not be recognized until the extension of the credit was approved by Congress in 2013. Our effective income tax benefit rate was 38.0% in 2012. The effective tax rate varied from statutory rates in 2012 primarily as a result of adjustments to estimates used in the 2011 estimated tax calculations versus amounts used in the subsequent tax return filing for the 2011 period, net of the effects of permanent differences on the lower level of pre-tax earnings in the 2012 tax calculations. Net Income (Loss). Continuing operations reflected income of $5.6 million, or $0.42 per diluted share in 2013, compared with a loss from continuing operations of $653 thousand, or $0.05 per diluted share in 2012. Our discontinued operations reflected a loss of $266 thousand, or $0.02 per diluted share in 2013, compared with a loss of $274 thousand, or $0.02 per diluted share in 2012. Including discontinued operations, our net income was $5.3 million, or $0.40 per diluted share, in 2013 compared with a net loss of $927 thousand, or $0.07 per diluted share, in 2012. LIQUIDITY AND CAPITAL RESOURCES We believe our operating cash flows, credit availability under our senior loan and security agreement and other sources of financing are adequate to finance our normal foreseeable liquidity requirements. However, deterioration in our markets or significant additional cash expenditures above our normal liquidity requirements could require supplemental financing or other funding sources. There can be no assurance that such supplemental financing or other sources of funding can be obtained or will be obtained on terms favorable to us. During the year ended December 27, 2014, we generated funds of $24.6 million from the May 2014 equity offering, net of issuance costs including the underwriter discount. Additionally, we generated $3.4 million from operating activities and $6.8 million from proceeds related to the sales of capitalized assets and the sale of an equity investment. These funds were used to finance our operations, invest $17.7 million in business acquisitions, invest $9.5 million for purchases of property, plant and equipment, reduce debt $3.5 million, $2.7 million to fund outstanding checks and $1.2 million for deposits for future equipment purchases. Excluding assets acquired and liabilities assumed in the Atlas and Burtco acquisitions and the change in the current portion of debt, working capital increased $1.1 million in 2014. The increase in working capital was primarily a result of an increase in current deferred income tax assets offset by a decrease in accounts payable and accrued expenses. Capital asset acquisitions for the year ended December 27, 2014, excluding those acquired in business acquisitions, were $32.8 million; $9.5 million through funded debt and $23.3 million of assets acquired under capital leases and notes payable, while depreciation and amortization was $12.9 million. We expect capital expenditures to be approximately $13.5 million in 2015 while depreciation and amortization is expected to be approximately $14.1 million. Planned capital expenditures in 2015 are primarily for new equipment. Debt Facilities On March 14, 2014, we amended our senior credit facility ("amended senior credit facility"), effective as of March 19, 2014 to permit the acquisition of Atlas Carpet Mills, Inc. by means of an over advance ("Tranche B Advance") of $5.4 million which Table of Contents 19 increased to $5.8 million and matured on June 30, 2014. The Tranche B Advance bore interest at a rate of 3.50% plus LIBOR, subject also to various availability percentages, limitations, covenants and conditions. In addition, the revolving portion of the facility ("Tranche A Advance") provides for a maximum of $150.0 million of revolving credit, subject to borrowing base availability. The borrowing base is currently equal to specified percentages of our eligible accounts receivable, inventories, fixed assets and real property less reserves established, from time to time, by the administrative agent under the facility. In addition, the term of the amended senior credit facility was extended from August 1, 2018 to March 14, 2019. At our election, Tranche A Advances of the amended senior credit facility bears interest at annual rates equal to either (a) LIBOR for 1, 2 or 3 month periods, as selected by us, plus an applicable margin of either 1.50%, 1.75% or 2.00%, or (b) the higher of the prime rate, the Federal Funds rate plus 0.5%, or a daily LIBOR rate plus 1.00%, plus an applicable margin of either 0.50%, 0.75% or 1.00%. The applicable margin is determined based on availability under the amended senior credit facility with margins increasing as availability decreases. We pay an unused line fee on the average amount by which the aggregate commitments exceed utilization of the senior credit facility equal to 0.375% per annum. The amended senior credit facility includes certain affirmative and negative covenants that impose restrictions on our financial and business operations. The amended senior credit facility required us to maintain a fixed charge coverage ratio of 1.1 to 1.0 during any period that borrowing availability was less than $14.4 million through May 31, 2014 and increased to $16.5 million after May 31, 2014. The amendment also provided for a waiver of the measurement and application of the fixed charge coverage ratio that would otherwise have been required by a reduction in excess availability from March 14, 2014 through and including April 13, 2014. The weighted-average interest rate on borrowings outstanding under the amended senior credit facility was 2.29% at December 27, 2014 and 2.66% at December 28, 2013. As of December 27, 2014, the unused borrowing availability under the amended senior credit facility was $40.2 million. Notes Payable - Buildings. On November 7, 2014, we entered into a ten-year $8.3 note payable to purchase a previously leased distribution center in Adairsville, Georgia. The note payable is scheduled to mature on November 7, 2024 and is secured by the distribution center. The note payable bears interest at a variable rate equal to one month LIBOR plus 2.0% and is payable in equal monthly installments of principal of $35, plus interest calculated on the declining balance of the note, with a final payment of $4,165 due on maturity. In addition, we entered into an interest swap with an amortizing notional amount effective November 7, 2014 which effectively fixes the interest rate at 4.50%. On January 23, 2015, we entered into a ten-year $6,290 note payable to finance an owned facility in Saraland, Alabama. The note payable is scheduled to mature on January 7, 2025 and is secured by the facility. The note payable bears interest at a variable rate equal to one month LIBOR plus 2.0% and is payable in equal monthly installments of principal of $26, plus interest calculated on the declining balance of the note, with a final payment of $3,145 due on maturity. In addition, we entered into a forward interest rate swap with an amortizing $5.7 million notional amount effective January 7, 2017 which effectively fixes the interest rate at 4.30%. Obligation to Development Authority of Gordon County. On November 2, 2012, we signed a 6% seller-financed note of $5.5 million with Lineage PCR, Inc. (“Lineage”) related to the acquisition of the continuous carpet dyeing facility in Calhoun, Georgia. Effective December 28, 2012 through a series of agreements between us, the Development Authority of Gordon County, Georgia (the “Authority”) and Lineage, obligations with identical payment terms as the original note to Lineage are now payment obligations to the Authority. These transactions were consummated in order to provide us with a tax abatement to the related real estate and equipment at this facility. The tax abatement plan provides for abatement for certain components of the real and personal property taxes for up to ten years. At any time, we have the option to pay off the obligation, plus a nominal amount. The debt to the Authority bears interest at 6% and is payable in equal monthly installments of principal and interest of $106 thousand over 57 months. Note Payable - Robertex Acquisition. On July 1, 2013, we signed a 4.5% seller-financed note of $4.0 million, which was recorded at a fair value of $3.7 million with Robert P. Rothman related to the acquisition of Robertex Associates, LLC ("Robertex") in Calhoun, Georgia. The note is payable in five annual installments of principal of $800 thousand plus interest. The note matures June 30, 2018. Equipment Notes Payable. Our equipment financing notes have terms ranging from three to seven years, are secured by the specific equipment financed, bear interest ranging from 1.00% to 6.86% and are due in monthly installments of principal and interest ranging from $1 thousand to $53 thousand through December 2021. The notes do not contain financial covenants. (See Note 10 to our Consolidated Financial Statements). Capital Lease Obligations. Our capital lease obligations have terms ranging from four to seven years, are secured by the specific equipment leased, bear interest ranging from 2.90% to 7.37% and are due in monthly installments of principal and interest ranging from $1 thousand to $43 thousand through January 2022. (See Note 10 to our Consolidated Financial Statements). Table of Contents 20 Equity Offering On May 20, 2014, we completed a public offering of 2.5 million shares of our common stock. Net proceeds from the offering were $24.6 million and were used to reduce the balance under our revolving credit facility and to pay off the $5.8 million Tranche B Advance associated with the recent acquisition of Atlas Carpet Mills which matured on June 30, 2014. Contractual Obligations The following table summarizes our future minimum payments under contractual obligations as of December 27, 2014. (1) Interest rates used for variable rate debt were those in effect at December 27, 2014. Stock-Based Awards We recognize compensation expense related to share-based stock awards based on the fair value of the equity instrument over the period of vesting for the individual stock awards that were granted. At December 27, 2014, the total unrecognized compensation expense related to unvested restricted stock awards was $1.8 million with a weighted-average vesting period of 3.6 years. At December 27, 2014, there was no unrecognized compensation expense related to unvested stock options Off-Balance Sheet Arrangements We have no off-balance sheet arrangements at December 27, 2014 or December 28, 2013. Income Tax Considerations During 2014, our tax provision of $1.1 million included $569 thousand of increase in our valuation allowances related to state income tax loss carryforwards and state income tax credit carryforwards. The reserve increase was based on a number of factors including current and future earnings assumptions by taxing jurisdiction. During 2015, we anticipate cash outlays for income taxes to be approximately $3.0 million less than our provision for 2015. For 2016 and 2017, we expect our cash outlay for taxes to exceed our tax provision based on the anticipated differences between the book basis and tax basis of long-lived, depreciable assets. Such differences could be in the range of $2.0 million to $3.0 million in each of the periods, although further utilization of tax loss carryforwards and tax credit carryforwards could reduce such differences. At December 27, 2014, we were in a net deferred tax asset position of $3.3 million. We performed an analysis, including an evaluation of certain tax planning strategies available to us, related to the net deferred tax asset and believe that the net deferred tax asset is recoverable in future periods. Approximately $8.7 million of future taxable income would be required to realize the deferred tax asset. Discontinued Operations - Environmental Contingencies We have reserves for environmental obligations established at five previously owned sites that were associated with our discontinued textile businesses. Each site has a Corrective Action Plan (“CAP”) with the applicable authoritative state regulatory body responsible for oversight for environmental compliance. The CAP for four of these sites involves natural attenuation (degradation of the contaminants through naturally occurring events) over periods estimated at 10 to 20 years and the CAP on the remaining site involves a pump and treat remediation process, estimated to occur over a period of 25 years. Additionally, we have a reserve for an environmental liability on the property of a facility and related business that was sold in 2004. The CAP has a specified remaining remediation term estimated to be 3 years subsequent to 2014. The total costs for remediation for all of these sites during 2014 were $136 thousand, all of which related to normal ongoing remediation costs. We expect normal remediation costs to range from approximately $50 thousand to $150 thousand annually. We have a reserve of $1.6 million for environmental liabilities at these sites as of December 27, 2014. The liability established represents our best estimate of loss Table of Contents 21 and is the reasonable amount to which there is any meaningful degree of certainty given the periods of estimated remediation and the dollars applicable to such remediation for those periods. The actual timeline to remediate, and thus, the ultimate cost to complete such remediation through these remediation efforts, may differ significantly from our estimates. Pre-tax costs for environmental remediation obligations classified as discontinued operations were primarily a result of specific events requiring action and additional expense in each period. Fair Value of Financial Instruments At December 27, 2014, we had $1.9 million of liabilities measured at fair value that fall under a level 3 classification in the hierarchy (those subject to significant management judgment or estimation). Certain Related Party Transactions During 2014, we purchased a portion of our requirements for polyester fiber from Engineered Floors, an entity controlled by Robert E. Shaw. Mr. Shaw reported holding approximately 8.5% of our Common Stock, which as of year-end represented approximately 4% of the total vote of all classes of our Common Stock. Engineered Floors is our principal supplier of polyester fiber and polyester broadloom carpet. Total purchases from Engineered Floors for 2014 and 2013 were approximately $11.3 million and $12.0 million, respectively; or approximately 3.6% and 4.7% of our consolidated costs of sales in 2014 and 2013, respectively. Purchases from Engineered Floors are based on market value, negotiated prices. We have no contractual arrangements or commitments with Mr. Shaw associated with our business relationship with Engineered Floors. Transactions with Engineered Floors were reviewed and approved by our board of directors. During 2013, we entered into a 10-year lease with the Rothman Family Partnership to lease a manufacturing facility as part of the Robertex acquisition. The Rothman Family Partnership includes Robert P. Rothman who is an associate of the Company. Rent paid to the Rothman Family Partnership during 2014 was $257 thousand. The lease was based on current market values for similar facilities. During 2014, we entered into a 5-year lease with the seller of Atlas Carpet Mills, Inc. to lease three manufacturing facilities as part of the acquisition. The seller is an associate of the Company. Rent paid to the seller during 2014 was $343. The lease was based on current market values for similar facilities. Recent Accounting Pronouncements In December 2011, the Financial Accounting Standards Board ("FASB") issued ASU No. 2011-11, “Balance Sheet (Topic 210): Disclosures about Offsetting Assets and Liabilities.” The amendments in this ASU required an entity to disclose information about offsetting assets and liabilities and related arrangements to enable users of its financial statements to understand the effect of those arrangements on its financial position. An entity was required to apply the amendments for annual reporting periods beginning on or after January 1, 2013, and interim periods within those annual periods. An entity had to provide the disclosures required by those amendments retrospectively for all comparative periods presented. In January 2013, the FASB issued ASU No. 2013-01, "Balance Sheet (Topic 210)-Clarifying the Scope of Disclosures about Offsetting Assets and Liabilities". The ASU clarified that ordinary trade receivables and payables were not in the scope of ASU No. 2011-11. ASU No. 2011-11 applied only to derivatives, repurchase agreements and reverse purchase agreements, and securities borrowing and securities lending transactions that were either offset in accordance with specific criteria contained in the Codification or subject to a master netting arrangement or similar agreement. The effective date was the same as the effective date of ASU 2011-11. The adoption of these ASUs did not have a material effect on our Consolidated Financial Statements. In February 2013, the FASB issued ASU No. 2013-04, "Liabilities (Topic 405): Obligations Resulting from Joint and Several Liability Arrangements for Which the Total Amount of the Obligation Is Fixed at the Reporting Date". This ASU provided guidance for the recognition, measurement, and disclosure of obligations resulting from joint and several liability arrangements for which the total amount of the obligation within the scope of this guidance was fixed at the reporting date, except for obligations addressed within existing guidance in GAAP. For public entities, the ASU was effective for fiscal years, and interim periods within those years, beginning after December 15, 2013. The ASU shall be applied retrospectively to all prior periods presented for those obligations within the scope of this Subtopic that existed at the beginning of an entity's fiscal year of adoption. Early adoption was permitted. The adoption of this ASU did not have a material effect on our Consolidated Financial Statements. In July 2013, the FASB issued ASU No. 2013-11, "Income Taxes (Topic 740) - Presentation of an Unrecognized Tax Benefit When a Net Operating Loss Carryforward, a Similar Tax Loss, or a Tax Credit Carryforward Exists". This ASU required an unrecognized tax benefit, or a portion of an unrecognized tax benefit, to be presented in the financial statements as a reduction to a deferred tax asset for a net operating loss carryforward, a similar tax loss, or a tax credit carryforward, except to the extent that a net operating loss carryforward, a similar tax loss, or a tax credit carryforward was not available at the reporting date, the unrecognized tax benefit will be presented in the financial statements as a liability and not combined with deferred tax assets. This ASU was effective for annual and interim periods beginning after December 15, 2013, with early adoption permitted. The adoption of this ASU did not have a material effect on our Consolidated Financial Statements. Table of Contents 22 In April 2014, the Financial Accounting Standards Board ("FASB") issued ASU No. 2014-08, "Presentation of Financial Statements (Topic 205) and Property, Plant, and Equipment (Topic 360) - Reporting Discontinued Operations and Disclosures of Disposals of Components of an Entity". The ASU was issued to change the requirements for reporting discontinued operations and to enhance the disclosures in this area. The ASU requires a disposal of a component of an entity or a group of components of an entity to be reported in discontinued operations if the disposal represents a strategic shift and will have a major effect on an entity's operations and financial results. The ASU will be effective prospectively for interim and annual reporting periods beginning after December 15, 2014. The adoption of this ASU will only impact the reporting and disclosures of future disposals, if any. In May 2014, the FASB issued ASU No. 2014-09, "Revenue from Contracts with Customers (Topic 606)". The ASU requires an entity to recognize the amount of revenue to which it expects to be entitled for the transfer of promised goods or services to customers. The ASU will replace most existing revenue recognition guidance in U.S. GAAP when it becomes effective. The new standard is effective for annual reporting periods beginning after December 15, 2016, including interim periods within that reporting period. Early application is not permitted. The standard permits the use of either the retrospective or cumulative effect transition method. We have not yet selected a transition method. We will be evaluating the effect that the ASU will have on our Consolidated Condensed Financial Statements and related disclosures In August 2014, the FASB issued ASU No. 2014-15, "Presentation of Financial Statements - Going Concern (Subtopic 205-40): Disclosure of Uncertainties about an Entity's Ability to Continue as a Going Concern." The guidance requires an entity to evaluate whether there are conditions or events, in the aggregate, that raise substantial doubt about the entity’s ability to continue as a going concern within one year after the date that the financial statements are issued and to provide related footnote disclosures in certain circumstances. The guidance is effective for the annual period ending after December 15, 2016, and for annual and interim periods thereafter. Early application is permitted. We do not believe the adoption of this ASU will have a significant impact on our Consolidated Condensed Consolidated Financial Statements Critical Accounting Policies Certain estimates and assumptions are made when preparing our financial statements. Estimates involve judgments with respect to, among other things, future economic factors that are difficult to predict. As a result, actual amounts could differ from estimates made when our financial statements are prepared. The Securities and Exchange Commission requires management to identify its most critical accounting policies, defined as those that are both most important to the portrayal of our financial condition and operating results and the application of which requires our most difficult, subjective, and complex judgments. Although our estimates have not differed materially from our experience, such estimates pertain to inherently uncertain matters that could result in material differences in subsequent periods. We believe application of the following accounting policies require significant judgments and estimates and represent our critical accounting policies. Other significant accounting policies are discussed in Note 1 to our Consolidated Financial Statements. • Revenue recognition. Revenues, including shipping and handling amounts, are recognized when the following criteria are met: there is persuasive evidence that a sales agreement exists, delivery has occurred or services have been rendered, the price to the buyer is fixed or determinable, and collection is reasonably assured. Delivery is considered to have occurred when the customer takes title to products, which is generally on the date of shipment. At the time revenue is recognized, we record a provision for the estimated amount of future returns based primarily on historical experience and any known trends or conditions. • Accounts receivable allowances. We provide allowances for expected cash discounts and doubtful accounts based upon historical experience and periodic evaluations of the financial condition of our customers. If the financial conditions of our customers were to significantly deteriorate, or other factors impair their ability to pay their debts, credit losses could differ from allowances recorded in our Consolidated Financial Statements. • Customer claims and product warranties. We provide product warranties related to manufacturing defects and specific performance standards for our products. We record reserves for the estimated costs of defective products and failure to meet applicable performance standards. The levels of reserves are established based primarily upon historical experience and our evaluation of pending claims. Because our evaluations are based on historical experience and conditions at the time our financial statements are prepared, actual results could differ from the reserves in our Consolidated Financial Statements. • Inventories. Inventories are stated at the lower of cost or market. Cost is determined using the last-in, first-out method (LIFO), which generally matches current costs of inventory sold with current revenues, for substantially all inventories. Reserves are also established to adjust inventories that are off-quality, aged or obsolete to their estimated net realizable value. Additionally, rates of recoverability per unit of off-quality, aged or obsolete inventory are estimated based on historical rates of recoverability and other known conditions or circumstances that may affect future recoverability. Actual results could differ from assumptions used to value our inventory. Table of Contents 23 • Goodwill. Goodwill is tested annually for impairment during the fourth quarter or earlier if significant events or substantive changes in circumstances occur that may indicate that goodwill may not be recoverable. The goodwill impairment tests are based on determining the fair value of the specified reporting units based on management judgments and assumptions using the discounted cash flows. The valuation approaches are subject to key judgments and assumptions that are sensitive to change such as judgments and assumptions about sales growth rates, operating margins and the weighted average cost of capital (“WACC”). When developing these key judgments and assumptions, we consider economic, operational and market conditions that could impact the fair value of the reporting unit. However, estimates are inherently uncertain and represent only management’s reasonable expectations regarding future developments. These estimates and the judgments and assumptions upon which the estimates are based will, in all likelihood, differ in some respects from actual future results. Should a significant or prolonged deterioration in economic conditions occur key judgments and assumptions could be impacted. • Contingent Consideration. Contingent consideration liabilities represent future amounts we may be required to pay in conjunction with various business combinations. The ultimate amount of future payments is based on sales levels for one contingent liability and incremental gross margin growth related to another contingent liability. We estimate the fair value of the contingent consideration liability related to sales levels by forecasting estimated cash payments based on projected sales and discounting the cash payment to its present value using a risk-adjusted rate of return. We estimate the fair value of the contingent consideration liability associated with incremental gross margin growth by employing Monte Carlo simulations to estimate the volatility and systematic relative risk of gross margin levels and discounting the associated cash payment amounts to their present values using a credit-risk-adjusted interest rate. We evaluate our estimates of the fair value of contingent consideration liabilities on a periodic basis. Any changes in the fair value of contingent consideration liabilities are recorded through earnings. The total estimated fair value of contingent consideration liabilities was $1.9 million and $2.8 million at December 27, 2014 and December 28, 2013, respectively, and was included in accrued expenses and other liabilities in our consolidated balance sheets. • Self-insured accruals. We estimate costs required to settle claims related to our self-insured medical, dental and workers' compensation plans. These estimates include costs to settle known claims, as well as incurred and unreported claims. The estimated costs of known and unreported claims are based on historical experience. Actual results could differ from assumptions used to estimate these accruals. • Income taxes. The Company’s effective tax rate is based on its income, statutory tax rates and tax planning opportunities available in the jurisdictions in which it operates. Tax laws are complex and subject to different interpretations by the taxpayer and respective governmental taxing authorities. Deferred tax assets represent amounts available to reduce income taxes payable on taxable income in a future period. The Company evaluates the recoverability of these future tax benefits by assessing the adequacy of future expected taxable income from all sources, including reversal of taxable temporary differences, forecasted operating earnings and available tax planning strategies. These sources of income inherently rely on estimates, including business forecasts and other projections of financial results over an extended period of time. In the event that the Company is not able to realize all or a portion of its deferred tax assets in the future, a valuation allowance is provided. The Company would recognize such amounts through a charge to income in the period in which that determination is made or when tax law changes are enacted. The Company had valuation allowances of $4.3 million at December 27, 2014 and $3.7 million at December 28, 2013. For further information regarding the Company’s valuation allowances, see Note 14 to the consolidated financial statements. • Loss contingencies. We routinely assess our exposure related to legal matters, environmental matters, product liabilities or any other claims against our assets that may arise in the normal course of business. If we determine that it is probable a loss has been incurred, the amount of the loss, or an amount within the range of loss, that can be reasonably estimated will be recorded.

<s>[INST] OVERVIEW After the downturn of 2008 2009, we put together a growth plan to take advantage of the unique opportunities that, we believe, has driven our sales success over the last 5 years. Since 2009, our carpet product sales have grown 96%, while the industry, we estimate, grew only around 12%. While we had planned on 10% growth per year, we became capacity constrained in 2013 as our sales grew over 30%. As a result, we accelerated our plan to grow our capacity from $350 million to a range of $550 to $600 million, depending upon product mix. In addition, we made the decision to merge our two west coast dye houses as a result of the purchase of Atlas Carpet Mills (“Atlas”) in the first quarter of 2014. Further, in the fourth quarter, we decided to discontinue the Carousel brand, a small noncore line of products that was part of the 2013 Robertex acquisition (See Note 21 in Consolidated Financial Statements). Therefore, 2014 was a year of expansion and facility realignment which impacted virtually all of our facilities. The investments we made have included both capital expenditures and temporary increases in operating costs due to implementation of the capacity expansion plan. We began the year by expanding capacity at Colormaster, our continuous dyeline. We completed the training and fully commissioning of our expanded Roanoke yarn facility designed to support our growth with internal supply and lessen our dependence on externally supplied yarn. We acquired and began the integration process of Atlas. We expanded our Eton residential tufting operations, doubling the number of machines in service. We realigned our Calhoun wool operations, a change designed to increase capacity and lower costs. Further, we moved the finished goods for our residential east coast business to our newly opened Adairsville facility, consolidating four warehousing operations into one facility. We added continuous yarn dyeing capability to our Colormaster facility and expanded our yarn skein dye operations in Calhoun. Similarly, we shut down our Atmore carpet and yarn dye operations, converting that mill to a dry mill dedicated to serving our Masland Contract brand. As part of this process, we decommissioned our Atmore wastewater treatment plant. Further, on the west coast, we merged our newly acquired Atlas dye house into our Susan Street dye facility. We upgraded our machine tufted rug capability during the year with added capacity as well as installing skein dye yarn capability to support our custom wool rug programs. We purchased Burtco Enterprises, LLC (“Burtco”) and its excellence in computerized yarn placement tufting technology, using this as the foundation for our newly formed Masland Hospitality sales force. A prime focus in 2015 is on training our workforce which has increased 45% since the beginning of 2013. Further, in 2015 we are focused on improving waste, yields and efficiencies in our operations. We are seeing the positive impact of our expanded sales force, the result of our efforts in 2013 and 2014 to significantly increase our field coverage. Several of the initiatives above were undertaken as a warehousing/distribution/manufacturing restructuring plan approved by our Board of Directors on January 20, 2014. This plan was developed to align our warehousing, distribution and manufacturing to support our growth and manufacturing strategy and to create a better cost structure and to improve distribution capabilities and customer service. The key element and first major step of this plan was securing a 292,000 square foot facility that serves as a finished goods warehouse and a cutorder and distribution center in Adairsville, Georgia on May 1, 2014. In June of 2014, the Board of Directors approved a modification of this plan to include the elimination of both carpet dyeing and yarn dyeing in our Atmore, Alabama facility designed to more fully accommodate our distribution and manufacturing realignment. As a result, the dyeing operations in Atmore were moved to our Colormaster continuous dyeing facility, our Calhoun Wool skein dyeing operation and other outside dyeing processors. Expenses of this plan were $4 [/INST] Negative. </s>

DIXIE GROUP INC

2016-03-09

2015-12-26

Item 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The following discussion and analysis should be read in conjunction with our consolidated financial statements and related notes appearing elsewhere in this report. OVERVIEW Our business consists principally of marketing, manufacturing and selling carpet and rugs to high-end residential and commercial customers through our various sales forces and brands. We focus exclusively on the upper-end of the soft floorcovering market where we believe we have strong brands and competitive advantages with our style and design capabilities and customer relationships. Our Fabrica, Masland, and Dixie Home brands have a significant presence in the high-end residential soft floorcovering markets. Our Atlas Carpet Mills, Masland Contract and Masland Hospitality brands, participate in the upper end specified commercial marketplace. Dixie International sells all of our brands outside of the North American market. During 2015, our net sales increased 3.9% compared with 2014. Sales of residential products decreased 0.4% in 2015 versus 2014, while, we estimate, the industry was down slightly. We anticipate the residential remodeling market to have marginal growth for next year. Commercial product sales increased 14.4% during 2015, while, we believe, the industry reflected an increase in the low single digits. We anticipate the commercial market to have moderate growth for next year. We have completed the bulk of our capacity expansion and consolidation initiatives. However, during these endeavors, we experienced high training, quality and waste costs. We experienced a dramatically changed labor market in 2014 and 2015 as we no longer could easily recruit individuals with previous industry experience; therefore, our new hires required extensive training. In addition, we had significantly higher labor turnover than we had experienced in the period immediately prior to our expansion. We believe we have significantly improved our quality throughout 2015 as our new associates became trained in their new roles; however, we are still experiencing higher waste and claims cost from inventory produced during this period of consolidation. The status of our restructuring and facilities consolidation plans are discussed below. Our Warehousing, Distribution & Manufacturing Consolidation Plan was developed to align our warehousing, distribution and manufacturing with our growth and manufacturing strategy. The plan was designed to create a better cost structure as well as improve distribution capabilities and customer service. In June of 2014, the Board of Directors approved a modification of this plan to include the elimination of both carpet dyeing and yarn dyeing in our Atmore, Alabama facility. Elimination of dyeing at this facility was designed to more fully accommodate our distribution and manufacturing realignment. Accordingly, the dyeing operations in Atmore were moved to our Colormaster continuous dyeing facility, our Calhoun Wool skein dyeing operation and other outside dyeing processors. Total expenses of the Warehousing, Distribution & Manufacturing Consolidation Plan are anticipated to be approximately $6.5 million. Expenses incurred in 2015 were $2.0 million and $6.1 million since initiation of the plan in 2014. We estimate additional spending primarily related to the movement of our Saraland, Alabama rug operation moving from a rented facility into a company-owned facility of approximately $406 thousand under this plan through early 2016. These expenses of the plan primarily consist of moving and relocating inventory and equipment, facility restoration, information technology expenses and expenses relating to conversion and realignment of equipment. We also incurred non-cash asset impairment charges of $1.1 million subsequent to the first quarter of 2014 related to manufacturing changes and equipment taken out of service in our facilities. On March 19, 2014, we acquired Atlas Carpet Mills. As a part of the Atlas acquisition, we discontinued operations at the Atlas dyeing facility in Los Angeles and moved the carpet dyeing of their products to our Susan Street dyeing operation located in Santa Ana, California. We initiated an Atlas Integration Plan to accommodate the dyeing move and address the modification of computer systems. The costs of these initiatives were $1.7 million. This plan was completed in the second quarter of 2015. In April 2015, the Company's Board of Directors approved the Corporate Office Consolidation Plan, to cover the costs of consolidating three of the Company's existing leased divisional and corporate offices to a single leased facility located in Dalton, Georgia. The Company paid a fee to terminate one of the leases, did not renew a second facility and vacated the third facility. Related to the vacated facility, the Company recorded the estimated costs related to the fulfillment of its contractual lease obligation and on-going facilities maintenance, net of an estimate of sub-lease expectations. Costs related to the consolidation include the lease termination fee, contractual lease obligations and moving costs. Expenses of this plan were $728 thousand in 2015 with estimated remaining costs to be approximately $60 thousand. Table of Contents 16 RESULTS OF OPERATIONS Fiscal Year Ended December 26, 2015 Compared with Fiscal Year Ended December 27, 2014 Net Sales. Net sales for the year ended December 26, 2015 were $422.5 million compared with $406.6 million in the year-earlier period, an increase of 3.9% for the year-over-year comparison. Sales for the carpet industry were down slightly for annual 2015 compared with the prior year. Our 2015 year-over-year carpet sales comparison reflected an increase of 4.5% in net sales. Sales of residential carpet were down 0.4% and sales of commercial carpet increased 14.4%. Revenue from carpet yarn processing and carpet dyeing and finishing services decreased 11.9% in 2015 compared with 2014. We believe our growth in both the residential and commercial sales were positively affected by the introduction of new and innovative product offerings. Cost of Sales. Cost of sales, as a percentage of net sales, decreased 1.6 percentage points, as a percentage of net sales in 2015 compared with 2014. During the expansion and restructuring initiatives, we have experienced high training, quality and waste costs. These costs were offset by improvements in operating efficiencies and lower raw material costs. Gross Profit. Gross profit, as a percentage of net sales, increased 1.6 percentage points in 2015 compared with 2014. The increase in gross profit as a percentage of net sales was attributable to the factors discussed above. Selling and Administrative Expenses. Selling and administrative expenses were $100.4 million in 2015 compared with $93.2 million in 2014, or an increase of 0.9% as a percentage of sales. Our increase in selling and administrative expenses as a percentage of sales was primarily driven by the higher levels of investment in new products in our Residential and Commercial brands compared with the prior year. Other Operating Expense, Net. Net other operating (income) expense was an expense of $872 thousand in 2015 compared with expense of $904 thousand in 2014. Operating Income (Loss). Operations reflected operating income of $2.0 million in 2015 compared with an operating loss of $5.2 million in 2014. Facility consolidation expenses of $2.9 million and $5.5 million were included in the 2015 and 2014 results, respectively. In addition, related asset impairment expenses of $1.1 million were included in the 2014 operating results. Interest Expense. Interest expense increased $633 thousand in 2015 principally due to higher interest rates associated with previously locked in future interest rate swaps from 2015 until 2021 to fix a portion of the Company's revolving credit facility. Other (Income) Expense, Net. Other (income) expense, net was an expense of $47 thousand compared with income of $154 thousand in 2014. Earnings from equity investments of $209 thousand were included in 2014. Table of Contents 17 Gain on Purchase of Businesses. During 2014, we recognized gains of $11.1 million on business acquisitions. The acquisition of Atlas resulted in a gain of $10.9 million and the acquisition of Burtco resulted in a gain of $173 thousand. Income Tax Provision (Benefit). Our effective income tax rate was a benefit of 23.9% in 2015. In 2015, we increased our valuation allowances by $977 thousand related to state income tax loss carryforwards and state income tax credit carryforwards. This was the result of a pretax loss in 2015 that put the Company in a three-year cumulative loss. Therefore, we cannot rely on future earnings to project the utilization of these carryforwards. Additionally, 2015 included approximately $441 thousand of federal tax credits. Our effective income tax rate was 61.0% in 2014 and included an increase of $569 thousand in increased valuation allowances related to state income tax carryforwards and state income tax credit carryforwards. Loss from Discontinued Operations and Loss on Disposal of Discontinued Operations, net of tax. In the fourth quarter of 2014, we discontinued the Carousel specialty tufting and weaving operation that was part of the 2013 Robertex, Inc. acquisition. As a result, we recognized a loss on the disposal of the discontinued operation of $1.5 million, net of tax, which included the impairment of certain intangibles associated with Carousel and its related machinery and equipment. Additionally, 2014 included a loss from the discontinued Carousel operations of $598 thousand, net of tax. Net Income (Loss). Continuing operations reflected a loss of $2.3 million, or $0.15 per diluted share in 2015, compared with income from continuing operations of $673 thousand, or $0.03 per diluted share in 2014. Our discontinued operations reflected a loss of $148 thousand, or $0.01 per diluted share in 2015 compared with a loss of $608 thousand, or $0.04 per diluted share, and a loss on disposal of discontinued operations of $1.5 million, or $0.10 per diluted share in 2014. Including discontinued operations, we had a net loss of $2.4 million, or $0.16 per diluted share, in 2015 compared with a net loss of $1.4 million, or $0.11 per diluted share, in 2014. Fiscal Year Ended December 27, 2014 Compared with Fiscal Year Ended December 28, 2013 Net Sales. Net sales for the year ended December 27, 2014 were $406.6 million compared with $344.4 million in the year-earlier period, an increase of 18.1%, or 7.1% excluding Atlas, for the year-over-year comparison. Sales for the carpet industry were flat for annual 2014 compared with the prior year. Our 2014 year-over-year carpet sales comparison reflected an increase of 18.1% in net sales, or 7.5% excluding Atlas. Sales of residential carpet were up 8.2% and sales of commercial carpet increased 45.5%, or 5.5% excluding Atlas. Revenue from carpet yarn processing and carpet dyeing and finishing services increased $1.9 million in 2014 compared with 2013 primarily as a result of processing services performed by Atlas under an equity investment relationship. We Table of Contents 18 believe our growth in both the residential and commercial sales were positively affected by the introduction of new and innovative products and the expansion of our wool product offerings. Cost of Sales. Cost of sales, as a percentage of net sales, increased 1.3 percentage points, as a percentage of net sales in 2014 compared with 2013. The expansion and restructuring initiatives undertaken along with the expansion of our workforce negatively affected our operating results in the form of training costs, production inefficiencies, increased levels of waste and scrap and generally higher operating costs. Gross Profit. Gross profit increased $9.9 million in 2014 compared with 2013. The increase in gross profit was primarily attributable to higher sales. However, the gross profit dollars in 2014 were negatively impacted by our actions taken to address our capacity constraints. Selling and Administrative Expenses. Selling and administrative expenses were $93.2 million in 2014 compared with $76.2 million in 2013, or an increase of 0.7% as a percentage of sales. Our selling expense increase as a percentage of sales was primarily driven by the higher relative selling expense of Atlas and higher levels of investment in new products and marketing in our Masland Contract brand compared with the prior year. Other Operating (Income) Expense, Net. Net other operating (income) expense was an expense of $904 thousand in 2014 compared with expense of $494 thousand in 2013. The change in 2014 was primarily a result of an increase in losses on currency valuations and the amortization of an intangible asset associated with the 2014 Atlas acquisition. Operating Income (Loss). Operations reflected an operating loss of $5.2 million in 2014 compared with operating income of $8.9 million in 2013. Facility consolidation expenses of $5.5 million and related asset impairment expenses of $1.1 million were included in the 2014 operating results. Interest Expense. Interest expense increased $546 thousand in 2014 principally due to higher levels of debt to support our growth and the acquisition of capital assets under various debt arrangements. Other (Income) Expense, Net. Other (income) expense, net was income of $154 thousand in 2014 compared with expense of $26 thousand in 2013. $209 thousand of earnings from equity investments were included in 2014. Gain on Purchase of Businesses. During 2014, we recognized gains of $11.1 million on business acquisitions. The acquisition of Atlas resulted in a gain of $10.9 million and the acquisition of Burtco resulted in a gain of $173 thousand. Income Tax Provision (Benefit). Our effective income tax rate was 61.0% in 2014 and included an increase of $569 thousand in increased valuation allowances related to state income tax carryforwards and state income tax credit carryforwards. Our income tax provision was a benefit of $643 thousand in 2013 on positive earnings primarily as a result of the reversal of $1.2 million of previously established reserves for state income tax loss and tax credit carryforwards. The recognition or reversal of such reserves established by taxing jurisdiction is based on a number of factors including current and forecasted earnings. Additionally, 2013 included certain tax credits of approximately $520 thousand related to the years 2009 - 2011 determined to be available for utilization and $304 thousand of 2012 research and development tax credits that could not be recognized until the extension of the credit was approved by Congress in 2013. Loss from Discontinued Operations and Loss on Disposal of Discontinued Operations, net of tax. In the fourth quarter of 2014, we discontinued the Carousel specialty tufting and weaving operation that was part of the 2013 Robertex, Inc. acquisition. As a result, we recognized a loss on the disposal of the discontinued operation of $1.5 million, net of tax, which included the impairment of certain intangibles associated with Carousel and its related machinery and equipment. Additionally, 2014 included a loss from the discontinued Carousel operations of $598 thousand, net of tax, compared with a loss of $198 thousand, net of tax in 2013. Net Income (Loss). Continuing operations reflected income of $673 thousand, or $0.03 per diluted share in 2014, compared with income from continuing operations of $5.6 million, or $0.42 per diluted share in 2013. Our discontinued operations reflected a loss of $608 thousand, or $0.04 per diluted share, and a loss on disposal of discontinued operations of $1.5 million, or $0.10 per diluted share in 2014 compared with a loss from discontinued operations of $266 thousand, or $0.02 per diluted share in 2013. Including discontinued operations, we had a net loss of $1.4 million, or $0.11 per diluted share, in 2014 compared with net income of $5.3 million, or $0.40 per diluted share, in 2013. Table of Contents 19 LIQUIDITY AND CAPITAL RESOURCES During the year ended December 26, 2015, cash provided by operations was $8.6 million. Inventories increased $10.9 million which was offset by an increase in accounts payable and accrued expenses of $7.6 million. Inventories were increased to improve service to our customers and to build inventories from a supplier that was going through a year-end software conversion. Capital asset acquisitions for the year ended December 26, 2015 were $12.2 million; $6.8 million of cash used in investing activities, $3.3 million of equipment acquired under notes and capital leases, $1.9 million of previous deposits utilized for capital additions and $200 thousand for accrued purchases. Depreciation and amortization for the year ended December 26, 2015 were $14.1 million. We expect capital expenditures to be approximately $10.0 million in 2016 for capital expenditures while depreciation and amortization is expected to be approximately $13.5 million. Planned capital expenditures in 2016 are primarily for new equipment. During the year ended December 26, 2015, cash used in financing activities was $2.0 million. In January 2015, we entered into a ten-year $6.3 million mortgage note payable to finance an owned facility in Saraland, Alabama. We had additional proceeds of $1.0 million from equipment notes payable. These proceeds are offset by payments on notes payable and lease obligations of $9.7 million. We believe our operating cash flows, credit availability under our revolving credit facility and other sources of financing are adequate to finance our anticipated liquidity requirements. As of December 26, 2015, the unused borrowing availability under our revolving credit facility was $39.8 million. Our revolving credit facility requires us to maintain a fixed charge coverage ratio of 1.1 to 1.0 during any period that borrowing availability is less than $16.5 million. As of the date hereof, our fixed coverage ratio was less than 1.1 to 1.0, accordingly the unused availability accessible by us is the amount above $16.5 million. Significant additional cash expenditures above our normal liquidity requirements or significant deterioration in economic conditions could affect our business and require supplemental financing or other funding sources. There can be no assurance that such supplemental financing or other sources of funding can be obtained or will be obtained on terms favorable to us. Debt Facilities Revolving Credit Facility. The revolving credit facility provides for a maximum of $150.0 million of revolving credit, subject to borrowing base availability. The borrowing base is currently equal to specified percentages of the Company's eligible accounts receivable, inventories, fixed assets and real property less reserves established, from time to time, by the administrative agent under the facility. The revolving credit facility matures on March 14, 2019. The revolving credit facility is secured by a first priority lien on substantially all of our assets. At our election, advances of the revolving credit facility bear interest at annual rates equal to either (a) LIBOR for 1, 2 or 3 month periods, as selected by us, plus an applicable margin of either 1.50%, 1.75% or 2.00%, or (b) the higher of the prime rate, the Federal Funds rate plus 0.5%, or a daily LIBOR rate plus 1.00%, plus an applicable margin of either 0.50%, 0.75% or 1.00%. The applicable margin is determined based on availability under our revolving credit facility with margins increasing as availability decreases. We pay an unused line fee on the average amount by which the aggregate commitments exceed utilization of the senior credit facility equal to 0.375% per annum. The weighted-average interest rate on borrowings outstanding under our revolving credit facility was 2.23% at December 26, 2015 and 2.29% at December 27, 2014. The revolving credit facility includes certain affirmative and negative covenants that impose restrictions on our financial and business operations. The revolving credit facility requires us to maintain a fixed charge coverage ratio of 1.1 to 1.0 during any period that borrowing availability is less than $16.5 million. As of December 26, 2015, our unused borrowing availability under the revolving credit facility was $39.8 million. As of December 26, 2015, our fixed charge coverage ratio was less than 1.1 to 1.0, accordingly, the unused availability accessible by us is the amount above $16.5 million. Notes Payable - Buildings. On November 7, 2014, we entered into a ten-year $8.3 million note payable to purchase a previously leased distribution center in Adairsville, Georgia. The note payable is scheduled to mature on November 7, 2024 and is secured by the distribution center. The note payable bears interest at a variable rate equal to one month LIBOR plus 2.0% and is payable in equal monthly installments of principal of $35 thousand, plus interest calculated on the declining balance of the note, with a final payment of $4.2 million due on maturity. In addition, we entered into an interest swap with an amortizing notional amount effective November 7, 2014 which effectively fixes the interest rate at 4.50%. On January 23, 2015, we entered into a ten-year $6.3 million note payable to finance an owned facility in Saraland, Alabama. The note payable is scheduled to mature on January 7, 2025 and is secured by the facility. The note payable bears interest at a variable rate equal to one month LIBOR plus 2.0% and is payable in equal monthly installments of principal of $26 thousand, plus interest calculated on the declining balance of the note, with a final payment of $3.1 million due on maturity. In addition, we entered into a forward interest rate swap with an amortizing $5.7 million notional amount effective January 7, 2017 which effectively fixes the interest rate at 4.30%. Table of Contents 20 Obligation to Development Authority of Gordon County. On November 2, 2012, we signed a 6% seller-financed note of $5.5 million with Lineage PCR, Inc. (“Lineage”) related to the acquisition of the continuous carpet dyeing facility in Calhoun, Georgia. Effective December 28, 2012 through a series of agreements between us, the Development Authority of Gordon County, Georgia (the “Authority”) and Lineage, obligations with identical payment terms as the original note to Lineage are now payment obligations to the Authority. These transactions were consummated in order to provide us with a tax abatement to the related real estate and equipment at this facility. The tax abatement plan provides for abatement for certain components of the real and personal property taxes for up to ten years. At any time, we have the option to pay off the obligation, plus a nominal amount. The debt to the Authority bears interest at 6% and is payable in equal monthly installments of principal and interest of $106 thousand over 57 months. Note Payable - Robertex Acquisition. On July 1, 2013, we signed a 4.5% seller-financed note of $4.0 million, which was recorded at a fair value of $3.7 million with Robert P. Rothman related to the acquisition of Robertex Associates, LLC ("Robertex") in Calhoun, Georgia. The note is payable in five annual installments of principal of $800 thousand plus interest. The note matures June 30, 2018. Equipment Notes Payable. Our equipment financing notes have terms ranging from three to seven years, are secured by the specific equipment financed, bear interest ranging from 1.00% to 6.86% and are due in monthly installments of principal and interest ranging from $3 thousand to $53 thousand through September 2022. The notes do not contain financial covenants. (See Note 10 to our Consolidated Financial Statements). Capital Lease Obligations. Our capital lease obligations have terms ranging from three to seven years, are secured by the specific equipment leased, bear interest ranging from 2.90% to 7.37% and are due in monthly installments of principal and interest ranging from $1 thousand to $43 thousand through January 2022. (See Note 10 to our Consolidated Financial Statements). Contractual Obligations The following table summarizes our future minimum payments under contractual obligations as of December 26, 2015. (1) Interest rates used for variable rate debt were those in effect at December 26, 2015. Stock-Based Awards We recognize compensation expense related to share-based stock awards based on the fair value of the equity instrument over the period of vesting for the individual stock awards that were granted. At December 26, 2015, the total unrecognized compensation expense related to unvested restricted stock awards was $2.5 million with a weighted-average vesting period of 5.0 years. At December 26, 2015, there was no unrecognized compensation expense related to unvested stock options. Off-Balance Sheet Arrangements We have no off-balance sheet arrangements at December 26, 2015 or December 27, 2014. Income Tax Considerations During 2015, we increased our valuation allowances by $977 thousand related to state income tax loss carryforwards and state income tax credit carryforwards. The increase was based on a number of factors including current and future earnings assumptions by taxing jurisdictions. During 2016 and 2017, we do not anticipate any cash outlays for income taxes. This is due to tax loss carryforwards and tax credit carryforwards that will be used to offset taxable income. At December 26, 2015, we were in a net deferred tax asset position of $4.7 million. We performed an analysis, including an evaluation of certain tax planning strategies available to us, related to the net Table of Contents 21 deferred tax asset and believe that the net deferred tax asset is recoverable in future periods. Approximately $12.4 million of future taxable income would be required to realize the deferred tax asset. Discontinued Operations - Environmental Contingencies We have reserves for environmental obligations established at five previously owned sites that were associated with our discontinued textile businesses. We have a reserve of $1.6 million for environmental liabilities at these sites as of December 26, 2015. The liability established represents our best estimate of loss and is the reasonable amount to which there is any meaningful degree of certainty given the periods of estimated remediation and the dollars applicable to such remediation for those periods. The actual timeline to remediate, and thus, the ultimate cost to complete such remediation through these remediation efforts, may differ significantly from our estimates. Pre-tax cost for environmental remediation obligations classified as discontinued operations were primarily a result of specific events requiring action and additional expense in each period. Fair Value of Financial Instruments At December 26, 2015, we had $584 thousand of liabilities measured at fair value that fall under a level 3 classification in the hierarchy (those subject to significant management judgment or estimation). Certain Related Party Transactions During 2015, we purchased a portion of our product needs in the form of fiber, yarn and carpet from Engineered Floors, an entity substantially controlled by Robert E. Shaw, a shareholder of our company. Mr. Shaw reported holding approximately 8.4% of our Common Stock, which as of year-end represented approximately 4% of the total vote of all classes of our Common Stock. Engineered Floors is one of several suppliers of such materials. Total purchases from Engineered Floors for 2015, 2014 and 2013 were approximately $8.8 million, $11.3 million and $12.0 million, respectively; or approximately 2.8%, 3.6% and 4.6% of our consolidated costs of sales in 2015, 2014 and 2013, respectively. Purchases from Engineered Floors are based on market value, negotiated prices. We have no contractual commitments with Mr. Shaw associated with our business relationship with Engineered Floors. Transactions with Engineered Floors were reviewed by our board of directors. We are party to a 5-year lease with the seller of Atlas Carpet Mills, Inc. to lease three manufacturing facilities as part of the acquisition in 2014. The lessor is controlled by an associate of the Company. Rent paid to the lessor during 2015 and 2014 was $458 thousand and $343 thousand, respectively. The lease was based on current market values for similar facilities. We are party to a 10-year lease with the Rothman Family Partnership to lease a manufacturing facility as part of the Robertex acquisition in 2013. The lessor is controlled by an associate of the Company. Rent paid to the lessor during 2015, 2014 and 2013 was $262 thousand, $257 thousand and $127 thousand, respectively. The lease was based on current market values for similar facilities. In addition, we have a note payable to Robert P. Rothman related to the acquisition of Robertex, Inc. (See Note 10). Recent Accounting Pronouncements See Note 2 in the Notes to the Consolidated Financial Statements of this Form 10-K for a discussion of new accounting pronouncements which is incorporated herein by reference. Critical Accounting Policies Certain estimates and assumptions are made when preparing our financial statements. Estimates involve judgments with respect to, among other things, future economic factors that are difficult to predict. As a result, actual amounts could differ from estimates made when our financial statements are prepared. The Securities and Exchange Commission requires management to identify its most critical accounting policies, defined as those that are both most important to the portrayal of our financial condition and operating results and the application of which requires our most difficult, subjective, and complex judgments. Although our estimates have not differed materially from our experience, such estimates pertain to inherently uncertain matters that could result in material differences in subsequent periods. We believe application of the following accounting policies require significant judgments and estimates and represent our critical accounting policies. Other significant accounting policies are discussed in Note 1 to our Consolidated Financial Statements. • Revenue recognition. Revenues, including shipping and handling amounts, are recognized when the following criteria are met: there is persuasive evidence that a sales agreement exists, delivery has occurred or services have been rendered, the price to the buyer is fixed or determinable, and collection is reasonably assured. Delivery is considered to have occurred when the customer takes title to products, which is generally on the date of shipment. At the time revenue is recognized, we record a provision for the estimated amount of future returns including product warranties and customer claims based primarily on historical experience and any known trends or conditions. Table of Contents 22 • Customer claims and product warranties. We provide product warranties related to manufacturing defects and specific performance standards for our products. We record reserves for the estimated costs of defective products and failure to meet applicable performance standards. The levels of reserves are established based primarily upon historical experience and our evaluation of pending claims. Because our evaluations are based on historical experience and conditions at the time our financial statements are prepared, actual results could differ from the reserves in our Consolidated Financial Statements. • Accounts receivable allowances. We provide allowances for expected cash discounts and doubtful accounts based upon historical experience and periodic evaluations of the financial condition of our customers. If the financial conditions of our customers were to significantly deteriorate, or other factors impair their ability to pay their debts, credit losses could differ from allowances recorded in our Consolidated Financial Statements. • Inventories. Inventories are stated at the lower of cost or market. Cost is determined using the last-in, first-out method (LIFO), which generally matches current costs of inventory sold with current revenues, for substantially all inventories. Reserves are also established to adjust inventories that are off-quality, aged or obsolete to their estimated net realizable value. Additionally, rates of recoverability per unit of off-quality, aged or obsolete inventory are estimated based on historical rates of recoverability and other known conditions or circumstances that may affect future recoverability. Actual results could differ from assumptions used to value our inventory. • Goodwill. Goodwill is tested annually for impairment during the fourth quarter or earlier if significant events or substantive changes in circumstances occur that may indicate that goodwill may not be recoverable. The goodwill impairment tests are based on determining the fair value of the specified reporting units based on management judgments and assumptions using the discounted cash flows. The valuation approaches are subject to key judgments and assumptions that are sensitive to change such as judgments and assumptions about sales growth rates, operating margins and the weighted average cost of capital (“WACC”). When developing these key judgments and assumptions, we consider economic, operational and market conditions that could impact the fair value of the reporting unit. However, estimates are inherently uncertain and represent only management’s reasonable expectations regarding future developments. These estimates and the judgments and assumptions upon which the estimates are based will, in all likelihood, differ in some respects from actual future results. Should a significant or prolonged deterioration in economic conditions occur key judgments and assumptions could be impacted. • Contingent Consideration. Contingent consideration liabilities represent future amounts we may be required to pay in conjunction with various business combinations. The ultimate amount of future payments is based on incremental gross margin growth related to the contingent liability. We estimate the fair value of the contingent consideration liability by forecasting estimated cash payments based on incremental gross margin growth and discounting the associated cash payment amounts to their present values using a credit-risk-adjusted interest rate. We evaluate our estimates of the fair value of contingent consideration liabilities on a periodic basis. Any changes in the fair value of contingent consideration liabilities are recorded through earnings. The total estimated fair value of contingent consideration liabilities was $584 thousand and $1.9 million at December 26, 2015 and December 27, 2014, respectively, and was included in accrued expenses and other liabilities in our consolidated balance sheets. • Self-insured accruals. We estimate costs required to settle claims related to our self-insured medical, dental and workers' compensation plans. These estimates include costs to settle known claims, as well as incurred and unreported claims. The estimated costs of known and unreported claims are based on historical experience. Actual results could differ from assumptions used to estimate these accruals. • Income taxes. The Company’s effective tax rate is based on its income, statutory tax rates and tax planning opportunities available in the jurisdictions in which it operates. Tax laws are complex and subject to different interpretations by the taxpayer and respective governmental taxing authorities. Deferred tax assets represent amounts available to reduce income taxes payable on taxable income in a future period. The Company evaluates the recoverability of these future tax benefits by assessing the adequacy of future expected taxable income from all sources, including reversal of taxable temporary differences, forecasted operating earnings and available tax planning strategies. These sources of income inherently rely on estimates, including business forecasts and other projections of financial results over an extended period of time. In the event that the Company is not able to realize all or a portion of its deferred tax assets in the future, a valuation allowance is provided. The Company would recognize such amounts through a charge to income in the period in which that determination is made or when tax law changes are enacted. The Company had valuation allowances of $5.3 million at December 26, 2015 and $4.3 million at December 27, 2014. For further information regarding the Company’s valuation allowances, see Note 14 to the consolidated financial statements. • Loss contingencies. We routinely assess our exposure related to legal matters, environmental matters, product liabilities or any other claims against our assets that may arise in the normal course of business. If we determine that it is probable a loss has been incurred, the amount of the loss, or an amount within the range of loss, that can be reasonably estimated will be recorded. Table of Contents 23

<s>[INST] OVERVIEW Our business consists principally of marketing, manufacturing and selling carpet and rugs to highend residential and commercial customers through our various sales forces and brands. We focus exclusively on the upperend of the soft floorcovering market where we believe we have strong brands and competitive advantages with our style and design capabilities and customer relationships. Our Fabrica, Masland, and Dixie Home brands have a significant presence in the highend residential soft floorcovering markets. Our Atlas Carpet Mills, Masland Contract and Masland Hospitality brands, participate in the upper end specified commercial marketplace. Dixie International sells all of our brands outside of the North American market. During 2015, our net sales increased 3.9% compared with 2014. Sales of residential products decreased 0.4% in 2015 versus 2014, while, we estimate, the industry was down slightly. We anticipate the residential remodeling market to have marginal growth for next year. Commercial product sales increased 14.4% during 2015, while, we believe, the industry reflected an increase in the low single digits. We anticipate the commercial market to have moderate growth for next year. We have completed the bulk of our capacity expansion and consolidation initiatives. However, during these endeavors, we experienced high training, quality and waste costs. We experienced a dramatically changed labor market in 2014 and 2015 as we no longer could easily recruit individuals with previous industry experience; therefore, our new hires required extensive training. In addition, we had significantly higher labor turnover than we had experienced in the period immediately prior to our expansion. We believe we have significantly improved our quality throughout 2015 as our new associates became trained in their new roles; however, we are still experiencing higher waste and claims cost from inventory produced during this period of consolidation. The status of our restructuring and facilities consolidation plans are discussed below. Our Warehousing, Distribution & Manufacturing Consolidation Plan was developed to align our warehousing, distribution and manufacturing with our growth and manufacturing strategy. The plan was designed to create a better cost structure as well as improve distribution capabilities and customer service. In June of 2014, the Board of Directors approved a modification of this plan to include the elimination of both carpet dyeing and yarn dyeing in our Atmore, Alabama facility. Elimination of dyeing at this facility was designed to more fully accommodate our distribution and manufacturing realignment. Accordingly, the dyeing operations in Atmore were moved to our Colormaster continuous dyeing facility, our Calhoun Wool skein dyeing operation and other outside dyeing processors. Total expenses of the Warehousing, Distribution & Manufacturing Consolidation Plan are anticipated to be approximately $6.5 million. Expenses incurred in 2015 were $2.0 million and $6.1 million since initiation of the plan in 2014. We estimate additional spending primarily related to the movement of our Saraland, Alabama rug operation moving from a rented facility into a companyowned facility of approximately $406 thousand under this plan through early 2016. These expenses of the plan primarily consist of moving and relocating inventory and equipment, facility restoration, information technology expenses and expenses relating to conversion and realignment of equipment. We also incurred noncash asset impairment charges of $1.1 million subsequent to the first quarter of 2014 related to manufacturing changes and equipment taken out of service in our facilities. On March 19, 2014, we acquired Atlas Carpet Mills. As a part of the Atlas acquisition, we discontinued operations at the Atlas dyeing facility in Los Angeles and moved the carpet dyeing of their products to our Susan Street dyeing operation located in Santa Ana, California. We initiated an Atlas Integration Plan to accommodate the dyeing move and address the modification of computer systems. The costs of these initiatives were $1.7 million. This plan was completed in the second quarter of 2015. In April 2015, the Company's Board of Directors approved the Corporate Office Consolidation Plan, to cover the costs of consolidating three of the Company's existing leased divisional and corporate [/INST] Negative. </s>

DIXIE GROUP INC

2017-03-13

2016-12-31

Item 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The following discussion and analysis should be read in conjunction with our consolidated financial statements and related notes appearing elsewhere in this report. OVERVIEW Our business consists principally of marketing, manufacturing and selling floorcovering products to high-end residential and commercial customers through our various sales forces and brands. We focus exclusively on the upper-end of the floorcovering market where we believe we have strong brands and competitive advantages with our style and design capabilities and customer relationships. Our Fabrica, Masland, and Dixie Home brands have a significant presence in the high-end residential floorcovering markets. Our Atlas Carpet Mills, Masland Contract and Masland Hospitality brands, participate in the upper-end specified commercial marketplace. Dixie International sells all of our brands outside of the North American market. During 2016, our net sales decreased 5.9%, or 7.2% on a “net sales as adjusted” basis, compared with 2015. Sales of residential products decreased 1.8%, or 3.0% on a “net sales as adjusted” basis, in 2016 versus 2015, while, we estimate, the industry was down in low single digits. We anticipate the residential housing market will have steady but moderate growth over next several years. Commercial product sales decreased 10.0%, or 11.5% on a “net sales as adjusted” basis, during 2016, while, we believe, the industry was down slightly. We anticipate the commercial market to have moderate growth for next year. (See Reconciliation of Net Sales to Net Sales as Adjusted below.) In 2016, we incurred an operating loss of $3.4 million compared with operating income of $2.0 million in 2015. Despite improvements in quality-related costs due to more strict and consistent quality standards and reduced associate medical expenses from a new plan design, the unabsorbed fixed cost due to the lower sales volume substantially offset those cost savings in 2016. In addition, operations were impacted by the reduction of inventories as we under produced our sales volume, thus negatively affecting our cost structure during the year. During 2016, we completed our capacity expansion and facility consolidation plans which began in 2014. Under these plans, we aligned our warehousing, distribution and manufacturing with our growth and manufacturing strategy. They were designed to create a better cost structure as well as improve distribution capabilities and provide for more efficient manufacturing processes. In addition, we consolidated three of our leased divisional and corporate offices to a single leased facility. Total expenses of the plans since inception were $9.9 million including $1.5 million during 2016. Despite a difficult year from a profitability perspective, we have made several changes to improve our results in the future. By completing our restructuring plans earlier in the year, we have set the stage for a more productive manufacturing environment. We reduced our claims expense significantly as our workforce training has taken affect and improved our quality. We have reduced inventory to levels commensurate with our sales and our service is in line with our customers expectations. In addition, the industry announced a price increase based on increases in cost of both labor and raw material. This price increase includes both residential and commercial products. In response to the high rate of growth for hard surface products in the last several years, we decided to initiate a series of product launches in luxury vinyl tile and engineered wood hard surface flooring products. During the fourth quarter of 2016, we began offering luxury vinyl tile (“LVT”) products under the Calibre brand which was our first hard surface offering in the commercial markets. These new LVT products are being sold by our existing Masland Contract sales force. Residentially, our Dixie Home and Masland Residential brands will be supplying Stainmaster PetProtect® luxury vinyl tile in 2017. Finally, we are preparing to launch a high-end engineered wood line through our Fabrica brand. The growth rate, measured as market sales volume in square feet, has been substantially higher for hard surface products than soft surface products over the past 4 years. Table of Contents 16 RESULTS OF OPERATIONS Fiscal Year Ended December 31, 2016 Compared with Fiscal Year Ended December 26, 2015 Our fiscal year ended December 31, 2016 had 53 weeks and fiscal year ended December 26, 2015 had 52 weeks. Discussions below related to percentage changes in net sales for the annual periods have been adjusted to reflect the comparable number of weeks and are qualified with the term “net sales as adjusted”. For comparative purposes, we define "net sales as adjusted" as net sales less the last week of sales in a 53 week fiscal year. We believe “net sales as adjusted” will assist our financial statement users in obtaining comparable data between the reporting periods. (See reconciliation of net sales to net sales as adjusted in the table below.) Reconciliation of Net Sales to Net Sales as Adjusted Net Sales. Net sales for the year ended December 31, 2016 were $397.5 million compared with $422.5 million in the year-earlier period, a decrease of 5.9%, or 7.2% on a “net sales as adjusted” basis, for the year-over-year comparison. Sales for the carpet industry were down slightly for 2016 compared with the prior year. Our 2016 year-over-year carpet sales comparison reflected a decrease of 4.7%, or 6.0% on a “net sales as adjusted” basis, in net sales. Sales of residential carpet were down 1.8%, or 3.0% on a “net sales as adjusted” basis, and sales of commercial carpet decreased 10.0%, or 11.5% on a “net sales as adjusted” basis. Revenue from carpet yarn processing and carpet dyeing and finishing services decreased 45.4%, or 45.7% on a “net sales as adjusted” basis, in 2016 compared with 2015. We experienced weaker demand across all brands during 2016 compared with 2015. Cost of Sales. Cost of sales, as a percentage of net sales, increased 1.1 percentage points, as a percentage of net sales in 2016 compared with 2015. During 2015, we were challenged with high quality-related costs as we consolidated several of our facilities. In addition, we experienced high associate medical expenses. During 2016, we reduced our quality-related costs through several quality improvement initiatives and lowered our associate medical expenses with a new plan design. These improvements were substantially offset by unabsorbed fixed cost due to the lower sales volumes experienced in 2016. In addition, operations were impacted by the reduction of inventories as we under produced our sales volume, thus negatively affecting our cost structure during the year. Table of Contents 17 Gross Profit. Gross profit, as a percentage of net sales, decreased 1.1 percentage points in 2016 compared with 2015. The decrease in gross profit as a percentage of net sales was attributable to the factors discussed above. Selling and Administrative Expenses. Selling and administrative expenses were $97.0 million in 2016 compared with $100.4 million in 2015, or an increase of 0.6% as a percentage of sales. Selling and administrative expenses increased as a percentage of sales primarily as a result of the lower sales volumes offset in part to lower sample expenses during 2016. Other Operating Expense, Net. Net other operating (income) expense was an expense of $401 thousand in 2016 compared with expense of $872 thousand in 2015. We recognized a gain of $841 thousand from a settlement related to the 2010 BP oil spill offset by a $460 thousand expense related to the disposal of certain machinery and equipment. Facility Consolidation Expenses, Net. Facility consolidation expenses were $1.5 million in 2016 compared with $2.9 million in the year-earlier period. Facility consolidation expenses decreased in 2016 as we completed our consolidation plans during the year. During 2016, we initially accrued $690 thousand to finalize the cleanup of the site of our former waste water treatment plant that was disposed of in 2014. During the fourth quarter of 2016, we lowered the accrual by $359 thousand as we were able to refine the plan. Accordingly, if the actual costs are higher or lower, we would record an additional charge or benefit, respectively, as appropriate. Operating Income (Loss). Operations reflected an operating loss of $3.4 million in 2016 compared with operating income of $2.0 million in 2015. The increase in operating loss was attributable to the factors above. Interest Expense. Interest expense increased $457 thousand in 2016 principally due to long-term fixed interest rate swap contracts that are at higher rates than a year ago offset by lower levels of debt during 2016. Other (Income) Expense, Net. Other (income) expense, net was an expense of $22 thousand compared with expense of $47 thousand in 2015. Income Tax Provision (Benefit). Our effective income tax rate was a benefit of 41.0% in 2016. In 2016, we increased our valuation allowances by $106 thousand related to state income tax loss carryforwards and state income tax credit carryforwards. Additionally, 2016 included approximately $395 thousand of federal tax credits. Our effective income tax rate was a benefit of 23.9% in 2015. In 2015, we increased our valuation allowances by $977 thousand related to state income tax loss carryforwards and state income tax credit carryforwards. Additionally, 2015 included approximately $441 thousand of federal tax credits. Net Income (Loss). Continuing operations reflected a loss of $5.2 million, or $0.33 per diluted share in 2016, compared with a loss from continuing operations of $2.3 million, or $0.15 per diluted share in 2015. Our discontinued operations reflected a loss of $131 thousand, or $0.01 per diluted share and income on disposal of discontinued operations of $60 thousand, or $0.00 per diluted share in 2016 compared with a loss of $148 thousand, or $0.01 per diluted share in 2015. Including discontinued operations, we had a net loss of $5.3 million, or $0.34 per diluted share, in 2016 compared with a net loss of $2.4 million, or $0.16 per diluted share, in 2015. Table of Contents 18 Fiscal Year Ended December 26, 2015 Compared with Fiscal Year Ended December 27, 2014 Net Sales. Net sales for the year ended December 26, 2015 were $422.5 million compared with $406.6 million in the year-earlier period, an increase of 3.9% for the year-over-year comparison. Sales for the carpet industry were down slightly for annual 2015 compared with the prior year. Our 2015 year-over-year carpet sales comparison reflected an increase of 4.5% in net sales. Sales of residential carpet were down 0.4% and sales of commercial carpet increased 14.4%. Revenue from carpet yarn processing and carpet dyeing and finishing services decreased 11.9% in 2015 compared with 2014. We believe our growth in both the residential and commercial sales were positively affected by the introduction of new and innovative product offerings. Cost of Sales. Cost of sales, as a percentage of net sales, decreased 1.6 percentage points, as a percentage of net sales in 2015 compared with 2014. During the expansion and restructuring initiatives, we have experienced high training, quality and waste costs. These costs were offset by improvements in operating efficiencies and lower raw material costs. Gross Profit. Gross profit, as a percentage of net sales, increased 1.6 percentage points in 2015 compared with 2014. The increase in gross profit as a percentage of net sales was attributable to the factors discussed above. Selling and Administrative Expenses. Selling and administrative expenses were $100.4 million in 2015 compared with $93.2 million in 2014, or an increase of 0.9% as a percentage of sales. Our increase in selling and administrative expenses as a percentage of sales was primarily driven by the higher levels of investment in new products in our Residential and Commercial brands compared with the prior year. Other Operating Expense, Net. Net other operating (income) expense was an expense of $872 thousand in 2015 compared with expense of $904 thousand in 2014. Operating Income (Loss). Operations reflected operating income of $2.0 million in 2015 compared with an operating loss of $5.2 million in 2014. Facility consolidation expenses of $2.9 million and $5.5 million were included in the 2015 and 2014 results, respectively. In addition, related asset impairment expenses of $1.1 million were included in the 2014 operating results. Interest Expense. Interest expense increased $633 thousand in 2015 principally due to higher interest rates associated with previously locked in future interest rate swaps from 2015 until 2021 to fix a portion of the Company's revolving credit facility. Other (Income) Expense, Net. Other (income) expense, net was an expense of $47 thousand compared with income of $154 thousand in 2014. Earnings from equity investments of $209 thousand were included in 2014. Table of Contents 19 Gain on Purchase of Businesses. During 2014, we recognized gains of $11.1 million on business acquisitions. The acquisition of Atlas resulted in a gain of $10.9 million and the acquisition of Burtco resulted in a gain of $173 thousand. Income Tax Provision (Benefit). Our effective income tax rate was a benefit of 23.9% in 2015. In 2015, we increased our valuation allowances by $977 thousand related to state income tax loss carryforwards and state income tax credit carryforwards. This was the result of a pretax loss in 2015 that put the Company in a three-year cumulative loss. Therefore, we cannot rely on future earnings to project the utilization of these carryforwards. Additionally, 2015 included approximately $441 thousand of federal tax credits. Our effective income tax rate was 61.0% in 2014 and included an increase of $569 thousand in increased valuation allowances related to state income tax carryforwards and state income tax credit carryforwards. Loss from Discontinued Operations and Loss on Disposal of Discontinued Operations, net of tax. In the fourth quarter of 2014, we discontinued the Carousel specialty tufting and weaving operation that was part of the 2013 Robertex, Inc. acquisition. As a result, we recognized a loss on the disposal of the discontinued operation of $1.5 million, net of tax, which included the impairment of certain intangibles associated with Carousel and its related machinery and equipment. Additionally, 2014 included a loss from the discontinued Carousel operations of $598 thousand, net of tax. Net Income (Loss). Continuing operations reflected a loss of $2.3 million, or $0.15 per diluted share in 2015, compared with income from continuing operations of $673 thousand, or $0.03 per diluted share in 2014. Our discontinued operations reflected a loss of $148 thousand, or $0.01 per diluted share in 2015 compared with a loss of $608 thousand, or $0.04 per diluted share, and a loss on disposal of discontinued operations of $1.5 million, or $0.10 per diluted share in 2014. Including discontinued operations, we had a net loss of $2.4 million, or $0.16 per diluted share, in 2015 compared with a net loss of $1.4 million, or $0.11 per diluted share, in 2014. LIQUIDITY AND CAPITAL RESOURCES During the year ended December 31, 2016, cash provided by operations was $23.9 million. Inventories decreased $17.9 million and receivables decreased $7.2 million which was offset by a decrease in accounts payable and accrued expenses of $6.8 million. In order to better service our customers during our facility consolidations, we had increased inventory levels over the past few years. In addition, inventories were increased last year to build inventories from a supplier that was going through a year-end software conversion. Now that those activities are complete, we decreased inventories to more normal levels. Receivables decreased on lower sales volume. Capital asset acquisitions for the year ended December 31, 2016 were $5.3 million; $4.9 million of cash used in investing activities, $169 thousand of equipment acquired under capital leases and $258 thousand for accrued purchases. Depreciation and amortization for the year ended December 31, 2016 were $13.5 million. We expect capital expenditures to be approximately $8.0 million in 2017 while depreciation and amortization is expected to be approximately $13.3 million. Planned capital expenditures in 2017 are primarily for new equipment. During the year ended December 31, 2016, cash used in financing activities was $19.2 million. We had payments of $10.0 million on the revolving credit facility and payments of $10.5 million on notes payable and lease obligations. We believe our operating cash flows, credit availability under our revolving credit facility and other sources of financing are adequate to finance our anticipated liquidity requirements under our current operating conditions. As of December 31, 2016, the unused borrowing availability under our revolving credit facility was $45.6 million. Our revolving credit facility requires us to maintain a fixed charge coverage ratio of 1.1 to 1.0 during any period that borrowing availability is less than $16.5 million. As of the date hereof, our fixed coverage ratio was less than 1.1 to 1.0, accordingly the unused availability accessible by us was $29.1 million (the amount above $16.5 million) at December 31, 2016. Significant additional cash expenditures above our normal liquidity requirements or significant deterioration in economic conditions could affect our business and require supplemental financing or other funding sources. There can be no assurance that such supplemental financing or other sources of funding can be obtained or will be obtained on terms favorable to us. Debt Facilities Revolving Credit Facility. On September 23, 2016, we amended our revolving credit facility to revise certain definitions and extend the maturity date from March 2019 to September 2021. The revolving credit facility provides for a maximum of $150.0 million of revolving credit, subject to borrowing base availability. The borrowing base is currently equal to specified percentages of our eligible accounts receivable, inventories, fixed assets and real property less reserves established, from time to time, by the administrative agent under the facility. The revolving credit facility is secured by a first priority lien on substantially all of our assets. At our election, advances of the revolving credit facility bear interest at annual rates equal to either (a) LIBOR for 1, 2 or 3 month periods, as selected by us, plus an applicable margin ranging between 1.50% and 2.00%, or (b) the higher of the prime rate, the Federal Funds rate plus 0.5%, or a daily LIBOR rate plus 1.00%, plus an applicable margin ranging between 0.50% and 1.00%. The applicable margin is determined based on availability under the revolving credit facility with margins increasing as availability decreases, with the exception that the applicable margin cannot go below 1.75% until after March 31, 2017. As of December 31, 2016, the applicable margin on our revolving credit facility was 1.75%. We pay an unused line fee on the average amount by which Table of Contents 20 the aggregate commitments exceed utilization of the revolving credit facility equal to 0.375% per annum. The weighted-average interest rate on borrowings outstanding under the revolving credit facility was 4.40% at December 31, 2016 and 3.12% at December 26, 2015. The revolving credit facility includes certain affirmative and negative covenants that impose restrictions on our financial and business operations. The revolving credit facility requires us to maintain a fixed charge coverage ratio of 1.1 to 1.0 during any period that borrowing availability was less than $16.5 million. As of December 31, 2016, the unused borrowing availability under the revolving credit facility was $45.6 million; however, since our fixed charge coverage ratio was less than 1.1 to 1.0, the unused availability accessible by us was $29.1 million (the amount above $16.5 million) at December 31, 2016. Notes Payable - Buildings. On November 7, 2014, we entered into a ten-year $8.3 million note payable to purchase a previously leased distribution center in Adairsville, Georgia. The note payable is scheduled to mature on November 7, 2024 and is secured by the distribution center. The note payable bears interest at a variable rate equal to one month LIBOR plus 2.0% and is payable in equal monthly installments of principal of $35 thousand, plus interest calculated on the declining balance of the note, with a final payment of $4.2 million due on maturity. In addition, we entered into an interest swap with an amortizing notional amount effective November 7, 2014 which effectively fixes the interest rate at 4.50%. On January 23, 2015, we entered into a ten-year $6.3 million note payable to finance an owned facility in Saraland, Alabama. The note payable is scheduled to mature on January 7, 2025 and is secured by the facility. The note payable bears interest at a variable rate equal to one month LIBOR plus 2.0% and is payable in equal monthly installments of principal of $26 thousand, plus interest calculated on the declining balance of the note, with a final payment of $3.1 million due on maturity. In addition, we entered into a forward interest rate swap with an amortizing $5.7 million notional amount effective January 7, 2017 which will effectively fix the interest rate at 4.30%. Acquisition Note Payable - Development Authority of Gordon County. On November 2, 2012, we signed a 6% seller-financed note of $5.5 million with Lineage PCR, Inc. (“Lineage”) related to the acquisition of the continuous carpet dyeing facility in Calhoun, Georgia. Effective December 28, 2012 through a series of agreements between us, the Development Authority of Gordon County, Georgia (the “Authority”) and Lineage, obligations with identical payment terms as the original note to Lineage are now payment obligations to the Authority. These transactions were consummated in order to provide us with a tax abatement to the related real estate and equipment at this facility. The tax abatement plan provides for abatement for certain components of the real and personal property taxes for up to ten years. At any time, we have the option to pay off the obligation, plus a nominal amount. The debt to the Authority bears interest at 6% and is payable in equal monthly installments of principal and interest of $106 thousand over 57 months. Acquisition Note Payable - Robertex. On July 1, 2013, we signed a 4.5% seller-financed note of $4.0 million, which was recorded at a fair value of $3.7 million with Robert P. Rothman related to the acquisition of Robertex Associates, LLC ("Robertex") in Calhoun, Georgia. The note is payable in five annual installments of principal of $800 thousand plus interest. The note matures June 30, 2018. Notes Payable - Equipment and Other. Our equipment financing notes have terms ranging from five to seven years, bear interest ranging from 1.00% to 6.86% and are due in monthly or quarterly installments through their maturity dates. The notes are secured by the specific equipment financed and do not contain financial covenants. (See Note 10 to our Consolidated Financial Statements). Capital Lease Obligations. Our capital lease obligations have terms ranging from three to seven years, bear interest ranging from 2.90% to 7.37% and are due in monthly or quarterly installments through their maturity dates. The capital lease obligations are secured by the specific equipment leased. (See Note 10 to our Consolidated Financial Statements). Contractual Obligations The following table summarizes our future minimum payments under contractual obligations as of December 31, 2016 (1) Interest rates used for variable rate debt were those in effect at December 31, 2016. Table of Contents 21 Stock-Based Awards We recognize compensation expense related to share-based stock awards based on the fair value of the equity instrument over the period of vesting for the individual stock awards that were granted. At December 31, 2016, the total unrecognized compensation expense related to unvested restricted stock awards was $1.9 million with a weighted-average vesting period of 6.9 years. At December 31, 2016, the total unrecognized compensation expense related to Directors' Stock Performance Units was $41 thousand with a weighted-average vesting period of 0.3 years. At December 31, 2016, there was no unrecognized compensation expense related to unvested stock options. Off-Balance Sheet Arrangements We have no off-balance sheet arrangements at December 31, 2016 or December 26, 2015. Income Tax Considerations During 2016, we increased our valuation allowances by $106 thousand related to state income tax loss carryforwards and state income tax credit carryforwards. The increase was based on a number of factors including current and future earnings assumptions by taxing jurisdictions. During 2017 and 2018, we do not anticipate any cash outlays for income taxes. This is due to tax loss carryforwards and tax credit carryforwards that will be used to offset taxable income. At December 31, 2016, we were in a net deferred tax asset position of $7.6 million. We performed an analysis, including an evaluation of certain tax planning strategies available to us, related to the net deferred tax asset and believe that the net deferred tax asset is recoverable in future periods. Approximately $20.0 million of future taxable income would be required to realize the deferred tax asset. Discontinued Operations - Environmental Contingencies We have reserves for environmental obligations established at five previously owned sites that were associated with our discontinued textile businesses. We have a reserve of $1.7 million for environmental liabilities at these sites as of December 31, 2016. The liability established represents our best estimate of loss and is the reasonable amount to which there is any meaningful degree of certainty given the periods of estimated remediation and the dollars applicable to such remediation for those periods. The actual timeline to remediate, and thus, the ultimate cost to complete such remediation through these remediation efforts, may differ significantly from our estimates. Pre-tax cost for environmental remediation obligations classified as discontinued operations were primarily a result of specific events requiring action and additional expense in each period. Fair Value of Financial Instruments At December 31, 2016, we had $200 thousand of liabilities measured at fair value that fall under a level 3 classification in the hierarchy (those subject to significant management judgment or estimation). Certain Related Party Transactions During 2016, we purchased a portion of our product needs in the form of fiber, yarn and carpet from Engineered Floors, an entity substantially controlled by Robert E. Shaw, a shareholder of our company. An affiliate of Mr. Shaw reported holding approximately 7.4% of our Common Stock, which as of year-end represented approximately 3.4% of the total vote of all classes of our Common Stock. Engineered Floors is one of several suppliers of such materials. Total purchases from Engineered Floors for 2016, 2015 and 2014 were approximately $7.3 million, $8.8 million and $11.3 million, respectively; or approximately 2.4%, 2.8% and 3.6% of our consolidated costs of sales in 2016, 2015 and 2014, respectively. Purchases from Engineered Floors are based on market value, negotiated prices. We have no contractual commitments with Mr. Shaw associated with our business relationship with Engineered Floors. Transactions with Engineered Floors are reviewed annually by our board of directors. We are party to a 5-year lease with the seller of Atlas Carpet Mills, Inc. to lease three manufacturing facilities as part of the acquisition in 2014. The lessor is controlled by an associate of our company. Rent paid to the lessor during 2016, 2015 and 2014 was $793 thousand, $458 thousand and $343 thousand, respectively. The lease was based on current market values for similar facilities. We are party to a 10-year lease with the Rothman Family Partnership to lease a manufacturing facility as part of the Robertex acquisition in 2013. The lessor is controlled by an associate of our company. Rent paid to the lessor during 2016, 2015 and 2014 was $267 thousand, $262 thousand and $257 thousand, respectively. The lease was based on current market values for similar facilities. In addition, we have a note payable to Robert P. Rothman related to the acquisition of Robertex, Inc. (See Note 10 to our Consolidated Financial Statements). Table of Contents 22 Recent Accounting Pronouncements See Note 2 in the Notes to the Consolidated Financial Statements of this Form 10-K for a discussion of new accounting pronouncements which is incorporated herein by reference. Critical Accounting Policies Certain estimates and assumptions are made when preparing our financial statements. Estimates involve judgments with respect to, among other things, future economic factors that are difficult to predict. As a result, actual amounts could differ from estimates made when our financial statements are prepared. The Securities and Exchange Commission requires management to identify its most critical accounting policies, defined as those that are both most important to the portrayal of our financial condition and operating results and the application of which requires our most difficult, subjective, and complex judgments. Although our estimates have not differed materially from our experience, such estimates pertain to inherently uncertain matters that could result in material differences in subsequent periods. We believe application of the following accounting policies require significant judgments and estimates and represent our critical accounting policies. Other significant accounting policies are discussed in Note 1 to our Consolidated Financial Statements. • Revenue recognition. Revenues, including shipping and handling amounts, are recognized when the following criteria are met: there is persuasive evidence that a sales agreement exists, delivery has occurred or services have been rendered, the price to the buyer is fixed or determinable, and collection is reasonably assured. Delivery is considered to have occurred when the customer takes title to products, which is generally on the date of shipment. At the time revenue is recognized, we record a provision for the estimated amount of future returns including product warranties and customer claims based primarily on historical experience and any known trends or conditions. • Customer claims and product warranties. We provide product warranties related to manufacturing defects and specific performance standards for our products. We record reserves for the estimated costs of defective products and failure to meet applicable performance standards. The levels of reserves are established based primarily upon historical experience and our evaluation of pending claims. Because our evaluations are based on historical experience and conditions at the time our financial statements are prepared, actual results could differ from the reserves in our Consolidated Financial Statements. • Accounts receivable allowances. We provide allowances for expected cash discounts and doubtful accounts based upon historical experience and periodic evaluations of the financial condition of our customers. If the financial conditions of our customers were to significantly deteriorate, or other factors impair their ability to pay their debts, credit losses could differ from allowances recorded in our Consolidated Financial Statements. • Inventories. Inventories are stated at the lower of cost or market. Cost is determined using the last-in, first-out method (LIFO), which generally matches current costs of inventory sold with current revenues, for substantially all inventories. Reserves are also established to adjust inventories that are off-quality, aged or obsolete to their estimated net realizable value. Additionally, rates of recoverability per unit of off-quality, aged or obsolete inventory are estimated based on historical rates of recoverability and other known conditions or circumstances that may affect future recoverability. Actual results could differ from assumptions used to value our inventory. • Goodwill. Goodwill is tested annually for impairment during the fourth quarter or earlier if significant events or substantive changes in circumstances occur that may indicate that goodwill may not be recoverable. The goodwill impairment tests are based on determining the fair value of the specified reporting units based on management judgments and assumptions using the discounted cash flows and comparable company market valuation approaches. We have identified our reporting unit as our floorcovering business for the purposes of allocating goodwill and assessing impairments. The valuation approaches are subject to key judgments and assumptions that are sensitive to change such as judgments and assumptions about sales growth rates, operating margins, the weighted average cost of capital (“WACC”) and comparable company market multiples. When developing these key judgments and assumptions, we consider economic, operational and market conditions that could impact the fair value of the reporting unit. However, estimates are inherently uncertain and represent only management’s reasonable expectations regarding future developments. These estimates and the judgments and assumptions upon which the estimates are based will, in all likelihood, differ in some respects from actual future results. Should a significant or prolonged deterioration in economic conditions occur or a decline in comparable company market multiples, then key judgments and assumptions could be impacted. We performed our annual assessment of goodwill in the fourth quarters of 2016, 2015 and 2014 and no impairment was indicated. • Contingent Consideration. Contingent consideration liabilities represent future amounts we may be required to pay in conjunction with various business combinations. The ultimate amount of future payments is based on incremental gross margin growth related to the contingent liability. We estimate the fair value of the contingent consideration liability by forecasting estimated cash payments based on incremental gross margin growth and discounting the associated cash payment amounts to their present values using a credit-risk-adjusted interest rate. We evaluate our estimates of the fair Table of Contents 23 value of contingent consideration liabilities on a periodic basis. Any changes in the fair value of contingent consideration liabilities are recorded through earnings. The total estimated fair value of contingent consideration liabilities was $200 thousand and $584 thousand at December 31, 2016 and December 26, 2015, respectively, and was included in accrued expenses and other liabilities in our consolidated balance sheets. • Self-insured accruals. We estimate costs required to settle claims related to our self-insured medical, dental and workers' compensation plans. These estimates include costs to settle known claims, as well as incurred and unreported claims. The estimated costs of known and unreported claims are based on historical experience. Actual results could differ from assumptions used to estimate these accruals. • Income taxes. Our effective tax rate is based on income, statutory tax rates and tax planning opportunities available in the jurisdictions in which we operate. Tax laws are complex and subject to different interpretations by the taxpayer and respective governmental taxing authorities. Deferred tax assets represent amounts available to reduce income taxes payable on taxable income in a future period. We evaluate the recoverability of these future tax benefits by assessing the adequacy of future expected taxable income from all sources, including reversal of taxable temporary differences, forecasted operating earnings and available tax planning strategies. These sources of income inherently rely on estimates, including business forecasts and other projections of financial results over an extended period of time. In the event that we are not able to realize all or a portion of our deferred tax assets in the future, a valuation allowance is provided. We would recognize such amounts through a charge to income in the period in which that determination is made or when tax law changes are enacted. We had valuation allowances of $5.4 million at December 31, 2016 and $5.3 million at December 26, 2015. For further information regarding our valuation allowances, see Note 14 to the consolidated financial statements. • Loss contingencies. We routinely assess our exposure related to legal matters, environmental matters, product liabilities or any other claims against our assets that may arise in the normal course of business. If we determine that it is probable a loss has been incurred, the amount of the loss, or an amount within the range of loss, that can be reasonably estimated will be recorded.

<s>[INST] OVERVIEW Our business consists principally of marketing, manufacturing and selling floorcovering products to highend residential and commercial customers through our various sales forces and brands. We focus exclusively on the upperend of the floorcovering market where we believe we have strong brands and competitive advantages with our style and design capabilities and customer relationships. Our Fabrica, Masland, and Dixie Home brands have a significant presence in the highend residential floorcovering markets. Our Atlas Carpet Mills, Masland Contract and Masland Hospitality brands, participate in the upperend specified commercial marketplace. Dixie International sells all of our brands outside of the North American market. During 2016, our net sales decreased 5.9%, or 7.2% on a “net sales as adjusted” basis, compared with 2015. Sales of residential products decreased 1.8%, or 3.0% on a “net sales as adjusted” basis, in 2016 versus 2015, while, we estimate, the industry was down in low single digits. We anticipate the residential housing market will have steady but moderate growth over next several years. Commercial product sales decreased 10.0%, or 11.5% on a “net sales as adjusted” basis, during 2016, while, we believe, the industry was down slightly. We anticipate the commercial market to have moderate growth for next year. (See Reconciliation of Net Sales to Net Sales as Adjusted below.) In 2016, we incurred an operating loss of $3.4 million compared with operating income of $2.0 million in 2015. Despite improvements in qualityrelated costs due to more strict and consistent quality standards and reduced associate medical expenses from a new plan design, the unabsorbed fixed cost due to the lower sales volume substantially offset those cost savings in 2016. In addition, operations were impacted by the reduction of inventories as we under produced our sales volume, thus negatively affecting our cost structure during the year. During 2016, we completed our capacity expansion and facility consolidation plans which began in 2014. Under these plans, we aligned our warehousing, distribution and manufacturing with our growth and manufacturing strategy. They were designed to create a better cost structure as well as improve distribution capabilities and provide for more efficient manufacturing processes. In addition, we consolidated three of our leased divisional and corporate offices to a single leased facility. Total expenses of the plans since inception were $9.9 million including $1.5 million during 2016. Despite a difficult year from a profitability perspective, we have made several changes to improve our results in the future. By completing our restructuring plans earlier in the year, we have set the stage for a more productive manufacturing environment. We reduced our claims expense significantly as our workforce training has taken affect and improved our quality. We have reduced inventory to levels commensurate with our sales and our service is in line with our customers expectations. In addition, the industry announced a price increase based on increases in cost of both labor and raw material. This price increase includes both residential and commercial products. In response to the high rate of growth for hard surface products in the last several years, we decided to initiate a series of product launches in luxury vinyl tile and engineered wood hard surface flooring products. During the fourth quarter of 2016, we began offering luxury vinyl tile (“LVT”) products under the Calibre brand which was our first hard surface offering in the commercial markets. These new LVT products are being sold by our existing Masland Contract sales force. Residentially, our Dixie Home and Masland Residential brands will be supplying Stainmaster PetProtect® luxury vinyl tile in 2017. Finally, we are preparing to launch a highend engineered wood line through our Fabrica brand. The growth rate, measured as market sales volume in square feet, has been substantially higher for hard surface products than soft surface products over the past 4 years. Table of Contents 16 RESULTS OF OPERATIONS Fiscal Year Ended December 31, 2016 Compared with Fiscal Year Ended December 26, 2015 Our fis [/INST] Negative. </s>

DIXIE GROUP INC

2018-03-13

2017-12-30

Item 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The following discussion and analysis should be read in conjunction with our consolidated financial statements and related notes appearing elsewhere in this report. OVERVIEW Our business consists principally of marketing, manufacturing and selling floorcovering products to high-end residential and commercial customers through our various sales forces and brands. We focus exclusively on the upper-end of the floorcovering market where we believe we have strong brands and competitive advantages with our style and design capabilities and customer relationships. Our Fabrica, Masland, and Dixie Home brands have a significant presence in the high-end residential floorcovering markets. Our Atlas Carpet Mills and Masland Contract brands, participate in the upper-end specified commercial marketplace. Dixie International sells all of our brands outside of the North American market. Our business is primarily concentrated in areas of the soft floorcovering markets which include broadloom carpet, carpet tiles and rugs. However, over the past few years, there has been a significant shift in the flooring marketplace as hard surface products have grown at a rate much faster than soft surface products. We have responded to this accelerated shift to hard surface flooring by launching several initiatives in both our residential and commercial brands. Our commercial brands offer luxury vinyl flooring (“LVF”) products under the Calibré brand in the commercial markets. Our residential brands, Dixie Home and Masland Residential, offer Stainmaster® PetProtect™ luxury vinyl flooring. Beginning in 2018, our residential brand, Fabrica, will offer a high-end engineered wood line. During 2017, our net sales increased 3.8%, or 5.2% on a “net sales as adjusted” for the difference in the number of weeks in the period, compared with 2016. Sales of residential products increased 8.0%, or 9.3% on a “net sales as adjusted” basis, in 2017 versus 2016, while, we estimate, the industry was up in low single digits. We anticipate the residential housing market will have steady but moderate growth over next several years. Commercial product sales decreased 0.8%, or increased 0.9% on a “net sales as adjusted” basis, during 2017, while, we believe, the industry was down in the low single digits. We anticipate the commercial market to have moderate growth for next year. (See Reconciliation of Net Sales to Net Sales as Adjusted below.) In 2017, we had operating income of $4.0 million compared with an operating loss of $3.4 million in 2016. Despite the improved sales volumes in 2017, our gross profit was adversely affected by rising costs in raw materials and increased operating costs. Additionally, we incurred startup costs related to several manufacturing initiatives including (1) adding yarn processing at our Atmore, Alabama facility, (2) installing a pre-coat line for our modular tile products, (3) completing our Colormaster beck dye and skein dye consolidation, and (4) starting up our Porterville yarn operation in California. With the completion of these initiatives, we have in place a foundation that will allow us to operate more efficiently and reduce waste costs. In addition, as set forth below, we incurred expenses related to our Profit Improvement Plan during the year as we consolidated our two commercial brands. During the fourth quarter of 2017, we announced a Profit Improvement Plan to improve profitability through lower cost and streamlined decision making and aligning processes to maximize efficiency. The plan includes consolidating the management of Dixie's two commercial brands, Atlas Carpet Mills and Masland Contract, under one management team, sharing operations in sales, marketing, product development and manufacturing. Specific to this plan includes focusing nearly all commercial solution dyed make-to-order production in our Atmore, Alabama operations where we have developed such make-to-order capabilities over the last 5 years. Further, we are aligning our west coast production facilities, better utilizing our west coast real estate by moving production to our Porterville, California and Atmore, Alabama operations and preparing for more efficient distribution of our west coast products. In addition, we had reductions in related support functions such as accounting and information services. As a result of this plan, we took a charge of approximately $636 thousand in the fourth quarter of 2017. We estimate additional charges of approximately $746 in fiscal 2018. We estimate annualized reductions in cost in excess of $3 million per year once the Plan is fully implemented in 2018. Table of Contents 17 RESULTS OF OPERATIONS Fiscal Year Ended December 30, 2017 Compared with Fiscal Year Ended December 31, 2016 Our fiscal year ended December 30, 2017 had 52 weeks and fiscal year ended December 31, 2016 had 53 weeks. Discussions below related to percentage changes in net sales for the annual periods have been adjusted to reflect the comparable number of weeks and are qualified with the term “net sales as adjusted”. For comparative purposes, we define "net sales as adjusted" as net sales less the last week of sales in a 53 week fiscal year. We believe “net sales as adjusted” will assist our financial statement users in obtaining comparable data between the reporting periods. (See reconciliation of net sales to net sales as adjusted in the table below.) Reconciliation of Net Sales to Net Sales as Adjusted Net Sales. Net sales for the year ended December 30, 2017 were $412.5 million compared with $397.5 million in the year-earlier period, an increase of 3.8%, or 5.2% on a “net sales as adjusted” basis, for the year-over-year comparison. Sales for the industry were flat for 2017 compared with the prior year. Our 2017 year-over-year floorcovering sales comparison reflected an increase of 5.0%, or 6.5% on a “net sales as adjusted” basis, in net sales. Sales of residential floorcovering products were up 8.0%, or 9.3% on a “net sales as adjusted” basis, and sales of commercial floorcovering products decreased 0.8%, or increased 0.9% on a “net sales as adjusted” basis. The increase in net sales was due to strong demand for our residential products through our mass merchant distribution channels. We gained market space on the west coast vacated by Royalty Carpet Mills when they ceased operations during June of 2017. Gross Profit. Gross profit, as a percentage of net sales, increased 0.5 percentage points in 2017 compared with 2016. Despite the improved sales volumes in 2017, our gross profit was adversely affected by rising costs in raw materials and increased operating costs. We incurred startup costs related to several manufacturing initiatives including (1) adding yarn processing at our Atmore, Alabama facility, (2) installing a pre-coat line for our modular tile products, (3) completing our Colormaster beck dye and skein dye consolidation, and (4) starting up our Porterville yarn operation in California. With the completion of these initiatives, we have in place a foundation that will allow us to operate more efficiently and reduce waste costs. Table of Contents 18 Selling and Administrative Expenses. Selling and administrative expenses were $96.2 million in 2017 compared with $97.0 million in 2016, or a decrease of 1.1% as a percentage of sales. Selling and administrative expenses decreased as a percentage of sales primarily as a result of the higher sales volumes during 2017. In addition, selling and administrative expenses decreased as a result of lower sampling expenses in 2017 compared with 2016. Other Operating Expense, Net. Net other operating expense was an expense of $441 thousand in 2017 compared with expense of $401 thousand in 2016. Facility Consolidation and Severance Expenses, Net. Facility consolidation expenses were $636 thousand in 2017 compared with $1.5 million in the year-earlier period. Facility consolidation expenses decreased in 2017 as we completed our Warehousing, Distribution & Manufacturing Consolidation Plan during 2016. During 2017, we announced a Profit Improvement Plan which included the consolidation of our two commercial brands. This plan will consolidate the brands into one management team, sharing operations in sales, marketing, product development and manufacturing. As a result of this plan, we incurred expenses of $636 thousand during 2017 primarily related to severance costs. Operating Income (Loss). Operations reflected operating income of $4.0 million in 2017 compared with an operating loss of $3.4 million in 2016. Despite the improved sales volumes in 2017, our gross profit was adversely affected by rising costs in raw materials and increased operating costs. We incurred startup costs related to several manufacturing initiatives including (1) adding yarn processing at our Atmore, Alabama facility, (2) installing a pre-coat line for our modular tile products, (3) completing our Colormaster beck dye and skein dye consolidation, and (4) starting up our Porterville yarn operation in California. With the completion of these initiatives, we have in place a foundation that will allow us to operate more efficiently and reduce waste costs. In addition, we incurred expenses related to our Profit Improvement Plan during the year as we consolidated our two commercial brands. Interest Expense. Interest expense increased $347 thousand in 2017 principally due to higher levels of debt and higher rates than a year ago. Income Tax Provision (Benefit). On December 22, 2017, the President signed the Tax Cuts and Jobs Act (the “Tax Act”). The Tax Act, among other things, lowered the U.S. corporate income tax rate from 35% to 21% effective January 1, 2018. Consequently, we wrote down our net deferred tax assets as of December 30, 2017 by $8.2 million to reflect the estimated impact of the Tax Act. This amount included a charge of $1.8 million related to the re-measurement of certain net deferred tax assets using the lower U.S. corporate income tax rate and a charge of $6.4 million to increase our valuation allowance related to our net deferred tax asset. The majority of the increase in the valuation allowance is related to the revised treatment of net operating losses under the Tax Act. Absent the impact of the Tax Act, our effective income tax benefit rate for 2017 would have been 36.4%. While we have substantially completed our provisional analysis of the income tax effects of the Tax Act and recorded a reasonable estimate of such effects, the charge related to the Tax Act may differ, possibly materially, due to, among other things, further refinement of our calculations, changes in interpretations and assumptions that we have made or additional guidance that may be issued related to the Tax Act. We will complete our analysis over a one-year measurement period from the enactment date, and any adjustments during this measurement period will be included in income from continuing operations as an adjustment to income tax expense in the reporting period when such adjustments are determined. Our effective income tax rate was a benefit of 41.0% in 2016. In 2016, we increased our valuation allowances by $106 thousand related to state income tax loss carryforwards and state income tax credit carryforwards. Additionally, 2016 included approximately $395 thousand of federal tax credits. Net Loss. Continuing operations reflected a loss of $9.3 million, or $0.59 per diluted share in 2017, compared with a loss from continuing operations of $5.2 million, or $0.33 per diluted share in 2016. Our discontinued operations reflected a loss of $233 thousand, or $0.01 per diluted share in 2017 compared with a loss of $131 thousand, or $0.01 per diluted share and income on disposal of discontinued operations of $60 thousand, or $0.00 per diluted share in 2016. Including discontinued operations, we had a net loss of $9.6 million, or $0.60 per diluted share, in 2017 compared with a net loss of $5.3 million, or $0.34 per diluted share, in 2016. Table of Contents 19 Fiscal Year Ended December 31, 2016 Compared with Fiscal Year Ended December 26, 2015 Our fiscal year ended December 31, 2016 had 53 weeks and fiscal year ended December 26, 2015 had 52 weeks. Discussions below related to percentage changes in net sales for the annual periods have been adjusted to reflect the comparable number of weeks and are qualified with the term “net sales as adjusted”. For comparative purposes, we define "net sales as adjusted" as net sales less the last week of sales in a 53 week fiscal year. We believe “net sales as adjusted” will assist our financial statement users in obtaining comparable data between the reporting periods. (See reconciliation of net sales to net sales as adjusted in the table below.) Reconciliation of Net Sales to Net Sales as Adjusted Net Sales. Net sales for the year ended December 31, 2016 were $397.5 million compared with $422.5 million in the year-earlier period, a decrease of 5.9%, or 7.2% on a “net sales as adjusted” basis, for the year-over-year comparison. Sales for the carpet industry were down slightly for 2016 compared with the prior year. Our 2016 year-over-year carpet sales comparison reflected a decrease of 4.7%, or 6.0% on a “net sales as adjusted” basis, in net sales. Sales of residential carpet were down 1.8%, or 3.0% on a “net sales as adjusted” basis, and sales of commercial carpet decreased 10.0%, or 11.5% on a “net sales as adjusted” basis. Revenue from carpet yarn processing and carpet dyeing and finishing services decreased 45.4%, or 45.7% on a “net sales as adjusted” basis, in 2016 compared with 2015. We experienced weaker demand across all brands during 2016 compared with 2015. Cost of Sales. Cost of sales, as a percentage of net sales, increased 1.1 percentage points, as a percentage of net sales in 2016 compared with 2015. During 2015, we were challenged with high quality-related costs as we consolidated several of our facilities. In addition, we experienced high associate medical expenses. During 2016, we reduced our quality-related costs through several quality improvement initiatives and lowered our associate medical expenses with a new plan design. These improvements were substantially offset by unabsorbed fixed cost due to the lower sales volumes experienced in 2016. In addition, operations were impacted by the reduction of inventories as we under produced our sales volume, thus negatively affecting our cost structure during the year. Table of Contents 20 Gross Profit. Gross profit, as a percentage of net sales, decreased 1.1 percentage points in 2016 compared with 2015. The decrease in gross profit as a percentage of net sales was attributable to the factors discussed above. Selling and Administrative Expenses. Selling and administrative expenses were $97.0 million in 2016 compared with $100.4 million in 2015, or an increase of 0.6% as a percentage of sales. Selling and administrative expenses increased as a percentage of sales primarily as a result of the lower sales volumes offset in part to lower sample expenses during 2016. Other Operating Expense, Net. Net other operating (income) expense was an expense of $401 thousand in 2016 compared with expense of $872 thousand in 2015. We recognized a gain of $841 thousand from a settlement related to the 2010 BP oil spill offset by a $460 thousand expense related to the disposal of certain machinery and equipment. Facility Consolidation and Severance Expenses, Net. Facility consolidation expenses were $1.5 million in 2016 compared with $2.9 million in the year-earlier period. Facility consolidation expenses decreased in 2016 as we completed our consolidation plans during the year. During 2016, we initially accrued $690 thousand to finalize the cleanup of the site of our former waste water treatment plant that was disposed of in 2014. During the fourth quarter of 2016, we lowered the accrual by $359 thousand as we were able to refine the plan. Accordingly, if the actual costs are higher or lower, we would record an additional charge or benefit, respectively, as appropriate. Operating Income (Loss). Operations reflected an operating loss of $3.4 million in 2016 compared with operating income of $2.0 million in 2015. The increase in operating loss was attributable to the factors above. Interest Expense. Interest expense increased $457 thousand in 2016 principally due to long-term fixed interest rate swap contracts that are at higher rates than a year ago offset by lower levels of debt during 2016. Other Expense, Net. Other expense, net was an expense of $22 thousand compared with expense of $47 thousand in 2015. Income Tax Benefit. Our effective income tax rate was a benefit of 41.0% in 2016. In 2016, we increased our valuation allowances by $106 thousand related to state income tax loss carryforwards and state income tax credit carryforwards. Additionally, 2016 included approximately $395 thousand of federal tax credits. Our effective income tax rate was a benefit of 23.9% in 2015. In 2015, we increased our valuation allowances by $977 thousand related to state income tax loss carryforwards and state income tax credit carryforwards. Additionally, 2015 included approximately $441 thousand of federal tax credits. Net Loss. Continuing operations reflected a loss of $5.2 million, or $0.33 per diluted share in 2016, compared with a loss from continuing operations of $2.3 million, or $0.15 per diluted share in 2015. Our discontinued operations reflected a loss of $131 thousand, or $0.01 per diluted share and income on disposal of discontinued operations of $60 thousand, or $0.00 per diluted share in 2016 compared with a loss of $148 thousand, or $0.01 per diluted share in 2015. Including discontinued operations, we had a net loss of $5.3 million, or $0.34 per diluted share, in 2016 compared with a net loss of $2.4 million, or $0.16 per diluted share, in 2015. LIQUIDITY AND CAPITAL RESOURCES During the year ended December 30, 2017, cash used in operations was $9.6 million. Inventories increased $16.4 million, receivables increased $2.9 million and accounts payable and accrued expenses decreased $3.2 million. In order to better service our customers, we increased inventory levels. Receivables increased on higher sales volume. Capital asset acquisitions for the year ended December 30, 2017 were $13.6 million; $12.7 million of cash used in investing activities, $680 thousand of equipment acquired under capital leases and notes payable and $179 thousand for accrued purchases. Depreciation and amortization for the year ended December 30, 2017 were $12.9 million. We expect capital expenditures to be approximately $6.0 million in 2018 while depreciation and amortization is expected to be approximately $13.0 million. Planned capital expenditures in 2018 are primarily for new equipment. During the year ended December 30, 2017, cash provided by financing activities was $22.2 million. We had borrowings of $27.1 million on the revolving credit facility and $7.6 million on notes payables and payments of $10.7 million on notes payable and lease obligations. We believe our operating cash flows, credit availability under our revolving credit facility and other sources of financing are adequate to finance our anticipated liquidity requirements under current operating conditions. As of December 30, 2017, the unused borrowing availability under our revolving credit facility was $32.9 million. Our revolving credit facility requires us to maintain a fixed charge coverage ratio of 1.1 to 1.0 during any period that borrowing availability is less than $16.5 million. As of the date hereof, our fixed coverage ratio was less than 1.1 to 1.0, accordingly the unused availability accessible by us was $16.4 million (the amount above $16.5 million) at December 30, 2017. Significant additional cash expenditures above our normal liquidity requirements, significant deterioration in economic conditions or continued operating losses could affect our business and require supplemental financing or other funding sources. There can be no assurance that such supplemental financing or other sources of funding can be obtained or will be obtained on terms favorable to us. Table of Contents 21 Debt Facilities Revolving Credit Facility. The revolving credit facility provides for a maximum of $150.0 million of revolving credit, subject to borrowing base availability. The borrowing base is currently equal to specified percentages of our eligible accounts receivable, inventories, fixed assets and real property less reserves established, from time to time, by the administrative agent under the facility. The revolving credit facility matures on September 23, 2021. The revolving credit facility is secured by a first priority lien on substantially all of our assets. At our election, advances of the revolving credit facility bear interest at annual rates equal to either (a) LIBOR for 1, 2 or 3 month periods, as selected by us, plus an applicable margin ranging between 1.50% and 2.00%, or (b) the higher of the prime rate, the Federal Funds rate plus 0.5%, or a daily LIBOR rate plus 1.00%, plus an applicable margin ranging between 0.50% and 1.00%. The applicable margin is determined based on availability under the revolving credit facility with margins increasing as availability decreases. As of December 30, 2017, the applicable margin on our revolving credit facility was 1.75%. We pay an unused line fee on the average amount by which the aggregate commitments exceed utilization of the revolving credit facility equal to 0.375% per annum. The weighted-average interest rate on borrowings outstanding under the revolving credit facility was 4.12% at December 30, 2017 and 4.40% at December 31, 2016. The revolving credit facility includes certain affirmative and negative covenants that impose restrictions on our financial and business operations. The revolving credit facility restricts our borrowing availability if our fixed charge coverage ratio is less than 1.1 to 1.0. During any period that our fixed charge coverage ratio is less than 1.1 to 1.0, our borrowing availability is reduced by $16.5 million. As of December 30, 2017, the unused borrowing availability under the revolving credit facility was $32.9 million; however, since our fixed charge coverage ratio was less than 1.1 to 1.0, the unused availability accessible by us was $16.4 million (the amount above $16.5 million) at December 30, 2017. Notes Payable - Buildings. On November 7, 2014, we entered into a ten-year $8.3 million note payable to purchase a previously leased distribution center in Adairsville, Georgia. The note payable is scheduled to mature on November 7, 2024 and is secured by the distribution center. The note payable bears interest at a variable rate equal to one month LIBOR plus 2.0% and is payable in equal monthly installments of principal of $35 thousand, plus interest calculated on the declining balance of the note, with a final payment of $4.2 million due on maturity. In addition, we entered into an interest swap with an amortizing notional amount effective November 7, 2014 which effectively fixes the interest rate at 4.50%. On January 23, 2015, we entered into a ten-year $6.3 million note payable to finance an owned facility in Saraland, Alabama. The note payable is scheduled to mature on January 7, 2025 and is secured by the facility. The note payable bears interest at a variable rate equal to one month LIBOR plus 2.0% and is payable in equal monthly installments of principal of $26 thousand, plus interest calculated on the declining balance of the note, with a final payment of $3.1 million due on maturity. In addition, we entered into a forward interest rate swap with an amortizing $5.7 million notional amount effective January 7, 2017 which effectively fixes the interest rate at 4.30%. Acquisition Note Payable - Development Authority of Gordon County. On November 2, 2012, we signed a 6% seller-financed note of $5.5 million with Lineage PCR, Inc. (“Lineage”) related to the acquisition of the continuous carpet dyeing facility in Calhoun, Georgia. Effective December 28, 2012 through a series of agreements between us, the Development Authority of Gordon County, Georgia (the “Authority”) and Lineage, obligations with identical payment terms as the original note to Lineage were now payment obligations to the Authority. These transactions were consummated in order to provide us with a tax abatement to the related real estate and equipment at this facility. The tax abatement plan provided for abatement for certain components of the real and personal property taxes for up to ten years. At any time, we had the option to pay off the obligation, plus a nominal amount. The debt to the Authority bore interest at 6% and was payable in equal monthly installments of principal and interest of $106 thousand over 57 months. The note matured on November 2, 2017 and the final installment was paid at that time. Acquisition Note Payable - Robertex. On July 1, 2013, we signed a 4.5% seller-financed note of $4.0 million, which was recorded at a fair value of $3.7 million with Robert P. Rothman related to the acquisition of Robertex Associates, LLC ("Robertex") in Calhoun, Georgia. The note is payable in five annual installments of principal of $800 thousand plus interest. The note matures June 30, 2018. Notes Payable - Equipment and Other. Our equipment financing notes have terms ranging from one to seven years, bear interest ranging from 1.00% to 7.68% and are due in monthly or quarterly installments through their maturity dates. The notes are secured by the specific equipment financed and do not contain financial covenants. (See Note 9 to our Consolidated Financial Statements). Capital Lease Obligations. Our capital lease obligations have terms ranging from three to seven years, bear interest ranging from 3.55% to 7.37% and are due in monthly or quarterly installments through their maturity dates. The capital lease obligations are secured by the specific equipment leased. (See Note 9 to our Consolidated Financial Statements). Table of Contents 22 Contractual Obligations The following table summarizes our future minimum payments under contractual obligations as of December 30, 2017 (1) Interest rates used for variable rate debt were those in effect at December 30, 2017. Stock-Based Awards We recognize compensation expense related to share-based stock awards based on the fair value of the equity instrument over the period of vesting for the individual stock awards that were granted. At December 30, 2017, the total unrecognized compensation expense related to unvested restricted stock awards was $1.4 million with a weighted-average vesting period of 7.3 years. At December 30, 2017, the total unrecognized compensation expense related to Directors' Stock Performance Units was $34 thousand with a weighted-average vesting period of 0.3 years. At December 30, 2017, the total unrecognized compensation expense related to unvested stock options was $211 thousand with a weighted-average vesting period of 1.4 years. Off-Balance Sheet Arrangements We have no off-balance sheet arrangements at December 30, 2017 or December 31, 2016. Income Tax Considerations On December 22, 2017, the President signed the Tax Cuts and Jobs Act (the “Tax Act”). The Tax Act, among other things, lowered the U.S. corporate income tax rate from 35% to 21% effective January 1, 2018. Consequently, we wrote down our net deferred tax assets as of December 30, 2017 by $8.2 million to reflect the estimated impact of the Tax Act. This amount included a charge of $1.8 million related to the re-measurement of certain net deferred tax assets using the lower U.S. corporate income tax rate and a charge of $6.4 million to increase our valuation allowance related to our net deferred tax asset. The majority of the increase in the valuation allowance is related to the revised treatment of net operating losses under the Tax Act. While we have substantially completed our provisional analysis of the income tax effects of the Tax Act and recorded a reasonable estimate of such effects, the charge related to the Tax Act may differ, possibly materially, due to, among other things, further refinement of our calculations, changes in interpretations and assumptions that we have made or additional guidance that may be issued related to the Tax Act. We will complete our analysis over a one-year measurement period from the enactment date, and any adjustments during this measurement period will be included in income from continuing operations as an adjustment to income tax expense in the reporting period when such adjustments are determined. During 2018 and 2019, we do not anticipate any cash outlays for income taxes. This is due to tax loss carryforwards and tax credit carryforwards that will be used to offset taxable income. At December 30, 2017, we were in a net deferred tax liability position of $1.1 million. Discontinued Operations - Environmental Contingencies We have reserves for environmental obligations established at five previously owned sites that were associated with our discontinued textile businesses. We have a reserve of $1.7 million for environmental liabilities at these sites as of December 30, 2017. The liability established represents our best estimate of loss and is the reasonable amount to which there is any meaningful degree of certainty given the periods of estimated remediation and the dollars applicable to such remediation for those periods. The actual timeline to remediate, and thus, the ultimate cost to complete such remediation through these remediation efforts, may differ significantly from our estimates. Pre-tax cost for environmental remediation obligations classified as discontinued operations were primarily a result of specific events requiring action and additional expense in each period. Table of Contents 23 Fair Value of Financial Instruments At December 30, 2017, we had $25 thousand of liabilities measured at fair value that fall under a level 3 classification in the hierarchy (those subject to significant management judgment or estimation). Certain Related Party Transactions During 2017, we purchased a portion of our product needs in the form of fiber, yarn and carpet from Engineered Floors, an entity substantially controlled by Robert E. Shaw, a shareholder of our company. An affiliate of Mr. Shaw reported holding approximately 7.4% of our Common Stock, which as of year-end represented approximately 3.5% of the total vote of all classes of our Common Stock. Engineered Floors is one of several suppliers of such materials. Total purchases from Engineered Floors for 2017, 2016 and 2015 were approximately $7.2 million, $7.3 million and $8.8 million, respectively; or approximately 2.3%, 2.4% and 2.8% of our consolidated costs of sales in 2017, 2016 and 2015, respectively. Purchases from Engineered Floors are based on market value, negotiated prices. We have no contractual commitments with Mr. Shaw associated with our business relationship with Engineered Floors. Transactions with Engineered Floors are reviewed annually by our board of directors. We are party to a 5-year lease with the seller of Atlas Carpet Mills, Inc. to lease three manufacturing facilities as part of the acquisition in 2014. The lessor is controlled by an associate of our company. Rent paid to the lessor during 2017, 2016 and 2015 was $978 thousand, $793 thousand and $458 thousand, respectively. The lease was based on current market values for similar facilities. We are party to a 10-year lease with the Rothman Family Partnership to lease a manufacturing facility as part of the Robertex acquisition in 2013. The lessor is controlled by an associate of our company. Rent paid to the lessor during 2017, 2016 and 2015 was $273 thousand, $267 thousand and $262 thousand, respectively. The lease was based on current market values for similar facilities. In addition, we have a note payable to Robert P. Rothman related to the acquisition of Robertex, Inc. (See Note 9 to our Consolidated Financial Statements). Recent Accounting Pronouncements See Note 2 in the Notes to the Consolidated Financial Statements of this Form 10-K for a discussion of new accounting pronouncements which is incorporated herein by reference. Critical Accounting Policies Certain estimates and assumptions are made when preparing our financial statements. Estimates involve judgments with respect to, among other things, future economic factors that are difficult to predict. As a result, actual amounts could differ from estimates made when our financial statements are prepared. The Securities and Exchange Commission requires management to identify its most critical accounting policies, defined as those that are both most important to the portrayal of our financial condition and operating results and the application of which requires our most difficult, subjective, and complex judgments. Although our estimates have not differed materially from our experience, such estimates pertain to inherently uncertain matters that could result in material differences in subsequent periods. We believe application of the following accounting policies require significant judgments and estimates and represent our critical accounting policies. Other significant accounting policies are discussed in Note 1 to our Consolidated Financial Statements. • Revenue recognition. Revenues, including shipping and handling amounts, are recognized when the following criteria are met: there is persuasive evidence that a sales agreement exists, delivery has occurred or services have been rendered, the price to the buyer is fixed or determinable, and collection is reasonably assured. Delivery is considered to have occurred when the customer takes title to products, which is generally on the date of shipment. At the time revenue is recognized, we record a provision for the estimated amount of future returns including product warranties and customer claims based primarily on historical experience and any known trends or conditions. • Customer claims and product warranties. We provide product warranties related to manufacturing defects and specific performance standards for our products. We record reserves for the estimated costs of defective products and failure to meet applicable performance standards. The levels of reserves are established based primarily upon historical experience and our evaluation of pending claims. Because our evaluations are based on historical experience and conditions at the time our financial statements are prepared, actual results could differ from the reserves in our Consolidated Financial Statements. • Accounts receivable allowances. We provide allowances for expected cash discounts and doubtful accounts based upon historical experience and periodic evaluations of the financial condition of our customers. If the financial conditions of our customers were to significantly deteriorate, or other factors impair their ability to pay their debts, credit losses could differ from allowances recorded in our Consolidated Financial Statements. Table of Contents 24 • Inventories. Inventories are stated at the lower of cost or market. Cost is determined using the last-in, first-out method (LIFO), which generally matches current costs of inventory sold with current revenues, for substantially all inventories. Reserves are also established to adjust inventories that are off-quality, aged or obsolete to their estimated net realizable value. Additionally, rates of recoverability per unit of off-quality, aged or obsolete inventory are estimated based on historical rates of recoverability and other known conditions or circumstances that may affect future recoverability. Actual results could differ from assumptions used to value our inventory. • Goodwill. Goodwill is tested annually for impairment during the fourth quarter or earlier if significant events or substantive changes in circumstances occur that may indicate that goodwill may not be recoverable. The goodwill impairment tests are based on determining the fair value of the specified reporting units based on management judgments and assumptions using the discounted cash flows and comparable company market valuation approaches. We have identified our reporting unit as our floorcovering business for the purposes of allocating goodwill and assessing impairments. The valuation approaches are subject to key judgments and assumptions that are sensitive to change such as judgments and assumptions about sales growth rates, operating margins, the weighted average cost of capital (“WACC”), synergies from the viewpoint of a market participant and comparable company market multiples. When developing these key judgments and assumptions, we consider economic, operational and market conditions that could impact the fair value of the reporting unit. However, estimates are inherently uncertain and represent only management’s reasonable expectations regarding future developments. These estimates and the judgments and assumptions upon which the estimates are based will, in all likelihood, differ in some respects from actual future results. If we were unable to maintain cash flow at current levels for a prolonged period of time, we could fail to meet our goodwill tests. We are concentrated in the soft floorcovering part of the market and this area of the market has been shrinking. If we are unable to develop products that allow us to maintain or enhance our position in the upper end of the soft floorcovering portion of the market or are unable to generate growth through the offering of hard surface products we could lose the ability to generate sufficient cash flows to justify our calculations. Should a significant or prolonged deterioration in economic conditions occur, a substantial increase in our cost of capital occur or a decline in comparable company market multiples, then key judgments and assumptions could be impacted. We performed our annual assessment of goodwill in the fourth quarters of 2017, 2016 and 2015 and no impairment was indicated. In addition, at December 30, 2017, our reporting segment was not at risk of failing the goodwill impairment test. The estimated fair value exceeded the carrying amount at the date of testing in excess of 30%. • Self-insured accruals. We estimate costs required to settle claims related to our self-insured medical, dental and workers' compensation plans. These estimates include costs to settle known claims, as well as incurred and unreported claims. The estimated costs of known and unreported claims are based on historical experience. Actual results could differ from assumptions used to estimate these accruals. • Income taxes. Our effective tax rate is based on income, statutory tax rates and tax planning opportunities available in the jurisdictions in which we operate. Tax laws are complex and subject to different interpretations by the taxpayer and respective governmental taxing authorities. Deferred tax assets represent amounts available to reduce income taxes payable on taxable income in a future period. We evaluate the recoverability of these future tax benefits by assessing the adequacy of future expected taxable income from all sources, including reversal of taxable temporary differences, forecasted operating earnings and available tax planning strategies. These sources of income inherently rely on estimates, including business forecasts and other projections of financial results over an extended period of time. In the event that we are not able to realize all or a portion of our deferred tax assets in the future, a valuation allowance is provided. We recognize such amounts through a charge to income in the period in which that determination is made or when tax law changes are enacted. We had valuation allowances of $13.0 million at December 30, 2017 and $5.4 million at December 31, 2016. On December 22, 2017, the President signed the Tax Cuts and Jobs Act (the “Tax Act”). The Tax Act, among other things, lowered the U.S. corporate income tax rate from 35% to 21% effective January 1, 2018. Consequently, we wrote down our net deferred tax assets as of December 30, 2017 by $8.2 million to reflect the estimated impact of the Tax Act. This amount included a charge of $1.8 million related to the re-measurement of certain net deferred tax assets using the lower U.S. corporate income tax rate and a charge of $6.4 million to increase our valuation allowance related to our net deferred tax asset. The majority of the increase in the valuation allowance is related to the revised treatment of net operating losses under the Tax Act. While we have substantially completed our provisional analysis of the income tax effects of the Tax Act and recorded a reasonable estimate of such effects, the charge related to the Tax Act may differ, possibly materially, due to, among other things, further refinement of our calculations, changes in interpretations and assumptions that we have made or additional guidance that may be issued related to the Tax Act. We will complete our analysis over a one-year measurement period from the enactment date, and any adjustments during this measurement period will be included in income from continuing operations as an adjustment to income tax expense in the reporting period when such adjustments are determined. At December 30, 2017, we were in a net deferred tax liability position of $1.1 million. For further information regarding our valuation allowances, see Note 13 to the consolidated financial statements and for information regarding our assumption of future taxable income see Income Tax Considerations included in this report. • Loss contingencies. We routinely assess our exposure related to legal matters, environmental matters, product liabilities or any other claims against our assets that may arise in the normal course of business. If we determine that it is probable a loss has been incurred, the amount of the loss, or an amount within the range of loss, that can be reasonably estimated will be recorded. Table of Contents 25

<s>[INST] OVERVIEW Our business consists principally of marketing, manufacturing and selling floorcovering products to highend residential and commercial customers through our various sales forces and brands. We focus exclusively on the upperend of the floorcovering market where we believe we have strong brands and competitive advantages with our style and design capabilities and customer relationships. Our Fabrica, Masland, and Dixie Home brands have a significant presence in the highend residential floorcovering markets. Our Atlas Carpet Mills and Masland Contract brands, participate in the upperend specified commercial marketplace. Dixie International sells all of our brands outside of the North American market. Our business is primarily concentrated in areas of the soft floorcovering markets which include broadloom carpet, carpet tiles and rugs. However, over the past few years, there has been a significant shift in the flooring marketplace as hard surface products have grown at a rate much faster than soft surface products. We have responded to this accelerated shift to hard surface flooring by launching several initiatives in both our residential and commercial brands. Our commercial brands offer luxury vinyl flooring (“LVF”) products under the Calibré brand in the commercial markets. Our residential brands, Dixie Home and Masland Residential, offer Stainmaster® PetProtect™ luxury vinyl flooring. Beginning in 2018, our residential brand, Fabrica, will offer a highend engineered wood line. During 2017, our net sales increased 3.8%, or 5.2% on a “net sales as adjusted” for the difference in the number of weeks in the period, compared with 2016. Sales of residential products increased 8.0%, or 9.3% on a “net sales as adjusted” basis, in 2017 versus 2016, while, we estimate, the industry was up in low single digits. We anticipate the residential housing market will have steady but moderate growth over next several years. Commercial product sales decreased 0.8%, or increased 0.9% on a “net sales as adjusted” basis, during 2017, while, we believe, the industry was down in the low single digits. We anticipate the commercial market to have moderate growth for next year. (See Reconciliation of Net Sales to Net Sales as Adjusted below.) In 2017, we had operating income of $4.0 million compared with an operating loss of $3.4 million in 2016. Despite the improved sales volumes in 2017, our gross profit was adversely affected by rising costs in raw materials and increased operating costs. Additionally, we incurred startup costs related to several manufacturing initiatives including (1) adding yarn processing at our Atmore, Alabama facility, (2) installing a precoat line for our modular tile products, (3) completing our Colormaster beck dye and skein dye consolidation, and (4) starting up our Porterville yarn operation in California. With the completion of these initiatives, we have in place a foundation that will allow us to operate more efficiently and reduce waste costs. In addition, as set forth below, we incurred expenses related to our Profit Improvement Plan during the year as we consolidated our two commercial brands. During the fourth quarter of 2017, we announced a Profit Improvement Plan to improve profitability through lower cost and streamlined decision making and aligning processes to maximize efficiency. The plan includes consolidating the management of Dixie's two commercial brands, Atlas Carpet Mills and Masland Contract, under one management team, sharing operations in sales, marketing, product development and manufacturing. Specific to this plan includes focusing nearly all commercial solution dyed maketoorder production in our Atmore, Alabama operations where we have developed such maketoorder capabilities over the last 5 years. Further, we are aligning our west coast production facilities, better utilizing our west coast real estate by moving production to our Porterville, California and Atmore, Alabama operations and preparing for more efficient distribution of our west coast products. In addition, we had reductions in related support functions such as accounting and information services. As a result of this plan, we took a charge of approximately $636 thousand in the fourth quarter of 2017. We estimate additional charges of approximately $74 [/INST] Positive. </s>

DIXIE GROUP INC

2019-03-08

2018-12-29

Item 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The following discussion and analysis should be read in conjunction with our consolidated financial statements and related notes appearing elsewhere in this report. OVERVIEW Our business consists principally of marketing, manufacturing and selling floorcovering products to high-end residential and commercial customers through our various sales forces and brands. We focus exclusively on the upper-end of the floorcovering market where we believe we have strong brands and competitive advantages with our style and design capabilities and customer relationships. Our Fabrica, Masland, and Dixie Home brands have a significant presence in the high-end residential floorcovering markets. Our Atlas | Masland Contract brand participates in the upper-end specified commercial marketplace. Dixie International sells all of our brands outside of the North American market. Our business is primarily concentrated in areas of the soft floorcovering markets which include broadloom carpet, carpet tiles and rugs. However, over the past few years, there has been a significant shift in the flooring marketplace as hard surface products have grown at a rate much faster than soft surface products. We have responded to this accelerated shift to hard surface flooring by launching several initiatives in both our residential and commercial brands. Our commercial brands offer Luxury Vinyl Flooring (“LVF”) products under the Calibré brand in the commercial markets. Our residential brands, Dixie Home and Masland Residential, offer Stainmaster® PetProtect™ Luxury Vinyl Flooring and our premium residential brand, Fabrica, offers a high-end engineered wood line. For 2019 we are building on the momentum we gained by tripling our residential hard surface business in 2018 with the launch of TruCor™, our new solid polymer core or “SPC” Luxury Vinyl Flooring line. This latest addition to our rigid core Luxury Vinyl Flooring offering is designed to create an extremely durable and waterproof Luxury Vinyl Flooring product with a broader range of price points to meet the needs of various consumers. To facilitate this growth, in 2019 we are expanding our distribution of hard surface products to our west coast distribution center as well as our east coast service center. During 2018, our net sales decreased 1.8% compared with 2017. Sales of residential products increased 3.6% in 2018 versus 2017. Residential soft surface sales were up 1.4% in 2018 as compared to 2017, while, we estimate, the industry was up in the low to mid-single digits. Residential hard surface sales tripled in 2018 relative to sales in 2017. We anticipate the residential housing market, though having slowed recently, will have steady but moderate growth over the next several years. Commercial product sales decreased 13.2% during 2018. Soft surface sales of commercial products were down 19.5%, while, we believe, the industry was down in the mid-single digits. We anticipate the commercial market to be relatively flat in 2019. In 2018, we had an operating loss of $15.8 million compared with an operating income of $3.9 million in 2017. The reduced sales volume in 2018 adversely affected our gross profit as we under absorbed our costs since we had increased our capacity anticipating higher volume production. In addition, we had rising raw material costs which, passed on to our customers through higher prices, were recovered after we experienced such cost increases. The majority of our higher costs were in the first and fourth quarters of the year as we suffered with reduced demand in those time periods. We reduced plant running schedules in the fourth quarter to reduce inventories to a more appropriate level. We incurred charges during the year totaling $14.1 million comprised of $2.7 million in inventory write-downs, $3.2 million in restructuring charges, $6.7 million in asset impairments, including the write-off of goodwill and intangibles, and a $1.5-million-dollar charge for settlement of a class action litigation. Our debt declined by $5.2 million over the course of 2018. To offset those higher costs, we continued the implementation of our previously announced Profit Improvement Plan (“the Plan”). The Plan, begun in the fourth quarter of 2017, resulted in the reduction of 284 associates during 2018 and is anticipated to result in the reduction of approximately 330 associates by the end of the first quarter of 2019. Expenses related to the Plan totaled approximately $9.2 million in 2018. The Plan expenses included inventory write downs, restructuring costs, and asset impairments as we re-configured our commercial business and right sized our residential manufacturing operations for lower unit demand. Total cost reductions as a result of the Plan are expected to be over $17 million on an annual basis once fully implemented in 2019. We began the structural consolidation of our commercial business with the closure of our Chickamauga tufting operation as we moved the equipment to other facilities. This plant closure, complete at the end of 2018, lowered our cost and improved our response time to this segment of the marketplace. We began the process of exiting our Commerce, California Atlas tufting facilities this past fall and will be completely out of those commercial tufting operations by the end of the first quarter of 2019. The bulk of the Atlas equipment was transferred to our Atmore, Alabama commercial tufting operation with various other items moved to our Santa Ana, California and Eton, Georgia operations. We moved our commercial rug operation and commercial samples support function from California to our Saraland facility near Mobile, Alabama. We reduced our staffing to better match production to meet our demand in our Atmore, Eton, Adairsville and Roanoke facilities as we were able to take advantage of the increased productivity of our associates in these operations. In addition to the physical movement of equipment and inventory, we consolidated our commercial design functions in Saraland as well as consolidated our entire sales support functions. Our sales forces were merged to create Atlas | Masland Contract, now equipped with a much broader product line and providing modular carpet tile, broadloom carpet, luxury vinyl flooring, and commercial wool and nylon rugs. This combined sales force has the added benefit of not only a broad product line but distinct design capabilities in custom products as well. In the fourth quarter of 2018, our testing of goodwill indicated a full impairment of the value of the asset. In accordance with the results of our tests the value of the goodwill asset was written off to asset impairment. The amount of the adjustment was $3.4 million. Table of Contents 18 NASDAQ NOTICE On January 31, 2019, we received a deficiency notice from NASDAQ stating that we no longer comply with NASDAQ Marketplace Rule 5550(a)(2) because the bid price of our common stock closed below the required minimum $1.00 per share for the previous 30 consecutive business days. The notice also indicated that, in accordance with Marketplace Rule 5810(c)(3)(A), we have a period of 180 calendar days, until July 30, 2019, to regain compliance with Rule 5550(a)(2). If at any time before July 30, 2019 the bid price of our common stock closes at $1.00 per share or more for a minimum of 10 consecutive business days, NASDAQ will notify us that we have regained compliance with Rule 5550(a)(2). To the extent that we are unable to resolve the listing deficiency, there is a risk that our common stock may be delisted from NASDAQ, which would adversely impact liquidity of our common stock and potentially result in even lower bid prices for our common stock. Since the initial notice, the NASDAQ has determined that for the 12 consecutive business days from February 4 to February 20, 2019, the closing bid price of our common stock has been at $1.00 per share or greater. Accordingly, we have regained compliance with Listing Rule 5550(a)(2) and this matter is now closed. Table of Contents 19 RESULTS OF OPERATIONS Fiscal Year Ended December 29, 2018 Compared with Fiscal Year Ended December 30, 2017 Net Sales. Net sales for the year ended December 29, 2018 were $405.0 million compared with $412.5 million in the year-earlier period, a decrease of 1.8% for the year-over-year comparison. Sales of residential floorcovering products were up 3.6% and sales of commercial floorcovering products decreased 13.2%. The decrease in commercial net sales was due to distractions caused by the restructuring of our commercial operations and sales force during 2018. Gross Profit. Gross profit, as a percentage of net sales, decreased 3.0 percentage points in 2018 compared with 2017. Gross profit in 2018 was negatively impacted by inventory write downs of $2.7 million taken during the year as part of our Profit Improvement Plan. Selling and Administrative Expenses. Selling and administrative expenses were $92.5 million in 2018 compared with $96.2 million in 2017, or a decrease of .5% as a percentage of sales. The improved results in the 2018 selling expenses are the result of changes made as part of our Profit Improvement Plan. Other Operating Expense, Net. Net other operating expense was an expense of $458 thousand in 2018 compared with expense of $441 thousand in 2017. Facility Consolidation and Severance Expenses, Net. Facility consolidation expenses were $3.2 million in 2018 compared with $636 thousand in the year-earlier period. Facility consolidation expenses increased in 2018 as we continued our Profit Improvement Plan, announced in 2017, which includes the consolidation of our two commercial brands, consolidation of commercial manufacturing operations and sales forces, and an overall review of corporate wide operations and functions. As a result of this plan, we incurred expenses of $3.2 million during 2018 primarily related to facility consolidation expenses and severance costs. Asset Impairments. The asset impairments recorded in 2018 were $6.7 million. There were no asset impairment expenses in 2017. The asset impairments incurred in 2018 included the impairment of fixed assets as part of our Profit Improvement Plan ($1.2 million). We also incurred intangible asset impairments ($2.1 million) and goodwill impairment ($3.4 million). Operating Income (Loss). Operations reflected an operating loss of $15.8 million in 2018 compared with an operating income of $3.9 million in 2017. The operating results for 2018 were impacted by the lower sales volume, settlement of a class action lawsuit, and facility consolidation, asset impairments, and severance costs related to the Profit Improvement Plan. Interest Expense. Interest expense increased $752 thousand in 2018 principally due to higher levels of debt and higher rates than a year ago. Table of Contents 20 Income Tax Provision (Benefit). Our effective income tax rate was a benefit of 3.72% in 2018. The benefit relates to certain federal and state credits and also includes a benefit for the reduction of certain indefinite lived assets not covered by our valuation allowance. In 2018 we increased our valuation allowance by $4 million related to our net deferred tax asset and specific state net operating loss and state credit carryforwards. On December 22, 2017, the President signed the Tax Cuts and Jobs Act (the “Tax Act”). The Tax Act, among other things, lowered the U.S. corporate income tax rate from 35% to 21% effective January 1, 2018. The income tax expense for 2017 was $7.5 million, which included a charge of $1.4 million related to the re-measurement of certain net deferred tax assets using the lower U.S. corporate income tax rate and a charge of $6.4 million to increase our valuation allowance related to our net deferred tax asset. The majority of the increase in the valuation allowance is related to the revised treatment of net operating losses under the Tax Act. Absent the impact of the Tax Act, our effective income tax benefit rate for 2017 would have been 36.4%. Net Loss. Continuing operations reflected a loss of $21.5 million, or $1.36 per diluted share in 2018, compared with a loss from continuing operations of $9.3 million, or $0.59 per diluted share in 2017. Our discontinued operations reflected an income of $95 thousand, or $0.01 per diluted share in 2018 compared with a loss of $233 thousand, or $0.01 per diluted share in 2017. Including discontinued operations, we had a net loss of $21.4 million, or $1.35 per diluted share, in 2018 compared with a net loss of $9.6 million, or $0.60 per diluted share, in 2017. Fiscal Year Ended December 30, 2017 Compared with Fiscal Year Ended December 31, 2016 Our fiscal year ended December 30, 2017 had 52 weeks and fiscal year ended December 31, 2016 had 53 weeks. Discussions below related to percentage changes in net sales for the annual periods have been adjusted to reflect the comparable number of weeks and are qualified with the term “net sales as adjusted”. For comparative purposes, we define "net sales as adjusted" as net sales less the last week of sales in a 53 week fiscal year. We believe “net sales as adjusted” will assist our financial statement users in obtaining comparable data between the reporting periods. (See reconciliation of net sales to net sales as adjusted in the table below.) Table of Contents 21 Reconciliation of Net Sales to Net Sales as Adjusted Net Sales. Net sales for the year ended December 30, 2017 were $412.5 million compared with $397.5 million in the year-earlier period, an increase of 3.8%, or 5.2% on a “net sales as adjusted” basis, for the year-over-year comparison. Sales for the industry were flat for 2017 compared with the prior year. Our 2017 year-over-year floorcovering sales comparison reflected an increase of 5.0%, or 6.5% on a “net sales as adjusted” basis, in net sales. Sales of residential floorcovering products were up 8.0%, or 9.3% on a “net sales as adjusted” basis, and sales of commercial floorcovering products decreased 0.8%, or increased 0.9% on a “net sales as adjusted” basis. The increase in net sales was due to strong demand for our residential products through our mass merchant distribution channels. We gained market space on the west coast vacated by Royalty Carpet Mills when they ceased operations during June of 2017. Gross Profit. Gross profit, as a percentage of net sales, increased 0.5 percentage points in 2017 compared with 2016. Despite the improved sales volumes in 2017, our gross profit was adversely affected by rising costs in raw materials and increased operating costs. We incurred startup costs related to several manufacturing initiatives including (1) adding yarn processing at our Atmore, Alabama facility, (2) installing a pre-coat line for our modular tile products, (3) completing our Colormaster beck dye and skein dye consolidation, and (4) starting up our Porterville yarn operation in California. With the completion of these initiatives, we have in place a foundation that will allow us to operate more efficiently and reduce waste costs. Selling and Administrative Expenses. Selling and administrative expenses were $96.2 million in 2017 compared with $97.0 million in 2016, or a decrease of 1.1% as a percentage of sales. Selling and administrative expenses decreased as a percentage of sales primarily as a result of the higher sales volumes during 2017. In addition, selling and administrative expenses decreased as a result of lower sampling expenses in 2017 compared with 2016. Other Operating Expense, Net. Other operating expense, net was an expense of $441 thousand in 2017 compared with expense of $401 thousand in 2016. Facility Consolidation and Severance Expenses, Net. Facility consolidation expenses were $636 thousand in 2017 compared with $1.5 million in the year-earlier period. Facility consolidation expenses decreased in 2017 as we completed our Warehousing, Distribution & Manufacturing Consolidation Plan during 2016. During 2017, we announced a Profit Improvement Plan which included the consolidation of our two commercial brands. This plan will consolidate the brands into one management team, sharing operations in sales, marketing, product development and manufacturing. As a result of this plan, we incurred expenses of $636 thousand during 2017 primarily related to severance costs. Operating Income (Loss). Operations reflected operating income of $4.0 million in 2017 compared with an operating loss of $3.4 million in 2016. Despite the improved sales volumes in 2017, our gross profit was adversely affected by rising costs in raw materials and increased operating costs. We incurred startup costs related to several manufacturing initiatives including (1) adding yarn processing at our Atmore, Alabama facility, (2) installing a pre-coat line for our modular tile products, (3) completing our Colormaster beck dye and skein dye consolidation, and (4) starting up our Porterville yarn operation in California. With the completion of these initiatives, we have in place a foundation that will allow us to operate more efficiently and reduce waste costs. In addition, we incurred expenses related to our Profit Improvement Plan during the year as we consolidated our two commercial brands. Interest Expense. Interest expense increased $347 thousand in 2017 principally due to higher rates than a year ago. Income Tax Provision (Benefit). On December 22, 2017, the President signed the Tax Cuts and Jobs Act (the “Tax Act”). The Tax Act, among other things, lowered the U.S. corporate income tax rate from 35% to 21% effective January 1, 2018. Consequently, we wrote down our net deferred tax assets as of December 30, 2017 by $8.2 million to reflect the estimated impact of the Tax Act. This amount included a charge of $1.8 million related to the re-measurement of certain net deferred tax assets using the lower U.S. corporate income tax rate and a charge of $6.4 million to increase our valuation allowance related to our net deferred tax asset. The majority of the increase in the valuation allowance is related to the revised treatment of net operating losses under the Tax Act. Absent the impact of the Tax Act, our effective income tax benefit rate for 2017 would have been 36.4%. Our effective income tax rate was a benefit of 41.0% in 2016. In 2016, we increased our valuation allowances by $106 thousand related to state income tax loss carryforwards and state income tax credit carryforwards. Additionally, 2016 included approximately $395 thousand of federal tax credits. Table of Contents 22 Net Loss. Continuing operations reflected a loss of $9.3 million, or $0.59 per diluted share in 2017, compared with a loss from continuing operations of $5.2 million, or $0.33 per diluted share in 2016. Our discontinued operations reflected a loss of $233 thousand, or $0.01 per diluted share in 2017 compared with a loss of $131 thousand, or $0.01 per diluted share and income on disposal of discontinued operations of $60 thousand, or $0.00 per diluted share in 2016. Including discontinued operations, we had a net loss of $9.6 million, or $0.60 per diluted share, in 2017 compared with a net loss of $5.3 million, or $0.34 per diluted share, in 2016. LIQUIDITY AND CAPITAL RESOURCES During the year ended December 29, 2018, cash provided by operations was $5.1 million. Inventories decreased $8.5 million, receivables decreased $3.8 million and accounts payable and accrued expenses decreased $4.2 million. Inventories were planned more closely in 2018 and decreased with lower demand. Receivables decreased on lower sales volume. In addition to items related to the general operating expenses, accounts payable and accrued expenses includes a liability of $1.5 million for settlement of a class action lawsuit and severances related to the Profit Improvement Plan. Capital asset acquisitions for the year ended December 29, 2018 were $4.1 million. In 2018 proceeds from sale of equipment totaled $1.9 million, primarily related to assets in our plants that were closed as part of our Profit Improvement Plan. Approximately $389 thousand of equipment was acquired under capital leases and accounts payable. Depreciation and amortization for the year ended December 29, 2018 were $12.7 million. We expect capital expenditures to be approximately $6.0 million in 2019 while depreciation and amortization is expected to be approximately $13.0 million. Planned capital expenditures in 2019 are primarily for new equipment. During the year ended December 29, 2018, cash used in financing activities was $2.9 million. We had borrowings of $1.5 million on the revolving credit facility and $3.3 million on notes payables and payments of $10.4 million on notes payable and lease obligations. We believe our operating cash flows, credit availability under our revolving credit facility and other sources of financing are adequate to finance our anticipated liquidity requirements under current operating conditions. As of December 29, 2018, the unused borrowing availability under our revolving credit facility was $31.9 million. Our revolving credit facility requires us to maintain a fixed charge coverage ratio of 1.1 to 1.0 during any period that borrowing availability is less than $16.5 million. As of the date hereof, our fixed coverage ratio was less than 1.1 to 1.0, accordingly the unused availability accessible by us was $15.4 million (the amount above $16.5 million) at December 29, 2018. Significant additional cash expenditures above our normal liquidity requirements, significant deterioration in economic conditions or continued operating losses could affect our business and require supplemental financing or other funding sources. There can be no assurance that such supplemental financing or other sources of funding can be obtained or will be obtained on terms favorable to us. See Note 23 to our Consolidated Financial Statements for additional information regarding liquidity and capital resources. Debt Facilities Revolving Credit Facility. The revolving credit facility provides for a maximum of $150.0 million of revolving credit, subject to borrowing base availability. The borrowing base is currently equal to specified percentages of our eligible accounts receivable, inventories, fixed assets and real property less reserves established, from time to time, by the administrative agent under the facility. The revolving credit facility matures on September 23, 2021. The revolving credit facility is secured by a first priority lien on substantially all of our assets. At our election, advances of the revolving credit facility bear interest at annual rates equal to either (a) LIBOR for 1, 2 or 3 month periods, as selected by us, plus an applicable margin ranging between 1.50% and 2.00%, or (b) the higher of the prime rate, the Federal Funds rate plus 0.5%, or a daily LIBOR rate plus 1.00%, plus an applicable margin ranging between 0.50% and 1.00%. The applicable margin is determined based on availability under the revolving credit facility with margins increasing as availability decreases. As of December 29, 2018, the applicable margin on our revolving credit facility was 1.75%. We pay an unused line fee on the average amount by which the aggregate commitments exceed utilization of the revolving credit facility equal to 0.375% per annum. The weighted-average interest rate on borrowings outstanding under the revolving credit facility was 4.58% at December 29, 2018 and 4.12% at December 30, 2017. The revolving credit facility includes certain affirmative and negative covenants that impose restrictions on our financial and business operations. The revolving credit facility restricts our borrowing availability if our fixed charge coverage ratio is less than 1.1 to 1.0. During any period that our fixed charge coverage ratio is less than 1.1 to 1.0, our borrowing availability is reduced by $16.5 million. As of December 29, 2018, the unused borrowing availability under the revolving credit facility was $31.9 million; however, since our fixed charge coverage ratio was less than 1.1 to 1.0, the unused availability accessible by us was $15.4 million (the amount above $16.5 million) at December 29, 2018. Table of Contents 23 Notes Payable - Buildings. On November 7, 2014, we entered into a ten-year $8.3 million note payable to purchase a previously leased distribution center in Adairsville, Georgia. The note payable is scheduled to mature on November 7, 2024 and is secured by the distribution center. The note payable bears interest at a variable rate equal to one-month LIBOR plus 2.0% and is payable in equal monthly installments of principal of $35 thousand, plus interest calculated on the declining balance of the note, with a final payment of $4.2 million due on maturity. In addition, we entered into an interest rate swap with an amortizing notional amount effective November 7, 2014 which effectively fixes the interest rate at 4.50%. On January 23, 2015, we entered into a ten-year $6.3 million note payable to finance an owned facility in Saraland, Alabama. The note payable is scheduled to mature on January 7, 2025 and is secured by the facility. The note payable bears interest at a variable rate equal to one-month LIBOR plus 2.0% and is payable in equal monthly installments of principal of $26 thousand, plus interest calculated on the declining balance of the note, with a final payment of $3.1 million due on maturity. In addition, we entered into a forward interest rate swap with an amortizing notional amount effective January 7, 2017 which effectively fixes the interest rate at 4.30%. Acquisition Note Payable - Development Authority of Gordon County. On November 2, 2012, we signed a 6.00% seller-financed note of $5.5 million with Lineage PCR, Inc. (“Lineage”) related to the acquisition of the continuous carpet dyeing facility in Calhoun, Georgia. Effective December 28, 2012, through a series of agreements between us, the Development Authority of Gordon County, Georgia (the “Authority”) and Lineage, obligations with identical payment terms as the original note to Lineage were now payment obligations to the Authority. These transactions were consummated in order to provide a tax abatement to us related to the real estate and equipment at this facility. The tax abatement plan provided for abatement for certain components of the real and personal property taxes for up to ten years. At any time, we have the option to pay off the obligation, plus a nominal amount. The debt to the Authority bore interest at 6.00% and was payable in equal monthly installments of principal and interest of $106 thousand over 57 months. The note matured on November 2, 2017 and the final installment was paid at that time. Acquisition Note Payable - Robertex. On July 1, 2013, we signed a 4.50% seller-financed note of $4.0 million, which was recorded at a fair value of $3.7 million, with Robert P. Rothman related to the acquisition of Robertex Associates, LLC ("Robertex") in Calhoun, Georgia. The note was payable in five annual installments of principal of $800 thousand plus interest. The note matured on June 30, 2018. Notes Payable - Equipment and Other. Our equipment financing notes have terms ranging from 1 to 7 years, bear interest ranging from 1.00% to 7.68% and are due in monthly installments through their maturity dates. Our equipment financing notes are secured by the specific equipment financed and do not contain any financial covenants. Capital Lease Obligations. Our capitalized lease obligations have terms ranging from 3 to 7 years, bear interest ranging from 3.55% to 7.76% and are due in monthly or quarterly installments through their maturity dates. Our capital lease obligations are secured by the specific equipment leased. (See Note 10 to our Consolidated Financial Statements). Table of Contents 24 Contractual Obligations The following table summarizes our future minimum payments under contractual obligations as of December 29, 2018 (1) Interest rates used for variable rate debt were those in effect at December 29, 2018. Stock-Based Awards We recognize compensation expense related to share-based stock awards based on the fair value of the equity instrument over the period of vesting for the individual stock awards that were granted. At December 29, 2018, the total unrecognized compensation expense related to unvested restricted stock awards was $1.5 million with a weighted-average vesting period of 7.7 years. At December 29, 2018, the total unrecognized compensation expense related to Directors' Stock Performance Units was $24 thousand with a weighted-average vesting period of 0.3 years. At December 29, 2018, the total unrecognized compensation expense related to unvested stock options was $72 thousand with a weighted-average vesting period of 0.4 years. Off-Balance Sheet Arrangements We have no off-balance sheet arrangements at December 29, 2018 or December 30, 2017. Income Tax Considerations In the tax year ended December 29, 2018 we increased our valuation allowances by $4 million related to our net deferred tax asset and specific state net operating loss and state credit carryforwards. During 2019 and 2020, we do not anticipate any cash outlays for income taxes to exceed $100 thousand. This is due to tax loss carryforwards and tax credit carryforwards that will be used to offset taxable income. At December 29, 2018, we were in a net deferred tax liability position of $568 thousand. Discontinued Operations - Environmental Contingencies We have reserves for environmental obligations established at five previously owned sites that were associated with our discontinued textile businesses. We have a reserve of $1.7 million for environmental liabilities at these sites as of December 29, 2018. The liability established represents our best estimate of loss and is the reasonable amount to which there is any meaningful degree of certainty given the periods of estimated remediation and the dollars applicable to such remediation for those periods. The actual timeline to remediate, and thus, the ultimate cost to complete such remediation through these remediation efforts, may differ significantly from our estimates. Pre-tax cost for environmental remediation obligations classified as discontinued operations were primarily a result of specific events requiring action and additional expense in each period. Fair Value of Financial Instruments At December 29, 2018, we had no liabilities measured at fair value that fall under a level 3 classification in the hierarchy (those subject to significant management judgment or estimation). Certain Related Party Transactions We are a party to a five-year lease with the seller of Atlas Carpet Mills, Inc. to lease three manufacturing facilities as part of the acquisition in 2014. The lessor is controlled by an associate of ours. Rent paid to the lessor during 2018, 2017, and 2016 was $1,003, $978, and $793, respectively. The lease was based on current market values for similar facilities. We purchase a portion of our product needs in the form of fiber, yarn and carpet from Engineered Floors, an entity substantially controlled by Robert E. Shaw, a shareholder of ours. An affiliate of Mr. Shaw holds approximately 7.2% of our Common Stock, Table of Contents 25 which represents approximately 3.5% of the total vote of all classes of our Common Stock. Engineered Floors is one of several suppliers of such materials to us. Total purchases from Engineered Floors for 2018, 2017 and 2016 were approximately $8,200, $7,200 and $7,300, respectively; or approximately 2.6%, 2.3%, and 2.4% of our cost of goods sold in 2018, 2017, and 2016, respectively. Purchases from Engineered Floors are based on market value, negotiated prices. We have no contractual commitments with Mr. Shaw associated with our business relationship with Engineered Floors. Transactions with Engineered Floors are reviewed annually by our board of directors. We are a party to a ten-year lease with the Rothman Family Partnership to lease a manufacturing facility as part of the Robertex acquisition in 2013. The lessor is controlled by an associate of ours. Rent paid to the lessor during 2018, 2017, and 2016 was $278, $273, and $267, respectively. The lease was based on current market values for similar facilities. In addition, we have a note payable to Robert P. Rothman related to the acquisition of Robertex Inc. (See Note 10 to our Consolidated Financial Statements). Recent Accounting Pronouncements In February 2016, the FASB issued ASU No. 2016-02, "Leases (Topic 842)," which requires lessees to recognize on the balance sheet right-of-use assets, representing the right to use the underlying asset for the lease term, and a lease liability for all leases with terms greater than 12 months. We have completed the process of identifying our population of leases and we have identified and implemented internal procedures and controls to properly disclose and report our results beginning with our quarterly report on Form 10-Q for the quarter ending March 30, 2019. With the adoption of the new lease standard, for operating leases we will recognize right of use assets of approximately $10.3 million and a corresponding lease liability of the same amount at the beginning of fiscal year 2019. See Note 2 to our Consolidated Financial Statements of this Form 10-K for a discussion of the standard described above and other new accounting pronouncements which is incorporated herein by reference. Critical Accounting Policies Certain estimates and assumptions are made when preparing our financial statements. Estimates involve judgments with respect to, among other things, future economic factors that are difficult to predict. As a result, actual amounts could differ from estimates made when our financial statements are prepared. The Securities and Exchange Commission requires management to identify its most critical accounting policies, defined as those that are both most important to the portrayal of our financial condition and operating results and the application of which requires our most difficult, subjective, and complex judgments. Although our estimates have not differed materially from our experience, such estimates pertain to inherently uncertain matters that could result in material differences in subsequent periods. We believe application of the following accounting policies require significant judgments and estimates and represent our critical accounting policies. Other significant accounting policies are discussed in Note 1 to our Consolidated Financial Statements. • Revenue recognition. The Company derives its revenues primarily from the sale of floorcovering products and processing services. Revenues are recognized when control of these products or services is transferred to its customers, in an amount that reflects the consideration the Company expects to be entitled to in exchange for those products and services. Sales, value add, and other taxes the Company collects concurrent with revenue-producing activities are excluded from revenue. Shipping and handling fees charged to customers are reported within revenue. Incidental items that are immaterial in the context of the contract are recognized as expense. The Company does not have any significant financing components as payment is received at or shortly after the point of sale. The Company determined revenue recognition through the following steps: ▪ Identification of the contract with a customer ▪ Identification of the performance obligations in the contract ▪ Determination of the transaction price ▪ Allocation of the transaction price to the performance obligations in the contract ▪ Recognition of revenue when, or as, the performance obligation is satisfied • Variable Consideration. The nature of the Company’s business gives rise to variable consideration, including rebates, allowances, and returns that generally decrease the transaction price, which reduces revenue. These variable amounts are generally credited to the customer, based on achieving certain levels of sales activity, product returns, or price concessions. Variable consideration is estimated at the most likely amount that is expected to be earned. Estimated amounts are included in the transaction price to the extent it is probable that a significant reversal of cumulative revenue recognized will not occur when the uncertainty associated with the variable consideration is resolved. Estimates of variable consideration are estimated based upon historical experience and known trends. Table of Contents 26 • Customer claims and product warranties. The Company generally provides product warranties related to manufacturing defects and specific performance standards for its products for a period of up to two years. The Company accrues for estimated future assurance warranty costs in the period in which the sale is recorded. The costs are included in Cost of Sales in the Consolidated Condensed Statements of Operations and the product warranty reserve is included in accrued expenses in the Consolidated Condensed Balance Sheets. The Company calculates its accrual using the portfolio approach based upon historical experience and known trends. The Company does not provide an additional service-type warranty. • Accounts receivable allowances. We provide allowances for expected cash discounts and doubtful accounts based upon historical experience and periodic evaluations of the financial condition of our customers. If the financial conditions of our customers were to significantly deteriorate, or other factors impair their ability to pay their debts, credit losses could differ from allowances recorded in our Consolidated Financial Statements. • Inventories. Inventories are stated at the lower of cost or market. Cost is determined using the last-in, first-out method (LIFO), which generally matches current costs of inventory sold with current revenues, for substantially all inventories. Reserves are also established to adjust inventories that are off-quality, aged or obsolete to their estimated net realizable value. Additionally, rates of recoverability per unit of off-quality, aged or obsolete inventory are estimated based on historical rates of recoverability and other known conditions or circumstances that may affect future recoverability. Actual results could differ from assumptions used to value our inventory. • Goodwill. Goodwill is tested annually for impairment during the fourth quarter or earlier if significant events or substantive changes in circumstances occur that may indicate that goodwill may not be recoverable. The goodwill impairment tests are based on determining the fair value of the specified reporting units based on management judgments and assumptions using the discounted cash flows and comparable company market valuation approaches. We have identified our reporting unit as our floorcovering business for the purposes of allocating goodwill and assessing impairments. The valuation approaches are subject to key judgments and assumptions that are sensitive to change such as judgments and assumptions about sales growth rates, operating margins, the weighted average cost of capital (“WACC”), synergies from the viewpoint of a market participant and comparable company market multiples. When developing these key judgments and assumptions, we consider economic, operational and market conditions that could impact the fair value of the reporting unit. However, estimates are inherently uncertain and represent only management’s reasonable expectations regarding future developments. These estimates and the judgments and assumptions upon which the estimates are based will, in all likelihood, differ in some respects from actual future results. We performed our annual assessment of goodwill in the fourth quarter of 2018 and an impairment was indicated. In accordance with the results of our testing, the goodwill was considered impaired and the asset was removed and a corresponding expense was recorded for asset impairment on the Consolidated Statements of Operations. (See Note 7 to our Consolidated Financial Statements) • Self-insured accruals. We estimate costs required to settle claims related to our self-insured medical, dental and workers' compensation plans. These estimates include costs to settle known claims, as well as incurred and unreported claims. The estimated costs of known and unreported claims are based on historical experience. Actual results could differ from assumptions used to estimate these accruals. • Income taxes. Our effective tax rate is based on income, statutory tax rates and tax planning opportunities available in the jurisdictions in which we operate. Tax laws are complex and subject to different interpretations by the taxpayer and respective governmental taxing authorities. Deferred tax assets represent amounts available to reduce income taxes payable on taxable income in a future period. We evaluate the recoverability of these future tax benefits by assessing the adequacy of future expected taxable income from all sources, including reversal of taxable temporary differences, forecasted operating earnings and available tax planning strategies. These sources of income inherently rely on estimates, including business forecasts and other projections of financial results over an extended period of time. In the event that we are not able to realize all or a portion of our deferred tax assets in the future, a valuation allowance is provided. We recognize such amounts through a charge to income in the period in which that determination is made or when tax law changes are enacted. We had valuation allowances of $17.0 million at December 29, 2018 and $13.0 million at December 30, 2017. On December 22, 2017, the President signed the Tax Cuts and Jobs Act (the "Tax Act"). The Tax Act, among other things, lowered the U.S. corporate income tax rate from 35% to 21% effective January 1, 2018. Consequently, we wrote down our net deferred tax assets as of December 30, 2017 by $8.2 million to reflect the estimated impact of the Tax Act. This amount included a charge of $1.8 million related to the re-measurement of certain net deferred tax assets using the lower U.S. corporate income tax rate and a charge of $6.4 million to increase our valuation allowance related to our net deferred tax asset. The majority of the increase in the valuation allowance is related to the revised treatment of net operating losses under the Tax Act. Pursuant to Staff Accounting Bulletin No. 118, we have completed our analysis and all adjustments have been included in income from continuing operations as an adjustment to income tax expense. At December 29, 2018, we were in a net deferred tax liability position of $568 thousand. For further information regarding our valuation allowances, see Note 14 to our Consolidated Financial Statements. • Loss contingencies. We routinely assess our exposure related to legal matters, environmental matters, product liabilities or any other claims against our assets that may arise in the normal course of business. If we determine that it is probable Table of Contents 27 a loss has been incurred, the amount of the loss, or an amount within the range of loss, that can be reasonably estimated will be recorded.

<s>[INST] OVERVIEW Our business consists principally of marketing, manufacturing and selling floorcovering products to highend residential and commercial customers through our various sales forces and brands. We focus exclusively on the upperend of the floorcovering market where we believe we have strong brands and competitive advantages with our style and design capabilities and customer relationships. Our Fabrica, Masland, and Dixie Home brands have a significant presence in the highend residential floorcovering markets. Our Atlas | Masland Contract brand participates in the upperend specified commercial marketplace. Dixie International sells all of our brands outside of the North American market. Our business is primarily concentrated in areas of the soft floorcovering markets which include broadloom carpet, carpet tiles and rugs. However, over the past few years, there has been a significant shift in the flooring marketplace as hard surface products have grown at a rate much faster than soft surface products. We have responded to this accelerated shift to hard surface flooring by launching several initiatives in both our residential and commercial brands. Our commercial brands offer Luxury Vinyl Flooring (“LVF”) products under the Calibré brand in the commercial markets. Our residential brands, Dixie Home and Masland Residential, offer Stainmaster® PetProtect™ Luxury Vinyl Flooring and our premium residential brand, Fabrica, offers a highend engineered wood line. For 2019 we are building on the momentum we gained by tripling our residential hard surface business in 2018 with the launch of TruCor™, our new solid polymer core or “SPC” Luxury Vinyl Flooring line. This latest addition to our rigid core Luxury Vinyl Flooring offering is designed to create an extremely durable and waterproof Luxury Vinyl Flooring product with a broader range of price points to meet the needs of various consumers. To facilitate this growth, in 2019 we are expanding our distribution of hard surface products to our west coast distribution center as well as our east coast service center. During 2018, our net sales decreased 1.8% compared with 2017. Sales of residential products increased 3.6% in 2018 versus 2017. Residential soft surface sales were up 1.4% in 2018 as compared to 2017, while, we estimate, the industry was up in the low to midsingle digits. Residential hard surface sales tripled in 2018 relative to sales in 2017. We anticipate the residential housing market, though having slowed recently, will have steady but moderate growth over the next several years. Commercial product sales decreased 13.2% during 2018. Soft surface sales of commercial products were down 19.5%, while, we believe, the industry was down in the midsingle digits. We anticipate the commercial market to be relatively flat in 2019. In 2018, we had an operating loss of $15.8 million compared with an operating income of $3.9 million in 2017. The reduced sales volume in 2018 adversely affected our gross profit as we under absorbed our costs since we had increased our capacity anticipating higher volume production. In addition, we had rising raw material costs which, passed on to our customers through higher prices, were recovered after we experienced such cost increases. The majority of our higher costs were in the first and fourth quarters of the year as we suffered with reduced demand in those time periods. We reduced plant running schedules in the fourth quarter to reduce inventories to a more appropriate level. We incurred charges during the year totaling $14.1 million comprised of $2.7 million in inventory writedowns, $3.2 million in restructuring charges, $6.7 million in asset impairments, including the writeoff of goodwill and intangibles, and a $1.5milliondollar charge for settlement of a class action litigation. Our debt declined by $5.2 million over the course of 2018. To offset those higher costs, we continued the implementation of our previously announced Profit Improvement Plan (“the Plan”). The Plan, begun in the fourth quarter of 2017, resulted in the reduction of 284 associates during 2018 and is anticipated to result in [/INST] Negative. </s>

DIXIE GROUP INC

2020-03-12

2019-12-28

Item 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The following discussion and analysis should be read in conjunction with our consolidated financial statements and related notes appearing elsewhere in this report. OVERVIEW Our business consists principally of marketing, manufacturing and selling floorcovering products to high-end residential and commercial customers through our various sales forces and brands. We focus exclusively on the upper-end of the floorcovering market where we believe we have strong brands and competitive advantages with our style and design capabilities and customer relationships. Our Fabrica, Masland, and Dixie Home brands have a significant presence in the high-end residential floorcovering markets. Our Atlas | Masland Contract brand participates in the upper-end specified commercial marketplace. Dixie International sells all of our brands outside of the North American market. Our business is primarily concentrated in areas of the soft floorcovering markets which include broadloom carpet, carpet tiles and rugs. However, in response to a significant shift in the flooring marketplace toward hard surface products, we have launched multiple hard surface initiatives in both our residential and commercial brands over the last few years. Our commercial brands offer Luxury Vinyl Flooring (“LVF”) products under the Calibré brand in the commercial markets. Our residential brands, Dixie Home and Masland Residential, offer Stainmaster® PetProtect™ Luxury Vinyl Flooring and our premium residential brand, Fabrica, offers a high-end engineered wood line. In 2019, we successfully launched TRUCOR™, our new solid polymer core or “SPC” Luxury Vinyl Flooring line. This latest addition to our rigid core Luxury Vinyl Flooring offering is designed to create an extremely durable and waterproof Luxury Vinyl Flooring product with a broader range of price points to meet the needs of various consumers. To build on the momentum of TRUCOR™ in 2020 we have planned a significant increase in the product offerings of this line. Additional hard surface initiatives planned in 2020 include the introduction of new styles in the Fabrica line of wood products, new LVF tiles utilizing "Integrated Grout Technology", and a TRUCOR PRIME WPC program to include oversize planks in contemporary styles. In addition to our hard surface initiatives, we continue to grow our soft surface business through innovative product offerings such as the Crafted Collection of modular tile featuring our Sustaina backing. Our Sustaina cushion backing for modular tile is PVC and polyurethane free and it is composed of 81.5% total recycled content allowing us to offer an appealing set of patterns to our environmentally conscious customers. During 2019, our net sales decreased 7.5% compared with net sales in 2018. Sales of residential products decreased 7.2% in 2019 versus 2018. Residential soft surface sales were down 8.8% in 2019 as compared to 2018, while, we estimate, the industry was down in the mid to upper single digits. Our residential soft surface sales in 2019 were negatively impacted by a change in emphasis to hard surfaces by certain mass merchant customers. Residential hard surface sales increased by 47% in 2019 relative to sales in 2018. Despite recent slow activity, we anticipate the residential housing market will have steady but moderate growth over the next several years. Commercial product sales decreased 9.4% during 2019. Soft surface sales of commercial products were down 12.4%, while, we believe, the industry was down marginally. We anticipate the commercial market to be relatively flat in 2020. In 2019, we had an operating income of $21.3 million compared with an operating loss of $15.8 million in 2018. In 2019, we recorded a $25.1 million gain on the sale of our building in Santa Ana, California. Without this gain on sale we had an operating loss of $3.8 million. Gross profit as a percent of sales improved year over year despite the reduced sales volume in 2019 and the resulting under absorbed manufacturing costs. This was primarily the result of non-recurring costs incurred in the prior year and improvements in operations, both related to the Profit Improvement Plan (the "Plan"). We also reduced plant running schedules in the fourth quarter to reduce inventories to a more appropriate level. We incurred $5 million in restructuring expenses related to the Plan and an additional $572 thousand in cost of sales for inventory write downs related to the Plan. Since inception, the Plan has resulted in the reduction of over 300 associates. The Plan, begun in the fourth quarter of 2017, was completed at the end of 2019. Our debt declined by $39.7 million over the course of 2019. Expenses related to the Plan totaled approximately $5.6 million in 2019. The Plan expenses included inventory write downs, restructuring costs, and asset impairments as we re-configured our commercial business and right sized our residential manufacturing operations for lower unit demand. Total cost reductions as a result of the Plan are expected to be in excess of $18 million on an annual basis when compared to the 2017 cost structure. We began the structural consolidation of our commercial business with the closure of our Chickamauga tufting operation as we moved the equipment to other facilities. This plant closure, complete at the end of 2018, lowered our cost and improved our response time to this segment of the marketplace. We exited our Commerce, California Atlas tufting facilities in 2019. The bulk of the Atlas equipment was transferred to our Atmore, Alabama commercial tufting operation with various other items moved to our Santa Ana, California and Eton, Georgia operations. We moved our commercial rug operation and commercial samples support function from California to our Saraland facility near Mobile, Alabama. We reduced our staffing to better match production to meet our demand in our Atmore, Eton, Adairsville and Roanoke facilities as we were able to take advantage of the increased productivity of our associates in these operations. In addition to the physical movement of equipment and inventory, we consolidated our commercial design functions in Saraland as well as consolidated our entire sales support functions. Our sales forces were merged to create Atlas | Masland Contract, now equipped with a much broader product line and providing modular carpet tile, broadloom carpet, luxury vinyl flooring, and commercial wool and nylon rugs. This combined sales force has the added benefit of not only a broad product line but distinct design capabilities in custom products as well. Table of Contents 18 RESULTS OF OPERATIONS Fiscal Year Ended December 28, 2019 Compared with Fiscal Year Ended December 29, 2018 Net Sales. Net sales for the year ended December 28, 2019 were $374.6 million compared with $405.0 million in the year-earlier period, a decrease of 7.5% for the year-over-year comparison. Sales of residential floorcovering products were down 7.2% primarily due to our mass merchant customers shifting their emphasis from soft surface to hard surface floor coverings. Sales of commercial floorcovering products decreased 9.4%. The decrease in commercial net sales was due to distractions caused by the restructuring of our commercial operations and sales force during the first half of 2019. Gross Profit. Gross profit, as a percentage of net sales, increased 1.5 percentage points in 2019 compared with 2018. Gross profit in 2019 was favorably impacted by savings from our Profit Improvement Plan. Gross profit in 2018 was negatively impacted by inventory write downs related to the Profit Improvement Plan. Selling and Administrative Expenses. Selling and administrative expenses were $83.8 million in 2019 compared with $92.5 million in 2018, a decrease of .4% as a percentage of sales. The improved results in the 2019 selling expenses are the result of changes made as part of our Profit Improvement Plan. Other Operating Expense, Net. Net other operating expense was an income of $24.0 million in 2019 compared with expense of $458 thousand in 2018. In 2019 we recognized a gain of $25.1 million for the sale of our Susan Street manufacturing facility in Santa Ana, California. Facility Consolidation and Severance Expenses, Net. Facility consolidation expenses were $5.0 million in 2019 compared with $3.2 million in the year-earlier period. Facility consolidation expenses increased in 2019 as we completed our Profit Improvement Plan, announced in 2017, which included the consolidation of our two commercial brands, consolidation of commercial manufacturing operations and sales forces, and an overall review of corporate wide operations and functions. As a result of this plan, we incurred expenses of $5.0 million during 2019 primarily related to facility consolidation expenses and severance costs. Asset Impairments. There were no expenses related to asset impairments recorded in 2019. The asset impairments recorded in 2018 were $6.7 million. The asset impairments incurred in 2018 included the impairment of fixed assets as part of our Profit Improvement Plan ($1.2 million). We also incurred intangible asset impairments ($2.1 million) and goodwill impairment ($3.4 million). Operating Income (Loss). Operations reflected an operating income of $21.3 million in 2019 compared with an operating loss of $15.8 million in 2018. The operating results for 2019 were heavily impacted by the $25.1 million gain on the sale of our building in Santa Ana, California. This gain was partially offset by lower gross profit as a result of lower sales volume and expenses related to the Profit Improvement Plan. Table of Contents 19 Interest Expense. Interest expense decreased $47 thousand in 2019 as compared to 2018 principally due to lower levels of debt in the last quarter of the year as a result of the sale of our building in Santa Ana, California. Income Tax Provision (Benefit). Our effective income tax rate was a benefit of 4.39% in 2019. The benefit relates to certain federal and state credits and also includes a benefit for the reduction of certain indefinite lived assets not covered by our valuation allowance. In 2019, we decreased our valuation allowance by $3.7 million related to our net deferred tax asset and specific state net operating loss and state credit carryforwards. Our effective income tax rate was a benefit of 3.72% in 2018. The benefit relates to certain federal and state credits and also includes a benefit for the reduction of certain indefinite lived assets not covered by our valuation allowance. In 2018, we increased our valuation allowance by $4 million related to our net deferred tax asset and specific state net operating loss and state credit carryforwards. Net Loss. Continuing operations reflected an income of $15.6 million, or $.95 per diluted share in 2019, compared with a loss from continuing operations of $21.5 million, or $1.36 per diluted share in 2018. Our discontinued operations reflected a loss of $348 thousand, or $0.02 per diluted share in 2019 compared with income of $95 thousand, or $0.01 per diluted share in 2018. Including discontinued operations, we had a net income of $15.3 million, or $0.96 per diluted share, in 2019 compared with a net loss of $21.4 million, or $1.35 per diluted share, in 2018. Fiscal Year Ended December 29, 2018 Compared with Fiscal Year Ended December 30, 2017 Net Sales. Net sales for the year ended December 29, 2018 were $405.0 million compared with $412.5 million in the year-earlier period, a decrease of 1.8% for the year-over-year comparison. Sales of residential floorcovering products were up 3.6% and sales of commercial floorcovering products decreased 13.2%. The decrease in commercial net sales was due to distractions caused by the restructuring of our commercial operations and sales force during 2018. Gross Profit. Gross profit, as a percentage of net sales, decreased 3.0 percentage points in 2018 compared with 2017. Gross profit in 2018 was negatively impacted by inventory write downs of $2.7 million taken during the year as part of our Profit Improvement Plan. Selling and Administrative Expenses. Selling and administrative expenses were $92.5 million in 2018 compared with $96.2 million in 2017, or a decrease of .5% as a percentage of sales. The improved results in the 2018 selling expenses are the result of changes made as part of our Profit Improvement Plan. Other Operating Expense, Net. Net other operating expense was an expense of $458 thousand in 2018 compared with expense of $441 thousand in 2017. Facility Consolidation and Severance Expenses, Net. Facility consolidation expenses were $3.2 million in 2018 compared with $636 thousand in the year-earlier period. Facility consolidation expenses increased in 2018 as we continued our Profit Improvement Table of Contents 20 Plan, announced in 2017, which includes the consolidation of our two commercial brands, consolidation of commercial manufacturing operations and sales forces, and an overall review of corporate wide operations and functions. As a result of this plan, we incurred expenses of $3.2 million during 2018 primarily related to facility consolidation expenses and severance costs. Asset Impairments. The asset impairments recorded in 2018 were $6.7 million. There were no asset impairment expenses in 2017. The asset impairments incurred in 2018 included the impairment of fixed assets as part of our Profit Improvement Plan ($1.2 million). We also incurred intangible asset impairments ($2.1 million) and goodwill impairment ($3.4 million). Operating Income (Loss). Operations reflected an operating loss of $15.8 million in 2018 compared with an operating income of $3.9 million in 2017. The operating results for 2018 were impacted by the lower sales volume, settlement of a class action lawsuit, and facility consolidation, asset impairments, and severance costs related to the Profit Improvement Plan. Interest Expense. Interest expense increased $752 thousand in 2018 principally due to higher levels of debt and higher rates than a year ago. Income Tax Provision (Benefit). Our effective income tax rate was a benefit of 3.72% in 2018. The benefit relates to certain federal and state credits and also includes a benefit for the reduction of certain indefinite lived assets not covered by our valuation allowance. In 2018 we increased our valuation allowance by $4 million related to our net deferred tax asset and specific state net operating loss and state credit carryforwards. On December 22, 2017, the President signed the Tax Cuts and Jobs Act (the “Tax Act”). The Tax Act, among other things, lowered the U.S. corporate income tax rate from 35% to 21% effective January 1, 2018. The income tax expense for 2017 was $7.5 million, which included a charge of $1.4 million related to the re-measurement of certain net deferred tax assets using the lower U.S. corporate income tax rate and a charge of $6.4 million to increase our valuation allowance related to our net deferred tax asset. The majority of the increase in the valuation allowance is related to the revised treatment of net operating losses under the Tax Act. Absent the impact of the Tax Act, our effective income tax benefit rate for 2017 would have been 36.4%. Net Loss. Continuing operations reflected a loss of $21.5 million, or $1.36 per diluted share in 2018, compared with a loss from continuing operations of $9.3 million, or $0.59 per diluted share in 2017. Our discontinued operations reflected an income of $95 thousand, or $0.01 per diluted share in 2018 compared with a loss of $233 thousand, or $0.01 per diluted share in 2017. Including discontinued operations, we had a net loss of $21.4 million, or $1.35 per diluted share, in 2018 compared with a net loss of $9.6 million, or $0.60 per diluted share, in 2017. LIQUIDITY AND CAPITAL RESOURCES During the year ended December 28, 2019, cash provided by operations was $11.7 million. Inventories decreased $9.7 million, receivables decreased $5.2 million and accounts payable and accrued expenses decreased $3.7 million. Inventories were planned more closely in 2019 and decreased with lower demand. Receivables decreased on lower sales volume. In addition to lower operating demands on accounts payable as a result of lower volume, accounts payable and accrued expenses decreased due to balances in the prior year end related to a class action lawsuit and severances related to restructuring that were paid in full or significantly lower in the 2019 year end balances as compared to 2018. Capital asset acquisitions for the year ended December 28, 2019 were $4.2 million. In 2019 proceeds from sale of equipment totaled $37.2 million, primarily related to the sale of our building in Santa Ana, California. Depreciation and amortization for the year ended December 28, 2019 were $11.4 million. We expect capital expenditures to be approximately $5.0 million in 2020 while depreciation and amortization is expected to be approximately $11.0 million. Planned capital expenditures in 2020 are primarily for new equipment. During the year ended December 28, 2019, cash used in financing activities was $43.9 million. We had net payments of $39.5 million on the revolving credit facility. Notes payable were reduced by payments, net of new borrowings, of $7.5 million and borrowings on finance leases net of payments increased cash by $7.3 million. The balance in amount of checks outstanding in excess of cash at year end 2019 decreased from prior year resulting in a cash outflow of $3.1 million. We believe our operating cash flows, credit availability under our revolving credit facility and other sources of financing are adequate to finance our anticipated liquidity requirements under current operating conditions. Included in the unused borrowing availability under our credit line, as of the sale of our Susan Street facility in October, 2019 and the enactment of Amendment Thirteen to our loan agreement, is an additional availability block of $5,000 to be reduced upon reaching a specially defined fixed charge coverage ratio of 1.1 to 1.0 for a consecutive period of 3 months or 6 months. Contingent upon reaching the desired fixed coverage ratio, the availability block will reduce to $2,500 when the three-month threshold is reached and $0 once reaching the six-month threshold. As of December 28, 2019, the unused borrowing availability under our revolving credit facility was $33.8 million. However, our revolving credit facility reduces our funds available to borrow by $15 million if our fixed charge coverage ratio is less than 1.1 to 1.0. As of the date hereof, our fixed coverage ratio was less than 1.1 to 1.0, accordingly the unused availability accessible by us was $18.8 million (the amount above $15.0 million) at December 28, 2019. Significant additional cash expenditures above our normal liquidity requirements, significant deterioration in economic conditions or continued operating losses could affect our business Table of Contents 21 and require supplemental financing or other funding sources. There can be no assurance that such supplemental financing or other sources of funding can be obtained or will be obtained on terms favorable to us. Debt Facilities Revolving Credit Facility. During the fourth quarter 2019, the Company amended its credit agreement with Wells Fargo Capital Finance to reduce the size of the Senior Credit Facility from $150,000 to $120,000 and adjust the availability limitation related to the fixed coverage ratio from $16,500 to $15,000 upon closing of the sale lease back of the Susan Street property. The changes to the credit facility were implemented by the twelfth and thirteenth amendments to the credit agreement, effective October 3, 2019 and October 22, 2019, respectively. These amendments were intended to permit the sale and leaseback of the Company's Susan Street Facility and, upon completion of the sale, to adjust the credit agreement's borrowing base. The borrowing base is currently equal to specified percentages of the Company's eligible accounts receivable, inventories, fixed assets and real property less reserves established, from time to time, by the administrative agent under the facility. The revolving credit facility matures on September 23, 2021. The revolving credit facility is secured by a first priority lien on substantially all of the Company's assets. At the Company's election, advances of the revolving credit facility bear interest at annual rates equal to either (a) LIBOR for 1, 2 or 3 month periods, as selected by the Company, plus an applicable margin ranging between 1.50% and 2.00%, or (b) the higher of the prime rate, the Federal Funds rate plus 0.5%, or a daily LIBOR rate plus 1.00%, plus an applicable margin ranging between 0.50% and 1.00%. The applicable margin is determined based on availability under the revolving credit facility with margins increasing as availability decreases. As of December 28, 2019, the applicable margin on our revolving credit facility was 1.75%. The Company pays an unused line fee on the average amount by which the aggregate commitments exceed utilization of the revolving credit facility equal to 0.375% per annum. The weighted-average interest rate on borrowings outstanding under the revolving credit facility was 4.79% at December 28, 2019 and 4.58% at December 29, 2018. The revolving credit facility includes certain affirmative and negative covenants that impose restrictions on the Company's financial and business operations. The revolving credit facility restricts the Company's borrowing availability if its fixed charge coverage ratio is less than 1.1 to 1.0. During any period that the fixed charge coverage ratio is less than 1.1 to 1.0, the Company's borrowing availability is reduced by $15,000. As part of Amendment Thirteen to the credit agreement an additional availability block of $5,000 was established to be reduced upon reaching a specially defined fixed charge coverage ratio of 1.1 to 1.0 for a consecutive period of 3 months or 6 months. Contingent upon reaching the desired fixed coverage ratio, the availability block will reduce to $2,500 when the three-month threshold is reached and $0 once reaching the six-month threshold. Amendment Thirteen also adjusted the size of the restricted borrowing availability that is triggered when the fixed charge coverage ratio is less than 1.1 to 1.0. Effective with the thirteenth amendment, and after giving effect to the "availability block", availability under the credit agreement is reduced by $20,000. As of December 28, 2019, the unused borrowing availability under the revolving credit facility was $33,787; however, since the Company's fixed charge coverage ratio was less than 1.1 to 1.0, the unused availability accessible by the Company was $18,787 (the amount above $15,000) at December 28, 2019. Availability under the credit agreement will vary based on seasonal business factors and periodic changes to the qualified asset base, which consists of accounts receivable, inventories and fixed assets. Notes Payable - Buildings. On November 7, 2014, we entered into a ten-year $8.3 million note payable to purchase a previously leased distribution center in Adairsville, Georgia. The note payable is scheduled to mature on November 7, 2024 and is secured by the distribution center. The note payable bears interest at a variable rate equal to one-month LIBOR plus 2.0% and is payable in equal monthly installments of principal of $35 thousand, plus interest calculated on the declining balance of the note, with a final payment of $4.2 million due on maturity. In addition, we entered into an interest rate swap with an amortizing notional amount effective November 7, 2014 which effectively fixes the interest rate at 4.50%. Notes Payable - Equipment and Other. Our equipment financing notes have terms ranging from 1 to 7 years, bear interest ranging from 1.00% to 7.68% and are due in monthly installments through their maturity dates. Our equipment financing notes are secured by the specific equipment financed and do not contain any financial covenants. Finance Lease - Buildings. On January 14, 2019, the Company, entered into a purchase and sale agreement (the “Purchase and Sale Agreement”) with Saraland Industrial, LLC, an Alabama limited liability company (the “Purchaser”). Pursuant to the terms of the Purchase and Sale Agreement, the Company sold its Saraland facility, and approximately 17.12 acres of surrounding property located in Saraland, Alabama (the “Property”) to the Purchaser for a purchase price of $11,500. Concurrent with the sale of the Property, the Company and the Purchaser entered into a twenty-year lease agreement (the “Lease Agreement”), whereby the Company will lease back the Property at an annual rental rate of $977, subject to annual rent increases of 1.25%. Under the Lease Agreement, the Company has two (2) consecutive options to extend the term of the Lease by ten years for each such option. This transaction was recorded as a failed sale and leaseback as the present value of lease payments exceeded 90% of its fair value. The Company recorded a liability for the amounts received, will continue to depreciate the asset, and has imputed an interest rate so that the net carrying amount of the financial liability and remaining assets will be zero at the end of the lease term. Concurrently with the sale, the Company paid off the approximately $5,000 mortgage on the property to First Tennessee Bank National Association and terminated the related fixed interest rate swap agreement. Table of Contents 22 Finance Lease Obligations. Our finance lease obligations have terms ranging from 3 to 7 years, bear interest ranging from 3.55% to 7.76% and are due in monthly or quarterly installments through their maturity dates. Our capital lease obligations are secured by the specific equipment leased. (See Note 10 to our Consolidated Financial Statements). Contractual Obligations The following table summarizes our future minimum payments under contractual obligations as of December 28, 2019 (1) Interest rates used for variable rate debt were those in effect at December 29, 2018. Stock-Based Awards We recognize compensation expense related to share-based stock awards based on the fair value of the equity instrument over the period of vesting for the individual stock awards that were granted. At December 28, 2019, the total unrecognized compensation expense related to unvested restricted stock awards was $989 thousand with a weighted-average vesting period of 8.6 years. At December 28, 2019, the total unrecognized compensation expense related to Directors' Stock Performance Units was $5 thousand with a weighted-average vesting period of 0.3 years. At December 28, 2019, there was no unrecognized compensation expense related to unvested stock options. Off-Balance Sheet Arrangements We have no off-balance sheet arrangements at December 28, 2019 or December 29, 2018. Income Tax Considerations In the tax year ended December 28, 2019 we decreased our valuation allowances by $3.7 million related to our net deferred tax asset and specific state net operating loss and state credit carryforwards. During 2020 and 2021, we do not anticipate any cash outlays for income taxes to exceed $1.5 Million. This is due to tax loss carryforwards and tax credit carryforwards that will be used to partially offset taxable income. At December 28, 2019, we were in a net deferred tax liability position of $91 thousand. Discontinued Operations - Environmental Contingencies We have reserves for environmental obligations established at five previously owned sites that were associated with our discontinued textile businesses. We have a reserve of $2.0 million for environmental liabilities at these sites as of December 28, 2019. The liability established represents our best estimate of loss and is the reasonable amount to which there is any meaningful degree of certainty given the periods of estimated remediation and the dollars applicable to such remediation for those periods. The actual timeline to remediate, and thus, the ultimate cost to complete such remediation through these remediation efforts, may differ significantly from our estimates. Pre-tax cost for environmental remediation obligations classified as discontinued operations were primarily a result of specific events requiring action and additional expense in each period. Fair Value of Financial Instruments At December 28, 2019, we had no liabilities measured at fair value that fall under a level 3 classification in the hierarchy (those subject to significant management judgment or estimation). Table of Contents 23 Certain Related Party Transactions We were a party to a five-year lease with the seller of Atlas Carpet Mills, Inc. to lease three manufacturing facilities as part of the acquisition in 2014. The lessor was controlled by an associate of ours. Rent paid to the lessor during 2019, 2018, and 2017 was $497, $1,003, and $978, respectively. The lease was based on current market values for similar facilities. These leases terminated as of September, 2019. We purchase a portion of our product needs in the form of fiber, yarn and carpet from Engineered Floors, an entity substantially controlled by Robert E. Shaw, a shareholder of ours. An affiliate of Mr. Shaw holds approximately 7.5% of our Common Stock, which represents approximately 3.5% of the total vote of all classes of our Common Stock. Engineered Floors is one of several suppliers of such materials to us. Total purchases from Engineered Floors for 2019, 2018 and 2017 were approximately $5,900, $8,200, and $7,200 respectively; or approximately 2.1%, 2.6%, and 2.3% of our cost of goods sold in 2019, 2018, and 2017, respectively. Purchases from Engineered Floors are based on market value, negotiated prices. We have no contractual commitments with Mr. Shaw associated with our business relationship with Engineered Floors. Transactions with Engineered Floors are reviewed annually by our board of directors. We are a party to a ten-year lease with the Rothman Family Partnership to lease a manufacturing facility as part of the Robertex acquisition in 2013. The lessor is controlled by a former associate of ours. Rent paid to the lessor during 2019, 2018, and 2017 was $284, $278, and $273, respectively. The lease was based on current market values for similar facilities. Recent Accounting Pronouncements In February 2016, the Financial Accounting Standards Board ("FASB") issued Accounting Standards Update ("ASU") No. 2016-02, "Leases (Topic 842)," which requires lessees to recognize on the Consolidated Balance Sheets right-of-use assets, representing the right to use the underlying asset for the lease term, and a lease liability for all leases with terms greater than 12 months. The guidance also requires qualitative and quantitative disclosures designed to assess the amount, timing, and uncertainty of cash flows arising from leases. In July 2018, the FASB issued ASU No. 2018-11, "Leases (Topic 842)" providing an optional transition method allowing entities to apply the new lease standard at the adoption date and recognize a cumulative effect adjustment in the period of adoption. The Company elected this transition method. The Company adopted the new standard effective December 30, 2018, the first day of the Company's fiscal year. Consistent with the optional transition method allowed as part of the modified retrospective transition approach provided in ASU No. 2018-11, the Company did not adjust comparative periods. The new standard applied to leases that have commenced as of the effective date, December 30, 2018, with a cumulative effect adjustment recorded as of that date. The Company also elected to apply the package of practical expedients allowed in ASC 842-10-65-1 whereby the Company need not reassess whether any expired or existing contracts are or contain leases, the Company need not reassess the lease classification for any expired or existing leases, and the Company need not reassess initial direct costs for any existing leases. The Company's adoption of the ASU resulted in the addition of Right of Use Assets on the Consolidated Balance Sheet for the right to use the underlying assets of operating leases. The Company did not elect to use hindsight for transition when considering judgments and estimates such as assessments of lessee options to extend or terminate a lease or purchase the underlying asset. In addition, the corresponding liability for the remaining balance of the operating leases is included in the liability section of the Consolidated Balance Sheet. For all asset classes, the Company elected to not recognize a right-of-use asset and lease liability for leases with a term of twelve months or less. The adoption of this ASU did not result in a material adjustment to the Consolidated Statements of Stockholders' Equity or the Consolidated Statements of Operations. See Note 2 to our Consolidated Financial Statements of this Form 10-K for a discussion of the standard described above and other new accounting pronouncements which is incorporated herein by reference. Critical Accounting Policies Certain estimates and assumptions are made when preparing our financial statements. Estimates involve judgments with respect to, among other things, future economic factors that are difficult to predict. As a result, actual amounts could differ from estimates made when our financial statements are prepared. The Securities and Exchange Commission requires management to identify its most critical accounting policies, defined as those that are both most important to the portrayal of our financial condition and operating results and the application of which requires our most difficult, subjective, and complex judgments. Although our estimates have not differed materially from our experience, such estimates pertain to inherently uncertain matters that could result in material differences in subsequent periods. We believe application of the following accounting policies require significant judgments and estimates and represent our critical accounting policies. Other significant accounting policies are discussed in Note 1 to our Consolidated Financial Statements. • Revenue recognition. The Company derives its revenues primarily from the sale of floorcovering products and processing services. Revenues are recognized when control of these products or services is transferred to its customers, in an amount that reflects the consideration the Company expects to be entitled to in exchange for those products and services. Sales, value add, and other taxes the Company collects concurrent with revenue-producing activities are excluded from revenue. Table of Contents 24 Shipping and handling fees charged to customers are reported within revenue. Incidental items that are immaterial in the context of the contract are recognized as expense. The Company does not have any significant financing components as payment is received at or shortly after the point of sale. The Company determined revenue recognition through the following steps: ▪ Identification of the contract with a customer ▪ Identification of the performance obligations in the contract ▪ Determination of the transaction price ▪ Allocation of the transaction price to the performance obligations in the contract ▪ Recognition of revenue when, or as, the performance obligation is satisfied • Variable Consideration. The nature of the Company’s business gives rise to variable consideration, including rebates, allowances, and returns that generally decrease the transaction price, which reduces revenue. These variable amounts are generally credited to the customer, based on achieving certain levels of sales activity, product returns, or price concessions. Variable consideration is estimated at the most likely amount that is expected to be earned. Estimated amounts are included in the transaction price to the extent it is probable that a significant reversal of cumulative revenue recognized will not occur when the uncertainty associated with the variable consideration is resolved. Estimates of variable consideration are estimated based upon historical experience and known trends. • Customer claims and product warranties. The Company generally provides product warranties related to manufacturing defects and specific performance standards for its products for a period of up to two years. The Company accrues for estimated future assurance warranty costs in the period in which the sale is recorded. The costs are included in Cost of Sales in the Consolidated Statements of Operations and the product warranty reserve is included in accrued expenses in the Consolidated Balance Sheets. The Company calculates its accrual using the portfolio approach based upon historical experience and known trends. The Company does not provide an additional service-type warranty. • Accounts receivable allowances. We provide allowances for expected cash discounts and doubtful accounts based upon historical experience and periodic evaluations of the financial condition of our customers. If the financial conditions of our customers were to significantly deteriorate, or other factors impair their ability to pay their debts, credit losses could differ from allowances recorded in our Consolidated Financial Statements. • Inventories. Inventories are stated at the lower of cost or market. Cost is determined using the last-in, first-out method (LIFO), which generally matches current costs of inventory sold with current revenues, for substantially all inventories. Reserves are also established to adjust inventories that are off-quality, aged or obsolete to their estimated net realizable value. Additionally, rates of recoverability per unit of off-quality, aged or obsolete inventory are estimated based on historical rates of recoverability and other known conditions or circumstances that may affect future recoverability. Actual results could differ from assumptions used to value our inventory. • Goodwill. Goodwill is tested annually for impairment during the fourth quarter or earlier if significant events or substantive changes in circumstances occur that may indicate that goodwill may not be recoverable. The goodwill impairment tests are based on determining the fair value of the specified reporting units based on management judgments and assumptions using the discounted cash flows and comparable company market valuation approaches. We have identified our reporting unit as our floorcovering business for the purposes of allocating goodwill and assessing impairments. The valuation approaches are subject to key judgments and assumptions that are sensitive to change such as judgments and assumptions about sales growth rates, operating margins, the weighted average cost of capital (“WACC”), synergies from the viewpoint of a market participant and comparable company market multiples. When developing these key judgments and assumptions, we consider economic, operational and market conditions that could impact the fair value of the reporting unit. However, estimates are inherently uncertain and represent only management’s reasonable expectations regarding future developments. These estimates and the judgments and assumptions upon which the estimates are based will, in all likelihood, differ in some respects from actual future results. We performed our annual assessment of goodwill in the fourth quarter of 2018 and an impairment was indicated. In accordance with the results of our testing, the goodwill was considered impaired and the asset was removed and a corresponding expense was recorded for asset impairment on the Consolidated Statements of Operations. (See Note 7 to our Consolidated Financial Statements) • Self-insured accruals. We estimate costs required to settle claims related to our self-insured medical, dental and workers' compensation plans. These estimates include costs to settle known claims, as well as incurred and unreported claims. The estimated costs of known and unreported claims are based on historical experience. Actual results could differ from assumptions used to estimate these accruals. • Income taxes. Our effective tax rate is based on income, statutory tax rates and tax planning opportunities available in the jurisdictions in which we operate. Tax laws are complex and subject to different interpretations by the taxpayer and respective governmental taxing authorities. Deferred tax assets represent amounts available to reduce income taxes payable on taxable income in a future period. We evaluate the recoverability of these future tax benefits by assessing the Table of Contents 25 adequacy of future expected taxable income from all sources, including reversal of taxable temporary differences, forecasted operating earnings and available tax planning strategies. These sources of income inherently rely on estimates, including business forecasts and other projections of financial results over an extended period of time. In the event that we are not able to realize all or a portion of our deferred tax assets in the future, a valuation allowance is provided. We recognize such amounts through a charge to income in the period in which that determination is made or when tax law changes are enacted. We had valuation allowances of $13.3 million at December 28, 2019 and $17.0 million at December 29, 2018. At December 28, 2019, we were in a net deferred tax liability position of $91 thousand. For further information regarding our valuation allowances, see Note 15 to the Consolidated Financial Statements. • Loss contingencies. We routinely assess our exposure related to legal matters, environmental matters, product liabilities or any other claims against our assets that may arise in the normal course of business. If we determine that it is probable a loss has been incurred, the amount of the loss, or an amount within the range of loss, that can be reasonably estimated will be recorded.

<s>[INST] OVERVIEW Our business consists principally of marketing, manufacturing and selling floorcovering products to highend residential and commercial customers through our various sales forces and brands. We focus exclusively on the upperend of the floorcovering market where we believe we have strong brands and competitive advantages with our style and design capabilities and customer relationships. Our Fabrica, Masland, and Dixie Home brands have a significant presence in the highend residential floorcovering markets. Our Atlas | Masland Contract brand participates in the upperend specified commercial marketplace. Dixie International sells all of our brands outside of the North American market. Our business is primarily concentrated in areas of the soft floorcovering markets which include broadloom carpet, carpet tiles and rugs. However, in response to a significant shift in the flooring marketplace toward hard surface products, we have launched multiple hard surface initiatives in both our residential and commercial brands over the last few years. Our commercial brands offer Luxury Vinyl Flooring (“LVF”) products under the Calibré brand in the commercial markets. Our residential brands, Dixie Home and Masland Residential, offer Stainmaster® PetProtect™ Luxury Vinyl Flooring and our premium residential brand, Fabrica, offers a highend engineered wood line. In 2019, we successfully launched TRUCOR™, our new solid polymer core or “SPC” Luxury Vinyl Flooring line. This latest addition to our rigid core Luxury Vinyl Flooring offering is designed to create an extremely durable and waterproof Luxury Vinyl Flooring product with a broader range of price points to meet the needs of various consumers. To build on the momentum of TRUCOR™ in 2020 we have planned a significant increase in the product offerings of this line. Additional hard surface initiatives planned in 2020 include the introduction of new styles in the Fabrica line of wood products, new LVF tiles utilizing "Integrated Grout Technology", and a TRUCOR PRIME WPC program to include oversize planks in contemporary styles. In addition to our hard surface initiatives, we continue to grow our soft surface business through innovative product offerings such as the Crafted Collection of modular tile featuring our Sustaina backing. Our Sustaina cushion backing for modular tile is PVC and polyurethane free and it is composed of 81.5% total recycled content allowing us to offer an appealing set of patterns to our environmentally conscious customers. During 2019, our net sales decreased 7.5% compared with net sales in 2018. Sales of residential products decreased 7.2% in 2019 versus 2018. Residential soft surface sales were down 8.8% in 2019 as compared to 2018, while, we estimate, the industry was down in the mid to upper single digits. Our residential soft surface sales in 2019 were negatively impacted by a change in emphasis to hard surfaces by certain mass merchant customers. Residential hard surface sales increased by 47% in 2019 relative to sales in 2018. Despite recent slow activity, we anticipate the residential housing market will have steady but moderate growth over the next several years. Commercial product sales decreased 9.4% during 2019. Soft surface sales of commercial products were down 12.4%, while, we believe, the industry was down marginally. We anticipate the commercial market to be relatively flat in 2020. In 2019, we had an operating income of $21.3 million compared with an operating loss of $15.8 million in 2018. In 2019, we recorded a $25.1 million gain on the sale of our building in Santa Ana, California. Without this gain on sale we had an operating loss of $3.8 million. Gross profit as a percent of sales improved year over year despite the reduced sales volume in 2019 and the resulting under absorbed manufacturing costs. This was primarily the result of nonrecurring costs incurred in the prior year and improvements in operations, both related to the Profit Improvement Plan (the "Plan"). We also reduced plant running schedules in the fourth quarter to reduce inventories to a more appropriate level. We incur [/INST] Negative. </s>

JOY GLOBAL INC

2015-12-21

2015-10-30

Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations The following discussion should be read in conjunction with the Consolidated Financial Statements and related notes. References made to years are for fiscal year periods. The purpose of this discussion and analysis is to enhance the understanding and evaluation of the results of operations, financial position, cash flows, indebtedness and other key financial information of Joy Global Inc. and its subsidiaries for fiscal 2015, 2014 and 2013. For a more complete understanding of this discussion, please read the Notes to Consolidated Financial Statements included in this report. Overview We are a leading manufacturer and servicer of high productivity mining equipment for the extraction of metals and minerals. We manufacture and market original equipment and parts and perform services for both underground and surface mining, as well as certain industrial applications. Our equipment is used in major mining regions throughout the world to mine coal, copper, iron ore, oil sands, gold and other minerals. We operate in two business segments: Underground and Surface. We are a major manufacturer of underground mining machinery for the extraction and haulage of coal and other bedded minerals. We are also a major producer of surface mining equipment for the extraction and haulage of copper, coal and other minerals and ores. We offer comprehensive direct service, which includes our smart service offerings, near major mining regions worldwide and provide extensive operational support for many types of equipment used in mining. Our principal manufacturing facilities are located in the United States, including facilities in Alabama, Pennsylvania, Texas and Wisconsin, and internationally, including facilities in Australia, Canada, China, France, South Africa and the United Kingdom. Acquisition of Montabert S.A.S. On June 1, 2015, we completed the acquisition of 100% of the equity of Montabert for approximately $121.5 million, gross of cash acquired of $7.1 million dollars. Montabert specializes in the design, production and distribution of high quality hydraulic rock breakers, pneumatic equipment, drilling attachments, drifters and related parts and tools. This acquisition expands the Company's product and service capabilities for hard rock mining, tunneling and rock excavation, further diversifying our commodity and end market exposures. Montabert's results of operations have been included as part of the Underground segment from the date of the acquisition forward. Acquisition of Mining Technologies International Inc. On May 30, 2014, we closed on the purchase of certain assets of MTI for $44.4 million. MTI is a Canadian manufacturer of underground hard rock mining equipment serving the North American markets and a world leading supplier of raise bore drilling consumables. We have acquired substantially all of the assets associated with MTI's hard rock drilling, loaders, dump trucks, shaft sinking and raise bore product lines. MTI's results of operations have been included as part of the Underground segment from the acquisition date forward. Operating Results Net sales in fiscal 2015 were $3.2 billion, compared to $3.8 billion in fiscal 2014. The decrease in net sales of $606.2 million, or 16%, in the current year reflected a decrease in original equipment sales of $371.6 million, or 31%, and a decrease in service sales of $234.6 million, or 9%. Original equipment sales decreased in all regions except Africa, which had a slight increase. The decrease in original equipment sales was led by Latin America, which decreased by $138.8 million. Service sales decreased in all regions except Eurasia, which increased due to the fiscal 2015 acquisition of Montabert, and China. The decrease in service sales was led by North America, which decreased by $127.6 million. Compared to the prior year, net sales in fiscal 2015 included a $173.8 million unfavorable effect of foreign currency translation, due primarily to the decline in the value of the Australian dollar and South African rand relative to the U.S. dollar. Operating loss in fiscal 2015 was $1.1 billion, or 35.0% of net sales, compared to income of $527.5 million, or 14.0% of net sales, in fiscal 2014. The decrease in operating income of $1.6 billion, or 310%, in the current year was due to $1.3 billion of impairment charges, loss of margins on lower sales volumes of $214.5 million, a less favorable product mix of $58.1 million, lower manufacturing cost absorption of $26.3 million, and higher product development, selling and administrative expenses of $7.8 million, which included an $11.9 million increase in restructuring costs and $46.7 million increase in mark to market pension adjustments. These items were partially offset by reduced period costs (defined as any costs of sales other than those costs associated with selling inventory at standard costs) of $13.7 million, which included increased excess purchase accounting charges of $4.3 million. Compared to the prior year, operating (loss) income in fiscal 2015 included a $19.1 million unfavorable effect of foreign currency translation. Loss from continuing operations in fiscal 2015 was $1.2 billion, or $12.08 per diluted share, compared to income of $338.1 million, or $3.35 per diluted share, in fiscal 2014. Bookings in fiscal 2015 were $2.7 billion, compared to $3.6 billion in fiscal 2014. The decrease in bookings of $917.3 million, or 25%, in the current year reflected a decrease in original equipment bookings of $498.4 million, or 49%, and a decrease in service bookings of $418.9 million, or 16%. Original equipment bookings decreased in all regions. The decrease in original equipment bookings was led by Latin America, China and North America, which decreased by $162.0 million, $130.3 million and $115.9 million, respectively. Service bookings decreased in all regions except Eurasia. The decrease in service bookings was led by North America, which decreased by $261.9 million. Compared to the prior year, bookings in fiscal 2015 included a $188.6 million unfavorable effect of foreign currency translation, due primarily to the decline in the value of the Australian dollar and South African rand relative to the U.S. dollar. Impairment Charges We concluded that an indicator was present that suggested impairment may exist for our goodwill as of July 31, 2015, as our total shareholders’ equity exceeded our market capitalization due to the prolonged suppressed global commodity markets, their related effect on the global mining investment environment and the resulting impact on our market capitalization. Based on this indicator of impairment, we performed an interim test for impairment of goodwill as of the last day of our fiscal third quarter. We concluded our step one evaluation on our reporting units and determined that the estimated fair value of our Underground reporting unit was lower than the carrying value of the reporting unit, while the result of our interim test for the Surface reporting unit was that the estimated fair value of the reporting unit exceeded its carrying value. However, given the timing of the decline in our market capitalization, we were unable to complete step two of the Underground goodwill impairment test until we were engaged in the preparation of our annual financial statements. Upon completion of step two of our goodwill impairment test, we recorded a non-cash goodwill impairment charge of $1.2 billion. This impairment charge represents a complete impairment of goodwill in the Underground reporting unit. As of October 30, 2015, we again determined there was an indicator of potential goodwill impairment due to the continued deterioration of our markets and the resulting effects on our market capitalization. As a result we performed another interim impairment test of our goodwill and indefinite-lived intangible assets. The result of our step one evaluation was that the fair value of the Surface reporting unit again exceeded its carrying value. Although we have concluded there is no impairment on the goodwill of $354.6 million associated with our Surface segment as of year end, we will continue to closely monitor in the future considering the uncertainty in the markets and the continued decline in our stock price after year end. Should there still be further market declines and/or stock price declines in future periods, there is increasing risk that Surface segment goodwill may be impaired. We will continue to update our evaluation as market conditions and the follow on impacts to our share price warrant. As of July 31, 2015, we also assessed our tangible and intangible finite-lived assets for impairment due to the prolonged suppressed global commodity markets and their related effect on the global mining investment environment. No impairment was identified related to our finite-lived intangible assets as of July 31, 2015. However, during the fourth quarter of fiscal 2015, we determined that there was an additional risk that certain tangible and intangible finite-lived assets may not be recoverable due to continued deterioration of our markets. Each asset group was considered and it was determined that the cash flows of an asset group in China and a steel mill would be insufficient to support their carrying value. As a result of our analysis, non-cash impairment charges of $42.6 million and $57.9 million were recorded in the fourth quarter of fiscal 2015 by our Underground segment for property, plant and equipment and customer relationship intangible assets, respectively, related to an asset group in China. In addition, charges of $19.2 million and $2.1 million were recorded in the fourth quarter of fiscal 2015 by our Surface segment for property, plant and equipment and the customer relationship intangible asset, respectively, related to a steel mill. In addition, we also assessed our indefinite-lived trademarks as of July 31, 2015 due to the prolonged suppressed global commodity markets and their related effect on the global mining investment environment. No impairment was identified related to our indefinite-lived trademarks as of July 31, 2015. However, during the fourth quarter of fiscal 2015 we re-assessed our indefinite-lived trademarks due to the continued deterioration of our markets, developing an estimate of fair value using a discounted cash flow model. As a result of this analysis, a non-cash impairment charge of $10.8 million was recorded in the fourth quarter of fiscal 2015 by our Underground segment. Total impairment charges of $1.3 billion were recorded as a result of each of these analyses. These charges are recorded in the Consolidated Statement of Operations under the heading Impairment charges. Retirement Plans Mark to Market Adjustment In the fourth quarter of 2015, we voluntarily changed our method of accounting for actuarial gains and losses and the calculation of expected return on plan assets for all of our pension and other post-retirement benefit plans. We elected to recognize actuarial gains and losses in the income statement immediately, as it more clearly depicts the impact of current economic conditions in our consolidated results of operations. Historically, we deferred actuarial gains and losses from these plans and recognized the financial impact in the statement of operations over future years using a method commonly referred to as the corridor method. Specifically, the net loss (gain) in excess of 10% of the projected benefit obligation or the market related value of plan assets was amortized on a straight line basis over the average remaining service period (or over the average life of the participants if all or almost all of the plan participants are inactive). With the immediate recognition of actuarial gains and losses, actuarial gains and losses from these plans are immediately recognized in our results of operations in an annual adjustment that is recorded in the fourth quarter of each year, or more frequently should a re-measurement event occur. The remaining components of net periodic benefit costs, primarily service and interest costs and the expected return on plan assets, will continue to be recorded on a quarterly basis. In addition, for purposes of calculating the expected return on plan assets, we will no longer use an averaging technique for the market-related value of plan assets, but we are voluntarily changing to the actual fair value of plan assets to adjust for changes in actual versus expected rates of return. The impact of this change will be recorded annually as part of the adjustment described above. Collectively, the immediate recognition of actuarial gains and losses and the immediate recognition of actual versus expected rates of return on plan assets are referred to herein as the "mark to market pension and postretirement plan adjustment." Our operating segment results align with our internal management reporting, whose primary use is to drive operating decisions and to assess performance. We will continue to report service cost, interest cost, and the expected return on plan assets at the segment levels. However, the annual recognition of actuarial gains and losses (“the mark to market adjustment”) will be recorded as part of corporate activities and reflected as such in our reporting. These changes have been applied retrospectively. As a result, we have booked year end mark to market adjustment losses of $63.3 million and $9.8 million in fiscal 2015 and 2014, respectively, and a gain of $1.7 million in fiscal 2013, before considering the capitalization of any such amounts into inventory. See additional impacts of the new accounting policy in Note 2, Significant Accounting Policies. Market Outlook Over the course of 2015, pricing for most major commodities served by the company's customers fell as supply curtailments were slow to materialize in a tepid global growth environment. Global growth is expected to improve modestly in calendar 2016. Commodity prices are not expected to see any material improvement with current over-supplied conditions, which will continue to strain cash flows for most mining companies. We expect further austerity driven cost reduction measures and asset consolidation to define the mining industry in 2016. Slowing global growth, particularly in China, impacted copper markets during the year with prices falling in calendar fourth quarter. In response to the decline in pricing this year, several major mining companies have recently announced significant production cuts over the next 18 months. Accordingly, some forecasts have the refined copper market returning to a deficit in 2016. While a return to deficit could provide some support to pricing, a weaker than expected demand profile will likely keep copper pricing low. The combination of regulatory pressures along with sustained low natural gas pricing has resulted in calendar 2015 being one of the most challenging years on record for the U.S. coal market. Coal fired power plant closures and coal-to-gas switching are expected to drive a significant reduction in coal burn in the U.S. this calendar year. The significant reduction in coal burn along with decreased export opportunities due to the strong U.S. dollar will likely see coal production fall substantially in 2015. With the expectation of continued low natural gas pricing and further coal fired power plant closures, we expect coal burn to be down in 2016. The international seaborne thermal coal market remains oversupplied. Reduced Chinese coal imports have outweighed the increases in India and Southeast Asia and left the market oversupplied. During the year, currency fluctuations benefiting Australia and Russia also resulted in excess supply in the market. However, in response to low prices, exports from Indonesia have fallen through the calendar third quarter which has helped to reduce the surplus in the market. The seaborne thermal coal supply surplus is expected to persist into 2016 although increasing imports into India and Southeast Asia along with fewer new projects will help to rebalance the market. Seaborne metallurgical coal markets have also seen reduced demand as a result of global steel production contracting through October. As a result, metallurgical coal spot prices have fallen, putting a significant amount of global supply below their cash operating costs. Iron ore markets have faced a similar trend down with weakening demand driving prices down. While global steel demand is projected to increase in 2016 following a contraction in 2015, new supply growth is expected to exceed demand growth resulting in prices likely trending at or below current levels. The global mining market is expected to remain under pressure in 2016 as oversupplied markets continue to rebalance. Supply curtailments along with improving demand in some markets will could provide some relief. However, with most mining companies' cash flows under pressure, industry capital expenditures are expected to continue to decline. Company Outlook With global mining capital expenditures expected to step down again in 2016, we remain intensely focused on cost reduction and cash generation. We exceeded our cost reduction targets again in 2015 and are pro-actively taking actions to achieve another cost reduction in 2016. Our cash generation in the fourth quarter was strong and was driven by good results in bringing our inventory in closer alignment with current order levels. We believe there are additional opportunities to structurally reduce our inventories in 2016 by leveraging our global supply chain and the recent investments we have made in our service network. We will also continue to drive our growth strategies with service, new product development, and expansion of our hard rock platform. While adoption rates are slowed by current market conditions, we have expanded our design capabilities to deliver value-added, new Joy branded service products and consumables to our customers and are well positioned to drive growth in this area in the future. Our hybrid excavator, underground hard rock loader and prototype hard rock mechanical cutting machine are all currently operating and proving out their capabilities with customers in the field. These organically developed new products in combination with the recent acquisitions and our global service network will enable us to drive growth in current and adjacent markets in the future. We believe that our strategies and operational execution will position us well for the future, but the state of our end markets sets up another challenging year in 2016. Results of Operations Fiscal 2015 Compared With Fiscal 2014 Net Sales The following table sets forth fiscal 2015 and 2014 net sales included in our Consolidated Statements of Operations: Underground net sales in fiscal 2015 were $1.8 billion, compared to $2.1 billion in fiscal 2014. The decrease in Underground net sales of $301.0 million, or 14%, in the current year reflected a decrease in original equipment sales of $178.0 million, or 24%, and a decrease in service sales of $123.0 million, or 9%. Original equipment sales decreased in all regions except Africa. The decrease in original equipment sales was led by China and Eurasia, which decreased by $84.7 million and $74.1 million, respectively. Service sales decreased in all regions except Eurasia and China. The decrease in service sales was led by North America and Africa, which decreased by $74.2 million and $51.8 million, respectively. Compared to the prior year, Underground net sales in fiscal 2015 included a $131.7 million unfavorable effect of foreign currency translation, due primarily to the decline in the value of the Australian dollar and South African rand relative to the U.S. dollar. Surface net sales in fiscal 2015 were $1.5 billion compared to $1.8 billion in fiscal 2014. The decrease in Surface net sales of $332.8 million, or 18%, in the current year reflected a decrease in original equipment sales of $210.2 million, or 42%, and a decrease in service sales of $122.6 million, or 9%. Original equipment sales decreased in all regions except North America, which was flat, and China. The decrease in original equipment sales was led by Latin America, which decreased by $138.8 million. Service sales decreased in all regions except China, which was flat. The decline in service sales was led by North America, which decreased by $65.5 million. Compared to the prior year, Surface net sales in fiscal 2015 included a $42.1 million unfavorable effect of foreign currency translation, due primarily to the decline in the value of the Australian dollar relative to the U.S. dollar. Operating (Loss) Income The following table sets forth fiscal 2015 and 2014 operating (loss) income included in our Consolidated Statements of Operations: Underground operating loss in fiscal 2015 was $1.2 billion, or 64.8% of net sales, compared to income of $285.3 million, or 13.7% of net sales, in fiscal 2014. The decrease in Underground operating income of $1.4 billion, or 504%, was due to impairment charges of $1.3 billion, loss of margins on lower sales volumes of $106.6 million, a less favorable product mix of $42.1 million and lower manufacturing cost absorption of $5.7 million. These items were partially offset by lower period costs of $29.3 million, which includes increased excess purchase accounting charges of $4.3 million, and decreased product development, selling and administrative expenses of $6.1 million, which included a $1.5 million increase in restructuring costs. Compared to the prior year, Underground operating loss in fiscal 2015 included an $18.4 million unfavorable effect of foreign currency translation, due primarily to the decline in the value of the Australian dollar and South African rand relative to the U.S. dollar. Surface operating income in fiscal 2015 was $173.7 million, or 11.5% of net sales, compared to $342.8 million, or 18.6% of net sales, in fiscal 2014. The decrease in Surface operating income of $169.1 million, or 49%, was due to impairment charges of $21.3 million, loss of margins on lower sales volumes of $116.1 million, a less favorable product mix of $22.5 million, lower manufacturing cost absorption of $21.7 million, and higher period costs of $6.5 million. These items were partially offset by reduced product development, selling and administrative expenses of $23.3 million, which included an $8.8 million increase in restructuring costs. Corporate expense in fiscal 2015 was $102.7 million, compared to $57.1 million in fiscal 2014. The increase in corporate expense of $45.7 million, or 80%, was primarily due to the $46.7 million increase in mark to market pension adjustments and the $1.6 million increase in restructuring costs, partially offset by lower performance based compensation. Product Development, Selling and Administrative Expense Product development, selling and administrative expense in fiscal 2015 was $616.7 million, or 19.4% of net sales, compared to $608.9 million, or 16.1% of net sales, in fiscal 2014. The increase in product development, selling and administrative expense of $7.8 million, or 1%, was primarily due to the incremental expenses associated with the Company's recent acquisitions of Montabert and MTI in fiscal 2015 and 2014, respectively, an increase in bad debt expense, higher pension expense as a result of the magnitude of the fiscal 2015 mark to market adjustment, an increase in legal and professional fees, higher share-based compensation expense and incremental expenses for restructuring activities undertaken in the current fiscal year. These increases were partially offset by lower performance based compensation, favorable foreign currency impacts and cost savings from headcount reductions and other restructuring activities. Restructuring activities continued in 2015 to better align the company's workforce and overall cost structure with current and expected future demand. In the fourth quarter of fiscal 2015, we incurred a $1.3 billion impairment charge, covering goodwill, other intangible assets and certain items of property, plant, and equipment. This charge was primarily recorded by the Underground segment. See the notes to the accompanying financial statements for further information. Net Interest Expense Net interest expense in fiscal 2015 was $53.4 million, compared to $55.3 million in fiscal 2014. The decrease in net interest expense of $1.9 million, or 3%, was primarily due to the reduction in the borrowing spreads and commitment fees as a result of the third quarter fiscal 2014 refinancing, as well as increased interest earned on interest bearing assets. Debt Retirement During the fourth quarter of 2015, the Company elected to redeem the entire $250.0 million aggregate principal amount of its 6.0% Senior Notes due 2016 to reduce interest expense and improve bank and credit rating leveraging metrics. The cost of redemption, including the payment of the make whole premium, was funded with a combination of cash on hand and borrowings under the Company's unsecured revolving credit facility. Provision for Income Taxes The provision for income taxes in fiscal 2015 was $0.9 million, compared to $134.1 million in fiscal 2014. Our effective rate was (0.1)% in fiscal 2015, compared to 28.4% in the prior year. The adoption of mark to market accounting impacted the effective rate for each year as a result of the required adjustment to income before taxes and the volatility of the adjustment. The adoption of mark to market accounting increased our 2015 effective tax rate by 190 basis points and increased our 2014 effective tax rate by 10 basis points. A net discrete tax expense of $0.2 million was also recorded in fiscal 2015, compared to a benefit of $21.4 million in fiscal 2014. Excluding the impact of discrete items, the effective tax rate is (0.1)% in fiscal 2015 versus 32.9% in fiscal 2014. The decrease in the effective tax rate for the year, excluding discrete items, was primarily attributable to impairment charges on certain assets of the Company's Underground business segment. The discrete tax expense in fiscal 2015 was primarily attributable to the establishment of valuation allowances against the deferred tax assets of various foreign subsidiaries for which a benefit is not currently available, offset by U.S. foreign tax credits in connection with dividends received from non-U.S. subsidiaries. Bookings Bookings represent new customer orders for original equipment and services. Service bookings include orders for parts, components, and rebuilds, but are exclusive of long-term maintenance and repair arrangements and life cycle management arrangements awarded to us during the reporting period. We record bookings when firm orders are received and add the bookings to our backlog. Bookings for fiscal 2015 and 2014 are as follows: Underground bookings in fiscal 2015 were $1.6 billion, compared to $1.8 billion in fiscal 2014. The decrease in Underground bookings of $262.1 million, or 14%, in the current year reflected a decrease in original equipment bookings of $114.7 million, or 21%, and a decrease in service bookings of $147.4 million, or 11%. Original equipment bookings decreased in all regions except North America and Australia. The decrease in original equipment bookings was led by China, which decreased by $109.2 million. Service bookings decreased in all regions except Eurasia, which increased in part due to the acquisition of Montabert. The decrease in service bookings was led by North America, which decreased by $85.4 million. Compared to prior year, Underground bookings in fiscal 2015 included a $141.1 million unfavorable impact of foreign currency translation, due primarily to the decline in the value of the Australian dollar and South African rand relative to the U.S. dollar. Surface bookings for fiscal 2015 were $1.3 billion, compared to $1.9 billion in fiscal 2014. The decrease in Surface bookings of $643.6 million, or 34%, in the current year reflected a decrease in original equipment bookings of $366.6 million, or 70%, and a decrease in service bookings of $276.9 million, or 20%. Original equipment bookings decreased in all regions except Eurasia. The decrease in original equipment bookings was led by Latin America and North America, which decreased by $162.0 million and $128.9 million, respectively. Service bookings decreased in all regions except China, which was flat. The decrease in service bookings was led by North America, which decreased by $183.3 million. Compared to prior year, Surface bookings in fiscal 2015 included a $47.5 million unfavorable impact of foreign currency translation, due primarily to the decline in the value of the Australian dollar relative to the U.S. dollar. Fiscal 2014 Compared With Fiscal 2013 Net Sales The following table sets forth fiscal 2014 and 2013 net sales included in our Consolidated Statements of Operations: Underground net sales in fiscal 2014 were $2.1 billion, compared to $2.7 billion in fiscal 2013. The decrease in Underground net sales of $612.1 million, or 23%, reflected a decrease in original equipment sales of $534.2 million, or 42%, and a decrease in service sales of $77.9 million, or 6%. Original equipment sales decreased in all regions except Eurasia. The decline in original equipment sales was led by North America and Australia, which decreased by $184.0 million and $170.4 million, respectively. Service sales decreased in all regions except North America and Africa. The decline in service sales was led by China and Australia, which decreased by $92.2 million and $53.6 million, respectively. Compared to the prior year, net sales in fiscal 2014 included a $64.3 million unfavorable effect of foreign currency translation, due primarily to the decline in the value of the Australian dollar and South African rand relative to the U.S. dollar. Surface net sales in fiscal 2014 were $1.8 billion, compared to $2.5 billion in fiscal 2013. The decrease in Surface net sales of $651.6 million, or 26%, reflected a decrease in original equipment of $559.0 million, or 53%, and a decrease in service sales of $92.6 million, or 6%. Original equipment sales decreased in all regions. The decline in original equipment sales was led by North America and Latin America, which decreased by $189.2 million and $163.0 million, respectively. Service sales decreased in all regions except Latin America. The decline in service sales was led by North America and Australia, which decreased by $51.6 million and $32.8 million, respectively. Compared to the prior year, net sales in fiscal 2014 included a $30.5 million unfavorable effect of foreign currency translation, due primarily to the decline in the value of the Australian dollar relative to the U.S. dollar. Operating Income The following table sets forth fiscal 2014 and 2013 operating income included in our Consolidated Statements of Operations: Underground operating income in fiscal 2014 was $285.3 million, or 13.7% of net sales, compared to $388.8 million, or 14.4% of net sales, in fiscal 2013. The decrease in Underground operating income of $103.5 million, or 27%, was due to margins on lower sales volumes of $212.1 million, a less favorable product mix of $8.4 million, lower manufacturing cost absorption of $49.9 million and a decrease in other income of $0.2 million, These items were partially offset by reduced product development, selling and administrative expenses of $36.1 million and the prior year non-cash impairment charge of certain acquired trademarks of $130.2 million. Compared to the prior year, Underground operating income in fiscal 2014 included a $16.9 million unfavorable effect of foreign currency translation. Surface operating income in fiscal 2014 was $342.8 million, or 18.6% of net sales, compared to $539.9 million, or 21.6% of net sales, in fiscal 2013. The decrease in Surface operating income of $197.1 million, or 37%, was due to margins on lower sales volumes of $216.0 million, a less favorable product mix of $18.3 million and higher period costs of $18.9 million. These items were partially offset by higher manufacturing cost absorption of $8.0 million, an increase in other income of $7.0 million, the prior year non-cash impairment charge of certain acquired trademarks of $25.0 million and reduced product development, selling and administrative expenses of $16.0 million, which includes a $5.5 million decrease in restructuring costs and a $2.6 million of lower pension and post-retirement costs. Compared to the prior year, Surface operating income in fiscal 2014 included a $0.5 million unfavorable effect of foreign currency translation. Corporate expense in fiscal 2014 was $57.1 million, compared to $48.1 million in fiscal 2013. The increase in corporate expense of $9.0 million, or 19%, in the current year was primarily due to a decrease in other income of $28.0 million, which in fiscal 2013 included a claim settlement and an acquisition settlement of $15.0 million and $13.5 million, respectively. This increase in expense was partially offset by $13.9 million of lower charges year over year for the annual mark to market pension and post-retirement plan adjustment as well as reduced incentive based compensation expenses. Product Development, Selling and Administrative Expense Product development, selling and administrative expense in fiscal 2014 was $608.9 million, or 16.1% of net sales, compared to $656.1 million, or 13.1% of net sales, in fiscal 2013. The decrease in product development, selling and administrative expense of $47.3 million, or 6%, was primarily driven by lower sales volumes, lower incentive-based compensation expense, reduced restructuring activities and savings from the Company's cost reduction programs. These costs were partially offset by an increase in product development, selling and administrative expense for its allocated portion of the year end mark to market pension and other post-retirement adjustments. In addition, in the fourth quarter of fiscal 2013, we reviewed our brand portfolio and developed a strategy to increase the visibility of our core brands in furtherance of our One Joy Global initiative. During this review, we determined that the indefinite life assumption was no longer appropriate for most of our previously acquired trademarks. As a result, a non-cash impairment charge of $155.2 million was recorded in the fourth quarter of fiscal 2013, of which $130.2 million was recorded by our Underground segment and $25.0 million was recorded by our Surface segment. Net Interest Expense Net interest expense in fiscal 2014 was $55.3 million, compared to $57.5 million in fiscal 2013. The decrease in net interest expense of $2.2 million, or 4%, was primarily due to a lower balance on our Term Loan (as defined below), savings from our debt refinancing that occurred in the third quarter of fiscal 2014 and interest income on higher balances of interest bearing assets. Provision for Income Taxes The provision for income taxes in fiscal 2014 was $134.1 million, compared to $241.2 million in fiscal 2013. Our effective rate was 28.4% in fiscal 2014 as compared to 31.0% in fiscal 2013. The adoption of mark to market accounting impacted our effective tax rate for each year as a result of the required adjustment to income before taxes and the volatility of the adjustment. The adoption of mark to market accounting increased our effective tax rate by 10 basis points and 90 basis points in fiscal 2014 and fiscal 2013, respectively. A net discrete tax benefit of $21.4 million was recorded for fiscal 2014, compared to a benefit of $5.2 million in fiscal 2013. Excluding the impact of discrete items, the effective tax rate was 32.9% in fiscal 2014 and 31.7% in fiscal 2013, respectively. The increase in the effective tax rate for the year, excluding discrete items, was primarily attributable to the geographic mix of earnings and increased net operating losses of certain foreign subsidiaries without a currently recognizable tax benefit. The discrete tax benefits in fiscal 2014 were primarily attributable to favorable income tax audit settlements and release of certain reserves for which the statute of limitations had expired. Bookings Bookings for fiscal 2014 and fiscal 2013 are as follows: Underground bookings in fiscal 2014 were $1.8 billion, compared to $2.3 billion in fiscal 2013. The decrease in Underground bookings of $464.4 million, or 20%, reflected a decrease in original equipment bookings of $455.1 million, or 45%, and a decrease in service orders of $9.4 million, or 1%. Original equipment bookings decreased in all regions except Eurasia. The decline in original equipment orders was primarily in Australia and North America, which decreased by $208.0 million and $147.6 million, respectively. Service bookings decreased in all regions except North America and China. The decline in service bookings was led by Australia and Africa, which decreased by $35.8 million and $5.8 million, respectively. Compared to prior year, Underground bookings in fiscal 2014 included a $79.2 million unfavorable impact of foreign currency translation, due primarily to the decline in the value of the Australian dollar and South African rand relative to the U.S. dollar. Surface bookings in fiscal 2014 were $1.9 billion, compared to $1.8 billion in fiscal 2013. The increase in Surface bookings of $138.2 million, or 8%, reflected an increase in original equipment bookings of $79.4 million, or 18%, and an increase in service orders of $58.8 million, or 4%. Original equipment bookings increased in all regions except Eurasia and Africa. The increase in original equipment orders was led by North America and Latin America, which increased by $60.7 million and $59.3 million, respectively. Service bookings increased in Latin America, North America and Africa by $62.8 million, $20.2 million and $7.6 million, respectively, with decreases in all other regions. Compared to prior year, Surface bookings in fiscal 2014 included a $35.4 million unfavorable impact of foreign currency translation, due primarily to the decline in the value of the Australian dollar relative to the U.S. dollar. Liquidity and Capital Resources The following table summarizes the major elements of our working capital as of October 30, 2015 and October 31, 2014: We currently use trade working capital and cash flow from continuing operations as two financial measurements to evaluate the performance of our operations and our ability to meet our financial obligations. We require trade working capital investment because our direct service model requires us to maintain certain inventory levels in order to maximize our customers’ machine availability. This information also provides management with a focus on our receivable terms and collectability efforts and our ability to obtain advance payments on original equipment orders. As part of the continuous improvement of our purchasing and manufacturing processes, we continue to strive for alignment of inventory levels with customer demand and current production schedules. Cash provided by continuing operations for fiscal 2015 was $355.3 million, compared to $363.4 million provided by continuing operations in fiscal 2014. The decrease in cash provided by continuing operations during the year was primarily due to lower earnings, partially offset by changes in trade working capital levels and the collection of long-term receivables. Included in cash provided by operating activities for the year ended October 30, 2015 is a loss on the retirement of debt of $14.3 million, which represents the make whole premium on the redemption of our 6.0% Senior Notes due 2016. Cash used by investing activities for fiscal 2015 was $181.5 million, compared to $125.5 million used by investing activities in fiscal 2014. The increase in cash used by investing activities was primarily due to the current year acquisition of Montabert, partially offset by lower capital expenditures. Capital expenditures were $71 million in fiscal 2015 versus $91 million in fiscal 2014. Cash used by financing activities for fiscal 2015 was $325.0 million, compared to $367.3 million used by financing activities in fiscal 2014. The decrease in cash used by financing activities was primarily due to a decrease in treasury share repurchases, partially offset by the early redemption of our 2016 Notes in the fourth quarter of fiscal 2015. During each quarter of fiscal 2015 we paid cash dividends of $0.20 per outstanding share of common stock resulting in $78.0 million in dividends paid during the fiscal year. On December 16, 2015, our Board of Directors declared a cash dividend of $0.01 per outstanding share of common stock. This dividend will be paid on January 15, 2016 to all shareholders of record at the close of business on December 30, 2015. In fiscal 2016, we expect capital spending to be between $70.0 million and $90.0 million. Capital projects will be focused on continuing investments in our global service infrastructure and operational excellence initiatives. Retiree Benefits We sponsor pension plans in the U.S. and in other countries. The significance of the funding requirements of these plans is largely dependent on the value of the plan assets, the investment returns on the plan assets, actuarial assumptions, including discount rates, and the impact of the Pension Protection Act of 2006. During fiscal 2015, we contributed $13.1 million to our defined benefit employee pension plans, and we expect contributions to be approximately $10.0 million in fiscal 2016. As of October 30, 2015, we have a net unfunded pension and other postretirement liability of $195.4 million. As mentioned throughout this document, during the fourth quarter of the current fiscal year, we voluntarily changed our method of accounting for actuarial gains and losses and for the calculation of the expected rate of return on plan assets for all of our pension and other post-retirement plans. As a result, we incurred fourth quarter non-cash mark to market losses related to this change of $63.3 million and $9.8 million for fiscal 2015 and fiscal 2014, respectively. In the fourth quarter of fiscal 2013, we recognized a non-cash gain of $1.7 million related to the mark to market adjustment. These non-cash losses are prior to the impact of any amounts capitalized into inventory on the balance sheet. Credit Facilities and Senior Notes On December 14, 2015, we amended our Credit Agreement. This amendment to the Credit Agreement increased the consolidated leverage ratio from its current limit of 3.0x beginning in the second quarter of fiscal 2016 and continuing through the first quarter of fiscal 2018, with a maximum ratio of 4.5x for the fourth quarter of fiscal 2016 through the second quarter of fiscal 2017. The amendment also reduced the aggregate revolving commitments of the lenders from $1.0 billion to $850.0 million and added a letter of credit sublimit of $500.0 million. In addition, we also agreed to limit priority debt (secured indebtedness and the unsecured indebtedness of our foreign subsidiaries) to 10% of consolidated net worth and to limit cash dividends to $25.0 million per year in the aggregate. We may continue to request an increase of up to $250.0 million of additional aggregate revolving commitments, subject to the terms and conditions contained in the Credit Agreement. Under the terms of the Credit Agreement, we pay a commitment fee ranging from 0.09% to 0.30% on the unused portion of the revolving credit facility based on our credit rating. Letters of credit issued under applicable provisions of the Credit Agreement represent an unfunded utilization of the Credit Agreement for purposes of calculating the periodic commitment fee due. Eurodollar rate loans bear interest for a period from the applicable borrowing date until a date one week or one, two, three or six months thereafter, as selected by the Company, at the corresponding Eurodollar rate plus a margin of 1.0% to 2.0% depending on the Company’s credit rating. Base rate loans bear interest from the applicable borrowing date at a rate equal to (i) the highest of (a) the federal funds rate plus 0.5%, (b) the rate of interest in effect for such day as publicly announced by the administrative agent as its “prime rate,” or (c) a daily rate equal to the one-month Eurodollar rate plus 1.0%, plus (ii) a margin that varies according to the Company’s credit rating. Swing line loans bear interest at either the base rate described above or the daily floating Eurodollar rate plus the applicable margin, as selected by the Company. The Credit Agreement is guaranteed by each of our current and future material domestic subsidiaries and requires the maintenance of certain financial covenants, including leverage and interest coverage ratios. The Credit Agreement also restricts payment of dividends or other returns of capital to shareholders when the consolidated leverage ratio exceeds a stated level amount. As of October 30, 2015, we were in compliance with all financial covenants of the Credit Agreement. As of October 30, 2015, there was $58.6 million of outstanding borrowings under the Credit Agreement. Outstanding standby letters of credit issued under the Credit Agreement, which count toward the credit limit, totaled $129.4 million. As of October 30, 2015, there was $812.0 million available for borrowings under the Credit Agreement. The amount available for borrowings under the Credit Agreement would have been $662.0 million had the amendment been in effect at year end. On July 29, 2014, we entered into a term loan agreement which matures July 29, 2019 and provides for a commitment of up to $375.0 million (as amended, the "Term Loan"). The Term Loan amended our prior term loan, dated as of June 16, 2011 (the "Prior Term Loan"). The Prior Term Loan had been scheduled to mature on July 16, 2016 and provided an initial commitment of $500.0 million, which had been drawn in full in conjunction with our fiscal 2011 acquisition of LeTourneau Technologies Inc., and had been amortized to $375.0 million at the date of amendment. We utilized the $375.0 million commitment under the Term Loan to repay the balance outstanding under the Prior Term Loan. On December 14, 2015, the Term Loan was amended to be consistent with the revolving Credit Agreement, including with respect to the maximum leverage ratio and restrictions on priority debt and dividends and other restricted payments. The Term Loan requires quarterly principal payments beginning in fiscal 2016 and contains terms and conditions that are substantially the same as the terms and conditions of the Credit Agreement. The Term Loan is guaranteed by each of our current and future material domestic subsidiaries and requires the maintenance of certain financial covenants, including leverage and interest coverage ratios. As of October 30, 2015, we were in compliance with all financial covenants of the Term Loan. As stated above, the Credit Agreement and Term Loan are guaranteed by each of our current and future material domestic subsidiaries and require the maintenance of certain financial covenants, including leverage and interest coverage ratios. Such calculations are adjusted for non-cash expense items, including those related to pension and postretirement obligations. As such, we do not anticipate that the adoption of accelerated amortization under mark to market accounting will impact our ability to maintain such covenants. On October 12, 2011, we issued $500.0 million aggregate principal amount of 5.125% Senior Notes due in 2021 (the "2021 Notes") at a discount of $4.2 million in an offering that was registered under the Securities Act. Interest on the 2021 Notes is paid semi-annually in arrears on October 15 and April 15 of each year, and the 2021 Notes are guaranteed by each of our current and future material domestic subsidiaries. At our option, we may redeem some or all of the 2021 Notes at a redemption price of the greater of 100% of the principal amount of the 2021 Notes to be redeemed or the sum of the present values of the principal amounts and the remaining scheduled interest payments using a discount rate equal to the sum of a treasury rate of a comparable treasury issue plus 0.5%. In November 2006, we issued $250.0 million aggregate principal amount of 6.0% Senior Notes due 2016 and $150.0 million aggregate principal amount of 6.625% Senior Notes due 2036 (the "2016 Notes" and "2036 Notes," respectively). Interest on the 2016 Notes and 2036 Notes is paid semi-annually in arrears on May 15 and November 15 of each year, and the 2016 Notes and 2036 Notes are guaranteed by each of our current and future material domestic subsidiaries. The 2016 Notes and 2036 Notes were issued in a private placement under an exemption from registration provided by the Securities Act. In the second quarter of fiscal 2007, the 2016 Notes and 2036 Notes were exchanged for substantially identical notes in an exchange that was registered under the Securities Act. The terms of the indenture permit us to redeem some or all of the 2016 Notes and 2036 Notes at a redemption price of the greater of 100% of the principal amount of the 2016 Notes and 2036 Notes to be redeemed or the sum of the present values of the principal amounts and the remaining scheduled interest payments using a discount rate equal to the sum of a treasury rate of a comparable treasury issue plus 0.3% for the 2016 Notes and 0.375% for the 2036 Notes. In October of fiscal 2015 we redeemed the entire $250.0 million aggregate principal amount of our 2016 Notes at a redemption price equal to the principal amount thereof, plus accrued and unpaid interest up to, but excluding, the redemption date, plus a “make whole” premium calculated in accordance with the indenture. This resulted in a $14.3 million loss on early debt retirement, which was recorded in the fourth quarter of fiscal 2015. Stock Repurchase Program In August 2013, our Board of Directors authorized the Company to repurchase up to $1.0 billion in shares of our common stock until August 2016. Under the program, the Company may repurchase shares in the open market in accordance with applicable SEC rules and regulations. During the year ended October 30, 2015, we purchased 954,580 shares of common stock for approximately $50.0 million, all of which occurred in the first quarter. During the year ended October 31, 2014, we purchased 4,712,025 shares of common stock for approximately $269.3 million. Since its inception, the Company has repurchased 9,771,605 shares of common stock under the program for approximately $533.4 million, leaving $466.6 million available under the program. Advance Payments and Progress Billings As part of the negotiation process associated with original equipment orders, contracts generally require advance payments and progress billings from our customers to support the procurement of inventory and other resources. As of October 30, 2015, advance payments and progress billings were $229.5 million. As orders are shipped or costs are incurred, the advance payments and progress billings are recognized as revenue in the consolidated financial statements. Financial Condition We believe our liquidity and capital resources are adequate to meet our projected needs. We had $102.9 million in cash and cash equivalents as of October 30, 2015, of which $98.8 million is held by foreign entities, and $812.0 million is available for borrowings under the Credit Agreement. Subsequent to year end, the Company's unsecured revolving credit facility was modified to amend the total facility size to $850.0 million from $1.0 billion, among other things. Even considering the amendment, we still expect to meet our U.S. funding needs without repatriating undistributed profits that are indefinitely reinvested outside the U.S., which would result in the incurrence of additional U.S. corporate income taxes on such undistributed profits. In addition, we reduced our first quarter fiscal 2016 dividends from $0.20 per share to $0.01 per share. If maintained, this action would reduce annual cash outlay by approximately $75.0 million. Requirements for working capital, dividends, pension contributions, capital expenditures, acquisitions, stock repurchases and principal and interest payments on our Term Loan and senior notes will be adequately funded by cash on hand and continuing operations, supplemented by short and long term borrowings, as required. Off-Balance Sheet Arrangements We lease various assets under operating leases. The aggregate payments under operating leases as of October 30, 2015 are disclosed in the table in the Disclosures about Contractual Obligations and Commercial Commitments section below. No significant changes to lease commitments have occurred during fiscal 2015. We have no other off-balance sheet arrangements. Disclosures about Contractual Obligations and Commercial Commitments The following table sets forth our contractual obligations and commercial commitments as of October 30, 2015: * Includes interest. ** Includes minimum required contributions to our pension and other postretirement benefit plans and required contributions for our unfunded other postretirement benefit plans. Critical Accounting Policies Our discussion and analysis of financial condition and results of operations is based on our Consolidated Financial Statements, which have been prepared in accordance with GAAP. The preparation of these Consolidated Financial Statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues, expenses and related disclosure of contingent assets and liabilities. We continually evaluate our estimates and judgments, including those related to bad debts, inventory, goodwill and intangible assets, warranty, pension and postretirement benefits and costs, income taxes and contingencies. We base our estimates on historical experience and assumptions that we believe to be reasonable under the circumstances. Actual results may differ from these estimates. We believe the accounting policies described below are the policies that most frequently require us to make estimates and judgments, and therefore are critical to the understanding of our results of operations. Revenue Recognition We recognize revenue on products and services when the following criteria are satisfied: persuasive evidence of a sales arrangement exists, product delivery and transfer of title and risk and rewards has occurred or services have been rendered, the price is fixed and determinable and collectability is reasonably assured. We recognize revenue on long-term contracts, such as contracts to manufacture mining shovels, draglines, roof support systems and conveyor systems, using the percentage-of-completion method. When using the percentage-of-completion method, sales and gross profit are recognized as work is performed based on the relationship between actual costs incurred and total estimated costs at completion. Sales and gross profit are adjusted prospectively for revisions in estimated total contract costs and contract values. Estimated losses are recognized in full when identified. Approximately 92% of our sales in fiscal 2015 were recorded at the time of shipment or delivery of the product (depending on the terms of the agreement) or performance of the service, with the remaining 8% of sales recorded using percentage-of-completion accounting. We have life cycle management arrangements with customers to supply parts and service for terms of 1 to 17 years. These arrangements are established based on the conditions in which the equipment will be operating, the time horizon that the arrangements will cover and the expected operating cycle that will be required for the equipment. Based on this information, a model is created representing the projected costs and revenues of servicing the respective machines over the specified arrangement terms. Accounting for these arrangements requires us to make various estimates, including estimates of the relevant machine’s long-term maintenance requirements. Under these arrangements, customers are generally billed monthly based on hours of operation or units of production achieved by the equipment, with the respective deferred revenues recorded when billed. Revenue is recognized in the period in which parts are supplied or services provided. These arrangements are reviewed quarterly by comparison of actual results to original estimates or most recent analysis, with revenue recognition adjusted appropriately for future estimated costs. If a loss is expected at any time, the full amount of the loss is recognized immediately. We have certain customer agreements that are considered multiple element arrangements. These agreements primarily consist of the sale of multiple pieces of equipment or equipment with subsequent installation services. These agreements are assessed for the purpose of identifying deliverables and determining whether the delivered item has value to the customer on a standalone basis and whether delivery or performance of the undelivered item is considered probable and substantially in our control. If those criteria are met, revenue is allocated to each identified unit of accounting based on our estimate of the relative selling prices of the deliverables and is recognized as the revenue recognition criteria are met for each element. The relative selling price is estimated by using recent sales transactions for similar items. The difference between the total of the separate selling prices and the total contract consideration is allocated pro-rata across each of the units of accounting included in the arrangement. Revenue recognition involves judgments, including assessments of expected returns, the likelihood of nonpayment and estimates of expected costs and profits on long-term contracts. In determining when to recognize revenue, we analyze various factors, including the specifics of the transaction, historical experience, creditworthiness of the customer and current market and economic conditions. Changes in judgments on these factors could impact the timing and amount of revenue recognized with a resulting impact on the timing and amount of associated income. Inventories Inventories are carried at the lower of cost or net realizable value using the first-in, first-out method for all inventories, except for inventories in those jurisdictions for which another method is required by law. Cost includes direct materials, direct labor and manufacturing overhead. We evaluate the need to record valuation adjustments for inventory on a regular basis. Inventory in excess of our estimated usage requirements is written down to its estimated net realizable value. Inherent in the estimates of net realizable value are estimates related to our future manufacturing schedules, customer demand, possible alternative uses and ultimate realization of potentially excess inventory. Goodwill and Other Intangible Assets Finite-lived intangible assets include engineering drawings, customer relationships, patents, unpatented technology and trademarks. Finite-lived intangible assets are amortized to reflect the pattern of economic benefits consumed, which is principally the straight-line method. Intangible assets that are subject to amortization are evaluated for potential impairment whenever events or circumstances indicate that the carrying amount may not be recoverable. As of July 31, 2015, we assessed our tangible and intangible finite-lived assets for impairment due to the prolonged suppressed global commodity markets and their related effect on the global mining investment environment. No impairment was identified related to our finite-lived intangible assets as of July 31, 2015. However, during the fourth quarter of fiscal 2015, we determined that there was an additional risk that certain tangible and intangible finite-lived assets may not be recoverable due to continued deterioration of our markets. Each asset group was considered and it was determined that the cash flows of an asset group in China and a steel mill would be insufficient to support their carrying value. In connection with the evaluation of these asset groups, we developed an estimate of fair value using a discounted cash flow model. Assumptions critical to the process included forecasted financial information, discount rates and applicable customer retention rates. This fair value determination was categorized as Level 3 in the fair value hierarchy. See Note 19, Fair Value Measurements, for the definition of Level 3 inputs. As a result of this analysis, customer relationship non-cash impairment charges of $57.9 million and $2.1 million were recorded in the fourth quarter of fiscal 2015 by our Underground and Surface segments, respectively. These charges are recorded in the Consolidated Statement of Operations under the heading Impairment charges. Indefinite-lived intangible assets are composed of certain trademarks and are not amortized but are evaluated for impairment annually or more frequently if events or changes occur that suggest an impairment in carrying value, such as a significant adverse change in the business climate. Indefinite-lived intangible assets are evaluated for impairment by comparing each asset's fair value to its book value. We first determine qualitatively whether it is more likely than not that an indefinite-lived asset is impaired. If we conclude that it is more likely than not that an indefinite-lived asset is impaired, then we determine the fair value by using the discounted cash flow model based on royalties estimated to be derived in the future use of the asset were we to license the use of the indefinite-lived asset. We assessed our indefinite-lived trademarks as of July 31, 2015 due to the prolonged suppressed global commodity markets and their related effect on the global mining investment environment. No impairment was identified related to our indefinite-lived trademarks as of July 31, 2015. However, during the fourth quarter of fiscal 2015 we re-assessed our indefinite-lived trademarks due to the continued deterioration of our markets, developing an estimate of fair value using a discounted cash flow model. Assumptions critical to the process included forecasted financial information, discount rates and royalty rates. The estimates of the fair values of the indefinite-lived trademarks are based on the best information currently available. However, further adjustments may be necessary in the future if conditions differ substantially from the assumptions utilized. This fair value determination was categorized as Level 3 in the fair value hierarchy. See Note 19, Fair Value Measurements, for the definition of Level 3 inputs. As a result of this analysis, a non-cash impairment charge of $10.8 million was recorded in the fourth quarter of fiscal 2015 by our Underground segment. This charge is recorded in the Consolidated Statement of Operations under the heading Impairment charges. Goodwill represents the excess of the purchase price over the fair value of identifiable net assets acquired in a business combination. Goodwill is assigned to specific reporting units, which we have identified as our operating segments, and is tested for impairment at least annually, during the fourth quarter of our fiscal year, or more frequently upon the occurrence of an event or when circumstances indicate that a reporting unit’s carrying amount is greater than its fair value. Goodwill is evaluated for impairment by comparing the fair value of each of our reporting units to their book value. We generally first determine, based on a qualitative assessment, whether it is more likely than not that the fair value of a reporting unit is less than its carrying amount. If we conclude that it is more likely than not that the fair value of a reporting unit is less than its carrying amount, we then determine the fair value of the reporting unit based on a discounted cash flow model. If the fair value of the reporting unit exceeds its carrying value, goodwill is not impaired. If the carrying value of the reporting unit exceeds its fair value, the impairment test continues by comparing the carrying value of the reporting unit’s goodwill to the implied fair value of goodwill. The implied fair value of goodwill is determined by deducting the fair value of a reporting unit’s identifiable assets and liabilities from the fair value of the reporting unit as a whole, as if that reporting unit had just been acquired and the fair value of the individual assets acquired and liabilities assumed were being determined initially. If goodwill is impaired, we recognize a non-cash impairment loss based on the amount by which the book value of goodwill exceeds its implied fair value. As of July 31, 2015, we concluded that an indicator was present that suggested impairment may exist for our goodwill, as our total shareholders’ equity exceeded our market capitalization due to the prolonged suppressed global commodity markets, their related effect on the global mining investment environment and the resulting impact on our market capitalization. Based on this indicator of impairment, we performed an interim test for impairment of goodwill as of the last day of our fiscal third quarter. We concluded our step one evaluation on our reporting units and determined that the estimated fair value of our Underground reporting unit was lower than the carrying value of the reporting unit, while the result of our interim test for the Surface reporting unit was that the estimated fair value of the reporting unit exceeded carrying value. However, given the timing of the decline in our market capitalization, we were unable to complete step two of the Underground goodwill impairment test until we were engaged in the preparation of our annual financial statements. Step two of the analysis requires us to perform a theoretical purchase price allocation for the Underground reporting unit to determine the implied fair value of goodwill and to compare the implied fair value of goodwill to the recorded amount of goodwill. Upon completion of step two of our goodwill impairment test, we recorded a non-cash goodwill impairment charge of $1.2 billion. This impairment charge represents a complete impairment of goodwill in the Underground reporting unit, and it is recorded in the Consolidated Statement of Operations under the heading Impairment charges. As of October 30, 2015, we determined there was an indicator of potential goodwill impairment due to the continued deterioration of our markets and the resulting effects on our market capitalization. As a result we performed another interim impairment test of our goodwill and indefinite-lived intangible assets. The result of our step one evaluation was that the estimated fair value of the Surface reporting unit again exceeded its carrying value. Although we have concluded there is no impairment on the goodwill associated with our Surface segment as of year end of $354.6 million, we will continue to closely monitor in the future considering the uncertainty in the markets and the continued decline in our stock price after year end. Should there be still further market declines and/or stock price declines in future periods, there is increasing risk that Surface segment goodwill may be impaired. We will continue to update our evaluation as market conditions and the follow on impacts to our share price warrant. In connection with our goodwill impairment test, we worked with a third party appraisal firm throughout the process, including during both our step one assessments and in the determination of the fair value of Underground goodwill using a discounted cash flow model. In connection with obtaining an independent third party valuation, management provided certain information and assumptions that were utilized in the fair value calculation. Assumptions critical to the process included forecasted financial information, discount rates, working capital, and terminal growth rates. This fair value determination was categorized as Level 3 in the fair value hierarchy. See Note 19, Fair Value Measurements, for the definition of Level 3 inputs. See Note 7, Goodwill and Intangible Assets, for additional details regarding the results of our goodwill and other intangible impairment testing performed in fiscal 2015. The process of evaluating the potential impairment of goodwill and other intangible assets is highly subjective and requires significant judgment at many points during the analysis. Qualitative assessments regarding goodwill and other intangible assets involve a high degree of judgment and can entail subjective considerations. The discounted cash flow model involves many assumptions, including operating results forecasts and discount rates. Inherent in the operating results forecasts are certain assumptions regarding revenue growth rates, projected cost saving initiatives and projected long-term growth rates in the determination of terminal values. Accrued Warranties We provide for the estimated costs that may be incurred under product warranties to remedy deficiencies of quality or performance of our products. Warranty costs are accrued at the time revenue is recognized. These product warranties extend over either a specified period of time, units of production or machine hours depending on the product subject to the warranty. We accrue a provision for estimated future warranty costs based on the historical relationship of warranty costs to sales. We periodically review the adequacy of the accrual for product warranties and adjust the warranty percentage and accrued warranty reserve for actual experience as necessary. Pension and Postretirement Benefits and Costs In the fourth quarter of 2015, we voluntarily changed our method of accounting for actuarial gains and losses and the calculation of expected return on plan assets for all of our pension and other postretirement benefit plans. We elected to recognize actuarial gains and losses in the statement of operations immediately, as it more clearly depicts the impact of current economic conditions in our consolidated results of operations. Furthermore, after implementing various de-risking strategies related to these plans in previous years, all of our major plans are currently frozen, with our U.S. and U.K. defined benefit pension plans funded at 92.0% and 95.6%, respectively, as of October 30, 2015. This change has been reported through retrospective application of this new policy to all periods presented. Historically, we deferred actuarial gains and losses from these plans and recognized the financial impact in the statement of operations over future years using a method referred to as the corridor method. Specifically, the net loss (gain) in excess of 10% of the projected benefit obligation or the market related value of plan assets was amortized on a straight line basis over the average remaining service period (or over the average life of the participants if all or almost all of the plan participants are inactive). With the immediate recognition of actuarial gains and losses, actuarial gains and losses from these plans are immediately recognized in our results of operations in an annual adjustment that is recorded in the fourth quarter of each year, or more frequently should a re-measurement event occur. The remaining components of net periodic benefit costs, primarily service and interest costs and the expected return on plan assets, will continue to be recorded on a quarterly basis. In addition, for purposes of calculating the expected return on plan assets, we will no longer use an averaging technique for the market-related value of plan assets, but we are voluntarily changing to the actual fair value of plan assets to adjust for changes in actual versus expected rates of return. The impact of this change will be recorded annually as part of the adjustment described above. Collectively, the immediate recognition of actuarial gains and losses and the immediate recognition of actual versus expected rates of return on plan assets are referred to herein as the "mark to market pension and postretirement plan adjustment." Consistent with prior periods, pension and other postretirement benefit costs and liabilities are still dependent on assumptions used in calculating such amounts. The primary assumptions include discount rates, expected returns on plan assets, mortality rates and rates of compensation increases, as discussed below: Discount rates: We generally estimate the discount rate for pension and other postretirement benefit obligations using a process based on a hypothetical investment in a portfolio of high-quality bonds that approximates the estimated cash flows of the pension and other postretirement benefit obligations. We believe this approach permits a matching of future cash outflows related to benefit payments with future cash inflows associated with bond coupons and maturities. Expected returns on plan assets: Our expected return on plan assets is derived from reviews of asset allocation strategies and anticipated future long-term performance of individual asset classes, weighted by the allocation of our plan assets. Our analysis gives appropriate consideration to recent plan performance and historical returns; however, the assumptions are primarily based on long-term, prospective rates of return. Mortality rates: Fiscal 2014 mortality rates are based on the IRS prescribed annuitant and non-annuitant mortality for 2014 under the Pension Protection Act of 2006. Fiscal 2015 mortality rates are based on the annuitant and non-annuitant mortality tables (RP-2014) released by the Society of Actuaries late in fiscal 2014, adjusted for the mortality improvement scale (MP-2014), as well as for the Company’s historical plan experience levels. Adoption of these modified tables had a $35.0 million expense impact to our pension and postretirement plans, which was recognized as part of our fourth quarter fiscal 2015 mark to market adjustment. Further, we considered the recently released updates to the 2014 mortality improvement scale, noting that the modifications would not be significant to our assumptions. Rates of compensation increases: The rates of compensation increases reflect our long-term actual experience and its outlook, including consideration of expected rates of inflation. As mentioned above, actual results that differ from these assumptions are immediately recognized in our results of operations in an annual adjustment that is recorded in the fourth quarter of each year, or more frequently should a re-measurement event occur. While we believe that the assumptions used are appropriate, differences in actual experience or changes in assumptions may affect our pension and other postretirement plan obligations and future expense. As such, a 0.25% change in the discount rate and the expected return on net assets would have the following effects on pension expense and the projected benefit obligation as of and for the fiscal year ended October 30, 2015: Income Taxes Deferred taxes are accounted for under the asset and liability method whereby deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax basis. Deferred tax assets and liabilities are measured using current statutory tax rates. Deferred income tax provisions are based on changes in the deferred tax assets and liabilities from period to period. Additionally, we analyze our ability to recognize the net deferred tax assets created in each jurisdiction in which we operate to determine if valuation allowances are necessary based on the “more likely than not” criteria. As required under the application of fresh start accounting, the release of pre-emergence tax valuation reserves was not recorded in the statement of operations but instead was treated first as a reduction of excess reorganization value until exhausted, then intangible assets until exhausted, and thereafter reported as additional paid in capital. Consequently, a net tax charge will be incurred in future years when these tax assets are utilized. We will continue to monitor the appropriateness of the existing valuation allowances and determine annually the amount of valuation allowances that are required to be maintained. As of October 30, 2015, there were $63.3 million of valuation allowances against pre-emergence net operating loss carryforwards. All future reversals of pre-emergence valuation allowances will be recorded to additional paid in capital. We estimate the effective tax rate expected to be applicable for the full year on an interim basis. The estimated effective tax rate contemplates the expected jurisdiction where income is earned (e.g., United States compared to non-United States), as well as tax planning strategies. If the actual results are different from these estimates, adjustments to the effective tax rate may be required in the period such determination is made. Additionally, discrete items are treated separately from the effective rate analysis and are recorded separately as an income tax provision or benefit at the time they are recognized. To the extent recognized, these items will impact the effective tax rate in the aggregate but will not adjust the amount used for future periods within the same year. New Accounting Pronouncements Our new accounting pronouncements are set forth under Item 15, Exhibits and Financial Statements Schedules, and are incorporated herein by reference.

<s>[INST] The purpose of this discussion and analysis is to enhance the understanding and evaluation of the results of operations, financial position, cash flows, indebtedness and other key financial information of Joy Global Inc. and its subsidiaries for fiscal 2015, 2014 and 2013. For a more complete understanding of this discussion, please read the Notes to Consolidated Financial Statements included in this report. Overview We are a leading manufacturer and servicer of high productivity mining equipment for the extraction of metals and minerals. We manufacture and market original equipment and parts and perform services for both underground and surface mining, as well as certain industrial applications. Our equipment is used in major mining regions throughout the world to mine coal, copper, iron ore, oil sands, gold and other minerals. We operate in two business segments: Underground and Surface. We are a major manufacturer of underground mining machinery for the extraction and haulage of coal and other bedded minerals. We are also a major producer of surface mining equipment for the extraction and haulage of copper, coal and other minerals and ores. We offer comprehensive direct service, which includes our smart service offerings, near major mining regions worldwide and provide extensive operational support for many types of equipment used in mining. Our principal manufacturing facilities are located in the United States, including facilities in Alabama, Pennsylvania, Texas and Wisconsin, and internationally, including facilities in Australia, Canada, China, France, South Africa and the United Kingdom. Acquisition of Montabert S.A.S. On June 1, 2015, we completed the acquisition of 100% of the equity of Montabert for approximately $121.5 million, gross of cash acquired of $7.1 million dollars. Montabert specializes in the design, production and distribution of high quality hydraulic rock breakers, pneumatic equipment, drilling attachments, drifters and related parts and tools. This acquisition expands the Company's product and service capabilities for hard rock mining, tunneling and rock excavation, further diversifying our commodity and end market exposures. Montabert's results of operations have been included as part of the Underground segment from the date of the acquisition forward. Acquisition of Mining Technologies International Inc. On May 30, 2014, we closed on the purchase of certain assets of MTI for $44.4 million. MTI is a Canadian manufacturer of underground hard rock mining equipment serving the North American markets and a world leading supplier of raise bore drilling consumables. We have acquired substantially all of the assets associated with MTI's hard rock drilling, loaders, dump trucks, shaft sinking and raise bore product lines. MTI's results of operations have been included as part of the Underground segment from the acquisition date forward. Operating Results Net sales in fiscal 2015 were $3.2 billion, compared to $3.8 billion in fiscal 2014. The decrease in net sales of $606.2 million, or 16%, in the current year reflected a decrease in original equipment sales of $371.6 million, or 31%, and a decrease in service sales of $234.6 million, or 9%. Original equipment sales decreased in all regions except Africa, which had a slight increase. The decrease in original equipment sales was led by Latin America, which decreased by $138.8 million. Service sales decreased in all regions except Eurasia, which increased due to the fiscal 2015 acquisition of Montabert, and China. The decrease in service sales was led by North America, which decreased by $127.6 million. Compared to the prior year, net sales in fiscal 2015 included a $173.8 million unfavorable effect of foreign currency translation, due primarily to the decline in the value of the Australian dollar and South African rand relative to the U.S. dollar. Operating loss in fiscal 2015 was $1.1 billion, or 35.0% of net sales, compared to income of $527.5 million, or 14.0% of net sales, in fiscal 2014. The decrease in operating income of $1.6 billion, or 310 [/INST] Positive. </s>

JOY GLOBAL INC

2016-12-16

2016-10-28

Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations The following discussion should be read in conjunction with the Consolidated Financial Statements and related notes. References made to years are for fiscal year periods. The purpose of this discussion and analysis is to enhance the understanding and evaluation of the results of operations, financial position, cash flows, indebtedness and other key financial information of Joy Global Inc. and its subsidiaries for fiscal 2016, 2015 and 2014. For a more complete understanding of this discussion, please read the Notes to Consolidated Financial Statements included in this report. Overview We are a leading manufacturer and servicer of high productivity mining equipment for the extraction of metals and minerals. We manufacture and market original equipment and parts and perform services for both underground and surface mining, as well as certain industrial applications. Our equipment is used in major mining regions throughout the world to mine coal, copper, iron ore, oil sands, gold and other minerals. We operate in two business segments: Underground and Surface. We are a major manufacturer of underground mining machinery for the extraction and haulage of coal and other bedded minerals. We are also a major producer of surface mining equipment for the extraction and haulage of copper, coal and other minerals and ores. We offer comprehensive direct service, which includes our smart service offerings, near major mining regions worldwide and provide extensive operational support for many types of equipment used in mining. Our principal manufacturing facilities are located in the United States, including facilities in Alabama, Texas and Wisconsin, and internationally, including facilities in Australia, Canada, China, France, South Africa and the United Kingdom. Pending Merger with Komatsu America On July 21, 2016, we entered into the Merger Agreement with Komatsu America, Merger Sub and (solely for the purposes specified in the Merger Agreement) Komatsu Ltd., providing for the merger of Merger Sub with and into Joy Global, with Joy Global surviving the Merger as a wholly owned subsidiary of Komatsu America. At the effective time of the Merger, each outstanding share of Joy Global common stock (other than dissenting shares and shares owned by Joy Global, Komatsu America or their respective subsidiaries) will be cancelled and converted into the right to receive $28.30 per share in cash, without interest. The closing of the Merger is subject to the satisfaction or waiver of various closing conditions, including (i) the approval of the Merger Agreement by the holders of a majority of our outstanding shares of common stock, which was obtained on October 19, 2016, (ii) the receipt of specified required regulatory approvals in agreed jurisdictions, (iii) the absence of any law, judgment or injunction prohibiting the consummation of the Merger, (iv) the accuracy of each party’s representations and warranties, (v) each party’s performance in all material respects of its obligations under the Merger Agreement and (vi) no "Company Material Adverse Effect," as defined in the Merger Agreement, having occurred with respect to Joy Global. The Merger is not subject to any financing condition. We and Komatsu America are required to use reasonable best efforts to take all actions necessary to complete the Merger. We are also subject to customary representations, warranties and covenants under the Merger Agreement, including covenants (i) to conduct our business in the ordinary course prior to the completion of the Merger, (ii) not to engage in certain types of transactions during this period without the prior written consent of Komatsu America, (iii) to convene and hold a meeting of our shareholders for the purpose of obtaining shareholder approval of the Merger, which was held on October 19, 2016, and (iv) to refrain from soliciting alternative acquisition proposals or providing information to or participating in discussions or negotiations with third parties regarding alternative acquisition proposals, subject to customary exceptions that would be reasonably expected to lead to a Superior Company Proposal, as defined in the Merger Agreement. The Merger Agreement contains customary termination rights, including that we or Komatsu America may terminate the Merger Agreement (i) if the Merger is not completed on or prior to July 21, 2017, subject to extension by either party for up to two sequential three-month periods for the purpose of obtaining regulatory approvals, (ii) a governmental entity has issued a final and non-appealable order permanently enjoining or prohibiting the Merger (subject to certain limitations set forth in the Merger Agreement), or (iii) the Merger Agreement is not approved by our shareholders. The Merger Agreement also provides that, upon termination of the Merger Agreement under specified circumstances, including termination by either party because our shareholders do not approve the Merger Agreement or because we enter into another agreement with respect to a Superior Company Proposal, we would be required to pay Komatsu America a termination fee of $75.0 million. If the Merger Agreement is terminated under other specified circumstances, including because the required regulatory approvals have not been obtained or because the transaction has been enjoined, Komatsu America would be required to pay us a termination fee of $150.0 million. For further information regarding the Merger and the Merger Agreement, please refer to our definitive proxy statement filed on September 2, 2016, as amended and supplemented on September 29, 2016 and October 3, 2016, the Merger Agreement, which is attached as Annex A to the definitive proxy statement filed on September 2, 2016, and our Current Reports on Form 8-K filed on July 21, 2016, October 13, 2016 and October 19, 2016. The foregoing description of the Merger does not purport to be complete and is subject to, and is qualified in its entirety by reference to, the Merger Agreement. The transaction is on track to close in mid-2017, or may occur in early 2017 depending on the progress of the remaining regulatory clearance procedures. Disposition of Longview, Texas Steel Mill Business On August 5, 2016, we completed the sale our steel mill business to Nucor Corporation. The steel mill business was sold for $28.3 million. The steel mill's results of operations were included as part of the Surface segment until the date of the sale. Acquisition of Montabert S.A.S. On June 1, 2015, we completed the acquisition of 100% of the equity of Montabert for approximately $121.5 million, gross of cash acquired of $7.1 million dollars. Montabert specializes in the design, production and distribution of high quality hydraulic rock breakers, pneumatic equipment, drilling attachments, drifters and related parts and tools. This acquisition expanded the Company's product and service capabilities for hard rock mining, tunneling and rock excavation, which further diversified our commodity and end market exposures. Montabert's results of operations have been included as part of the Underground segment from the date of the acquisition forward. Acquisition of Mining Technologies International Inc. On May 30, 2014, we closed on the purchase of certain assets of MTI for $44.4 million. MTI is a Canadian manufacturer of underground hard rock mining equipment serving the North American markets and a world leading supplier of raise bore drilling consumables. We acquired substantially all of the assets associated with MTI's hard rock drilling, loaders, dump trucks, shaft sinking and raise bore product lines. MTI's results of operations have been included as part of the Underground segment from the acquisition date forward. Operating Results Net sales in fiscal 2016 were $2.4 billion, compared to $3.2 billion in fiscal 2015. The decrease in net sales of $800.7 million, or 25%, in the current year reflected a decrease in original equipment sales of $300.3 million, or 37%, and a decrease in service sales of $500.4 million, or 21%. Original equipment sales decreased in all regions except Eurasia and North America. The decrease in original equipment sales was led by Latin America, Australia and China, which decreased by $101.0 million, $95.2 million and $89.4 million, respectively. Service sales decreased in all regions except Eurasia. The decrease in service sales was led by North America, which decreased by $376.6 million. Compared to the prior year, net sales in fiscal 2016 included a $87.4 million unfavorable effect of foreign currency translation, due primarily to the decline in the value of the South African rand relative to the U.S. dollar. Operating loss in fiscal 2016 was $41.4 million, or 1.7% of net sales, compared to a loss of $1.1 billion, or 35.0% of net sales, in fiscal 2015. The decrease in operating loss of $1.068 billion, or 96%, in the current year was due to a decrease in impairment charges of $1.3 billion, lower product development, selling and administrative expenses of $106.5 million, which included a $39.7 million decrease in mark to market pension adjustments, and reduced period costs (defined as any costs of sales other than those costs associated with selling inventory at standard costs) of $46.2 million. These items were partially offset by lower sales volumes of $308.0 million, lower manufacturing cost absorption of $40.4 million, higher restructuring costs of $56.4 million and a less favorable product mix of $21.0 million. Compared to the prior year, operating loss in fiscal 2016 included a $4.3 million unfavorable effect of foreign currency translation. Loss from continuing operations in fiscal 2016 was $63.8 million, or $0.65 per diluted share, compared to a loss of $1.2 billion, or $12.08 per diluted share, in fiscal 2015. Bookings in fiscal 2016 were $2.3 billion, compared to $2.7 billion in fiscal 2015. The decrease in bookings of $380.3 million, or 14%, in the current year reflected a decrease in original equipment bookings of $107.5 million, or 21%, and a decrease in service bookings of $272.8 million, or 13%. Original equipment bookings decreased in all regions except Latin America and Eurasia. The decrease in original equipment bookings was led by North America and China, which decreased by $85.7 million and $67.0 million, respectively. Service bookings decreased in all regions except Eurasia and Latin America. The decrease in service bookings was led by North America, which decreased by $255.3 million. Compared to the prior year, bookings in fiscal 2016 included a $109.7 million unfavorable effect of foreign currency translation, due primarily to the decline in the value of the British pound sterling and South African rand relative to the U.S. dollar. Results for all periods presented reflect the voluntary change in our method of accounting for actuarial gains and losses and the calculation of our expected returns on plan assets for all of our pension and other postretirement benefit plans. Refer to our Form 10-K for the fiscal year ended October 30, 2015 for additional information. Impairment Charges During fiscal 2016, we assessed for impairment the long-lived assets of an asset group in China. This assessment was performed as a result of our decision to idle certain facilities in China due to the continued market challenges in that region. As a result of such assessment, it was determined that the cash flows associated with this asset group would be insufficient to support their carrying values. Valuations were performed over property, plant and equipment using the market approach for real property. Personal property was valued primarily using the cost approach. As a result of this analysis, we recorded non-cash, pre-tax impairment charges of $12.4 million for the year ended October 28, 2016 for our Underground segment related to such property, plant, and equipment. We also assessed our indefinite-lived trademarks using the relief-from-royalty methodology during fiscal 2016 due to our decision to idle certain facilities in China and the continued market challenges in that region. As a result, a valuation was performed over trademarks using the relief-from-royalty methodology and a non-cash, pre-tax impairment charge of $6.6 million was recorded for the year ended October 28, 2016 by our Underground segment. Total fiscal 2016 impairment charges of $19.0 million were recorded as a result of each of these analyses. These charges are recorded in the Consolidated Statement of Operations under the heading Restructuring and other impairment charges. Market Outlook Although most prices of commodities served by the company improved in the second half of 2016, prices remain substantially below cycle peaks. As a result, prices in many cases have not yet reached a level that stimulates new investment, as industry efforts remain focused on production efficiency and balance sheet improvement. While global economic growth has shown signs of improvement over the past several months, mining industry sentiment remains muted and growth in equipment spending is not expected to recover in 2017. While copper traded in a tight range for most of the year, fundamentals have recently turned positive. The improving sentiment has largely been led from the supply side as evidence of increasing supply disruptions surfaced during the third quarter. Optimistic outlooks for improving demand, particularly from infrastructure and electric grid investments helped push copper prices up during November 2016, the strongest month since June 2015. The expected slowdown in supply growth in 2017, along with an improving demand outlook, should result in a relatively tight copper market next year. 2016 has once again been a difficult year for U.S. coal markets as the dual challenge of regulatory pressures and low natural gas prices influence a reduction in coal burn. The decline in U.S. coal burn along with reduced export opportunities has U.S. coal production down for 2016. The demand associated with power plant retirements over the past several years is not expected to return. Although U.S. coal inventories are expected to normalize over the course of 2017, sustained lower natural gas prices will challenge the coal production outlook next year. While seaborne metallurgical coal and thermal coal markets have rallied strongly over the course of 2016, their fate remains largely tied to Chinese domestic production policy. Seaborne coal prices began to increase appreciably in July as the Chinese government mandated a reduction in the number of production days in an effort to combat significantly oversupplied domestic markets. At the same time, a number of weather-related production disruptions in recent months resulted in a seaborne market that became significantly undersupplied during the second half of the year. The combination of these events resulted in seaborne prices at four-year highs during November. While it remains unclear how long the supply tightness will last in seaborne markets, it is expected that prices will retreat from current levels over the course of 2017. Part of the rally in seaborne metallurgical coal and iron ore markets has been stronger than expected steel production during 2016. Encouraging housing and industrial production data in China have been the primary drivers behind iron ore prices rising from January. Looking into 2017, global steel demand is only expected to be marginally better than 2016, but still relatively weak by historical terms. As such, it is expected that iron ore prices will retreat in 2017 after following metallurgical coal prices higher in recent weeks. Given the expected supply growth of iron ore in 2017, prices are projected to trend lower over the course of 2017. Other metals markets including nickel, platinum and palladium continue to rebalance and have seen pricing improvements since the beginning of the year. While these markets all have different dynamics, they all appear set to improve in 2017, as supply reductions are balanced against an improving demand outlook. As markets continue to rebalance in 2017 with some selective pricing improvement, the industry as a whole remains cautious on the sustainability of the current recovery. Although global economic activity is expected to improve in 2017 and could provide a catalyst to the industry, a sustained improvement in underlying sentiment remains elusive. In light of this backdrop, capital spending in the mining industry is expected to decline in 2017, the smallest decline in the past four years. Company Review and Outlook Despite the continued market headwinds, we were able to achieve a number of important operational and strategic objectives over the course of 2016. Driving a company with world-class safety performance remains one of our core values. During the year, we had an increase in facilities around the world that achieved zero-incidence rates for the entire year. Additionally, we achieved the lowest level company-wide recordable incident rate in company history. Early fiscal 2016, we experienced another significant step-down in the U.S. and China coal markets, which necessitated further strategic and proactive cost reduction actions to structurally position the business for profitable future growth and positive cash generation. We accomplished these objectives over the course of the year, achieving year-over-year cost reduction, a decremental margin ahead of our target, and significant cash generation. At the same time, in the China market, we re-focused the business on customers who value our differentiated equipment and service offerings and are best positioned for success in this market over the coming years. We are committed to strategic growth and market penetration into the industrial minerals and tunneling markets. We are now realizing approximately 50% of our business coming from non-coal market. By demonstrating our product differentiation and lowest total cost of ownership, we were able to gain market share by converting several mine operations from traditional drill and blast to our high-productivity continuous mining methods. This strategic focus led to multiple orders of heavy continuous miners and flexible conveyor trains. We remained focused on our new product development growth strategies in our service business including consumables and continued market penetration in hard rock. During 2016, we made significant advances with our hybrid shovel, underground hard rock Joy SR Hybrid Drive LHDs and prototype DynaCut™ hard rock continuous mining system. These products have all been in the field for well over a year proving their capabilities. The hybrid shovel and LHDs are now commercially available and the DynaCut system is set to go to market in the next few years. Additionally, despite the market step-down and reduction of our active fleet of equipment, we achieved growth in our consumables offerings and expect to see stronger growth rates as new equipment bookings increase when the industry recovers over the next 12 to 18 months. Although some commodity prices have recovered in recent months, our customers remain cautious and are very selective with capital deployment, which will continue to impact the timing and level of incoming orders, and lead to the expected fifth consecutive year of decreased capital expenditures for the industry. We will continue to manage operational and working capital efficiencies and advance our growth strategies in fiscal 2017. Results of Operations Fiscal 2016 Compared With Fiscal 2015 Net Sales The following table sets forth fiscal 2016 and 2015 net sales included in our Consolidated Statements of Operations: Underground net sales in fiscal 2016 were $1.3 billion, compared to $1.8 billion in fiscal 2015. The decrease in Underground net sales of $484.2 million, or 27%, in the current year reflected a decrease in original equipment sales of $194.2 million, or 35%, and a decrease in service sales of $290.0 million, or 24%. Original equipment sales decreased in all regions except Eurasia and Latin America. The decrease in original equipment sales was led by Australia and China, which decreased by $102.0 million and $74.2 million, respectively. Service sales also decreased in all regions except Eurasia and Latin America. The decrease in service sales was led by North America, which decreased by $223.8 million. Compared to the prior year, Underground net sales in fiscal 2016 included a $67.1 million unfavorable effect of foreign currency translation, due primarily to the decline in the value of the South African rand relative to the U.S. dollar. Surface net sales in fiscal 2016 were $1.2 billion compared to $1.5 billion in fiscal 2015. The decrease in Surface net sales of $332.5 million, or 22%, in the current year reflected a decrease in original equipment sales of $107.0 million, or 36%, and a decrease in service sales of $225.6 million, or 19%. Original equipment sales decreased in all regions except North America. The decrease in original equipment sales was led by Latin America, which decreased by $103.8 million. Service sales decreased in all regions except Eurasia. The decrease in service sales was led by North America, which decreased by $160.6 million. Compared to the prior year, Surface net sales in fiscal 2016 included a $20.3 million unfavorable effect of foreign currency translation, due primarily to the decline in the value of the South African rand, the Chilean peso and the Australian dollar relative to the U.S. dollar. Operating Loss The following table sets forth fiscal 2016 and 2015 operating (loss) income included in our Consolidated Statements of Operations: Underground operating loss in fiscal 2016 was $47.6 million, or 4% of net sales, compared to a loss of $1,151.7 million, or 65% of net sales, in fiscal 2015. The decrease in Underground operating loss of $1.1 billion, or 96%, was due to a decrease in impairment charges of $1.3 billion, lower product development, selling and administrative expenses of $54.0 million and reduced period costs of $14.8 million. These items were partially offset by lower sales volumes of $177.1 million, higher restructuring costs of $58.4 million, lower manufacturing cost absorption of $29.4 million and a less favorable product mix of $20.9 million. Compared to the prior year, Underground operating loss in fiscal 2016 included a $3.9 million unfavorable effect of foreign currency translation. Surface operating income in fiscal 2016 was $90.5 million, or 8% of net sales, compared to $173.7 million, or 12% of net sales, in fiscal 2015. The decrease in Surface operating income of $83.2 million, or 48%, was due to lower sales volumes of $134.0 million and lower manufacturing cost absorption of $10.9 million. These items were partially offset by reduced period costs of $30.2 million, a decrease in impairment charges of $21.3 million and lower product development, selling and administrative expenses of $13.2 million. Compared to the prior year, Surface operating loss in fiscal 2016 included a $0.4 million unfavorable effect of foreign currency translation. Corporate expense in fiscal 2016 was $59.9 million, compared to $102.7 million in fiscal 2015. The decrease in corporate expense of $42.9 million, or 42%, was primarily due to the $41.0 million Corporate decrease in mark to market pension adjustments. Product Development, Selling and Administrative Expense Product development, selling and administrative expense in fiscal 2016 was $476.7 million, or 20% of net sales, compared to $583.2 million, or 18% of net sales, in fiscal 2015. The decrease in product development, selling and administrative expense of $106.5 million, or 18%, was primarily due to headcount reductions, as well as other savings from the Company's cost reduction programs. In addition, the Company incurred lower warranty and bad debt expenses on lower sales volumes, fewer litigation charges, less defined benefit employee pension and postretirement plan expense primarily due to a lower mark to market adjustment, reduced amortization due to the prior year intangible asset impairments and favorable foreign currency impacts during the current year. These items were partially offset by higher overall incentive based compensation and the incremental expenses associated with the Company's recent acquisition of Montabert in fiscal 2015. In addition, we incurred $5.4 million of merger related costs in fiscal 2016. Goodwill Impairment Charges The Company incurred a $1.2 billion goodwill impairment charge in fiscal 2015. This charge was recorded by the Underground segment. See the notes to the accompanying financial statements for further information. Restructuring and Other Impairment Charges Restructuring and other impairment charges in fiscal 2016 were $89.9 million, compared to $172.4 million in fiscal 2015. The decrease in restructuring and other impairment charges is due to the fiscal 2015 impairment charge of $139.0 million, covering other intangible assets, certain items of property, plant, and equipment, as well as other items. The decrease in these impairment charges in fiscal 2016 was partially offset by an increase in restructuring charges as a result of the Company's continued efforts to better align the company's overall cost structure with anticipated levels of future demand. The fiscal 2016 restructuring charges include approximately $19.0 million of impairment charges that are directly related to our restructuring activities. Net Interest Expense Net interest expense in fiscal 2016 was $45.7 million, compared to $53.4 million in fiscal 2015. The decrease in net interest expense of $7.7 million, or 14%, was primarily due to the fourth quarter fiscal 2015 redemption of the $250.0 million aggregate principal amount of our 2016 senior notes. The cost of redemption, including the payment of the make whole premium, was funded with a combination of cash on hand and borrowings under the Company's credit agreement, which were drawn at a lower interest rate than the rate on the 2016 senior notes and were repaid in the first quarter of fiscal 2016. The reduction was also attributed to lower short-term borrowings. The overall reduction was partially offset by an increase in interest expense on the term loan and revolving credit facility due to our lower credit rating and a reduction in interest bearing assets as a result of the fourth quarter fiscal 2015 customer payment of a long-term receivable. Loss on Early Debt Retirement During fiscal 2015, the Company elected to redeem the entire $250.0 million aggregate principal amount of its 6.0% Senior Notes due 2016 (the "2016 Notes") to reduce interest expense and improve bank and credit rating leveraging metrics. The cost of redemption, including the payment of the make whole premium, was funded with a combination of cash on hand and borrowings under the Company's unsecured revolving credit facility. These borrowings were repaid in the first quarter of fiscal 2016. Provision for Income Taxes The benefit for income taxes in fiscal 2016 was $23.3 million, compared to a provision of $0.9 million in fiscal 2015. The effective rate was 26.8% in fiscal 2016, compared to (0.1)% in the prior year. A net discrete tax benefit of $12.2 million was recorded in fiscal 2016, compared to an expense of $0.2 million in fiscal 2015. The decrease in the effective tax rate for the year, excluding discrete items, was primarily attributable to a beneficial geographic mix of earnings, offset by net operating losses of certain foreign subsidiaries without a currently recognizable tax benefit. The discrete tax benefit in fiscal 2016 was primarily attributable to the recognition of previously uncertain tax benefits. Bookings Bookings represent new customer orders for original equipment and services. Service bookings include orders for parts, components and rebuilds, but are exclusive of long-term maintenance and repair arrangements and life cycle management arrangements awarded to us during the period. We record bookings when firm orders are received and add the bookings to our backlog. Bookings for fiscal 2016 and 2015 are as follows: Underground bookings in fiscal 2016 were $1.2 billion, compared to $1.6 billion in fiscal 2015. The decrease in Underground bookings of $354.3 million, or 23%, in the current year reflected a decrease in original equipment bookings of $164.0 million, or 37%, and a decrease in service bookings of $190.3 million, or 17%. Original equipment bookings decreased in all regions except Eurasia and Latin America. The decrease in original equipment bookings was led by North America and China, which decreased by $115.3 million and $68.0 million, respectively. Service bookings decreased in all regions except Eurasia and Latin America. The decrease in service bookings was led by North America, which decreased by $197.8 million. Compared to prior year, Underground bookings in fiscal 2016 included a $95.7 million unfavorable impact of foreign currency translation, due primarily to the decline in the value of the British pound sterling and South African rand relative to the U.S. dollar. Surface bookings in fiscal 2016 were $1.2 billion, compared to $1.3 billion in fiscal 2015. The decrease in Surface bookings of $112.0 million, or 9%, in the current year reflected a decrease in original equipment bookings of $7.2 million, or 5%, and a decrease in service bookings of $104.9 million, or 9%. Original equipment bookings increased in all regions except Eurasia and North America, which decreased by $33.0 million and $6.2 million, respectively. Service bookings decreased in all regions except Eurasia. The decrease in service bookings was led by North America, which decreased by $72.2 million. Compared to prior year, Surface bookings in fiscal 2016 included a $14.0 million unfavorable impact of foreign currency translation, due primarily to the decline in the value of the South African rand, Canadian dollar and Australian dollar relative to the U.S. dollar. Fiscal 2015 Compared With Fiscal 2014 Net Sales The following table sets forth fiscal 2015 and 2014 net sales included in our Consolidated Statements of Operations: Underground net sales in fiscal 2015 were $1.8 billion, compared to $2.1 billion in fiscal 2014. The decrease in Underground net sales of $301.0 million, or 14%, in the current year reflected a decrease in original equipment sales of $178.0 million, or 24%, and a decrease in service sales of $123.0 million, or 9%. Original equipment sales decreased in all regions except Africa. The decrease in original equipment sales was led by China and Eurasia, which decreased by $84.7 million and $74.1 million, respectively. Service sales decreased in all regions except Eurasia and China. The decrease in service sales was led by North America and Africa, which decreased by $74.2 million and $51.8 million, respectively. Compared to the prior year, Underground net sales in fiscal 2015 included a $131.7 million unfavorable effect of foreign currency translation, due primarily to the decline in the value of the Australian dollar and South African rand relative to the U.S. dollar. Surface net sales in fiscal 2015 were $1.5 billion, compared to $1.8 billion in fiscal 2014. The decrease in Surface net sales of $332.8 million, or 18%, reflected a decrease in original equipment of $210.2 million, or 42%, and a decrease in service sales of $122.6 million, or 9%. Original equipment sales decreased in all regions except North America, which was flat, and China. The decrease in original equipment sales was led by Latin America, which decreased by $138.8 million. Service sales decreased in all regions except China, which was flat. The decline in service sales was led by North America, which decreased by $65.5 million. Compared to the prior year, Surface net sales in fiscal 2015 included a $42.1 million unfavorable effect of foreign currency translation, due primarily to the decline in the value of the Australian dollar relative to the U.S. dollar. Operating (Loss) Income The following table sets forth fiscal 2015 and 2014 operating (loss) income included in our Consolidated Statements of Operations: Underground operating loss in fiscal 2015 was $1.2 billion, or 65% of net sales, compared to operating income of $285.3 million, or 14% of net sales, in fiscal 2014. The decrease in Underground operating income of $1.4 billion was due to impairment charges of $1.3 billion, lower sales volumes of $106.6 million, a less favorable product mix of $42.1 million and lower manufacturing cost absorption of $5.7 million. These items were partially offset by lower period costs of $29.3 million, which includes increased excess purchase accounting charges of $4.3 million, and decreased product development, selling and administrative expenses of $6.1 million, which included a $1.5 million increase in restructuring costs. Compared to the prior year, Underground operating loss in fiscal 2015 included an $18.4 million unfavorable effect of foreign currency translation, due primarily to the decline in the value of the Australian dollar and South African rand relative to the U.S. dollar. Surface operating income in fiscal 2015 was $173.7 million, or 12% of net sales, compared to $342.8 million, or 19% of net sales, in fiscal 2014. The decrease in Surface operating income of $169.1 million, or 49%, was due to impairment charges of $21.3 million, lower sales volumes of $116.1 million, a less favorable product mix of $22.5 million, lower manufacturing cost absorption of $21.7 million, and higher period costs of $6.5 million. These items were partially offset by reduced product development, selling and administrative expenses of $23.3 million, which included an $8.8 million increase in restructuring costs. Corporate expense in fiscal 2015 was $102.7 million, compared to $57.1 million in fiscal 2014. The increase in corporate expense of $45.7 million, or 80%, was primarily due to the $46.7 million increase in mark to market pension adjustments and the $1.6 million increase in restructuring costs, partially offset by lower performance based compensation. Product Development, Selling and Administrative Expense Product development, selling and administrative expense in fiscal 2015 was $583.2 million, or 18% of net sales, compared to $587.3 million, or 16% of net sales, in fiscal 2014. The decrease in product development, selling and administrative expense of $4.1 million, or 1%, was primarily driven by lower performance based compensation, favorable foreign currency impacts and cost savings from headcount reductions and other restructuring activities. These items were partially offset by the incremental expenses associated with the Company's recent acquisitions of Montabert and MTI in fiscal 2015 and fiscal 2015, respectively, an increase in bad debt expense, higher pension expense as a result of the magnitude of the fiscal 2015 mark to market adjustment, an increase in legal and professional fees and higher share-based compensation. Goodwill Impairment Charges The Company incurred a $1.2 billion goodwill impairment charge in fiscal 2015. This charge was recorded by the Underground segment. See the notes to the accompanying financial statements for further information. Restructuring and Other Impairment Charges Restructuring and other impairment charges in fiscal 2015 were $172.4 million, compared to $21.6 million in fiscal 2014. The increase in restructuring and other impairment charges is primarily due to the fiscal 2015 impairment charge of $139.0 million, covering other intangible assets, certain items of property, plant, and equipment and other items. In addition, there was an increase in restructuring charges as a result of the Company's continued efforts to better align the company's overall cost structure with anticipated levels of future demand. Net Interest Expense Net interest expense in fiscal 2015 was $53.4 million, compared to $55.3 million in fiscal 2014. The decrease in net interest expense of $1.9 million, or 3%, was primarily due to the reduction in the borrowing spreads and commitment fees as a result of the third quarter fiscal 2014 refinancing, as well as an increased interest earned on interest bearing assets. Loss on Early Debt Retirement During fiscal 2015, the Company elected to redeem the entire $250.0 million aggregate principal amount of its 6.0% Senior Notes due 2016 to reduce interest expense and improve bank and credit rating leveraging metrics. The cost of redemption, including the payment of the make whole premium, was funded with a combination of cash on hand and borrowings under the Company's unsecured revolving credit facility. These borrowings were repaid in the first quarter of fiscal 2016. Provision for Income Taxes The provision for income taxes in fiscal 2015 was $0.9 million, compared to $134.1 million in fiscal 2014. The effective rate was (0.1)% in fiscal 2015, compared to 28.4% in the prior year. A net discrete tax expense of $0.2 million was recorded in fiscal 2015, compared to a benefit of $21.4 million in fiscal 2014. The decrease in the effective tax rate for the year, excluding discrete items, was primarily attributable to impairment charges on certain assets of the Company's Underground business segment. The discrete tax expense in fiscal 2015 was primarily attributable to the establishment of valuation allowances against the deferred tax assets of various foreign subsidiaries for which a benefit is not currently available, offset by U.S. foreign tax credits in connection with dividends received from non-U.S. subsidiaries. Bookings Bookings for fiscal 2015 and fiscal 2014 are as follows: Underground bookings in fiscal 2015 were $1.6 billion, compared to $1.8 billion in fiscal 2014. The decrease in Underground bookings of $262.1 million, or 14%, in the current year reflected a decrease in original equipment bookings of $114.7 million, or 21%, and a decrease in service bookings of $147.4 million, or 11%. Original equipment bookings decreased in all regions except North America and Australia. The decrease in original equipment bookings was led by China, which decreased by $109.2 million. Service bookings decreased in all regions except Eurasia, which increased in part due to the acquisition of Montabert. The decrease in service bookings was led by North America, which decreased by $85.4 million. Compared to prior year, Underground bookings in fiscal 2015 included a $141.1 million unfavorable impact of foreign currency translation, due primarily to the decline in the value of the Australian dollar and South African rand relative to the U.S. dollar. Surface bookings in fiscal 2015 were $1.3 billion, compared to $1.9 billion in fiscal 2014. The decrease in Surface bookings of $643.6 million, or 34%, in the current year reflected a decrease in original equipment bookings of $366.7 million, or 70%, and a decrease in service bookings of $276.9 million, or 20%. Original equipment bookings decreased in all regions except Eurasia. The decrease in original equipment bookings was led by Latin America and North America, which decreased by $162.0 million and $128.9 million, respectively. Service bookings decreased in all regions except China, which was flat. The decrease in service bookings was led by North America, which decreased by $183.3 million. Compared to prior year, Surface bookings in fiscal 2015 included a $47.5 million unfavorable impact of foreign currency translation, due primarily to the decline in the value of the Australian dollar relative to the U.S. dollar. Liquidity and Capital Resources The following table summarizes the major elements of our working capital as of October 28, 2016 and October 30, 2015: We currently use trade working capital and cash flow from continuing operations as two financial measurements to evaluate the performance of our operations and our ability to meet our financial obligations. We require trade working capital investment because our direct service model requires us to maintain certain inventory levels in order to maximize our customers’ machine availability. This information also provides management with a focus on our receivable terms and collectability efforts and our ability to obtain advance payments on original equipment orders. As part of operational excellence initiatives in our purchasing and manufacturing processes, we continue to align inventory levels with customer demand and current production schedules. Cash provided by continuing operations for fiscal 2016 was $253.6 million, compared to $355.3 million provided by continuing operations in fiscal 2015. The decrease in cash provided by continuing operations during the year was primarily due to lower earnings excluding non-cash impairment charges and the collection of long-term receivables in the prior year, partially offset by increased cash from trade working capital levels. Cash provided by investing activities for fiscal 2016 was $9.7 million, compared to $181.5 million used by investing activities in fiscal 2015. The increase in cash from investing activities was primarily due to the payments made in the prior year for the acquisition of Montabert, the proceeds received in the current year for the sale of the steel mill business, lower capital expenditures year over year and the monetization of non-core assets in the current year. Cash used by financing activities for fiscal 2016 was $84.7 million, compared to $325.0 million used by financing activities in fiscal 2015. The decrease in cash used by financing activities was primarily due to the early redemption of our 2016 Notes in the fourth quarter of fiscal 2015, lower dividends and no share repurchases in the current year. These items were partially offset by our first quarter payoff of amounts previously outstanding under our Credit Agreement resulting from the previously mentioned redemption of our 2016 Notes. During each quarter of fiscal 2016 we paid cash dividends of $0.01 per outstanding share of common stock resulting in $4.0 million in dividends paid during the fiscal year. In addition, on December 14, 2016, our Board of Directors declared a cash dividend of $0.01 per outstanding share of common stock. This dividend will be paid on January 13, 2017 to all shareholders of record at the close of business on December 30, 2016. In fiscal 2017, we expect capital spending to be between $50 million and $70 million. Capital projects will be focused on continuing investments in our global service infrastructure and operational excellence initiatives. Restructuring Programs Restructuring activities continued in fiscal 2016 to better align the Company's workforce and overall cost structure with current and expected future demand. For the 2017 fiscal year, total restructuring charges are anticipated to be approximately $9 million, with estimated cash costs of up to $5 million. These amounts include expected costs for activities not yet implemented. Retiree Benefits We sponsor pension plans in the U.S. and in other countries. The significance of the funding requirements of these plans is largely dependent on the value of the plan assets, the investment returns on the plan assets, actuarial assumptions, including discount rates and the impact of the Pension Protection Act of 2006. During fiscal 2016, we contributed $13.7 million to our defined benefit employee pension and postretirement plans. We expect contributions to our defined benefit pension and postretirement plans to be approximately $15 million in fiscal 2017. As of October 28, 2016, we have a net unfunded pension and other postretirement liability of $187.6 million. Credit Facilities and Senior Notes On July 29, 2014 we entered into a revolving credit agreement that matures on July 29, 2019 (the "Credit Agreement"). On December 14, 2015, we entered into an amendment to our Credit Agreement that increased the maximum consolidated leverage ratio for the period beginning in the second quarter of fiscal 2016 through the first quarter of fiscal 2018. The amendment increased the permitted ratio from 3.0x to 3.5x for the second quarter of fiscal 2016, to 4.25x in the third quarter of fiscal 2016, and to 4.5x in the fourth quarter of fiscal 2016. The ratio will then begin to decline on a quarterly basis beginning in the third quarter of fiscal 2017 and return to 3.0x in the second quarter of fiscal 2018. The amendment also reduced the aggregate amount of revolving commitments of the lenders from $1.0 billion to $850.0 million and added a letter of credit sublimit of $500.0 million. In addition, we also agreed to limit priority debt (secured indebtedness and the unsecured indebtedness of our foreign subsidiaries) to 10% of consolidated net worth and to limit cash dividends to $25.0 million per year in the aggregate. We may continue to request an increase of up to $250.0 million of additional aggregate revolving commitments, subject to the terms and conditions contained in the Credit Agreement. Under the terms of the Credit Agreement, we pay a commitment fee ranging from 0.09% to 0.30% on the unused portion of the revolving credit facility based on our credit rating. Letters of credit issued under applicable provisions of the Credit Agreement represent an unfunded utilization of the Credit Agreement for purposes of calculating the periodic commitment fee due. Eurodollar rate loans bear interest for a period from the applicable borrowing date until a date one week or one, two, three or six months thereafter, as selected by the Company, at the corresponding Eurodollar rate plus a margin of 1.0% to 2.0% depending on the Company’s credit rating. Base rate loans bear interest from the applicable borrowing date at a rate equal to (i) the highest of (a) the federal funds rate plus 0.5%, (b) the rate of interest in effect for such day as publicly announced by the administrative agent as its “prime rate,” or (c) a daily rate equal to the one-month Eurodollar rate plus 1.0%, plus (ii) a margin that varies according to the Company’s credit rating. Swing line loans bear interest at either the base rate described above or the daily floating Eurodollar rate plus the applicable margin, as selected by the Company. The Credit Agreement is guaranteed by each of our current and future material domestic subsidiaries and requires the maintenance of certain financial covenants, including leverage and interest coverage ratios. The Credit Agreement also restricts payment of dividends or other returns of capital to shareholders if the consolidated leverage ratio exceeds the maximum amount set forth therein. As of October 28, 2016, we were in compliance with all financial covenants of the Credit Agreement. As of October 28, 2016, there were no direct borrowings under the Credit Agreement. Total interest expense recognized for direct borrowings under the Credit Agreement for the years ended October 28, 2016 and October 30, 2015 was $0.5 million and $1.2 million, respectively. As of October 28, 2016, outstanding standby letters of credit issued under the Credit Agreement, which count toward the $850.0 million credit limit, totaled $98.9 million, and our available borrowing capacity under the Credit Agreement was $751.1 million. On July 29, 2014, we also entered into a term loan agreement that matures July 29, 2019 and provides for a commitment of up to $375.0 million (as amended, the "Term Loan"). The Term Loan replaced our prior term loan, dated as of June 16, 2011. The prior term loan had been scheduled to mature on July 16, 2016 and provided an initial commitment of $500.0 million, which had been drawn in full in conjunction with our fiscal 2011 acquisition of LeTourneau Technologies Inc., and had been amortized to $375.0 million at the date that we entered into the Term Loan. We utilized the $375.0 million commitment under the Term Loan to repay the balance outstanding under the prior term loan. On December 14, 2015, the Term Loan was amended to be consistent with the revolving Credit Agreement with respect to the maximum leverage ratio, restrictions on priority debt and dividends and other restricted payments. The Term Loan requires quarterly principal payments that began in fiscal 2016. Payments of $18.8 million were made on the Term Loan during the year ended October 28, 2016. The Term Loan contains terms and conditions that are the same as the terms and conditions of the Credit Agreement. The Term Loan is guaranteed by each of our current and future material domestic subsidiaries and requires the maintenance of certain financial covenants, including leverage and interest coverage ratios. As of October 28, 2016, we were in compliance with all financial covenants of the Term Loan. On October 12, 2011, we issued $500.0 million aggregate principal amount of 5.125% Senior Notes due in 2021 (the "2021 Notes") in an offering that was registered under the Securities Act. Interest on the 2021 Notes is paid semi-annually in arrears on October 15 and April 15 of each year, and the 2021 Notes are guaranteed by each of our current and future material domestic subsidiaries. At our option, we may redeem some or all of the 2021 Notes at a redemption price of the greater of 100% of the principal amount of the 2021 Notes to be redeemed or the sum of the present values of the principal amounts and the remaining scheduled interest payments using a discount rate equal to the sum of a treasury rate of a comparable treasury issue plus 0.5%. In November 2006, we issued $150.0 million aggregate principal amount of 6.625% Senior Notes due 2036. Interest on the 2036 Notes is paid semi-annually in arrears on May 15 and November 15 of each year, and the 2036 Notes are guaranteed by each of our current and future material domestic subsidiaries, as well as certain current immaterial domestic subsidiaries. The 2036 Notes were originally issued in a private placement under an exemption from registration under the Securities Act. In the second quarter of fiscal 2007, the 2036 Notes were exchanged for substantially identical notes in an exchange that was registered under the Securities Act. At our option, we may redeem some or all of the 2036 Notes at a redemption price of the greater of 100% of the principal amount of the 2036 Notes to be redeemed or the sum of the present values of the principal amounts and the remaining scheduled interest payments using a discount rate equal to the sum of a treasury rate of a comparable treasury issue plus 0.375%. In November 2006, we also issued $250.0 million aggregate principal amount of 6.0% Senior Notes due 2016. In October of fiscal 2015 we redeemed the entire $250.0 million aggregate principal amount of our 2016 Notes at a redemption price equal to the principal amount thereof, plus accrued and unpaid interest up to, but excluding, the redemption date, plus a “make whole” premium calculated in accordance with the indenture. This resulted in a $14.3 million loss on early debt retirement, which was recorded in the fourth quarter of fiscal 2015. Stock Repurchase Program In August 2013, our Board of Directors authorized the repurchase of up to $1.0 billion in shares of our common stock until August 2016. Under the program, we were permitted to repurchase shares in the open market in accordance with applicable SEC rules and regulations. During the year ended October 28, 2016, we did not repurchase any shares of common stock. During the year ended October 30, 2015, we repurchased 954,580 shares of common stock for $50.0 million. Cumulatively, we repurchased 9,771,605 shares of common stock for $533.4 million. The repurchase program expired in August 2016. Advance Payments and Progress Billings As part of the negotiation process associated with original equipment orders and some service contacts, advance payments and progress billings are generally required from our customers to support the procurement of inventory and other resources. In addition, we have life cycle management arrangements in which our billings have exceeded our service performance. As of October 28, 2016, advance payments and progress billings were $173.1 million. As orders are shipped or costs are incurred, the advance payments and progress billings are recognized as revenue in the consolidated financial statements. Goodwill and Other Intangible Assets Finite-lived intangible assets are amortized to reflect the pattern of economic benefits consumed, which is principally the straight-line method. Intangible assets that are subject to amortization are evaluated for potential impairment whenever events or circumstances indicate that the carrying amount may not be recoverable. No impairment was identified related to our finite-lived intangible assets as of October 28, 2016. Indefinite-lived intangible assets are not amortized but are evaluated for impairment annually or more frequently if events or changes occur that suggest an impairment in carrying value, such as a significant adverse change in the business climate. Due to the Company's decision to idle certain facilities in China and the continued market challenges in that region, we conducted an assessment of our indefinite-lived trademarks during fiscal 2016 using the relief-from-royalty methodology, which evaluates the estimated licensing cost of an intangible asset as an alternative to ownership. This valuation concluded that the carrying value of the Company's indefinite-lived trademarks exceeded the estimated licensing cost. As a result, the Company recorded a $6.6 million non-cash, pre-tax impairment charge to its Underground segment during fiscal 2016. This resulted in the full impairment of our indefinite-lived intangible assets. Assumptions critical to the process include forecasted information and discount rates. This fair value determination is categorized as Level 3 in the fair value hierarchy. Refer to Note 20, Fair Value Measurements, for the definition of Level 3 inputs. This charge is recorded in the Consolidated Statement of Operations under the heading Restructuring and other impairment charges. Goodwill represents the excess of the purchase price over the fair value of identifiable net assets acquired in a business combination. Goodwill is assigned to specific reporting units, and is tested for impairment at least annually during the fourth quarter of our fiscal year or more frequently upon the occurrence of an event or when circumstances indicate that a reporting unit’s carrying amount is greater than its fair value. Our annual goodwill impairment test was performed as of July 30, 2016. This goodwill impairment test focused on our Surface reporting unit, as all Underground goodwill was fully impaired in fiscal 2015. After completing our step one analysis, we concluded that the estimated fair value of our Surface reporting unit exceeded its carrying value by 54%. We determined that there were no indicators of impairment since our annual impairment test was performed that would warrant an interim impairment test. Although we have concluded that there is no impairment on the goodwill of $350.8 million associated with our Surface reporting unit as of October 28, 2016, we will continue to closely monitor this in the future considering the volatility and uncertainty in the global commodity markets that our surface mining equipment services. Should there be further market declines, particularly in Latin American copper or North American coal and iron ore, which are the most significant markets serviced by our Surface reporting unit, there would be an increased risk that we would be required to recognize impairment to the Surface reporting unit's goodwill. Financial Condition Based on our available cash and our available borrowings under our credit facility, we believe our liquidity and capital resources are adequate to meet our projected needs for the next twelve months, without taking into consideration the pending Merger with Komatsu America. In this regard, we had $276.7 million in cash and cash equivalents as of October 28, 2016, of which $122.1 million is held by foreign entities, and $751.1 million is available for borrowings under the Credit Agreement. Further, we continue to effectively manage our cash flows from operations, which includes continuing to drive working capital improvements, continuing to track the results of our cost savings measures, and continuing to institute additional measures as needed. During fiscal 2016, the Company amended its Credit Agreement which, among other aspects, reduced the aggregate amount of revolving commitments of the lenders from $1.0 billion to $850.0 million and increased the consolidated leverage ratio from a permitted limit of 3.0x to 3.5x for the second quarter of fiscal 2016, to 4.25x in the third quarter of fiscal 2016, and to 4.5x in the fourth quarter of fiscal 2016. The ratio will then begin to decline on a quarterly basis beginning in the third quarter of fiscal 2017 and return to 3.0x in the second quarter of fiscal 2018. Even considering the commitment reduction, we expect to meet our U.S. funding needs without repatriating undistributed offshore profits that are indefinitely reinvested outside the U.S., which would result in the incurrence of additional U.S. corporate income taxes on such repatriated undistributed profits. In addition, during fiscal 2016 we reduced dividends from $0.20 per share to $0.01 per share. This action reduced fiscal 2016 annual cash outlays by approximately $75.0 million from fiscal 2015 levels. Under the Merger Agreement, we are restricted from paying dividends, other than our regular quarterly dividend in an amount of $0.01 per share. In addition, as discussed in the Credit Facilities and Senior Notes section above, the Credit Agreement constrains the extent to which we may increase our dividend rate in future quarters until the expiration of the Covenant Relief Period in our fiscal second quarter of 2018. We expect our requirements for working capital, dividends, pension contributions, capital expenditures and principal and interest payments on our Term Loan and Senior Notes will still be adequately funded by cash on hand and continuing operations (including our monetization of non-core assets) and supplemented by short and long term borrowings, as required. However, as discussed in the Credit Facilities and Senior Notes section above, the Credit Agreement contains certain financial tests and other covenants that limit our ability to incur additional indebtedness. Our ability to comply with financial tests may be adversely affected by changes in economic or business conditions beyond our control, especially in the current volatile market environment. Borrowing limitations can have material adverse effects on our liquidity and we will continue to monitor the impact of any changes in business and economic conditions on our ability to obtain financing. Off-Balance Sheet Arrangements We lease various assets under operating leases. The aggregate payments under operating leases as of October 28, 2016 are disclosed in the table in the Disclosures about Contractual Obligations and Commercial Commitments section below. No significant changes to lease commitments have occurred during fiscal 2016. We have no other off-balance sheet arrangements. Disclosures about Contractual Obligations and Commercial Commitments The following table sets forth our contractual obligations and commercial commitments as of October 28, 2016: * Includes interest. ** Includes minimum required contributions to our pension and other postretirement benefit plans and required contributions for our unfunded other postretirement benefit plans. Critical Accounting Policies Our discussion and analysis of financial condition and results of operations is based on our Consolidated Financial Statements, which have been prepared in accordance with GAAP. The preparation of these Consolidated Financial Statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues, expenses and related disclosure of contingent assets and liabilities. We continually evaluate our estimates and judgments, including those related to bad debts, inventory, goodwill and intangible assets, warranty, pension and postretirement benefits and costs, income taxes and contingencies. We base our estimates on historical experience and assumptions that we believe to be reasonable under the circumstances. Actual results may differ from these estimates. We believe the accounting policies described below are the policies that most frequently require us to make estimates and judgments, and therefore are critical to the understanding of our results of operations. Revenue Recognition We recognize revenue on products and services when the following criteria are satisfied: persuasive evidence of a sales arrangement exists, product delivery and transfer of title and risk and rewards has occurred or services have been rendered, the price is fixed and determinable and collectability is reasonably assured. We recognize revenue on long-term contracts, such as contracts to manufacture mining shovels, draglines, roof support systems and conveyor systems, using the percentage-of-completion method. When using the percentage-of-completion method, sales and gross profit are recognized as work is performed based on the relationship between actual costs incurred and total estimated costs at completion. Sales and gross profit are adjusted prospectively for revisions in estimated total contract costs and contract values. Estimated losses are recognized in full when identified. Approximately 94% of our sales in fiscal 2016 were recorded at the time of shipment or delivery of the product (depending on the terms of the agreement) or performance of the service, with the remaining 6% of sales recorded using percentage-of-completion accounting. We have life cycle management arrangements with customers to supply parts and service for terms of 1 to 17 years. These arrangements are established based on the conditions in which the equipment will be operating, the time horizon that the arrangements will cover and the expected operating cycle that will be required for the equipment. Based on this information, a model is created representing the projected costs and revenues of servicing the respective machines over the specified arrangement terms. Accounting for these arrangements requires us to make various estimates, including estimates of the relevant machine’s long-term maintenance requirements. Under these arrangements, customers are generally billed monthly based on hours of operation or units of production achieved by the equipment, with the respective deferred revenues recorded when billed. Revenue is recognized in the period in which parts are supplied or services provided. These arrangements are reviewed quarterly by comparison of actual results to original estimates or most recent analysis, with revenue recognition adjusted appropriately for future estimated costs. If a loss is expected at any time, the full amount of the loss is recognized immediately. We have certain customer agreements that are considered multiple element arrangements. These agreements primarily consist of the sale of multiple pieces of equipment or equipment with subsequent installation services. These agreements are assessed for the purpose of identifying deliverables and determining whether the delivered item has value to the customer on a standalone basis and whether delivery or performance of the undelivered item is considered probable and substantially in our control. If those criteria are met, revenue is allocated to each identified unit of accounting based on our estimate of the relative selling prices of the deliverables and is recognized as the revenue recognition criteria are met for each element. The relative selling price is estimated by using recent sales transactions for similar items. The difference between the total of the separate selling prices and the total contract consideration is allocated pro-rata across each of the units of accounting included in the arrangement. Revenue recognition involves judgments, including assessments of expected returns, the likelihood of nonpayment and estimates of expected costs and profits on long-term contracts. In determining when to recognize revenue, we analyze various factors, including the specifics of the transaction, historical experience, creditworthiness of the customer and current market and economic conditions. Changes in judgments on these factors could impact the timing and amount of revenue recognized with a resulting impact on the timing and amount of associated income. Inventories Inventories are carried at the lower of cost or market. The first-in, first-out method is used for all inventories, except for inventories in those jurisdictions for which the weighted average method is required by law. Cost includes direct materials, direct labor and manufacturing overhead. We evaluate the need to record valuation adjustments for inventory on a regular basis. Inventory in excess of our estimated usage requirements is written down to its estimated net realizable value. Inherent in the estimates of net realizable value are estimates related to our future manufacturing schedules, customer demand, possible alternative uses and ultimate realization of potentially excess inventory. Goodwill and Other Intangible Assets Finite-lived intangible assets include customer relationships, engineering drawings, patents, trademarks and unpatented technology. Finite-lived intangible assets are amortized to reflect the pattern of economic benefits consumed, which is principally the straight-line method. Intangible assets that are subject to amortization are evaluated for potential impairment whenever events or circumstances indicate that the carrying amount may not be recoverable. No impairments were identified related to our finite-lived intangible assets as of October 28, 2016. However, during fiscal 2015, we assessed our tangible and intangible finite-lived assets for impairment due to the prolonged suppressed global commodity markets and their related effect on the global mining investment environment. Each asset group was considered and it was determined that the cash flows of an asset group in China and a steel mill would be insufficient to support their carrying value. In connection with the evaluation of these asset groups, we developed an estimate of fair value using a discounted cash flow model. As a result of this analysis, customer relationship non-cash pre-tax impairment charges of $57.9 million and $2.1 million were recorded in fiscal 2015 by our Underground and Surface segments, respectively. These charges are recorded in the Consolidated Statement of Operations under the heading Restructuring and other impairment charges. Assumptions critical to the process included forecasted financial information, discount rates and applicable customer retention rates. This fair value determination was categorized as Level 3 in the fair value hierarchy. See Note 20, Fair Value Measurements, for the definition of Level 3 inputs. No other impairments were identified related to our finite-lived intangible assets as of October 30, 2015. Indefinite-lived intangible assets are composed of certain trademarks and are not amortized but are evaluated for impairment annually or more frequently if events or changes occur that suggest an impairment in carrying value, such as a significant adverse change in the business climate. Indefinite-lived intangible assets are evaluated for impairment by comparing each asset's fair value to its book value. We first determine qualitatively whether it is more likely than not that an indefinite-lived asset is impaired. If we conclude that it is more likely than not that an indefinite-lived asset is impaired, then we determine the fair value by using the discounted cash flow model based on royalties estimated to be derived in the future use of the asset were we to license the use of the indefinite-lived assets. Due to the Company's decision to idle certain facilities in China and the continued market challenges in that region, we conducted an assessment of our indefinite-lived trademarks in fiscal 2016 using the relief-from-royalty methodology, which evaluates the estimated licensing cost of an intangible asset as an alternative to ownership. This valuation concluded that the carrying value of the Company's indefinite-lived trademarks exceeded the estimated licensing cost. As a result, the Company recorded a $6.6 million non-cash, pre-tax impairment charge to its Underground segment in the year ended October 28, 2016. This charge is recorded in the Consolidated Statement of Operations under the heading Restructuring and other impairment charges. It resulted in the full impairment of our indefinite-lived intangible assets. Assumptions critical to the process include forecasted information and discount rates. This fair value determination is categorized as Level 3 in the fair value hierarchy. Refer to Note 20, Fair Value Measurements, for the definition of Level 3 inputs. In addition, we assessed our indefinite-lived trademarks in fiscal 2015 due to the prolonged suppressed global commodity markets and their related effect on the global mining investment environment. We developed an estimate of fair value using a similar process as the process described above. As a result, the Company recorded a $10.8 million non-cash, pre-tax impairment charge to its Underground segment in the year ended October 30, 2015. This charge is recorded in the Consolidated Statement of Operations under the heading Restructuring and other impairment charges. Goodwill represents the excess of the purchase price over the fair value of identifiable net assets acquired in a business combination. Goodwill is assigned to specific reporting units, which we have identified as our operating segments, and is tested for impairment at least annually, during the fourth quarter of our fiscal year, or more frequently upon the occurrence of an event or when circumstances indicate that a reporting unit’s carrying amount is greater than its fair value. Goodwill is evaluated for impairment by comparing the fair value of each of our reporting units to their book value. We generally first determine, based on a qualitative assessment, whether it is more likely than not that the fair value of a reporting unit is less than its carrying amount. If we conclude that it is more likely than not that the fair value of a reporting unit is less than its carrying amount, we then determine the fair value of the reporting unit based on a discounted cash flow model. If the fair value of the reporting unit exceeds its carrying value, goodwill is not impaired. If the carrying value of the reporting unit exceeds its fair value, the impairment test continues by comparing the carrying value of the reporting unit’s goodwill to the implied fair value of goodwill. The implied fair value of goodwill is determined by deducting the fair value of a reporting unit’s identifiable assets and liabilities from the fair value of the reporting unit as a whole, as if that reporting unit had just been acquired and the fair value of the individual assets acquired and liabilities assumed were being determined initially. If goodwill is impaired, we recognize a non-cash impairment loss based on the amount by which the book value of goodwill exceeds its implied fair value. Our fiscal 2016 annual goodwill impairment analysis focused on our Surface reporting unit, as all Underground goodwill was fully impaired in fiscal 2015. After completing our step one analysis using a discounted cash flow model, we concluded that the estimated fair value of our Surface reporting unit exceeded its carrying value by 54%. Although we have concluded that there is no impairment on the goodwill of $350.8 million associated with our Surface reporting unit as of October 28, 2016, we will continue to closely monitor this in the future considering the volatility and uncertainty in the global commodity markets that our surface mining equipment services. Should there be further market declines, particularly in Latin American copper or North American coal and iron ore, which are the most significant markets serviced by our Surface reporting unit, there would be an increased risk that we would be required to recognize impairment to the Surface reporting unit's goodwill. In addition, in fiscal 2015 we concluded that an indicator was present that suggested impairment may exist for our goodwill, as our total shareholders’ equity exceeded our market capitalization due to the prolonged suppressed global commodity markets, their related effect on the global mining investment environment and the resulting impact on our market capitalization. Based on this indicator of impairment, we worked with a third party appraisal firm to perform an analysis for impairment of goodwill using a discounted cash flow model. The result of our analysis for the Surface reporting unit was that the fair value of the reporting unit exceeded carrying value. However, we determined that the estimated fair value of our Underground reporting unit was lower than the carrying value of the reporting unit, and we recorded a non-cash, pre-tax goodwill impairment charge of $1.2 billion. This impairment charge represents a complete impairment of goodwill in the Underground reporting unit, and it is recorded in the Consolidated Statement of Operations under the heading Goodwill impairment charges. Assumptions critical to the process included forecasted financial information and discount rates. This fair value determination was categorized as Level 3 in the fair value hierarchy. See Note 20, Fair Value Measurements, for the definition of Level 3 inputs. The process of evaluating the potential impairment of goodwill and other intangible assets is highly subjective and requires significant judgment at many points during the analysis. Qualitative assessments regarding goodwill and other intangible assets involve a high degree of judgment and can entail subjective considerations. The discounted cash flow model involves many assumptions, including operating results forecasts and discount rates. Inherent in the operating results forecasts are certain assumptions regarding revenue growth rates, projected cost saving initiatives and projected long-term growth rates in the determination of terminal values. Accrued Warranties We provide for the estimated costs that may be incurred under product warranties to remedy deficiencies of quality or performance of our products. Warranty costs are accrued at the time revenue is recognized. These product warranties extend over either a specified period of time, units of production or machine hours depending on the product subject to the warranty. We accrue a provision for estimated future warranty costs based on the historical relationship of warranty costs to sales. We periodically review the adequacy of the accrual for product warranties and adjust the warranty percentage and accrued warranty reserve for actual experience as necessary. Pension and Postretirement Benefits and Costs We recognize actuarial gains and losses in the statement of operations immediately. With the immediate recognition of actuarial gains and losses, the gains and losses from these plans are recognized in our results of operations through an annual adjustment that is recorded in the fourth quarter of each year, or more frequently should a re-measurement event occur. The remaining components of net periodic benefit costs, primarily service and interest costs and the expected return on plan assets, are recorded on a quarterly basis. For purposes of calculating the expected return on plan assets, we use the actual fair value of plan assets to adjust for changes in actual versus expected rates of return. The impact of these changes is recorded annually as part of the adjustment described above. Collectively, the immediate recognition of actuarial gains and losses and the immediate recognition of actual versus expected rates of return on plan assets are referred to herein as the "mark to market pension and postretirement plan adjustment." Pension and other postretirement benefit costs and liabilities are dependent on assumptions used in calculating such amounts. The primary assumptions include discount rates, expected returns on plan assets, mortality rates and rates of compensation increases, as discussed below: Discount rates: We generally estimate the discount rate for pension and other postretirement benefit obligations using a process based on a hypothetical investment in a portfolio of high-quality bonds that approximates the estimated cash flows of the pension and other postretirement benefit obligations. We believe this approach permits a matching of future cash outflows related to benefit payments with future cash inflows associated with bond coupons and maturities. Expected returns on plan assets: Our expected return on plan assets is derived from reviews of asset allocation strategies and anticipated future long-term performance of individual asset classes, weighted by the allocation of our plan assets. Our analysis gives appropriate consideration to recent plan performance and historical returns; however, the assumptions are primarily based on long-term, prospective rates of return. Mortality rates: Mortality rates used for fiscal 2015 balance sheet and fiscal 2016 benefit cost in the US are based on the RP-2014 mortality table, adjusted for bottom-quartile benefits, in conjunction with an adjusted version of mortality improvement scale MP-2014. Fiscal 2016 balance sheet mortality rates are based on the same RP-2014 table, in conjunction with the updated mortality improvement scale MP-2016 (with certain adjustments). Adoption of the modified MP-2016 mortality improvement scale had an $11.0 million income impact to our pension and postretirement plans. Various factors such as the Company’s historical plan experience levels and the development of new tables by the Society of Actuaries are considered when evaluating the mortality assumption. Rates of compensation increases: The rates of compensation increases reflect our long-term actual experience and its outlook, including consideration of expected rates of inflation. As mentioned above, actual results that differ from these assumptions are immediately recognized in our results of operations in an annual adjustment that is recorded in the fourth quarter of each year, or more frequently should a re-measurement event occur. While we believe that the assumptions used are appropriate, differences in actual experience or changes in assumptions may affect our pension and other postretirement plan obligations and future expense. As such, a 0.25% change in the discount rate and the expected return on net assets would have the following effects on pension expense and the projected benefit obligation as of and for the fiscal year ended October 28, 2016: Income Taxes Deferred taxes are accounted for under the asset and liability method whereby deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax basis. Deferred tax assets and liabilities are measured using current statutory tax rates. Deferred income tax provisions are based on changes in the deferred tax assets and liabilities from period to period. Additionally, we analyze our ability to recognize the net deferred tax assets created in each jurisdiction in which we operate to determine if valuation allowances are necessary based on the “more likely than not” criteria. As required under the application of fresh start accounting, the release of pre-emergence tax valuation reserves was not recorded in the statement of operations but instead was treated first as a reduction of excess reorganization value until exhausted, then intangible assets until exhausted, and thereafter reported as additional paid in capital. Consequently, a net tax charge will be incurred in future years when these tax assets are utilized. We will continue to monitor the appropriateness of the existing valuation allowances and determine annually the amount of valuation allowances that are required to be maintained. As of October 28, 2016, there were $62.4 million of valuation allowances against pre-emergence net operating loss carryforwards. All future reversals of pre-emergence valuation allowances will be recorded to additional paid in capital. In accordance with FASB Accounting Standards Codification 740, Income Taxes, each interim period is considered integral to the annual period and tax expense is measured using an estimated annual effective tax rate. An entity is required to record income tax expense each quarter based on its best estimate of the annual effective tax rate for the full fiscal year and use that rate to provide for income taxes on a current year-to-date basis, as adjusted for discrete taxable events that occur during the interim period. If, however, the entity is unable to reliably estimate its annual effective tax rate due to the Company’s inability to forecast income by jurisdiction or as a result of rate volatility caused by minor changes in income when projecting near break-even earnings, then the actual effective tax rate for the year-to-date period may be the best annual effective tax rate estimate. For the interim periods in fiscal 2016, the Company determined that the estimated annual effective rate method would not provide a reliable estimate due to the volatility of income tax (benefit) expense resulting from modest changes in forecasted annual pre-tax results. Therefore, the Company recorded a tax benefit for these interim periods based on the actual effective rate (i.e., the “cut-off” method). The effective tax rate for the interim periods in fiscal 2015 was calculated based on an estimated annual effective tax rate in addition to discrete items. New Accounting Pronouncements Our new accounting pronouncements are set forth under Item 15, Exhibits and Financial Statements Schedules, and are incorporated herein by reference.

<s>[INST] The purpose of this discussion and analysis is to enhance the understanding and evaluation of the results of operations, financial position, cash flows, indebtedness and other key financial information of Joy Global Inc. and its subsidiaries for fiscal 2016, 2015 and 2014. For a more complete understanding of this discussion, please read the Notes to Consolidated Financial Statements included in this report. Overview We are a leading manufacturer and servicer of high productivity mining equipment for the extraction of metals and minerals. We manufacture and market original equipment and parts and perform services for both underground and surface mining, as well as certain industrial applications. Our equipment is used in major mining regions throughout the world to mine coal, copper, iron ore, oil sands, gold and other minerals. We operate in two business segments: Underground and Surface. We are a major manufacturer of underground mining machinery for the extraction and haulage of coal and other bedded minerals. We are also a major producer of surface mining equipment for the extraction and haulage of copper, coal and other minerals and ores. We offer comprehensive direct service, which includes our smart service offerings, near major mining regions worldwide and provide extensive operational support for many types of equipment used in mining. Our principal manufacturing facilities are located in the United States, including facilities in Alabama, Texas and Wisconsin, and internationally, including facilities in Australia, Canada, China, France, South Africa and the United Kingdom. Pending Merger with Komatsu America On July 21, 2016, we entered into the Merger Agreement with Komatsu America, Merger Sub and (solely for the purposes specified in the Merger Agreement) Komatsu Ltd., providing for the merger of Merger Sub with and into Joy Global, with Joy Global surviving the Merger as a wholly owned subsidiary of Komatsu America. At the effective time of the Merger, each outstanding share of Joy Global common stock (other than dissenting shares and shares owned by Joy Global, Komatsu America or their respective subsidiaries) will be cancelled and converted into the right to receive $28.30 per share in cash, without interest. The closing of the Merger is subject to the satisfaction or waiver of various closing conditions, including (i) the approval of the Merger Agreement by the holders of a majority of our outstanding shares of common stock, which was obtained on October 19, 2016, (ii) the receipt of specified required regulatory approvals in agreed jurisdictions, (iii) the absence of any law, judgment or injunction prohibiting the consummation of the Merger, (iv) the accuracy of each party’s representations and warranties, (v) each party’s performance in all material respects of its obligations under the Merger Agreement and (vi) no "Company Material Adverse Effect," as defined in the Merger Agreement, having occurred with respect to Joy Global. The Merger is not subject to any financing condition. We and Komatsu America are required to use reasonable best efforts to take all actions necessary to complete the Merger. We are also subject to customary representations, warranties and covenants under the Merger Agreement, including covenants (i) to conduct our business in the ordinary course prior to the completion of the Merger, (ii) not to engage in certain types of transactions during this period without the prior written consent of Komatsu America, (iii) to convene and hold a meeting of our shareholders for the purpose of obtaining shareholder approval of the Merger, which was held on October 19, 2016, and (iv) to refrain from soliciting alternative acquisition proposals or providing information to or participating in discussions or negotiations with third parties regarding alternative acquisition proposals, subject to customary exceptions that would be reasonably expected to lead to a Superior Company Proposal, as defined in the Merger Agreement. The Merger Agreement contains customary termination rights, including that we or Komatsu America may terminate the Merger Agreement (i) if the Merger is not completed on or prior to July 21, 2017, subject to extension by either party for up to two sequential threemonth periods for the purpose of obtaining regulatory approvals, (ii) [/INST] Negative. </s>

WHITE MOUNTAINS INSURANCE GROUP LTD

2015-02-27

2014-12-31

Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations The following discussion contains “forward-looking statements”. White Mountains intends statements that are not historical in nature, which are hereby identified as forward-looking statements, to be covered by the safe harbor provisions of the Private Securities Litigation Reform Act of 1995. White Mountains cannot promise that its expectations in such forward-looking statements will turn out to be correct. White Mountains’s actual results could be materially different from and worse than its expectations. See “FORWARD-LOOKING STATEMENTS” on page 109 for specific important factors that could cause actual results to differ materially from those contained in forward-looking statements. The following discussion also includes three non-GAAP financial measures, adjusted comprehensive income, adjusted book value per share and adjusted capital, that have been reconciled to their most comparable GAAP financial measures (see page 86). White Mountains believes these measures to be more relevant than comparable GAAP measures in evaluating White Mountains’s financial performance and condition. RESULTS OF OPERATIONS FOR THE YEARS ENDED December 31, 2014, 2013 and 2012 Overview-Year Ended December 31, 2014 versus Year Ended December 31, 2013 White Mountains ended 2014 with an adjusted book value per share of $665, an increase of 3.6% during the year, including dividends, compared to an increase of 9.5% during 2013, including dividends. White Mountains reported adjusted comprehensive income of $136 million in 2014 compared to adjusted comprehensive income of $340 million in 2013. The decrease was driven by $87 million of after-tax foreign currency exchange losses, $58 million of after-tax adverse prior year loss reserve development at OneBeacon and lower investment returns, partially offset by strong underwriting performance at Sirius Group. OneBeacon’s book value per share increased 2.2% during 2014, including dividends, compared to an increase of 17.3% during 2013, including dividends. OneBeacon’s GAAP combined ratio was 102% for 2014 compared to 92% for 2013. OneBeacon’s results reflect a $109 million pre-tax increase to loss reserves in the fourth quarter, of which $75 million is related to prior accident years and $34 million related to the current accident year. Full year 2014 results reflect a $90 million pre-tax increase to prior accident year reserves. The reserve increases were driven primarily by professional liability (including lawyers’ professional liability) and management liability within the Professional Insurance business, and to a lesser extent the Entertainment and Government Risks businesses. Sirius Group’s GAAP combined ratio was 76% for 2014 compared to 82% for 2013. The improvement in the combined ratio for 2014 was driven by lower catastrophe losses and higher favorable loss reserve development, partially offset by higher acquisition expenses. Sirius Group’s combined ratio includes 7 points of catastrophe losses in 2014 compared to 10 points in 2013 and includes 11 points of favorable loss reserve development in 2014 compared to 6 points in 2013. White Mountains’s total net written premiums increased 7% to $2,122 million in 2014, driven by growth at both OneBeacon and Sirius Group. OneBeacon’s net written premiums increased 12% to $1,217 million in 2014, primarily related to OneBeacon’s newer businesses, particularly OneBeacon Crop Insurance, OneBeacon Program Group and OneBeacon Surety Group. Sirius Group’s net written premiums increased 1% to $883 million in 2014, as increases in the accident and health, property (excluding property catastrophe excess) and aviation lines were mostly offset by decreases in property catastrophe excess and trade credit business. White Mountains’s GAAP pre-tax total return on invested assets was 1.9% for 2014, compared to 4.1% for 2013. 2014 included 1.9% of foreign currency losses, while foreign currency translation did not meaningfully impact investment returns in 2013. In local currencies, the fixed income portfolio was up 2.7% for 2014, a decent absolute result for the year but behind the longer duration Barclays Intermediate Aggregate Index as interest rates fell. In local currencies, the fixed income portfolio was up 0.5% for 2013. In local currencies, the equity portfolio (common equity securities, convertibles and other long-term investments) was up 8.0% for 2014, a strong absolute result for the year but mixed against benchmarks, underperforming the S&P 500 and outperforming the small-cap Russell 2000. In local currencies, the equity portfolio was up 18.9% for 2013. WM Life Re reported losses of $9 million in 2014 compared to $17 million of losses in 2013. During 2014, White Mountains completed the acquisitions of four insurance marketing/technology service businesses: (i) Tranzact, a leading provider of end-to-end customer acquisition solutions to the insurance sector, (ii) QuoteLab, an advertising technology company focused on the insurance industry, (iii) Wobi, an Israeli online insurance price comparison business, and (iv) Star & Shield, which includes the attorney-in-fact for SSIE, a Florida-domiciled reciprocal insurance exchange providing private passenger auto insurance to members of the public safety community and their families. In addition, White Mountains purchased a 45% interest in durchblicker.at, Austria’s first independent price comparison portal for insurance, gas/electricity and financial services. In 2014, White Mountains deployed almost $400 million of capital, including approximately $235 million through the purchase of insurance service businesses and $134 million through share repurchases. Additionally, in June 2014, White Mountains committed $21 million to fund a 50/50 joint venture with DavidShield for the international development, marketing and distribution of PassportCard travel insurance. The transaction with DavidShield is expected to close in the first quarter of 2015, subject to Israeli regulatory approvals. Overview-Year Ended December 31, 2013 versus Year Ended December 31, 2012 White Mountains ended 2013 with an adjusted book value per share of $642, an increase of 9.5% during the year, including dividends, compared to an increase of 8.6% during 2012, including dividends. White Mountains reported adjusted comprehensive income of $340 million in 2013 compared to adjusted comprehensive income of $245 million in 2012. Good investment results driven by the effects of a rising stock market and White Mountains’s high-quality, short-duration fixed income portfolio, which performed well as interest rates rose in 2013, as well as solid underwriting performance at both OneBeacon and Sirius Group, contributed to growth in adjusted book value per share for 2013. OneBeacon’s book value per share increased 17.3% during 2013, including dividends, compared to a decrease of 0.8% during 2012, including dividends. OneBeacon’s GAAP combined ratio was 92% for 2013 compared to 98% for 2012. The combined ratio for 2013 reflects lower catastrophe losses, which were negligible in 2013 while contributing 5 points to OneBeacon’s combined ratio in 2012, and a lower expense ratio. Sirius Group’s GAAP combined ratio was 82% for 2013 compared to 90% for 2012. The improvement in the combined ratio for 2013 was driven by lower catastrophe losses and higher favorable loss reserve development. Sirius Group’s combined ratio includes 10 points of catastrophe losses in 2013 compared to 13 points in 2012 and includes 6 points of favorable loss reserve development in 2013 compared to 4 points in 2012. White Mountains’s total net written premiums decreased 7% to $1,979 million in 2013, primarily related to OneBeacon’s exit from the collector car and boat and energy businesses and lower premiums in the accident and health and trade credit lines at Sirius Group, partially offset by growth in all of OneBeacon’s ongoing specialty lines and an increase in property lines at Sirius Group. OneBeacon’s net written premiums decreased 8% to $1,089 million in 2013. Excluding the $206 million of net premiums written in 2012 from the exited businesses, White Mountains’s net written premiums decreased 3% and OneBeacon’s net written premiums increased 12% in 2013. Sirius Group’s net written premiums decreased 8% to $877 million in 2013. White Mountains’s GAAP pre-tax total return on invested assets was 4.1% for 2013, compared to 4.9% for 2012. Foreign currency translation did not meaningfully impact investment returns in 2013, while 2012 included 0.5% of foreign currency gains. In local currencies, the fixed income portfolio was up 0.5% for 2013, outperforming the longer duration Barclays Intermediate Aggregate Bond Index of (1.0)% as interest rates rose. In local currencies, the fixed income portfolio was up 3.8% for 2012. In local currencies, the equity portfolio was up 18.9% for 2013, a strong absolute result for the year but behind benchmarks. The shortfall against benchmarks was due primarily to underperformance in White Mountains’s value oriented common equity security portfolio (up 23.2% versus the S&P 500 return of 32.4%) and the impact of convertible fixed maturity investments in the equity portfolio (as opposed to common equity securities), which tend to lag benchmarks in strong up markets. WM Life Re reported losses of $17 million in 2013 compared to $19 million of losses in 2012. Adjusted Book Value Per Share The following table presents White Mountains’s adjusted book value per share, a non-GAAP financial measure, for the years ended December 31, 2014, 2013 and 2012 and reconciles this non-GAAP measure to the most comparable GAAP measure. (See “NON-GAAP FINANCIAL MEASURES” on page 86.) December 31, Book value per share numerators (in millions): White Mountains’s common shareholders’ equity(1) $ 3,996.6 $ 3,905.5 $ 3,731.8 Equity in net unrealized (gains) losses from Symetra’s fixed maturity portfolio (34.9 ) 40.4 (57.7 ) Adjusted book value per share numerator(1) $ 3,961.7 $ 3,945.9 $ 3,674.1 Book value per share denominators (in thousands of shares): Common shares outstanding(1) 5,986.2 6,176.7 6,291.0 Unearned restricted shares (25.7 ) (33.0 ) (38.7 ) Adjusted book value per share denominator(1) 5,960.5 6,143.7 6,252.3 Book value per share $ 667.63 $ 632.30 $ 593.20 Adjusted book value per share $ 664.66 $ 642.27 $ 587.63 Dividends paid per share $ 1.00 $ 1.00 $ 1.00 (1) Excludes out-of-the-money stock options. The following table is a summary of goodwill and intangible assets that are included in White Mountains’s adjusted book value as of December 31, 2014, 2013 and 2012: December 31, Millions Goodwill Tranzact $ 145.1 $ - $ - QuoteLab 18.3 - - Wobi 5.5 - - Total goodwill 168.9 - - Intangible assets Tranzact 142.8 - - QuoteLab 32.5 - - Other 22.2 20.7 18.1 Total intangible assets 197.5 20.7 18.1 Total goodwill and intangible assets (1) 366.4 20.7 18.1 Goodwill and intangible assets attributed to non-controlling interests (141.8 ) (1.3 ) (1.9 ) Goodwill and intangible assets included in adjusted book value $ 224.6 $ 19.4 $ 16.2 (1) See Note 6 - “Goodwill and Other Intangible Assets” for details of other intangible assets. Review of Consolidated Results A summary of White Mountains’s consolidated financial results for the years ended December 31, 2014, 2013 and 2012 follows: Year Ended December 31, Millions Gross written premiums $ 2,498.8 $ 2,296.9 $ 2,438.0 Net written premiums $ 2,121.5 $ 1,978.8 $ 2,126.9 Revenues Earned insurance and reinsurance premiums $ 2,058.9 $ 1,987.3 $ 2,063.6 Net investment income 105.0 110.9 153.6 Net realized and unrealized investment gains 283.9 161.7 118.2 Other revenue - foreign currency translation (losses) gains (56.5 ) (1.0 ) 39.9 Other revenue - Tuckerman Fund I(1) - - 24.1 Other revenue - Symetra warrants - 10.8 17.7 Other revenue - other 118.9 47.7 18.6 Other revenue 62.4 57.5 100.3 Total revenues 2,510.2 2,317.4 2,435.7 Expenses Losses and LAE 1,169.3 1,040.5 1,193.9 Insurance and reinsurance acquisition expenses 399.8 376.9 430.2 Other underwriting expenses 309.3 331.3 321.8 General and administrative expenses 287.5 179.6 150.6 General and administrative expenses - Tuckerman Fund I(1) - - 21.0 Accretion of fair value adjustment to loss and LAE reserves .7 1.7 10.6 Interest expense 41.9 42.5 44.8 Total expenses 2,208.5 1,972.5 2,172.9 Pre-tax income 301.7 344.9 262.8 Income tax (expense) benefit (53.3 ) (76.6 ) 15.7 Net income from continuing operations 248.4 268.3 278.5 Net (loss) gain on sale of discontinued operations, net of tax (1.6 ) 46.6 (91.0 ) Net loss from discontinued operations, net of tax (1.8 ) (42.1 ) (24.0 ) Equity in earnings of unconsolidated affiliates, net of tax 45.6 36.6 29.9 Net income 290.6 309.4 193.4 Net loss attributable to non-controlling interests 22.1 12.4 14.0 Net income attributable to White Mountains’s common shareholders 312.7 321.8 207.4 Change in equity in net unrealized gains (losses) from investments in Symetra common shares, net of tax 75.3 (98.1 ) 57.7 Change in foreign currency translation and other, net of tax (180.2 ) 23.5 36.7 Comprehensive income 207.8 247.2 301.8 Comprehensive loss (income) attributable to non-controlling interests 3.3 (5.2 ) 0.8 Comprehensive income attributable to White Mountains’s common shareholders 211.1 242.0 302.6 Change in net unrealized (losses) gains from Symetra’s fixed maturity portfolio, net of tax (75.3 ) 98.1 (57.7 ) Adjusted comprehensive income(2) $ 135.8 $ 340.1 $ 244.9 (1) On December 31, 2011, Tuckerman Fund I was dissolved and all of the net assets of the fund, which consisted of the LLC units of Hamer and Bri-Mar, two small manufacturing companies, were distributed. As of October 1, 2012, Hamer and Bri-Mar are no longer consolidated and are accounted for as investments in unconsolidated affiliates. (2) Adjusted comprehensive income is a non-GAAP measure. For a description of the most comparable GAAP measure (see NON-GAAP FINANCIAL MEASURES on page 86). Consolidated Results-Year Ended December 31, 2014 versus Year Ended December 31, 2013 White Mountains’s total revenues increased 8% to $2,510 million in 2014, which was driven by an increase in net unrealized gains from the investment portfolio and other revenues from the newly-acquired insurance service businesses. Earned insurance and reinsurance premiums increased 4%, with OneBeacon up 5% and Sirius Group up 1% over 2013. Net investment income was down 5% to $105 million, due to a lower fixed maturity asset base and lower investment yields. White Mountains reported net realized and unrealized investment gains of $284 million in 2014, which included $141 million of net realized and unrealized foreign currency gains, compared to $162 million of gains in 2013, which included $1 million of net realized and unrealized foreign currency gains. Net realized and unrealized foreign currency gains on investments are primarily related to GAAP foreign currency translation and are more than offset in comprehensive net income and adjusted book value per share by foreign currency losses recognized in other comprehensive income in 2014 (see “Foreign Currency Translation” on page 73). Other revenue increased to $62 million in 2014 from $58 million in 2013. Other revenue in 2014 included $57 million in foreign currency translation losses compared to $1 million in foreign currency translation losses in 2013. Other revenue in 2014 included $65 million from QuoteLab and $43 million from Tranzact. Other revenue in 2013 included transaction gains of $42 million, composed of a $23 million gain on OneBeacon’s sale of Essentia, a $7 million gain on Sirius Group’s acquisition of Empire, a $7 million gain on Sirius Group’s acquisition of Ashmere and a $4 million gain from the extension of the transition service agreement for services provided by OneBeacon on business sold to Tower in the personal lines transaction in 2010. In addition, 2013 included $11 million of mark-to-market gains on the Symetra warrants, which were exercised in June 2013. Other revenue included $4 million of WM Life Re’s losses in 2014 compared to $13 million of WM Life Re’s losses in 2013. See Note 9 - “Derivatives” for details regarding WM Life Re’s total impact on White Mountains’s statement of operations. Other revenues in 2014 also included third-party investment management fee income at WM Advisors of $12 million, compared to $11 million in 2013. White Mountains’s total expenses increased 12% to $2,209 million in 2014. Losses and LAE, insurance and reinsurance acquisition expenses increased 12% and 6% in 2014, while other underwriting expenses decreased 7% in 2014. The increase in loss and LAE includes the $109 million reserve charge recorded by OneBeacon related to the actuarial analysis performed in the fourth quarter of 2014, which was partially offset by a $28 million decrease in OneBeacon’s incentive compensation expense accrual, contributing to the decrease in other underwriting expenses in 2014 (see “Summary of Operations by Segment” on page 56). General and administrative expenses in 2014 included $61 million from QuoteLab and $37 million from Tranzact. Consolidated Results-Year Ended December 31, 2013 versus Year Ended December 31, 2012 White Mountains’s total revenues decreased 5% to $2,317 million in 2013, primarily due to lower earned insurance and reinsurance premiums, net investment income and other revenues, partially offset by higher net realized and unrealized investment gains. Earned insurance and reinsurance premiums decreased 4% to $1,987 million in 2013. Net investment income was down 28% to $111 million in 2013, due to a lower fixed maturity asset base, resulting primarily from $749 million of share repurchases since January 2012, and lower investment yields. White Mountains reported net realized and unrealized investment gains of $162 million in 2013, which included $1 million of net realized and unrealized foreign currency gains, compared to $118 million of gains in 2012, which included $57 million of net realized and unrealized foreign currency losses. Most of the net realized and unrealized foreign currency gains (losses) on investments are related to GAAP foreign currency translation and are offset by amounts recognized in other comprehensive income (see “Foreign Currency Translation” on page 73). Other revenue decreased to $58 million in 2013 from $100 million in 2012. Other revenue in 2013 included transaction gains of $42 million, compared to $28 million of net transaction gains in 2012. Transaction gains in 2013 included a $23 million gain on OneBeacon’s sale of Essentia, a $7 million gain on Sirius Group’s acquisition of Empire, a $7 million gain on Sirius Group’s acquisition of Ashmere and a $4 million gain from the extension of the transition service agreement for services provided by OneBeacon on business sold to Tower in the personal lines transaction in 2010, while 2012 included a $15 million gain on Sirius Group’s sale of IMG, $14 million of gains from Sirius Group’s acquisitions that closed in 2012, a $5 million gain on OneBeacon’s sale of a shell company and a $6 million loss from OneBeacon’s repurchase of its senior notes. Other revenue in 2013 also included $1 million in foreign currency translation losses, compared to $40 million in foreign currency translation gains in 2012. In addition, 2013 included $11 million of mark-to-market gains on the Symetra warrants compared to $18 million of gains in 2012. Other revenue included $13 million of WM Life Re’s losses in 2013 compared to $25 million of WM Life Re’s losses in 2012. See Note 9 - “Derivatives” for details regarding WM Life Re’s total impact on White Mountains’s statement of operations. Other revenues also included third-party investment management fee income at WM Advisors of $11 million in both 2013 and 2012. In 2012, White Mountains reported other revenue of $24 million related to the consolidation of Hamer and Bri-Mar. Effective October 1, 2012, the results of Hamer and Bri-Mar are no longer consolidated in White Mountains’s financial statements. White Mountains’s total expenses decreased 9% to $1,973 million in 2013. Losses and LAE decreased 13% in 2013, exceeding the 4% decrease in earned insurance and reinsurance premiums primarily as a result of lower catastrophe losses and higher favorable loss reserve development in 2013. Insurance and reinsurance acquisition expenses decreased 12% in 2013, exceeding the 9% decrease in net written premiums primarily due to changes in business mix at OneBeacon driven by the termination of the underwriting arrangement with Hagerty Insurance Agency and higher profit commissions accrued at Sirius Group on ceded European property business, while other underwriting expenses increased 3%, primarily due to higher incentive compensation expenses at Sirius Group. Income Taxes The Company and its Bermuda-domiciled subsidiaries are not subject to Bermuda income tax under current Bermuda law. In the event there is a change in the current law such that taxes are imposed, the Company and its Bermuda-domiciled subsidiaries would be exempt from such tax until March 31, 2035, pursuant to the Bermuda Exempted Undertakings Tax Protection Act of 1966. The Company has subsidiaries and branches that operate in various other jurisdictions around the world that are subject to tax in the jurisdictions in which they operate. The jurisdictions in which the Company’s subsidiaries and branches are subject to tax are Australia, Belgium, Canada, Denmark, Germany, Gibraltar, Israel, Luxembourg, Malaysia, the Netherlands, Peru, Singapore, Sweden, Switzerland, the United Kingdom and the United States. White Mountains reported income tax expense of $53 million in 2014 on pre-tax income of $302 million. White Mountains’s effective tax rate for 2014 was 18%, which was lower than the U.S. statutory rate of 35% due primarily to income generated in jurisdictions with lower tax rates than the United States. White Mountains reported income tax expense of $77 million in 2013 on pre-tax income of $345 million. White Mountains’s effective tax rate for 2013 was 22%, which was lower than the U.S. statutory rate of 35% due primarily to income generated in jurisdictions with lower tax rates than the United States. In addition, the effective tax rate reflects a $7 million release of a valuation allowance at OneBeacon related to the restructuring of a surplus note issued to a consolidated insurance reciprocal exchange. White Mountains reported an income tax benefit of $16 million in 2012 on pre-tax income of $263 million. Effective January 1, 2013, Sweden reduced its corporate tax rate from 26.3% to 22.0% and Luxembourg increased its corporate tax rate from 28.8% to 29.2%. This resulted in a reduction in deferred tax liabilities in Sweden and an increase in deferred tax assets in Luxembourg as of December 31, 2012. As a result, Sirius Group recognized $73 million in tax benefits from these changes. During 2012, Sirius Group also had a net release of valuation allowances on deferred tax assets in Luxembourg, resulting in a tax benefit of $41 million, and White Mountains established a valuation allowance on deferred tax assets of a group of U.S. companies reported in the Other Operations segment, resulting in a tax expense of $38 million. In total, White Mountains recognized $76 million in overall net tax benefits from these changes. Excluding the impact of these changes, White Mountains’s effective tax rate for 2012 was 23%, which was lower than the U.S. statutory rate of 35% due primarily to income generated in jurisdictions with lower tax rates than the United States. Discontinued Operations During 2014, White Mountains recorded a net loss on sale of discontinued operations of $2 million and a net loss from discontinued operations of $2 million. The net loss on sale of discontinued operations included a $19 million loss at OneBeacon on the Runoff Transaction, which included a $24 million after-tax loss from the change in the estimated value of the surplus notes issued with the Runoff Transaction, partially offset by a $5 million after-tax reduction in the loss on sale from the Runoff Transaction related to the change in the treatment of the $7 million pre-tax ($5 million after-tax) reserve charge recorded during the second quarter of 2013 (as described below). Previously, OneBeacon expected that the Runoff SPA would be amended to provide for the transfer of $7 million of additional assets to support the reserve charge. The Runoff SPA was instead revised to increase the cap on seller financing. The $19 million net loss on sale recorded in 2014 from the Runoff Transaction was partially offset by a $14 million gain from a payment received from Allianz, the purchaser of White Mountains’s former subsidiary Fireman’s Fund Insurance Company (“FFIC”), related to the utilization of alternative minimum tax credits associated with the tax loss on the sale of FFIC in 1991 and a $3 million gain from an interim payment from Allstate that primarily related to the favorable development on loss reserves transferred in the sale of Esurance and Answer Financial. The $2 million net loss from discontinued operations in 2014 related entirely to the Runoff Business. During 2013, White Mountains recorded a net gain on sale of discontinued operations of $46 million and a net loss from discontinued operations of $42 million. During 2013, OneBeacon recorded a $79 million pre-tax loss and LAE provision for the Runoff Business. This reserve charge included a $7 million increase in loss and LAE reserves recorded in the second quarter of 2013, which partially offset $8 million of other revenue associated with a settlement award in the second quarter of 2013 in the Safeco v. American International Group, Inc. (“AIG”) class action related to AIG's alleged underreporting of workers' compensation premiums to the National Workers’ Compensation Reinsurance Pool. The net $71 million pre-tax ($46 million after-tax) of net losses from discontinued operations were fully offset by a $46 million after-tax reduction in the loss on sale of discontinued operations, as prescribed by the terms of the Runoff SPA, which stated that the buyer assumed the risk that loss and LAE reserves develop unfavorably from September 30, 2012 onward. During 2012, White Mountains recorded a net loss from discontinued operations of $24 million and a net loss on sale of discontinued operations of $92 million, substantially all of which related to the Runoff Transaction and the results of the Runoff Business. I. Summary of Operations By Segment White Mountains conducts its operations through four segments: (1) OneBeacon, (2) Sirius Group, (3) HG Global/BAM and (4) Other Operations. While investment results are included in these segments, because White Mountains manages the majority of its investments through its wholly-owned subsidiary, WM Advisors, a discussion of White Mountains’s consolidated investment operations is included after the discussion of operations by segment. White Mountains’s segment information is presented in Note 15 -“Segment Information” to the Consolidated Financial Statements. OneBeacon Financial results and GAAP combined ratios for OneBeacon for the years ended December 31, 2014, 2013 and 2012 follow: Year Ended December 31, Millions Gross written premiums $ 1,323.4 $ 1,162.9 $ 1,259.2 Net written premiums $ 1,216.9 $ 1,088.6 $ 1,179.2 Earned insurance and reinsurance premiums $ 1,177.1 $ 1,120.4 $ 1,132.0 Net investment income 41.7 41.1 53.6 Net realized and unrealized investment gains 40.4 49.4 55.7 Other revenue (losses) 5.8 31.2 (.5 ) Total revenues 1,265.0 1,242.1 1,240.8 Losses and LAE 815.1 622.1 650.0 Insurance and reinsurance acquisition expenses 203.3 208.9 249.4 Other underwriting expenses 179.2 204.8 205.2 General and administrative expenses 13.8 12.0 13.4 Interest expense on debt 13.0 13.0 16.9 Total expenses 1,224.4 1,060.8 1,134.9 Pre-tax income $ 40.6 $ 181.3 $ 105.9 GAAP Ratios: Losses and LAE % % % Expense Combined % % % The following table presents OneBeacon’s book value per share. December 31, (Millions, except per share amounts) OneBeacon’s common shareholders’ equity $ 1,047.0 $ 1,104.3 $ 1,014.5 OneBeacon common shares outstanding 95.3 95.4 95.4 OneBeacon book value per common share $ 10.99 $ 11.58 $ 10.63 Dividends paid per common share $ .84 $ .84 $ .84 OneBeacon Results-Year Ended December 31, 2014 versus Year Ended December 31, 2013 OneBeacon ended 2014 with a book value per share of $10.99, an increase of 2.2% during 2014, including dividends, compared to an increase of 17.3% during 2013, including dividends. During 2014, OneBeacon’s book value per share was significantly impacted by (1) a fourth quarter increase in loss and LAE reserves of $109 million ($71 million after-tax) resulting from an actuarial and claims analysis of its ongoing specialty loss reserves, as further described below; (2) a $21 million after-tax loss from discontinued operations, driven primarily by valuation adjustments related to the surplus notes provided in conjunction with the seller financing of the Runoff Transaction; and (3) an after-tax other comprehensive loss of $12 million, primarily due to a decrease in the weighted average discount rate (from 4.7% to 3.9%), as well as a change in the mortality assumptions, used for the annual remeasurement of OneBeacon’s legacy pension plan. OneBeacon’s GAAP combined ratio increased to 102% for 2014 from 92% for 2013. The increase was primarily driven by a 13 point increase in the loss ratio (primarily due to the fourth quarter reserve increase described below), partially offset by a 3 point improvement in the expense ratio. Net unfavorable loss and LAE reserve development was 8 points ($90 million) for 2014, driven primarily by professional liability, especially lawyers’ liability claims, which OneBeacon put into runoff and sold the renewal rights to in December 2014, and management liability businesses. Net loss reserve development for 2013 was negligible. A large loss in Specialty Property and elevated Crop losses due to lower corn prices also contributed to the increase in OneBeacon’s 2014 loss ratio. Catastrophe losses contributed 1 point to OneBeacon’s GAAP combined ratios for both 2014 and 2013. The decrease in the expense ratio was driven by lower incentive compensation expenses. OneBeacon’s net written premiums increased 12% in 2014 to $1,217 million, primarily due to an $80 million increase from its newer businesses, particularly OneBeacon Crop Insurance, OneBeacon Program Group and OneBeacon Surety Group. 2014 Fourth Quarter Loss and LAE Reserve Increase Through the first nine months of 2014, OneBeacon recorded $14.3 million of unfavorable loss and LAE reserve development, driven by greater-than-expected large losses in several underwriting units, primarily in the professional and management liability lines within Professional Insurance. This large loss activity, which occurred mostly during the second and third quarters of 2014, also impacted the current accident year loss and LAE estimates. Additionally, OneBeacon incurred higher-than-usual claim coverage determination costs, a component of LAE expenses, during the first nine months of 2014. Other underwriting units also reported increased claim activity, including Entertainment, Government Risks, and Accident. Since the increased level of loss and LAE activity continued into the early part of the fourth quarter, the high level of activity in the second and third quarters no longer seemed to be isolated occurrences. As such, during the fourth quarter of 2014, OneBeacon enhanced its actuarial and claims review in several areas. OneBeacon isolated the recent large loss activity in each of its underwriting units and examined the emergence of large losses relative to the timing and amounts of expected large losses. OneBeacon also conducted additional analyses in the lawyers’ professional liability line within the Professional Insurance underwriting unit. These new analyses included a claim level review and the application of additional actuarial methods and loss development assumptions. The results of these analyses indicated that the assumed tail risk included in the loss development patterns used to record IBNR reserves for this line were insufficient and needed to be increased for remaining long-tail exposures. OneBeacon’s claims and actuarial staff also conducted an in-depth review of coverage determination, litigation and other claim-specific adjusting expenses as a result of an emerging trend of increased expenses in these areas over recent quarters, particularly coverage determination expenses. This review concluded that the ultimate costs of these loss adjustment expenses were larger than previously estimated, causing management to record an increase in estimated LAE expenses, primarily in Professional Insurance. Finally, OneBeacon also recorded unfavorable prior year development in other underwriting units, including Entertainment and Government Risks. The unfavorable loss development in Entertainment and Government Risks resulted from heavier than expected claim activity during the fourth quarter, predominantly in the general liability and commercial auto liability lines. In order to fully reflect these recent trends, OneBeacon recorded a $109.2 million increase in loss and LAE reserves, which included a $75.5 million increase in prior accident year loss and LAE reserves and a $33.7 million increase in the current accident year loss and LAE reserves recorded at September 30, 2014. The components of the 2014 fourth quarter loss and LAE reserve increase and the net loss and LAE development for the full year are provided below: Millions 2014 Fourth Quarter Reserve Increases Full Year 2014 Underwriting Unit Current Accident Year Prior Accident Year Total Net Prior Year Development Professional Insurance $ 22.9 $ 46.4 $ 69.3 $ 59.1 Specialty Property (1.1 ) 5.7 4.6 1.1 Crop 3.8 - 3.8 - Other 2.8 (.4 ) 2.4 1.6 Specialty Products 28.4 51.7 80.1 61.8 Entertainment 1.5 11.6 13.1 13.5 Government Risks 1.2 7.1 8.3 8.5 Accident - 3.5 3.5 6.0 Other 2.6 1.6 4.2 - Specialty Industries 5.3 23.8 29.1 28.0 Total $ 33.7 $ 75.5 $ 109.2 $ 89.8 As noted above, OneBeacon increased its provision for current accident year losses and LAE by $33.7 million in the fourth quarter of 2014. In making its loss and LAE reserve picks for the 2014 accident year, OneBeacon considered the results of the enhanced actuarial and claim review and the fact that reported large claims were approaching estimated ultimate held reserves for large losses sooner than originally expected. $3.8 million of the increase is related to higher-than-expected reports of crop losses that emerged in the fourth quarter. The remaining $29.9 million of the increase reflects an increase in management’s best estimate of current losses and LAE as of December 31, 2014 from those recorded in the first nine months of 2014. This increase primarily affected the Professional Insurance underwriting unit, which represented $22.9 million of the total provision. Reinsurance protection. OneBeacon purchases reinsurance in order to minimize the loss from large risks or catastrophic events. OneBeacon also purchases individual property reinsurance coverage for certain risks to reduce large loss volatility through property-per-risk excess of loss reinsurance programs and individual risk facultative reinsurance. OneBeacon also maintains excess of loss casualty reinsurance programs that provide protection for individual risk or catastrophe losses involving workers compensation, general liability, automobile liability, professional liability or umbrella liability. The availability and cost of reinsurance protection is subject to market conditions, which are outside of management’s control. Limiting risk of loss through reinsurance arrangements serves to mitigate the impact of large losses; however, the cost of this protection in an individual period may exceed the benefit. OneBeacon’s net combined ratio was higher than the gross combined ratio by 2 points for both 2014 and 2013 as a result of the cost of the reinsurance programs more than offsetting the benefits from ceded losses. OneBeacon Discontinued Operations - Runoff Transaction In October 2012, OneBeacon entered into a definitive agreement to sell its Runoff Business to Armour. The Runoff Transaction closed in the fourth quarter of 2014. See Note 22 - “Discontinued Operations” for more details regarding the Runoff Transaction. During 2014, OneBeacon reported a $21 million after-tax net loss in discontinued operations related to the Runoff Transaction, which included a $19 million after-tax loss from sale of the Runoff Business (further described below) and a $2 million after-tax loss from the underwriting results of the Runoff Business. As part of closing the Runoff Transaction on December 23, 2014, OneBeacon provided financing in the form of surplus notes with a par value of $101 million issued by OneBeacon Insurance Company (“OBIC”), one of the entities that were transferred from OneBeacon to Armour as part of the transaction (the “OBIC Surplus Notes”). As of December 31, 2014, the OBIC Surplus Notes had a fair value of $65 million, based on a discounted cash flow model, resulting in a total valuation adjustment of $36 million pre-tax ($23 million after tax) included in loss from sale of discontinued operations. Subsequent to closing, the OBIC Surplus Notes are included in OneBeacon’s investment portfolio, categorized within other long-term investments, and subsequent changes in value thereon will be reflected in continuing operations. See “Critical Accounting Estimates” for a sensitivity analysis of potential changes in these key variables that can impact the estimated fair value of the OBIC Surplus Notes. Also during 2014, OneBeacon’s expectation of the treatment of a $7 million reserve charge related to the Runoff Business and recorded during 2013 changed. Previously, OneBeacon had expected that the Runoff SPA would be amended to provide for the transfer of $7 million of additional assets to support this reserve charge; the Runoff SPA was instead revised, in part, to increase the cap on seller financing. As a result, the $7 million reserve charge ($5 million after-tax) was recorded as a reduction to the estimated loss on sale of discontinued operations. These changes, along with certain other adjustments, resulted in a net increase in the estimated loss on the sale of the Runoff Business of $29 million ($19 million after tax) for the full year 2014, resulting in a pre-tax loss on sale at closing of $98 million ($64 million after tax) recognized since the third quarter of 2012. Subsequent to the closing of the Runoff Transaction, on January 22, 2015, three holders of insurance policies issued by the companies we sold to Armour in the Runoff Transaction filed a Petition for Review with the Commonwealth Court of Pennsylvania (“Commonwealth Court”) requesting that the Commonwealth Court vacate the PID’s orders approving the Runoff Transaction and denying their right to intervene in the PID’s regulatory review of the Runoff Transaction. OneBeacon believes the claims made by the petitioners are without merit and intends to intervene in the proceedings before the Commonwealth Court to vigorously defend the propriety of the PID’s orders in their entirety. OneBeacon Results-Year Ended December 31, 2013 versus Year Ended December 31, 2012 OneBeacon ended 2013 with a book value per share of $11.58, an increase of 17.3% during 2013, including dividends, compared to a decrease of 0.8% during 2012, including dividends. Investment and underwriting results both contributed to the increase in OneBeacon’s book value per share for 2013. OneBeacon’s 2013 results also included a $23 million pre-tax ($15 million after-tax) gain from the sale of Essentia Insurance Company (“Essentia”), a $7 million tax benefit related to the release of a valuation allowance at OneBeacon related to the restructuring of a surplus note issued to a consolidated insurance reciprocal exchange and a $4 million pre-tax ($3 million after-tax) benefit from the extension of the transition service agreement for services provided by OneBeacon on business sold to Tower in the personal lines transaction in 2010. OneBeacon’s GAAP return on investments was 3.8% for 2013, compared to a return of 4.4% for 2012. OneBeacon’s GAAP combined ratio decreased to 92% for 2013 from 98% for 2012, which reflects both lower loss and expense ratios as compared to 2012. The decrease in the loss ratio was driven by a decrease in catastrophe losses which were negligible in 2013 compared to 5 points of net catastrophe losses ($56 million, including $8 million of ceded reinstatement premiums) for 2012, due primarily to the impact of hurricane Sandy. Favorable loss reserve development for 2013 was negligible, compared to 1 point ($7 million) for 2012. The decrease in the expense ratio for 2013 was primarily from lower insurance acquisition expenses due to changes in business mix driven by the termination of the underwriting arrangement with Hagerty Insurance Agency, partially offset by higher non-claims litigation expenses. OneBeacon’s net written premiums decreased 8% in 2013 to $1,089 million, primarily due to the exit from the collector car and boat and energy businesses, partially offset by growth in nearly all of OneBeacon’s ongoing specialty lines. In January 2013, OneBeacon terminated its relationship with Hagerty and sold Essentia, the wholly owned subsidiary that wrote OneBeacon’s Hagerty collector car and boat business, to Markel Corporation. Excluding the $206 million of net written premiums from the exited businesses in 2012, net written premiums increased 12%. OneBeacon’s other revenue in 2013 included a $23 million gain from the sale of Essentia and a $4 million benefit from the extension of the transition service agreement. OneBeacon’s losses and LAE expenses decreased 4%, driven by lower catastrophe losses and lower earned premiums, while insurance and reinsurance acquisition expenses decreased 16%, primarily due to changes in business mix and lower net written premiums driven by the termination of the underwriting arrangement with Hagerty Insurance Agency. Other underwriting expenses were consistent with prior year. Interest expense decreased 23% to $13 million in 2013, reflecting a lower interest rate on outstanding debt. Reinsurance protection. OneBeacon's net combined ratio was higher than the gross combined ratio by 2 points for 2013 as a result of the cost of the reinsurance programs more than offsetting the benefits from ceded losses. OneBeacon’s net combined ratio for 2012 was lower than its gross combined ratio by 1 point, primarily due to the significant amount of reinsurance cessions related to hurricane Sandy, which were partially offset by the impact of the cost of facultative reinsurance and property reinsurance, and also the cost of catastrophe reinsurance and marine reinsurance. OneBeacon Discontinued Operations - Runoff Transaction As a result of a comprehensive actuarial analysis conducted by OneBeacon during the fourth quarter of 2013, OneBeacon recorded $72 million of unfavorable prior year non-A&E loss and LAE development related to the Runoff Business. The increase in loss reserves was concentrated in the workers compensation, personal auto liability and excess liability lines of business. In addition, OneBeacon increased its estimate of adjusting and other expenses, a component of LAE reserves. Workers compensation unpaid loss reserves increased by $37 million due to changes in how OneBeacon evaluates various estimated settlement rates, mortality and medical inflation assumptions. These three key assumptions, which were previously evaluated implicitly as part of overall case incurred activity, were separately analyzed and then reviewed under varying assumptions and an array of resulting reserve estimates to generate an actuarial indication that management selected for its best estimate. For personal auto liability, a $17 million loss provision was recorded based on a ground-up analysis of unlimited medical automobile no-fault claims from the 1970s and 1980s, which produced a range of estimates at varying medical inflation rates. The remaining $5 million loss reserve increase was driven by adverse prior year loss development recorded on a few large excess liability claims. Finally, OneBeacon recorded a provision to increase its LAE reserves by $13 million for adjusting and other expenses due to a change in assumptions of staff efficiency associated with handling and settling runoff claims. For the full year 2013, OneBeacon recorded a $79 million loss and LAE provision for the Runoff Business. The $79 million loss and LAE adverse development recorded in 2013 was partially offset by other revenue of $8 million associated with a settlement award in the second quarter of 2013 in the Safeco v. American International Group, Inc. (“AIG”) class action related to AIG’s alleged underreporting of workers' compensation premiums to the National Workers' Compensation Reinsurance Pool. The $72 million ($47 million after-tax) increase in Runoff Business loss and LAE reserves was recorded in the fourth quarter of 2013 as a component of discontinued operations and offset by an equal after-tax amount which decreased the estimated ultimate loss on sale of the Runoff Business. The terms of the Runoff SPA prescribe that the buyer has assumed the risk that loss and LAE reserves develop unfavorably from September 30, 2012 onward, resulting in the offset. During the fourth quarter of 2013, OneBeacon also increased the estimated pre-tax transaction costs associated with the Runoff Transaction, which was partially offset by the accretion of interest on the original sales price and, coupled with the $47 million after-tax provision for loss and LAE, resulted in a $46 million after-tax reduction in the ultimate loss on sale from discontinued operations. This reduction in the ultimate loss on sale was essentially offset by a $46 million after-tax loss from discontinued operations, driven by the unfavorable loss reserve development. Sirius Group Financial results and GAAP combined ratios for Sirius Group for the years ended December 31, 2014, 2013 and 2012 follows: Year Ended December 31, Millions Gross written premiums $ 1,136.6 $ 1,120.4 $ 1,178.8 Net written premiums $ 882.5 $ 876.6 $ 947.7 Earned insurance and reinsurance premiums $ 873.9 $ 866.4 $ 931.6 Net investment income 41.1 48.8 65.0 Net realized and unrealized investment gains 209.2 26.7 17.3 Other revenue-foreign currency translation (losses) gains (56.5 ) (1.0 ) 39.9 Other (losses) revenue (5.9 ) 17.8 30.7 Total revenues 1,061.8 958.7 1,084.5 Losses and LAE 345.3 418.4 543.9 Insurance and reinsurance acquisition expenses 193.6 166.5 180.8 Other underwriting expenses 129.7 126.1 116.4 General and administrative expenses 29.8 30.5 35.3 Accretion of fair value adjustment to loss and LAE reserves .7 1.7 10.6 Interest expense on debt 26.3 26.3 26.2 Total expenses 725.4 769.5 913.2 Pre-tax income $ 336.4 $ 189.2 $ 171.3 GAAP Ratios: Loss and LAE % % % Expense Combined % % % Sirius Group Results-Year Ended December 31, 2014 versus Year Ended December 31, 2013 Sirius Group’s GAAP combined ratio was 76% for 2014 compared to 82% for 2013. The decrease was due to lower catastrophe losses and higher favorable loss reserve development, partially offset by higher acquisition and incentive compensation expenses. The 2014 combined ratio included 7 points ($59 million) of catastrophe losses, including $18 million from flooding in the Jammu and Kashmir regions in India and $8 million from Cyclone Hudhud in eastern India and Nepal, compared to 10 points ($85 million) of catastrophe losses in 2013. Favorable loss reserve development was 11 points ($98 million) in 2014 primarily due to decreases in property loss reserves, including reductions for prior period catastrophe losses, in addition to decreases in aviation, accident and health, and casualty loss reserves. Favorable loss reserve development was 6 points ($48 million) in 2013 primarily due to reductions in property loss reserves, including $24 million of favorable loss reserve development on prior year’s catastrophe losses. Sirius Group’s gross and net written premiums each increased 1% to $1,137 million and $883 million for 2014. Increases in the accident and health, property (excluding property catastrophe excess), and aviation lines were partially offset by decreases in the property catastrophe excess and trade credit lines. Net earned premiums also increased 1% for 2014. In 2014, Sirius Group’s other revenue was a loss of $6 million, which was primarily due to a $7 million mark-to-market loss on the interest rate cap associated with the SIG Preference Shares, somewhat offset by a $1 million gain on the sale of Citation as a “shell company.” In 2013, Sirius Group’s other revenue primarily consisted of pre-tax transaction gains of $14 million from White Mountains Solutions’ acquisitions of Ashmere and Empire. Additionally, Sirius Group recorded $57 million of foreign currency translation losses in 2014 compared to $1 million of foreign currency translation losses in 2013. (See “Foreign Currency Translation” on page 73.) Sirius Group’s insurance and reinsurance acquisition expenses increased $27 million in 2014, as 2013 included the benefit from $19 million of profit commissions accrued by Sirius Group on ceded European property treaties, compared to $6 million on these European treaties in 2014. In addition, in 2014, additional profit commissions of $6 million were due from Sirius Group for prior accident year assumed treaties as a result of favorable loss reserve development on these treaties. Sirius Group is also experiencing higher up front acquisition expenses on certain treaty renewals due to overall softening market conditions. Sirius Group’s other underwriting expenses were up 3% in 2014, primarily due to higher incentive compensation expenses. Reinsurance protection. Sirius Group's reinsurance protection primarily consists of pro-rata and excess of loss protections to cover aviation, trade credit, and certain accident and health and property exposures. Sirius Group's proportional reinsurance programs provide protection for part of the non-proportional treaty accounts written in Europe, the Americas, Asia, the Middle East and Australia. This reinsurance is designed to increase underwriting capacity where appropriate, and to reduce exposure both to large catastrophe losses and to a frequency of smaller loss events. Attachment points and coverage limits vary by region around the world. Sirius Group’s net combined ratio was 1 point lower than the gross combined ratio for 2014 and equaled the gross combined ratio for 2013. For 2014, the net combined ratio was lower than the gross combined ratio as ceded loss recoveries, primarily in the accident and health and aviation lines, mostly offset the premiums ceded under Sirius Group’s reinsurance protection programs. The net and gross combined ratios were the same for 2013 as the cost of property retrocessions was offset by loss recoveries on catastrophe losses in Europe and Asia and profit commissions on ceded business. Sirius Group Results-Year Ended December 31, 2013 versus Year Ended December 31, 2012 Sirius Group’s GAAP combined ratio was 82% for 2013 compared to 90% for 2012. The decrease was primarily due to lower catastrophe losses, higher favorable loss reserve development and lower agricultural losses. The 2013 combined ratio included 10 points ($85 million) of catastrophe losses, net of reinsurance and reinstatement premiums, primarily comprised of $27 million of flood losses in Central Europe, $20 million of hail storm losses in Germany and France, and $8 million of losses from typhoon Fitow in China, while the 2012 combined ratio included 13 points ($117 million) of catastrophe losses, comprised mainly of $98 million of losses from hurricane Sandy. Favorable loss reserve development was 6 points ($48 million) in 2013, which included $24 million of favorable loss reserve development on prior year’s catastrophe losses. Other major reductions in loss reserve estimates recognized included property ($17 million), aviation/space ($10 million) and accident and health ($9 million), partially offset by a $12 million increase in asbestos loss reserves. Favorable loss reserve development was 4 points ($34 million) for 2012, primarily attributable to favorable development in property and casualty lines, offset by a $46 million increase in asbestos reserves. Additionally, the combined ratio for 2012 included 3 points of agricultural losses, primarily as a result of a drought in the Midwestern United States. Sirius Group’s gross written premiums decreased 5% for 2013 to $1,120 million, while net written premiums decreased 8% for 2013 to $877 million. These decreases were primarily from the accident and health and trade credit lines of business, partially offset by increases in the property lines. Net earned premiums decreased 7% for 2013 to $866 million due to lower accident and health and trade credit premiums. The effects of foreign currency translation on premiums were not material in 2013. In 2013, Sirius Group’s other revenue primarily consisted of pre-tax transaction gains of $14 million from White Mountains Solutions’s acquisitions of Ashmere and Empire, compared to pre-tax transaction gains of $14 million in 2012 from White Mountains Solutions’s acquisitions of PICO, Citation, Woodridge and Oakwood. Other revenues in 2012 also included $15 million on the sale of Sirius Group’s interest in an affiliate, IMG, a managing general underwriter in the medical and travel business. Additionally, Sirius Group recorded $1 million of foreign currency translation losses in 2013 compared to $40 million of foreign currency translation gains in 2012. (See “Foreign Currency Translation” on page 73.) Sirius Group’s insurance and reinsurance acquisition expenses decreased $14 million in 2013, primarily due to lower business volume and higher profit commissions earned on ceded European property treaties. Sirius Group’s other underwriting expenses increased $10 million in 2013, primarily due to increased incentive compensation expenses and higher professional fees, primarily related to Lloyd’s Syndicate 1945. General and administrative expenses decreased by $5 million, primarily due to lower severance and separation costs in 2013 as a result of reductions in staff in 2012. Accretion of fair value adjustment to losses and LAE reserves decreased by $9 million due to the acceleration of the amortization of the purchase accounting established for the acquisition of Scandinavian Reinsurance Company Ltd. (“Scandinavian Re”) due to a treaty commutation in the first quarter of 2012. Reinsurance protection. Sirius Group’s net combined ratio equaled the gross combined ratio for 2013 and was 6 points higher than the gross combined ratio for 2012. The net and gross combined ratios were the same for 2013 as the cost of property retrocessions was offset by loss recoveries on catastrophe losses in Europe and Asia and profit commissions on ceded business. In 2012, the gross combined ratio was lower than the net combined ratio primarily due to the cost of property retrocessions with limited ceded property loss recoveries. HG Global/BAM The following table presents the components of pre-tax income included in White Mountains’s HG Global/BAM segment related to the consolidation of HG Global, which includes HG Re and its other wholly-owned subsidiaries, and BAM for the years ended December 31, 2014, 2013 and 2012: Year Ended December 31, 2014 Millions HG Global BAM Eliminations Total Gross written premiums $ - $ 16.2 $ - $ 16.2 Assumed (ceded) written premiums 12.3 (12.3 ) - - Net written premiums $ 12.3 $ 3.9 $ - $ 16.2 Earned insurance and reinsurance premiums $ 1.4 $ .4 $ - $ 1.8 Net investment income 1.4 5.7 - 7.1 Net investment income - BAM Surplus Notes 15.7 - (15.7 ) - Net realized and unrealized investment gains 1.7 6.6 - 8.3 Other revenue - .6 - .6 Total revenues 20.2 13.3 (15.7 ) 17.8 Insurance and reinsurance acquisition expenses .3 1.8 - 2.1 Other underwriting expenses - .4 - .4 General and administrative expenses 1.6 35.9 - 37.5 Interest expense - BAM Surplus Notes - 15.7 (15.7 ) - Total expenses 1.9 53.8 (15.7 ) 40.0 Pre-tax income (loss) $ 18.3 $ (40.5 ) $ - $ (22.2 ) Year Ended December 31, 2013 Millions HG Global BAM Eliminations Total Gross written premiums $ - $ 13.6 $ - $ 13.6 Assumed (ceded) written premiums 10.6 (10.6 ) - - Net written premiums $ 10.6 $ 3.0 $ - $ 13.6 Earned insurance and reinsurance premiums $ .4 $ .1 $ - $ .5 Net investment income 1.0 4.7 - 5.7 Net investment income - BAM Surplus Notes 40.2 - (40.2 ) - Net realized and unrealized investment losses (2.0 ) (9.3 ) - (11.3 ) Other revenue - .4 - .4 Total revenues 39.6 (4.1 ) (40.2 ) (4.7 ) Insurance and reinsurance acquisition expenses .1 1.4 - 1.5 Other underwriting expenses - .4 - .4 General and administrative expenses 1.4 32.5 - 33.9 Interest expense - BAM Surplus Notes - 40.2 (40.2 ) - Total expenses 1.5 74.5 (40.2 ) 35.8 Pre-tax income (loss) $ 38.1 $ (78.6 ) $ - $ (40.5 ) Year Ended December 31, 2012 Millions HG Global BAM Eliminations Total Gross written premiums $ - $ - $ - $ - Assumed (ceded) written premiums - - - - Net written premiums $ - $ - $ - $ - Earned insurance and reinsurance premiums $ - $ - $ - $ - Net investment income .3 1.9 - 2.2 Net investment income - BAM Surplus Notes 18.4 - (18.4 ) - Net realized and unrealized investment gains - - - - Other revenue - - - - Total revenues 18.7 1.9 (18.4 ) 2.2 Insurance and reinsurance acquisition expenses - - - - Other underwriting expenses - .2 - .2 General and administrative expenses 4.5 19.6 - 24.1 Interest expense - BAM Surplus Notes - 18.4 (18.4 ) - Total expenses 4.5 38.2 (18.4 ) 24.3 Pre-tax income (loss) $ 14.2 $ (36.3 ) $ - $ (22.1 ) HG Global/BAM Results-Year Ended December 31, 2014 versus Year Ended December 31, 2013 In 2014, BAM insured $7.8 billion of municipal bonds, $7.4 billion of which were in the primary market, up 66% from 2013. As of December 31, 2014, BAM’s total claims paying resources were approximately $581 million on total insured par of $12.4 billion. HG Global reported pre-tax income of $18 million in 2014, which was driven by $16 million of interest income on the BAM Surplus Notes, compared to $38 million in 2013, which was driven by $40 million of interest income on the BAM Surplus Notes. The decrease in interest income on the BAM Surplus Notes was due to a change in the interest rate. (See LIQUIDITY AND CAPITAL RESOURCES, HG Global/BAM, on page 77.) White Mountains reported $41 million of pre-tax losses on BAM in 2014, driven by $16 million of interest expense on the BAM Surplus Notes and $36 million of operating expenses, partially offset by $7 million of net realized and unrealized investment gains, compared to $79 million in pre-tax losses in 2013, driven by $40 million of interest expense on the BAM Surplus Notes, $33 million of operating expenses and $9 million of net realized and unrealized investment losses. BAM’s affairs are managed on a statutory accounting basis, and it does not report stand-alone GAAP financial results. BAM’s statutory net loss was $32 million for 2014, compared to $29 million for 2013. As a mutual insurance company that is owned by its members, BAM’s results do not affect White Mountains’s adjusted book value per share. However, White Mountains is required to consolidate BAM’s results in its GAAP financial statements and its results are attributed to non-controlling interests. HG Global/BAM Results-Year Ended December 31, 2013 versus Year Ended December 31, 2012 HG Global reported pre-tax income of $38 million in 2013, which was driven by $40 million of interest income on the BAM Surplus Notes, compared to $14 million in 2012, which was driven by $18 million of interest income on the BAM Surplus Notes, partially offset by startup and operational costs. White Mountains reported $79 million of pre-tax losses on BAM in 2013, driven by $40 million of interest expense on the BAM Surplus Notes and $33 million of operating expenses, compared to $36 million in pre-tax losses in 2012 that were driven by $18 million of interest expense on the BAM Surplus Notes and startup and operational costs. BAM’s results for 2013 were also impacted by $9 million of realized and unrealized investment losses resulting from an increase in interest rates. BAM’s statutory net loss was $29 million in 2013 and $18 million in 2012. The following table presents amounts from HG Global, which includes HG Re and its other wholly-owned subsidiaries, and BAM that are contained within White Mountains’s consolidated balance sheet as of December 31, 2014: As of December 31, 2014 Millions HG Global BAM Eliminations and Segment Adjustment Total Segment Assets Fixed maturity investments $ 114.4 $ 419.4 $ - $ 533.8 Short-term investments 6.6 34.8 - 41.4 Total investments 121.0 454.2 - 575.2 Cash .3 17.3 - 17.6 BAM Surplus Notes 503.0 - (503.0 ) - Accrued interest receivable on BAM Surplus Notes 74.4 - (74.4 ) - Other assets 5.7 17.0 (.5 ) 22.2 Total assets $ 704.4 $ 488.5 $ (577.9 ) $ 615.0 Liabilities BAM Surplus Notes(1) $ - $ 503.0 $ (503.0 ) $ - Accrued interest payable on BAM Surplus Notes(2) - 74.4 (74.4 ) - Preferred dividends payable to White Mountains's subsidiaries(3) 93.3 - - 93.3 Preferred dividends payable to non-controlling interests 2.9 - - 2.9 Other liabilities 24.7 33.0 (.5 ) 57.2 Total liabilities 120.9 610.4 (577.9 ) 153.4 Equity White Mountains’s common shareholders’ equity 565.5 - - 565.5 Non-controlling interests 17.9 (121.9 ) - (104.0 ) Total equity 583.4 (121.9 ) - 461.5 Total liabilities and equity $ 704.3 $ 488.5 $ (577.9 ) $ 614.9 (1) Under GAAP, the BAM Surplus Notes are classified as debt by the issuer. Under U.S. Statutory accounting, they are classified as Surplus. (2) Under GAAP, interest accrues daily on the BAM Surplus Notes. Under U.S. Statutory accounting, interest is not accrued on the BAM Surplus Notes until it has been approved for payment by insurance regulators. (3) For segment reporting, the HG Global preferred dividend receivable at White Mountains is reclassified from the Other Operations segment to the HG Global/BAM segment. Dividends on HG Global preferred shares payable to White Mountains’s subsidiaries are eliminated in White Mountains’s consolidated financial statements. The following table presents the gross par value of policies priced and closed by BAM for the years ended December 31, 2014 and 2013: Year Ended December 31, Millions Gross par value of primary market policies priced $ 7,641.1 $ 4,451.5 Gross par value of secondary market policies priced 470.9 351.0 Total gross par value of market policies priced 8,112.0 4,802.5 Less: Gross par value of policies priced yet to close (379.5 ) (97.6 ) Gross par value of policies closed that were previously priced 97.5 3.3 Total gross par value of market policies closed $ 7,830.0 $ 4,708.2 The following table presents BAM’s total claims paying resources as of December 31, 2014 and 2013: As of December 31, Millions Policyholders’ surplus $ 448.7 $ 469.0 Contingency reserve 4.7 1.1 Qualified statutory capital 453.4 470.1 Net unearned premiums 6.4 3.0 Present value of future installment premiums 1.4 - Collateral trusts 120.0 105.4 Claims paying resources $ 581.2 $ 578.5 Other Operations A summary of White Mountains’s financial results from its Other Operations segment for the years ended December 31, 2014, 2013 and 2012 follows: Year Ended December 31, Millions Earned insurance premiums $ 6.1 $ - $ - Net investment income 15.1 15.3 32.8 Net realized and unrealized investment gains 26.0 96.9 45.2 Other revenue-QuoteLab 65.3 - - Other revenue-Tranzact 43.2 - - Other revenue-Tuckerman Fund I(1) - - 24.1 Other revenue-Symetra warrants - 10.8 17.7 Other revenue 9.9 (1.7 ) (11.6 ) Total revenues 165.6 121.3 108.2 Losses and LAE 8.9 - - Insurance and reinsurance acquisition expenses .8 - - General and administrative expenses-QuoteLab 60.6 - - General and administrative expenses-Tranzact 37.4 - - General and administrative expenses-Tuckerman Fund I(1) - - 21.0 General and administrative expenses 108.4 103.2 77.8 Interest expense on debt 2.6 3.2 1.7 Total expenses 218.7 106.4 100.5 Pre-tax (loss) income $ (53.1 ) $ 14.9 $ 7.7 (1) On December 31, 2011, Tuckerman Fund I was dissolved and all of the net assets of the fund, which consisted of the LLC units of Hamer and Bri-Mar, two small manufacturing companies, were distributed. As of October 1, 2012, Hamer and Bri-Mar are no longer consolidated and are accounted for as investments in unconsolidated affiliates. Other Operations Results-Year Ended December 31, 2014 versus Year Ended December 31, 2013 White Mountains’s Other Operations segment reported pre-tax loss of $(53) million in 2014 compared to pre-tax income of $15 million in 2013. White Mountains’s Other Operations segment reported net realized and unrealized investment gains of $26 million in 2014 compared to $97 million in 2013. (See Summary of Investment Results on page 69.) The Other Operations segment reported net investment income of $15 million in both 2014 and 2013. Other revenues in 2014 included $65 million from QuoteLab and $43 million from Tranzact, which are revenues recorded since their acquisition in 2014. Other revenues in 2014 also included third-party investment management fee income at WM Advisors of $12 million, compared to $11 million in 2013. Other revenue in 2013 included $11 million of mark-to-market gains on the Symetra warrants prior to their exercise in the second quarter of 2013. (See Investment in Symetra Common Shares on page 72.) General and administrative expenses increased 100% in 2014 primarily due to expenses related to QuoteLab and Tranzact, including amortization of intangible assets, which substantially offset their revenues in pre-tax income. The increase from these new businesses was partially offset by a decrease in incentive compensation accruals in 2014. General and administrative expenses in 2013 included a $10 million reduction related to an adjustment to the fair value of variable annuity death benefit expenses at WM Life Re, which was mostly offset in other revenues by a component of the change in the fair value of WM Life Re's derivative assets and liabilities. WM Life Re reported losses of $9 million in 2014 compared to $17 million in 2013. WM Life Re’s results in 2013 included $7 million of gains associated with changes in projected surrender assumptions, partially offset by increased trading expenses. See Note 9 - “Derivatives” for details regarding WM Life Re’s total impact on White Mountains’s statement of operations. White Mountains’s Other Operations segment reported $12 million of GAAP pre-tax losses relating to SSIE in 2014, which included $2 million of unfavorable loss reserve development reported in the second quarter, as well as a $3 million goodwill impairment charge. As a reciprocal insurance exchange that is owned by its policyholders, SSIE’s results are attributed to non-controlling interests and do not affect White Mountains’s adjusted book value per share. Share repurchases. White Mountains repurchased and retired 217,879 of its common shares for $134 million in 2014 at an average price per share of $617.29, or approximately 93% of White Mountains’s December 31, 2014 adjusted book value per share. Other Operations Results-Year Ended December 31, 2013 versus Year Ended December 31, 2012 White Mountains’s Other Operations segment reported pre-tax income of $15 million in 2013 compared to pre-tax income of $8 million in 2012. White Mountains’s Other Operations segment reported net realized and unrealized investment gains of $97 million in 2013 compared to $45 million in 2012. (See Summary of Investment Results on page 69.) The Other Operations segment reported net investment income of $15 million in 2013 compared to $33 million in 2012, primarily due to a lower average invested asset base, mainly a result of White Mountains’s investment of approximately $600 million in HG Global in July 2012 and share repurchases, and a shift in the investment portfolio from fixed maturity investments towards common equity securities. The value of White Mountains’s investment in Symetra warrants prior to their exercise during the second quarter of 2013 increased $11 million in 2013 compared to an increase of $18 million in 2012. (See Investment in Symetra Common Shares on page 72.) WM Life Re reported losses of $17 million in 2013 compared to $19 million in 2012. The improvement in WM Life Re’s results was primarily due to $7 million of gains in 2013 associated with changes in projected surrender assumptions, partially offset by increased trading expenses. See Note 9 - “Derivatives” for details regarding WM Life Re’s total impact on White Mountains’s statement of operations. Share repurchases. White Mountains repurchased and retired 141,535 of its common shares for $80 million in 2013 at an average price per share of $563.91, or approximately 88% of White Mountains’s December 31, 2013 adjusted book value per share. II. Summary of Investment Results For purposes of discussing rates of return, all percentages are presented gross of management fees and trading expenses in order to produce a better comparison to benchmark returns, while all dollar amounts are presented net of any management fees and trading expenses. A summary of White Mountains’s consolidated pre-tax investment results for the years ended December 31, 2014, 2013 and 2012 follows: Pre-tax investment results Year Ended December 31, Millions Net investment income $ 105.0 $ 110.9 $ 153.6 Net realized and unrealized investment gains(1) 283.9 161.7 118.2 Change in foreign currency translation on investments recognized through other comprehensive income(2) (274.3 ) 11.3 95.5 Total GAAP pre-tax investment gains $ 114.6 $ 283.9 $ 367.3 (1) Includes foreign currency gains (losses) of $141.4, $1.0 and $(57.2). (2) Excludes non-investment related foreign currency gains (losses) that are also recognized through other comprehensive income of $105.8, $(8.6) and $(55.9). Gross investment returns and benchmarks returns Year Ended December 31, Fixed maturity investments 0.9 % 0.5 % 4.9 % Short-term investments (2.0 )% 0.1 % 0.3 % Total fixed income investment returns: In U.S. dollars 0.5 % 0.4 % 4.4 % Barclays U.S. Intermediate Aggregate Index 4.1 % (1.0 )% 3.6 % Common equity securities 7.5 % 23.2 % 9.8 % Convertible fixed maturity and preferred investments 0.3 % 7.8 % 6.0 % Other long-term investments 7.0 % 6.9 % 2.4 % Total common equity securities, convertible fixed maturity and preferred investments and other long-term investments returns: In U.S. dollars 7.1 % 18.9 % 7.7 % S&P 500 Index (total return) 13.7 % 32.4 % 16.0 % Total consolidated portfolio 1.9 % 4.1 % 4.9 % Investment Returns-Year Ended December 31, 2014 versus Year Ended December 31, 2013 White Mountains’s GAAP pre-tax total return on invested assets was 1.9% for 2014, compared to 4.1% for 2013. 2014 included 1.9% of foreign currency losses, while foreign currency translation did not meaningfully impact investment returns in 2013. Fixed income results White Mountains maintains a high-quality, short-duration fixed income portfolio. As of December 31, 2014, the fixed income portfolio duration was approximately 2.0 years, including short-term investments, compared to 2.1 years as of December 31, 2013. In local currencies, the fixed income portfolio was up 2.7% for 2014, a decent absolute result for the year but behind the longer duration Barclays U.S. Intermediate Aggregate Bond Index return of 4.1%. The portfolio’s short duration positioning contributed to the underperformance versus the benchmark as interest rates fell in 2014. Including foreign currency losses, the fixed income portfolio was up 0.5% for 2014. In local currencies, the fixed income portfolio was up 0.5% for 2013, outperforming the longer duration Barclays U.S. Intermediate Aggregate Bond Index return of -1.0%. The portfolio’s short duration positioning contributed to the outperformance versus the benchmark as interest rates rose in 2013. Including foreign currency losses, the fixed income portfolio was up 0.4% for 2013. Common equity securities, convertibles and other long-term investments results White Mountains maintains a value-oriented equity portfolio that consists of common equity securities, convertibles and other long-term investments, including hedge funds and private equity funds. White Mountains’s management believes that prudent levels of investments in common equity securities, convertibles and other long-term investments are likely to enhance long-term after-tax total returns. White Mountains’s portfolio of common equity securities, convertibles and other long-term investments represented approximately 18% of GAAP invested assets as of December 31, 2014. In local currencies, the equity portfolio was up 8.0% for 2014, a strong absolute result for the year but mixed against benchmarks, underperforming the S&P 500 return of 13.7% and outperforming the small-cap Russell 2000 return of 4.9%. Including foreign currency losses, the equity portfolio was up 7.1% for 2014. White Mountains’s portfolio of common equity securities, convertibles and other long-term investments represented approximately 20% of GAAP invested assets as of December 31, 2013. In local currencies, the equity portfolio was up 18.9% for 2013, a strong absolute result for the year but behind benchmarks. The shortfall against benchmarks was due primarily to underperformance in White Mountains’s value oriented common equity security portfolio (up 23.2% vs. the S&P 500 return of 32.4%) and the impact of convertibles in the equity portfolio (as opposed to common equity securities), which tend to lag benchmarks in strong up markets. Foreign currency translation did not meaningfully impact equity returns in 2013. White Mountains’s equity investment style is generally value-oriented. The portfolio is constructed to provide an element of downside protection; management expects the portfolio to underperform indices in strong up markets but outperform those indices in down markets. White Mountains has established separate accounts with third party registered investment advisers to manage its publicly-traded common equity securities and convertibles. The largest of these separate account relationships are with Prospector, Lateef and Silchester. Using a value orientation, Prospector invests in positions in the United States and other developed markets. Prospector’s investment strategy consists of a bottom-up fundamental value analysis with an emphasis on balance sheet strength. Prospector puts particular emphasis on (i) private market value, (ii) free cash flow yield and (iii) absolute and relative valuation. Prospector invests across the capital structure and often invests in convertibles that it believes provide better risk/return tradeoffs, given their income and redemption features. The Prospector portfolio accounted for approximately 30% of White Mountains’s common equity securities, convertibles and other long-term investments as of December 31, 2014. The Prospector portfolio returned 6.6% for 2014, lagging the S&P 500 return of 13.7%. Prospector’s underperformance relative to the S&P 500 in 2014 reflected an underweight position and underperformance in the technology and healthcare sectors. Like many managers, Prospector’s underweight position in large cap stocks also negatively impacted its performance relative to the S&P 500 in 2014. For reference, the small cap Russell 2000 Index returned 4.9% for 2014. The Prospector portfolio accounted for approximately 50% of White Mountains’s common equity securities, convertibles and other long-term investments as of December 31, 2013. The Prospector portfolio returned 23.2% for 2013, lagging the S&P 500 return of 32.4%. Prospector’s underperformance relative to the S&P 500 return in 2013 reflected an overweight position in gold mining, an underweight position in the consumer discretionary, technology and industrial sectors and the impact of convertible fixed maturity positions (as opposed to common equity securities), which tend to lag the index in strong up markets. Total annualized total returns for White Mountains’s separate accounts managed by Prospector compared to the annualized total returns of the S&P 500 Index are as follows: Periods ending December 31, 2014 Annualized returns 1-year 3-years 5-years 10-years(1) Prospector separate accounts 6.6% 12.2% 10.7% 8.0% S&P 500 Index 13.7% 20.4% 15.4% 7.7% (1) Represents the inception of the Prospector separate account in the beginning of 2005, which was established in connection with an investment management agreement between Prospector and White Mountains whereby Prospector serves as a discretionary adviser with respect to specified assets, primarily equity securities. The Lateef separate account is a highly concentrated portfolio of high quality mid- and large-cap growth companies. Lateef is a growth at a reasonable price manager focused on investing in high return on invested capital businesses at reasonable valuations. Lateef uses a bottom up, fundamental research-driven investment process that is focused on absolute returns, low turnover and a long-term investment horizon. As a highly concentrated portfolio of 15 to 20 positions, relative performance to the S&P 500 is often driven, positively or negatively, by individual positions, especially in the short-term. The Lateef separate account returned 6.5% for 2014, lagging the S&P 500 return of 13.7%. The Lateef separate account returned 30.5% for 2013, compared to the S&P 500 return of 32.4%. White Mountains has an investment in the Calleva Trust, an open-ended unit trust established as an Undertaking for Collective Investment in Transferable Securities (“UCITS”) under the European Communities Regulations and is managed by Silchester. Silchester invests primarily in value-oriented non-U.S. equity securities. Silchester’s investment strategy focuses on companies with low market multiples of earnings, cash flow, asset value or dividends. In local currencies, the Silchester portfolio returned 8.6% for 2014 and 32.6% for 2013. White Mountains also maintains a portfolio of other long-term investments that consists of private equity partnerships, hedge funds, certain unconsolidated insurance service businesses and surplus note investments. Approximately 60% of these long-term investments as of December 31, 2014 are in private equity funds, with a general emphasis on narrow, sector-focused funds and hedge funds, with a general emphasis on long-short equity funds. White Mountains’s other long-term investments returned 7.0% for 2014, outperforming the HFRX Equal Weighted Strategies Index return of -0.5%. White Mountains’s other long-term investments returned 6.9% for 2013, which outperformed the HFRX Equal Weighted Strategies Index return of 6.3%. Investment Returns-Year Ended December 31, 2013 versus Year Ended December 31, 2012 White Mountains’s GAAP pre-tax total return on invested assets was 4.1% for 2013 compared to 4.9% for 2012. Foreign currency translation did not meaningfully impact investment returns in 2013, while 2012 included 0.5% of foreign currency gains. Fixed income results White Mountains maintains a high-quality, short-duration fixed income portfolio. As of December 31, 2013, the fixed income portfolio duration was approximately 2.1 years, including short-term investments, compared to 2.4 years as of December 31, 2012. In local currencies, the fixed income portfolio was up 0.5% for 2013, outperforming the longer duration Barclays U.S. Intermediate Aggregate Bond Index return of -1.0%. The portfolio’s short duration positioning contributed to the outperformance versus the benchmark as interest rates rose in 2013. Including foreign currency losses, the fixed income portfolio was up 0.4% for 2013. In local currencies, the fixed income portfolio was up 3.8% for 2012, compared to the Barclays U.S. Intermediate Aggregate Bond Index return of 3.6%. Including foreign currency gains, the fixed income portfolio was up 4.4% for 2012. Common equity securities, convertibles and other long-term investments results White Mountains’s portfolio of common equity securities, convertibles and other long-term investments represented approximately 20% of GAAP invested assets as of December 31, 2013. In local currencies, the equity portfolio was up 18.9% for 2013, a strong absolute result for the year but behind benchmarks. The shortfall against benchmarks was due primarily to underperformance in White Mountains’s value oriented common equity security portfolio (up 23.2% vs. the S&P 500 return of 32.4%) and the impact of convertible fixed maturity investments in the equity portfolio (as opposed to common equity securities), which tend to lag benchmarks in strong up markets. Foreign currency translation did not meaningfully impact equity returns in 2013. White Mountains’s portfolio of common equity securities, convertibles and other long-term investments represented approximately 20% of GAAP invested assets as of December 31, 2012. In local currencies, the equity portfolio was up 7.8% in 2012, underperforming the S&P 500 return of 16.0%. Foreign currency translation did not meaningfully impact equity returns in 2012. The Prospector portfolio returned 23.2% for 2013 and 7.7% for 2012, lagging the S&P 500 return of 32.4% and 16.0%, respectively, in both periods. Prospector’s underperformance relative to the S&P 500 returns for both periods reflected an overweight position in gold mining, an underweight position in the consumer discretionary, technology and industrial sectors and the impact of convertible fixed maturity investments (as opposed to common equity securities), which tend to lag benchmarks in strong up markets. The Lateef separate account, which consists of a highly concentrated portfolio where relative performance is often influenced by one or two positions, returned 32.6% for 2013 compared to the S&P 500 return of 32.4%. Lateef’s performance in 2013 reflects specific positions in the industrial, technology and consumer discretionary sectors. The Lateef separate account, which was established on May 11, 2012, returned 7.0% for 2012, outperforming the S&P 500 return of 6.6%. In local currencies, the Silchester portfolio, which invests primarily in value-oriented non-U.S. equity securities, returned 32.6% for 2013, compared to the S&P 500 return of 32.4%. In local currencies, the Silchester portfolio returned 15.9% for 2012 compared to the S&P 500 return of 16.0%. White Mountains’s other long-term investments returned 6.9% for 2013, which outperformed the HFRX Equal Weighted Strategies Index return of 6.3% for 2013. White Mountains’s other long-term investments returned 2.4% for 2012, which was essentially in line with the HFRX Equal Weighted Strategies Index return of 2.5%. Investment in Symetra Common Shares During 2014, 2013 and 2012, White Mountains recorded $44 million, $35 million and $30 million in after-tax equity in earnings from its investment in Symetra’s common shares. The table below illustrates (1) the per-Symetra common share value used in the calculation of White Mountains’s adjusted book value per share, (2) Symetra’s quoted stock price and (3) Symetra’s book value per common share excluding unrealized gains and losses from its fixed maturity portfolio: As of December 31, Value per Symetra Common Share Value of the investment in Symetra’s common shares used in the calculation of White Mountains’s adjusted book value per share $18.65 $18.00 $16.58 Symetra’s quoted stock price $23.05 $18.96 $12.98 Symetra’s book value per common share excluding unrealized gains and losses from its fixed maturity portfolio $20.47 $19.95 $18.97 During the second quarter of 2013, White Mountains executed a cashless exercise of its Symetra warrants. The warrants were marked up to their fair value of $41 million at the date of exercise, June 20, 2013, resulting in a $15 million realized gain reported in the second quarter of 2013. The cashless exercise resulted in the net issuance of 2,648,879 additional common shares of Symetra in exchange for the warrants to purchase 9,487,872 Symetra common shares. Portfolio Composition The following table presents the composition of White Mountains’s investment portfolio as of December 31, 2014 and 2013: As of December 31, 2014 As of December 31, 2013 $ in millions Carrying value % of total Carrying value (1) % of total Fixed maturity investments $ 4,784.3 69.5 % $ 5,266.8 71.0 % Short-term investments 871.7 12.7 635.9 9.0 Common equity securities 801.6 11.6 1,156.8 16.0 Convertible fixed maturity and preferred investments 20.5 0.3 80.5 1.0 Other long-term investments 408.2 5.9 288.9 3.0 Total investments $ 6,886.3 % $ 7,428.9 % (1) Carrying value includes $236.3 as of December 31, 2013 that is classified as assets held for sale relating to discontinued operations. The breakdown of White Mountains’s fixed maturity and convertibles as of December 31, 2014 by credit class, based upon issue credit ratings provided by Standard & Poor’s, or if unrated by Standard & Poor’s, long term obligation ratings provided by Moody’s, is as follows: As of December 31, 2014 $ in millions Amortized cost % of total Carrying Value % of total U.S. government and government-sponsored entities(1) $ 679.7 14.5 % $ 685.5 14.3 % AAA/Aaa 690.6 14.8 704.0 14.7 AA/Aa 766.5 16.4 778.4 16.2 A/A 1,148.1 24.6 1,183.3 24.6 BBB/Baa 1,177.5 25.2 1,235.9 25.7 Other/not rated 210.0 4.5 217.7 4.5 Total fixed maturity investments and convertible fixed maturity and preferred investments $ 4,672.4 % $ 4,804.8 % (1) Includes mortgage-backed securities which carry the full faith and credit guaranty of the U.S. government (i.e., GNMA) or are guaranteed by a government sponsored entity (i.e., FNMA, FHLMC). The cost or amortized cost and carrying value of White Mountains’s fixed maturity investments and convertible fixed maturity investments as of December 31, 2014 is presented below by contractual maturity. Actual maturities could differ from contractual maturities because certain borrowers may call or prepay their obligations with or without call or prepayment penalties. As of December 31, 2014 Millions Amortized cost Carrying Value Due in one year or less $ 331.2 $ 337.5 Due after one year through five years 1,968.3 2,032.3 Due after five years through ten years 434.4 453.9 Due after ten years 40.2 46.1 Mortgage-backed and asset-backed securities 1,811.1 1,840.9 Preferred stocks 79.6 85.8 Total fixed maturity and convertible fixed maturity investments $ 4,664.8 $ 4,796.5 Foreign Currency Translation White Mountains’s non-U.S. dollar-denominated assets and liabilities are valued using period-end exchange rates, and its non-U.S. dollar-denominated foreign revenues and expenses are valued using average exchange rates over the period. Foreign currency exchange rate risk is the risk that White Mountains will incur losses on a U.S. dollar basis due to adverse changes in foreign currency exchange rates. As of December 31, 2014, the following currencies represented the largest exposure to foreign currency risk as a percent of White Mountains’s common shareholders’ equity; the Swedish krona (6.2%), the British pound sterling (4.1%), the euro (1.2%) and the Canadian dollar (1.2%). See “Foreign Currency Exchange Risk” on page 112. A summary of the impact of foreign currency translation on White Mountains’s consolidated financial results for the years ended December 31, 2014, 2013 and 2012 follows: Year Ended December 31, Millions Net realized investment gains (losses) - foreign currency(1) $ 25.1 $ (17.3 ) $ (8.6 ) Net unrealized investment gains (losses) - foreign currency(1) 116.3 18.3 (48.6 ) Net realized and unrealized investment gains (losses) - foreign currency(1) 141.4 1.0 (57.2 ) Other revenue - foreign currency translation (losses) gains (56.5 ) (1.0 ) 39.9 Income tax expense (3.6 ) (2.4 ) (3.1 ) Total foreign currency translation gains (losses) recognized through net income, after tax 81.3 (2.4 ) (20.4 ) Change in foreign currency translation on investments recognized through other comprehensive income, after tax (274.3 ) 11.3 95.5 Change in foreign currency translation on non-investment net liabilities recognized through other comprehensive income, after tax 105.8 (8.6 ) (55.9 ) Total foreign currency translation (losses) gains recognized through other comprehensive income, after tax (168.5 ) 2.7 39.6 Total foreign currency (losses) gains recognized through comprehensive income, after tax $ (87.2 ) $ .3 $ 19.2 (1) Component of net realized and unrealized investments gains on the income statement. Portfolio Composition by Currency The following table provides detail of White Mountains’s total investment portfolio denominated in various currencies and their corresponding U.S. dollar carrying values, as converted using spot exchange rates as of December 31, 2014 and 2013: Carrying Value at Carrying Value at December 31, 2014 December 31, 2013 Millions Local Currency USD Local Currency USD(1) U.S. Dollar 5,950.2 $ 5,950.2 6,315.4 $ 6,315.4 Swedish Krona 2,664.0 342.7 3,151.3 489.8 Euro 181.6 220.2 191.4 263.7 British Pound Sterling 117.5 182.8 69.6 115.1 Canadian Dollar 73.3 63.2 74.1 69.7 Other - 127.2 - 175.2 Total Investments $ 6,886.3 $ 7,428.9 (1) Carrying value includes $236.3 that is classified as assets held for sale relating to discontinued operations. As of December 31, 2014, White Mountains’s investment portfolio included approximately $0.9 billion in non-U.S. dollar-denominated investments, most of which are held at Sirius International and are denominated in Swedish krona, British pound sterling or euro. The value of the investments in this portfolio is impacted by changes in the exchange rate between the U.S. dollar and those currencies. During 2014, the U.S. dollar strengthened 21% against the Swedish krona, 6% against the British pound sterling and 14% against the euro. These foreign currency movements resulted in approximately $133 million of foreign currency investment losses for the year ended December 31, 2014, which are recorded as components of net realized and unrealized investment gains (recognized in pre-tax income) and change in foreign currency translation on investments (recognized in other comprehensive income). During 2013, the U.S. dollar weakened 1% against the Swedish krona, 2% against the British pound sterling and 4% against the euro, which resulted in $12 million of foreign currency investment gains for the year. During 2012, the U.S. dollar weakened 6% against the Swedish krona, 5% against the British pound sterling and 2% against the euro, which resulted in $38 million of foreign currency investment gains for the year. Sirius International holds a large portfolio of investments that are denominated in U.S. dollars, but its functional currency is the Swedish krona. When Sirius International prepares its stand-alone GAAP financial statements, it translates its U.S. dollar-denominated investments to Swedish krona and recognizes the related foreign currency translation gains or losses through pre-tax income. When White Mountains consolidates Sirius International, it translates Sirius International’s stand-alone GAAP financial statements to U.S. dollars and recognizes the foreign currency gains or losses arising from this translation, including those associated with Sirius International’s U.S. dollar-denominated investments, through other comprehensive income. Since White Mountains reports its financial statements in U.S. dollars, there is no net effect to adjusted book value per share or to investment returns from foreign currency translation on its U.S. dollar-denominated investments at Sirius International. However, net realized and unrealized investment gains, other revenues and other comprehensive income can be significantly affected during periods of high volatility in the foreign exchange rate between the U.S. dollar and other currencies, especially the Swedish krona. The amount of foreign currency translation on Sirius International’s U.S. dollar denominated investments recognized as a decrease of other comprehensive income and an increase of net income was $116 million in 2014. The amount of foreign currency translation on Sirius International’s U.S. dollar denominated investments recognized as an increase of other comprehensive income and a decrease of net income was $10 million in 2013. The amount of foreign currency translation on Sirius International’s U.S. dollar denominated investments recognized as an increase of other comprehensive income and a decrease of net income was $40 million in 2012. LIQUIDITY AND CAPITAL RESOURCES Operating Cash and Short-term Investments Holding company level. The primary sources of cash for the Company and certain of its intermediate holding companies are expected to be distributions and tax sharing payments received from its insurance and reinsurance operating subsidiaries, capital raising activities, net investment income, proceeds from sales and maturities of investments and, from time to time, proceeds from the sales of operating subsidiaries. The primary uses of cash are expected to be repurchases of the Company’s common shares, payments on and repurchases/retirements of its debt obligations, dividend payments to holders of the Company’s common shares, to non-controlling interest holders of OneBeacon Ltd.’s common shares and to holders of the SIG Preference Shares, purchases of investments, payments to tax authorities, contributions to operating subsidiaries, operating expenses and, from time to time, purchases of operating subsidiaries. Operating subsidiary level. The primary sources of cash for White Mountains’s insurance and reinsurance operating subsidiaries are expected to be premium collections, net investment income, proceeds from sales and maturities of investments, contributions from holding companies, capital raising activities and, from time to time, proceeds from the sales of operating subsidiaries. The primary uses of cash are expected to be claim payments, policy acquisition costs, purchases of investments, payments on and repurchases/retirements of its debt obligations, distributions and tax sharing payments made to holding companies, distributions to non-controlling interest holders, operating expenses and, from time to time, purchases of operating subsidiaries. Both internal and external forces influence White Mountains’s financial condition, results of operations and cash flows. Claim settlements, premium levels and investment returns may be impacted by changing rates of inflation and other economic conditions. In many cases, significant periods of time, sometimes several years or more, may lapse between the occurrence of an insured loss, the reporting of the loss to White Mountains and the settlement of the liability for that loss. The exact timing of the payment of claims and benefits cannot be predicted with certainty. White Mountains’s insurance and reinsurance operating subsidiaries maintain portfolios of invested assets with varying maturities and a substantial amount of cash and short-term investments to provide adequate liquidity for the payment of claims. Management believes that White Mountains’s cash balances, cash flows from operations, routine sales and maturities of investments and the liquidity provided by the WTM Bank Facility are adequate to meet expected cash requirements for the foreseeable future on both a holding company and insurance and reinsurance operating subsidiary level. Dividend Capacity Under the insurance laws of the states and jurisdictions that White Mountains’s insurance and reinsurance operating subsidiaries are domiciled, an insurer is restricted with respect to the timing and the amount of dividends it may pay without prior approval by regulatory authorities. Accordingly, there can be no assurance regarding the amount of such dividends that may be paid by such subsidiaries in the future. Following is a description of the dividend capacity of White Mountains’s insurance and reinsurance operating subsidiaries: OneBeacon: On December 23, 2014, OBIC distributed Atlantic Specialty Insurance Company (“ASIC”) to its immediate parent at a value of $701 million as part of the Runoff Transaction. OBIC also distributed $151 million of cash and investments to its immediate parent in accordance with the prescribed minimum capital to be included in the company at the time of its sale to Armour, as approved by the PID. ASIC is now OneBeacon’s top-tier regulated U.S. insurance operating subsidiary and has the ability to pay dividends to its immediate parent during any twelve-month period without the prior approval of regulatory authorities in an amount set by formula based on the lesser of net investment income, as defined by statute, or 10% of statutory surplus, in both cases as most recently reported to regulatory authorities, subject to the availability of earned surplus and subject to dividends paid in prior periods. Based upon the formula above, ASIC has the ability to pay $45 million of dividends during 2015 without prior approval of regulatory authorities. As of December 31, 2014, ASIC had $722 million of statutory surplus and $88 million of earned surplus. During 2014, ASIC did not pay any dividends to its immediate parent. Also in 2014, OneBeacon contributed $67 million to ASIC. Split Rock has the ability to declare or pay dividends or make capital distributions during any 12-month period without the prior approval of Bermuda regulatory authorities on the condition that any such declaration or payment of dividends or capital distributions does not cause a breach of any of its regulatory solvency and liquidity requirements. During 2015, Split Rock has the ability to make capital distributions without the prior approval of regulatory authorities, subject to meeting all appropriate liquidity and solvency requirements, of $19 million, which is equal to 15% of its December 31, 2014 statutory capital (excluding earned surplus). During 2014, Split Rock paid $10 million of dividends and $10 million of capital distributions to its immediate parent. During 2014, OneBeacon’s unregulated insurance operating subsidiaries paid $5 million of dividends to their immediate parent. As of December 31, 2014, OneBeacon’s unregulated insurance operating subsidiaries had $78 million of net unrestricted cash, short-term investments, and fixed maturity investments. As of December 31, 2014, OneBeacon’s unregulated insurance operating subsidiaries also had $101 million in par value of OBIC Surplus Notes, with a carrying value of $65 million classified as other long-term investments. During 2014, OneBeacon Ltd. paid $80 million of regular quarterly dividends to its common shareholders. White Mountains received $60 million of these dividends. As of December 31, 2014, OneBeacon Ltd. and its intermediate holding companies had $107 million of net unrestricted cash, short-term investments and fixed maturity investments and $89 million of common equity securities, convertibles and other long-term investments outside of its regulated and unregulated insurance operating subsidiaries. Sirius Group: In 2014, Sirius Group established Sirius Bermuda as a class 3A licensed Bermuda insurer. Sirius Bermuda, which owns Sirius International, has the ability to declare or pay dividends or make capital distributions during any 12-month period without the prior approval of Bermuda regulatory authorities on the condition that any such declaration or payment of dividends or capital distributions does not cause a breach of any of its regulatory solvency and liquidity requirements. During 2015, Sirius Bermuda has the ability, subject to meeting all appropriate liquidity and solvency requirements, to make dividend or capital distributions without the prior approval of regulatory authorities, subject to meeting all appropriate liquidity and solvency requirements, of $350 million, which is equal to 15% of its December 31, 2014 statutory capital, excluding earned surplus. The amount of dividends available to be paid by Sirius Bermuda in any given year is also subject to cash flow and earnings generated by Sirius International’s business, as well as to dividends received from its subsidiaries, including Sirius International. Sirius International has the ability to pay dividends to Sirius Bermuda subject to the availability of unrestricted equity, calculated in accordance with the Swedish Act on Annual Accounts in Insurance Companies and the Swedish Supervisor Authorities (“Swedish FSA”). Unrestricted equity is calculated on a consolidated group account basis and on a parent account basis. Differences between the two include but are not limited to accounting for goodwill, subsidiaries (with parent accounts stated at original foreign exchange rates), taxes and pensions. Sirius International’s ability to pay dividends is limited to the “lower of” unrestricted equity as calculated within the group and parent accounts. As of December 31, 2014, Sirius International had $467 million (based on the December 31, 2014 SEK to USD exchange rate) of unrestricted equity on a parent account basis (the lower of the two) available to pay dividends in 2015. The amount of dividends available to be paid by Sirius International in any given year is also subject to cash flow and earnings generated by Sirius International’s business, as well as to dividends received from its subsidiaries, including Sirius America. Earnings generated by Sirius International’s business that are allocated to the Safety Reserve are not available to pay dividends (see “Safety Reserve” on the next page). During 2014, Sirius International distributed $221 million of dividends to its immediate parent. Subject to certain limitations under Swedish law, Sirius International is permitted to transfer certain portions of its pre-tax income to its Swedish parent companies to minimize taxes (referred to as a group contribution). On January 1, 2013, new tax legislation became effective in Sweden that limits the deductibility of interest paid on certain intra-group debt instruments. Uncertainty exists with respect to the interpretation of the legislation on existing intra-group debt instruments within the Sirius Group structure. In 2014 Sirius International did not transfer any of its 2013 pre-tax income to its Swedish parent companies. Sirius America has the ability to pay dividends to Sirius International during any twelve-month period without the prior approval of regulatory authorities in an amount set by formula based on the lesser of net investment income, as defined by statute, or 10% of statutory surplus, in both cases as most recently reported to regulatory authorities, subject to the availability of earned surplus and subject to dividends paid in prior periods. Based upon the formula above, Sirius America does not have the ability to pay dividends during 2015 without prior approval of regulatory authorities. As of December 31, 2014, Sirius America had $621 million of statutory surplus and $82 million of earned surplus. During 2014, Sirius America did not pay any dividends to its immediate parent. As of December 31, 2014, Sirius Group and its intermediate holding companies had $20 million of net unrestricted cash, short-term investments and fixed maturity investments outside of its regulated and unregulated insurance and reinsurance operating subsidiaries. During 2014, Sirius Group distributed $50 million to its immediate parent. Capital Maintenance There is a capital maintenance agreement between Sirius International and Sirius America which obligates Sirius International to make contributions to Sirius America’s surplus in order for Sirius America to maintain surplus equal to at least 125% of the company action level risk based capital as defined in the NAIC Property/Casualty Risk-Based Capital Report. The agreement provides for a maximum contribution to Sirius America of $200 million. Sirius International also provides Sirius America with accident year stop loss reinsurance, which protects Sirius America’s accident year loss and allocated loss adjustment expense ratio in excess of 70%, with a limit of $90 million. This stop loss contract was in effect for all of 2014 and has been renewed for all of 2015 with the same terms. Safety Reserve Subject to certain limitations under Swedish law, Sirius International is permitted to transfer pre-tax income amounts into an untaxed reserve referred to as a safety reserve. As of December 31, 2014, Sirius International’s safety reserve amounted to SEK 10.4 billion, or $1.3 billion (based on the December 31, 2014 SEK to USD exchange rate). Under GAAP, an amount equal to the safety reserve, net of a related deferred tax liability established at the Swedish tax rate of 22.0%, is classified as shareholder’s equity. Generally, this deferred tax liability is only required to be paid by Sirius International if it fails to maintain prescribed levels of premium writings and loss reserves in future years. As a result of the indefinite deferral of these taxes, Swedish regulatory authorities apply no taxes to the safety reserve when calculating solvency capital under Swedish insurance regulations. Accordingly, under local statutory requirements, an amount equal to the deferred tax liability on Sirius International’s safety reserve ($296 million as of December 31, 2014) is included in solvency capital. Access to the safety reserve is restricted to coverage of insurance or reinsurance underwriting losses. Access for any other purpose requires the approval of Swedish regulatory authorities. Similar to the approach taken by Swedish regulatory authorities, most major rating agencies generally include the $1.3 billion balance of the safety reserve, without any provision for deferred taxes, in Sirius International’s regulatory capital when assessing Sirius International’s financial strength. Stand By Letter of Credit Facilities On November 25, 2014, Sirius International entered into two stand by letter of credit facility agreements totaling $200 million to provide capital support for its Lloyds Syndicate 1945. One letter of credit is a $125 million facility from Nordea Bank Finland plc (“the Nordea facility”), $100 million of which is issued on an unsecured basis. The second letter of credit is a $75 million facility with Lloyds Bank plc (“the Lloyds Bank facility”), $25 million of which is issued on an unsecured basis. The Nordea facility and the Lloyds Bank facility are renewable annually. The unsecured portions of the Nordea and Lloyds Bank facilities are subject to various affirmative, negative and financial covenants that White Mountains considers to be customary for such borrowings, including certain minimum net worth and maximum debt to capitalization standards. An uncured breach of these covenants could result in an event of default under the Nordea and the Lloyds Bank facilities, which would allow providers to demand cash collateralization of the unsecured LOCs and/or cancel and return the issued LOCs. In addition, a failure by Sirius International or its subsidiaries to pay principal and interest on a credit facility, mortgage or similar debt agreement (collectively “covered debt”), where such failure results in the acceleration of at least $75 million principal amount of covered debt, could trigger cash collateralization of the unsecured portions of the Nordea and the Lloyds Bank facilities and/or cancellation and return of the issued LOCs. As of December 31, 2014, Sirius International and SIG were in compliance with all of the covenants under the Nordea and the Lloyds Bank facilities and anticipate they will continue to remain in compliance with these covenants for the foreseeable future. Sirius International has other secured letter of credit and trust arrangements with various financial institutions to support its insurance operations. HG Global/BAM: As of December 31, 2014, HG Global had $613 million face value of preferred shares outstanding, of which White Mountains owned 96.9%. Holders of the HG Global preferred shares receive cumulative dividends at a fixed annual rate of 6.0% on a quarterly basis, when and if declared by HG Global. HG Global did not declare or pay any preferred dividends in 2014 or 2013. As of December 31, 2014, HG Global has accrued $96 million of dividends payable to holders of its preferred shares, $93 million of which is payable to White Mountains and eliminated in consolidation. HG Re is a Special Purpose Insurer subject to regulation and supervision by the BMA, but does not require regulatory approval to pay dividends. However, HG Re’s dividend capacity is limited by amounts held in the collateral trusts pursuant to the FLRT with BAM. As of December 31, 2014, HG Re had statutory capital of $445 million, of which $403 million was held as collateral in the Supplemental Trust pursuant to the FLRT with BAM and $44 million relates to accrued interest on the BAM Surplus Notes held by HG Re. Effective January 1, 2014, HG Global and BAM agreed to change the interest rate on the BAM Surplus Notes for the five years ending December 31, 2018 from a fixed rate of 8.0% to a variable rate equal to the one-year U.S. treasury rate plus 300 basis points, set annually, which was 3.13% for 2014 and is 3.15% for 2015. Prior to the end of 2018, BAM has the option to extend the variable rate period for an additional three years. At the end of the variable rate period, the interest rate will be fixed at the higher of the then current variable rate or 8.0%. BAM is required to seek regulatory approval to pay interest and principal on its surplus notes only when adequate capital resources have accumulated beyond BAM’s initial capitalization and a level that continues to support its outstanding obligations, business plan and ratings. Other Operations: During 2014, White Mountains contributed $15 million to WM Advisors. During 2014, WM Advisors did not pay any dividends to its immediate parent. As of December 31, 2014, WM Advisors held $26 million of net unrestricted cash, short-term investments and fixed maturity investments. As of December 31, 2014, the Company and its intermediate holding companies had $275 million of net unrestricted cash, short-term investments and fixed maturity investments, $173 million of common equity securities and convertibles and $106 million of other long-term investments included in its Other Operations segment. During 2014, White Mountains paid a $6 million common share dividend. WM Life Re Keep-Well Agreement Sirius Group initially fronted the reinsurance contracts covering guaranteed living and death benefits of Japanese variable annuity contracts for, and was 100% reinsured by, WM Life Re. In October 2013, White Mountains and Tokio Marine completed a novation whereby Sirius Group’s obligations on the reinsurance contracts were transferred to WM Life Re. As a result, Sirius Group no longer has any obligation or liability relating to these agreements. In connection with this novation agreement, White Mountains and Life Re Bermuda entered into a keep-well agreement, which obligates White Mountains to make capital contributions to Life Re Bermuda in the event that Life Re Bermuda’s shareholder’s equity falls below $75 million, provided however that in no event shall the amount of all capital contributions made by White Mountains under this agreement exceed $127 million. As of December 31, 2014, Life Re Bermuda had $76 million of shareholder’s equity and White Mountains’s maximum capital commitment under the keep-well agreement was $118 million. WM Life Re is in runoff and all of its contracts will mature by June 30, 2016. In addition, from time to time WM Life Re borrows funds under an internal revolving credit facility with an intermediate holding company of White Mountains. $23 million was outstanding under this facility as of December 31, 2014. The summary balance sheet below presents Life Re Bermuda’s net assets as of December 31, 2014 reported to Tokio Marine as required under the terms of the novation agreement: December 31, Millions Cash and short-term investments $ 41.7 Direct obligations of the government of Japan 9.5 Reinsurance premium receivable 1.1 Settlements due from brokers and dealers - Derivative instruments 56.4 Total assets 108.7 Variable annuity liabilities (.8 ) Counterparty collateral held 9.9 Intercompany line of credit outstanding 23.0 Accounts payable and accrued expenses .6 Total liabilities 32.7 Total shareholder’s equity $ 76.0 Insurance Float Insurance float is an important aspect of White Mountains’s insurance operations. Insurance float represents funds that an insurance or reinsurance company holds for a limited time. In an insurance or reinsurance operation, float arises because premiums are collected before losses are paid. This interval can extend over many years. During that time, the insurer or reinsurer invests the funds. When the premiums that an insurer or reinsurer collects do not cover the losses and expenses it eventually must pay, the result is an underwriting loss, which can be considered as the cost of insurance float. One manner in which White Mountains calculates its insurance float is by taking its insurance liabilities and subtracting its insurance assets. In prior periods, White Mountains had calculated its insurance float by taking its net investment assets and subtracting its total adjusted capital. With the acquisitions of Tranzact, QuoteLab and Wobi in 2014, the previous presentation had become less meaningful. The current presentation simplifies the insurance float calculation by including only insurance assets and liabilities, which is also more consistent with traditional insurance float presentations. Although insurance float can be calculated using numbers determined under GAAP, insurance float is not a GAAP concept and, therefore, there is no comparable GAAP measure. Insurance float can increase in a number of ways, including through acquisitions of insurance and reinsurance operations, organic growth in existing insurance and reinsurance operations and recognition of losses that do not immediately cause a corresponding reduction in investment assets. Conversely, insurance float can decrease in a number of other ways, including sales of insurance and reinsurance operations, shrinking or runoff of existing insurance and reinsurance operations, the acquisition of operations that do not have substantial investment assets (e.g., an agency) and the recognition of gains that do not cause a corresponding increase in investment assets. It is White Mountains’s intention to generate low-cost float over time through a combination of acquisitions and organic growth in its existing insurance and reinsurance operations. However, White Mountains seeks to increase overall profits sometimes by reducing insurance float, such as in the Runoff Transaction. Certain operational leverage metrics can be measured with ratios that are calculated using insurance float. There are many activities that do not change the amount of insurance float at an insurance or reinsurance company but can have a significant impact on the company’s operational leverage metrics. For example, investment gains and losses, foreign currency gains and losses, debt issuances and repurchases/repayments, common and preferred share issuances and repurchases and dividends paid to shareholders are all activities that do not change insurance float but that can meaningfully impact operational leverage metrics that are calculated using insurance float. The following table illustrates White Mountains’s consolidated insurance float position as of December 31, 2014 and 2013: December 31, ($ in millions) Loss and LAE reserves $ 3,159.8 $ 3,079.3 Unearned insurance and reinsurance premiums 955.3 901.4 Ceded reinsurance payable 105.7 71.9 Funds held under insurance and reinsurance contracts 138.9 127.1 Deferred tax on safety reserve (1) 295.7 357.2 Insurance liabilities 4,655.4 4,536.9 Cash in regulated insurance and reinsurance subsidiaries $ 120.0 $ 194.0 Reinsurance recoverable on paid and unpaid losses 507.5 453.5 Insurance and reinsurance premiums receivable 547.7 518.9 Funds held by ceding entities 129.0 106.3 Deferred acquisition costs 177.1 174.7 Ceded unearned insurance and reinsurance premiums 94.0 92.4 Insurance assets 1,575.3 1,539.8 Insurance float $ 3,080.1 $ 2,997.1 Insurance float as a multiple of total adjusted capital 0.6x 0.6x Insurance float as a multiple of White Mountains’s common shareholders’ equity 0.8x 0.8x (1) While classified as a liability for GAAP purposes, as a result of the indefinite deferral of these taxes, Swedish regulatory authorities apply no taxes to the safety reserve when calculating solvency capital under Swedish insurance regulations. Accordingly, under local statutory requirements, an amount equal to the deferred tax liability on Sirius International’s safety reserve is included in solvency capital (see “Safety Reserve” on page 77). During 2014, insurance float increased by $83 million, primarily due to growth in OneBeacon’s specialty business, partially offset by the continued runoff of Sirius Group’s casualty business and payments of losses incurred in 2010, 2011 and 2012 related to major catastrophes, primarily from hurricane Sandy and earthquakes in Chile, Japan and New Zealand. These catastrophe losses increased White Mountains’s insurance float when they were first recorded, which is now reversing and decreasing insurance float as the catastrophe losses are paid or reserves reduced. Financing The following table summarizes White Mountains’s capital structure as of December 31, 2014 and 2013: December 31, ($ in millions) OBH Senior Notes, carrying value $ 274.7 $ 274.7 SIG Senior Notes, carrying value 399.7 399.6 WTM Bank Facility - - Tranzact Bank Facility, carrying value 67.4 - Other debt 4.8 2.1 Total debt 746.6 676.4 Total White Mountains’s common shareholders’ equity 3,996.6 3,905.5 Non-controlling interest - OneBeacon Ltd. 258.7 273.7 Non-controlling interest - SIG Preference Shares 250.0 250.0 Non-controlling interests - other, excluding reciprocals 168.6 65.8 Total capital(1) 5,420.5 5,171.4 Equity in net unrealized (gains) losses from Symetra’s fixed maturity portfolio, net of applicable taxes (34.9 ) 40.4 Total adjusted capital $ 5,385.6 $ 5,211.8 Total debt to total adjusted capital % % Total debt and SIG Preference Shares to total adjusted capital % % (1) The non-controlling interests in reciprocals are not included in total capital. See Note 14 - “Common Shareholders’ Equity and Non-controlling Interests” for further breakdown of non-controlling interests. Management believes that White Mountains has the flexibility and capacity to obtain funds externally as needed through debt or equity financing on both a short-term and long-term basis. However, White Mountains can provide no assurance that, if needed, it would be able to obtain additional debt or equity financing on satisfactory terms, if at all. On August 14, 2013, White Mountains entered into an unsecured revolving credit facility with a syndicate of lenders administered by Wells Fargo Bank, N.A., which has a total commitment of $425 million and a maturity date of August 14, 2018 (the “WTM Bank Facility”). As of December 31, 2014, the WTM Bank Facility was undrawn. The WTM Bank Facility contains various affirmative, negative and financial covenants that White Mountains considers to be customary for such borrowings, including certain minimum net worth and maximum debt to capitalization standards. These covenants can restrict White Mountains in several ways, including its ability to incur additional indebtedness. An uncured breach of these covenants could result in an event of default under the WTM Bank Facility, which would allow lenders to declare any amounts owed under the WTM Bank Facility to be immediately due and payable. In addition, a default under the WTM Bank Facility could occur if certain of White Mountains’s subsidiaries fail to pay principal and interest on “covered debt”, or fail to otherwise comply with obligations in such covered debt agreements where such a default gives the holder of the covered debt the right to accelerate at least $75 million of the principal amount of covered debt. As of December 31, 2014, White Mountains was in compliance with all of the covenants under the WTM Bank Facility and anticipates it will continue to remain in compliance with these covenants for the foreseeable future. It is possible that, in the future, one or more of the rating agencies may lower White Mountains’s existing ratings. If one or more of its ratings were lowered, White Mountains could incur higher borrowing costs on future borrowings and its ability to access the capital markets could be impacted. On October 10, 2014, Tranzact entered into a secured credit facility with a syndicate of lenders administered by The PrivateBank and Trust Company (the “Tranzact Bank Facility”). The Tranzact Bank Facility consists of a $70 million term loan facility, which was fully drawn at closing and had an outstanding balance of $69 million as of December 31, 2014, and a revolving credit facility for an additional $4.5 million, which was undrawn as of December 31, 2014. The Tranzact Bank Facility is secured by intellectual property and the common stock of Tranzact and its subsidiaries. The Tranzact Bank Facility carries a variable interest rate, based on the U.S. dollar LIBOR rate. Tranzact has entered into an interest rate swap agreement to effectively fix the rate it pays on the $70 million term loan portion of the facility (see Note 9 - Derivatives for details). The Tranzact Bank Facility contains various affirmative, negative and financial covenants which White Mountains considers to be customary for such borrowings, including a minimum fixed charge coverage ratio and a minimum leverage ratio. Failure to meet one or more of these covenants could result in an event of default, which ultimately could eliminate availability under these facilities and result in acceleration of principal repayment on any amounts outstanding. As of December 31, 2014, Tranzact was in compliance with all of the covenants under the Tranzact Bank Facility and anticipates it will continue to remain in compliance with these covenants for the foreseeable future. In November 2012, OBH issued $275 million face value of senior unsecured debt through a public offering, at an issue price of 99.9%. The net proceeds from the issuance of the OBH Senior Notes were used to repurchase OBH’s previously issued Senior Notes. The OBH Senior Notes, which are fully and unconditionally guaranteed as to the payment of principal and interest by OneBeacon Ltd., bear an annual interest rate of 4.60%, payable semi-annually in arrears on May 9 and November 9, until maturity on November 9, 2022. In March 2007, SIG issued $400 million face value of senior unsecured notes at an issue price of 99.715%. The SIG Senior Notes bear an annual interest rate of 6.375%, payable semi-annually in arrears on March 20 and September 20, until maturity in March 2017. The OBH Senior Notes and the SIG Senior Notes were issued under an indenture and fiscal agency agreement, respectively, that contain restrictive covenants which, among other things, limit the ability of OneBeacon Ltd., OBH, SIG and their respective subsidiaries to create liens and enter into sale and leaseback transactions and limits the ability of OneBeacon Ltd., OBH, SIG and their respective subsidiaries to consolidate, merge or transfer their properties and assets. The indenture and fiscal agency agreement do not contain any financial ratios or specified levels of net worth or liquidity to which OneBeacon Ltd., OBH or SIG must adhere. As of December 31, 2014, OneBeacon Ltd., OBH and SIG were in compliance with all of the covenants under the OBH Senior Notes and the SIG Senior Notes, and anticipate they will continue to remain in compliance with these covenants for the foreseeable future. In addition, a failure by OneBeacon Ltd. or its subsidiaries to pay principal and interest on covered debt or to comply with obligations in covered debt agreements that results in the acceleration of at least $75 million of principal amount of covered debt, could trigger the acceleration of the OBH Senior Notes. A failure by SIG to pay principal and interest on covered debt or to comply with obligations in covered debt agreements that results in the acceleration of at least $25 million of the principal amount of covered debt, could trigger the acceleration of the SIG Senior Notes. Interest Rate Cap In May 2007, SIG issued $250 million non-cumulative perpetual preference shares, with an initial fixed annual dividend rate of 7.506%. In June 2017, the fixed rate will move to a floating rate equal to the greater of (i) 7.506% and (ii) 3-month LIBOR plus 320 basis points. In July 2013, SIG executed a 5-year forward LIBOR cap for the period from June 2017 to June 2022 to protect against a significant increase in interest rates during that 5-year period. The Interest Rate Cap economically fixes the annual dividend rate on the SIG Preference Shares from June 2017 to June 2022 at 8.30%. The cost of the Interest Rate Cap was an upfront premium of 395 basis points of the $250 million notional value, or $10 million for the full notional amount. Capital Lease In December 2011, OneBeacon sold the majority of its fixed assets and capitalized software. OneBeacon entered into lease financing arrangements with US Bancorp Equipment Finance, Inc. (“US Bancorp”) and Fifth Third Equipment Finance Company (“Fifth Third”) whereby OneBeacon sold furniture and equipment and capitalized software, respectively, at a cost equal to net book value. OneBeacon then leased the fixed assets back from US Bancorp for a lease term of five years and leased the capitalized software back from Fifth Third for a lease term of four years. OneBeacon received cash proceeds of $23 million as a result of entering into the sale-leaseback transactions. At the end of the lease terms, OneBeacon will have the obligation to purchase the leased assets for a nominal fee, after which all rights, title and interest would transfer back. As of December 31, 2014, OneBeacon had a capital lease obligation of $7 million included within other liabilities and a capital lease asset of $7 million included within other assets. Contractual Obligations and Commitments Below is a schedule of White Mountains’s material contractual obligations and commitments as of December 31, 2014: Millions Due in Less Than One Year Due in One to Three Years Due in Three to Five Years Due After Five Years Total Loss and LAE reserves(1) $ 987.6 $ 912.1 $ 435.4 $ 824.7 $ 3,159.8 Debt 6.0 424.6 42.9 275.0 748.5 Interest on debt 40.9 68.0 27.7 38.0 174.6 Long-term incentive compensation 78.4 76.3 3.3 8.5 166.5 Pension and other benefit plan obligations 10.3 6.8 6.4 39.5 63.0 Operating leases 16.5 28.8 25.8 28.9 100.0 Capital leases 5.3 1.8 - - 7.1 Total contractual obligations $ 1,145.0 $ 1,518.4 $ 541.5 $ 1,214.6 $ 4,419.5 (1) Represents expected future cash outflows resulting from loss and LAE payments. The amounts presented are gross of reinsurance recoverables on unpaid losses of $484 and net of the discount on OneBeacon’s workers compensation loss and LAE reserves of $1 as of December 31, 2014. White Mountains’s loss reserves do not have contractual maturity dates. However, based on historical payment patterns, the preceding table includes an estimate of when management expects White Mountains’s loss reserves to be paid. The timing of claim payments is subject to significant uncertainty. White Mountains maintains a portfolio of marketable investments with varying maturities and a substantial amount of short-term investments to provide adequate liquidity for the payment of claims. The SIG Preference Shares are not included in the table above, as these perpetual preferred shares have no stated maturity date and are redeemable only at the option of SIG. See “Sirius Group’s Preference Shares and Senior Notes” on page 21 for more details. The balances included in the table above regarding White Mountains’s long-term incentive compensation plans include amounts payable for performance shares and units, as well as deferred compensation balances. Exact amounts to be paid for performance shares cannot be predicted with certainty, as the ultimate amounts of these liabilities are based on the future performance of White Mountains and in some cases the market price of the Company’s and OneBeacon Ltd.’s common shares at the time the payments are made. The estimated payments reflected in the table are based on current accrual factors (including performance relative to targets and common share price) and assume that all outstanding balances were 100% vested as of December 31, 2014. There are no provisions within White Mountains’s operating leasing agreements that would trigger acceleration of future lease payments. The capital lease that OneBeacon entered into in conjunction with the sale-leaseback of certain of OneBeacon’s fixed assets and capitalized software contains provisions that could trigger an event of default, including a failure to make payments when due under the capital lease. If an event of default were to occur, the lessor would have a number of remedies available including the acceleration of future lease payments or the possession of the property covered under the lease agreement. White Mountains does not finance its operations through the securitization of its trade receivables, through special purpose entities or through synthetic leases. Further, except as noted in the following paragraph, White Mountains has not entered into any material arrangements requiring it to guarantee payment of third-party debt or lease payments or to fund losses of an unconsolidated special purpose entity. White Mountains also has future binding commitments to fund certain other long-term investments. These commitments, which total approximately $82 million, do not have fixed funding dates and are therefore excluded from the table above. WM Life Re reinsures death and living benefit guarantees associated with certain variable annuities issued in Japan. WM Life Re has assumed the risk related to a shortfall between the account value and the guaranteed value that must be paid by the ceding company to an annuitant or to an annuitant’s beneficiary in accordance with the underlying annuity contracts. WM Life Re uses derivative instruments, including put options, interest rate swaps, total return swaps and futures contracts on major equity indices, currency pairs and government bonds, to mitigate the risks associated with changes in the fair value of the reinsured variable annuity guarantees. As of December 31, 2014, the total guarantee value was approximately ¥134.2 billion (approximately $1.1 billion) and the related account values were approximately 113% of this amount. Based on current account value to guaranty value ratio in the annuities reinsured by WM Life Re as of December 31, 2014, WM Life Re expects $9 million of future cash outflows related to its reinsurance contracts, commencing in June 2015 through June 2016. White Mountains purchases derivative instruments, including futures and over-the-counter option contracts on interest rates, major equity indices, and foreign currencies, to mitigate the risks associated with changes in the fair value of the reinsured variable annuity guarantees. As of December 31, 2014, the fair value of these derivative instruments was $56 million. In addition, WM Life Re held approximately $33 million of cash and fixed maturity investments as of December 31, 2014 posted as collateral to its reinsurance and derivatives counterparties. Share Repurchases During the past several years, White Mountains’s board of directors authorized the Company to repurchase its common shares, from time to time, subject to market conditions. Shares may be repurchased on the open market or through privately negotiated transactions. The repurchase authorizations do not have a stated expiration date. As of December 31, 2014, White Mountains may repurchase an additional 338,092 shares under these board authorizations. In addition, from time to time White Mountains has repurchased its common shares through tender offers that were separately approved by its board of directors. During 2014, the Company repurchased 217,879 common shares for $134 million at an average share price of $617, which was 93% of White Mountains’s adjusted book value per share of $665 as of December 31, 2014. These share repurchases were comprised of 207,404 common shares repurchased under the board authorization for $128 million at an average share price of $618 and 10,475 common shares repurchased pursuant to employee benefit plans. Shares repurchased pursuant to employee benefit plans do not fall under the board authorizations referred to above. During 2013, the Company repurchased 141,535 common shares for $80 million at an average share price of $564, which was 88% of White Mountains’s adjusted book value per share of $642 as of December 31, 2013. These repurchases were comprised of 140,000 common shares repurchased in a private transaction under the board authorization for $79 million at an average share price of $564 and 1,535 common shares repurchased pursuant to employee benefit plans. During 2012, the Company repurchased 1,329,640 common shares for $669 million at an average share price of $503, which was 86% of White Mountains’s adjusted book value per share of $588 as of December 31, 2012. These repurchases were comprised of (1) 502,801 common shares repurchased under the board authorization for $256 million at an average share price of $508; (2) 816,829 common shares repurchased through a fixed-price tender offer for $409 million at a share price of $500; and (3) 10,010 common shares repurchased pursuant to employee benefit plans. Cash Flows Detailed information concerning White Mountains’s cash flows during 2014, 2013 and 2012 follows: Cash flows from operations for the years ended 2014, 2013 and 2012 Net cash flows provided from (used for) continuing operations was $207 million, $(29) million and $(30) million in 2014, 2013 and 2012, respectively. Cash flows from continuing operations increased $236 million in 2014 compared to 2013 primarily due to lower amounts of cash used for the settlement and purchase of derivative instruments at WM Life Re in 2014 compared to 2013. Cash used for continuing operations was relatively flat in 2013 when compared to 2012 as an increase at OneBeacon due to inflows from premiums exceeding loss and LAE payments and an increase in unrestricted cash collateral held in respect of its surety business, was partially offset by cash used for the settlements and purchases of derivative instruments at WM Life Re and payments made on losses related to hurricane Sandy. Net cash flows used for discontinued operations was $88 million, $72 million and $196 million in 2014, 2013 and 2012, respectively. The cash outflows from discontinued operations in all years presented were primarily due to the runoff of reserves related to the Runoff Business. White Mountains does not believe that these trends will have a meaningful impact on its future liquidity or its ability to meet its future cash requirements. Cash flows from investing and financing activities for the year ended December 31, 2014 Financing and Other Capital Activities During the first quarter of 2014, the Company declared and paid a $6 million cash dividend to its common shareholders. During 2014, the Company repurchased and retired 217,879 of its common shares for $134 million, which included 10,475 common shares repurchased under employee benefit plans. During the first quarter of 2014, White Mountains made payments totaling $27 million on WTM Performance Shares. During 2014, White Mountains borrowed and repaid a total of $65 million under the WTM Bank Facility and paid $1 million of interest on the WTM Bank Facility. During 2014, OneBeacon Ltd. declared and paid $80 million of cash dividends to its common shareholders. White Mountains received a total of $60 million of these dividends. During 2014, OneBeacon paid a total of $13 million of interest on the OBH Senior Notes. During 2014, OneBeacon contributed $67 million to ASIC. During 2014, Sirius Group paid $50 million of dividends to its immediate parent. During 2014, Sirius Group paid $19 million of dividends on the SIG Preference Shares and $26 million of interest on the SIG Senior Notes. During 2014, White Mountains contributed $15 million to WM Advisors. During 2014, WTM Life Re borrowed a total of $82 million and repaid a total of $89 million under an internal revolving credit facility with an intermediate holding company of White Mountains. During 2014, BAM received $16 million in surplus contributions from its members. During 2014, QuoteLab paid $2 million of dividends, of which $1 million was paid to White Mountains. Acquisitions and Dispositions During 2014, White Mountains purchased 63% of Tranzact for a purchase price of $178 million. Immediately after the closing, Tranzact completed a recapitalization that allowed for the return of $44 million to White Mountains. During 2014, White Mountains acquired approximately 45% of the outstanding common shares of durchblicker.at, for EUR 9 million (approximately $12 million based upon the foreign exchange spot rate at the date of acquisition). During 2014, White Mountains acquired 60% of the outstanding Class A common units of QuoteLab for an initial purchase price of $28 million. During 2014, White Mountains acquired 54% of the outstanding common shares of Wobi for NIS 14 million (approximately $4 million based upon the foreign exchange spot rate at the date of acquisition). In addition to the common shares, White Mountains also purchased NIS 13 million (approximately $4 million based upon the foreign exchange spot rate at the date of acquisition) of newly-issued convertible preferred shares of Wobi. During 2014, White Mountains acquired certain assets and liabilities of Star & Shield Holdings LLC, including SSRM, the attorney-in-fact for SSIE, for a purchase price of $2 million. During the first nine months of 2014, White Mountains also purchased $17 million of surplus notes issued by SSIE. During 2014, OneBeacon transferred $51 million of cash in connection with the sale of the Runoff Business. During 2014, Sirius Group purchased all of the outstanding shares of Olympus Re for $12 million in cash. During 2014, WM Solutions completed the shell sale of Citation and received $13 million as consideration. Cash flows from investing and financing activities for the year ended December 31, 2013 Financing and Other Capital Activities During the first quarter of 2013, the Company declared and paid a $6 million cash dividend to its common shareholders. During 2013, the Company repurchased and retired 141,535 of its common shares for $80 million, which included 1,535 common shares repurchased under employee benefit plans. During the first quarter of 2013, White Mountains made payments totaling $11 million on WTM Performance Shares. During the first quarter of 2013, White Mountains repaid $75 million that was outstanding under a previous revolving credit facility as of December 31, 2012. In addition, during 2013, White Mountains borrowed and repaid a total of $200 million under its revolving credit facilities and paid $4 million of interest on its revolving credit facilities. During 2013, OneBeacon Ltd. declared and paid $80 million of cash dividends to its common shareholders. White Mountains received a total of $60 million of these dividends. During 2013, OneBeacon paid a total of $13 million of interest on the OBH Senior Notes. During 2013, OneBeacon contributed $135 million to Split Rock and $35 million to OBIC. During 2013, Sirius Group paid $250 million of dividends to its immediate parent, $75 million of which had been declared and accrued in December 2012. During 2013, Sirius Group paid $19 million of dividends on the SIG Preference Shares and $26 million of interest on the SIG Senior Notes. During 2013, Sirius Group executed the Interest Rate Cap for $10 million. During 2013, White Mountains contributed $70 million to WM Life Re. During 2013, WTM Life Re borrowed a total of $145 million and repaid a total of $115 million under an internal revolving credit facility with an intermediate holding company of White Mountains. During 2013, BAM received $17 million in surplus contributions from its members. Acquisitions and Dispositions During 2013, OneBeacon completed the sale of Essentia and received $31 million as consideration. During 2013, White Mountains Solutions acquired Ashmere for a purchase price of $10 million and Empire for a purchase price of $3 million. Cash flows from investing and financing activities for the year ended December 31, 2012 Financing and Other Capital Activities During the first quarter of 2012, the Company declared and paid a $7 million cash dividend to its common shareholders. During 2012, the Company repurchased and retired 1,329,640 of its common shares for $669 million, which included 10,010 common shares repurchased under employee benefit plans. During the first quarter of 2012, White Mountains made payments totaling $58 million on WTM Performance Shares. In December 2012, White Mountains borrowed $150 million under a previous revolving credit facility. White Mountains repaid $75 million of this amount in December 2012 and the remaining $75 million in January 2013. During 2012, White Mountains paid $2 million of interest on its previous revolving credit facility. During 2012, OneBeacon Ltd. declared and paid $80 million of cash dividends to its common shareholders. White Mountains received a total of $60 million of these dividends. During 2012, OBH issued $275 million face value of senior unsecured notes through a public offering, at an issue price of 99.9%. The net proceeds from the issuance of the OBH Senior Notes were used to repurchase and retire the remaining $270 million principal outstanding on OBH’s previously issued senior notes. During 2012, OneBeacon paid a total of $16 million of interest on OBH’s previously issued senior notes. During 2012, Sirius Group declared $115 million and paid $40 million of dividends to its immediate parent. In January 2013, Sirius Group paid the remaining $75 million of accrued dividends to its immediate parent. During 2012, Sirius Group paid $19 million of dividends on the SIG Preference Shares and $26 million of interest on the SIG Senior Notes. During 2012, White Mountains contributed $25 million to WM Life Re. Acquisitions and Dispositions During 2012, White Mountains capitalized HG Global with approximately $600 million in cash and HG Global capitalized BAM by purchasing $503 million of BAM Surplus Notes. During 2012, OneBeacon completed the sale of a shell company, Pennsylvania General Insurance, and received $15 million as consideration. During 2012, White Mountains Solutions acquired PICO and Citation for a purchase price of $15 million and Woodridge and Oakwood for a purchase price of $35 million. TRANSACTIONS WITH RELATED PERSONS See Note 20-“Transactions with Related Persons” in the accompanying Consolidated Financial Statements. NON-GAAP FINANCIAL MEASURES This report includes three non-GAAP financial measures that have been reconciled to their most comparable GAAP financial measures. White Mountains believes these measures to be more relevant than comparable GAAP measures in evaluating White Mountains’s results of operations and financial condition. Adjusted comprehensive income is a non-GAAP financial measure that excludes the change in equity in net unrealized gains and losses from Symetra’s fixed maturity portfolio, net of applicable taxes, from comprehensive income. In the calculation of comprehensive income under GAAP, fixed maturity investments are marked-to-market while the liabilities to which those assets are matched are not. Symetra attempts to earn a “spread” between what it earns on its investments and what it pays out on its products. In order to try to fix this spread, Symetra invests in a manner that tries to match the duration and cash flows of its investments with the required cash outflows associated with its life insurance and structured settlements products. As a result, Symetra typically earns the same spread on in-force business whether interest rates fall or rise. Further, at any given time, some of Symetra’s structured settlement obligations may extend 40 or 50 years into the future, which is further out than the longest maturing fixed maturity investments regularly available for purchase in the market (typically 30 years). For these long-dated products, Symetra is unable to fully match the obligation with assets until the remaining expected payout schedule comes within the duration of securities available in the market. If at that time, these fixed maturity investments have yields that are lower than the yields expected when the structured settlement product was originally priced, the spread for the product will shrink and Symetra will ultimately harvest lower returns for its shareholders. GAAP comprehensive income increases when rates decline, which would suggest an increase in the value of Symetra - the opposite of what is happening to the intrinsic value of the business. Therefore, White Mountains’s management and Board of Directors use adjusted comprehensive income when assessing Symetra’s quarterly financial performance. In addition, this measure is typically the predominant component of change in adjusted book value per share, which is used in calculation of White Mountains’s performance for both short-term (annual bonus) and long-term incentive plans. The reconciliation of adjusted comprehensive income to comprehensive income is included on page 53. Adjusted book value per share is a non-GAAP measure which is derived by expanding the GAAP calculation of book value per White Mountains common share to exclude equity in net unrealized gains and losses from Symetra’s fixed maturity portfolio, net of applicable taxes. In addition, the number of common shares outstanding used in the calculation of adjusted book value per share are adjusted to exclude unearned restricted common shares, the compensation cost of which, at the date of calculation, has yet to be amortized. The reconciliation of adjusted book value per share to GAAP book value per share is included on page 52. Total capital at White Mountains is comprised of White Mountains’s common shareholders’ equity, debt and non-controlling interests that White Mountains (i) benefits from the return on or (ii) has the ability to utilize the net assets supporting the non-controlling interest. As such, non-controlling interests attributable to reciprocals are excluded from total adjusted capital. Total adjusted capital also excludes the equity in net unrealized gains and losses from Symetra’s fixed maturity portfolio, net of applicable taxes from total capital. The reconciliation of total capital to total adjusted capital is included on page 79. CRITICAL ACCOUNTING ESTIMATES Management’s Discussion and Analysis of Financial Condition and Results of Operations discuss the Company’s consolidated financial statements, which have been prepared in accordance with GAAP. The financial statements presented herein include all adjustments considered necessary by management to fairly present the financial position, results of operations and cash flows of White Mountains. The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities as of the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Certain of these estimates are considered critical in that they involve a higher degree of judgment and are subject to a significant degree of variability. On an ongoing basis, management evaluates its estimates, including those related to fair value measurements of investments and other financial instruments, valuation of liabilities associated with an assumed reinsurance agreement covering benefit guarantees on variable annuities in Japan, its property-casualty loss and LAE reserves and its property-casualty reinsurance contracts. Management bases it estimates on historical experience and on various other factors that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. 1. Loss and LAE Reserves General White Mountains establishes loss and LAE reserves that are estimates of amounts needed to pay claims and related expenses in the future for insured events that have already occurred. The process of estimating reserves involves a considerable degree of judgment by management and, as of any given date, is inherently uncertain. See Note 3-“Reserves for Unpaid Loss and Loss Adjustment Expenses” for a description of White Mountains’s loss and LAE reserves and actuarial methods. White Mountains performs an actuarial review of its recorded reserves each quarter. White Mountains’s actuaries compare the previous quarter’s estimates of paid loss and LAE, case reserves and IBNR to amounts indicated by actual experience. Differences between previous estimates and actual experience are evaluated to determine whether a given actuarial method for estimating loss and LAE should be relied upon to a greater or lesser extent than it had been in the past. While some variance is expected each quarter due to the inherent uncertainty in loss and LAE, persistent or large variances would indicate that prior assumptions and/or reliance on certain reserving methods may need to be revised going forward. OneBeacon OneBeacon, like other insurance companies, categorizes and tracks its insurance reserves by “line of business”, such as general liability, automobile liability and workers compensation. Furthermore, OneBeacon regularly reviews the appropriateness of reserve levels at the line of business level, taking into consideration the variety of trends that impact the ultimate settlement of claims for the subsets of claims in each particular line of business. In its selection of recorded reserves, OneBeacon historically gave greater weight to adjusted paid loss development methods, which are not dependent on the consistency of case reserving practices, over methods that rely on reported losses. In recent years, the amount of weight given to methods based on reported losses has increased with OneBeacon’s confidence that its case reserving practices have been more consistently applied. Upon completion of each quarterly review, OneBeacon’s actuaries select indicated reserve levels based on the results of the actuarial methods described previously, which are the primary consideration in determining management’s best estimate of required reserves. However, in making its best estimate, management also considers other qualitative factors that may lead to a difference between held reserves and actuarially indicated reserves in the future. Typically, these factors exist when management and OneBeacon’s actuaries conclude that there is insufficient historical incurred and paid loss information or that trends included in the historical incurred and paid loss information are unlikely to repeat in the future. Such factors include, among others, recent entry into new markets or new products, improvements in the claims department that are expected to lessen future ultimate loss costs, legal and regulatory developments, or other volatilities that may arise. Loss and LAE Reserves by Line of Business OneBeacon’s loss and LAE reserves, net of reinsurance recoverables, as of December 31, 2014 and 2013 were as follows: December 31, 2014 December 31, 2013 Millions Case IBNR Total Case(1) IBNR(1) Total(1) Automobile liability $ 42.2 $ 45.4 $ 87.6 $ 32.3 $ 32.8 $ 65.1 General liability - occurrence 50.8 184.2 235.0 42.1 140.3 182.4 General liability - claims made 89.8 205.1 294.9 65.3 176.4 241.7 Medical malpractice 86.8 102.7 189.5 67.1 124.6 191.7 Other casualty 44.3 36.3 80.6 49.8 29.3 79.1 Workers compensation 47.1 65.2 112.3 39.0 50.4 89.4 Property 53.4 38.3 91.7 35.3 22.7 58.0 Other 27.7 61.3 89.0 26.0 40.7 66.7 Total $ 442.1 $ 738.5 $ 1,180.6 $ 356.9 $ 617.2 $ 974.1 (1) During 2014, OneBeacon changed its presentation of line of business reserves and restated the 2013 case reserves, IBNR and total reserves to report consistent line of business activity for both years presented. As a result, for "General liability - claims made," case reserves increased $0.6 million, IBNR increased $3.3 million, and total reserves increased by $3.9 million, with corresponding decreases to "General liability - occurrence", and for "Other," case reserves increases increased by $3.8 million, IBNR increased $8.6 million, and total reserves increased by $12.4 million, with corresponding decreases to "Property," compared to the previous presentation for 2013. For loss and allocated LAE reserves, the key assumption as of December 31, 2014 was that the impact of the various reserving factors, as described below, on future paid losses would be similar to the impact of those factors on the historical loss data with the exception of severity trends, which have been relatively stable over the relevant historical period. The actuarial methods used would project losses assuming continued stability in severity trends. Management has considered future increases in loss severity trends, including the impact of expected inflation, in making its reserve selections. The major causes of material uncertainty (“reserving factors”) generally will vary for each product line, as well as for each separately analyzed component of the product line. The following section details reserving factors by product line. There could be other reserving factors that may impact ultimate claim costs. Each reserving factor presented will have a different impact on estimated reserves. Also, reserving factors can have offsetting or compounding effects on estimated reserves. For example, in workers compensation, the use of expensive medical procedures that result in medical cost inflation may enable workers to return to work faster, thereby lowering indemnity costs. Thus, in almost all cases, it is impossible to discretely measure the effect of a single reserving factor and construct a meaningful sensitivity expectation. Actual results will likely vary from expectations for each of these assumptions, resulting in an ultimate claim liability that is different from that being estimated currently. Additional causes of material uncertainty exist in most product lines and may impact the types of claims that could occur within a particular operating segment or book of business. Examples where reserving factors, within an underwriting unit or book of business, are subject to change include changing types of insured (e.g. type of insured vehicle, size of account, industry insured, jurisdiction, etc.), changing underwriting standards, or changing policy provisions (e.g. deductibles, policy limits, or endorsements). General liability General liability policies are written on a claims made or occurrence or form. General liability claims made policies provide professional and management liability coverage. Professional liability policies cover the defense expenses and damages related to negligence claims brought against the insured professional services firm or government entity. The coverage focuses on damages resulting from an alleged failure to perform, error or omission in the product or service provided by the policyholder. Management liability policies cover the defense expenses and damages related to alleged wrongful acts committed by the directors and officers of the insured organization. General liability occurrence policies cover businesses for any liability resulting from bodily injury and property damage arising from general business operations, accidents on a premises and the products manufactured or sold. General liability-occurrence reserves generally include two components: bodily injury and property damage. Bodily injury payments reimburse the claimant for damages pertaining to physical injury as a result of the policyholder's legal obligation arising from nonintentional acts such as negligence, subject to the insurance policy provisions. In some cases the damages can include future wage loss (which is a function of future earnings power and wage inflation) and future medical treatment costs. Property damage payments result from damages to the claimant's private property arising from the policyholder's legal obligation for non-intentional acts. In most cases, property damage losses are a function of costs as of the loss date, or soon thereafter. Defense costs are also a part of the insured costs covered by liability policies and can be significant, sometimes greater than the cost of the actual paid claims, though for some products this risk is mitigated by policy language such that the insured portion of defense costs erodes the amount of policy limit available to pay the claim. General liability is generally considered a long tail line of business, as it takes a relatively long period of time to finalize and settle claims from a given accident year. The speed of claim reporting and claim settlement is a function of the specific coverage provided and the jurisdiction, among other factors. There are numerous components underlying the general liability product line. Some of these have relatively moderate payment patterns (with most of the claims for a given accident year closed within 5 to 7 years), while others can have extreme lags in both reporting and payment of claims (e.g., a reporting lag of a decade for “construction defect” claims). Examples of common reserving factors that can change and, thus, affect estimated general liability reserves include: • Changes in claim handling philosophies (e.g., case reserving standards), including the use of third-party claims administrators • Changes in policy provisions or court interpretations of such provisions • New theories of liability (e.g., cyber-related claims) • Trends in litigation or jury awards • Changes in the propensity to sue, in general with specificity to particular issues • Changes in statutes of limitations • Changes in the underlying court system • Distortions from losses resulting from large single accounts or single issues • Changes in tort or case law • Subrogation opportunities • Shifts in lawsuit mix between federal and state courts • Changes in settlement patterns, including frequency and severity Property Property covers losses to a business' premises, inventory and equipment as a result of weather, fire, theft and other causes. For property coverage, it generally takes a relatively short period of time to close claims. The relatively high attachment points and insured values of the property policies underwritten in the Specialty Property underwriting operating segment present a potentially longer tail and greater uncertainty than our standard property business. Commercial multiple peril The general liability occurrence and property coverages described above are often provided under a multiple peril package policy sold to insureds includes general liability and property insurance. Because commercial multiple peril provides a combination of property and liability coverage, typically for small businesses, it includes both short- and long-tail coverages. The reserving risk for this line is dominated by the liability coverage portion of this product, except occasionally in the event of catastrophic or large single losses. Medical malpractice Medical professional liability policies cover the defense expenses and damages related to negligence claims brought against the insured health care institution or provider. The coverage focuses on damages resulting from an alleged failure to perform, error or omission in the service provided by the policyholder. See the above discussions with regard to reserving factors for general liability, which are similar to the reserving factors for medical malpractice. Workers compensation Workers compensation covers an employer’s liability for injuries, disability or death of employees, without regard to fault, as prescribed by state workers compensation law and other statutes. Workers compensation is generally considered a long tail coverage, as it takes a relatively long period of time to finalize claims from a given accident year. While certain payments such as initial medical treatment or temporary wage replacement for the injured worker are made quickly, some other payments are made over the course of several years, such as awards for permanent partial injuries. In addition, some payments can run as long as the injured worker’s life, such as permanent disability benefits and ongoing medical care. Despite the possibility of long payment tails, the reporting lags are generally short, settlements are generally not complex, and most of the liability can be considered high frequency with moderate severity. The largest reserve risk generally comes from the low frequency, high severity claims providing lifetime coverage for medical expense arising from a worker’s injury. Examples of common reserving factors that can change and, thus, affect the estimated workers compensation reserves include: • Changes in the type, frequency of utilization or cost of medical treatments (e.g., changes in the use of pharmaceutical drugs, types of health providers used, use of preferred provider networks and other medical cost containment practices) • Availability of new medical processes and equipment • Degree of patient responsiveness to treatment • Mortality trends of injured workers with lifetime indemnity and medical treatment benefits • Degree of cost shifting between workers compensation and health insurance • Time required to recover from the injury and return to regular or transitional work • Future wage inflation for states that index benefits • Changes in claims handling philosophies (e.g., case reserving standards) Commercial automobile liability The commercial automobile product line is a mix of property and liability coverages and, therefore, includes both short and long tail coverages. The payments that are made quickly typically pertain to auto physical damage (included in the property line) claims and property damage (liability) claims. The payments that take longer to finalize and are more difficult to estimate relate to bodily injury claims. Commercial automobile reserves are typically analyzed in two components; liability and collision/comprehensive claims. This second component has minimum reserve risk and fast payouts and, accordingly, separate reserving factors are not presented. The liability component includes claims for both bodily injury and property damage. In general, claim reporting lags are minor, claim complexity is not a major issue, and the line is viewed as high frequency, low to moderate severity. In addition to the examples of common reserving factors related to general liability described above, other examples of common reserving factors that can change and, thus, also affect estimated commercial automobile liability reserves include: • Frequency of claims with payment capped by policy limits • Change in average severity of accidents, or proportion of severe accidents • Frequency of visits to health providers • Number of medical procedures given during visits to health providers • Types of health providers used • Types of medical treatments received • Changes in cost of medical treatments • Degree of patient responsiveness to treatment Crop Insurance Multiperil crop and crop-hail is generally considered a very short tailed coverage yet the reserve estimate often contains a fair amount of uncertainty. As a new business, a lack of historical data means external data is heavily relied upon where available and applicable. Crop reserving factors that can change and, thus, affect estimated crop reserves include changes in crop prices, estimated acreage covered, claim reporting or payment patterns, or claim handling philosophies (e.g., case reserving standards). Surety Surety is generally considered a short tailed coverage. As a new business, a lack of historical data means external data is heavily relied upon where available and applicable. Surety reserving factors that can change and, thus, affect estimated surety reserves include probability of default of the bond which can be impacted by general economic conditions, size of payment (severity) which is impacted by the bond limit, or amount and collectability of assets or other collateral available to mitigate loss. OneBeacon Loss and LAE Development Loss and LAE development-2014 During 2014, OneBeacon experienced $90 million of net unfavorable loss and LAE reserve development on prior accident year reserves, of which $75 million related to the 2014 fourth quarter reserving increase and the remaining amount primarily driven by unfavorable development in the professional liability and management liability businesses included within Professional Insurance. See “RESULTS OF OPERATIONS - OneBeacon” on page 57. Loss and LAE development-2013 During 2013, OneBeacon experienced no net loss and LAE reserve development on prior accident year reserves. OneBeacon experienced unfavorable development primarily related to its property, general liability and accident and health lines, which was offset by favorable development in its other liability and ocean marine lines. Loss and LAE development-2012 During 2012, OneBeacon experienced $7 million of net favorable loss and LAE reserve development on prior accident year reserves. The favorable reserve development was primarily from workers' compensation, multiple peril liability and general liability lines. This favorable development was partially offset by unexpected adverse development on excess property claims. Range of Reserves OneBeacon’s range of loss and LAE reserve estimates was evaluated to consider the strengths and weaknesses of the various actuarial methods applied against OneBeacon’s historical claims experience data. The following table shows the recorded loss and LAE reserves and the high and low ends of OneBeacon’s range of reasonable loss reserve estimates, net of reinsurance recoverable on unpaid losses, as of December 31, 2014 and 2013. The high and low ends of the range of reserve estimates in the table below are based on the results of various actuarial methods described above. December 31, 2014 December 31, 2013 Millions Low Recorded High Low Recorded High Total $ $ 1,180.6 $ 1,308 $ $ 974.1 $ 1,087 As a result of the loss and LAE reserve increases recorded in the fourth quarter of 2014 (see “Management's Discussion and Analysis of Financial Condition and Results of Operations-OneBeacon”), and in recognition of the various sensitivities and volatilities associated with loss and LAE reserves described below, particularly the risks and uncertainties associated with large losses and OneBeacon’s newer businesses, management has recorded its best estimate of loss and LAE reserves at a higher level with the actuarial range of reasonable outcomes as compared to the prior year. The recorded reserves represent management’s best estimate of unpaid loss and LAE reserves. OneBeacon uses the results of several different actuarial methods to develop its estimate of ultimate reserves. While it has not determined the statistical probability of actual ultimate paid losses falling within the range, OneBeacon believes that it is reasonably likely that actual ultimate paid losses will fall within the range noted above because the range was developed by using several different generally accepted actuarial methods. Although OneBeacon believes its reserves are reasonably stated, ultimate losses may deviate, perhaps materially, from the recorded reserve amounts and could be above the high end of the range of actuarial projections. This is because the ranges are developed based on known events as of the valuation date, whereas the ultimate disposition of losses is subject to the outcome of events and circumstances that may be unknown as of the valuation date. Sensitivity Analysis The following discussion includes disclosure of possible variations from current estimates of loss reserves due to changes in a few of the many key assumptions. Each of the impacts described below is estimated individually, without consideration for any correlation among key assumptions. Further, there is uncertainty around other assumptions not explicitly quantified in the discussion below. Therefore, it would be inappropriate to take each of the amounts described below and add them together in an attempt to estimate volatility for OneBeacon’s reserves in total. It is important to note that the volatilities and variations discussed below are not meant to be a worst-case scenario, and therefore it is possible that future volatilities and variations may be more than amounts discussed below. • Various sources of inflation volatility impact all of OneBeacon’s reserves in different ways. Using its internal economic capital model, OneBeacon has derived a distribution of future loss payments under the range of inflation scenarios and related claim cost trends in its economic scenario set, holding all other sources of reserve volatility constant. At the 75th percentile of modeled outcomes, the estimated impact of claim cost inflation above OneBeacon’s actuarially indicated reserves is $39 million, net of reinsurance. • The volatility associated with the frequency and severity of large losses, defined as net claims greater than or equal to $2.5 million, can have a material impact on OneBeacon’s results. The frequency and severity of large claims is driven primarily by the random nature of the insurance process but also by claim cost inflation and parameter risk. These large losses often emerge over a long time period potentially leading to a material impact on OneBeacon’s reserves. One way OneBeacon considers this sensitivity is by examining the volatility of large losses in the current accident year using its economic capital model. At the 75th percentile of modeled outcomes, OneBeacon estimates that large losses could exceed the mean by $19 million, net of reinsurance. • As OneBeacon starts up new businesses, its initial loss estimates and development patterns are often based on industry data. As actual losses develop OneBeacon will revise its initial expectations with its actual experience. However, depending on the tail for the specific business, it can be a few years before OneBeacon has sufficient internal data to rely on. As of December 31, 2014, OneBeacon has $168 million of inception-to-date premium from its newer businesses (Programs, Crop, Environmental and Surety). A 10% error in OneBeacon’s initial loss ratio estimates could result in approximately $17 million adverse net variance in loss reserves. OneBeacon also considers variations and sensitivities for certain lines of business, such as: • Professional liability: Recorded loss and allocated LAE reserves, net of reinsurance recoverable, for professional liability were $527 million as of December 31, 2014. A key assumption for professional liability is the implicit loss cost trend, particularly the severity inflation trend component of loss costs. Across the entire reserve base, a 5.0 point change in assumed annual severity would have changed the estimated net reserve by approximately $82 million as of December 31, 2014, in either direction. • Multiple peril liability: Recorded loss and LAE reserves, net of reinsurance recoverable for multiple peril were $62 million as of December 31, 2014. Reported loss development patterns are a key assumption for this line of business, particularly for more mature accident years. Historically, assumptions on reported loss development patterns have been impacted by, among other things, emergence of new types of claims (e.g. construction defect claims) or a shift in the mixture between smaller, more routine claims and larger, more complex claims. If case reserve adequacy for multiple peril claims changed by 10.0 points this would have changed the estimated net reserve by approximately $2 million as of December 31, 2014, in either direction. • Workers compensation: Recorded workers compensation loss and LAE reserves, net of reinsurance recoverable, were $112 million as of December 31, 2014. The two most important assumptions for workers compensation reserves are loss development factors and loss cost trends, particularly medical cost inflation. Loss development patterns are dependent on medical cost inflation. Approximately half of the workers compensation net reserves are related to future medical costs. Across the entire reserve base, a 0.5 point change in calendar year medical inflation would have changed the estimated net reserve by approximately $8 million as of December 31, 2014, in either direction. Sirius Group The estimation of net reinsurance loss and LAE reserves is subject to the same risk as the estimation of insurance loss and LAE reserves. In addition to those risk factors which give rise to inherent uncertainties in establishing insurance loss and LAE reserves, the inherent uncertainties of estimating such reserves are even greater for the reinsurer, due primarily to: (1) the claim-tail for reinsurers and insurers working through MGUs being further extended because claims are first reported to either the original primary insurance company or the MGU and then through one or more intermediaries or reinsurers, (2) the diversity of loss development patterns among different types of direct insurance contracts, reinsurance treaties or facultative contracts, (3) the necessary reliance on the ceding companies, intermediaries and MGUs for information regarding reported claims and (4) the differing reserving practices among ceding companies and MGUs. Loss and LAE Reserves by Class of Business Sirius Group’s net loss and LAE reserves by class of business as of December 31, 2014 and 2013 were as follows: Net loss and LAE reserves by class of business December 31, 2014 December 31, 2013 Millions Case IBNR Total Case IBNR Total Casualty (excluding A&E) $ 139.0 $ 193.3 $ 332.3 $ 168.4 $ 221.4 $ 389.8 Property (excluding catastrophe excess) 170.9 92.4 263.3 183.5 94.6 278.1 A&E(1) 69.4 140.8 210.2 61.1 132.7 193.8 Property catastrophe excess 111.2 20.5 131.7 145.1 53.5 198.6 Aviation and space 85.0 34.0 119.0 88.9 37.6 126.5 Accident and health 38.3 61.4 99.7 32.2 76.8 109.0 Marine 65.5 28.6 94.1 74.2 26.8 101.0 Trade Credit 57.4 22.0 79.4 66.9 22.9 89.8 Contingency 2.5 3.1 5.6 3.1 4.9 8.0 Agriculture 1.2 3.4 4.6 1.9 4.1 6.0 Runoff(2) 73.9 73.8 147.7 82.4 94.1 176.5 Total $ 814.3 $ 673.3 $ 1,487.6 $ 907.7 $ 769.4 $ 1,677.1 (1) Sirius Group’s A&E exposures are principally the result of runoff of businesses acquired in the 1990s. (2) Included in this class are primarily the runoff exposures from various acquisitions. In order to reduce the potential uncertainty of loss reserve estimation, Sirius Group obtains information from numerous sources to assist in the reserving process. Sirius Group’s underwriting and pricing actuaries devote considerable effort to understanding and analyzing each ceding company’s operations and loss history during the underwriting of the business, using a combination of client and industry statistics. Such statistics normally include historical premium and loss data by class of business, individual claim information for larger claims, distributions of insurance limits provided and the risk characteristics of the underlying insureds, loss reporting and payment patterns, and rate change history. This analysis is used to project expected loss ratios for each treaty during the upcoming contract period. These expected ultimate loss ratios are aggregated across all treaties and are input directly into the loss reserving process. For primary insured business, a similar portfolio analysis is performed for each MGU program taking into account expected changes in the aggregated risk profile of the policyholders within each program. The aggregation of risks yields a more stable indication of expected losses that is used to estimate ultimate losses and thus IBNR for recently written business. Sirius Group’s expected annual loss reporting assumptions are updated at least once a year. Expected loss ratios underlying the current accident year are updated quarterly, to reflect new business that is underwritten by the company. Backlogs in the recording of assumed reinsurance can also complicate the accuracy of loss reserve estimation. As of December 31, 2014, there were no significant backlogs related to the processing of assumed reinsurance information at Sirius Group. Sirius Group relies heavily on information reported by MGUs and ceding companies, as discussed above. In order to determine the accuracy and completeness of such information, Sirius Group underwriters, actuaries, and claims personnel perform audits of certain MGUs and ceding companies where customary. Generally, ceding company audits are not customary outside the United States. In such cases, Sirius Group reviews information from ceding companies for unusual or unexpected results. Any material findings are discussed with the ceding companies. Sirius Group sometimes encounters situations where it is determined that a claim presentation from a ceding company is not in accordance with contract terms. Most situations are resolved amicably and without the need for litigation or arbitration. However, in the infrequent situations where a resolution is not possible, Sirius Group will vigorously defend its position in such disputes. Sirius Group also obtains reinsurance whereby another reinsurer contractually agrees to indemnify Sirius Group for all or a portion of the risks underwritten by Sirius Group. Such arrangements, where one reinsurer provides reinsurance to another reinsurer, are usually referred to as “retrocessional reinsurance” arrangements. Sirius Group establishes estimates of amounts recoverable from reinsurers on its direct business and retrocessional reinsurance on its reinsurance business in a manner consistent with the loss and LAE liability associated with reinsurance contracts offered to its customers, net of an allowance for uncollectible amounts, if any. Net reinsurance loss reserves represent loss and LAE reserves reduced by ceded reinsurance recoverable on unpaid losses. Sirius Group Loss and LAE Development Loss and LAE development-2014 In 2014, Sirius Group had net favorable loss reserve development of $98 million. The major reductions in loss reserve estimates were recognized in property ($54 million), aviation and space ($13 million), accident and health ($13 million) lines and casualty ($13 million). The casualty reduction is net of a $10 million increase in asbestos and environmental loss reserves. For the property loss estimates decrease, $24 million represented reduction of loss reserves previously held above the actuarial central estimate. This amount represented an IBNR provision established between 2010-2012 in response to the large catastrophe events, including the 2010 earthquake in Chile, the 2010/2011 earthquakes in New Zealand, the 2011 earthquake in Japan, and hurricane Sandy in 2012, and the inherent uncertainty associated with deriving initial loss estimates. When examined in 2014, the loss estimates for these events had stabilized and had proven to be redundant in aggregate; as a result, the additional amount above the actuarial central estimate was reversed. Loss and LAE development-2013 In 2013, Sirius Group had net favorable loss reserve development of $48 million, which included $24 million of favorable loss reserve development on prior years’ catastrophe losses. Other major reductions in loss reserve estimates recognized included property ($17 million), aviation and space ($10 million), and accident and health ($9 million) lines, partially offset by a $12 million increase in asbestos loss reserves. Loss and LAE development-2012 In 2012, Sirius Group had net favorable loss reserve development of $34 million. The major reductions in loss reserve estimates were recognized in casualty runoff ($32 million), property ($28 million), marine/energy ($12 million), trade credit ($7 million) and aviation and space ($5 million) lines, partially offset by a $46 million increase in asbestos loss reserves and a $4 million increase in accident and health. Range of Reserves The actuarial methods described above are used to calculate a point estimate of loss and LAE reserves for each company within Sirius Group. These point estimates are then aggregated to produce an actuarial point estimate for the entire segment. Once a point estimate is established, Sirius Group’s actuaries estimate loss reserve ranges to measure the sensitivity of the actuarial assumptions used to set the point estimates. These ranges are calculated from historical variations in loss ratios, payment and reporting patterns by class and type of business. The actuarial analysis is a primary consideration for management in determining its best estimate of loss and LAE reserves. Management records reserves in the upper portion of the actuarial range of central estimates in response to potential volatility in the actuarial indications and estimates for large claims. The following table illustrates Sirius Group’s recorded net loss and LAE reserves and high and low estimates as of December 31, 2014 and 2013. Net loss and LAE reserves December 31, 2014 December 31, 2013 Millions Low Recorded High Low Recorded High Total $ 1,351 $ 1,487.6 $ 1,572 $ 1,486 $ 1,677.1 $ 1,790 As mentioned previously, a $24 million decrease in the property reserves in 2014 represented a reduction of loss reserves previously held above the actuarial central estimate. When examined in 2014, the loss estimates for the major catastrophe events that occurred in 2010 to 2012 had stabilized and had proven to be redundant in aggregate; as a result, the additional amount above the actuarial central estimate was reversed. This is the primary reason why the recorded reserves are lower in the range of actuarial estimates in 2014 as compared to 2013. The probability that ultimate losses will fall outside of the range of estimates by class of business is higher for each class of business individually than it is for the sum of the estimates for all classes taken together due to the effects of diversification. Management believes that it is reasonably likely that actual ultimate losses will fall within the total range noted above because the ranges were developed by using generally accepted actuarial methods supplemented with input of underwriting and claims staff. However, due to the inherent uncertainty, ultimate losses may deviate, perhaps materially, from the recorded reserve amounts and could be above or below the range of actuarial projections. Sensitivity Analysis The following discussion includes disclosure of possible variations from current estimates of loss reserves due to changes in a few of the many key assumptions. Each of the impacts described below is estimated individually, without consideration for any correlation among key assumptions. Further, there is uncertainty around other assumptions not explicitly quantified in the discussion below. Therefore, it would be inappropriate to take each of the amounts described below and add them together in an attempt to estimate volatility for Sirius Group’s reserves in total. It is important to note that the volatilities and variations discussed below are not meant to be best-case or worst-case scenarios, and therefore it is possible that future volatilities and variations may be more than amounts discussed below. • Sustained Economic and Tort Inflation. Future inflation beyond the recent historical levels could impact the required reserves. For example, Sirius America has casualty and runoff loss reserves of roughly $385 million excluding asbestos and environmental at the end of fourth quarter 2014. The estimated additional claim payments for Sirius America due to hypothetical increases in the inflation rate of 200 to 800 basis points beginning in 2017 and continuing through 2021 is estimated to be $36 to $182 million. • Catastrophe Losses. As time has passed, the emerging claims information for major events including natural catastrophes has been better than expected. There is $185 million in net reserves remaining for major events which occurred during 2010-2014, of which $44 million is held as net IBNR above client estimates formally rendered. Some, but perhaps not all, of this additional IBNR may be needed to handle adverse reporting from clients. • Asbestos and Environmental (A&E). The internal actuarial and claims analysis suggests that Sirius Group’s A&E losses are covered by its previous paid activity and current reserves. However, the ongoing nature of the litigation surrounding these complex exposures can significantly affect Sirius Group’s liabilities. Sirius Group ended 2014 with $210 million in net reserves for A&E claims. Applying varying assumptions and industry benchmarks yielded a net range of A&E reserves from $160 million to $255 million. Further information is detailed below about Sirius Group’s A&E exposure. Sirius Group A&E Reserves Sirius Group's A&E exposure is primarily from reinsurance contracts written between 1974 through 1985 by acquired companies, mainly MONY Reinsurance Company and Christiania General Insurance Company. The exposures are mostly higher layer excess of loss treaty and facultative coverages with relatively low limits exposed for each claim. In 2014 and 2013, Sirius Group increased its net A&E exposure through incoming runoff portfolios acquired by White Mountains Solutions. These acquisitions added $23 million in net asbestos reserves and $2 million in net environmental reserves in 2014 and $13 million in net asbestos reserves and $1 million in net environmental reserves in 2013. The acquisition of companies having modest portfolios of A&E exposure has been typical of several prior White Mountains Solutions transactions and is likely to be an element of at least some future acquisitions. However, the acquisition of new A&E liabilities is undertaken only after careful due diligence and utilizing conservative reserving assumptions in relation to industry benchmarks. In the case of the portfolios acquired during 2014 and 2013, the exposures arise almost entirely from old assumed reinsurance contracts having small limits of liability. Sirius Group recorded $8 million and $12 million of asbestos-related incurred losses and LAE on its already existing asbestos reserves in 2014 and 2013. The 2014 and 2013 incurred losses were primarily the result of management’s monitoring of a variety of metrics including actual paid and reported claims activity as compared to the most recent in-depth analysis performed in 2012, net paid and reported survival ratios, peer comparisons, and industry benchmarks. Sirius Group recorded an increase of $2 million and an increase of $1 million of environmental losses in 2014 and 2013 on its already existing reserves. Net incurred loss activity for asbestos and environmental in the last two years was as follows: Net incurred loss and LAE activity Year Ended December 31, Millions Asbestos $ 8.0 $ 11.8 Environmental 1.6 .8 Total $ 9.6 $ 12.6 Sirius Group’s net reserves for A&E losses were $210 million and $194 million as of December 31, 2014 and 2013, respectively. Sirius Group’s A&E three-year net paid survival ratio was approximately 8.8 years and 8.0 years as of December 31, 2014 and 2013 which are fairly consistent with industry survival ratios. The following tables show gross and net loss and LAE payments for A&E exposures for the years ending December 31, 2005 through December 31, 2014: Millions Asbestos paid loss and LAE Environmental paid loss and LAE Year Ended December 31, Gross Net Gross Net $ 11.7 $ 12.2 $ 4.8 $ 4.0 9.8 7.9 .6 .5 12.3 10.7 2.0 1.7 19.7 14.3 2.2 1.6 11.4 10.3 1.5 1.5 14.5 12.1 .8 .9 20.4 15.6 3.2 3.6 34.7 29.4 2.3 1.5 25.9 20.3 1.9 1.8 21.9 16.9 1.4 1.6 Sirius Group A&E Claims Activity Sirius Group utilizes specialized claims handling processes on A&E exposures. The issues presented by these types of claims require expertise and an awareness of the various trends and developments in relevant jurisdictions. Generally, Sirius Group sets up claim files for each reported claim by each cedant for each individual insured. In many instances, a single claim notification from a cedant could involve several years and layers of coverage resulting in a file being set up for each involvement. Precautionary claim notices are submitted by the ceding companies in order to preserve their right to pursue coverage under the reinsurance contract. Such notices do not contain an incurred loss amount. Accordingly, an open claim file is not established. As of December 31, 2014, Sirius Group had 2,492 open claim files for asbestos and 490 open claim files for environmental exposures. Sirius Group’s A&E claim activity for the last two years is illustrated in the table below. Year Ended December 31, A&E Claims Activity Asbestos Total asbestos claims at the beginning of the year 2,023 1,859 Asbestos claims acquired during the year Asbestos claims reported during the year Asbestos claims closed during the year (251 ) (294 ) Total asbestos claims at the end of the year 2,492 2,023 Environmental Total environmental claims at the beginning of the year Environmental claims acquired during the year Environmental claims reported during the year Environmental claims closed during the year (34 ) (117 ) Total environmental claims at the end of the year Total Total A&E claims at the beginning of the year 2,422 2,140 A&E claims acquired during the year A&E claims reported during the year A&E claims closed during the year (285 ) (411 ) Total A&E claims at the end of the year 2,982 2,422 The costs associated with administering the underlying A&E claims by Sirius Group’s clients tend to be higher than non-A&E claims due to generally higher legal costs incurred by ceding companies in connection with A&E claims ceded to Sirius Group under the reinsurance contracts. 2. Fair Value Measurements General White Mountains measures certain assets and liabilities at estimated fair value in its consolidated financial statements, with changes therein recognized in current period earnings. In addition, White Mountains discloses estimated fair value for certain liabilities measured at historical or amortized cost. Fair value is defined as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants (an exit price) at a particular measurement date. Fair value measurements are categorized into a hierarchy that distinguishes between inputs based on market data from independent sources (“observable inputs”) and a reporting entity’s internal assumptions based upon the best information available when external market data is limited or unavailable (“unobservable inputs”). Quoted prices in active markets for identical assets have the highest priority (“Level 1”), followed by observable inputs other than quoted prices including prices for similar but not identical assets or liabilities (“Level 2”), and unobservable inputs, including the reporting entity’s estimates of the assumptions that market participants would use, having the lowest priority (“Level 3”). Assets and liabilities carried at fair value include substantially all of the investment portfolio; derivative instruments, both exchange traded and over the counter instruments; and reinsurance assumed liabilities associated with variable annuity benefit guarantees. Valuation of assets and liabilities measured at fair value require management to make estimates and apply judgment to matters that may carry a significant degree of uncertainty. In determining its estimates of fair value, White Mountains uses a variety of valuation approaches and inputs. Whenever possible, White Mountains estimates fair value using valuation methods that maximize the use of observable prices and other inputs. Where appropriate, assets and liabilities measured at fair value have been adjusted for the effect of counterparty credit risk. Invested Assets White Mountains’s invested assets that are measured at fair value include fixed maturity investments, common equity securities, convertibles and other long-term investments, including hedge funds and private equity funds. Where available, the estimated fair value of investments is based upon quoted prices in active markets. In circumstances where quoted prices are unavailable, White Mountains uses fair value estimates based upon other observable inputs including matrix pricing, benchmark interest rates, market comparables, and other relevant inputs. Where observable inputs are not available, the estimated fair value is based upon internal pricing models using assumptions that include inputs that may not be observable in the marketplace but which reflect management’s best judgment given the circumstances and consistent with what other market participants would use when pricing such instruments. As of December 31, 2014, approximately 93% of the investment portfolio recorded at fair value was priced based upon quoted market prices or other observable inputs. Investments valued using Level 1 inputs include fixed maturity investments, primarily investments in U.S. Treasuries, common equity securities and short-term investments, which include U.S. Treasury Bills. Investments valued using Level 2 inputs comprise fixed maturity investments including corporate debt, state and other governmental debt, convertible fixed maturity investments and mortgage and asset-backed securities. Fair value estimates for investments that trade infrequently and have few or no observable market prices are classified as Level 3 measurements. Level 3 fair value estimates based upon unobservable inputs include White Mountains’s investments in hedge funds and private equity funds, as well as investments in certain fixed maturity securities where quoted market prices are unavailable. White Mountains determines when transfers between levels have occurred as of the beginning of the period. White Mountains uses brokers and outside pricing services to assist in determining fair values. For investments in active markets, White Mountains uses the quoted market prices provided by outside pricing services to determine fair value. The outside pricing services used by White Mountains have indicated that if no observable inputs are available for a security, they will not provide a price. In those circumstances, White Mountains estimates the fair value using industry standard pricing models and observable inputs such as benchmark interest rates, market comparables, broker quotes, issuer spreads, bids, offers, credit rating prepayment speeds and other relevant inputs. White Mountains performs procedures to validate the market prices obtained from the outside pricing sources. Such procedures, which cover substantially all of its fixed maturity investments include, but are not limited to, evaluation of model pricing methodologies and a review of the pricing services’ quality control processes and procedures on at least an annual basis, comparison of market prices to prices obtained from a different independent pricing vendors on at least a semi-annual basis, monthly analytical reviews of certain prices, and review of assumptions utilized by the pricing service for selected measurements on an ad hoc basis throughout the year. White Mountains also performs back-testing of selected sales activity to determine whether there are any significant differences between the market price used to value the security prior to sale and the actual sale price on an ad-hoc basis throughout the year. Prices provided by the pricing services that vary by more than 5% and $1 million from the expected price based on these procedures are considered outliers. Also considered outliers are prices that haven’t changed from period to period and prices that have trended unusually compared to market conditions. In circumstances where the results of White Mountains’s review process do not appear to support the market price provided by the pricing services, White Mountains challenges the price. During the past year, approximately 21 securities fell outside White Mountains’s expected results, thereby triggering the challenge with the pricing service. If White Mountains cannot gain satisfactory evidence to support the challenged price, it relies upon its own pricing methodologies to estimate the fair value of the security in question. The fair values of such securities are considered to be Level 3 measurements. The following table summarizes White Mountains’s fair value measurements and the percentage of Level 3 investments as of December 31, 2014: December 31, 2014 Millions Fair value Level 3 Inputs Level 3 Inputs as a % of total fair value U.S. Government and agency obligations $ 188.1 $ - - Debt securities issued by industrial corporations 2,311.2 5.6 - Municipal obligations 83.2 - - Mortgage-backed and asset-backed securities 1,840.9 - - Foreign government, agency and provincial obligations 275.1 - - Preferred stocks 85.8 71.1 % Fixed maturity investments 4,784.3 76.7 % Common equity securities 801.6 40.2 % Convertible fixed maturity and preferred investments 20.5 8.2 % Short-term investments 871.7 - - Other long-term investments(1) 385.0 385.0 % Total investments $ 6,863.1 $ 510.1 % (1) Excludes carrying value of $23.2 associated with other long-term investment limited partnerships accounted for using the equity method. White Mountains uses quoted market prices where available as the inputs to estimate fair value for its investments in active markets. Such measurements are considered to be either Level 1 or Level 2 measurements, depending on whether the quoted market price inputs are for identical securities (Level 1) or similar securities (Level 2). Level 3 measurements for fixed maturity investments as of December 31, 2014 include securities for which the estimated fair value has not been determined based upon quoted market price inputs for identical or similar securities. See Note 5 for tables that summarize the changes in White Mountains’s fair value measurements by level for the years ended December 31, 2014 and 2013 and for amount of total gains (losses) included in earnings attributable to unrealized investment gains (losses) for Level 3 investments for years ended December 31, 2014, 2013 and 2012. Other Long-Term Investments Other long-term investments accounted for at fair value as of December 31, 2014 include $92 million in hedge funds and $151 million in private equity funds. As of December 31, 2014, White Mountains held investments in 12 hedge funds and 32 private equity funds. The largest investment in a single fund was $22 million and $18 million as of December 31, 2014 and 2013. The fair value of White Mountains’s investments in hedge funds and private equity funds is based upon White Mountains’s proportionate interest in the underlying fund’s net asset value, which is deemed to approximate fair value. White Mountains employs a number of procedures to assess the reasonableness of the fair value measurements for its other long-term investments including obtaining and reviewing each fund’s audited financial statements and discussing each fund’s pricing with the fund’s manager. However, since the fund managers do not provide sufficient information to independently evaluate the pricing inputs and methods for each underlying investment, the inputs are considered to be unobservable. Accordingly, the fair values of White Mountains’s investments in hedge funds and private equity funds have been classified as Level 3. In circumstances where the underlying investments are publicly traded, such as the investments made by hedge funds, the fund manager uses current market prices to determine fair value. In circumstances where the underlying investments are not publicly traded, such as the investments made by private equity funds, the private equity fund managers generally consider the need for a liquidity discount on each of the underlying investments when determining the fund’s net asset value. In circumstances where White Mountains’s portion of a fund’s net asset value is deemed to differ from fair value due to illiquidity or other factors associated with White Mountains’s investment in the fund, the net asset value is adjusted accordingly. As of December 31, 2014, there were no circumstances where illiquidity or other factors required an adjustment to the net asset value related to any of its investments in hedge funds or private equity funds. Sensitivity analysis of likely returns on hedge fund and private equity fund investments White Mountains’s investment portfolio includes investments in hedge funds and private equity funds. As of December 31, 2014, the value of investments in hedge funds and in private equity funds was $92 million and $151 million, respectively. The underlying investments are typically publicly traded and private common equity securities and investments, and, as such, are subject to market risks that are similar to White Mountains’s common equity securities. The following illustrates the estimated effect on December 31, 2014 fair value resulting from a 10% change and a 30% change in market value: December 31, 2014 Change in fair value Change in fair value Millions 10% decline 10% increase 30% decline 30% increase Hedge funds $ (9.2 ) $ 9.2 $ (27.6 ) $ 27.6 Private equity funds $ (15.1 ) $ 15.1 $ (45.3 ) $ 45.3 Hedge fund and private equity fund returns are commonly measured against the benchmark returns of hedge fund indices and/or the S&P 500 Index. The historical returns for each index in the past five years are listed below: Year Ended December 31, HFRX Equal Weighted Strategies Index (0.5 )% 6.3 % 2.5 % (6.2 )% 5.3 % S&P 500 Index 13.7 % 32.4 % 16.0 % 2.1 % 15.1 % Variable Annuity Reinsurance Liabilities White Mountains has entered into agreements to reinsure death and living benefit guarantees associated with certain variable annuities in Japan. White Mountains carries the benefit guarantees at fair value. The fair value of the guarantees is estimated using actuarial and capital market assumptions related to the projected discounted cash flows over the term of the reinsurance agreement. The valuation uses assumptions about surrenders rates, market volatilities and other factors, and includes a risk margin which represents the additional compensation a market participant would require to assume the risks related to the business. The selection of surrender rates, market volatility assumptions, risk margins and other factors require the use of significant management judgment. Assumptions regarding future policyholder behavior, including surrender and lapse rates, are generally unobservable inputs and significantly impact the fair value estimate. Market conditions including, but not limited to, changes in interest rates, equity indices, market volatility and foreign currency exchange rates as well as variations in actuarial assumptions regarding policyholder behavior may result in significant fluctuations in the fair value of the liabilities associated with these guarantees that could materially affect results of operations. All of White Mountains’s variable annuity reinsurance liabilities ($0.7 million) were classified as Level 3 measurements as of December 31, 2014. Generally, the liabilities associated with these guarantees increase with declines in the equity markets, interest rates and currencies against the Japanese yen, as well as with increases in market volatilities. The collective account values were approximately 113% and 104% of the guarantee value as of December 31, 2014 and 2013. In 2008, particularly in the fourth quarter, as a result of worldwide declines in equity markets, interest rates and the strengthening of the Japanese yen, the underlying investment accounts declined substantially and the collective account values were significantly lower than the guarantee value for several years. The liability is also affected by annuitant related behavioral and actuarial assumptions, including surrender and mortality rates. WM Life Re lowered its projected surrender rates in 2011 and 2010 to reflect the behavior observed during the turbulent markets experienced throughout those years. During 2014 and 2013, policyholder account values rallied, as surrender charges in the underlying annuities expired and observed surrender rates increased to higher than expected levels. WM Life Re, as a result, increased its projected surrender rates used in the valuation of its variable annuity reinsurance liability at the end of 2013 and again at the end of 2014. WM Life Re uses derivative instruments, including put options, interest rate swaps, total return swaps on bond and equity indices and forwards and futures contracts on major equity indices, currency pairs and government bonds, to mitigate the risks associated with changes in the fair value of the reinsured variable annuity guarantees. The types of inputs used to estimate the fair value of these derivative instruments, with the exception of actuarial assumptions regarding policyholder behavior and risk margins, are generally the same as those used to estimate the fair value of the variable annuity liabilities. As of December 31, 2014, the value of bond funds tracking the WGBI was approximately ¥51 billion ($426 million). By country, the largest exposures, together comprising approximately 90% of the WGBI, were the United States (40%), France (10%), Italy (10%), Germany (9%), the United Kingdom (8%), Spain (6%), the Netherlands (3%), Belgium (3%) and Canada (2%). Eurozone countries together comprised approximately 43%. To reduce hedging basis risk (i.e., the risk that changes in the WGBI will cause WM Life Re's variable annuity guarantee liabilities to change in value at a different rate than the derivative hedges), in December 2009 WM Life Re entered into a series of total return swap contracts on the performance of the WGBI. As of December 31, 2010, approximately 49% of WM Life Re's WGBI-related liability was hedged with WGBI swaps. Because these swaps were denominated in US dollars, WM Life Re continued to hedge the results into Japanese yen to match the benchmark denominated in Japanese yen. In 2011, driven in large part by instability of Eurozone markets, WM Life Re significantly increased coverage of its WGBI exposure. Because the market for WGBI total return swaps was, and continues to be illiquid, WM Life Re entered into a series of total return swaps on the JP Morgan European Government Bond Index (JPM European GBI). Although the JPM European GBI is not an exact match for the European component of the WGBI, its structure and holdings are substantially similar. These swaps are denominated in Japanese yen. As of December 31, 2014, the total notional amounts of JPM European GBI swaps were ¥15 billion ($125 million). At that date, over 100% of the total exposure the European component of the WGBI was hedged with total return swaps. The JPM European GBI total return swaps have maturities laddered to approximate the maturities of the policies reinsured. Under the terms of these swap contracts, WM Life Re receives cash flows based on a fixed return, reset at the beginning of each month based on current LIBOR and is required to pay cash flows based on the performance of the JPM European GBI during that month plus a fixed amount. WM Life Re hedges the residual WGBI-related liability exposure with the limited types of available derivatives that most closely fit the country and term exposures of the WGBI. Since liability exposures are determined by the performance of the overall account value, including the funds that track the Nomura BPI, TOPIX, and MSCI Kokusai, periodic portfolio rebalancing may be required. At such times and within limits, exchange-traded futures may be used to maintain overall neutral exposure as opposed to entering into new, or unwinding existing, swaps. As of December 31, 2014, the value of bond funds tracking the Nomura BPI was approximately ¥56 billion ($466 million). In January 2010, because the types and tenors of liquid Japanese bond futures currently available are extremely limited, to more closely track the performance of bond funds tracking the Nomura BPI, WM Life Re entered into its first total return swap contract on the performance of that index. As of December 31, 2014, the total notional amount of Nomura BPI swaps was ¥36 billion ($301 million), covering over 100% of WM Life Re's Nomura BPI-related liability exposure. Of these swaps, ¥13 billion ($109 million), which mature between 2015 and 2016, track the government bond component of the index only (approximately 80% of the index), leaving WM Life Re exposed to credit spread risk on the non-government portion. However, WM Life Re was able to temporarily convert these swaps into swaps that track the complete index through August 2014 and again through August 2015, at which time they will revert back to swaps that track the government bond component only unless WM Life Re is able to roll the conversion for another period of time. The remaining ¥33 billion ($276 million) track the complete index. Of these, one with a notional amount of ¥5 billion ($42 million) matured in February 2015. The market for these swaps is extremely illiquid and there is no guaranty that WM Life Re will be able to, if appropriate, add to or unwind its position at a reasonable cost. Under the contracts, WM Life Re receives cash flows based on a fixed return, reset at the beginning of each month based on current LIBOR and is required to pay cash flows based on the performance of the Nomura BPI during that period plus a fixed amount. Residual Nomura BPI exposure is hedged with liquid Japanese bond futures and is subject to basis risk relating to the difference between the tenor of the bond futures and the tenor of the assets in the annuity funds covered by WM Life Re’s variable annuity guarantees. As of December 31, 2014, the value of equity funds tracking the MSCI Kokusai was approximately ¥23 billion ($189 million). To reduce hedging basis risk, in 2011 WM Life Re entered into a series of total return swaps on the MSCI Kokusai, denominated in Japanese yen with maturities laddered during 2015 and 2016 to approximate the maturities of the policies reinsured. As of December 31, 2014, the total notional amount of MSCI Kokusai swaps was ¥15 billion ($125 million) and the percent of MSCI Kokusai fund exposure hedged by these swaps was over 100%. Residual MSCI Kokusai exposure is hedged with a variety of more liquid instruments, including exchange-traded futures. During 2009, WM Life Re entered into long term Japanese interest rate swaps, largely replacing its use of short-term Japanese Government Bond (“JGB”) futures to hedge its discount rate exposure. By doing so, WM Life Re better matched the term structure of its discount rate exposure, substantially reduced its exposure to changes in Japanese interest rate swap spreads and significantly reduced the potential costs associated with rolling JGB futures contracts during times of relative market illiquidity. During December 2012, after the relevant Japanese interest rate swap rates fell to their lowest level in many years, the resulting potential benefit, net of cost, to WM Life Re of maintaining its Japanese interest rate swap hedge portfolio was deemed to be limited. Therefore, the decision was made to unwind or offset these Japanese interest rate swaps. During December 2012, approximately 24% of the notional amount of Japanese interest rate swap contracts was unwound and during January 2013 the remaining 76% was unwound or offset. Because the valuation of WM Life Re’s put options and foreign exchange forwards incorporate Japanese interest rates, WM Life Re does continue to have minimal exposure to Japanese swap rates. The following table summarizes the estimated financial impact on WM Life Re's derivatives and benefit guarantee liabilities of instantaneous changes in individual market variables as of December 31, 2014. The table below assumes that all other market variables are constant and does not reflect the inter-dependencies between individual variables. Equity Market Returns Foreign Currency Exchange(1) Interest Rates(2) Market Volatility(3) Millions 20% (20)% 15% (15)% Favorable Unfavorable Decrease Increase Liabilities $ (5 ) $ $ (5 ) $ $ (1 ) $ $ (6 ) $ Hedge Assets (5 ) (10 ) Net $ - $ $ $ $ $ - $ (4 ) $ (1) The value of foreign currencies in Japanese yen terms. (2) In the unfavorable scenario, Japanese interest rates are decreased 70 bps, Japanese swap spreads are tightened by 25 bps, and foreign bond fund yields are increased 70 bps. Conversely, in the favorable scenario, Japanese interest rates are increased 70 bps, Japanese swap spreads are widened 25 bps and foreign bond fund yields are decreased 70 bps. (3) White Mountains’s sensitivities for market implied volatilities vary by term. For equity implied volatilities, White Mountains changes implied volatilities by 15% and 13% for years one and two, respectively. For foreign currency implied volatilities, White Mountains changes implied volatilities by 6% and 5.5% for years one and two, respectively. To test the impact of multiple variables moving simultaneously, WM Life Re performs capital market “shock” testing. Prior to 2009, in performing this testing, WM Life Re had not incorporated basis risk and other hedge underperformance relative to expectations in its models; it had assumed that its hedges would behave as modeled. However, the financial market turmoil of late 2008 and early 2009 demonstrated that, in periods of severe financial market disruption, various aspects of WM Life Re’s hedging program may underperform or over-perform. As a result, WM Life Re now also estimates the efficacy of its hedging program in its “shock” testing. Estimated hedge effectiveness is based on actual results during the recent stressed market environment encompassing the fourth quarter of 2008 and the first quarter of 2009. Hedge effectiveness assumptions also incorporate any subsequent changes to the hedging program that were not in place during this stress period. Although this period captures a historically volatile period that included large market movements over short time periods, hedges may be less effective than the current assumptions to the extent future market movements of the magnitude of these “shocks” occur more quickly than during this recent stress period. The table below summarizes as of December 31, 2014 and 2013, the estimated financial impact of simultaneous market events. Unlike the individual sensitivity analysis illustrated above, the analysis in the table below reflects the inter-dependencies between individual variables. As of December 31, 2014 As of December 31, 2013 Change in Millions Down Market Up Market Down Market Up Market Liabilities $ $ (6 ) $ $ (67 ) Hedge Assets(1) (6 ) (71 ) Net $ (9 ) $ - $ (24 ) $ (4 ) (1) Assumed hedge effectiveness in down and up markets of 93% and 106%, respectively, as of December 31, 2014 and 2013, adjusted for the unhedged portion of Japanese discount rate exposure. Some Japanese discount rate coverage remains primarily through WM Life Re's put option portfolio. WM Life Re applies shocks to the Japanese interest rates and foreign bond fund yields in opposite directions. In the down market scenario, Japanese interest rates are decreased 70 bps, Japanese interest rate swap spreads are tightened by 25 bps, and foreign bond fund yields are increased 70 bps. The “up market” scenario assumes opposite movements in the same variables. For other variables, the “down market” scenario assumes equity indices decrease 20%, foreign currencies depreciate by 15% against the Japanese yen and implied market volatility increases as described in footnote 3 to the table above. The “up market” scenario assumes opposite movements in the same variables. The size of the estimated impact on the liability of simultaneous market events, in both the “up market” and “down market” scenarios, is impacted by several factors, including the applicable account value to guaranty value ratios, term to maturity and surrender assumptions of policies reinsured. The decrease in magnitude of both the “up market” and “down market” shocks as of December 2014 versus the prior year was driven by the substantial decrease in WM Life Re’s liability, owing primarily to higher account values, shorter terms to maturity and lower implied volatilities. WM Life Re projects future surrender rates by year for policies based on a combination of actual experience and expected policyholder behavior. Actual policyholder behavior, either individually or collectively, may differ from projected behavior as a result of a number of factors such as the level of the account value versus guarantee value and applicable surrender charge, views of the primary insurance company's financial strength and ability to pay the guarantee at maturity, annuitants' need for money in a prolonged recession and time remaining to receive the guarantee at maturity. Policyholder behavior is especially difficult to predict given that WM Life Re’s reinsurance contracts are relatively new and the market turmoil seen over the last several years is unprecedented for this type of product in the Japanese market. Actual policyholder behavior may differ materially from WM Life Re's projections. During 2013, improved markets led to significantly higher ratios of annuitants’ account values to guarantee values and, as a result, annuitants have been surrendering their policies at higher rates than WM Life Re has observed in the past. In response to this trend, WM Life Re adjusted the projected surrender assumptions used in the valuation of its variable annuity reinsurance liability upward in the second quarter of 2013, which resulted in a gain of $2 million and again in the fourth quarter of 2013, which resulted in a gain of $5 million. In 2014 surrender rates continued to outpace assumptions and another adjustment was made in the fourth quarter of 2014. This adjustment resulted in a loss of $0.2 million because the policies most impacted have account values that are significantly higher than their guaranty values. At the account value levels as of December 31, 2014, the average assumed surrender rate was approximately 40% per annum. The potential change in the fair value of the liability due to a change in current surrender assumptions is as follows: Change in fair value of liability December 31, Millions Decrease 100% (to zero surrenders) $ - $ Increase 100% $ - $ (7 ) The amounts in the table above could increase in the future if the fair value of the variable annuity guarantee liability changes due to factors other than the surrender assumptions (e.g., a decline in the ratio of the annuitants’ aggregate account values to their aggregate guarantee values). As of December 31, 2011, WM Life Re increased the variable annuity guaranty liability by $6 million to partially reflect a “basis swap” implied by foreign exchange rates which results in lower projected returns (in Japanese yen) for the portion of funds invested in countries outside of Japan. Since the financial crisis in 2008, there has been a break in expected arbitrage free relationships between swap interest rates and foreign exchange rates (in particular, between the U.S. and Japan). This adjustment recognizes that this anomaly of trading values may be more than temporary. The balance of this reserve was $0.1 million as of December 31, 2014. The following table summarizes the changes in White Mountains’s variable annuity reinsurance liabilities and derivative instruments for the year ended December 31, 2014 and 2013: Variable Annuity (Liabilities) Derivative Instruments Millions Level 3 Level 3(1) Level 2(1)(2) Level 1(3) Total(4) Balance at January 1, 2014 $ (52.8 ) $ 63.4 $ 4.7 $ 1.1 $ 69.2 Purchases - - - - - Realized and unrealized gains (losses) 53.5 (38.6 ) (71.0 ) 37.2 (72.4 ) Transfers in (out) - - - - - Sales/settlements - (5.9 ) 100.1 (34.6 ) 59.6 Balance at December 31, 2014 $ .7 $ 18.9 $ 33.8 $ 3.7 $ 56.4 Variable Annuity (Liabilities) Derivative Instruments Millions Level 3 Level 3(1) Level 2(1)(2) Level 1(3) Total(4) Balance at January 1, 2013 $ (441.5 ) $ 140.5 $ (20.5 ) $ (21.7 ) $ 98.3 Purchases - 59.4 - - 59.4 Realized and unrealized gains (losses) 388.7 (136.5 ) (196.1 ) (69.4 ) (402.0 ) Transfers in (out) - - - - - Sales/settlements - - 221.3 92.2 313.5 Balance at December 31, 2013 $ (52.8 ) $ 63.4 $ 4.7 $ 1.1 $ 69.2 (1) Includes over-the-counter instruments. (2) Includes interest rate swaps, total return swaps and foreign currency forward contracts. Fair value measurement based upon bid/ask pricing quotes for similar instruments that are actively traded, where available. Swaps for which an active market does not exist have been priced using observable inputs including the swap curve and the underlying bond index. (3) Includes exchange traded equity index, foreign currency and interest rate futures. Fair value measurements based upon quoted prices for identical instruments that are actively traded. (4) In addition to derivative instruments, WM Life Re held cash, short-term and fixed maturity investments of $33.2 and $81.3 as of December 31, 2014 and 2013 posted as collateral to its counterparties. 3. Surplus Note Valuation BAM Surplus Notes As of December 31, 2014, White Mountains owned $503 million of surplus notes issued by BAM and has accrued $74 million in interest due thereon. Because BAM is consolidated in White Mountains’s financial statements, the BAM Surplus Notes and accrued interest are classified as intercompany notes, carried at face value and eliminated in consolidation. However, the BAM Surplus Notes and accrued interest are carried as assets at HG Global, of which White Mountains owns 97% of the equity, while the BAM Surplus Notes are carried as liabilities at BAM, which White Mountains has no ownership interest in and is completely attributed to non-controlling interests. Periodically, White Mountains’s management reviews the recoverability of amounts recorded from the BAM Surplus Notes and, as of December 31, 2014, believes such notes and interest thereon to be fully recoverable. However, the determination of future recoverability is judgmental, as BAM was recently established and the ability of BAM to repay the principal and interest due on the BAM Surplus Notes is dependent upon BAM’s expected results, particularly premium and MSC collections, years into the future. Any write-off of the carried amount of the BAM Surplus Notes and/or the accrued interest thereon would adversely impact White Mountains’s adjusted book value per share. See Item 1A., Risk Factors, “If BAM does not pay some or all of the interest and principal due on the BAM Surplus Notes, our adjusted book value per share, results of operations and financial condition could be materially adversely affected.” on page 39. No payment of the interest or principal on the BAM Surplus Notes may be made without the approval of the New York State Department of Financial Services. BAM is required to seek regulatory approval to pay interest and principal on its surplus notes only when adequate capital resources have accumulated beyond BAM’s initial capitalization and a level that continues to support its outstanding obligations, business plan and ratings. In addition, BAM’s ability to pay the interest and principal on the BAM Surplus Notes is dependent upon, among other things, whether BAM collects sufficient premiums and member surplus contributions. Interest payments on the BAM Surplus Notes are due quarterly but are subject to deferral, without penalty or default and without compounding, for repayment in the future. BAM has the right at any time to prepay principal in whole or in part. OneBeacon Runoff Transaction In the fourth quarter of 2014, in conjunction with the Runoff Transaction, OneBeacon provided financing in the form of surplus notes with a par value of $101 million, which had a fair value of $65 million at the date of closing and as of December 31, 2014. The OBIC Surplus Notes, issued by one of the transferred entities, OBIC (“Issuer”), were in the form of both seller priority and pari passu notes. Under the contractual terms of both the seller priority and pari passu notes, scheduled interest payments accrue at 6.0% until the scheduled maturity date of March 15, 2020 and at a floating interest rate thereafter, should any principal remain outstanding. All interest and principal due on the seller priority note must first be paid before any interest or principal can be paid on the pari passu note. As required by the PID, interest on the notes does not compound. The notes restrict the Issuer’s ability to make distributions to holders of its equity interest. All such distributions are prohibited while the seller priority note is outstanding, and while the pari passu note is outstanding, distributions are permitted only if the Issuer concurrently repays a pro rata amount of any outstanding principal on the pari passu note. Pursuant to the notes, the Issuer shall seek to redeem the notes annually each March 15 at a requested redemption amount such that the Issuer’s total adjusted capital following the proposed redemption payment would equal 200% of the Issuer’s “authorized control level RBC”, as such term is defined by the insurance laws of the Commonwealth of Pennsylvania and as prescribed by the PID. All redemptions or repayments of principal and payments of interest on the notes are subject to approval by the PID. Below is a table illustrating the valuation adjustments taken to arrive at the estimated fair value of the OBIC Surplus Notes as of December 31, 2014: Type of Surplus Note Millions Seller Priority Pari Passu Total Par Value $ 57.9 $ 43.1 $ 101.0 Fair value adjustments to reflect: Current market rates on public debt and contract-based repayments(1) 1.6 (8.2 ) (6.6 ) Regulatory approval (2) (4.6 ) (8.0 ) (12.6 ) Liquidity adjustment (3) (11.0 ) (5.7 ) (16.7 ) Total adjustments (14.0 ) (21.9 ) (35.9 ) Fair value $ 43.9 $ 21.2 $ 65.1 (1) Represents the value of the OBIC Surplus Notes, at current market yields on publicly traded debt, and assuming issuer is allowed to make principal and interest payments when its financial capacity is available, as measured by statutory capital in excess of a 250% RBC score. (2) Represents anticipated delay in securing regulatory approvals of interest and principal payments to reflect graduated changes in Issuer’s statutory surplus. (3) Represents impact of liquidity spread to account for OneBeacon’s sole ownership of the surplus notes, lack of a trading market and ongoing regulatory approval risk. The internal valuation model used to estimate the fair value is based on discounted expected cash flows. The estimated fair value of the OBIC Surplus Notes is sensitive to changes in treasury rates and public debt credit spreads, as well as changes in estimates with respect to other variables including a discount to reflect the private nature of the notes (and the related lack of liquidity), the credit quality of the notes - based on the financial performance of the Issuer relative to expectations, and the timing, amount, and likelihood of interest and principal payments on the notes, which are subject to regulatory approval and therefore may vary from the contractual terms. OneBeacon has assumed for estimating the fair value that interest payouts begin in year five and principal repayments begin on a graduating basis in year ten for the seller priority note and year fifteen for the pari passu note. Although these variables involve considerable judgment, the Company does not currently expect any resulting changes in the estimated value of the surplus notes to be material to its financial position. As a means to provide the degree of variability for each of the key assumptions that affect the fair value of the OBIC Surplus Notes, below is a table of sensitivities which measure hypothetical changes in such variables and the resulting pre-tax increase (or decrease) impact on the valuation of the OBIC Surplus Notes as of December 31, 2014. Estimates affecting fair value ($ in millions) Pre-tax increase (decrease) in fair value Liquidity Spread (1) -100 bp -50 bp +50 bp +100 bp Seller priority note $ 4.0 $ 2.0 $ (1.9 ) $ (3.6 ) Pari passu note 2.1 1.0 (.9 ) (1.9 ) Total OBIC Surplus Notes $ 6.1 $ 3.0 $ (2.8 ) $ (5.5 ) Credit Assignment (2) +2 Notches +1 Notch -1 Notch -2 Notches Seller priority note $ 5.7 $ 2.8 $ (2.6 ) $ (4.9 ) Pari passu note 3.0 1.4 (1.3 ) (2.5 ) Total OBIC Surplus Notes $ 8.7 $ 4.2 $ (3.9 ) $ (7.4 ) Principal Repayments (3) -3 Years -1 Year +1 Year +3 Years Seller priority note $ 1.7 $ 0.5 $ (.4 ) $ (1.3 ) Pari passu note .9 .2 (.2 ) (.6 ) Total OBIC Surplus Notes $ 2.6 $ 0.7 $ (0.6 ) $ (1.9 ) Interest Repayments (4) -3 Years -1 Year +1 Year +3 Years Seller priority note $ 5.2 $ 2.4 $ (3.1 ) $ (12.2 ) Pari passu note 5.6 2.5 (3.0 ) (11.0 ) Total OBIC Surplus Notes $ 10.8 $ 4.9 $ (6.1 ) $ (23.2 ) (1) Represents the sensitivity to changes in the estimate of the liquidity spread added to account for OneBeacon’s sole ownership of the OBIC Surplus Notes, lack of a liquid trading market, and ongoing regulatory approval risk. (2) Represents the sensitivity to changes in the estimate of the underlying equivalent credit quality of the OBIC Surplus Notes. Such credit quality is approximated by comparing the expected percentage of discounted payments missed, as calculated in a proprietary Stochastic simulation, to a series of benchmarks derived from data published by Standard & Poor’s. Note that “notch” is defined as the difference between, for example. a “B” and “B+” rated instrument. (3) Represents the sensitivity to changes in the estimate of timing of the first principal payment received by OneBeacon. The fair value model assumes a delay in the receipt of principal cash flows as a result of the regulatory approval required before such payments may occur; and assuming repayments are made with a graduated impact on statutory surplus. (4) Represents the sensitivity to changes in the estimate of timing of the first interest payment received by OneBeacon. The fair value model assumes a delay in the receipt of interest cash flows as a result of the regulatory approval required before such payments may occur; and assuming repayments are made with a graduated impact on statutory surplus. 4. Sirius Group Reinsurance Estimates There is a time lag from the point when premium and related commission and expense activity is recorded by a ceding company to the point when such information is reported by the ceding company to Sirius Group. This time lag can vary from one to several contractual reporting periods (i.e. quarterly/monthly). This lag is common in the reinsurance business, and slightly longer when a reinsurance intermediary is involved. As a result of this time lag in reporting, Sirius Group estimates a portion of its written premium and related commissions and expenses. Given the nature of Sirius Group’s business, estimated premium balances, net of related commissions and expenses, comprise a large portion of total premium balances receivable. The estimation process begins by identifying which major accounts have not reported activity at the most recent period end. In general, premium estimates for excess of loss business are based on expected premium income included in the contractual terms. For proportional business, Sirius Group’s estimates are derived from expected premium volume based on contractual terms or ceding company reports and other correspondence and communication with underwriters, intermediaries and ceding companies. Once premium estimates are determined, related commission and expense estimates are derived using contractual terms. Sirius Group closely monitors its estimation process on a quarterly basis and adjusts its estimates as more information and actual amounts become known. There is no assurance that the amounts estimated by Sirius Group will not deviate from the amounts reported by the ceding company or reinsurance intermediary. Any such deviations are reflected in the results of operations when they become known. The following table summarizes Sirius Group’s premium estimates and related commissions and expenses: December 31, 2014 December 31, 2013 Millions Gross Premium Estimates Net Premium Estimates Net Commission and Expense Estimates Net Amount Included in Reinsurance Balances Receivable Gross Premium Estimates Net Premium Estimates Net Commission and Expense Estimates Net Amount Included in Reinsurance Balances Receivable Property $ 106.7 $ 94.3 $ (34.0 ) $ 60.3 $ 90.5 $ 73.7 $ (28.7 ) $ 45.0 Property catastrophe excess 68.6 54.4 (5.0 ) 49.4 82.1 65.2 (5.5 ) 59.7 Accident and health 89.5 71.8 (30.8 ) 41.0 76.9 56.4 (22.2 ) 34.2 Aviation and space 37.5 30.7 (6.3 ) 24.4 34.4 28.7 (5.8 ) 22.9 Trade credit 22.7 19.2 (9.3 ) 9.9 36.8 27.2 (10.9 ) 16.3 Marine 15.2 13.6 (2.7 ) 10.9 17.3 16.0 (3.0 ) 13.0 Casualty 4.5 4.5 1.9 6.4 4.6 4.6 1.5 6.1 Agriculture 9.5 9.0 (2.3 ) 6.7 3.1 2.7 (0.3 ) 2.4 Contingency 6.7 5.9 (1.7 ) 4.2 4.3 2.9 (1.2 ) 1.7 Total $ 360.9 $ 303.4 $ (90.2 ) $ 213.2 $ 350.0 $ 277.4 $ (76.1 ) $ 201.3 The net amounts recorded in reinsurance balances receivable may not yet be due from the ceding company at the time of the estimate since actual reporting from the ceding company has not yet occurred. Therefore, based on the process described above, Sirius Group believes its estimated balances are collectible. FORWARD-LOOKING STATEMENTS This report may contain “forward-looking statements” within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934. All statements, other than statements of historical facts, included or referenced in this report which address activities, events or developments which White Mountains expects or anticipates will or may occur in the future are forward-looking statements. The words “will”, “believe”, “intend”, “expect”, “anticipate”, “project”, “estimate”, “predict” and similar expressions are also intended to identify forward-looking statements. These forward-looking statements include, among others, statements with respect to White Mountains’: • change in adjusted book value per share or return on equity; • business strategy; • financial and operating targets or plans; • incurred loss and loss adjustment expenses and the adequacy of its loss and loss adjustment expense reserves and related reinsurance; • projections of revenues, income (or loss), earnings (or loss) per share, dividends, market share or other financial forecasts; • expansion and growth of its business and operations; and • future capital expenditures. These statements are based on certain assumptions and analyses made by White Mountains in light of its experience and perception of historical trends, current conditions and expected future developments, as well as other factors believed to be appropriate in the circumstances. However, whether actual results and developments will conform to its expectations and predictions is subject to a number of risks and uncertainties that could cause actual results to differ materially from expectations, including: • the risks associated with Item 1A of this Report on Form 10-K; • claims arising from catastrophic events, such as hurricanes, earthquakes, floods, fires, terrorist attacks or severe winter weather; • the continued availability of capital and financing; • general economic, market or business conditions; • business opportunities (or lack thereof) that may be presented to it and pursued; • competitive forces, including the conduct of other property and casualty insurers and reinsurers; • changes in domestic or foreign laws or regulations, or their interpretation, applicable to White Mountains, its competitors or its customers; • an economic downturn or other economic conditions adversely affecting its financial position; • recorded loss reserves subsequently proving to have been inadequate; • actions taken by ratings agencies from time to time, such as financial strength or credit ratings downgrades or placing ratings on negative watch; and • other factors, most of which are beyond White Mountains’s control. Consequently, all of the forward-looking statements made in this report are qualified by these cautionary statements, and there can be no assurance that the actual results or developments anticipated by White Mountains will be realized or, even if substantially realized, that they will have the expected consequences to, or effects on, White Mountains or its business or operations. White Mountains assumes no obligation to publicly update any such forward-looking statements, whether as a result of new information, future events or otherwise.

<s>[INST] The following discussion also includes three nonGAAP financial measures, adjusted comprehensive income, adjusted book value per share and adjusted capital, that have been reconciled to their most comparable GAAP financial measures (see page 86). White Mountains believes these measures to be more relevant than comparable GAAP measures in evaluating White Mountains’s financial performance and condition. RESULTS OF OPERATIONS FOR THE YEARS ENDED December 31, 2014, 2013 and 2012 OverviewYear Ended December 31, 2014 versus Year Ended December 31, 2013 White Mountains ended 2014 with an adjusted book value per share of $665, an increase of 3.6% during the year, including dividends, compared to an increase of 9.5% during 2013, including dividends. White Mountains reported adjusted comprehensive income of $136 million in 2014 compared to adjusted comprehensive income of $340 million in 2013. The decrease was driven by $87 million of aftertax foreign currency exchange losses, $58 million of aftertax adverse prior year loss reserve development at OneBeacon and lower investment returns, partially offset by strong underwriting performance at Sirius Group. OneBeacon’s book value per share increased 2.2% during 2014, including dividends, compared to an increase of 17.3% during 2013, including dividends. OneBeacon’s GAAP combined ratio was 102% for 2014 compared to 92% for 2013. OneBeacon’s results reflect a $109 million pretax increase to loss reserves in the fourth quarter, of which $75 million is related to prior accident years and $34 million related to the current accident year. Full year 2014 results reflect a $90 million pretax increase to prior accident year reserves. The reserve increases were driven primarily by professional liability (including lawyers’ professional liability) and management liability within the Professional Insurance business, and to a lesser extent the Entertainment and Government Risks businesses. Sirius Group’s GAAP combined ratio was 76% for 2014 compared to 82% for 2013. The improvement in the combined ratio for 2014 was driven by lower catastrophe losses and higher favorable loss reserve development, partially offset by higher acquisition expenses. Sirius Group’s combined ratio includes 7 points of catastrophe losses in 2014 compared to 10 points in 2013 and includes 11 points of favorable loss reserve development in 2014 compared to 6 points in 2013. White Mountains’s total net written premiums increased 7% to $2,122 million in 2014, driven by growth at both OneBeacon and Sirius Group. OneBeacon’s net written premiums increased 12% to $1,217 million in 2014, primarily related to OneBeacon’s newer businesses, particularly OneBeacon Crop Insurance, OneBeacon Program Group and OneBeacon Surety Group. Sirius Group’s net written premiums increased 1% to $883 million in 2014, as increases in the accident and health, property (excluding property catastrophe excess) and aviation lines were mostly offset by decreases in property catastrophe excess and trade credit business. White Mountains’s GAAP pretax total return on invested assets was 1.9% for 2014, compared to 4.1% for 2013. 2014 included 1.9% of foreign currency losses, while foreign currency translation did not meaningfully impact investment returns in 2013. In local currencies, the fixed income portfolio was up 2.7% for 2014, a decent absolute result for the year but behind the longer duration Barclays Intermediate Aggregate Index as interest rates fell. In local currencies, the fixed income portfolio was up 0.5% for 2013. In local currencies, the equity portfolio (common equity securities, convertibles and other longterm investments) was up 8.0% [/INST] Negative. </s>

WHITE MOUNTAINS INSURANCE GROUP LTD

2016-02-29

2015-12-31

Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations The following discussion contains “forward-looking statements”. White Mountains intends statements that are not historical in nature, which are hereby identified as forward-looking statements, to be covered by the safe harbor provisions of the Private Securities Litigation Reform Act of 1995. White Mountains cannot promise that its expectations in such forward-looking statements will turn out to be correct. White Mountains’s actual results could be materially different from and worse than its expectations. See “FORWARD-LOOKING STATEMENTS” on page 96 for specific important factors that could cause actual results to differ materially from those contained in forward-looking statements. The following discussion also includes five non-GAAP financial measures, adjusted comprehensive income, adjusted book value per share, adjusted capital, consolidated portfolio returns excluding Symetra and common equity securities and other long-term investment returns excluding Symetra that have been reconciled to their most comparable GAAP financial measures (see page 75). White Mountains believes these measures to be more relevant than comparable GAAP measures in evaluating White Mountains’s financial performance and condition. RESULTS OF OPERATIONS FOR THE YEARS ENDED December 31, 2015, 2014 and 2013 Overview-Year Ended December 31, 2015 versus Year Ended December 31, 2014 White Mountains ended 2015 with an adjusted book value per share of $699, an increase of 5.3% during the year, including dividends, compared to an increase of 3.6% during 2014, including dividends. During 2015, White Mountains signed a definitive agreement to sell Sirius Group to CMI, and Symetra announced that it entered into a definitive merger agreement with Sumitomo Life pursuant to which Sumitomo Life will acquire all of the outstanding shares of Symetra. Substantially all of the benefit from the Symetra transaction was recorded in 2015, while the benefit from the Sirius Group transaction will be recorded at closing, which is expected in the first quarter of 2016. Including dividends, Symetra produced $264 million of adjusted comprehensive income for White Mountains in 2015, of which $241 million was recognized as an after-tax unrealized investment gain in the fourth quarter. Including the estimated gain of $84 per share for the Sirius Group sale, adjusted book value per share is approximately $783, an increase of 18.0% for the year ended December 31, 2015, including dividends. See page 44 for the calculation of the estimated gain per share from the Sirius Group transaction. White Mountains reported adjusted comprehensive income of $232 million in 2015 compared to $135 million in 2014. The increase is driven by $264 million of adjusted comprehensive income from Symetra and lower foreign currency losses, partially offset by lower investment returns excluding Symetra and increased incentive compensation expense recorded in connection with the agreements to sell Sirius Group and Symetra. OneBeacon’s book value per share increased 3.8% during 2015, including dividends, compared to an increase of 2.1% during 2014, including dividends. OneBeacon’s GAAP combined ratio was 96% for 2015 compared to 102% for 2014. The lower combined ratio is primarily the result of the $109 million loss reserve charge in the fourth quarter of 2014, partially offset by higher expense ratios driven by higher incentive compensation expense, changes in business mix and the impact of exiting the crop business. OneBeacon’s net written premiums decreased 7% to $1.1 billion in 2015, primarily due to the exit from crop and lawyers liability businesses, a decrease in the Healthcare business and the termination of an affiliated reinsurance treaty, partially offset by increases in OneBeacon’s newer Programs and Surety businesses. As a result of the agreement to sell Sirius Group, its results are reported as discontinued operations within White Mountains’s GAAP financial statements. Sirius Group’s results continue to inure to White Mountains through the closing date of the sale. Sirius Group’s GAAP combined ratio was 85% for 2015 compared to 76% for 2014. The increase was primarily due to lower favorable net loss reserve development and a significantly higher frequency of non-catastrophe per risk and pro rata loss events, including $18 million in losses from the Tianjin port explosions, partially offset by lower catastrophe losses. Additionally, the combined ratio for the year ended December 31, 2015 included 1 point from the cost of ILW covers purchased to mitigate the potential impact of major events on Sirius Group’s balance sheet pending the close of the sale to CMI. White Mountains’s GAAP pre-tax total return on invested assets was 3.6% for year ended December 31, 2015. Excluding the returns from Symetra, the GAAP pre-tax total return on invested assets was -0.2% for year ended December 31, 2015, which included 0.9% of currency losses, compared to a return of 1.9% for the year ended December 31, 2014, which included 1.9% of currency losses. In local currencies, the fixed income portfolio was up 1.1% for 2015, a decent absolute result for the year and essentially in-line with the Barclays Intermediate Aggregate Index. In local currencies and including Symetra, the equity (common equity securities and other long-term investments) portfolio was up 19.6% for the year; excluding Symetra, the equity portfolio was down 1.4% for the year. White Mountains’s portfolio of common stocks and ETFs, excluding Symetra, was up 3.3%, which was a good result and ahead of the S&P 500 while other long-term investments were down 10.1% reflecting unfavorable mark-to-market adjustments to the OneBeacon runoff surplus notes and losses in energy exposed private equity funds. In 2015, White Mountains deployed approximately $400 million of capital, including $284 million through share repurchases and approximately $120 million through the purchase of insurance service businesses, both in new investments and additional financings in existing investments to support growth in acquisitions. Overview-Year Ended December 31, 2014 versus Year Ended December 31, 2013 White Mountains ended 2014 with an adjusted book value per share of $665, an increase of 3.6% during the year, including dividends, compared to an increase of 9.5% during 2013, including dividends. White Mountains reported adjusted comprehensive income of $136 million in 2014 compared to adjusted comprehensive income of $340 million in 2013. The decrease was driven by $87 million of after-tax foreign currency exchange losses, $58 million of after-tax adverse prior year loss reserve development at OneBeacon and lower investment returns. OneBeacon’s book value per share increased 2.1% during 2014, including dividends, compared to an increase of 17.2% during 2013, including dividends. OneBeacon’s GAAP combined ratio was 102% for 2014 compared to 92% for 2013. OneBeacon’s 2014 results reflect a $109 million pre-tax increase to loss reserves in the fourth quarter of 2014, of which $75 million is related to prior accident years and $34 million related to the current accident year. Full year 2014 results reflect a $90 million pre-tax increase to prior accident year reserves. The reserve increases were driven primarily by professional liability (including lawyers’ professional liability) and management liability within Professional Insurance, and to a lesser extent the Entertainment and Government Risks businesses. In 2015, Professional Insurance was reorganized into Other Professional Lines, Management Liability, Financial Services and Healthcare. OneBeacon’s net written premiums increased 12% to $1.2 billion in 2014, primarily related to OneBeacon’s newer businesses, particularly Crop, Programs and Surety. Sirius Group’s GAAP combined ratio was 76% for 2014 compared to 82% for 2013. The improvement in the combined ratio for 2014 was driven by lower catastrophe losses and higher favorable loss reserve development, partially offset by higher acquisition expenses. Sirius Group’s combined ratio includes 7 points of catastrophe losses in 2014 compared to 10 points in 2013 and includes 11 points of favorable loss reserve development in 2014 compared to 6 points in 2013. White Mountains’s GAAP pre-tax total return on invested assets was 1.9% for 2014, compared to 4.1% for 2013. 2014 included 1.9% of foreign currency losses, while foreign currency translation did not meaningfully impact investment returns in 2013. In local currencies, the fixed income portfolio was up 2.7% for 2014, a decent absolute result for the year but behind the longer duration Barclays Intermediate Aggregate Index as interest rates fell. In local currencies, the fixed income portfolio was up 0.5% for 2013. In local currencies, the equity portfolio (common equity securities and other long-term investments) was up 8.0% for 2014, a strong absolute result for the year but mixed against benchmarks, underperforming the S&P 500 and outperforming the small-cap Russell 2000. In local currencies, the equity portfolio was up 19.0% for 2013. During 2014, White Mountains completed the acquisitions of four insurance service businesses: (i) Tranzact, a provider of end-to-end direct-to-consumer customer acquisition solutions to leading insurance carriers, (ii) MediaAlpha, an advertising technology company that develops platforms for the buying and selling of insurance and other vertical-specific performance media, (iii) Wobi, the only price comparison/aggregation business in Israel, and (iv) Star & Shield, which includes the attorney-in-fact for SSIE, a Florida-domiciled reciprocal insurance exchange providing private passenger auto insurance to members of the public safety community and their families. In 2014, White Mountains deployed almost $400 million of capital, including approximately $235 million through the purchase of insurance service businesses and $134 million through share repurchases. Adjusted Book Value Per Share The following table presents White Mountains’s adjusted book value per share, a non-GAAP financial measure, for the years ended December 31, 2015, 2014 and 2013 and reconciles this non-GAAP measure to the most comparable GAAP measure. (See “NON-GAAP FINANCIAL MEASURES” on page 75.) December 31, Book value per share numerators (in millions): White Mountains’s common shareholders’ equity(1) $ 3,913.2 $ 3,995.7 $ 3,905.1 Equity in net unrealized (gains) losses from Symetra’s fixed maturity portfolio - (34.9 ) 40.4 Adjusted book value per share numerator(1) $ 3,913.2 $ 3,960.8 $ 3,945.5 Book value per share denominators (in thousands of shares): Common shares outstanding(1) 5,623.7 5,986.2 6,176.7 Unearned restricted shares (25.0 ) (25.7 ) (33.0 ) Adjusted book value per share denominator(1) 5,598.7 5,960.5 6,143.7 Book value per share $ 695.84 $ 667.48 $ 632.22 Adjusted book value per share $ 698.95 $ 664.50 $ 642.20 Dividends paid per share $ 1.00 $ 1.00 $ 1.00 (1) Excludes stock options, which are anti-dilutive to book value. The following table presents the estimated net gain from the sale of Sirius Group as of December 31, 2015: Millions, except per share amounts Assets held for sale $ 4,407.0 Liabilities held for sale (2,884.0 ) Net assets held for sale 1,523.0 Assets to be contributed in exchange for December 31, 2015 carrying value of Symetra and other amounts to be retained by White Mountains 702.8 Assets to be contributed to reflect Symetra at transaction value 3.7 (1) Less: SIG Preference Shares (250.0 ) Total net assets 1,979.5 Transaction multiple above total net assets 27.3 % 540.4 Additional consideration 10.0 Gain from the sale of Sirius Group 550.4 Estimated compensation expense, transaction costs and other, net of applicable tax (80.0 ) Net gain from the sale of Sirius Group $ 470.4 Net gain from the sale of Sirius Group per share $ 84.02 (1) The is amount reflects the after-tax increase from the market value of Symetra at December 31, 2015 of $31.77 per share to the transaction value of Symetra of $32.00 per share. The following table is a summary of goodwill and intangible assets that are included in White Mountains’s adjusted book value as of December 31, 2015, 2014 and 2013: December 31, Millions Goodwill Tranzact $ 163.8 $ 145.1 $ - MediaAlpha 18.3 18.3 - Wobi 5.8 5.5 - Total goodwill 187.9 168.9 - Intangible assets Tranzact 156.1 142.8 - MediaAlpha 24.4 32.5 - Wobi and Other 7.3 7.0 5.1 Total intangible assets 187.8 182.3 5.1 Total goodwill and intangible assets (1) 375.7 351.2 5.1 Goodwill and intangible assets attributed to non-controlling interests (135.8 ) (141.8 ) (1.3 ) Goodwill and intangible assets included in adjusted book value $ 239.9 $ 209.4 $ 3.8 (1) See Note 6 - “Goodwill and Other Intangible Assets” for details of other intangible assets. Review of Consolidated Results A summary of White Mountains’s consolidated financial results for the years ended December 31, 2015, 2014 and 2013 follows: Year Ended December 31, Millions Gross written premiums $ 1,361.7 $ 1,362.2 $ 1,176.5 Net written premiums $ 1,172.6 $ 1,239.0 $ 1,102.2 Revenues Earned insurance premiums $ 1,188.2 $ 1,185.0 $ 1,120.9 Net investment income 60.8 59.5 59.8 Net realized and unrealized investment gains 225.4 78.5 133.9 Other revenue - Symetra warrants - - 10.8 Other revenue - other 334.2 131.1 36.2 Total revenues 1,808.6 1,454.1 1,361.6 Expenses Losses and LAE 708.9 824.0 622.1 Insurance acquisition expenses 220.1 206.2 210.4 Other underwriting expenses 218.6 179.6 205.2 General and administrative expenses 458.9 246.0 147.7 General and administrative expenses - amortization of intangible assets 28.6 11.7 1.4 Interest expense 18.6 15.6 16.2 Total expenses 1,653.7 1,483.1 1,203.0 Pre-tax income 154.9 (29.0 ) 158.6 Income tax benefit (expense) .7 14.8 (32.6 ) Net income from continuing operations 155.6 (14.2 ) 126.0 Net gain (loss) on sale of discontinued operations, net of tax 18.2 (1.6 ) 46.6 Net gain from discontinued operations, net of tax 80.6 260.2 99.9 Equity in earnings of unconsolidated affiliates, net of tax 25.1 45.6 36.6 Net income 279.5 290.0 309.1 Net loss attributable to non-controlling interests 18.1 22.2 12.5 Net income attributable to White Mountains’s common shareholders 297.6 312.2 321.6 Change in equity in net unrealized gains (losses) from investments in Symetra common shares, net of tax (34.9 ) 75.3 (98.1 ) Change in foreign currency translation and pension liability (.5 ) (10.7 ) 17.4 Change in foreign currency translation and other items from discontinued operations (65.0 ) (169.5 ) 6.1 Comprehensive income 197.2 207.3 247.0 Comprehensive loss (income) attributable to non-controlling interests - 3.3 (5.2 ) Comprehensive income attributable to White Mountains’s common shareholders 197.2 210.6 241.8 Change in net unrealized (losses) gains from Symetra’s fixed maturity portfolio, net of tax 34.9 (75.3 ) 98.1 Adjusted comprehensive income(1) $ 232.1 $ 135.3 $ 339.9 (1) Adjusted comprehensive income is a non-GAAP measure. For a description of the most comparable GAAP measure (see NON-GAAP FINANCIAL MEASURES on page 75). Consolidated Results-Year Ended December 31, 2015 versus Year Ended December 31, 2014 White Mountains’s total revenues increased 24% to $1.8 billion in 2015, which was driven by the $259 million unrealized investment gain from Symetra and increases in other revenues from the recently-acquired insurance service businesses. Earned insurance premiums in 2015 were in line with 2014. Net investment income increased 2% to $61 million, as lower investment expenses were mostly offset by lower common stock dividends. White Mountains reported net realized and unrealized investment gains of $225 million in 2015, which included $259 million from Symetra, compared to $79 million of gains in 2014. See “Summary of Investment Results” on page 58 for a discussion and analysis of White Mountains’s investment returns. Other revenue increased to $334 million in 2015 from $131 million in 2014. Other revenue in 2015 included $187 million from Tranzact and $106 million from MediaAlpha compared to $43 million from Tranzact and $65 million from MediaAlpha in 2014. Other revenues also included third-party investment management fee income at WM Advisors of $13 million in 2015, compared to $17 million in 2014. Other revenue included $1 million of WM Life Re’s losses in 2015 compared to $4 million of WM Life Re’s losses in 2014. See Note 9 - “Derivatives” for details regarding WM Life Re’s total impact on White Mountains’s statement of operations. Other revenue also included a $20 million pre-tax gain in 2015 from the sale of Hamer LLC, a small manufacturing company that White Mountains received in 2012 in connection with the liquidation of a limited partnership fund. White Mountains’s total expenses increased 11% to $1.7 billion in 2015, which was driven by increases in other expenses from the recently-acquired insurance services businesses, partially offset by lower expenses in OneBeacon’s insurance business. Losses and LAE decreased 14%, primarily due to the $109 million reserve charge recorded by OneBeacon related to the actuarial analysis performed in the fourth quarter of 2014, while insurance acquisition expenses and other underwriting expenses increased 7% and 22% in 2015 due to changes in business mix and higher incentive compensation expense (see “Summary of Operations by Segment” on page 47). General and administrative expenses in 2015 included $167 million from Tranzact and $99 million from MediaAlpha compared to $37 million from Tranzact and $61 million from MediaAlpha in 2014. Consolidated Results-Year Ended December 31, 2014 versus Year Ended December 31, 2013 White Mountains’s total revenues increased 7% to $1.5 billion in 2014, which was driven by other revenues from the newly-acquired insurance services businesses, offset by a decrease in net unrealized gains from the investment portfolio. Earned insurance premiums increased 6%, driven by an increase from OneBeacon’s newer businesses, particularly OneBeacon Crop Insurance, OneBeacon Program Group and OneBeacon Surety Group. Net investment income was in line with 2013 while net realized and unrealized investment gains decreased to $79 million in 2014 from $134 million in 2013. See “Summary of Investment Results” on page 58 for a discussion and analysis of White Mountains’s investment returns. Other revenue increased to $131 million in 2014 from $47 million in 2013. Other revenue in 2014 included $65 million from MediaAlpha and $43 million from Tranzact. Other revenue in 2013 included transaction gains of $27 million, composed of a $23 million gain on OneBeacon’s sale of Essentia and a $4 million gain from the extension of the transition service agreement for services provided by OneBeacon on business sold to Tower in the personal lines transaction in 2010. In addition, 2013 included $11 million of mark-to-market gains on the Symetra warrants, which were exercised in June 2013. Other revenue included $4 million of WM Life Re’s losses in 2014 compared to $13 million of WM Life Re’s losses in 2013. See Note 9 - “Derivatives” for details regarding WM Life Re’s total impact on White Mountains’s statement of operations. Other revenues in 2014 also included third-party investment management fee income at WM Advisors of $17 million, compared to $16 million in 2013. White Mountains’s total expenses increased 23% to $1.5 billion in 2014, driven by higher loss and LAE expenses at OneBeacon. Losses and LAE increased 32%, while insurance acquisition expenses and other underwriting expenses decreased 2% and 12% in 2014. The increase in loss and LAE includes the $109 million reserve charge recorded by OneBeacon related to the actuarial analysis performed in the fourth quarter of 2014, which was partially offset by lower incentive compensation expense accruals, contributing to the decrease in other underwriting expenses in 2014 (see “Summary of Operations by Segment” on page 47). General and administrative expenses in 2014 included $61 million from MediaAlpha and $37 million from Tranzact. Income Taxes The Company and its Bermuda-domiciled subsidiaries are not subject to Bermuda income tax under current Bermuda law. In the event there is a change in the current law such that taxes are imposed, the Company and its Bermuda-domiciled subsidiaries would be exempt from such tax until March 31, 2035, pursuant to the Bermuda Exempted Undertakings Tax Protection Act of 1966. The Company has subsidiaries and branches that operate in various other jurisdictions around the world that are subject to tax in the jurisdictions in which they operate. White Mountains reported income tax benefit of $1 million in 2015 on pre-tax income of $155 million. White Mountains’s effective tax rate for 2015 was near zero, which was lower than the U.S. statutory rate of 35% due primarily to income generated in jurisdictions with lower tax rates than the United States. White Mountains reported income tax benefit of $15 million in 2014 on pre-tax loss of $29 million. White Mountains’s effective tax rate for 2014 was 51%, which was higher than the U.S. statutory rate of 35% due primarily to losses generated in the U.S. and income generated in jurisdictions with lower tax rates than the United States. White Mountains reported an income tax expense of $33 million in 2013 on pre-tax income of $159 million. White Mountains’s effective tax rate for 2013 was 21%, which was lower than the U.S. statutory rate of 35% due primarily to income generated in jurisdictions with lower tax rates than the United States. In addition, the effective tax rate reflects a $7 million release of a valuation allowance at OneBeacon related to the restructuring of a surplus note issued to a consolidated insurance reciprocal exchange. I. Summary of Operations By Segment White Mountains conducts its operations through three segments: (1) OneBeacon, (2) HG Global/BAM and (3) Other Operations. While investment results are included in these segments, because White Mountains manages the majority of its investments through its wholly-owned subsidiary, WM Advisors, a discussion of White Mountains’s consolidated investment operations is included after the discussion of operations by segment. White Mountains’s segment information is presented in Note 16 -“Segment Information” to the Consolidated Financial Statements. As a result of the Sirius Group sale, the results of operations for Sirius Group have been classified as discontinued operations and are now presented separately, net of related income taxes, in the statement of comprehensive income. Prior year amounts have been reclassified to conform to the current period’s presentation (See Note 22 - “Discontinued Operations”.) OneBeacon Financial results and GAAP combined ratios for OneBeacon for the years ended December 31, 2015, 2014 and 2013 follow: Year Ended December 31, $ in millions Gross written premiums $ 1,315.9 $ 1,323.4 $ 1,162.9 Net written premiums $ 1,136.6 $ 1,216.9 $ 1,088.6 Earned insurance premiums $ 1,176.2 $ 1,177.1 $ 1,120.4 Net investment income 45.9 43.4 43.0 Net realized and unrealized investment (losses) gains (35.1 ) 40.4 49.4 Other revenue (.6 ) 5.8 31.2 Total revenues 1,186.4 1,266.7 1,244.0 Losses and LAE 700.7 815.1 622.1 Insurance acquisition expenses 213.8 203.3 208.9 Other underwriting expenses 218.2 179.2 204.8 General and administrative expenses 14.1 12.4 10.6 Amortization of intangible assets 1.3 1.4 1.4 Interest expense on debt 13.0 13.0 13.0 Total expenses 1,161.1 1,224.4 1,060.8 Pre-tax income $ 25.3 $ 42.3 $ 183.2 GAAP Ratios: Losses and LAE % % % Expense Combined % % % The following table presents OneBeacon’s book value per share. December 31, Millions, except per share amounts OneBeacon’s common shareholders’ equity $ 1,000.9 $ 1,045.8 $ 1,103.7 OneBeacon common shares outstanding 95.1 95.3 95.4 OneBeacon book value per common share $ 10.53 $ 10.97 $ 11.57 Dividends paid per common share $ .84 $ .84 $ .84 OneBeacon Results-Year Ended December 31, 2015 versus Year Ended December 31, 2014 OneBeacon ended 2015 with a book value per share of $10.53, an increase of 3.8% during 2015, including dividends, compared to an increase of 2.1% during 2014, including dividends. Improved underwriting results drove the increase in OneBeacon’s book value per share growth for 2015. OneBeacon’s GAAP combined ratio decreased to 96% for 2015 from 102% for 2014. The decrease was primarily driven by a 9 point decrease in the loss ratio from non-recurrence of adverse prior accident year loss reserve development in 2015, partially offset by an increase in the expense ratio and the impact of increasingly competitive markets on the current year accident loss ratio. There was no net loss reserve development in 2015, primarily attributable to favorable net loss reserve development from the Technology, Collector Cars and Boats, Specialty Property and Financial Services lines of business, offset by unfavorable net loss reserve development from the Entertainment and Ocean Marine lines of business. In 2014, there was $90 million, or 8 points, of unfavorable net prior accident year adverse loss reserve development (described below in “2014 Fourth Quarter Loss and LAE Reserve Increase.”). The increase in the expense ratio for 2015 was primarily due to higher incentive compensation expense, higher acquisition costs due to changes in business mix and the impact of exiting the crop business. During 2015, OneBeacon recognized a loss of $4 million in other revenues in connection with an assessment from the Michigan Catastrophic Claims Association payable to Markel Corporation pursuant to the indemnification provisions in the stock purchase agreement governing the sale of Essentia. OneBeacon previously recognized a pretax gain of $23 million in 2013 on its sale of Essentia, an indirect wholly-owned subsidiary which wrote legacy collector cars and boats business, to Markel Corporation. OneBeacon’s net written premiums decreased 7% in 2015 to $1.1 billion, primarily due to the exit from crop ($44 million) and lawyers liability ($28 million) businesses, a decrease in the Healthcare business ($33 million) and the termination of an affiliated reinsurance treaty ($20 million), partially offset by increases in OneBeacon’s newer Programs and Surety businesses ($67 million). Excluding the impact of OneBeacon’s exit from the Crop and lawyers liability businesses and the affiliated reinsurance treaty termination, consolidated net written premiums increased $13 million, or 1.1%. Reinsurance protection. OneBeacon purchases reinsurance in order to minimize the loss from large risks or catastrophic events. OneBeacon also purchases individual property reinsurance coverage for certain risks to reduce large loss volatility through property-per-risk excess of loss reinsurance programs and individual risk facultative reinsurance. OneBeacon also maintains excess of loss casualty reinsurance programs that provide protection for individual risk or catastrophe losses involving workers compensation, general liability, automobile liability, professional liability or umbrella liability. The availability and cost of reinsurance protection is subject to market conditions, which are outside of management’s control. Limiting risk of loss through reinsurance arrangements serves to mitigate the impact of large losses; however, the cost of this protection in an individual period may exceed the benefit. For 2015 and 2014, OneBeacon’s net combined ratio was higher than the gross combined ratio by 1 point and 2 points as a result of the cost of the reinsurance programs more than offsetting the benefits from ceded losses. OneBeacon Results-Year Ended December 31, 2014 versus Year Ended December 31, 2013 OneBeacon ended 2014 with a book value per share of $10.97, an increase of 2.1% during 2014, including dividends, compared to an increase of 17.2% during 2013, including dividends. During 2014, OneBeacon’s book value per share was significantly impacted by (1) a fourth quarter increase in loss and LAE reserves of $109 million ($71 million after-tax) resulting from an actuarial and claims analysis of its ongoing specialty loss reserves, as further described below; (2) a $21 million after-tax loss from discontinued operations, driven primarily by valuation adjustments related to the surplus notes provided in conjunction with the seller financing of the Runoff Transaction; and (3) an after-tax other comprehensive loss of $12 million, primarily due to a decrease in the weighted average discount rate (from 4.7% to 3.9%), as well as a change in the mortality assumptions, used for the annual remeasurement of OneBeacon’s legacy pension plan. OneBeacon’s GAAP combined ratio increased to 102% for 2014 from 92% for 2013. The increase was primarily driven by a 13 point increase in the loss ratio (primarily due to the fourth quarter reserve increase described below), partially offset by a 3 point improvement in the expense ratio. Net unfavorable loss and LAE reserve development was 8 points ($90 million) for 2014, driven primarily by professional liability, especially lawyers’ liability claims, which OneBeacon put into runoff and sold the renewal rights to in December 2014, and management liability businesses. Net loss reserve development for 2013 was negligible. A large loss in Specialty Property and elevated Crop losses due to lower corn prices also contributed to the increase in OneBeacon’s 2014 loss ratio. Catastrophe losses contributed 1 point to OneBeacon’s GAAP combined ratios for both 2014 and 2013. The decrease in the expense ratio was driven by lower incentive compensation expenses. OneBeacon’s net written premiums increased 12% in 2014 to $1.2 billion, primarily due to an $80 million increase from its newer businesses, particularly OneBeacon Crop Insurance, OneBeacon Program Group and OneBeacon Surety Group. 2014 Fourth Quarter Loss and LAE Reserve Increase Through the first nine months of 2014, OneBeacon recorded $14.3 million of unfavorable loss and LAE reserve development, driven by greater-than-expected large losses in several underwriting units, primarily in the professional and management liability lines within Professional Insurance. In 2015, Professional Insurance was reorganized into Other Professional Lines, Management Liability, Financial Services and Healthcare. This large loss activity, which occurred mostly during the second and third quarters of 2014, also impacted the current accident year loss and LAE estimates. Additionally, OneBeacon incurred higher-than-usual claim coverage determination costs, a component of LAE expenses, during the first nine months of 2014. Other underwriting units also reported increased claim activity, including Entertainment, Government Risks, and Accident. Since the increased level of loss and LAE activity continued into the early part of the fourth quarter, the high level of activity in the second and third quarters no longer seemed to be isolated occurrences. As such, during the fourth quarter of 2014, OneBeacon enhanced its actuarial and claims review in several areas. OneBeacon isolated the recent large loss activity in each of its underwriting units and examined the emergence of large losses relative to the timing and amounts of expected large losses. OneBeacon also conducted additional analyses in the lawyers’ professional liability line within Professional Insurance. These new analyses included a claim level review and the application of additional actuarial methods and loss development assumptions. The results of these analyses indicated that the assumed tail risk included in the loss development patterns used to record IBNR reserves for this line were insufficient and needed to be increased for remaining long-tail exposures. OneBeacon’s claims and actuarial staff also conducted an in-depth review of coverage determination, litigation and other claim-specific adjusting expenses as a result of an emerging trend of increased expenses in these areas over recent quarters, particularly coverage determination expenses. This review concluded that the ultimate costs of these loss adjustment expenses were larger than previously estimated, causing management to record an increase in estimated LAE expenses, primarily in Professional Insurance. Finally, OneBeacon also recorded unfavorable prior year development in other underwriting units, including Entertainment and Government Risks. The unfavorable loss development in Entertainment and Government Risks resulted from heavier than expected claim activity during the fourth quarter, predominantly in the general liability and commercial auto liability lines. In order to fully reflect these recent trends, OneBeacon recorded a $109 million increase in loss and LAE reserves, which included a $75 million increase in prior accident year loss and LAE reserves and a $34 million increase in the current accident year loss and LAE reserves recorded at September 30, 2014. The components of the 2014 fourth quarter loss and LAE reserve increase and the net loss and LAE development for the full year are provided below: Underwriting Unit 2014 Fourth Quarter Reserve Increases Full Year 2014 Millions Current Accident Year Prior Accident Year Total Net Prior Year Development Professional Insurance $ 22.9 $ 46.4 $ 69.3 $ 59.1 Specialty Property (1.1 ) 5.7 4.6 1.1 Crop 3.8 - 3.8 - Other 2.8 (.4 ) 2.4 1.6 Specialty Products 28.4 51.7 80.1 61.8 Entertainment 1.5 11.6 13.1 13.5 Government Risks 1.2 7.1 8.3 8.5 Accident - 3.5 3.5 6.0 Other 2.6 1.6 4.2 - Specialty Industries 5.3 23.8 29.1 28.0 Total $ 33.7 $ 75.5 $ 109.2 $ 89.8 As noted above, OneBeacon increased its provision for current accident year losses and LAE by $33.7 million in the fourth quarter of 2014. In making its loss and LAE reserve picks for the 2014 accident year, OneBeacon considered the results of the enhanced actuarial and claim review and the fact that reported large claims were approaching estimated ultimate held reserves for large losses sooner than originally expected. $3.8 million of the increase is related to higher-than-expected reports of crop losses that emerged in the fourth quarter. The remaining $29.9 million of the increase reflects an increase in management’s best estimate of current losses and LAE as of December 31, 2014 from those recorded in the first nine months of 2014. This increase primarily affected the Professional Insurance underwriting unit, which represented $22.9 million of the total provision. Reinsurance protection. OneBeacon’s net combined ratio was higher than the gross combined ratio by 2 points for both 2014 and 2013 as a result of the cost of the reinsurance programs more than offsetting the benefits from ceded losses. OneBeacon Discontinued Operations - Runoff Transaction In October 2012, OneBeacon entered into a definitive agreement to sell its Runoff Business to Armour. The Runoff Transaction closed in the fourth quarter of 2014. See Note 22 - “Discontinued Operations” for more details regarding the Runoff Transaction. During 2014, OneBeacon reported a $21 million after-tax net loss in discontinued operations related to the Runoff Transaction, which included a $19 million after-tax loss from sale of the Runoff Business (further described below) and a $2 million after-tax loss from the underwriting results of the Runoff Business. As part of closing the Runoff Transaction on December 23, 2014, OneBeacon provided financing in the form of surplus notes with a par value of $101 million issued by OneBeacon Insurance Company (“OBIC”), one of the entities that were transferred from OneBeacon to Armour as part of the transaction (the “OneBeacon Surplus Notes”). As of December 31, 2014, the OneBeacon Surplus Notes had a fair value of $65 million, based on a discounted cash flow model, resulting in a total valuation adjustment of $36 million pre-tax ($23 million after tax) included in loss from sale of discontinued operations. Subsequent to closing, the OneBeacon Surplus Notes are included in OneBeacon’s investment portfolio, categorized within other long-term investments, and subsequent changes in value thereon will be reflected in continuing operations. See “Critical Accounting Estimates” on page 76 for a sensitivity analysis of potential changes in these key variables that can impact the estimated fair value of the OneBeacon Surplus Notes. Also during 2014, OneBeacon’s expectation of the treatment of a $7 million reserve charge related to the Runoff Business and recorded during 2013 changed. Previously, OneBeacon had expected that the Runoff SPA would be amended to provide for the transfer of $7 million of additional assets to support this reserve charge; the Runoff SPA was instead revised, in part, to increase the cap on seller financing. As a result, the $7 million reserve charge ($5 million after-tax) was recorded as a reduction to the estimated loss on sale of discontinued operations. These changes, along with certain other adjustments, resulted in a net increase in the estimated loss on the sale of the Runoff Business of $29 million ($19 million after tax) for the full year 2014, resulting in a pre-tax loss on sale at closing of $98 million ($64 million after tax) recognized since the third quarter of 2012. HG Global/BAM The following table presents the components of pre-tax income included in White Mountains’s HG Global/BAM segment related to the consolidation of HG Global, which includes HG Re and its other wholly-owned subsidiaries, and BAM for the years ended December 31, 2015, 2014 and 2013: Year Ended December 31, 2015 Millions HG Global BAM Eliminations Total Gross written premiums $ - $ 25.9 $ - $ 25.9 Assumed (ceded) written premiums 19.3 (19.3 ) - - Net written premiums $ 19.3 $ 6.6 $ - $ 25.9 Earned insurance and reinsurance premiums $ 2.5 $ .8 $ - $ 3.3 Net investment income 1.9 4.2 - 6.1 Net investment income - BAM Surplus Notes 15.8 - (15.8 ) - Net realized and unrealized investment (losses) gains (.3 ) .9 - .6 Other revenue - .7 - .7 Total revenues 19.9 6.6 (15.8 ) 10.7 Insurance and reinsurance acquisition expenses .6 2.3 - 2.9 Other underwriting expenses - .4 - .4 General and administrative expenses 1.4 35.4 - 36.8 Interest expense - BAM Surplus Notes - 15.8 (15.8 ) - Total expenses 2.0 53.9 (15.8 ) 40.1 Pre-tax income (loss) $ 17.9 $ (47.3 ) $ - $ (29.4 ) Year Ended December 31, 2014 Millions HG Global BAM Eliminations Total Gross written premiums $ - $ 16.2 $ - $ 16.2 Assumed (ceded) written premiums 12.3 (12.3 ) - - Net written premiums $ 12.3 $ 3.9 $ - $ 16.2 Earned insurance and reinsurance premiums $ 1.4 $ .4 $ - $ 1.8 Net investment income 1.4 5.7 - 7.1 Net investment income - BAM Surplus Notes 15.7 - (15.7 ) - Net realized and unrealized investment gains 1.7 6.6 - 8.3 Other revenue - .6 - .6 Total revenues 20.2 13.3 (15.7 ) 17.8 Insurance and reinsurance acquisition expenses .3 1.8 - 2.1 Other underwriting expenses - .4 - .4 General and administrative expenses 1.6 35.9 - 37.5 Interest expense - BAM Surplus Notes - 15.7 (15.7 ) - Total expenses 1.9 53.8 (15.7 ) 40.0 Pre-tax income (loss) $ 18.3 $ (40.5 ) $ - $ (22.2 ) Year Ended December 31, 2013 Millions HG Global BAM Eliminations Total Gross written premiums $ - $ 13.6 $ - $ 13.6 Assumed (ceded) written premiums 10.6 (10.6 ) - - Net written premiums $ 10.6 $ 3.0 $ - $ 13.6 Earned insurance and reinsurance premiums $ .4 $ .1 $ - $ .5 Net investment income 1.0 4.7 - 5.7 Net investment income - BAM Surplus Notes 40.2 - (40.2 ) - Net realized and unrealized investment losses (2.0 ) (9.3 ) - (11.3 ) Other revenue - .4 - .4 Total revenues 39.6 (4.1 ) (40.2 ) (4.7 ) Insurance and reinsurance acquisition expenses .1 1.4 - 1.5 Other underwriting expenses - .4 - .4 General and administrative expenses 1.4 32.5 - 33.9 Interest expense - BAM Surplus Notes - 40.2 (40.2 ) - Total expenses 1.5 74.5 (40.2 ) 35.8 Pre-tax income (loss) $ 38.1 $ (78.6 ) $ - $ (40.5 ) HG Global/BAM Results-Year Ended December 31, 2015 versus Year Ended December 31, 2014 BAM is a mutual insurance company whose affairs are managed on a statutory accounting basis, and it does not report stand-alone GAAP financial results. BAM is owned by its members. Each municipal issuer insured by BAM becomes a “member” of BAM. The cost of policies issued by BAM is comprised of a risk premium and a contribution to BAM’s qualified statutory capital (a “Member Surplus Contribution”). In 2015, BAM insured $10.6 billion of municipal bonds, $10.0 billion of which were in the primary market, up 36% from 2014. The average total premium (including both risk premiums and Member Surplus Contributions), weighted by insured par, of insurance provided by BAM in the primary markets in 2015 was 48 basis points, up from 36 basis points in 2014. BAM’s “claims-paying resources” represent the capital BAM has available to pay claims and, as such, is a key indication of BAM’s financial strength. BAM’s claims-paying resources include BAM’s qualified statutory capital, including Member Surplus Contributions, net unearned premiums and the first loss reinsurance protection provided by HG Re, which is collateralized and held in trusts. BAM expects Member Surplus Contributions and HG Re’s reinsurance protection to be the primary drivers of continued growth of its claims-paying resources. In 2015, BAM’s claims paying resources increased 3% to $601.3 million at December 31, 2015. The increase was primarily driven by $29 million of Member Surplus Contributions and a $17 million increase in the HG Re collateral trusts, partially offset by BAM’s 2015 statutory net loss of $32 million. The following table presents BAM’s total claims paying resources as of December 31, 2015 and 2014: As of December 31, Millions Qualified statutory capital $ 449.6 $ 453.4 Net unearned premiums 12.5 6.4 Present value of future installment premiums 2.6 1.4 Collateral trusts 136.6 120.0 Claims paying resources $ 601.3 $ 581.2 As a mutual insurance company that is owned by its members, BAM’s results do not affect White Mountains’s adjusted book value per share. However, White Mountains is required to consolidate BAM’s results in its GAAP financial statements and its results are attributed to non-controlling interests. HG Global reported GAAP pre-tax income of $18 million in both 2015 and 2014, which was driven by $16 million of interest income on the BAM Surplus Notes in both periods. White Mountains reported $47 million of GAAP pre-tax losses on BAM in 2015, driven by $16 million of interest expense on the BAM Surplus Notes and $35 million of operating expenses, compared to $41 million in pre-tax losses in 2014, driven by $16 million of interest expense on the BAM Surplus Notes and $36 million of operating expenses, partially offset by $7 million of net realized and unrealized investment gains. HG Global/BAM Results-Year Ended December 31, 2014 versus Year Ended December 31, 2013 In 2014, BAM insured $7.8 billion of municipal bonds, $7.4 billion of which were in the primary market, up 66% from 2013. The average total premium (including both risk premium and Member Surplus Contributions), weighted by insured par, of insurance provided by BAM in the primary markets in 2014 was 36 basis points, down from 59 basis points in 2013. BAM’s claims paying resources as of December 31, 2014 increased $3 million from December 31, 2013. The increase was primarily driven by $16 million of Member Surplus Contributions, a $15 million increase in the HG Re collateral trusts and a $3 million increase in net unearned premiums, offset by BAM’s 2014 statutory net loss of $32 million. The following table presents BAM’s total claims paying resources as of December 31, 2014 and 2013: As of December 31, Millions Qualified statutory capital $ 453.4 $ 470.1 Net unearned premiums 6.4 3.0 Present value of future installment premiums 1.4 -- Collateral trusts 120.0 105.4 Claims paying resources $ 581.2 $ 578.5 HG Global reported pre-tax income of $18 million in 2014, which was driven by $16 million of interest income on the BAM Surplus Notes, compared to $38 million in 2013, which was driven by $40 million of interest income on the BAM Surplus Notes. The decrease in interest income on the BAM Surplus Notes was due to a change in the interest rate. (See “LIQUIDITY AND CAPITAL RESOURCES, HG Global/BAM”, on page 65.) White Mountains reported $41 million of pre-tax losses on BAM in 2014, driven by $16 million of interest expense on the BAM Surplus Notes and $36 million of operating expenses, partially offset by $7 million of net realized and unrealized investment gains, compared to $79 million in pre-tax losses in 2013, driven by $40 million of interest expense on the BAM Surplus Notes, $33 million of operating expenses and $9 million of net realized and unrealized investment losses. The following table presents amounts from HG Global, which includes HG Re and its other wholly-owned subsidiaries, and BAM that are contained within White Mountains’s consolidated balance sheet as of December 31, 2015 and 2014: As of December 31, 2015 Millions HG Global BAM Eliminations and Segment Adjustment Total Segment Assets Fixed maturity investments $ 130.6 $ 417.0 $ - $ 547.6 Short-term investments 5.6 43.3 - 48.9 Total investments 136.2 460.3 - 596.5 Cash .1 15.8 - 15.9 BAM Surplus Notes 503.0 - (503.0 ) - Accrued interest receivable on BAM Surplus Notes 90.2 - (90.2 ) - Other assets 9.5 26.8 (.8 ) 35.5 Total assets $ 739.0 $ 502.9 $ (594.0 ) $ 647.9 Liabilities BAM Surplus Notes(1) $ - $ 503.0 $ (503.0 ) $ - Accrued interest payable on BAM Surplus Notes(2) - 90.2 (90.2 ) - Preferred dividends payable to White Mountains's subsidiaries(3) 135.4 - - 135.4 Preferred dividends payable to non-controlling interests 4.3 - - 4.3 Other liabilities 41.5 49.7 (.8 ) 90.4 Total liabilities 181.2 642.9 (594.0 ) 230.1 Equity White Mountains’s common shareholders’ equity 540.7 - - 540.7 Non-controlling interests 17.1 (140.0 ) - (122.9 ) Total equity 557.8 (140.0 ) - 417.8 Total liabilities and equity $ 739.0 $ 502.9 $ (594.0 ) $ 647.9 As of December 31, 2014 Millions HG Global BAM Eliminations and Segment Adjustment Total Segment Assets Fixed maturity investments $ 114.4 $ 419.4 $ - $ 533.8 Short-term investments 6.6 34.8 - 41.4 Total investments 121.0 454.2 - 575.2 Cash .3 17.3 - 17.6 BAM Surplus Notes 503.0 - (503.0 ) - Accrued interest receivable on BAM Surplus Notes 74.4 - (74.4 ) - Other assets 5.7 17.0 (.5 ) 22.2 Total assets $ 704.4 $ 488.5 $ (577.9 ) $ 615.0 Liabilities BAM Surplus Notes(1) $ - $ 503.0 $ (503.0 ) $ - Accrued interest payable on BAM Surplus Notes(2) - 74.4 (74.4 ) - Preferred dividends payable to White Mountains's subsidiaries(3) 93.3 - - 93.3 Preferred dividends payable to non-controlling interests 2.9 - - 2.9 Other liabilities 24.8 33.0 (.5 ) 57.3 Total liabilities 121.0 610.4 (577.9 ) 153.5 Equity White Mountains’s common shareholders’ equity 565.5 - - 565.5 Non-controlling interests 17.9 (121.9 ) - (104.0 ) Total equity 583.4 (121.9 ) - 461.5 Total liabilities and equity $ 704.4 $ 488.5 $ (577.9 ) $ 615.0 (1) Under GAAP, the BAM Surplus Notes are classified as debt by the issuer. Under U.S. Statutory accounting, they are classified as Surplus. (2) Under GAAP, interest accrues daily on the BAM Surplus Notes. Under U.S. Statutory accounting, interest is not accrued on the BAM Surplus Notes until it has been approved for payment by insurance regulators. (3) For segment reporting, the HG Global preferred dividend receivable at White Mountains is reclassified from the Other Operations segment to the HG Global/BAM segment. Dividends on HG Global preferred shares payable to White Mountains’s subsidiaries are eliminated in White Mountains’s consolidated financial statements. The following table presents the gross par value of policies priced and closed by BAM for the years ended December 31, 2015 and 2014: Year Ended December 31, Millions Gross par value of primary market policies priced $ 9,911.8 $ 7,641.1 Gross par value of secondary market policies priced 611.1 470.9 Total gross par value of market policies priced 10,522.9 8,112.0 Less: Gross par value of policies priced yet to close (298.6 ) (379.5 ) Gross par value of policies closed that were previously priced 381.7 97.5 Total gross par value of market policies closed $ 10,606.0 $ 7,830.0 Other Operations A summary of White Mountains’s financial results from its Other Operations segment for the years ended December 31, 2015, 2014 and 2013 follows: Year Ended December 31, Millions Earned insurance premiums $ 8.7 $ 6.1 $ - Net investment income 8.8 9.0 11.1 Net realized and unrealized investment gains 259.9 29.8 95.8 Other revenue-MediaAlpha 105.5 65.3 - Other revenue-Tranzact 186.9 43.2 - Other revenue-Symetra warrants - - 10.8 Other revenue 41.7 16.2 4.6 Total revenues 611.5 169.6 122.3 Losses and LAE 8.2 8.9 - Insurance and reinsurance acquisition expenses 3.4 .8 - General and administrative expenses-MediaAlpha 99.0 60.6 - General and administrative expenses-Tranzact 167.3 37.4 - General and administrative expenses-amortization of intangible assets 27.3 10.3 - General and administrative expenses 141.7 98.1 103.2 Interest expense on debt 5.6 2.6 3.2 Total expenses 452.5 218.7 106.4 Pre-tax income (loss) $ 159.0 $ (49.1 ) $ 15.9 Other Operations Results-Year Ended December 31, 2015 versus Year Ended December 31, 2014 White Mountains’s Other Operations segment reported pre-tax income of $159 million in 2015 compared to a pre-tax loss of $49 million in 2014. White Mountains’s Other Operations segment reported net realized and unrealized investment gains of $260 million in 2015 compared to $30 million in 2014, primarily related to the $259 million unrealized gain from the investment in Symetra common shares. (See “Summary of Investment Results” on page 58.) The Other Operations segment reported net investment income of $9 million in both 2015 and 2014. Other revenues in 2015 includes $187 million from Tranzact and $106 million from MediaAlpha compared to $43 million from Tranzact and $65 million from MediaAlpha in 2014. White Mountains acquired its stake in Tranzact in October 2014 and acquired its stake in MediaAlpha in March 2014. Other revenue also includes a $20 million pre-tax gain in 2015 from the sale of Hamer LLC, a small manufacturing company that White Mountains received in 2012 in connection with the liquidation of a limited partnership fund. In addition, other revenues in 2015 included third-party investment management fee income at WM Advisors of $13 million, compared to $17 million in 2014. General and administrative expenses in 2015 included $167 million from Tranzact and $99 million from MediaAlpha compared to $37 million from Tranzact and $61 million from MediaAlpha in 2014. General and administrative expenses also included $36 million of increased incentive compensation expense recorded in connection with the agreements to sell Sirius Group and Symetra. WM Life Re reported losses of $6 million in 2015 compared to $9 million in 2014. See Note 9 - “Derivatives” for details regarding WM Life Re’s total impact on White Mountains’s statement of operations. White Mountains’s Other Operations segment reported a $4 million GAAP pre-tax loss relating to SSIE in 2015 compared to $12 million in 2014. As a reciprocal insurance exchange that is owned by its policyholders, SSIE’s results are attributed to non-controlling interests and do not affect White Mountains’s adjusted book value per share. Share repurchases. White Mountains repurchased and retired 387,495 of its common shares for $284 million in 2015 at an average price per share of $733.37, or approximately 105% of White Mountains’s December 31, 2015 adjusted book value per share. The average share price paid was approximately 94% of White Mountains’s December 31, 2015 adjusted book value per share including the estimated gain from the Sirius Group transaction. Other Operations Results-Year Ended December 31, 2014 versus Year Ended December 31, 2013 White Mountains’s Other Operations segment reported pre-tax loss of $49 million in 2014 compared to pre-tax income of $16 million in 2013. White Mountains’s Other Operations segment reported net realized and unrealized investment gains of $30 million in 2014 compared to $96 million in 2013. (See “Summary of Investment Results” on page 58.) The Other Operations segment reported net investment income of $9 million in 2014 compared to $11 million in 2013. Other revenues in 2014 included $65 million from MediaAlpha and $43 million from Tranzact, which are revenues recorded since their acquisition in 2014. Other revenues in 2014 also included third-party investment management fee income at WM Advisors of $17 million, compared to $16 million in 2013. Other revenue in 2013 included $11 million of mark-to-market gains on the Symetra warrants prior to their exercise in the second quarter of 2013. (See “Investment in Symetra Common Shares” on page 63.) General and administrative expenses increased in 2014 primarily due to expenses related to MediaAlpha and Tranzact, including amortization of intangible assets, which substantially offset their revenues in pre-tax income. The increase from these new businesses was partially offset by a decrease in incentive compensation accruals in 2014. General and administrative expenses in 2013 included a $10 million reduction related to an adjustment to the fair value of variable annuity death benefit expenses at WM Life Re, which was mostly offset in other revenues by a component of the change in the fair value of WM Life Re's derivative assets and liabilities. WM Life Re reported losses of $9 million in 2014 compared to $17 million in 2013. WM Life Re’s results in 2013 included $7 million of gains associated with changes in projected surrender assumptions, partially offset by increased trading expenses. See Note 9 - “Derivatives” for details regarding WM Life Re’s total impact on White Mountains’s statement of operations. White Mountains’s Other Operations segment reported $12 million of GAAP pre-tax losses relating to SSIE in 2014, which included $2 million of unfavorable loss reserve development reported in the second quarter, as well as a $3 million goodwill impairment charge. As a reciprocal insurance exchange that is owned by its policyholders, SSIE’s results are attributed to non-controlling interests and do not affect White Mountains’s adjusted book value per share. Share repurchases. White Mountains repurchased and retired 217,879 of its common shares for $134 million in 2014 at an average price per share of $617.29, or approximately 93% of White Mountains’s December 31, 2014 adjusted book value per share. Discontinued Operations Sirius Group On July 24, 2015, White Mountains entered into an agreement to sell Sirius Group to CM International Holding PTE Ltd., the Singapore-based investment arm of CMI. The purchase price will be paid in cash in an amount equal to 127.3% of Sirius Group’s closing date tangible common shareholder’s equity, plus $10 million. The transaction is expected to close in the first quarter of 2016 and is subject to regulatory approvals and other customary closing conditions. As a result of the agreement to sell Sirius Group, its results are reported as discontinued operations within White Mountains’s GAAP financial statements. Sirius Group’s results continue to inure to White Mountains through the closing date of the sale. Sirius Group Results-Year Ended December 31, 2015 versus Year Ended December 31, 2014 Sirius Group's GAAP combined ratio was 85% for the year ended December 31, 2015 compared to 76% for 2014. Loss and expense ratios for the 2015 periods were increased by a higher frequency of non-catastrophe per risk and pro rata loss events, which primarily impacted the property, aviation, contingency, and marine lines of business, as well as continued pressure on rates and terms due to continued competitive market conditions. The 2015 results included $18 million of losses after reinstatement premiums from the Tianjin port explosion. Also, the combined ratios for the year ended December 31, 2015 were higher by 1 point due to the cost of ILW Covers. The 2015 period included 3 points of catastrophe losses, primarily from the Chennai flood in Southern India and winter storms in the Northeastern United States, compared to 7 points in 2014. Favorable net loss reserve development was 6 points in 2015 primarily due to decreases in casualty and property loss reserves, compared to 11 points of favorable net loss reserve development in 2014. Reinsurance protection. In addition to the ILW Covers, Sirius Group’s reinsurance protection primarily consists of pro-rata and excess of loss protections to cover aviation, trade credit, and certain accident and health and property exposures. Sirius Group’s proportional reinsurance programs provide protection for part of the non-proportional treaty accounts written in Europe, the Americas, Asia, the Middle East and Australia. This reinsurance is designed to increase underwriting capacity where appropriate, and to reduce exposure both to large catastrophe losses and to a frequency of smaller loss events. Attachment points and coverage limits vary by region and line of business around the world. Sirius Group’s net combined ratio was 6 points higher than the gross combined ratio for the year ended December 31, 2015 and 1 point lower than the gross combined ratio for 2014. In 2015, the net combined ratio was higher than the gross combined ratio primarily due to the cost of property retrocessional coverage, including the ILW Covers, with limited or no loss recoveries. In 2014, the net combined ratio was lower than the gross combined ratio because ceded loss recoveries, primarily in the accident and health and aviation lines, mostly offset the premiums ceded under Sirius Group’s reinsurance protection programs. Sirius Group Results-Year Ended December 31, 2014 versus Year Ended December 31, 2013 Sirius Group’s GAAP combined ratio was 76% for 2014 compared to 82% for 2013. The decrease was due to lower catastrophe losses and higher favorable loss reserve development, partially offset by higher acquisition and incentive compensation expenses. The 2014 combined ratio included 7 points ($59 million) of catastrophe losses, including $18 million from flooding in the Jammu and Kashmir regions in India and $8 million from Cyclone Hudhud in eastern India and Nepal, compared to 10 points ($85 million) of catastrophe losses in 2013. Favorable loss reserve development was 11 points ($98 million) in 2014 primarily due to decreases in property loss reserves, including reductions for prior period catastrophe losses, in addition to decreases in aviation, accident and health, and casualty loss reserves. Favorable loss reserve development was 6 points ($48 million) in 2013 primarily due to reductions in property loss reserves, including $24 million of favorable loss reserve development on prior year’s catastrophe losses. Reinsurance protection. Sirius Group’s net combined ratio was 1 point lower than the gross combined ratio for 2014 and equaled the gross combined ratio for 2013. For 2014, the net combined ratio was lower than the gross combined ratio as ceded loss recoveries, primarily in the accident and health and aviation lines, mostly offset the premiums ceded under Sirius Group’s reinsurance protection programs. The net and gross combined ratios were the same for 2013 as the cost of property retrocessions was offset by loss recoveries on catastrophe losses in Europe and Asia and profit commissions on ceded business. OneBeacon Runoff During 2014, OneBeacon recorded a $19 million net loss on sale of discontinued operations on the Runoff Transaction, which included a $24 million after-tax loss from the change in the estimated value of the surplus notes issued with the Runoff Transaction, partially offset by a reduction in the loss on sale from the Runoff Transaction related to the change in the treatment of the $7 million pre-tax ($5 million after-tax) reserve charge recorded during the second quarter of 2013 (as described below). Previously, OneBeacon expected that the Runoff Business Stock Purchase Agreement (“Runoff SPA”) would be amended to provide for the transfer of $7 million of additional assets to support the reserve charge. The Runoff SPA was instead revised to increase the cap on seller financing. During 2013, OneBeacon recorded a $79 million pre-tax loss and LAE provision for the Runoff Business. This reserve charge included a $7 million increase in loss and LAE reserves recorded in the second quarter of 2013, which partially offset $8 million of other revenue associated with a settlement award in the second quarter of 2013 in the Safeco v. American International Group, Inc. (“AIG”) class action related to AIG's alleged underreporting of workers compensation premiums to the National Workers Compensation Reinsurance Pool. The $71 million pre-tax ($46 million after-tax) of net losses from discontinued operations were fully offset by a $46 million after-tax reduction in the loss on sale of discontinued operations, as prescribed by the terms of the Runoff SPA, which stated that the buyer assumed the risk that loss and LAE reserves develop unfavorably from September 30, 2012 onward. Esurance During 2015 and 2014, White Mountains recognized $18 million and $3 million of net income from discontinued operations related to the final settlement with Allstate for favorable development on loss reserves transferred in the sale of Esurance and Answer Financial. Since the closing of the transaction through September 30, 2015, White Mountains has received a net amount of $28 million from Allstate, primarily related to the favorable development on loss reserves. Fireman’s Fund During 2014, White Mountains recorded a gain in discontinued operations of $14 million from a payment received from Allianz, the purchaser of White Mountains's former subsidiary Fireman’s Fund Insurance Company (“FFIC”), related to the utilization of alternative minimum tax credits associated with the tax loss on the sale of FFIC in 1991. II. Summary of Investment Results - Total Operations White Mountains's total operations investment results include continuing operations and discontinued operations. As a result of the agreement to sell Sirius Group, its results are reported in discontinued operations within White Mountains’s GAAP financial statements. Sirius Group’s results continue to inure to White Mountains through the closing date of the sale. White Mountains will continue to manage Sirius Group's investment portfolio for a transition period after the sale. For purposes of discussing rates of return, all percentages are presented gross of management fees and trading expenses in order to produce a better comparison to benchmark returns, while all dollar amounts are presented net of any management fees and trading expenses. A summary of White Mountains’s consolidated pre-tax investment results, including the returns from discontinued operations, for the years ended December 31, 2015, 2014 and 2013 follows: Gross investment returns and benchmarks returns Year Ended December 31, Fixed maturity investments 0.3 % 0.9 % 0.5 % Short-term investments (0.9 )% (2.0 )% 0.1 % Total fixed income investment returns: In U.S. dollars 0.2 % 0.5 % 0.4 % In local currencies 1.1 % 2.7 % 0.5 % Barclays U.S. Intermediate Aggregate Index 1.2 % 4.1 % (1.0 )% Common equity securities 33.2 % 7.5 % 23.2 % Other long-term investments (10.1 )% 6.5 % 7.6 % Total common equity securities and other long-term investments returns: In U.S. dollars 19.3 % 7.2 % 18.9 % In local currencies 19.6 % 8.1 % 19.0 % In local currencies - excluding Symetra (1.4 )% 8.1 % 19.0 % S&P 500 Index (total return) 1.4 % 13.7 % 32.4 % Total consolidated portfolio In U.S. dollars 3.6 % 1.9 % 4.1 % In local currencies 4.5 % 3.8 % 4.2 % In local currencies - excluding Symetra 0.7 % 3.8 % 4.2 % Investment Returns-Year Ended December 31, 2015 versus Year Ended December 31, 2014 White Mountains’s GAAP pre-tax total return on invested assets was 3.6% for 2015, compared to 1.9% for 2014. The 2015 results were primarily driven by $259 million in pre-tax unrealized investment gains recognized in the fourth quarter of 2015 resulting from the Symetra transaction. The 2015 and 2014 returns included 0.9% and 1.9% of foreign currency losses. Excluding the results from Symetra, the GAAP total return on invested assets was 0.7% in local currencies for the year ended December 31, 2015. White Mountains’s total operations after tax realized and unrealized investment gains were $203 million and $214 million for 2015 and 2014. Fixed income results White Mountains maintains a high-quality, short-duration fixed income portfolio. As of December 31, 2015, the fixed income portfolio duration was approximately 2.2 years, including short-term investments, compared to 2.0 years as of December 31, 2014. In local currencies, the fixed income portfolio returned 1.1% for 2015, a decent absolute result for the year and essentially in-line with the longer duration Barclays U.S. Intermediate Aggregate Index return of 1.2%. Including foreign currency losses, the fixed income portfolio returned 0.2% for 2015. In local currencies, the fixed income portfolio returned 2.7% for 2014, a decent absolute result for the year but behind the longer duration Barclays U.S. Intermediate Aggregate Index return of 4.1%. The portfolio’s short duration positioning contributed to the underperformance versus the benchmark as interest rates fell in 2014. Including foreign currency losses, the fixed income portfolio returned 0.5% for 2014. Common equity securities and other long-term investments results White Mountains maintains an equity portfolio that consists of common equity securities and other long-term investments, including hedge funds, private equity funds, direct investments in privately held common and convertible securities and the OneBeacon surplus notes. White Mountains’s management believes that prudent levels of investments in common equity securities and other long-term investments are likely to enhance long-term after-tax total returns. White Mountains’s portfolio of common equity securities and other long-term investments represented approximately 23% and 18% of GAAP invested assets as of December 31, 2015 and December 31, 2014. When reflecting the closing of the Symetra sale on February 1, 2016, White Mountains’s portfolio of common equity securities and other long-term investments represented approximately 14% of GAAP invested assets as of December 31, 2015. In local currencies, the equity portfolio, including the Symetra gain, returned 19.6% for 2015. In local currencies, excluding the Symetra gain, the equity portfolio returned -1.4% for 2015, underperforming the S&P 500 Index return of 1.4%. The underperformance versus the benchmark for 2015 was primarily due to unfavorable mark-to-market adjustments to the OneBeacon runoff surplus notes, losses from energy exposed private equity funds, the write-off of TaCerto and unfavorable results from a distressed hedge fund. Within the equity portfolio, White Mountains’s portfolio of common equity securities, excluding Symetra, returned 3.3% in local currencies for 2015, a good absolute result for the year and ahead of the S&P 500 Index return of 1.4%. Including foreign currency losses and the Symetra gain, the equity portfolio returned 19.3% for 2015. In local currencies, the equity portfolio returned 8.1% for 2014, a strong absolute result but mixed against benchmarks, underperforming the S&P 500 Index return of 13.7% and outperforming the small-cap Russell 2000 return of 4.9%. Including foreign currency losses, the equity portfolio returned 7.2% for 2014. White Mountains has established relationships with third party registered investment advisers to manage publicly-traded common equity securities and convertibles. The largest of these relationships have been with Prospector Partners LLC (“Prospector”), Lateef Investment Management (“Lateef”) and Silchester International Investors (“Silchester”). During the second quarter of 2015, White Mountains instructed Prospector to liquidate its separate account portfolios and redeemed its investments in the Prospector Funds. White Mountains has since terminated its investment management agreements with Prospector. White Mountains continues to have publicly-traded common equity securities actively managed by Lateef and Silchester. During the second quarter of 2015, White Mountains purchased exchange traded funds (ETFs) that seek to provide investment results that, before expenses, generally correspond to the performance of the S&P 500 Index, Russell 1000 and Russell 1000 Value Indices. As of December 31, 2015, White Mountains had $355.8 million invested in ETFs (including discontinued operations). The following summarizes White Mountains's investments in ETFs by exposure to each index: Index Market Value Millions December 31, 2015 S&P 500 $ 297.3 Russell 1000 Value 40.8 Russell 1000 17.7 Total $ 355.8 In 2015, the ETFs earned the effective market return, before expenses, over the period in which White Mountains was invested in each respective fund. The Lateef separate account is a highly concentrated portfolio of high quality mid- and large-cap growth companies. Lateef is a growth at a reasonable price manager focused on investing in high return on invested capital businesses at reasonable valuations. Lateef uses a bottom up, fundamental research-driven investment process that is focused on absolute returns, low turnover and a long-term investment horizon. As a highly concentrated portfolio of 15 to 20 positions, relative performance to the S&P 500 Index return is often driven, positively or negatively, by individual positions, especially in the short-term. In U.S. dollars and local currencies, the Lateef separate account returned 3.6% for 2015, outperforming the S&P 500 Index return of 1.4% for 2015. In U.S. dollars and local currencies, the Lateef separate account returned 6.5% for 2014, lagging the S&P 500 Index return of 13.7%. White Mountains has an investment in the Calleva Trust, an open-ended unit trust established as an Undertaking for Collective Investment in Transferable Securities (“UCITS”) under the European Communities Regulations that is managed by Silchester. Silchester invests primarily in value-oriented non-U.S. equity securities. Silchester’s investment strategy focuses on companies with low market multiples of earnings, cash flow, asset value or dividends. In local currencies, the Silchester investment returned 6.5% for 2015, outperforming the MCSI EAFE Index return of 5.3%. Including currency losses, the Silchester investment returned 1.2% for 2015, underperforming the S&P 500 Index return of 1.4%. In 2014, the Silchester investment returned 8.6% in local currencies, outperforming the MCSI EAFE Index return of 5.9%. Including currency losses, the Silchester investment returned -1.7% in U.S. dollars, underperforming the S&P 500 Index return of 13.7%. White Mountains also maintains a portfolio of other long-term investments that consists primarily of hedge funds, private equity funds, direct investments in privately held common and convertible securities, the OneBeacon surplus notes and various other investments in limited partnerships. As of December 31, 2015, approximately 49% of these other long-term investments were in private equity funds, with a general emphasis on narrow, sector-focused funds, and hedge funds, with a general emphasis on long-short equity funds. As of December 31, 2014, White Mountains had investments in TaClaro Holdings B.V., which owns TaCerto.com (“TaCerto”), in the form of convertible preferred shares ($4.5 million), loans ($1.7 million) and common shares ($0.3 million). During the first quarter of 2015, TaCerto initiated a wind-down of its business. As a result, White Mountains reduced the carrying value of these investments to $0. In U.S. dollars, the other long-term investments portfolio returned -10.1% for 2015 underperforming the HFRX Equal Weighted Strategies Index return of -1.5% for 2015. The portfolio’s underperformance relative to the HFRX Equal Weighted Strategies Index return for 2015 was primarily due to unfavorable mark-to-market adjustments to the OneBeacon surplus notes, losses from energy exposed private equity funds, the write-off of TaCerto and unfavorable results from a distressed hedge fund. In U.S. dollars, the other long-term investments portfolio returned 6.5% for 2014, outperforming the HFRX Equal Weighted Strategies Index return of -0.5%. Investment Returns-Year Ended December 31, 2014 versus Year Ended December 31, 2013 White Mountains’s GAAP pre-tax total return on invested assets was 1.9% for 2014, compared to 4.1% for 2013. The 2014 results included 1.9% of foreign currency losses, while foreign currency translation did not meaningfully impact investment returns in 2013. Fixed income results White Mountains maintains a high-quality, short-duration fixed income portfolio. As of December 31, 2014, the fixed income portfolio duration was approximately 2.0 years, including short-term investments, compared to 2.1 years as of December 31, 2013. In local currencies, the fixed income portfolio returned 2.7% for 2014, a decent absolute result for the year but behind the longer duration Barclays U.S. Intermediate Aggregate Index return of 4.1%. The portfolio’s short duration positioning contributed to the underperformance versus the benchmark as interest rates fell in 2014. Including foreign currency losses, the fixed income portfolio returned 0.5% for 2014. In local currencies, the fixed income portfolio returned 0.5% for 2013, outperforming the Barclays U.S. Intermediate Aggregate Index return of -1.0%. Including foreign currency losses, the fixed income portfolio returned 0.4% for 2013. Common equity securities and other long-term investments results White Mountains’s portfolio of common equity securities and other long-term investments represented approximately 18% and 20% of GAAP invested assets as of December 31, 2014 and December 31, 2013. In local currencies, the equity portfolio returned 8.1% for 2014, a strong absolute result for the year but mixed against benchmarks, underperforming the S&P 500 Index return of 13.7% and outperforming the small-cap Russell 2000 return of 4.9%. In U.S. dollars, the equity portfolio returned 7.2% for 2014. In local currencies, the equity portfolio returned 19.0% for 2013, a strong absolute result for the year but behind the S&P 500 Index return of 32.4% The shortfall against the benchmark was due primarily to an underperformance in White Mountains’s value oriented common equity security portfolio, which returned 23.2%. Foreign currency translation did not meaningfully impact equity returns in 2013. The Prospector portfolio accounted for approximately 30% of White Mountains’s common equity securities and other long-term investments as of December 31, 2014. In local currencies, the Prospector portfolio returned 6.6% for 2014, underperforming the S&P 500 Index return of 13.7%. Prospector’s underperformance relative to the S&P 500 Index in 2014 reflected an underweight position and underperformance in the technology and healthcare sectors. Like many managers, Prospector’s underweight position in large cap stocks also negatively impacted its performance relative to the S&P 500 Index in 2014. As of December 31, 2013, the Prospector portfolio accounted for approximately 50% of White Mountains’s common equity securities and other long-term investments. In local currencies, the Prospector portfolio returned 23.2% for 2013, underperforming the S&P 500 Index return of 32.4%. Prospector’s underperformance relative to the S&P 500 Index return in 2013 reflected an overweight position in gold mining, an underweight position in the consumer discretionary, technology and industrial sectors and the impact of convertible fixed maturity positions (as opposed to common equity securities), which tend to lag the index in strong up markets. In local currencies and U.S. dollars, the Lateef separate account returned 6.5% for 2014, underperforming the S&P 500 Index return of 13.7%. In local currencies and U.S. dollars, the Lateef separate account returned 30.5% for 2013, slightly underperforming the S&P 500 Index return of 32.4%. In local currencies, the Silchester investment returned 8.6% for 2014, outperforming the MCSI EAFE Index return of 5.9%. Including currency losses, the Silchester investment returned -1.7% for 2014, underperforming the S&P 500 Index return of 13.7%. In 2013, the Silchester investment returned 32.6 % in local currencies, outperforming the MCSI EAFE index of 26.9%. Including currency losses, the Silchester investment returned 28.4%, underperforming the S&P 500 Index return of of 32.4%. In U.S. dollars, the other long-term investments returned 6.5% for 2014, outperforming the HFRX Equal Weighted Strategies Index return of -0.5%. In U.S. dollars, other long-term investments returned 7.6% for 2013, outperforming the HFRX Equal Weighted Strategies Index return of 6.3%. Summary of Investment Results - Continuing Operations White Mountains's continuing operations pre-tax investment results, as presented in the consolidated statement of operations for 2015, 2014, and 2013 are presented below. Pre-tax investment results Year Ended December 31 Millions Net investment income $ 60.8 $ 59.5 $ 59.8 Net realized and unrealized investment gains (1) 225.4 78.5 133.9 Total GAAP continuing operations pre-tax investment gains $ 286.2 $ 138.0 $ 193.7 (1) Includes foreign currency losses of $4.4, $9, and $2.1. A summary of White Mountains’s continuing operations pre-tax investment results for the years ended December 31, 2015, 2014 and 2013 follows: Year Ended December 31, Total fixed income investment returns: In U.S. dollars 1.4 % 2.4 % 0.0 % In local currencies 1.4 % 2.3 % 0.2 % Barclays U.S. Intermediate Aggregate Index 1.2 % 4.1 % (1.0 )% Total common equity securities and other long-term investments returns: In U.S. dollars 25.6 % 7.1 % 17.0 % In local currencies 26.1 % 7.9 % 17.2 % In local currencies - excluding Symetra (0.5 )% 7.9 % 17.2 % S&P 500 Index (total return) 1.4 % 13.7 % 32.4 % Total consolidated portfolio In U.S. dollars 7.5 % 3.7 % 4.8 % In local currencies 7.6 % 3.9 % 5.1 % In local currencies - excluding Symetra 0.9 % 3.9 % 5.1 % Portfolio Composition The following table presents the composition of White Mountains’s continuing operations investment portfolio as of December 31, 2015 and 2014: As of December 31, 2015 As of December 31, 2014 $ in millions Carrying value % of total Carrying value(1) % of total Fixed maturity investments $ 2,639.7 61.7 % $ 2,422.0 64.7 % Short-term investments 211.3 4.9 376.8 10.1 Common equity securities 1,113.9 26.0 611.7 16.3 Other long-term investments 315.8 7.4 331.9 8.9 Total investments $ 4,280.7 % $ 3,742.4 % The breakdown of White Mountains’s fixed maturity investment as of December 31, 2015 by credit class, based upon issue credit ratings provided by Standard & Poor’s, or if unrated by Standard & Poor’s, long term obligation ratings provided by Moody’s, is as follows: As of December 31, 2015 $ in millions Amortized cost % of total Carrying Value % of total U.S. government and government-sponsored entities(1) $ 491.1 18.6 % $ 490.5 18.6 % AAA/Aaa 443.0 16.8 441.9 16.7 AA/Aa 421.3 16.0 420.5 15.9 A/A 551.5 20.9 553.2 21.0 BBB/Baa 575.3 21.8 576.8 21.9 Other/not rated 156.9 5.9 156.8 5.9 Total fixed maturity investments $ 2,639.1 % $ 2,639.7 % (1) Includes mortgage-backed securities which carry the full faith and credit guaranty of the U.S. government (i.e., GNMA) or are guaranteed by a government sponsored entity (i.e., FNMA, FHLMC). The cost or amortized cost and carrying value of White Mountains’s fixed maturity investments as of December 31, 2015 is presented below by contractual maturity. Actual maturities could differ from contractual maturities because certain borrowers may call or prepay their obligations with or without call or prepayment penalties. As of December 31, 2015 Millions Amortized cost Carrying Value Due in one year or less $ 241.6 $ 242.0 Due after one year through five years 982.3 981.5 Due after five years through ten years 96.4 96.1 Due after ten years 69.9 70.4 Mortgage-backed and asset-backed securities 1,170.6 1,167.0 Preferred stocks 78.3 82.7 Total fixed maturity investments $ 2,639.1 $ 2,639.7 Summary of Investment Results - Discontinued Operations A summary of White Mountains’s discontinued operations' pre-tax investment results years ended December 31, 2015, 2014 and 2013 follows: Gross investment returns and benchmark returns Year Ended December 31, Total fixed income investment returns: In U.S. dollars (1.1 )% (1.3 )% 0.9 % In local currencies 0.9 % 3.0 % 0.7 % Barclays U.S. Intermediate Aggregate Index 1.2 % 4.1 % (1.0 )% Total common equity securities and other long-term investments returns: In U.S. dollars (4.4 )% 7.7 % 25.8 % In local currencies (4.5 )% 8.0 % 25.7 % S&P 500 Index (total return) 1.4 % 13.7 % 32.4 % Total consolidated portfolio In U.S. dollars (1.4 )% (0.5 )% 3.1 % In local currencies 0.4 % 3.5 % 3.0 % Foreign Currency Translation White Mountains’s holds non-U.S. dollar-denominated assets and liabilities, primarily within discontinued operations, which are valued using period-end exchange rates. White Mountains has non-U.S. dollar-denominated foreign revenues and expenses, primarily within discontinued operations, which are valued using average exchange rates over the period. Foreign currency exchange rate risk is the risk that White Mountains will incur losses on a U.S. dollar basis due to adverse changes in foreign currency exchange rates (see “Foreign Currency Exchange Risk” on page 98). Investment in Symetra Common Shares During the third quarter of 2015, Symetra announced that it entered into a definitive merger agreement with Sumitomo Life Insurance Company (“Sumitomo Life”) pursuant to which Sumitomo Life will acquire all of the outstanding shares of Symetra. Following the announcement and Symetra shareholders' November 5, 2015 meeting to approve the transaction, White Mountains relinquished its representation on Symetra’s board of directors. As a result, White Mountains changed its accounting for Symetra common shares from the equity method to fair value. The carrying value per Symetra share used in the calculation of White Mountains’s adjusted book value per share rose to $31.77 at December 31, 2015 from $18.65 at December 31, 2014. Including dividends, Symetra produced $264 million of adjusted comprehensive income for White Mountains in 2015, of which $241 million was recognized as an after-tax unrealized investment gain in the fourth quarter. On February 1, 2016, Symetra closed its definitive merger agreement with Sumitomo Life and White Mountains received proceeds of $658 million, or $32 per common share. Symetra’s total revenues and net income through September 30, 2015 were $1.6 billion and $90 million. As of September 30, 2015, Symetra had total assets of $35.0 billion and shareholders’ equity of $3.1 billion. Symetra’s total revenues and net income for the years ended December 31, 2014 and 2013 were $2.2 billion, $254 million and $2.1 billion and $221 million. As of December 31, 2014, Symetra had total assets of $33.0 billion and shareholders’ equity of $3.4 billion. Symetra’s shareholders’ equity excluding unrealized gains (losses) from its fixed maturity investments was $2.4 billion as of December 31, 2014. Since inception, White Mountains received a total of $149.0 million in cash dividends recorded as a reduction of White Mountains investment in Symetra under the equity method. White Mountains received a cash dividend of $2.3 million in the fourth quarter of 2015 recorded within net investment income. LIQUIDITY AND CAPITAL RESOURCES Operating Cash and Short-term Investments Holding company level. The primary sources of cash for the Company and certain of its intermediate holding companies are expected to be distributions and tax sharing payments received from its insurance and reinsurance operating subsidiaries, capital raising activities, net investment income, proceeds from sales and maturities of investments and, from time to time, proceeds from the sales of operating subsidiaries. The primary uses of cash are expected to be repurchases of the Company’s common shares, payments on and repurchases/retirements of its debt obligations, dividend payments to holders of the Company’s common shares, to non-controlling interest holders of OneBeacon Ltd.’s common shares and to non-controlling interest holders of other consolidated subsidiaries, purchases of investments, payments to tax authorities, contributions to operating subsidiaries, operating expenses and, from time to time, purchases of operating subsidiaries. Operating subsidiary level. The primary sources of cash for White Mountains’s insurance, reinsurance and other operating subsidiaries are expected to be premium and fee collections, net investment income, proceeds from sales and maturities of investments, contributions from holding companies, capital raising activities and, from time to time, proceeds from the sales of operating subsidiaries. The primary uses of cash are expected to be claim payments, policy acquisition costs, purchases of investments, payments on and repurchases/retirements of its debt obligations, distributions and tax sharing payments made to holding companies, distributions to non-controlling interest holders, operating expenses and, from time to time, purchases of operating subsidiaries. Both internal and external forces influence White Mountains’s financial condition, results of operations and cash flows. Claim settlements, premium levels and investment returns may be impacted by changing rates of inflation and other economic conditions. In many cases, significant periods of time, sometimes several years or more, may lapse between the occurrence of an insured loss, the reporting of the loss to White Mountains and the settlement of the liability for that loss. The exact timing of the payment of claims and benefits cannot be predicted with certainty. White Mountains’s insurance and reinsurance operating subsidiaries maintain portfolios of invested assets with varying maturities and a substantial amount of cash and short-term investments to provide adequate liquidity for the payment of claims. Management believes that White Mountains’s cash balances, cash flows from operations, routine sales and maturities of investments and the liquidity provided by White Mountains’s revolving credit facility (the “WTM Bank Facility”) and other revolving credit facilities are adequate to meet expected cash requirements for the foreseeable future on both a holding company and insurance and reinsurance operating subsidiary level. Dividend Capacity Under the insurance laws of the states and jurisdictions that White Mountains’s insurance and reinsurance operating subsidiaries are domiciled, an insurer is restricted with respect to the timing and the amount of dividends it may pay without prior approval by regulatory authorities. Accordingly, there can be no assurance regarding the amount of such dividends that may be paid by such subsidiaries in the future. Following is a description of the dividend capacity of White Mountains’s insurance and reinsurance operating subsidiaries: OneBeacon: OneBeacon’s top-tier regulated U.S. insurance operating subsidiary, Atlantic Specialty Insurance Company (“ASIC”), has the ability to pay dividends to its immediate parent during any 12-month period without the prior approval of regulatory authorities in an amount set by formula based on the lesser of net investment income, as defined by statute, or 10% of statutory surplus, in both cases as most recently reported to regulatory authorities, subject to the availability of earned surplus and subject to dividends paid in prior periods. Based upon the formula above, most recently calculated as of December 31, 2015, ASIC has the ability to pay $27 million of dividends during 2016 without prior approval of regulatory authorities. As of December 31, 2015, ASIC had $622 million of statutory surplus and $68 million of earned surplus. During 2015, ASIC paid $45 million of dividends to its immediate parent and redeemed and retired common shares held by its immediate parent at an aggregate price of $66 million. OneBeacon is in the process of seeking regulatory approval of the redomestication of ASIC from New York to Pennsylvania. Under the exiting dividend capacity formula for the Commonwealth of Pennsylvania, which is the greater of 10% of policyholder surplus or net income of the previous year, ASIC would have the ability to pay $62 million in dividends in 2016. OneBeacon expects that any distributions paid by ASIC prior to its redomestication to Pennsylvania would reduce the $62 million allowed under the dividend capacity formula. Split Rock has the ability to declare or pay dividends or make capital distributions to its immediate parent during any 12-month period without the prior approval of Bermuda regulatory authorities on the condition that any such declaration or payment of dividends or capital distributions does not cause a breach of any of its regulatory solvency and liquidity requirements. During 2016, Split Rock has the ability to pay dividends or make capital distributions without the prior approval of regulatory authorities, subject to meeting all appropriate liquidity and solvency requirements, of $37 million, which is equal to 15% of its December 31, 2015 statutory capital (excluding earned surplus). During 2015, Split Rock did not pay any dividends or make any capital distributions to its immediate parent. During 2015, OneBeacon contributed $85 million to Split Rock. During 2015, OneBeacon’s unregulated insurance operating subsidiaries paid $5 million of dividends to their immediate parent. As of December 31, 2015, OneBeacon’s unregulated insurance operating subsidiaries had $104 million of net unrestricted cash, short-term investments, and fixed maturity investments and surplus notes classified as other long-term investments that had a par value of $101 million and a fair value of $52 million. During 2015, OneBeacon Ltd. paid $80 million of regular quarterly dividends to its common shareholders. White Mountains received $60 million of these dividends. As of December 31, 2015, OneBeacon Ltd. and its intermediate holding companies had $65 million of net unrestricted cash, short-term investments and fixed maturity investments and $55 million of common equity securities and $52 million of other long-term investments outside of its regulated and unregulated insurance operating subsidiaries. HG Global/BAM: As of December 31, 2015, HG Global had $613 million face value of preferred shares outstanding, of which White Mountains owned 96.9%. Holders of the HG Global preferred shares receive cumulative dividends at a fixed annual rate of 6.0% on a quarterly basis, when and if declared by HG Global. HG Global did not declare or pay any preferred dividends in 2015 or 2014. As of December 31, 2015, HG Global has accrued $140 million of dividends payable to holders of its preferred shares, $135 million of which is payable to White Mountains and eliminated in consolidation. HG Re is a Special Purpose Insurer subject to regulation and supervision by the BMA, but does not require regulatory approval to pay dividends. However, HG Re’s dividend capacity is limited by amounts held in the collateral trusts pursuant to the first loss reinsurance treaty (“FLRT”) with BAM. As of December 31, 2015, HG Re had statutory capital of $461 million, of which $54 million primarily relates to accrued interest on the BAM Surplus Notes held by HG Re, and $402 million was held as collateral in the Supplemental Trust pursuant to the FLRT with BAM. Effective January 1, 2014, HG Global and BAM agreed to change the interest rate on the BAM Surplus Notes for the five years ending December 31, 2018 from a fixed rate of 8% to a variable rate equal to the one-year U.S. treasury rate plus 300 basis points, set annually, which was 3.15% for 2015 and is 3.54% for 2016. Prior to the end of 2018, BAM has the option to extend the variable rate period for an additional three years. At the end of the variable rate period, the interest rate will be fixed at the higher of the then current variable rate or 8%. BAM is required to seek regulatory approval to pay interest and principal on its surplus notes only when adequate capital resources have accumulated beyond BAM’s initial capitalization and a level that continues to support its outstanding obligations, business plan and ratings. BAM did not pay any interest on the BAM Surplus Notes in 2015, 2014 or 2013. Other Operations: During 2015, WM Advisors did not pay any dividends to its immediate parent. As of December 31, 2015, WM Advisors had $14 million of net unrestricted cash, short-term investments and fixed maturity investments. During 2015, White Mountains paid a $6 million common share dividend. As of December 31, 2015, the Company and its intermediate holding companies had $74 million of net unrestricted cash, short-term investments and fixed maturity investments, $292 million of common equity securities and $18 million of other long-term investments included in its Other Operations segment. WM Life Re Keep-Well Agreement Sirius Group initially fronted the reinsurance contracts covering guaranteed living and death benefits of Japanese variable annuity contracts for, and was 100% reinsured by, WM Life Re. In October 2013, White Mountains and Tokio Marine completed a novation whereby Sirius Group’s obligations on the reinsurance contracts were transferred to WM Life Re. As a result, Sirius Group no longer has any obligation or liability relating to these agreements. In connection with this novation agreement, White Mountains and Life Re Bermuda entered into a keep-well agreement, which obligates White Mountains to make capital contributions to Life Re Bermuda in the event that Life Re Bermuda’s shareholder’s equity falls below $75 million, provided however that in no event shall the amount of all capital contributions made by White Mountains under this agreement exceed $127 million. At December 31, 2015, Life Re Bermuda had $77 million of shareholder’s equity and White Mountains’s maximum capital commitment under the keep-well agreement was $111 million. WM Life Re is in runoff and all of its contracts will mature by June 30, 2016. In addition, from time to time WM Life Re borrows funds under an internal revolving credit facility with an intermediate holding company of White Mountains. There was no outstanding balance under this facility as of December 31, 2015. The summary balance sheet below presents Life Re Bermuda’s net assets as of December 31, 2015 reported to Tokio Marine as required under the terms of the novation agreement: December 31, Millions Cash and short-term investments $ 63.8 Direct obligations of the government of Japan - Reinsurance premium receivable .5 Settlements due from brokers and dealers .2 Derivative instruments 20.1 Total assets 84.6 Variable annuity liabilities (.3 ) Counterparty collateral held 6.9 Intercompany line of credit outstanding - Accounts payable and accrued expenses .5 Total liabilities 7.1 Total shareholder’s equity $ 77.5 Discontinued Operations - Sirius Group: Sirius Bermuda a class 3A licensed Bermuda insurer which owns Sirius International, has the ability to declare or pay dividends or make capital distributions to its immediate parent during any 12-month period without the prior approval of Bermuda regulatory authorities on the condition that any such declaration or payment of dividends or capital distributions does not cause a breach of any of its regulatory solvency and liquidity requirements. During 2016, Sirius Bermuda has the ability to pay dividends or make capital distributions without the prior approval of regulatory authorities, subject to meeting all appropriate liquidity and solvency requirements, of $635 million, which is equal to 25% of its December 31, 2015 regulatory capital available for distribution. The amount of dividends available to be paid by Sirius Bermuda in any given year is also subject to cash flow and earnings generated by Sirius Bermuda's business, as well as to dividends received from its subsidiaries, including Sirius International. During 2015, Sirius Bermuda paid $123 million of dividends to its immediate parent. Sirius International has the ability to pay dividends up to Sirius Bermuda subject to the availability of unrestricted equity, calculated in accordance with the Swedish Act on Annual Accounts in Insurance Companies and the Swedish Supervisor Authorities (“Swedish FSA”). Unrestricted equity is calculated on a consolidated group account basis and on a parent account basis. Differences between the two include but are not limited to accounting for goodwill, subsidiaries (with parent accounts stated at original foreign exchange rates), taxes and pensions. Sirius International’s ability to pay dividends is limited to the “lower of” unrestricted equity as calculated within the group and parent accounts. As of December 31, 2015, Sirius International had $334 million (based on the December 31, 2015 SEK to USD exchange rate) of unrestricted equity on a parent account basis (the lower of the two approaches) available to pay dividends in 2016. The amount of dividends available to be paid by Sirius International in any given year is also subject to cash flow and earnings generated by Sirius International’s business, as well as to dividends received from its subsidiaries. Earnings generated by Sirius International’s business that are allocated to the Safety Reserve are not available to pay dividends (see “Safety Reserve” on the next page). During 2015, Sirius International paid $195 million of dividends to its immediate parent. Subject to certain limitations under Swedish law, Sirius International is permitted to transfer certain portions of its pre-tax income to its Swedish parent companies to minimize taxes (referred to as a group contribution). On January 1, 2013, new tax legislation became effective in Sweden that limits the deductibility of interest paid on certain intra-group debt instruments. Uncertainty exists with respect to the interpretation of the legislation on existing intra-group debt instruments within the Sirius Group structure. During 2015, Sirius International did not transfer any of its 2014 pre-tax income via group contributions to its Swedish parent companies. Sirius America has the ability to pay dividends up to its immediate parent during any twelve-month period without the prior approval of regulatory authorities in an amount set by formula based on the lesser of net investment income, as defined by statute, or 10% of statutory surplus, in both cases as most recently reported to regulatory authorities, subject to the availability of earned surplus and subject to dividends paid in prior periods. Based upon the formula above, most recently calculated as of December 31, 2015, Sirius America does not currently have the ability to pay dividends during 2016 without prior approval of regulatory authorities. As of December 31, 2015, Sirius America had $518 million of statutory surplus and $37 million of earned surplus. During 2015, Sirius America paid an $85 million special dividend and a $40 million return of capital distribution totaling $125 million after receiving regulatory approval. During 2015, Sirius Group did not pay any dividends to its immediate parent. As of December 31, 2015, Sirius Group and its intermediate holding companies had $94 million of net unrestricted cash, short-term investments and fixed maturity investments outside of its regulated and unregulated insurance and reinsurance operating subsidiaries. Capital Maintenance There is a capital maintenance agreement between Sirius International and Sirius America which obligates Sirius International to make contributions to Sirius America’s surplus in order for Sirius America to maintain surplus equal to at least 125% of the company action level risk based capital as defined in the NAIC Property/Casualty Risk-Based Capital Report. The agreement provides for a maximum contribution to Sirius America of $200 million. During 2015, Sirius International has not made any contributions to the surplus of Sirius America. Sirius International also provides Sirius America with accident year stop loss reinsurance, which protects Sirius America’s accident year loss and allocated loss adjustment expense ratio in excess of 70%, with a limit of $90 million. This stop loss contract was in effect for all of 2015 and has been renewed for all of 2016 with the same attachment point and limits. Safety Reserve Subject to certain limitations under Swedish law, Sirius International is permitted to transfer pre-tax income amounts into an untaxed reserve referred to as a safety reserve. As of December 31, 2015, Sirius International’s safety reserve amounted to SEK 10.7 billion, or $1.3 billion (based on the December 31, 2015 SEK to USD exchange rate). During 2015, Sirius International transferred SEK 243 million or $28 million to the Safety reserve. Under GAAP, an amount equal to the safety reserve, net of a related deferred tax liability established at the Swedish tax rate of 22.0%, is classified as shareholder’s equity. Generally, this deferred tax liability is only required to be paid by Sirius International if it fails to maintain prescribed levels of premium writings and loss reserves in future years. As a result of the indefinite deferral of these taxes, Swedish regulatory authorities apply no taxes to the safety reserve when calculating solvency capital under Swedish insurance regulations. Accordingly, under local statutory requirements, an amount equal to the deferred tax liability on Sirius International’s safety reserve ($279 million as of December 31, 2015) is included in solvency capital. Access to the safety reserve is restricted to coverage of insurance and reinsurance losses. Access for any other purpose requires the approval of Swedish regulatory authorities. Similar to the approach taken by Swedish regulatory authorities, most major rating agencies generally include the $1.3 billion balance of the safety reserve, without any provision for deferred taxes, in Sirius International’s regulatory capital when assessing Sirius International’s financial strength. Insurance Float Insurance float is an important aspect of White Mountains’s insurance operations. Insurance float represents funds that an insurance or reinsurance company holds for a limited time. In an insurance or reinsurance operation, float arises because premiums are collected before losses are paid. This interval can extend over many years. During that time, the insurer or reinsurer invests the funds. When the premiums that an insurer or reinsurer collects do not cover the losses and expenses it eventually must pay, the result is an underwriting loss, which can be considered as the cost of insurance float. One manner to calculate insurance float is to take insurance liabilities and subtract insurance assets. Although insurance float can be calculated using numbers determined under GAAP, insurance float is not a GAAP concept and, therefore, there is no comparable GAAP measure. Insurance float can increase in a number of ways, including through acquisitions of insurance and reinsurance operations, organic growth in existing insurance and reinsurance operations and recognition of losses that do not immediately cause a corresponding reduction in investment assets. Conversely, insurance float can decrease in a number of other ways, including sales of insurance and reinsurance operations, shrinking or runoff of existing insurance and reinsurance operations, the acquisition of operations that do not have substantial investment assets (e.g., an agency) and the recognition of gains that do not cause a corresponding increase in investment assets. It is White Mountains’s intention to generate low-cost float over time through a combination of acquisitions and organic growth in its existing insurance and reinsurance operations. However, White Mountains seeks to increase overall profitability, which sometimes reduces insurance float, such as in the Sirius Group transaction. Certain operational leverage metrics can be measured with ratios that are calculated using insurance float. There are many activities that do not change the amount of insurance float at an insurance or reinsurance company but can have a significant impact on the company’s operational leverage metrics. For example, investment gains and losses, foreign currency gains and losses, debt issuances and repurchases/retirements, common and preferred share issuances and repurchases and dividends paid to shareholders are all activities that do not change insurance float but that can meaningfully impact operational leverage metrics that are calculated using insurance float. The following table illustrates White Mountains’s consolidated insurance float position as of December 31, 2015 and 2014: December 31, 2015 December 31, 2014 $ in millions Continuing Operations Discontinued Operations Total Continuing Operations Discontinued Operations Total Loss and LAE reserves $ 1,395.8 $ 1,644.4 $ 3,040.2 $ 1,350.0 $ 1,809.8 $ 3,159.8 Unearned insurance and reinsurance premiums 612.6 342.2 954.8 616.7 338.6 955.3 Ceded reinsurance payable 30.5 67.1 97.6 34.2 71.5 105.7 Funds held under insurance and reinsurance contracts 137.8 52.9 190.7 81.0 57.9 138.9 Deferred tax on safety reserve (1) - 279.2 279.2 - 295.7 295.7 Insurance liabilities 2,176.7 2,385.8 4,562.5 2,081.9 2,573.5 4,655.4 Cash in regulated insurance and reinsurance subsidiaries $ 43.9 $ 129.2 $ 173.1 $ 17.4 $ 102.6 $ 120.0 Reinsurance recoverable on paid and unpaid losses 194.0 293.3 487.3 173.9 333.6 507.5 Insurance and reinsurance premiums receivable 223.3 323.6 546.9 241.1 306.6 547.7 Funds held by ceding entities - 90.6 90.6 37.1 91.9 129.0 Deferred acquisition costs 107.6 74.6 182.2 107.2 69.9 177.1 Ceded unearned insurance and reinsurance premiums 29.5 87.7 117.2 17.8 76.2 94.0 Insurance assets 598.3 999.0 1,597.3 594.5 980.8 1,575.3 Insurance float $ 1,578.4 $ 1,386.8 $ 2,965.2 $ 1,487.4 $ 1,592.7 $ 3,080.1 Insurance float as a multiple of total adjusted capital 0.3x N/A 0.6x 0.3x N/A 0.6x Insurance float as a multiple of White Mountains’s common shareholders’ equity 0.4x N/A 0.8x 0.4x N/A 0.8x (1) While classified as a liability for GAAP purposes, as a result of the indefinite deferral of these taxes, Swedish regulatory authorities apply no taxes to the safety reserve when calculating solvency capital under Swedish insurance regulations. Accordingly, under local statutory requirements, an amount equal to the deferred tax liability on Sirius International’s safety reserve is included in solvency capital (see “Safety Reserve” on page 67). During 2015, insurance float from continuing operations increased by $91 million, primarily from an increase at OneBeacon of unrestricted collateral held relating to the growth of its Surety business. During 2015, insurance float from discontinued operations decreased by $206 million, primarily due to reduced loss and LAE reserve balances at Sirius Group resulting from payments. Financing The following table summarizes White Mountains’s capital structure as of December 31, 2015 and 2014: December 31, $ in millions WTM Bank Facility $ 50.0 $ - OBH Senior Notes, carrying value 274.8 274.7 OneBeacon Bank Facility - - Tranzact Bank Facility, carrying value 102.9 67.4 MediaAlpha Bank Facility, carrying value 14.7 - Other debt - 1.0 Total debt in continuing operations 442.4 343.1 Total debt in discontinued operations (1) 403.5 403.5 Total debt 845.9 746.6 Non-controlling interest - OneBeacon Ltd. 245.6 258.4 Non-controlling interest - SIG Preference Shares 250.0 250.0 Non-controlling interests - other, excluding mutuals and reciprocals (2) 115.2 168.6 Total White Mountains’s common shareholders’ equity 3,913.2 3,995.7 Total capital (2) 5,369.9 5,419.3 Equity in net unrealized gains from Symetra’s fixed maturity portfolio, net of applicable taxes - (34.9 ) Total adjusted capital $ 5,369.9 $ 5,384.4 Total debt to total adjusted capital % % Total debt and SIG Preference Shares to total adjusted capital % % (1) See Note 22 - “Discontinued Operations”. (2) Total capital only includes non-controlling interests that White Mountains (i) benefits from the return on or (ii) has the ability to utilize the net assets supporting the non-controlling interest. Management believes that White Mountains has the flexibility and capacity to obtain funds externally as needed through debt or equity financing on both a short-term and long-term basis. However, White Mountains can provide no assurance that, if needed, it would be able to obtain additional debt or equity financing on satisfactory terms, if at all. White Mountains has an unsecured revolving credit facility with a syndicate of lenders administered by Wells Fargo Bank, N.A., which has a total commitment of $425 million and a maturity date of August 14, 2018. During 2015, White Mountains borrowed $125 million and subsequently repaid $75 million under the WTM Bank Facility, resulting in a $50 million outstanding balance as of December 31, 2015. On September 29, 2015, OneBeacon Ltd. and OBH, as co-borrowers and co-guarantors, entered into a revolving credit facility administered by U.S. Bank N.A. and also including BMO Harris Bank N.A., which has a total commitment of $65 million and has a maturity date of September 29, 2019 (the “OneBeacon Bank Facility”). As of December 31, 2015 the OneBeacon Bank Facility was undrawn. The WTM and OneBeacon Bank Facilities contain various affirmative, negative and financial covenants that White Mountains considers to be customary for such borrowings, including certain minimum net worth and maximum debt to capitalization standards. Tranzact has a secured credit facility with a syndicate of lenders administered by The PrivateBank and Trust Company that has a maturity date of October 10, 2019 (the “Tranzact Bank Facility”). During 2015, Tranzact amended the Tranzact Bank Facility, which now consists of a $101 million term loan facility, which had an outstanding balance of $94 million as of December 31, 2015, and a revolving credit facility for an additional $15 million, which had an outstanding balance of $11 million as of December 31, 2015. The amendment increased the term loan facility by $31 million, the proceeds of which were used by Tranzact to finance its acquisition of TruBridge. During 2015, Tranzact repaid $7 million under the term loan portion and borrowed $24 million and repaid $13 million under the revolving portion of the Tranzact Bank Facility. The Tranzact Bank Facility is secured by the intellectual property and the common stock of Tranzact’s subsidiaries and contains various affirmative, negative and financial covenants which White Mountains considers to be customary for such borrowings, including a minimum fixed charge coverage ratio and a maximum leverage ratio. The Tranzact Bank Facility carries a variable interest rate, based on the U.S. dollar LIBOR rate. Tranzact has entered into an interest rate swap agreement to effectively fix the rate it pays on $70 million of the $101 million term loan portion of the facility. (See Note 9 - “Derivatives”). On July 23, 2015, MediaAlpha entered into a credit facility with Opus Bank, which has a total commitment of $20 million and has a maturity date of July 23, 2019 (the “MediaAlpha Bank Facility”). The MediaAlpha Bank Facility consists of a $15 million term loan facility, which was fully drawn as of December 31, 2015, and a revolving credit facility for an additional $5 million, which was undrawn as of December 31, 2015. The MediaAlpha Bank Facility is secured by the intellectual property and the common stock of MediaAlpha's subsidiaries and contains various affirmative, negative and financial covenants which White Mountains considers to be customary for such borrowings, including a maximum leverage ratio. The MediaAlpha Bank Facility carries a variable interest rate, based on the U.S. dollar LIBOR rate. In November 2012, OBH issued $275 million face value of senior unsecured debt through a public offering, at an issue price of 99.9% (the “OBH Senior Notes”). The net proceeds from the issuance of the OBH Senior Notes were used to repurchase OBH’s previously issued senior notes. The OBH Senior Notes, which are fully and unconditionally guaranteed as to the payment of principal and interest by OneBeacon Ltd., bear an annual interest rate of 4.60%, payable semi-annually in arrears on May 9 and November 9, until maturity on November 9, 2022. The OBH Senior Notes were issued under indentures that contain restrictive covenants which, among other things, limit the ability of OneBeacon Ltd., OBH and their respective subsidiaries to create liens and enter into sale and leaseback transactions and limits the ability of OneBeacon Ltd., OBH and their respective subsidiaries to consolidate, merge or transfer their properties and assets. The indentures do not contain any financial ratios or specified levels of net worth or liquidity to which OneBeacon Ltd. or OBH must adhere. In addition, a failure by OneBeacon Ltd. or its subsidiaries to pay principal and interest on covered debt or to comply with obligations in covered debt agreements that results in the acceleration of at least $75 million of principal amount of covered debt could trigger the acceleration of the OBH Senior Notes. It is possible that, in the future, one or more of the rating agencies may lower White Mountains’s existing ratings. If one or more of its ratings were lowered, White Mountains could incur higher borrowing costs on future borrowings and its ability to access the capital markets could be impacted. Capital Lease In December 2011, OneBeacon sold the majority of its fixed assets and capitalized software. OneBeacon entered into lease financing arrangements with US Bancorp Equipment Finance, Inc. (“US Bancorp”) and Fifth Third Equipment Finance Company (“Fifth Third”) whereby OneBeacon sold furniture and equipment and capitalized software, respectively, at a cost equal to net book value. OneBeacon then leased the fixed assets back from US Bancorp for a lease term of five years and leased the capitalized software back from Fifth Third for a lease term of four years. OneBeacon received cash proceeds of $23 million as a result of entering into the sale-leaseback transactions. In December 2015 the lease agreement with Fifth Third expired and OneBeacon purchased the leased assets under the agreement with a remaining book value of $1 million for a nominal amount. At the end of the lease term with US Bancorp on December 31, 2016, OneBeacon will purchase the leased furniture and equipment assets for a nominal amount, and all rights, title and interest will transfer back to it. As of December 31, 2015, OneBeacon had a capital lease obligation of $2 million included within other liabilities and a capital lease asset of $2 million included within other assets. Discontinued Operations In March 2007, Sirius Group issued $400 million face value of senior unsecured notes at an issue price of 99.715% (the “SIG Senior Notes”). The SIG Senior Notes bear an annual interest rate of 6.375%, payable semi-annually in arrears on March 20 and September 20, until maturity in March 2017. On November 25, 2014, Sirius International entered into two stand by letter of credit facility agreements totaling $200 million to provide capital support for its Lloyds Syndicate 1945. One letter of credit is a $125 million facility from Nordea Bank Finland plc (“the Nordea facility”), $100 million of which is issued on an unsecured basis. The second letter of credit is a $75 million facility with Lloyds Bank plc (“the Lloyds Bank facility”), $25 million of which is issued on an unsecured basis. The Nordea facility and the Lloyds Bank facility are renewable annually. The unsecured portions of the Nordea and Lloyds Bank facilities are subject to various affirmative, negative and financial covenants that White Mountains considers to be customary for such borrowings, including certain minimum net worth and maximum debt to capitalization standards. Sirius International has other secured letter of credit and trust arrangements with various financial institutions to support its insurance operations. Covenant Compliance At December 31, 2015, White Mountains was in compliance with all of the covenants under all of its debt and unsecured letter of credit facilities and expects to remain in compliance with these covenants for the foreseeable future. Contractual Obligations and Commitments Below is a schedule of White Mountains’s material contractual obligations and commitments as of December 31, 2015: Millions Due in Less Than One Year Due in One to Three Years Due in Three to Five Years Due After Five Years Total Loss and LAE reserves(1) $ 481.3 $ 513.2 $ 229.6 $ 171.7 $ 1,395.8 Debt 74.9 43.3 51.5 275.0 444.7 Interest on debt 18.0 32.3 27.2 25.4 102.9 Long-term incentive compensation 54.4 80.1 1.9 4.7 141.1 Pension and other benefit plan obligations 13.3 6.6 6.2 28.0 54.1 Operating leases 14.3 24.8 17.3 33.3 89.7 Capital leases 1.7 - - - 1.7 Total contractual obligations $ 657.9 $ 700.3 $ 333.7 $ 538.1 $ 2,230.0 (1) Represents expected future cash outflows resulting from loss and LAE payments. The amounts presented are gross of reinsurance recoverables on unpaid losses of $187 and net of the discount on OneBeacon’s workers compensation loss and LAE reserves of $1 as of December 31, 2015. White Mountains’s loss reserves do not have contractual maturity dates. However, based on historical payment patterns, the preceding table includes an estimate of when management expects White Mountains’s loss reserves to be paid. The timing of claim payments is subject to significant uncertainty. White Mountains maintains a portfolio of marketable investments with varying maturities and a substantial amount of short-term investments to provide adequate liquidity for the payment of claims. The SIG Preference Shares are not included in the table above, as these perpetual preferred shares have no stated maturity date and are redeemable only at the option of Sirius Group. The balances included in the table above regarding White Mountains’s long-term incentive compensation plans include amounts payable for performance shares and units, as well as deferred compensation balances. Exact amounts to be paid for performance shares cannot be predicted with certainty, as the ultimate amounts of these liabilities are based on the future performance of White Mountains and in some cases the market price of the Company’s and OneBeacon Ltd.’s common shares at the time the payments are made. The estimated payments reflected in the table are based on current accrual factors (including performance relative to targets and common share price) and assume that all outstanding balances were 100% vested as of December 31, 2015. There are no provisions within White Mountains’s operating leasing agreements that would trigger acceleration of future lease payments. The capital lease that OneBeacon entered into in conjunction with the sale-leaseback of certain of OneBeacon’s fixed assets and capitalized software contains provisions that could trigger an event of default, including a failure to make payments when due under the capital lease. If an event of default were to occur, the lessor would have a number of remedies available including the acceleration of future lease payments or the possession of the property covered under the lease agreement. White Mountains does not finance its operations through the securitization of its trade receivables, through special purpose entities or through synthetic leases. Further, White Mountains has not entered into any material arrangements requiring it to guarantee payment of third-party debt or lease payments or to fund losses of an unconsolidated special purpose entity. White Mountains also has future binding commitments to fund certain other long-term investments. These commitments, which total approximately $82 million, do not have fixed funding dates and are therefore excluded from the table above. WM Life Re reinsures death and living benefit guarantees associated with certain variable annuities issued in Japan. WM Life Re has assumed the risk related to a shortfall between the account value and the guaranteed value that must be paid by the ceding company to an annuitant or to an annuitant’s beneficiary in accordance with the underlying annuity contracts. WM Life Re uses derivative instruments, including put options, interest rate swaps, total return swaps and futures contracts on major equity indices, currency pairs and government bonds, to mitigate the risks associated with changes in the fair value of the reinsured variable annuity guarantees. As of December 31, 2015, the total guarantee value was approximately ¥50.7 billion (approximately $0.4 billion) and the related account values were approximately 109% of this amount. Based on current account value to guaranty value ratio in the annuities reinsured by WM Life Re as of December 31, 2015, WM Life Re expects $3 million of future cash outflows related to its reinsurance contracts through June 2016. White Mountains purchases derivative instruments, including futures and over-the-counter option contracts on interest rates, major equity indices, and foreign currencies, to mitigate the risks associated with changes in the fair value of the reinsured variable annuity guarantees. As of December 31, 2015, the fair value of these derivative instruments was $20 million. In addition, WM Life Re held approximately $6 million of cash and fixed maturity investments as of December 31, 2015 posted as collateral to its reinsurance and derivatives counterparties. Share Repurchase Programs The Company: During the past several years, White Mountains’s board of directors has authorized the Company to repurchase its common shares, from time to time, subject to market conditions. Most recently, in February 2016, White Mountains’s Board of Directors authorized the Company to repurchase an additional 1 million common shares. The repurchase authorizations do not have a stated expiration date. As of February 25, 2016, White Mountains may purchase an additional 1,393,532 shares under the board authorizations. In addition, from time to time White Mountains has also repurchased its common shares through tender offers that were separately approved by its board of directors. The following table presents common shares repurchased by the Company, as well as the average price per share as a percent of the adjusted book value per share. For 2016 and 2015, the average price per share as a percent of adjusted book value per share including the estimated gain from the Sirius Group transaction is presented. See page 44 for the estimated gain on Sirius Group transaction. Average price per share as % of Adjusted book Average value per share, Shares Cost price Adjusted book including estimated Dates Repurchased (millions) per share value per share gain on Sirius sale Year-to-date February 25, 2016 90,743 $ 66.3 $ 730.76 105% 93% Year ended December 31, 2015 387,495 $ 284.2 $ 733.37 105% 94% Year ended December 31, 2014 217,879 $ 134.5 $ 617.29 93% N/A Year ended December 31, 2013 141,535 $ 79.8 $ 563.91 88% N/A OneBeacon Ltd.: In 2007, OneBeacon Ltd.’s board of directors authorized the repurchase of up to $200 million of OneBeacon’s Class A common shares from time to time, subject to market conditions. This authorization does not have a stated expiration date. During 2015, 166,368 shares were repurchased under the share repurchase authorization for $2 million at an average share price of $12.62. Since the inception of this authorization, OneBeacon has repurchased and retired 5.8 million of its Class A common shares. During 2014 and 2013, no shares were repurchased under the share repurchase authorization. The amount of authorization remaining is $86 million as of December 31, 2015. Cash Flows Detailed information concerning White Mountains’s cash flows during 2015, 2014 and 2013 follows: Cash flows from continuing operations for the years ended 2015, 2014 and 2013 Net cash flows provided from (used for) continuing operations was $161 million, $59 million and $(40) million in 2015, 2014 and 2013, respectively. Cash flows from continuing operations increased $102 million in 2015 compared to 2014 primarily due to increased cash collateral received from OneBeacon’s Surety business and from higher amounts of cash provided by WTM Life Re from the sale and settlement of derivative instruments as its business runs off. Cash flows from continuing operations increased $99 million in 2014 compared to 2013 primarily due to lower amounts of cash used for the settlement and purchase of derivative instruments at WM Life Re in 2014 compared to 2013. White Mountains does not believe that these trends will have a meaningful impact on its future liquidity or its ability to meet its future cash requirements. Other items affecting cash flows from operations: During 2015, 2014 and 2013 White Mountains made long-term incentive payments totaling $57 million, $27 million and $11 million. OneBeacon paid a total of $13 million of interest on the OBH Senior Notes during each of 2015, 2014 and 2013. During 2015, Tranzact paid $4 million of interest on the Tranzact Bank Facility. Cash flows from investing and financing activities for the year ended December 31, 2015 Financing and Other Capital Activities During 2015, the Company declared and paid a $6 million cash dividend to its common shareholders. During 2015, the Company repurchased and retired 387,495 of its common shares for $284 million, which included 12,156 common shares repurchased under employee benefit plans and 13,500 common shares from the Prospector Offshore Fund redemption. During 2015, White Mountains borrowed a total of $125 million and subsequently repaid a total of $75 million under the WTM Bank Facility. During 2015, OneBeacon Ltd. declared and paid $80 million of cash dividends to its common shareholders. White Mountains received a total of $60 million of these dividends. During 2015, OneBeacon contributed $85 million to Split Rock. During 2015, White Mountains contributed $8 million to WM Life Re. During 2015, WM Life Re repaid $23 million under an internal revolving credit facility with an intermediate holding company of White Mountains. During 2015, BAM received $29 million in surplus contributions from its members. During 2015, MediaAlpha paid $4 million of dividends, of which $2 million was paid to White Mountains. During 2015, MediaAlpha borrowed $15 million under the term loan portion of the MediaAlpha Bank Facility and used the proceeds to make a $15 million return of capital payment to its shareholders, of which White Mountains received $9 million. During 2015, Tranzact paid $7 million of dividends, of which $4 million was paid to White Mountains. During 2015, Tranzact borrowed $31 million and repaid a total of $7 million under the term loan portion and borrowed $24 million and repaid $13 million under the revolving portion of the Tranzact Bank Facility. Acquisitions and Dispositions On December 22, 2015, White Mountains purchased a non-controlling interest in Captricity for $27 million. On September 1, 2015, Tranzact acquired 100% of the outstanding share capital of TruBridge for a purchase price of $31 million in cash. On May 27, 2015, White Mountains sold its interest in Hamer LLC and received cash proceeds of $24 million. On April 2, 2015, White Mountains closed on PassportCard, a 50/50 joint venture with DavidShield and contributed $21 million of assets to a newly formed entity, PassportCard Limited (formerly PPCI Global Limited). During 2015, White Mountains increased its ownership interest in Wobi through (i) the purchase of common and convertible preferred shares from a non-controlling interest shareholder for NIS 35 million (approximately $9 million) and (ii) the purchase of newly-issued convertible preferred shares for NIS 56 million (approximately $15 million). As of December 31, 2015, White Mountains’s ownership share of Wobi was 96.1% on a fully converted basis. On February 23, 2015, Wobi acquired 56.2% of the outstanding share capital of Cashboard for NIS 9.5 million (approximately $2.4 million based upon the foreign exchange spot rate at the date of acquisition). During the second quarter of 2015, Wobi purchased newly issued common shares of Cashboard for NIS 10 million (approximately $3 million) and during the fourth quarter of 2015, Wobi purchased all of the remaining shares from non-controlling interest holders for NIS 16 million (approximately $4 million). During 2015, White Mountains purchased $4 million of surplus notes issued by SSIE, which increased its investment in surplus notes issued by SSIE to $21 million as of December 31, 2015. Cash flows from investing and financing activities for the year ended December 31, 2014 Financing and Other Capital Activities During the first quarter of 2014, the Company declared and paid a $6 million cash dividend to its common shareholders. During 2014, the Company repurchased and retired 217,879 of its common shares for $134 million, which included 10,475 common shares repurchased under employee benefit plans. During 2014, White Mountains borrowed and repaid a total of $65 million under the WTM Bank Facility. During 2014, OneBeacon Ltd. declared and paid $80 million of cash dividends to its common shareholders. White Mountains received a total of $60 million of these dividends. During 2014, OneBeacon contributed $67 million to ASIC. During 2014, White Mountains contributed $15 million to WM Advisors. During 2014, WTM Life Re borrowed a total of $82 million and repaid a total of $89 million under an internal revolving credit facility with an intermediate holding company of White Mountains. During 2014, BAM received $16 million in surplus contributions from its members. During 2014, MediaAlpha paid $2 million of dividends, of which $1 million was paid to White Mountains. Acquisitions and Dispositions During 2014, White Mountains purchased 63% of Tranzact for a purchase price of $178 million. Immediately after the closing, Tranzact completed a recapitalization that allowed for the return of $44 million to White Mountains. During 2014, White Mountains acquired approximately 45% of the outstanding common shares of durchblicker.at, for EUR 9 million (approximately $12 million based upon the foreign exchange spot rate at the date of acquisition). During 2014, White Mountains acquired 60% of the outstanding Class A common units of MediaAlpha for an initial purchase price of $28 million. During 2014, White Mountains acquired 54% of the outstanding common shares of Wobi for NIS 14 million (approximately $4 million based upon the foreign exchange spot rate at the date of acquisition). In addition to the common shares, White Mountains also purchased NIS 32 million (approximately $9 million based upon the foreign exchange spot rates at the dates of acquisition) of newly-issued convertible preferred shares of Wobi. During 2014, White Mountains acquired certain assets and liabilities of Star & Shield Holdings LLC, including SSRM, the attorney-in-fact for SSIE, for a purchase price of $2 million. White Mountains also purchased $17 million of surplus notes issued by SSIE during 2014. During 2014, OneBeacon transferred $51 million of cash in connection with the sale of the Runoff Business. During 2014, WM Solutions completed the shell sale of Citation and received $13 million as consideration. Cash flows from investing and financing activities for the year ended December 31, 2013 Financing and Other Capital Activities During the first quarter of 2013, the Company declared and paid a $6 million cash dividend to its common shareholders. During 2013, the Company repurchased and retired 141,535 of its common shares for $80 million, which included 1,535 common shares repurchased under employee benefit plans. During the first quarter of 2013, White Mountains repaid $75 million that was outstanding under a previous revolving credit facility as of December 31, 2012. In addition, during 2013, White Mountains borrowed and repaid a total of $200 million under its revolving credit facilities. During 2013, OneBeacon Ltd. declared and paid $80 million of cash dividends to its common shareholders. White Mountains received a total of $60 million of these dividends. During 2013, OneBeacon contributed $135 million to Split Rock and $35 million to OBIC. During 2013, White Mountains contributed $70 million to WM Life Re. During 2013, WTM Life Re borrowed a total of $145 million and repaid a total of $115 million under an internal revolving credit facility with an intermediate holding company of White Mountains. During 2013, BAM received $17 million in surplus contributions from its members. Acquisitions and Dispositions During 2013, OneBeacon completed the sale of Essentia and received $31 million as consideration. TRANSACTIONS WITH RELATED PERSONS See Note 20-“Transactions with Related Persons” in the accompanying Consolidated Financial Statements. NON-GAAP FINANCIAL MEASURES This report includes five non-GAAP financial measures that have been reconciled to their most comparable GAAP financial measures. White Mountains believes these measures to be more relevant than comparable GAAP measures in evaluating White Mountains’s results of operations and financial condition. Adjusted comprehensive income is a non-GAAP financial measure that excludes the change in equity in net unrealized gains and losses from Symetra’s fixed maturity portfolio, net of applicable taxes, from comprehensive income. In the calculation of comprehensive income under GAAP, fixed maturity investments are marked-to-market while the liabilities to which those assets are matched are not. Symetra attempts to earn a “spread” between what it earns on its investments and what it pays out on its products. In order to try to fix this spread, Symetra invests in a manner that tries to match the duration and cash flows of its investments with the required cash outflows associated with its life insurance and structured settlements products. As a result, Symetra typically earns the same spread on in-force business whether interest rates fall or rise. Further, at any given time, some of Symetra’s structured settlement obligations may extend 40 or 50 years into the future, which is further out than the longest maturing fixed maturity investments regularly available for purchase in the market (typically 30 years). For these long-dated products, Symetra is unable to fully match the obligation with assets until the remaining expected payout schedule comes within the duration of securities available in the market. If at that time, these fixed maturity investments have yields that are lower than the yields expected when the structured settlement product was originally priced, the spread for the product will shrink and Symetra will ultimately harvest lower returns for its shareholders. GAAP comprehensive income increases when rates decline, which would suggest an increase in the value of Symetra - the opposite of what is happening to the intrinsic value of the business. Therefore, White Mountains’s management and Board of Directors use adjusted comprehensive income when assessing Symetra’s quarterly financial performance. In addition, this measure is typically the predominant component of change in adjusted book value per share, which is used in calculation of White Mountains’s performance for both short-term (annual bonus) and long-term incentive plans. The reconciliation of adjusted comprehensive income to comprehensive income is included on page 45. Adjusted book value per share is a non-GAAP measure which is derived by expanding the GAAP calculation of book value per White Mountains common share to exclude equity in net unrealized gains and losses from Symetra’s fixed maturity portfolio, net of applicable taxes. In addition, the number of common shares outstanding used in the calculation of adjusted book value per share are adjusted to exclude unearned restricted common shares, the compensation cost of which, at the date of calculation, has yet to be amortized. The reconciliation of adjusted book value per share to GAAP book value per share is included on page 43. Total capital at White Mountains is comprised of White Mountains’s common shareholders’ equity, debt and non-controlling interests that White Mountains (i) benefits from the return on or (ii) has the ability to utilize the net assets supporting the non-controlling interest. As such, non-controlling interests attributable to mutuals and reciprocals are excluded from total adjusted capital. Total adjusted capital also excludes the equity in net unrealized gains and losses from Symetra’s fixed maturity portfolio, net of applicable taxes from total capital. The reconciliation of total capital to total adjusted capital is included on page 69. Total consolidated portfolio returns excluding Symetra and total common equity securities and long-term investments returns excluding Symetra are non-GAAP financial measures that remove the $259 million pre-tax unrealized gain recognized in the fourth quarter of 2015 that was the result of the change in accounting for Symetra common shares from the equity method to fair value. White Mountains believes these measures to be more relevant by making the returns in the current year comparable to the prior periods which did not contain any investment returns from Symetra. For the year ended December 31, 2015 GAAP returns Remove Symetra Returns - excluding Symetra In local currencies: Total consolidated portfolio returns 4.5 % (3.8 )% 0.7 % Total common equity securities and other long-term investments returns 19.6 % (21.0 )% (1.4 )% CRITICAL ACCOUNTING ESTIMATES Management’s Discussion and Analysis of Financial Condition and Results of Operations discuss the Company’s consolidated financial statements, which have been prepared in accordance with GAAP. The financial statements presented herein include all adjustments considered necessary by management to fairly present the financial position, results of operations and cash flows of White Mountains. The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities as of the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Certain of these estimates are considered critical in that they involve a higher degree of judgment and are subject to a significant degree of variability. On an ongoing basis, management evaluates its estimates, including those related to fair value measurements of investments and other financial instruments, valuation of liabilities associated with an assumed reinsurance agreement covering benefit guarantees on variable annuities in Japan, its property-casualty loss and LAE reserves and its property-casualty reinsurance contracts. Management bases it estimates on historical experience and on various other factors that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. 1. Loss and LAE Reserves General White Mountains establishes loss and LAE reserves that are estimates of amounts needed to pay claims and related expenses in the future for insured events that have already occurred. The process of estimating reserves involves a considerable degree of judgment by management and, as of any given date, is inherently uncertain. See Note 3-“Reserves for Unpaid Loss and Loss Adjustment Expenses” for a description of White Mountains’s loss and LAE reserves and actuarial methods. White Mountains performs an actuarial review of its recorded reserves each quarter. White Mountains’s actuaries compare the previous quarter’s estimates of paid loss and LAE, case reserves and IBNR to amounts indicated by actual experience. Differences between previous estimates and actual experience are evaluated to determine whether a given actuarial method for estimating loss and LAE should be relied upon to a greater or lesser extent than it had been in the past. While some variance is expected each quarter due to the inherent uncertainty in loss and LAE, persistent or large variances would indicate that prior assumptions and/or reliance on certain reserving methods may need to be revised going forward. OneBeacon The process of establishing loss reserves is complex and imprecise as it must consider many variables that are subject to the outcome of future events. As a result, informed subjective estimates and judgments as to OneBeacon’s ultimate exposure to losses are an integral component of the loss reserving process. OneBeacon, like other insurance companies, categorize and track its insurance reserves by "line of business", such as general liability, automobile liability and workers compensation. Furthermore, OneBeacon regularly reviews the appropriateness of reserve levels at the line of business level, considering the variety of trends that impact the ultimate settlement of claims for the subsets of claims in each particular line of business. Upon completion of each quarterly review, OneBeacon’s actuaries select indicated reserve levels based on the results of the actuarial methods described previously, which are the primary consideration in determining management’s best estimate of required reserves. However, in making its best estimate, management also considers other qualitative factors that may lead to a difference between held reserves and actuarially indicated reserve levels. Typically, these factors exist when management and OneBeacon’s actuaries conclude that there is insufficient historical incurred and paid loss information or that there is particular uncertainty about whether trends included in the historical incurred and paid loss information are unlikely to repeat in the future. Such factors include, among others, recent entry into new markets or new products, improvements in the claims department that are expected to lessen future ultimate loss costs, legal and regulatory developments, or other volatilities that may arise. Loss and LAE Reserves by Line of Business OneBeacon’s loss and LAE reserves, net of reinsurance recoverables, as of December 31, 2015 and 2014 were as follows: December 31, 2015 December 31, 2014 Millions Case IBNR Total Case IBNR Total Automobile liability $ 49.8 $ 57.7 $ 107.5 $ 42.2 $ 45.4 $ 87.6 General liability - occurrence 68.5 198.7 267.2 50.8 184.2 235.0 General liability - claims made 88.0 182.5 270.5 89.8 205.1 294.9 Medical malpractice 84.4 94.5 178.9 86.8 102.7 189.5 Other casualty 52.8 38.7 91.5 44.3 36.3 80.6 Workers compensation 54.1 62.2 116.3 47.1 65.2 112.3 Property 33.9 37.6 71.5 53.4 38.3 91.7 Other 23.8 76.6 100.4 27.7 61.3 89.0 Total $ 455.3 $ 748.5 $ 1,203.8 $ 442.1 $ 738.5 $ 1,180.6 For loss and allocated LAE reserves, the key assumption as of December 31, 2015 was that the impact of the various reserving factors, as described below, on future paid losses would be similar to the impact of those factors on the historical loss data with the exception of severity trends. Severity trends have been relatively stable over the relevant historical period. The actuarial methods used would project losses assuming continued stability in severity trends. Management has considered a range of assumptions regards future increases in loss severity trends, including the impact of inflation, in making its reserve selections. The major causes of material uncertainty (“reserving factors”) generally will vary for each product line, as well as for each separately analyzed component of the product line. The following section details reserving factors by product line. There could be other reserving factors that may impact ultimate claim costs. Each reserving factor presented will have a different impact on estimated reserves. Also, reserving factors can have offsetting or compounding effects on estimated reserves. For example, in workers compensation, the use of expensive medical procedures that result in medical cost inflation may enable workers to return to work faster, thereby lowering indemnity costs. Thus, in almost all cases, it is impossible to discretely measure the effect of a single reserving factor and construct a meaningful sensitivity expectation. Actual results will likely vary from expectations for each of these assumptions, resulting in an ultimate claim liability that is different from that being estimated currently. Additional causes of material uncertainty exist in most product lines and may impact the types of claims that could occur within a particular operating segment or book of business. Examples where reserving factors, within an underwriting unit or book of business, are subject to change include changing types of insured (e.g., type of insured vehicle, size of account, industry insured, jurisdiction, etc.), changing underwriting standards, or changing policy provisions (e.g., deductibles, policy limits, or endorsements). General liability General liability policies are written on a claims made or occurrence form. General liability claims made policies provide professional and management liability coverage. Professional liability policies cover the defense expenses and damages related to negligence claims brought against the insured professional services firm or government entity. The coverage focuses on damages resulting from an alleged failure to perform, error or omission in the product or service provided by the policyholder. Management liability policies cover the defense expenses and damages related to alleged wrongful acts committed by the directors and officers of the insured organization. General liability occurrence policies cover businesses for any liability resulting from bodily injury and property damage arising from general business operations, accidents on a premises and the products manufactured or sold. General liability-occurrence reserves generally include two components: bodily injury and property damage. Bodily injury payments reimburse the claimant for damages pertaining to physical injury as a result of the policyholder's legal obligation arising from nonintentional acts such as negligence, subject to the insurance policy provisions. In some cases the damages can include future wage loss (which is a function of future earnings power and wage inflation) and future medical treatment costs. Property damage payments result from damages to the claimant's private property arising from the policyholder's legal obligation for non-intentional acts. In most cases, property damage losses are a function of costs as of the loss date, or soon thereafter. Defense costs are also a part of the insured costs covered by liability policies and can be significant, sometimes greater than the cost of the actual paid claims, though for some products this risk is mitigated by policy language such that the insured portion of defense costs erodes the amount of policy limit available to pay the claim. General liability is generally considered a long tail line of business, as it takes a relatively long period of time to finalize and settle claims from a given accident year. The speed of claim reporting and claim settlement is a function of the specific coverage provided and the jurisdiction, among other factors. There are numerous components underlying the general liability product line. Some of these have relatively moderate payment patterns (with most of the claims for a given accident year closed within 5 to 7 years), while others can have extreme lags in both reporting and payment of claims (e.g., a reporting lag of a decade for “construction defect” claims). Examples of common reserving factors that can change and, thus, affect estimated general liability reserves include: • Changes in claim handling philosophies (e.g., case reserving standards), including the use of third-party claims administrators • Changes in policy provisions or court interpretations of such provisions • New theories of liability (e.g., cyber-related claims) • Trends in litigation or jury awards • Changes in the propensity to sue, in general with specificity to particular issues • Changes in statutes of limitations • Changes in the underlying court system • Distortions from losses resulting from large single accounts or single issues • Changes in tort or case law • Subrogation opportunities • Shifts in lawsuit mix between federal and state courts • Changes in settlement patterns, including frequency and severity Property Property covers losses to a business' premises, inventory and equipment as a result of weather, fire, theft and other causes. For property coverage, it generally takes a relatively short period of time to close claims. The relatively high attachment points and insured values of the property policies underwritten in the Specialty Property underwriting unit present a potentially longer tail and greater uncertainty than our standard property business. Commercial multiple peril The general liability occurrence and property coverages described above are often provided under a multiple peril package policy, which includes both general liability and property insurance. Because commercial multiple peril provides a combination of property and liability coverage, typically for small businesses, it includes both short- and long-tail coverages. The reserving risk for this line is dominated by the liability coverage portion of this product, except occasionally in the event of catastrophic or large single losses. Medical malpractice Medical professional liability policies cover the defense expenses and damages related to negligence claims brought against the insured health care institution or provider. The coverage focuses on damages resulting from an alleged failure to perform, error or omission in the service provided by the policyholder. See the above discussions with regard to reserving factors for general liability, which are similar to the reserving factors for medical malpractice. Workers compensation Workers compensation covers an employer’s liability for injuries, disability or death of employees, without regard to fault, as prescribed by state workers compensation law and other statutes. Workers compensation is generally considered a long tail coverage, as it takes a relatively long period of time to finalize claims from a given accident year. While certain payments such as initial medical treatment or temporary wage replacement for the injured worker are made quickly, some other payments are made over the course of several years, such as awards for permanent partial injuries. In addition, some payments can run as long as the injured worker’s life, such as permanent disability benefits and ongoing medical care. Despite the possibility of long payment tails, the reporting lags are generally short, settlements are generally not complex, and most of the liability can be considered high frequency with moderate severity. The largest reserve risk generally comes from the low frequency, high severity claims providing lifetime coverage for medical expense arising from a worker’s injury. Examples of common reserving factors that can change and, thus, affect the estimated workers compensation reserves include: • Changes in the type, frequency of utilization or cost of medical treatments (e.g., changes in the use of pharmaceutical drugs, types of health providers used, use of preferred provider networks and other medical cost containment practices) • Availability of new medical processes and equipment • Degree of patient responsiveness to treatment • Mortality trends of injured workers with lifetime indemnity and medical treatment benefits • Degree of cost shifting between workers compensation and health insurance • Time required to recover from the injury and return to regular or transitional work • Future wage inflation for states that index benefits • Changes in claims handling philosophies (e.g., case reserving standards) Commercial automobile liability The commercial automobile product line is a mix of property and liability coverages and, therefore, includes both short and long tail coverages. The payments that are made quickly typically pertain to automobile physical damage (included in the property line) claims and property damage (liability) claims. The payments that take longer to finalize and are more difficult to estimate relate to bodily injury claims. Commercial automobile reserves are typically analyzed in two components; liability and collision/comprehensive claims. This second component has minimum reserve risk and fast payouts and, accordingly, separate reserving factors are not presented. The liability component includes claims for both bodily injury and property damage. In general, claim reporting lags are minor, claim complexity is not a major issue, and the line is viewed as high frequency, low to moderate severity. In addition to the examples of common reserving factors related to general liability described above, other examples of common reserving factors that can change and, thus, also affect estimated commercial automobile liability reserves include: • Frequency of claims with payment capped by policy limits • Change in average severity of accidents, or proportion of severe accidents • Frequency of visits to health providers • Number of medical procedures given during visits to health providers • Types of health providers used • Types of medical treatments received • Changes in cost of medical treatments • Degree of patient responsiveness to treatment Surety Surety is generally considered a short tailed coverage. As a new business, lack of historical data means external data is heavily relied upon where available and applicable. Surety reserving factors that can change and, thus, affect estimated surety reserves include probability of default of the bond which can be impacted by general economic conditions, size of payment (severity) which is impacted by the bond limit, or amount and collectability of assets or other collateral available to mitigate loss. OneBeacon Loss and LAE Development Loss and LAE development-2015 Net favorable loss reserve development was $2 million during the year ended December 31, 2015. The net favorable loss reserve development was primarily attributable to favorable loss reserve development from the Technology, Collector Cars and Boats, Specialty Property and Financial Services lines of business, offset by unfavorable net loss reserve development from the Entertainment and Ocean Marine lines of business. See “RESULTS OF OPERATIONS - OneBeacon” on page 47. Loss and LAE development-2014 During 2014, OneBeacon experienced $90 million of net unfavorable loss and LAE reserve development on prior accident year reserves, of which $75 million related to the 2014 fourth quarter reserving increase and the remaining amount primarily driven by unfavorable development in the professional liability and management liability businesses included within Professional Insurance. In 2015, Professional Insurance was reorganized into Other Professional Lines, Management Liability, Financial Services and Healthcare. Loss and LAE development-2013 During 2013, OneBeacon experienced no net loss and LAE reserve development on prior accident year reserves. OneBeacon experienced unfavorable development primarily related to its property, general liability and accident and health lines, which was offset by favorable development in its other liability and ocean marine lines. Range of Reserves OneBeacon’s range of loss and LAE reserve estimates was evaluated to consider the strengths and weaknesses of the various actuarial methods applied against OneBeacon’s historical claims experience data. The following table shows the recorded loss and LAE reserves and the high and low ends of OneBeacon’s range of reasonable loss reserve estimates, net of reinsurance recoverable on unpaid losses, as of December 31, 2015 and 2014. The high and low ends of the range of reserve estimates in the table below are based on the results of various actuarial methods described above. December 31, 2015 December 31, 2014 Millions Low Recorded High Low Recorded High Total $ 1,009 $ 1,203.8 $ 1,356 $ $ 1,180.6 $ 1,308 The recorded reserves represent management’s best estimate of unpaid loss and LAE reserves. OneBeacon uses the results of several different actuarial methods to develop its estimate of ultimate reserves. While it has not determined the statistical probability of actual ultimate paid losses falling within the range, OneBeacon believes that it is reasonably likely that actual ultimate paid losses will fall within the ranges noted above because the ranges were developed by using several different generally accepted actuarial methods. Although OneBeacon believes its reserves are reasonably stated, ultimate losses may deviate, perhaps materially, from the recorded reserve amounts and could be above the high end of the range of actuarial projections. This is because the ranges are developed based on known events as of the valuation date, whereas the ultimate disposition of losses is subject to the outcome of events and circumstances that may be unknown as of the valuation date. Sensitivity Analysis The following discussion includes disclosure of possible variations from current estimates of loss reserves due to changes in a few of the many key assumptions. Each of the impacts described below is estimated individually, without consideration for any correlation among key assumptions. Further, there is uncertainty around other assumptions not explicitly quantified in the discussion below. Therefore, it would be inappropriate to take each of the amounts described below and add them together in an attempt to estimate volatility for OneBeacon’s reserves in total. It is important to note that the volatilities and variations discussed below are not meant to be a worst-case scenarios or an all-inclusive list, and therefore it is possible that future volatilities and variations may be more than amounts discussed below. • Various sources of inflation volatility impact all of OneBeacon’s reserves in different ways. Using its internal economic capital model, OneBeacon has derived a distribution of future loss payments under the range of inflation scenarios and related claim cost trends in its economic scenario set, holding all other sources of reserve volatility constant. At the 75th percentile of modeled outcomes, the estimated impact of claim cost inflation above OneBeacon’s actuarially indicated reserves is $38 million, net of reinsurance. • The volatility associated with the frequency and severity of large losses, defined as claims greater than or equal to $2.5 million, can have a material impact on OneBeacon’s results. The frequency and severity of large claims is driven primarily by the random nature of the insurance process but also by claim cost inflation and parameter risk. These large losses often emerge over a long time period potentially leading to a material impact on OneBeacon’s reserves. One way OneBeacon considers this sensitivity is by examining the volatility of large losses in the current accident year using its economic capital model. At the 75th percentile of modeled outcomes, OneBeacon estimates that large losses could exceed the mean by $19 million gross of reinsurance and $8 million, net of reinsurance. • As OneBeacon starts up new businesses, its initial loss estimates and development patterns are often based on industry data. As actual losses develop OneBeacon will revise its initial expectations with its actual experience. However, depending on the tail for the specific business, it can be a few years before OneBeacon has sufficient internal data to rely on. As of December 31, 2015, OneBeacon has $259 million of inception-to-date premium from its newer businesses (Programs, Environmental and Surety). A 10% error in OneBeacon’s initial loss ratio estimates could result in approximately $26 million adverse net variance in loss reserves. OneBeacon also considers variations and sensitivities for certain lines of business, such as: • Professional liability: Recorded loss and allocated LAE reserves, net of reinsurance recoverable, for professional liability were $483 million as of December 31, 2015. A key assumption for professional liability is the implicit loss cost trend, particularly the severity inflation trend component of loss costs. Across the entire reserve base, a 5 point change in assumed annual severity trend would have changed the estimated net reserve by approximately $74 million as of December 31, 2015, in either direction. • Multiple peril liability: Recorded loss and LAE reserves, net of reinsurance recoverable for multiple peril were $66 million as of December 31, 2015. Reported loss development patterns are a key assumption for this line of business, particularly for more mature accident years. Historically, assumptions on reported loss development patterns have been impacted by, among other things, emergence of new types of claims (e.g. construction defect claims) or a shift in the mixture between smaller, more routine claims and larger, more complex claims. If case reserve adequacy for multiple peril claims changed by 10 points this would have changed the estimated net reserve by approximately $2 million as of December 31, 2015, in either direction. • Workers compensation: Recorded workers compensation loss and LAE reserves, net of reinsurance recoverable, were $116 million as of December 31, 2015. The two most important assumptions for workers compensation reserves are loss development factors and loss cost trends, particularly medical cost inflation. Loss development patterns are dependent on medical cost inflation. Approximately half of the workers compensation net reserves are related to future medical costs. Across the entire reserve base, a 1 point change in calendar year medical inflation would have changed the estimated net reserve by approximately $34 million as of December 31, 2015, in either direction. Discontinued Operations - Sirius Group The estimation of net reinsurance loss and LAE reserves is subject to the same risk as the estimation of insurance loss and LAE reserves. In addition to those risk factors which give rise to inherent uncertainties in establishing insurance loss and LAE reserves, the inherent uncertainties of estimating such reserves are even greater for the reinsurer, due primarily to: (1) the claim-tail for reinsurers and insurers working through MGUs being further extended because claims are first reported to either the original primary insurance company or the MGU and then through one or more intermediaries or reinsurers, (2) the diversity of loss development patterns among different types of direct insurance contracts, reinsurance treaties or facultative contracts, (3) the necessary reliance on the ceding companies, intermediaries and MGUs for information regarding reported claims and (4) the differing reserving practices among ceding companies and MGUs. Loss and LAE Reserves by Class of Business Sirius Group’s net loss and LAE reserves by class of business as of December 31, 2015 and 2014 were as follows: Net loss and LAE reserves by class of business December 31, 2015 December 31, 2014 Millions Case IBNR Total Case IBNR Total Casualty (excluding A&E) $ 114.3 $ 161.5 $ 275.8 $ 139.0 $ 193.3 $ 332.3 Property (excluding catastrophe excess) 156.6 99.0 255.6 170.9 92.4 263.3 A&E(1) 60.4 129.3 189.7 69.4 140.8 210.2 Property catastrophe excess 74.2 18.3 92.5 111.2 20.5 131.7 Aviation and space 89.4 28.3 117.7 85.0 34.0 119.0 Accident and health 31.4 81.3 112.7 38.3 61.4 99.7 Marine 57.6 31.8 89.4 65.5 28.6 94.1 Trade Credit 48.3 25.4 73.7 57.4 22.0 79.4 Contingency 5.9 5.9 11.8 2.5 3.1 5.6 Agriculture 2.4 5.9 8.3 1.2 3.4 4.6 Runoff(2) 66.2 67.9 134.1 73.9 73.8 147.7 Total $ 706.7 $ 654.6 $ 1,361.3 $ 814.3 $ 673.3 $ 1,487.6 (1) Sirius Group’s A&E exposures are principally the result of runoff of businesses acquired in the 1990s. (2) Included in this class are primarily the runoff exposures from various acquisitions. In order to reduce the potential uncertainty of loss reserve estimation, Sirius Group obtains information from numerous sources to assist in the reserving process. Sirius Group’s underwriters and pricing actuaries devote considerable effort to understanding and analyzing each ceding company’s operations and loss history during the underwriting of the business, using a combination of client and industry statistics. Such statistics normally include historical premium and loss data by class of business, individual claim information for larger claims, distributions of insurance limits provided and the risk characteristics of the underlying insureds, loss reporting and payment patterns, and rate change history. This analysis is used to project expected loss ratios for each treaty during the upcoming contract period. These expected ultimate loss ratios are aggregated across all treaties and are input directly into the loss reserving process. For primary insured business, a similar portfolio analysis is performed for each managing general underwriter (“MGU”) program taking into account expected changes in the aggregated risk profile of the policyholders within each program. The aggregation of risks yields a more stable indication of expected losses that is used to estimate ultimate losses and thus IBNR for recently written business. Sirius Group’s expected annual loss reporting assumptions are updated at least once a year. Expected loss ratios underlying the recent underwriting years are updated quarterly. Sirius Group relies heavily on information reported by MGUs and ceding companies, as discussed above. In order to determine the accuracy and completeness of such information, Sirius Group underwriters, actuaries, and claims personnel perform audits of certain MGUs and ceding companies where customary. Generally, ceding company audits are not customary outside the United States. In such cases, Sirius Group reviews information from ceding companies for unusual or unexpected results. Any material findings are discussed with the ceding companies. Sirius Group sometimes encounters situations where it is determined that a claim presentation from a ceding company is not in accordance with contract terms. Most situations are resolved amicably and without the need for litigation or arbitration. However, in the infrequent situations where a resolution is not possible, Sirius Group will vigorously defend its position in such disputes. Sirius Group also obtains reinsurance whereby another reinsurer contractually agrees to indemnify Sirius Group for all or a portion of the risks underwritten by Sirius Group. Such arrangements, where one reinsurer provides reinsurance to another reinsurer, are usually referred to as “retrocessional reinsurance” arrangements. Sirius Group establishes estimates of amounts recoverable from reinsurers on its direct business and retrocessional reinsurance on its reinsurance business in a manner consistent with the loss and LAE liability associated with reinsurance contracts offered to its customers, net of an allowance for uncollectible amounts, if any. Net reinsurance loss reserves represent loss and LAE reserves reduced by ceded reinsurance recoverable on unpaid losses. Sirius Group Loss and LAE Development Loss and LAE development-2015 In 2015, Sirius Group had net favorable loss reserve development of $51 million. The major reductions in loss reserve estimates were recognized in the property ($26 million), casualty and other runoff lines ($14 million). The remaining reductions were recognized across accident & health, aviation, credit, and marine lines of business. The decrease in property was driven primarily by reductions in the ultimate loss estimates for natural catastrophes that occurred between 2010 and 2014 due to less than expected claims activity. Loss and LAE development-2014 In 2014, Sirius Group had net favorable loss reserve development of $98 million. The major reductions in loss reserve estimates were recognized in property ($54 million), aviation and space ($13 million), accident and health ($13 million) lines and casualty ($13 million). The casualty reduction is net of a $10 million increase in asbestos and environmental loss reserves. For the property loss estimates decrease, $24 million represented reduction of loss reserves previously held above the actuarial central estimate. This amount represented an IBNR provision established between 2010-2012 in response to the large catastrophe events, including the 2010 earthquake in Chile, the 2010/2011 earthquakes in New Zealand, the 2011 earthquake in Japan, and hurricane Sandy in 2012, and the inherent uncertainty associated with deriving initial loss estimates. When examined in 2014, the loss estimates for these events had stabilized and had proven to be redundant in aggregate; as a result, the additional amount above the actuarial central estimate was reversed. Loss and LAE development-2013 In 2013, Sirius Group had net favorable loss reserve development of $48 million, which included $24 million of favorable loss reserve development on prior years’ catastrophe losses. Other major reductions in loss reserve estimates recognized included property ($17 million), aviation and space ($10 million), and accident and health ($9 million) lines, partially offset by a $12 million increase in asbestos loss reserves. Range of Reserves The actuarial methods described above are used to calculate a point estimate of loss and LAE reserves for each company within Sirius Group. These point estimates are then aggregated to produce an actuarial point estimate for the entire segment. Once a point estimate is established, Sirius Group’s actuaries estimate loss reserve ranges to measure the sensitivity of the actuarial assumptions used to set the point estimates. These ranges are calculated from historical variations in loss ratios, payment and reporting patterns by class and type of business. The actuarial analysis is a primary consideration for management in determining its best estimate of loss and LAE reserves. Management records reserves in the upper portion of the actuarial range of central estimates in response to potential volatility in the actuarial indications and estimates for large claims. The following table illustrates Sirius Group’s recorded net loss and LAE reserves and high and low estimates as of December 31, 2015 and 2014. Net loss and LAE reserves December 31, 2015 December 31, 2014 Millions Low Recorded High Low Recorded High Total $ 1,229 $ 1,361.3 $ 1,447 $ 1,351 $ 1,487.6 $ 1,572 The probability that ultimate losses will fall outside of the range of estimates by class of business is higher for each class of business individually than it is for the sum of the estimates for all classes taken together due to the effects of diversification. Management believes that it is reasonably likely that actual ultimate losses will fall within the total range noted above because the ranges were developed by using generally accepted actuarial methods supplemented with input of underwriting and claims staff. However, due to the inherent uncertainty, ultimate losses may deviate, perhaps materially, from the recorded reserve amounts and could be above or below the range of actuarial projections. Sensitivity Analysis The following discussion includes disclosure of possible variations from current estimates of loss reserves due to changes in a few of the many key assumptions. Each of the impacts described below is estimated individually, without consideration for any correlation among key assumptions. Further, there is uncertainty around other assumptions not explicitly quantified in the discussion below. Therefore, it would be inappropriate to take each of the amounts described below and add them together in an attempt to estimate volatility for Sirius Group’s reserves in total. It is important to note that the volatilities and variations discussed below are not meant to be best-case or worst-case scenarios, and therefore it is possible that future volatilities and variations may be more than amounts discussed below. • Sustained Economic and Tort Inflation. Future inflation beyond the recent historical levels could impact the required reserves. For example, Sirius America has loss reserves of roughly $725 million including asbestos and environmental at the end of fourth quarter 2015. The estimated additional claim payments for Sirius America due to hypothetical increases in the inflation rate of 200 to 800 basis points beginning in 2019 and continuing through 2023 is estimated to be $31 to $160 million. • Asbestos and Environmental (A&E). The internal actuarial and claims analysis suggests that Sirius Group’s A&E losses are covered by its previous paid activity and current reserves. However, the ongoing nature of the litigation surrounding these complex exposures can significantly affect Sirius Group’s liabilities. Sirius Group ended 2015 with $190 million in net reserves for A&E claims. Applying varying assumptions and industry benchmarks yielded a net range of A&E reserves from $164 million to $213 million. Further information is detailed below about Sirius Group’s A&E exposure. Sirius Group A&E Reserves Included in Sirius Group’s liabilities held for sale are A&E loss reserves. Sirius Group's A&E exposure is primarily from reinsurance contracts written between 1974 through 1985. The exposures are mostly higher layer excess of loss treaty and facultative coverages with relatively low limits exposed for each claim. In 2014, Sirius Group increased its net A&E exposure through incoming runoff portfolios acquired by Sirius Global Solutions. These acquisitions added $23 million in net asbestos reserves and $2 million in net environmental reserves in 2014. The acquisition of companies having modest portfolios of A&E exposure has been typical of several prior Sirius Global Solutions transactions and is likely to be an element of at least some future acquisitions. However, the acquisition of new A&E liabilities is undertaken only after careful due diligence and utilizing conservative reserving assumptions in relation to industry benchmarks. In the case of the portfolios acquired during 2014, the exposures arise almost entirely from old assumed reinsurance contracts having small limits of liability. Sirius Group recorded $8 million of asbestos-related net incurred losses and LAE on its already existing asbestos reserves in 2014 that was primarily the result of management’s monitoring of a variety of metrics including actual paid and reported claims activity. No amount was recorded in 2015. Sirius Group recorded an increase of $3 million and an increase of $2 million of environmental net losses in 2015 and 2014 on its already existing reserves. Net incurred loss activity for asbestos and environmental in the last two years was as follows: Net incurred loss and LAE activity Year Ended December 31, Millions Asbestos $ (.4 ) $ 8.0 Environmental 3.0 1.6 Total $ 2.6 $ 9.6 Sirius Group’s net reserves for A&E losses were $190 million and $210 million as of December 31, 2015 and 2014, respectively. Sirius Group’s A&E three-year net paid survival ratio was approximately 8.9 years and 8.8 years as of December 31, 2015 and 2014, which is fairly consistent with industry survival ratios. The following tables show gross and net loss and LAE payments for A&E exposures for the years ending December 31, 2006 through December 31, 2015: Millions Asbestos paid loss and LAE Environmental paid loss and LAE Year Ended December 31, Gross Net Gross Net $ 9.8 $ 7.9 $ .6 $ .5 12.3 10.7 2.0 1.7 19.7 14.3 2.2 1.6 11.4 10.3 1.5 1.5 14.5 12.1 .8 .9 20.4 15.6 3.2 3.6 34.7 29.4 2.3 1.5 25.9 20.3 1.9 1.8 21.9 16.9 1.4 1.6 22.0 19.4 4.3 3.6 Sirius Group A&E Claims Activity Sirius Group utilizes specialized claims handling processes on A&E exposures. The issues presented by these types of claims require expertise and an awareness of the various trends and developments in relevant jurisdictions. Generally, Sirius Group sets up claim files for each reported claim by each cedant for each individual insured. In many instances, a single claim notification from a cedant could involve several years and layers of coverage resulting in a file being set up for each involvement. Precautionary claim notices are submitted by the ceding companies in order to preserve their right to pursue coverage under the reinsurance contract. Such notices do not contain an incurred loss amount. Accordingly, an open claim file is not established. As of December 31, 2015, Sirius Group had 2,348 open claim files for asbestos and 462 open claim files for environmental exposures. Sirius Group’s A&E claim activity for the last two years is illustrated in the table below. Year Ended December 31, A&E Claims Activity Asbestos Total asbestos claims at the beginning of the year 2,492 2,023 Asbestos claims acquired during the year - Asbestos claims reported during the year Asbestos claims closed during the year (324 ) (251 ) Total asbestos claims at the end of the year 2,348 2,492 Environmental Total environmental claims at the beginning of the year Environmental claims acquired during the year - Environmental claims reported during the year Environmental claims closed during the year (97 ) (34 ) Total environmental claims at the end of the year Total Total A&E claims at the beginning of the year 2,982 2,422 A&E claims acquired during the year - A&E claims reported during the year A&E claims closed during the year (421 ) (285 ) Total A&E claims at the end of the year 2,810 2,982 The costs associated with administering the underlying A&E claims by Sirius Group’s clients tend to be higher than non-A&E claims due to generally higher legal costs incurred by ceding companies in connection with A&E claims ceded to Sirius Group under the reinsurance contracts. 2. Fair Value Measurements General White Mountains measures certain assets and liabilities at estimated fair value in its consolidated financial statements, with changes therein recognized in current period earnings. In addition, White Mountains discloses estimated fair value for certain liabilities measured at historical or amortized cost. Fair value is defined as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants (an exit price) at a particular measurement date. Fair value measurements are categorized into a hierarchy that distinguishes between inputs based on market data from independent sources (“observable inputs”) and a reporting entity's internal assumptions based upon the best information available when external market data is limited or unavailable (“unobservable inputs”). Quoted prices in active markets for identical assets or liabilities have the highest priority (“Level 1”), followed by observable inputs other than quoted prices, including prices for similar but not identical assets or liabilities (“Level 2”) and unobservable inputs, including the reporting entity's estimates of the assumptions that market participants would use, having the lowest priority (“Level 3”). Assets and liabilities carried at fair value include substantially all of the investment portfolio; derivative instruments, both exchange traded and over the counter instruments; and reinsurance assumed liabilities associated with variable annuity benefit guarantees. Valuation of assets and liabilities measured at fair value require management to make estimates and apply judgment to matters that may carry a significant degree of uncertainty. In determining its estimates of fair value, White Mountains uses a variety of valuation approaches and inputs. Whenever possible, White Mountains estimates fair value using valuation methods that maximize the use of observable prices and other inputs. Where appropriate, assets and liabilities measured at fair value have been adjusted for the effect of counterparty credit risk. Invested Assets White Mountains used quoted market prices or other observable inputs to determine fair value for the 91% of its investment portfolio. Investments valued using Level 1 inputs include fixed maturity investments, primarily investments in U.S. Treasuries, common equity securities and short-term investments, which include U.S. Treasury Bills. Investments valued using Level 2 inputs are primarily comprised of fixed maturity investments, which have been disaggregated into classes, including debt securities issued by corporations, municipal obligations, mortgage and asset-backed securities, foreign government obligations and preferred stocks. Fair value estimates for investments that trade infrequently and have few or no observable market prices are classified as Level 3 measurements. Investments valued using Level 2 inputs also include certain ETFs that track U.S. stock indices such as the S&P 500 but are traded on foreign exchanges and that management values using the fund's published NAV to account for the difference in market close times. Level 3 fair value estimates based upon unobservable inputs include White Mountains's investments in hedge funds and private equity funds, surplus notes, as well as certain investments in fixed maturity investments, common equity securities, and convertible fixed and preferred maturity investments where quoted market prices are unavailable or are not considered reasonable. White Mountains determines when transfers between levels have occurred as of the beginning of the period. White Mountains uses brokers and outside pricing services to assist in determining fair values. For investments in active markets, White Mountains uses the quoted market prices provided by outside pricing services to determine fair value. The outside pricing services White Mountains uses have indicated that they will only provide prices where observable inputs are available. In circumstances where quoted market prices are unavailable or are not considered reasonable, White Mountains estimates the fair value using industry standard pricing models and observable inputs such as benchmark yields, reported trades, broker-dealer quotes, issuer spreads, benchmark securities, bids, offers, prepayment speeds, reference data including research publications and other relevant inputs. Given that many fixed maturity investments do not trade on a daily basis, the outside pricing services evaluate a wide range of fixed maturity investments by regularly drawing parallels from recent trades and quotes of comparable securities with similar features. The characteristics used to identify comparable fixed maturity investments vary by asset type and take into account market convention. White Mountains's process to assess the reasonableness of the market prices obtained from the outside pricing sources covers substantially all of its fixed maturity investments and includes, but is not limited to, evaluation of model pricing methodologies, review of the pricing services' quality control processes and procedures on at least an annual basis, comparison of market prices to prices obtained from different independent pricing vendors on at least a semi-annual basis, monthly analytical reviews of certain prices and review of assumptions utilized by the pricing service for selected measurements on an ad hoc basis throughout the year. White Mountains also performs back-testing of selected sales activity to determine whether there are any significant differences between the market price used to value the security prior to sale and the actual sale price on an ad-hoc basis throughout the year. Prices provided by the pricing services that vary by more than 5% and $1.0 million from the expected price based on these procedures are considered outliers. Also considered outliers are prices that haven’t changed from period to period and prices that have trended unusually compared to market conditions. In circumstances where the results of White Mountains's review process does not appear to support the market price provided by the pricing services, White Mountains challenges the price. During the past year, 8 securities fell outside White Mountains’s expected results, thereby triggering the challenge with the pricing service. If White Mountains cannot gain satisfactory evidence to support the challenged price, it relies upon its own pricing methodologies to estimate the fair value of the security in question. The valuation process above is generally applicable to all of White Mountains’s fixed maturity investments. The techniques and inputs specific to asset classes within White Mountains’s fixed maturity investments for Level 2 securities that use observable inputs are as follow: Debt securities issued by corporations: The fair value of debt securities issued by corporations is determined from an evaluated pricing model that uses information from market sources and integrates relative credit information, observed market movements, and sector news. Key inputs include benchmark yields, reported trades, broker-dealer quotes, issuer spreads, two-sided markets, benchmark securities, bids, offers, and reference data including sector, coupon, credit quality ratings, duration, credit enhancements, early redemption features and market research publications. Mortgage and asset-backed securities: The fair value of mortgage and asset-backed securities is determined from an evaluated pricing model that uses information from market sources and leveraging similar securities. Key inputs include benchmark yields, reported trades, underlying tranche cash flow data, collateral performance, plus new issue data, as well as broker-dealer quotes, issuer spreads, two-sided markets, benchmark securities, bids, offers, and reference data including issuer, vintage, loan type, collateral attributes, prepayment speeds, default rates, recovery rates, cash flow stress testing, credit quality ratings and market research publications. Municipal obligations: The fair value of municipal obligations is determined from an evaluated pricing model that uses information from market makers, brokers-dealers, buy-side firms, and analysts along with general market information. Key inputs include benchmark yields, reported trades, issuer financial statements, material event notices and new issue data, as well as broker-dealer quotes, issuer spreads, two-sided markets, benchmark securities, bids, offers, and reference data including type, coupon, credit quality ratings, duration, credit enhancements, geographic location and market research publications. Foreign government obligations: The fair value of foreign government obligations is determined from an evaluated pricing model that uses feeds from data sources in each respective country, including active market makers and inter-dealer brokers. Key inputs include benchmark yields, reported trades, broker-dealer quotes, two-sided markets, benchmark securities, bids, offers, local exchange prices, foreign exchange rates and reference data including coupon, credit quality ratings, duration and market research publications. Preferred stocks: The fair value of preferred stocks is determined from an evaluated pricing model that calculates the appropriate spread over a comparable security for each issue. Key inputs include exchange prices (underlying and common stock of same issuer), benchmark yields, reported trades, broker-dealer quotes, issuer spreads, two-sided markets, benchmark securities, bids, offers, and reference data including sector, coupon, credit quality ratings, duration, credit enhancements, early redemption features and market research publications. Level 3 valuations are generated from techniques that use assumptions not observable in the market. These unobservable assumptions reflect White Mountains’s assumptions that market participants would use in valuing the investment. Generally, certain securities may start out as Level 3 when they are originally issued but as observable inputs become available in the market, they may be reclassified to Level 2. White Mountains employs a number of procedures to assess the reasonableness of the fair value measurements for its other long-term investments, including obtaining and reviewing the audited annual financial statements of hedge funds and private equity funds and periodically discussing each fund’s pricing with the fund manager. However, since the fund managers do not provide sufficient information to evaluate the pricing inputs and methods for each underlying investment, the inputs are considered to be unobservable. Accordingly, the fair values of White Mountains’s investments in hedge funds and private equity funds have been classified as Level 3 measurements. The fair value of White Mountains’s investments in hedge funds and private equity funds has been determined using net asset value. The following table summarizes White Mountains’s continuing operations fair value measurements and the percentage of Level 3 investments as of December 31, 2015. The major security types were based on the legal form of the securities. White Mountains has disaggregated its fixed maturity investments based on the issuing entity type, which impacts credit quality, with debt securities issued by U.S. government entities carrying minimal credit risk, while the credit and other risks associated with other issuers, such as corporations, foreign governments, municipalities or entities issuing asset-backed securities vary depending on the nature of the issuing entity type: December 31, 2015 $ in millions Fair value Level 3 Inputs Level 3 Inputs as a % of total fair value U.S. Government and agency obligations $ 160.0 $ - - Debt securities issued by industrial corporations 1,000.0 - - Municipal obligations 228.8 - - Mortgage-backed and asset-backed securities 1,167.0 - - Foreign government, agency and provincial obligations 1.2 - - Preferred stocks 82.7 70.0 % Fixed maturity investments 2,639.7 70.0 % Common equity securities 1,113.9 - - % Short-term investments 211.3 - - Other long-term investments(1) 297.3 297.3 % Total investments $ 4,262.2 $ 367.3 % (1) Excludes carrying value of $3.8 associated with other long-term investment limited partnerships accounted for using the equity method. Excludes carrying value of $14.7 associated with a tax advantaged federal affordable housing development fund accounted for using the proportional amortization method. White Mountains uses quoted market prices where available as the inputs to estimate fair value for its investments in active markets. Such measurements are considered to be either Level 1 or Level 2 measurements, depending on whether the quoted market price inputs are for identical securities (Level 1) or similar securities (Level 2). Level 3 measurements for fixed maturity investments as of December 31, 2015 include securities for which the estimated fair value has not been determined based upon quoted market price inputs for identical or similar securities. See Note 5 - “Investment Securities” for tables that summarize the changes in White Mountains’s fair value measurements by level for the years ended December 31, 2015 and 2014 and for amount of total gains (losses) included in earnings attributable to unrealized investment gains (losses) for Level 3 investments for years ended December 31, 2015, 2014 and 2013. Other Long-Term Investments White Mountains’s continuing operations other long-term investments accounted for at fair value as of December 31, 2015 include $37 million in hedge funds and $91 million in private equity funds. As of December 31, 2015, White Mountains held investments in 5 hedge funds and 22 private equity funds. The largest investment in a single fund was $23 million and $22 million as of December 31, 2015 and 2014. The fair value of White Mountains’s investments in hedge funds and private equity funds is based upon White Mountains’s proportionate interest in the underlying fund’s net asset value, which is deemed to approximate fair value. White Mountains employs a number of procedures to assess the reasonableness of the fair value measurements for its other long-term investments including obtaining and reviewing each fund’s audited financial statements and discussing each fund’s pricing with the fund’s manager. However, since the fund managers do not provide sufficient information to independently evaluate the pricing inputs and methods for each underlying investment, the inputs are considered to be unobservable. Accordingly, the fair values of White Mountains’s investments in hedge funds and private equity funds have been classified as Level 3. In circumstances where the underlying investments are publicly traded, such as the investments made by hedge funds, the fund manager uses current market prices to determine fair value. In circumstances where the underlying investments are not publicly traded, such as the investments made by private equity funds, the private equity fund managers generally consider the need for a liquidity discount on each of the underlying investments when determining the fund’s net asset value. In the event White Mountains believes that the valuation provided by the fund manager differs from its expectations due to illiquidity or other factors associated with its investment in the fund, White Mountains will adjust the fund manager’s net asset value to more appropriately represent the fair value of its interest in the investment. As of December 31, 2015, White Mountains determined that circumstances relating to certain underlying investments held in four separate private equity funds required an adjustment to the fund manager's net asset value. The total adjustment relating to these underlying investments resulted in a $5 million valuation adjustment to the private equity fund managers' net asset value as of December 31, 2015. Sensitivity analysis of likely returns on hedge fund and private equity fund investments White Mountains’s continuing operations investment portfolio includes investments in hedge funds and private equity funds. As of December 31, 2015, the value of investments in hedge funds and in private equity funds was $37 million and $91 million, respectively. The underlying investments are typically publicly traded and private common equity securities and investments, and, as such, are subject to market risks that are similar to White Mountains’s common equity securities. The following illustrates the estimated effect on December 31, 2015 fair value resulting from a 10% change and a 30% change in market value: December 31, 2015 Change in fair value Change in fair value Millions 10% decline 10% increase 30% decline 30% increase Hedge funds $ (3.7 ) $ 3.7 $ (11.1 ) $ 11.1 Private equity funds $ (9.1 ) $ 9.1 $ (27.3 ) $ 27.3 Hedge fund and private equity fund returns are commonly measured against the benchmark returns of hedge fund indices and/or the S&P 500 Index. The historical returns for each index in the past five years are listed below: Year Ended December 31, HFRX Equal Weighted Strategies Index (1.5 )% (0.5 )% 6.3 % 2.5 % (6.2 )% S&P 500 Index 1.4 % 13.7 % 32.4 % 16.0 % 2.1 % Variable Annuity Reinsurance Liabilities White Mountains has entered into agreements to reinsure death and living benefit guarantees associated with certain variable annuities in Japan. White Mountains carries the benefit guarantees at fair value. The fair value of the guarantees is estimated using actuarial and capital market assumptions related to the projected discounted cash flows over the term of the reinsurance agreement. The valuation uses assumptions about surrenders rates, market volatilities and other factors, and includes a risk margin which represents the additional compensation a market participant would require to assume the risks related to the business. The selection of surrender rates, market volatility assumptions, risk margins and other factors require the use of significant management judgment. Assumptions regarding future policyholder behavior, including surrender and lapse rates, are generally unobservable inputs and significantly impact the fair value estimate. Market conditions including, but not limited to, changes in interest rates, equity indices, market volatility and foreign currency exchange rates as well as variations in actuarial assumptions regarding policyholder behavior may result in significant fluctuations in the fair value of the liabilities associated with these guarantees that could materially affect results of operations. All of White Mountains’s variable annuity reinsurance liabilities of $(.3) million were classified as Level 3 measurements as of December 31, 2015. Generally, the liabilities associated with these guarantees increase with declines in the equity markets and currencies against the Japanese yen, as well as with increases in market volatilities. Currently, declines in interest rates generally have a positive impact on bond values and are associated with a decrease in liabilities. The collective account values were approximately 109% and 113% of the guarantee value as of December 31, 2015 and 2014. In 2008, particularly in the fourth quarter, as a result of worldwide declines in equity markets, interest rates and the strengthening of the Japanese yen, the underlying investment accounts declined substantially and the collective account values were significantly lower than the guarantee value for several years. The liability is also affected by annuitant related behavioral and actuarial assumptions, including surrender and mortality rates. WM Life Re lowered its projected surrender rates in 2011 and 2010 to reflect the behavior observed during the turbulent markets experienced throughout those years. During 2014, policyholder account values rallied, as surrender charges in the underlying annuities expired and observed surrender rates increased to higher than expected levels. WM Life Re, as a result, increased its projected surrender rates used in the valuation of its variable annuity reinsurance liability at the end of 2014. WM Life Re uses derivative instruments, including put options, interest rate swaps, total return swaps on bond and equity indices and forwards and futures contracts on major equity indices, currency pairs and government bonds, to mitigate the risks associated with changes in the fair value of the reinsured variable annuity guarantees. The types of inputs used to estimate the fair value of these derivative instruments, with the exception of actuarial assumptions regarding policyholder behavior and risk margins, are generally the same as those used to estimate the fair value of the variable annuity liabilities. As of December 31, 2015, the value of bond funds tracking the WGBI was approximately ¥18.6 billion ($154.3 million). By country, the largest exposures, together comprising approximately 92% of the WGBI, were the United States (43%), France (10%), Italy (10%), Germany (8%), the United Kingdom (8%), Spain (5%), the Netherlands (3%), Belgium (3%) and Canada (2%). Eurozone countries together comprised approximately 41%. To reduce hedging basis risk (i.e., the risk that changes in the WGBI will cause WM Life Re's variable annuity guarantee liabilities to change in value at a different rate than the derivative hedges), in December 2009 WM Life Re entered into a series of total return swap contracts on the performance of the WGBI. As of December 31, 2010, approximately 49% of WM Life Re's WGBI-related liability was hedged with WGBI swaps. Because these swaps were denominated in US dollars, WM Life Re continued to hedge the results into Japanese yen to match the benchmark denominated in Japanese yen. In 2011, driven in large part by instability of Eurozone markets, WM Life Re significantly increased coverage of its WGBI exposure. Because the market for WGBI total return swaps was, and continues to be illiquid, WM Life Re entered into a series of total return swaps on the JP Morgan European Government Bond Index (JPM European GBI). Although the JPM European GBI is not an exact match for the European component of the WGBI, its structure and holdings are substantially similar. These swaps are denominated in Japanese yen. As of December 31, 2015, the total notional amounts of JPM European GBI swaps were ¥4.1 billion ($34 million). At that date, over 100% of the total exposure the European component of the WGBI was hedged with total return swaps. The JPM European GBI total return swaps have maturities laddered to approximate the maturities of the policies reinsured. Under the terms of these swap contracts, WM Life Re receives cash flows based on a fixed return, reset at the beginning of each month based on current LIBOR and is required to pay cash flows based on the performance of the JPM European GBI during that month plus a fixed amount. WM Life Re hedges the residual WGBI-related liability exposure with the limited types of available derivatives that most closely fit the country and term exposures of the WGBI. Since liability exposures are determined by the performance of the overall account value, including the funds that track the Nomura BPI, TOPIX, and MSCI Kokusai, periodic portfolio rebalancing may be required. At such times and within limits, exchange-traded futures may be used to maintain overall neutral exposure as opposed to entering into new, or unwinding existing, swaps. As of December 31, 2015, the value of bond funds tracking the Nomura BPI was approximately ¥20.2 billion ($168 million). In January 2010, because the types and tenors of liquid Japanese bond futures are extremely limited, to more closely track the performance of bond funds tracking the Nomura BPI, WM Life Re entered into its first total return swap contract on the performance of that index and subsequently hedged the majority of its Japan bond exposure with total return swaps. As of December 31, 2015, all of these contracts had matured and were not renewed due to what is deemed to be minimal remaining risk. Nomura BPI exposure is hedged with liquid Japanese bond futures and is subject to basis risk relating to the difference between the tenor of the bond futures and the tenor of the assets in the annuity funds covered by WM Life Re’s variable annuity guarantees. As of December 31, 2015, the value of equity funds tracking the MSCI Kokusai was approximately ¥8.2 billion ($68.4 million). To reduce hedging basis risk, in 2011 WM Life Re entered into a series of total return swaps on the MSCI Kokusai, denominated in Japanese yen with maturities laddered during 2015 and 2016 to approximate the maturities of the policies reinsured. As of December 31, 2015, the total notional amount of MSCI Kokusai swaps was ¥5.6 billion ($46.7 million) and the percent of MSCI Kokusai fund exposure hedged by these swaps was over 100%. Residual MSCI Kokusai exposure is hedged with a variety of more liquid instruments, including exchange-traded futures. During 2009, WM Life Re entered into long term Japanese interest rate swaps, largely replacing its use of short-term Japanese Government Bond (“JGB”) futures to hedge its discount rate exposure. By doing so, WM Life Re better matched the term structure of its discount rate exposure, substantially reduced its exposure to changes in Japanese interest rate swap spreads and significantly reduced the potential costs associated with rolling JGB futures contracts during times of relative market illiquidity. During December 2012, after the relevant Japanese interest rate swap rates fell to their lowest level in many years, the resulting potential benefit, net of cost, to WM Life Re of maintaining its Japanese interest rate swap hedge portfolio was deemed to be limited. Therefore, the decision was made to unwind or offset these Japanese interest rate swaps. During December 2012, approximately 24% of the notional amount of Japanese interest rate swap contracts was unwound and during January 2013 the remaining 76% was unwound or offset. Because the valuation of WM Life Re’s put options and foreign exchange forwards incorporate Japanese interest rates, WM Life Re does continue to have minimal exposure to Japanese swap rates. The following table summarizes the estimated financial impact on WM Life Re's derivatives and benefit guarantee liabilities of instantaneous changes in individual market variables as of December 31, 2015. The table below assumes that all other market variables are constant and does not reflect the inter-dependencies between individual variables. Equity Market Returns Foreign Currency Exchange(1) Interest Rates(2) Market Volatility(3) Millions 20% (20)% 15% (15)% Favorable Unfavorable Decrease Increase Liabilities $ - $ $ - $ $ - $ $ - $ Hedge Assets (1 ) - - (1 ) Net $ (1 ) $ $ $ $ - $ (1 ) $ (1 ) $ (1) The value of foreign currencies in Japanese yen terms. (2) In the unfavorable scenario, Japanese interest rates are decreased 70 bps, Japanese swap spreads are tightened by 25 bps, and foreign bond fund yields are increased 70 bps. Conversely, in the favorable scenario, Japanese interest rates are increased 70 bps, Japanese swap spreads are widened 25 bps and foreign bond fund yields are decreased 70 bps. (3) White Mountains’s sensitivities for market implied volatilities vary by term. For equity implied volatilities, White Mountains changes implied volatilities by 15%. For foreign currency implied volatilities, White Mountains changes implied volatilities by 6%. To test the impact of multiple variables moving simultaneously, WM Life Re performs capital market “shock” testing. Prior to 2009, in performing this testing, WM Life Re had not incorporated basis risk and other hedge underperformance relative to expectations in its models; it had assumed that its hedges would behave as modeled. However, the financial market turmoil of late 2008 and early 2009 demonstrated that, in periods of severe financial market disruption, various aspects of WM Life Re’s hedging program may underperform or over-perform. As a result, WM Life Re now also estimates the efficacy of its hedging program in its “shock” testing. Estimated hedge effectiveness is based on actual results during the recent stressed market environment encompassing the fourth quarter of 2008 and the first quarter of 2009. Hedge effectiveness assumptions also incorporate any subsequent changes to the hedging program that were not in place during this stress period. Although this period captures a historically volatile period that included large market movements over short time periods, hedges may be less effective than the current assumptions to the extent future market movements of the magnitude of these “shocks” occur more quickly than during this recent stress period. The table below summarizes as of December 31, 2015 and 2014, the estimated financial impact of simultaneous market events. Unlike the individual sensitivity analysis illustrated above, the analysis in the table below reflects the inter-dependencies between individual variables. As of December 31, 2015 As of December 31, 2014 Change in millions Down Market Up Market Down Market Up Market Liabilities $ $ - $ $ (6 ) Hedge Assets(1) - (6 ) Net $ (3 ) $ - $ (9 ) $ - (1) Assumed hedge effectiveness in down and up markets of 93% and 106%, respectively, as of December 31, 2015 and 2014, adjusted for the unhedged portion of Japanese discount rate exposure. Some Japanese discount rate coverage remains primarily through WM Life Re's put option portfolio. WM Life Re applies shocks to the Japanese interest rates and foreign bond fund yields in opposite directions. In the down market scenario, Japanese interest rates are decreased 70 bps, Japanese interest rate swap spreads are tightened by 25 bps, and foreign bond fund yields are increased 70 bps. The “up market” scenario assumes opposite movements in the same variables. For other variables, the “down market” scenario assumes equity indices decrease 20%, foreign currencies depreciate by 15% against the Japanese yen and implied market volatility increases as described in footnote 3 on page 91. The “up market” scenario assumes opposite movements in the same variables. The size of the estimated impact on the liability of simultaneous market events, in both the “up market” and “down market” scenarios, is impacted by several factors, including the applicable account value to guaranty value ratios, term to maturity and surrender assumptions of policies reinsured. The increase in magnitude of the “down market” shock as of December 2015 versus the prior year was driven by the decrease in account values owing to market conditions. WM Life Re projects future surrender rates by year for policies based on a combination of actual experience and expected policyholder behavior. Actual policyholder behavior, either individually or collectively, may differ from projected behavior as a result of a number of factors such as the level of the account value versus guarantee value and applicable surrender charge, views of the primary insurance company's financial strength and ability to pay the guarantee at maturity, annuitants' need for money in a prolonged recession and time remaining to receive the guarantee at maturity. Policyholder behavior is especially difficult to predict given that WM Life Re’s reinsurance contracts are relatively new and the market turmoil seen over the last several years is unprecedented for this type of product in the Japanese market. Actual policyholder behavior may differ materially from WM Life Re's projections. During 2013, improved markets led to significantly higher ratios of annuitants’ account values to guarantee values and, as a result, annuitants surrendered their policies at higher rates than WM Life Re has observed in the past. In response to this trend, WM Life Re adjusted the projected surrender assumptions used in the valuation of its variable annuity reinsurance liability upward in the second quarter of 2013, which resulted in a gain of $2 million and again in the fourth quarter of 2013, which resulted in a gain of $5 million. In 2014 surrender rates continued to outpace assumptions and another adjustment was made in the fourth quarter of 2014. This adjustment resulted in a loss of $0.2 million because the policies most impacted had account values that were significantly higher than their guaranty values. At the account value levels as of December 31, 2015, the average assumed surrender rate was approximately 40% per annum. The potential change in the fair value of the liability due to a change in current surrender assumptions is as follows: Change in fair value of liability December 31, Millions Decrease 100% (to zero surrenders) $ (.1 ) $ - Increase 100% $ - $ - The amounts in the table above could increase in the future if the fair value of the variable annuity guarantee liability changes due to factors other than the surrender assumptions (e.g., a decline in the ratio of the annuitants’ aggregate account values to their aggregate guarantee values). As of December 31, 2011, WM Life Re increased the variable annuity guaranty liability by $6 million to partially reflect a “basis swap” implied by foreign exchange rates which results in lower projected returns (in Japanese yen) for the portion of funds invested in countries outside of Japan. Since the financial crisis in 2008, there has been a break in expected arbitrage free relationships between swap interest rates and foreign exchange rates (in particular, between the U.S. and Japan). This adjustment recognizes that this anomaly of trading values may be more than temporary. The balance of this reserve was $0 million as of December 31, 2015. The following table summarizes the changes in White Mountains’s variable annuity reinsurance liabilities and derivative instruments for the year ended December 31, 2015 and 2014: Variable Annuity (Liabilities) Derivative Instruments Millions Level 3 Level 3(1) Level 2(1)(2) Level 1(3) Total(4) Balance at January 1, 2015 $ .7 $ 18.9 $ 33.8 $ 3.7 $ 56.4 Purchases - - - - - Realized and unrealized gains (losses) (.4 ) (9.7 ) (7.5 ) 8.4 (8.8 ) Transfers in (out) - - - - - Sales/settlements - (6.5 ) (9.8 ) (11.2 ) (27.5 ) Balance at December 31, 2015 $ .3 $ 2.7 $ 16.5 $ 0.9 $ 20.1 Variable Annuity (Liabilities) Derivative Instruments Millions Level 3 Level 3(1) Level 2(1)(2) Level 1(3) Total(4) Balance at January 1, 2014 $ (52.8 ) $ 63.4 $ 4.7 $ 1.1 $ 69.2 Purchases - - - - - Realized and unrealized gains (losses) 53.5 (38.6 ) (71.0 ) 37.2 (72.4 ) Transfers in (out) - - - - - Sales/settlements - (5.9 ) 100.1 (34.6 ) 59.6 Balance at December 31, 2014 $ .7 $ 18.9 $ 33.8 $ 3.7 $ 56.4 (1) Includes over-the-counter instruments. (2) Includes interest rate swaps, total return swaps and foreign currency forward contracts. Fair value measurement based upon bid/ask pricing quotes for similar instruments that are actively traded, where available. Swaps for which an active market does not exist have been priced using observable inputs including the swap curve and the underlying bond index. (3) Includes exchange traded equity index, foreign currency and interest rate futures. Fair value measurements based upon quoted prices for identical instruments that are actively traded. (4) In addition to derivative instruments, WM Life Re held cash, short-term and fixed maturity investments of $5.8 and $33.2 as of December 31, 2015 and 2014 posted as collateral to its counterparties. 3. Surplus Note Valuation BAM Surplus Notes As of December 31, 2015, White Mountains owned $503 million of surplus notes issued by BAM and has accrued $90 million in interest due thereon. Because BAM is consolidated in White Mountains’s financial statements, the BAM Surplus Notes and accrued interest are classified as intercompany notes, carried at face value and eliminated in consolidation. However, the BAM Surplus Notes and accrued interest are carried as assets at HG Global, of which White Mountains owns 97% of the equity, while the BAM Surplus Notes are carried as liabilities at BAM, which White Mountains has no ownership interest in and is completely attributed to non-controlling interests. Periodically, White Mountains’s management reviews the recoverability of amounts recorded from the BAM Surplus Notes and, as of December 31, 2015, believes such notes and interest thereon to be fully recoverable. However, the determination of future recoverability is judgmental, as BAM was recently established and the ability of BAM to repay the principal and interest due on the BAM Surplus Notes is dependent upon BAM’s expected results, particularly premium and MSC collections, years into the future. Any write-off of the carried amount of the BAM Surplus Notes and/or the accrued interest thereon would adversely impact White Mountains’s adjusted book value per share. See Item 1A., Risk Factors, “If BAM does not pay some or all of the interest and principal due on the BAM Surplus Notes, our adjusted book value per share, results of operations and financial condition could be materially adversely affected.” on page 30. No payment of the interest or principal on the BAM Surplus Notes may be made without the approval of the New York State Department of Financial Services. BAM is required to seek regulatory approval to pay interest and principal on its surplus notes only when adequate capital resources have accumulated beyond BAM’s initial capitalization and a level that continues to support its outstanding obligations, business plan and ratings. In addition, BAM’s ability to pay the interest and principal on the BAM Surplus Notes is dependent upon, among other things, whether BAM collects sufficient premiums and member surplus contributions. Interest payments on the BAM Surplus Notes are due quarterly but are subject to deferral, without penalty or default and without compounding, for repayment in the future. BAM has the right at any time to prepay principal in whole or in part. OneBeacon Runoff Transaction In the fourth quarter of 2014, in conjunction with the Runoff Transaction, OneBeacon provided financing in the form of surplus notes with a par value of $101 million, which had a fair value of $65 million at the date of closing. As of December 31, 2015 and 2014 the surplus notes has a fair value of $52 million and $65 million. The OneBeacon surplus notes, issued by one of the transferred entities, OBIC, since renamed Bedivere (“Issuer”), were in the form of both seller priority and pari passu notes. Under the contractual terms of both the seller priority and pari passu notes, scheduled interest payments accrue at 6.0% until the scheduled maturity date of March 15, 2020 and at a floating interest rate thereafter, should any principal remain outstanding. As required by the PID, interest on the notes does not compound. The notes restrict the Issuer’s ability to make distributions to holders of its equity interest. All such distributions are prohibited while the seller priority note is outstanding, and while the pari passu note is outstanding, distributions are permitted only if the Issuer concurrently repays a pro rata amount of any outstanding principal on the pari passu note. Pursuant to the notes, the Issuer shall seek to redeem the notes annually each March 15 at a requested redemption amount such that the Issuer’s total adjusted capital following the proposed redemption payment would equal 200% of the Issuer’s “authorized control level RBC”, as such term is defined by the insurance laws of the Commonwealth of Pennsylvania and as prescribed by the PID. All redemptions or repayments of principal and payments of interest on the notes are subject to approval by the PID. Below is a table illustrating the valuation adjustments taken to arrive at the estimated fair value of the OneBeacon Surplus Notes as of December 31, 2015 and December 31, 2014: Type of Surplus Note Total as of December 31, 2015 Total as of December 31, 2014 Millions Seller Priority Pari Passu Par Value $ 57.9 $ 43.1 $ 101.0 $ 101.0 Fair value adjustments to reflect: Current market rates on public debt and contract-based repayments(1) (.4 ) (14.7 ) (15.1 ) (6.6 ) Regulatory approval (2) (11.7 ) (12.5 ) (24.2 ) (12.6 ) Liquidity adjustment (3) (7.8 ) (2.4 ) (10.2 ) (16.7 ) Total adjustments (19.9 ) (29.6 ) (49.5 ) (35.9 ) Fair value(4) $ 38.0 $ 13.5 $ 51.5 $ 65.1 (1) Represents the value of the OneBeacon surplus notes, at current market yields on publicly traded debt, and assuming issuer is allowed to make principal and interest payments when its financial capacity is available, as measured by statutory capital in excess of a 250% RBC score. (2) Represents anticipated delay in securing regulatory approvals of interest and principal payments to reflect graduated changes in Issuer's statutory surplus. The monetary impact of the anticipated delay is measured based on credit spreads of public securities with roughly equivalent percentages of discounted payments missed. (3) Represents impact of liquidity spread to account for OneBeacon’s sole ownership of the surplus notes, lack of a trading market and ongoing regulatory approval risk. (4) The decrease in the fair value of the surplus notes during the twelve months ended December 31, 2015 was primarily due to widening of non-investment grade credit spreads. The internal valuation model used to estimate the fair value is based on discounted expected cash flows using information as of the measurement date. The estimated fair value of the OneBeacon Surplus Notes is sensitive to changes in treasury rates and public debt credit spreads, as well as changes in estimates with respect to other variables including a discount to reflect the private nature of the notes (and the related lack of liquidity), the credit quality of the notes - based on the financial performance of the Issuer relative to expectations, and the timing, amount, and likelihood of interest and principal payments on the notes, which are subject to regulatory approval and therefore may vary from the contractual terms. As of December 31, 2015 and 2014, OneBeacon has assumed for estimating the fair value that interest payouts begin in year five (2020) and principal repayments begin on a graduating basis in year ten (2025) for the seller priority note and year fifteen (2030) for the pari passu note. Although these variables involve considerable judgment, the Company does not currently expect any resulting changes in the estimated value of the surplus notes to be material to its financial position. As a means to provide the degree of variability for each of the key assumptions that affect the fair value of the OneBeacon Surplus Notes, below is a table of sensitivities which measure hypothetical changes in such variables and the resulting pre-tax increase (or decrease) impact on the valuation of the OneBeacon surplus notes as of December 31, 2015. Estimates affecting fair value Pre-tax increase (decrease) in fair value Millions Liquidity Spread (1) -100 bp -50 bp +50 bp +100 bp Seller priority note $ 2.8 $ 1.4 $ (1.4 ) $ (2.6 ) Pari passu note 1.0 0.4 (.4 ) (0.8 ) Total OneBeacon Surplus Notes $ 3.8 $ 1.8 $ (1.8 ) $ (3.4 ) Credit Assignment (2) +2 Notches +1 Notch -1 Notch -2 Notches Seller priority note $ 8.7 $ 4.1 $ (3.6 ) $ (6.8 ) Pari passu note 2.7 1.3 (1.1 ) (2.1 ) Total OneBeacon Surplus Notes $ 11.4 $ 5.4 $ (4.7 ) $ (8.9 ) Principal Repayments (3) -3 Years -1 Year +1 Year +3 Years Seller priority note $ 2.5 $ 0.7 $ (.9 ) $ (2.3 ) Pari passu note .9 .3 (.1 ) (.4 ) Total OneBeacon Surplus Notes $ 3.4 $ 1.0 $ (1.0 ) $ (2.7 ) Interest Repayments (4) -3 Years -1 Year +1 Year +3 Years Seller priority note $ 6.6 $ 2.8 $ (4.2 ) $ (11.8 ) Pari passu note 6.0 2.6 (2.7 ) (6.8 ) Total OneBeacon Surplus Notes $ 12.6 $ 5.4 $ (6.9 ) $ (18.6 ) (1) Represents the sensitivity to changes in the estimate of the liquidity spread added to account for OneBeacon’s sole ownership of the OneBeacon Surplus Notes, lack of a liquid trading market, and ongoing regulatory approval risk. (2) Represents the sensitivity to changes in the estimate of the underlying equivalent credit quality of the OneBeacon Surplus Notes. Such credit quality is approximated by comparing the expected percentage of discounted payments missed, as calculated in a proprietary Stochastic simulation, to a series of benchmarks derived from data published by Standard & Poor’s. Note that “notch” is defined as the difference between, for example. a “B” and “B+” rated instrument. (3) Represents the sensitivity to changes in the estimate of timing of the first principal payment received by OneBeacon. The fair value model assumes a delay in the receipt of principal cash flows as a result of the regulatory approval required before such payments may occur; and assuming repayments are made with a graduated impact on statutory surplus. (4) Represents the sensitivity to changes in the estimate of timing of the first interest payment received by OneBeacon. The fair value model assumes a delay in the receipt of interest cash flows as a result of the regulatory approval required before such payments may occur; and assuming repayments are made with a graduated impact on statutory surplus. FORWARD-LOOKING STATEMENTS This report may contain “forward-looking statements” within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934. All statements, other than statements of historical facts, included or referenced in this report which address activities, events or developments which White Mountains expects or anticipates will or may occur in the future are forward-looking statements. The words “will”, “believe”, “intend”, “expect”, “anticipate”, “project”, “estimate”, “predict” and similar expressions are also intended to identify forward-looking statements. These forward-looking statements include, among others, statements with respect to White Mountains’: • change in adjusted book value per share or return on equity; • business strategy; • financial and operating targets or plans; • incurred loss and loss adjustment expenses and the adequacy of its loss and loss adjustment expense reserves and related reinsurance; • projections of revenues, income (or loss), earnings (or loss) per share, dividends, market share or other financial forecasts; • expansion and growth of its business and operations; and • future capital expenditures. These statements are based on certain assumptions and analyses made by White Mountains in light of its experience and perception of historical trends, current conditions and expected future developments, as well as other factors believed to be appropriate in the circumstances. However, whether actual results and developments will conform to its expectations and predictions is subject to a number of risks and uncertainties that could cause actual results to differ materially from expectations, including: • the risks associated with Item 1A of this Report on Form 10-K; • claims arising from catastrophic events, such as hurricanes, earthquakes, floods, fires, terrorist attacks or severe winter weather; • the continued availability of capital and financing; • general economic, market or business conditions; • business opportunities (or lack thereof) that may be presented to it and pursued; • competitive forces, including the conduct of other property and casualty insurers and reinsurers; • changes in domestic or foreign laws or regulations, or their interpretation, applicable to White Mountains, its competitors or its customers; • an economic downturn or other economic conditions adversely affecting its financial position; • recorded loss reserves subsequently proving to have been inadequate; • actions taken by ratings agencies from time to time, such as financial strength or credit ratings downgrades or placing ratings on negative watch; and • other factors, most of which are beyond White Mountains’s control. Consequently, all of the forward-looking statements made in this report are qualified by these cautionary statements, and there can be no assurance that the actual results or developments anticipated by White Mountains will be realized or, even if substantially realized, that they will have the expected consequences to, or effects on, White Mountains or its business or operations. White Mountains assumes no obligation to publicly update any such forward-looking statements, whether as a result of new information, future events or otherwise.

<s>[INST] The following discussion also includes five nonGAAP financial measures, adjusted comprehensive income, adjusted book value per share, adjusted capital, consolidated portfolio returns excluding Symetra and common equity securities and other longterm investment returns excluding Symetra that have been reconciled to their most comparable GAAP financial measures (see page 75). White Mountains believes these measures to be more relevant than comparable GAAP measures in evaluating White Mountains’s financial performance and condition. RESULTS OF OPERATIONS FOR THE YEARS ENDED December 31, 2015, 2014 and 2013 OverviewYear Ended December 31, 2015 versus Year Ended December 31, 2014 White Mountains ended 2015 with an adjusted book value per share of $699, an increase of 5.3% during the year, including dividends, compared to an increase of 3.6% during 2014, including dividends. During 2015, White Mountains signed a definitive agreement to sell Sirius Group to CMI, and Symetra announced that it entered into a definitive merger agreement with Sumitomo Life pursuant to which Sumitomo Life will acquire all of the outstanding shares of Symetra. Substantially all of the benefit from the Symetra transaction was recorded in 2015, while the benefit from the Sirius Group transaction will be recorded at closing, which is expected in the first quarter of 2016. Including dividends, Symetra produced $264 million of adjusted comprehensive income for White Mountains in 2015, of which $241 million was recognized as an aftertax unrealized investment gain in the fourth quarter. Including the estimated gain of $84 per share for the Sirius Group sale, adjusted book value per share is approximately $783, an increase of 18.0% for the year ended December 31, 2015, including dividends. See page 44 for the calculation of the estimated gain per share from the Sirius Group transaction. White Mountains reported adjusted comprehensive income of $232 million in 2015 compared to $135 million in 2014. The increase is driven by $264 million of adjusted comprehensive income from Symetra and lower foreign currency losses, partially offset by lower investment returns excluding Symetra and increased incentive compensation expense recorded in connection with the agreements to sell Sirius Group and Symetra. OneBeacon’s book value per share increased 3.8% during 2015, including dividends, compared to an increase of 2.1% during 2014, including dividends. OneBeacon’s GAAP combined ratio was 96% for 2015 compared to 102% for 2014. The lower combined ratio is primarily the result of the $109 million loss reserve charge in the fourth quarter of 2014, partially offset by higher expense ratios driven by higher incentive compensation expense, changes in business mix and the impact of exiting the crop business. OneBeacon’s net written premiums decreased 7% to $1.1 billion in 2015, primarily due to the exit from crop and lawyers liability businesses, a decrease in the Healthcare business and the termination of an affiliated reinsurance treaty, partially offset by increases in OneBeacon’s newer Programs and Surety businesses. As a result of the agreement to sell Sirius Group, its results are reported as discontinued operations within White Mountains’s GAAP financial statements. Sirius Group’s results continue to inure to White Mountains through the closing date of the sale. Sirius Group’s GAAP combined ratio was 85% for 2015 compared to 76% for 2014. The increase was primarily due to lower favorable net loss reserve development and a significantly higher frequency of noncatastrophe per risk and pro rata loss events, including $18 million in losses from the Tianjin port explosions, partially offset by lower catastrophe losses. Additionally, the combined ratio for the year ended December 31, 2015 included 1 point from the cost of ILW covers purchased to mitigate the potential impact of [/INST] Negative. </s>

WHITE MOUNTAINS INSURANCE GROUP LTD

2017-02-27

2016-12-31

Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations The following discussion contains “forward-looking statements”. White Mountains intends statements that are not historical in nature, which are hereby identified as forward-looking statements, to be covered by the safe harbor provisions of the Private Securities Litigation Reform Act of 1995. White Mountains cannot promise that its expectations in such forward-looking statements will turn out to be correct. White Mountains’s actual results could be materially different from and worse than its expectations. See “FORWARD-LOOKING STATEMENTS” on page 75 for specific important factors that could cause actual results to differ materially from those contained in forward-looking statements. The following discussion also includes four non-GAAP financial measures, adjusted comprehensive income, adjusted book value per share, consolidated portfolio returns excluding Symetra and common equity securities and other long-term investment returns excluding Symetra, and the return on common equity and other long-term investments including high-yield fixed maturity investments that have been reconciled to their most comparable GAAP financial measures on page 64. White Mountains believes these measures to be useful in evaluating White Mountains’s financial performance and condition. RESULTS OF OPERATIONS FOR THE YEARS ENDED December 31, 2016, 2015 and 2014 Overview-Year Ended December 31, 2016 versus Year Ended December 31, 2015 White Mountains ended 2016 with book value per share of $790 and adjusted book value per share of $794, an increase of 13.6% and 13.7% for the year, including dividends. Comprehensive income attributable to common shareholders increased to $558 million in 2016 compared to $197 million in 2015. The increases in 2016 are driven by larger transaction related gains. In 2016, a gain of $477 million from the sale of Sirius Group increased book value per share and adjusted book value per share by $90, while $82 million of comprehensive income generated from the sale of Tranzact increased book value per share and adjusted book value per share by $16. In 2015, White Mountains recognized $241 million of comprehensive income that increased book value per share and adjusted book value per share by $43, which was the result of a change in accounting for the investment in Symetra from the equity method to fair value, caused by White Mountains’s relinquishment of its representation on Symetra’s board of directors subsequent to Symetra entering into a merger agreement with Sumitomo Life. See Note 2 - “Significant Transactions” on page for a description of each transaction. For the year ended December 31, 2016, White Mountains repurchased and retired 1,106,145 of its common shares for $887 million at an average share price of $802.08, approximately 101% of White Mountains’s December 31, 2016 adjusted book value per share. OneBeacon’s book value per share increased 11.1% during 2016, including dividends, compared to an increase of 3.8% during 2015, including dividends. OneBeacon’s GAAP combined ratio was 97% for 2016 compared to 96% for 2015. OneBeacon’s current accident year loss ratio was 58% for the year ended December 31, 2016, compared to 60% for year ended December 31, 2015. OneBeacon had one point of net unfavorable loss reserve development in the year ended December 31, 2016 compared to insignificant loss reserve development in the year ended December 31, 2015. The decrease in the current accident year loss ratio reflects improved relative performance across most business units. The expense ratio was 38% for the year ended December 31, 2016, compared to 36% for the year ended December 31, 2015. The increase in the expense ratio was primarily due to lower earned premium volume and changing business mix. The increase in book value per share for the year ended December 31, 2016 included a $16 million tax benefit related to the settlement of IRS examinations for tax years 2007-2012. OneBeacon’s net written premiums were $1.1 billion for both the year ended December 31, 2016 and the year ended December 31, 2015. BAM insured municipal bonds with par value of $11.3 billion in 2016, compared to $10.6 billion in 2015. The average total premium (including both risk premiums and Member Surplus Contributions), weighted by insured par, of insurance provided by BAM in the primary and secondary markets in 2016 was 68 basis points, up from 52 basis points in 2015. As of December 31, 2016, BAM’s total claims paying resources were $644 million on total par insured of $33 billion. Total claims paying resources increased $43 million from December 31, 2015, reflecting positive cashflow building in the BAM system. The GAAP pre-tax total return on invested assets was 2.7% for 2016, compared to 3.6% for 2015. In local currencies, the fixed income portfolio, excluding high yield investments, returned 2.1% for 2016, essentially in-line with the longer duration Bloomberg Barclays U.S. Intermediate Aggregate Index. The portfolio of common equity securities, other long-term investments and high-yield fixed maturity investments returned 4.0% for 2016, underperforming the S&P 500 Index return of 12.0%. The underperformance versus the S&P 500 Index return was primarily attributable to the overall conservative positioning of the risk asset portfolio, including the new high-yield mandate, which we do not expect to keep pace with strong up markets. The underperformance was also due to unfavorable results from publicly-traded common equity securities managed by third party investment advisers and pockets of poor performance in other long-term investments, including unfavorable results from private equity funds and non-controlling interests in private capital investments. Sirius Group’s results inured to White Mountains until April 18, 2016, the closing date of the sale to CMI. For the 2016 period, White Mountains reported Sirius Group’s comprehensive income of $27 million and a combined ratio of 102%, which was driven by $17 million of recorded losses from the Ecuador earthquake that occurred on April 16, 2016. In 2016, White Mountains returned approximately $900 million of capital to shareholders, primarily through share repurchases. Overview-Year Ended December 31, 2015 versus Year Ended December 31, 2014 White Mountains ended 2015 with book value per share of $696 and adjusted book value per share of $699, an increase of 4.4% and 5.3% for the year, including dividends. During 2015, White Mountains signed an agreement to sell Sirius Group to CMI, and Symetra announced that it entered into a merger agreement with Sumitomo Life pursuant to which Sumitomo Life will acquire all of the outstanding shares of Symetra. Substantially all of the benefit from the Symetra transaction was recorded in 2015, while the benefit from the Sirius Group transaction was recorded at closing in the second quarter of 2016. Including dividends, Symetra produced $264 million of adjusted comprehensive income for White Mountains in 2015, of which $241 million was recognized as an after-tax unrealized investment gain in the fourth quarter. White Mountains reported comprehensive income attributable to common shareholders of $197 million and adjusted comprehensive income of $232 million in 2015 compared to comprehensive income attributable to common shareholders of $211 million and adjusted comprehensive income of $135 million in 2014. The increase in adjusted comprehensive income was driven by $264 million from Symetra and lower foreign currency losses, partially offset by lower investment returns excluding Symetra and increased incentive compensation expense recorded in connection with the agreements to sell Sirius Group and Symetra. Comprehensive income attributable to common shareholders was also affected by the change in net unrealized investment gains (losses) from White Mountains’s share of Symetra’s fixed maturity portfolio prior to the accounting change. Net unrealized investment losses from Symetra’s fixed maturity portfolio were $35 million in 2015 compared to net unrealized gains of $75 million in 2014. For the year ended December 31, 2015, White Mountains repurchased and retired 387,495 of its common shares for $284 million at an average share price of $733, approximately 105% of White Mountains’s December 31, 2015 adjusted book value per share. The average share price paid was approximately 94% of White Mountains’s December 31, 2015 adjusted book value per share including the estimated gain on the Sirius Group transaction, which was announced previous to when the vast majority of the 2015 share repurchases were completed but prior to the recording of the gain in adjusted book value per share, which occurred at closing on April 18, 2016. OneBeacon’s book value per share increased 3.8% during 2015, including dividends, compared to an increase of 2.1% during 2014, including dividends. OneBeacon’s GAAP combined ratio was 96% for 2015 compared to 102% for 2014. The lower combined ratio was primarily the result of the $109 million loss reserve charge in the fourth quarter of 2014, partially offset by higher expense ratios driven by higher incentive compensation expense, changes in business mix and the impact of exiting the Crop Business. OneBeacon’s net written premiums decreased 7% to $1.1 billion in 2015, primarily due to the exit from the Crop Business and lawyers liability business, a decrease in the Healthcare business and the termination of an affiliated reinsurance treaty, partially offset by increases in OneBeacon’s newer Programs and Surety businesses. Sirius Group’s GAAP combined ratio was 85% for 2015 compared to 76% for 2014. The increase was primarily due to lower favorable net loss reserve development and a significantly higher frequency of non-catastrophe per risk and pro rata loss events, including $18 million in losses from the Tianjin port explosions, partially offset by lower catastrophe losses. Additionally, the combined ratio for the year ended December 31, 2015 included 1 point from the cost of ILW covers purchased to mitigate the potential impact of major events on Sirius Group’s balance sheet pending the close of the sale to CMI. BAM insured municipal bonds with par value of $10.6 billion in 2015, compared to $7.8 billion in 2014. The average total premium (including both risk premiums and Member Surplus Contributions), weighted by insured par, of insurance provided by BAM in the primary and secondary markets in 2015 was 52 basis points, up from 43 basis points in 2014. As of December 31, 2015, BAM’s total claims paying resources were $601 million on total par insured of $22.6 billion. Total claims paying resources increased $20 million from December 31, 2014. The GAAP pre-tax total return on invested assets was 3.6% for 2015. Excluding the results from Symetra, the GAAP pre-tax total return on invested assets was -0.2% for 2015, which included 0.9% of currency losses, compared to a return of 1.9% for 2014, which included 1.9% of currency losses. In local currencies, the fixed income portfolio returned 1.1% for 2015, essentially in-line with the longer duration Bloomberg Barclays U.S. Intermediate Aggregate Index. The portfolio of common equity securities and other long-term investments returned 19.3% for 2015. Excluding the results from Symetra, the portfolio of common equity securities and other long-term investments returned -1.8% for 2015, underperforming the S&P 500 Index return of 1.4%. The underperformance versus the S&P 500 Index return was primarily due to unfavorable mark-to-market adjustments to the OneBeacon Surplus Notes and losses in energy exposed private equity funds and a distressed hedge fund. In 2015, White Mountains deployed approximately $400 million of capital, primarily through $284 million of share repurchases and approximately $120 million through the purchase of various private capital investments, both in new investments and additional financings in existing investments to support growth and acquisitions. Adjusted Book Value Per Share The following table presents White Mountains’s adjusted book value per share, a non-GAAP financial measure, for the years ended December 31, 2016, 2015 and 2014 and reconciles this non-GAAP measure to the most comparable GAAP measure. See “NON-GAAP FINANCIAL MEASURES” on page 64. December 31, Book value per share numerators (in millions): White Mountains’s common shareholders’ equity $ 3,603.3 $ 3,913.2 $ 3,995.7 Equity in net unrealized investment losses from Symetra’s fixed maturity portfolio (2) - - (34.9 ) Future proceeds from options (1) $ 29.7 - - Adjusted book value per share numerator $ 3,633.0 $ 3,913.2 $ 3,960.8 Book value per share denominators (in thousands of shares): Common shares outstanding 4,563.8 5,623.7 5,986.2 Unearned restricted shares (25.9 ) (25.0 ) (25.7 ) Options assumed issued (1) 40.0 - - Adjusted book value per share denominator 4,577.9 5,598.7 5,960.5 Book value per share $ 789.53 $ 695.84 $ 667.48 Adjusted book value per share $ 793.58 $ 698.95 $ 664.50 Dividends paid per share $ 1.00 $ 1.00 $ 1.00 (1) Adjusted book value per share at December 31, 2016 includes the impact of 40,000 non-qualified stock options exercisable for $742 per common share. Prior periods exclude the non-qualified stock options, which were anti-dilutive to book value. (2) For the year ended December 31, 2014, equity in net unrealized investment losses from Symetra’s fixed maturity portfolio includes tax expense of $2.6. The following table is a summary of goodwill and intangible assets that are included in White Mountains’s adjusted book value as of December 31, 2016, 2015 and 2014: December 31, Millions Goodwill MediaAlpha 18.3 18.3 18.3 Wobi 5.8 5.8 5.5 Buzzmove 7.6 - - Total goodwill 31.7 24.1 23.8 . Intangible assets MediaAlpha 18.3 24.4 32.5 Wobi and Other 5.9 6.9 6.2 Total intangible assets 24.2 31.3 38.7 Total goodwill and intangible assets (1) 55.9 55.4 62.5 Goodwill and other intangible assets held for sale - 331.9 303.9 Goodwill and intangible assets attributed to non-controlling interests (17.6 ) (136.4 ) (141.8 ) Goodwill and intangible assets included in adjusted book value $ 38.3 $ 250.9 $ 224.6 (1) See Note 6 - “Goodwill and Other Intangible Assets” on page for details of other intangible assets. Review of Consolidated Results A summary of White Mountains’s consolidated financial results for the years ended December 31, 2016, 2015 and 2014 follows: Year Ended December 31, Millions Gross written premiums $ 1,273.2 $ 1,361.7 $ 1,362.2 Net written premiums $ 1,145.8 $ 1,172.6 $ 1,239.0 Revenues Earned insurance premiums $ 1,114.0 $ 1,188.2 $ 1,185.0 Net investment income 86.8 60.8 59.5 Net realized and unrealized investment gains 10.3 225.4 78.5 Other revenue 149.6 147.3 88.1 Total revenues 1,360.7 1,621.7 1,411.1 Expenses Losses and LAE 664.0 708.9 824.0 Insurance acquisition expenses 211.6 220.1 206.2 Other underwriting expenses 209.5 218.6 179.6 General and administrative expenses 287.4 291.6 208.2 General and administrative expenses - amortization of intangible assets 12.5 10.6 8.3 Interest expense 16.1 14.6 14.2 Total expenses 1,401.1 1,464.4 1,440.5 Pre-tax (loss) income (40.4 ) 157.3 (29.4 ) Income tax benefit 45.4 .2 14.8 Net income (loss) from continuing operations 5.0 157.5 (14.6 ) Net gain from sale of Sirius Group, net of tax 363.2 - - Net gain from sale of Tranzact, net of tax 51.9 - - Net gain (loss) from sale of discontinued operations, net of tax - 18.2 (1.6 ) Net (loss) gain from discontinued operations, net of tax (.3 ) 78.7 260.6 Equity in earnings of unconsolidated affiliates, net of tax - 25.1 45.6 Net income 419.8 279.5 290.0 Net (loss) gain attributable to non-controlling interests (7.3 ) 18.1 22.2 Net income attributable to White Mountains’s common shareholders 412.5 297.6 312.2 Change in equity in net unrealized investment (losses) gains from investments in Symetra common shares - (34.9 ) 75.3 Change in foreign currency translation and pension liability .3 (.5 ) (10.7 ) Change in foreign currency translation and other items from discontinued operations 32.0 (65.0 ) (169.5 ) Change in foreign currency translation and other items from sale of Sirius Group 113.3 - - Comprehensive income 558.1 197.2 207.3 Comprehensive (income) loss attributable to non-controlling interests (.3 ) - 3.3 Comprehensive income attributable to White Mountains’s common shareholders 557.8 197.2 210.6 Change in net unrealized investment gains (losses) from Symetra’s fixed maturity portfolio (2) - 34.9 (75.3 ) Adjusted comprehensive income(1) $ 557.8 $ 232.1 $ 135.3 (1) Adjusted comprehensive income is a non-GAAP measure. For a description of the most comparable GAAP measure. See NON-GAAP FINANCIAL MEASURES on page 64. (2) Change in equity in net unrealized investment losses from investments in Symetra common shares includes tax benefit of $2.6 and tax expense of $5.8 for the years ended December 31, 2015 and 2014. Consolidated Results-Year Ended December 31, 2016 versus Year Ended December 31, 2015 White Mountains’s total revenues decreased 16% to $1.4 billion in 2016, which was driven by lower net realized and unrealized investment gains, primarily from $259 million of net unrealized investment gains recognized in 2015 related to Symetra that did not recur in 2016. Earned insurance premiums decreased by 6% in 2016, primarily due to OneBeacon writing less premiums in several lines of business. Net investment income increased 43% to $87 million, driven by a higher invested asset base resulting primarily from the sale of Sirius Group. White Mountains reported net realized and unrealized investment gains of $10 million in 2016, compared to gains of $225 million in 2015, which included the gain from Symetra. See “Summary of Investment Results” on page 50 for a discussion and analysis of White Mountains’s investment returns. Other revenue increased to $150 million in 2016 from $147 million in 2015. Other revenue in 2016 included $117 million from MediaAlpha compared to $106 million in 2015. Other revenue also included a $20 million pre-tax gain in 2015 from the sale of Hamer LLC, a small manufacturing company that White Mountains received in 2012 in connection with the liquidation of a limited partnership fund. White Mountains’s total expenses decreased 4% to $1.4 billion in 2016, which was driven by lower expenses in OneBeacon’s insurance business. Losses and LAE decreased 6% in 2016, which is in line with the decrease in earned premiums, while insurance acquisition expenses and other underwriting expenses both decreased 4% in 2016 reflecting decreased earned premiums and changes in business mix. See “Summary of Operations by Segment” on page 39. General and administrative expenses decreased 1% in 2016 to $287 million, which was primarily due to lower incentive compensation costs in 2016, partially offset by higher expenses from consolidated WM Capital Investments, driven by MediaAlpha with expenses of $110 million in 2016 compared to $99 million in 2015. Consolidated Results-Year Ended December 31, 2015 versus Year Ended December 31, 2014 White Mountains’s total revenues increased 15% to $1.6 billion in 2015, which was driven by other revenues associated with consolidated WM Capital Investments. Earned insurance premiums in 2015 were in line with 2014. Net investment income increased 2% to $61 million, as lower investment expenses were mostly offset by lower common stock dividends. White Mountains reported net realized and unrealized investment gains of $225 million in 2015, which included $259 million from Symetra, compared to $79 million of gains in 2014. See “Summary of Investment Results” on page 50 for a discussion and analysis of White Mountains’s investment returns. Other revenue increased to $147 million in 2015 from $88 million in 2014. Other revenue in 2015 included $106 million from MediaAlpha compared to $65 million from MediaAlpha in 2014. Other revenue also included a $20 million pre-tax gain in 2015 from the sale of Hamer LLC, a small manufacturing company that White Mountains received in 2012 in connection with the liquidation of a limited partnership fund. White Mountains’s total expenses increased 2% to $1.5 billion in 2015, which was driven by increases in other expenses associated with consolidated WM Capital Investments, partially offset by lower expenses in OneBeacon’s insurance business. Losses and LAE decreased 14%, primarily due to the $109 million reserve charge recorded by OneBeacon related to the actuarial analysis performed in the fourth quarter of 2014, while insurance acquisition expenses and other underwriting expenses increased 7% and 22% in 2015 due to changes in business mix and higher incentive compensation expense. See “Summary of Operations by Segment” on page 39. General and administrative expenses in 2015 included $99 million from MediaAlpha compared to $61 million from MediaAlpha in 2014. Income Taxes The Company and its Bermuda-domiciled subsidiaries are not subject to Bermuda income tax under current Bermuda law. In the event there is a change in the current law such that taxes are imposed, the Company and its Bermuda-domiciled subsidiaries would be exempt from such tax until March 31, 2035, pursuant to the Bermuda Exempted Undertakings Tax Protection Act of 1966. The Company has subsidiaries and branches that operate in various other jurisdictions around the world that are subject to tax in the jurisdictions in which they operate. White Mountains reported income tax benefit of $45 million in 2016 on pre-tax loss of $40 million. White Mountains’s effective tax rate for 2016 was different than the U.S. statutory rate of 35% due primarily to a $21 million tax benefit recognized in continuing operations related to the reversal of a valuation allowance that resulted from income that was recognized within discontinued operations, a $12.8 million favorable settlement of the 2007-2009 IRS exam and a $3.5 million favorable settlement of the 2010-2012 IRS exam. The rate was also impacted by income generated in jurisdictions with lower tax rates than the United States. The $21 million tax benefit recorded in continuing operations in 2016 related to the reversal of a valuation allowance was generated by the Tranzact Sale, which is accounted for in discontinued operations. See Note 8 - “Income Taxes” on page. White Mountains reported near break-even income tax in 2015 on pre-tax income of $157 million. White Mountains’s effective tax rate for 2015 was near zero, which was lower than the U.S. statutory rate of 35% due primarily to income generated in jurisdictions with lower tax rates than the United States. White Mountains reported an income tax benefit of $15 million in 2014 on pre-tax loss of $29 million. White Mountains’s effective tax rate for 2014 was 51%, which was higher than the U.S. statutory rate of 35% due primarily to losses generated in the United States and income generated in jurisdictions with lower tax rates than the United States. I. Summary of Operations By Segment White Mountains conducts its operations through three segments: (1) OneBeacon, (2) HG Global/BAM and (3) Other Operations. While investment results are included in these segments, because White Mountains manages the majority of its investments through its wholly-owned subsidiary, WM Advisors, a discussion of White Mountains’s consolidated investment operations is included after the discussion of operations by segment. White Mountains’s segment information is presented in Note 16 - “Segment Information” on page to the Consolidated Financial Statements. As a result of the Sirius Group and Tranzact sales, the results of operations for Sirius Group and Tranzact have been classified as discontinued operations and are now presented separately, net of related income taxes, in the statement of comprehensive income. Prior year amounts have been reclassified to conform to the current period’s presentation See Note 22 - “Held for Sale and Discontinued Operations” on page. OneBeacon Financial results and GAAP combined ratios for OneBeacon for the years ended December 31, 2016, 2015 and 2014 follow: Year Ended December 31, $ in millions Gross written premiums $ 1,221.3 $ 1,315.9 $ 1,323.4 Net written premiums $ 1,100.7 $ 1,136.6 $ 1,216.9 Earned insurance premiums $ 1,100.6 $ 1,176.2 $ 1,177.1 Net investment income 50.6 45.9 43.4 Net realized and unrealized investment gains (losses) 37.7 (35.1 ) 40.4 Other revenue 5.5 (.6 ) 5.8 Total revenues 1,194.4 1,186.4 1,266.7 Losses and LAE 656.0 700.7 815.1 Insurance acquisition expenses 206.0 213.8 203.3 Other underwriting expenses 209.0 218.2 179.2 General and administrative expenses 13.0 14.1 12.4 Amortization of intangible assets 1.2 1.3 1.4 Interest expense on debt 13.1 13.0 13.0 Total expenses 1,098.3 1,161.1 1,224.4 Pre-tax income $ 96.1 $ 25.3 $ 42.3 GAAP Ratios: Losses and LAE % % % Expense Combined % % % The following table presents OneBeacon’s book value per share. December 31, Millions, except per share amounts OneBeacon’s common shareholders’ equity $ 1,021.3 $ 1,000.9 $ 1,045.8 OneBeacon common shares outstanding 94.3 95.1 95.3 OneBeacon book value per common share $ 10.82 $ 10.53 $ 10.97 Dividends paid per common share $ .84 $ .84 $ .84 OneBeacon Results-Year Ended December 31, 2016 versus Year Ended December 31, 2015 OneBeacon ended 2016 with a book value per share of $10.82, an increase of 11.1% during 2016, including dividends, compared to an increase of 3.8% during 2015, including dividends. Solid underwriting results and investment returns drove the increase. The increase in book value for the year ended December 31, 2016 also included a $16 million tax benefit related to the settlement of IRS examinations for tax years 2007-2012. OneBeacon’s GAAP combined ratio increased to 97% for 2016 from 96% for 2015. The increase was primarily due to a higher expense ratio. The loss ratio of 59% for the year ended December 31, 2016 compared to the year ended December 31, 2015 ratio of 60%, as improved results primarily in the Entertainment, Accident and Inland Marine businesses were offset by lower results primarily in the Healthcare business. Net unfavorable loss reserve development for the year ended December 31, 2016 was 1 point and was primarily from the Healthcare ($41 million), Architects & Engineers ($15 million), and Programs ($13 million) businesses, partially offset by favorable net loss reserve development in the Accident ($16 million), Entertainment ($9 million), Technology ($9 million) and Financial Services ($8 million) businesses. Net loss reserve development was insignificant in the year ended December 31, 2015. The expense ratio increased by 2 points to 38% for the year ended December 31, 2016, compared to the year ended December 31, 2015, primarily due to lower premium volume and changing business mix. The increase in other revenue for the year ended December 31, 2016 compared to the year ended December 31, 2015 was primarily driven by a loss of $4 million OneBeacon recognized in 2015 that did not recur in 2016. The loss was for an assessment from the Michigan Catastrophic Claims Association payable to Markel Corporation pursuant to the indemnification provisions in the stock purchase agreement governing the sale of Essentia Insurance Company (“Essentia”). OneBeacon previously recognized a pretax gain of $23 million in 2013 on the sale of Essentia, an indirect wholly-owned subsidiary which wrote legacy collector cars and boats business, to Markel Corporation. OneBeacon’s net written premiums were $1.101 billion for the year ended December 31, 2016, a decrease of 3% compared to the year ended December 31, 2015. Decreases in the Programs ($32 million), Entertainment ($27 million) and Healthcare ($15 million) businesses were partially offset by increases in Financial Institutions ($18 million) and various other businesses. Reinsurance protection. OneBeacon purchases reinsurance in order to minimize the loss from large risks or catastrophic events. OneBeacon also purchases individual property reinsurance coverage for certain risks to reduce large loss volatility through property-per-risk excess of loss reinsurance programs and individual risk facultative reinsurance. OneBeacon also maintains excess of loss casualty reinsurance programs that provide protection for individual risk or catastrophe losses involving workers compensation, general liability, automobile liability, professional liability or umbrella liability. The availability and cost of reinsurance protection is subject to market conditions, which are outside of management’s control. Limiting risk of loss through reinsurance arrangements serves to mitigate the impact of large losses; however, the cost of this protection in an individual period may exceed the benefit. For 2016 and 2015, OneBeacon’s net combined ratio was higher than the gross combined ratio by 4 points and 1 point as a result of the cost of the reinsurance programs more than offsetting the benefits from ceded losses. OneBeacon Surplus Notes issued pursuant to the Runoff Transaction. As part of closing the Runoff Transaction on December 23, 2014, OneBeacon provided financing in the form of the OneBeacon Surplus Notes with a par value of $101 million issued by OneBeacon Insurance Company (“OBIC”), one of the entities that was transferred from OneBeacon to Armour as part of the transaction. As of December 31, 2016 and December 31, 2015, the OneBeacon Surplus Notes had a fair value of $72 million and $52 million, based on a discounted cash flow model. The OneBeacon Surplus Notes are included in OneBeacon’s investment portfolio, categorized within other long-term investments, and subsequent changes in value thereon are reflected in continuing operations. See “Critical Accounting Estimates” on page 65 for a sensitivity analysis of potential changes in these key variables that can impact the estimated fair value of the OneBeacon Surplus Notes and “Summary of Investment Results” on page 50 for a discussion and analysis of White Mountains’s investment returns. OneBeacon Results-Year Ended December 31, 2015 versus Year Ended December 31, 2014 OneBeacon ended 2015 with a book value per share of $10.53, an increase of 3.8% during 2015, including dividends, compared to an increase of 2.1% during 2014, including dividends. Improved underwriting results drove the increase in OneBeacon’s book value per share growth for 2015. OneBeacon’s GAAP combined ratio decreased to 96% for 2015 from 102% for 2014. The decrease was primarily driven by a 9 point decrease in the loss ratio from non-recurrence of adverse prior accident year loss reserve development in 2015, partially offset by an increase in the expense ratio and the impact of increasingly competitive markets on the current accident year loss ratio. There was no net loss reserve development in 2015, primarily attributable to favorable net loss reserve development from the Technology, Collector Cars and Boats, Specialty Property and Financial Services lines of business, offset by unfavorable net loss reserve development from the Entertainment and Ocean Marine lines of business. In 2014, there was $90 million, or 8 points, of unfavorable net prior accident year adverse loss reserve development (described below in “2014 Fourth Quarter Loss and LAE Reserve Increase.”). The increase in the expense ratio for 2015 was primarily due to higher incentive compensation expense, higher acquisition costs due to changes in business mix and the impact of exiting the Crop Business. During 2015, OneBeacon recognized a loss of $4 million in other revenues in connection with an assessment from the Michigan Catastrophic Claims Association payable to Markel Corporation pursuant to the indemnification provisions in the stock purchase agreement governing the sale of Essentia. OneBeacon’s net written premiums decreased 7% in 2015 to $1.1 billion, primarily due to the exit from the Crop Business ($44 million) and lawyers liability business ($28 million), a decrease in the Healthcare business ($33 million) and the termination of an affiliated reinsurance treaty ($20 million), partially offset by increases in OneBeacon’s newer Programs and Surety businesses ($67 million). Excluding the impact of OneBeacon’s exit from the Crop Business and lawyers liability business and the affiliated reinsurance treaty termination, consolidated net written premiums increased $13 million, or 1.1%. 2014 Fourth Quarter Loss and LAE Reserve Increase Through the first nine months of 2014, OneBeacon recorded $14 million of net unfavorable loss and LAE reserve development, driven by greater-than-expected large losses in several underwriting units, primarily in the professional and management liability lines within Professional Insurance. This large loss activity, which occurred mostly during the second and third quarters of 2014, also impacted the current accident year loss and LAE estimates. Additionally, OneBeacon incurred higher-than-usual claim coverage determination costs, a component of LAE expenses, during the first nine months of 2014. Other underwriting units also reported increased claim activity, including Entertainment, Government Risks, and Accident. Since the increased level of loss and LAE activity continued into the early part of the fourth quarter, the high level of activity in the second and third quarters no longer seemed to be isolated occurrences. As such, during the fourth quarter of 2014, OneBeacon enhanced its actuarial and claims review in several areas. OneBeacon isolated the recent large loss activity in each of its underwriting units and examined the emergence of large losses relative to the timing and amounts of expected large losses. OneBeacon also conducted additional analyses in the lawyers’ professional liability line within Professional Insurance. These new analyses included a claim level review and the application of additional actuarial methods and loss development assumptions. The results of these analyses indicated that the assumed tail risk included in the loss development patterns used to record IBNR reserves for this line were insufficient and needed to be increased for remaining long-tail exposures. OneBeacon’s claims and actuarial staff also conducted an in-depth review of coverage determination, litigation and other claim-specific adjusting expenses as a result of an emerging trend of increased expenses in these areas over recent quarters, particularly coverage determination expenses. This review concluded that the ultimate costs of these loss adjustment expenses were larger than previously estimated, causing management to record an increase in estimated LAE expenses, primarily in Professional Insurance. Finally, OneBeacon also recorded unfavorable prior year development in other underwriting units, including Entertainment and Government Risks. The unfavorable loss development in Entertainment and Government Risks resulted from heavier than expected claim activity during the fourth quarter, predominantly in the general liability and commercial auto liability lines. In order to fully reflect these recent trends, OneBeacon recorded a $109 million increase in loss and LAE reserves, which included a $75 million increase in prior accident year loss and LAE reserves and a $34 million increase in the current accident year loss and LAE reserves recorded at September 30, 2014. The components of the 2014 fourth quarter loss and LAE reserve increase and the net loss and LAE development for the full year are provided below: Millions 2014 Fourth Quarter Reserve Increases Full Year 2014 Underwriting Unit Current Accident Year Prior Accident Year Total Net Prior Year Development Professional Insurance $ 22.9 $ 46.4 $ 69.3 $ 59.1 Specialty Property (1.1 ) 5.7 4.6 1.1 Crop Business 3.8 - 3.8 - Other 2.8 (.4 ) 2.4 1.6 Specialty Products 28.4 51.7 80.1 61.8 Entertainment 1.5 11.6 13.1 13.5 Government Risks 1.2 7.1 8.3 8.5 Accident - 3.5 3.5 6.0 Other 2.6 1.6 4.2 - Specialty Industries 5.3 23.8 29.1 28.0 Total $ 33.7 $ 75.5 $ 109.2 $ 89.8 As noted above, OneBeacon increased its provision for current accident year losses and LAE by $34 million in the fourth quarter of 2014. In making its loss and LAE reserve picks for the 2014 accident year, OneBeacon considered the results of the enhanced actuarial and claim review and the fact that reported large claims were approaching estimated ultimate held reserves for large losses sooner than originally expected. $4 million of the increase was related to higher-than-expected reports of Crop Business losses that emerged in the fourth quarter. The remaining $30 million of the increase reflects an increase in management’s best estimate of current losses and LAE as of December 31, 2014 from those recorded in the first nine months of 2014. This increase primarily affected Professional Insurance, which represented $23 million of the total provision. Reinsurance protection. For 2015 and 2014, OneBeacon’s net combined ratio was higher than the gross combined ratio by 1 point and 2 points as a result of the cost of the reinsurance programs more than offsetting the benefits from ceded losses. OneBeacon Discontinued Operations - Runoff Transaction In October 2012, OneBeacon entered into an agreement to sell its Runoff Business to Armour. The Runoff Transaction closed in the fourth quarter of 2014. See Note 22 - “Held for Sale and Discontinued Operations” on page for more details regarding the Runoff Transaction. During 2014, OneBeacon reported a $21 million after-tax net loss in discontinued operations related to the Runoff Transaction, which included a $19 million after-tax loss from sale of the Runoff Business (further described below) and a $2 million after-tax loss from the underwriting results of the Runoff Business. As part of closing the Runoff Transaction on December 23, 2014, OneBeacon provided financing in the form of the OneBeacon Surplus Notes with a par value of $101 million issued by OneBeacon Insurance Company (“OBIC”), one of the entities that were transferred from OneBeacon to Armour as part of the transaction. As of December 31, 2014, the OneBeacon Surplus Notes had a fair value of $65 million, based on a discounted cash flow model, resulting in a total valuation adjustment of $36 million pre-tax ($23 million after tax) included in loss from sale of discontinued operations. Subsequent to closing, the OneBeacon Surplus Notes are included in OneBeacon’s investment portfolio, categorized within other long-term investments, and subsequent changes in value thereon are reflected in continuing operations. See “Critical Accounting Estimates” on page 65 for a sensitivity analysis of potential changes in these key variables that can impact the estimated fair value of the OneBeacon Surplus Notes and “Summary of Investment Results” on page 50 for a discussion and analysis of White Mountains’s investment returns. HG Global/BAM The following table presents the components of pre-tax income included in White Mountains’s HG Global/BAM segment related to the consolidation of HG Global, which includes HG Re and its other wholly-owned subsidiaries, and BAM for the years ended December 31, 2016, 2015 and 2014: Year Ended December 31, 2016 Millions HG Global BAM Eliminations Total Gross written premiums $ - $ 38.6 $ - $ 38.6 Assumed (ceded) written premiums 27.2 (27.2 ) - - Net written premiums $ 27.2 $ 11.4 $ - $ 38.6 Earned insurance and reinsurance premiums $ 4.4 $ 1.5 $ - $ 5.9 Net investment income 2.2 6.8 - 9.0 Net investment income - BAM Surplus Notes 17.8 - (17.8 ) - Net realized and unrealized investment gains .1 .6 - .7 Other revenue - 1.1 - 1.1 Total revenues 24.5 10.0 (17.8 ) 16.7 Insurance and reinsurance acquisition expenses .9 2.5 - 3.4 Other underwriting expenses - .4 - .4 General and administrative expenses 1.4 38.2 - 39.6 Interest expense - BAM Surplus Notes - 17.8 (17.8 ) - Total expenses 2.3 58.9 (17.8 ) 43.4 Pre-tax income (loss) $ 22.2 $ (48.9 ) $ - $ (26.7 ) Supplemental information: Member Surplus Contributions(1) $ - $ 38.0 $ - $ 38.0 Year Ended December 31, 2015 Millions HG Global BAM Eliminations Total Gross written premiums $ - $ 25.9 $ - $ 25.9 Assumed (ceded) written premiums 19.3 (19.3 ) - - Net written premiums $ 19.3 $ 6.6 $ - $ 25.9 Earned insurance and reinsurance premiums $ 2.5 $ .8 $ - $ 3.3 Net investment income 1.9 4.2 - 6.1 Net investment income - BAM Surplus Notes 15.8 - (15.8 ) - Net realized and unrealized investment (losses) gains (.3 ) .9 - .6 Other revenue - .7 - .7 Total revenues 19.9 6.6 (15.8 ) 10.7 Insurance and reinsurance acquisition expenses .6 2.3 - 2.9 Other underwriting expenses - .4 - .4 General and administrative expenses 1.4 35.4 - 36.8 Interest expense - BAM Surplus Notes - 15.8 (15.8 ) - Total expenses 2.0 53.9 (15.8 ) 40.1 Pre-tax income (loss) $ 17.9 $ (47.3 ) $ - $ (29.4 ) Supplemental information: Member Surplus Contributions(1) $ - $ 29.2 $ - $ 29.2 Year Ended December 31, 2014 Millions HG Global BAM Eliminations Total Gross written premiums $ - $ 16.2 $ - $ 16.2 Assumed (ceded) written premiums 12.3 (12.3 ) - - Net written premiums $ 12.3 $ 3.9 $ - $ 16.2 Earned insurance and reinsurance premiums $ 1.4 $ .4 $ - $ 1.8 Net investment income 1.4 5.7 - 7.1 Net investment income - BAM Surplus Notes 15.7 - (15.7 ) - Net realized and unrealized investment gains 1.7 6.6 - 8.3 Other revenue - .6 - .6 Total revenues 20.2 13.3 (15.7 ) 17.8 Insurance and reinsurance acquisition expenses .3 1.8 - 2.1 Other underwriting expenses - .4 - .4 General and administrative expenses 1.6 35.9 - 37.5 Interest expense - BAM Surplus Notes - 15.7 (15.7 ) - Total expenses 1.9 53.8 (15.7 ) 40.0 Pre-tax income (loss) $ 18.3 $ (40.5 ) $ - $ (22.2 ) Supplemental information: Member Surplus Contributions(1) $ - $ 16.2 $ - $ 16.2 (1) Member Surplus Contributions are recorded directly to BAM’s equity, which is recorded as non-controlling interest on White Mountains’s balance sheet. HG Global/BAM Results-Year Ended December 31, 2016 versus Year Ended December 31, 2015 BAM is a mutual insurance company whose affairs are managed on a statutory accounting basis, and it does not report stand-alone GAAP financial results. BAM is owned by its members, the municipalities that purchase BAM’s insurance for their debt issuances. BAM charges an insurance premium on each municipal bond insurance policy it insures. A portion of the premium is a Member Surplus Contribution, which is contributed to BAM’s qualified statutory capital and conveys to the issuer certain interests in BAM, including the right to receive dividends in the future, subject to regulatory approval. The remainder is a risk premium, which is recorded as gross written premiums. In 2016, BAM insured $11.3 billion of municipal bonds, $10.3 billion of which were in the primary market, up 7% from 2015. The average total premium (including both risk premiums and Member Surplus Contributions), weighted by insured par, of insurance provided by BAM in the primary and secondary markets in 2016 was 68 basis points, up from 52 basis points in 2015. HG Global reported GAAP pre-tax income of $22 million and $18 million in 2016 and 2015, which was driven by $18 million and $16 million of interest income on the BAM Surplus Notes. As a mutual insurance company that is owned by its members, BAM’s results do not affect White Mountains’s book value per share and adjusted book value per share. However, White Mountains is required to consolidate BAM’s results in its GAAP financial statements and its results are attributed to non-controlling interests. White Mountains reported $49 million of GAAP pre-tax losses on BAM in 2016, driven by $18 million of interest expense on the BAM Surplus Notes and $38 million of operating expenses, compared to $47 million of pre-tax losses in 2015, driven by $16 million of interest expense on the BAM Surplus Notes and $35 million of operating expenses. BAM’s “claims paying resources” represent the capital and other financial resources BAM has available to pay claims and, as such, is a key indication of BAM’s financial strength. BAM’s claims-paying resources include BAM’s qualified statutory capital, including Member Surplus Contributions, net unearned premiums, contingency reserves, present value of future installment premiums and the first loss reinsurance protection provided by HG Re, which is collateralized and held in trusts. BAM expects Member Surplus Contributions and HG Re’s reinsurance protection to be the primary drivers of continued growth of its claims-paying resources. In 2016, BAM’s claims paying resources increased 7% to $644 million at December 31, 2016. The increase was primarily driven by $38 million of Member Surplus Contributions and a $26 million increase in the HG Re collateral trusts, partially offset by BAM’s 2016 statutory net loss of $33 million. The following table presents BAM’s total claims paying resources as of December 31, 2016 and 2015: Millions As of December 31, 2016 As of December 31, 2015 Policyholders’ surplus $ 431.5 $ 437.2 Contingency reserve 22.7 12.4 Qualified statutory capital 454.2 449.6 Net unearned premiums 23.2 12.5 Present value of future installment premiums 3.3 2.6 Collateral trusts 163.0 136.6 Claims paying resources $ 643.7 $ 601.3 HG Global/BAM Results-Year Ended December 31, 2015 versus Year Ended December 31, 2014 In 2015, BAM insured $10.6 billion of municipal bonds, $10.0 billion of which were in the primary market, up 36% from 2014. The average total premium (including both risk premiums and Member Surplus Contributions), weighted by insured par, of insurance provided by BAM in the primary and secondary markets in 2015 was 52 basis points, up from 43 basis points in 2014. HG Global reported GAAP pre-tax income of $18 million in both 2015 and 2014, which was driven by $16 million of interest income on the BAM Surplus Notes in both periods. White Mountains reported $47 million of GAAP pre-tax losses on BAM in 2015, driven by $16 million of interest expense on the BAM Surplus Notes and $35 million of operating expenses, compared to $41 million of pre-tax losses in 2014, driven by $16 million of interest expense on the BAM Surplus Notes and $36 million of operating expenses, partially offset by $7 million of net realized and unrealized investment gains. In 2015, BAM’s claims paying resources increased 3% to $601 million at December 31, 2015. The increase was primarily driven by $29 million of Member Surplus Contributions and a $17 million increase in the HG Re collateral trusts, partially offset by BAM’s 2015 statutory net loss of $32 million. The following table presents BAM’s total claims paying resources as of December 31, 2015 and 2014: Millions As of December 31, 2015 As of December 31, 2014 Policyholders’ surplus $ 437.2 $ 448.7 Contingency reserve 12.4 4.7 Qualified statutory capital 449.6 453.4 Net unearned premiums 12.5 6.4 Present value of future installment premiums 2.6 1.4 Collateral trusts 136.6 120.0 Claims paying resources $ 601.3 $ 581.2 The following table presents amounts from HG Global, which includes HG Re and its other wholly-owned subsidiaries, and BAM that are contained within White Mountains’s consolidated balance sheet as of December 31, 2016 and 2015: As of December 31, 2016 Millions HG Global BAM Eliminations and Segment Adjustment Total Segment Assets Fixed maturity investments $ 155.2 $ 430.0 $ - $ 585.2 Short-term investments 6.4 38.1 - 44.5 Total investments 161.6 468.1 - 629.7 Cash 1.9 25.1 - 27.0 BAM Surplus Notes 503.0 - (503.0 ) - Accrued interest receivable on BAM Surplus Notes 108.0 - (108.0 ) - Other assets 12.5 39.9 (1.0 ) 51.4 Total assets $ 787.0 $ 533.1 $ (612.0 ) $ 708.1 Liabilities BAM Surplus Notes(1) $ - $ 503.0 $ (503.0 ) $ - Accrued interest payable on BAM Surplus Notes(2) - 108.0 (108.0 ) - Preferred dividends payable to White Mountains's subsidiaries(3) 180.5 - - 180.5 Preferred dividends payable to non-controlling interests 5.7 - - 5.7 Other liabilities 61.4 73.0 (1.0 ) 133.4 Total liabilities 247.6 684.0 (612.0 ) 319.6 Equity White Mountains’s common shareholders’ equity 522.8 - - 522.8 Non-controlling interests 16.6 (150.9 ) - (134.3 ) Total equity 539.4 (150.9 ) - 388.5 Total liabilities and equity $ 787.0 $ 533.1 $ (612.0 ) $ 708.1 As of December 31, 2015 Millions HG Global BAM Eliminations and Segment Adjustment Total Segment Assets Fixed maturity investments $ 130.6 $ 417.0 $ - $ 547.6 Short-term investments 5.6 43.3 - 48.9 Total investments 136.2 460.3 - 596.5 Cash .1 15.8 - 15.9 BAM Surplus Notes 503.0 - (503.0 ) - Accrued interest receivable on BAM Surplus Notes 90.2 - (90.2 ) - Other assets 9.5 26.8 (.8 ) 35.5 Total assets $ 739.0 $ 502.9 $ (594.0 ) $ 647.9 Liabilities BAM Surplus Notes(1) $ - $ 503.0 $ (503.0 ) $ - Accrued interest payable on BAM Surplus Notes(2) - 90.2 (90.2 ) - Preferred dividends payable to White Mountains's subsidiaries(3) 135.4 - - 135.4 Preferred dividends payable to non-controlling interests 4.3 - - 4.3 Other liabilities 41.5 49.7 (.8 ) 90.4 Total liabilities 181.2 642.9 (594.0 ) 230.1 Equity White Mountains’s common shareholders’ equity 540.7 - - 540.7 Non-controlling interests 17.1 (140.0 ) - (122.9 ) Total equity 557.8 (140.0 ) - 417.8 Total liabilities and equity $ 739.0 $ 502.9 $ (594.0 ) $ 647.9 (1) Under GAAP, the BAM Surplus Notes are classified as debt by the issuer. Under U.S. Statutory accounting, they are classified as Surplus. (2) Under GAAP, interest accrues daily on the BAM Surplus Notes. Under U.S. Statutory accounting, interest is not accrued on the BAM Surplus Notes until it has been approved for payment by insurance regulators. (3) For segment reporting, the HG Global preferred dividend receivable at White Mountains is reclassified from the Other Operations segment to the HG Global/BAM segment. Dividends on HG Global preferred shares payable to White Mountains’s subsidiaries are eliminated in White Mountains’s consolidated financial statements. The following table presents the gross par value of policies priced and closed by BAM for the years ended December 31, 2016 and 2015: Year Ended December 31, Millions Gross par value of primary market policies priced $ 10,390.5 $ 9,911.8 Gross par value of secondary market policies priced 967.4 611.1 Total gross par value of market policies priced 11,357.9 10,522.9 Less: Gross par value of policies priced yet to close (353.2 ) (298.6 ) Gross par value of policies closed that were previously priced 298.6 381.7 Total gross par value of market policies issued $ 11,303.3 $ 10,606.0 Other Operations A summary of White Mountains’s financial results from its Other Operations segment for the years ended December 31, 2016, 2015 and 2014 follows: Year Ended December 31, Millions Earned insurance premiums $ 7.5 $ 8.7 $ 6.1 Net investment income 27.2 8.8 9.0 Net realized and unrealized investment (losses) gains (28.1 ) 259.9 29.8 Other revenue-MediaAlpha 116.5 105.5 65.3 Other revenue - other 26.5 41.7 16.4 Total revenues 149.6 424.6 126.6 Losses and LAE 8.0 8.2 8.9 Insurance and reinsurance acquisition expenses 2.2 3.4 .8 Other underwriting expenses .1 - - General and administrative expenses-MediaAlpha 109.6 99.0 60.6 General and administrative expenses-amortization of intangible assets 11.3 9.3 6.9 General and administrative expenses - other 125.2 141.7 97.7 Interest expense on debt 3.0 1.6 1.2 Total expenses 259.4 263.2 176.1 Pre-tax (loss) income $ (109.8 ) $ 161.4 $ (49.5 ) Other Operations Results-Year Ended December 31, 2016 versus Year Ended December 31, 2015 White Mountains’s Other Operations segment reported pre-tax loss of $110 million in 2016 compared to pre-tax income of $161 million in 2015. The decrease is primarily due to the recognition of a $259 million unrealized investment gain on White Mountains’s investment in Symetra in the fourth quarter of 2015. This gain was the result of a change in accounting for the investment in Symetra from the equity method to fair value, caused by White Mountains’s relinquishment of its representation on Symetra’s board of directors subsequent to Symetra entering into a merger agreement with Sumitomo Life. White Mountains’s Other Operations segment reported net realized and unrealized investment losses of $28 million in 2016, compared to net realized and unrealized investment gains of $260 million in 2015, which included the gain from Symetra. The net realized and unrealized investment losses for the year ended December 31, 2016 included $21 million of losses in two private equity investments. See “Summary of Investment Results” on page 50. The Other Operations segment reported net investment income of $27 million in 2016 compared to $9 million in 2015, driven by a higher invested asset base resulting primarily from the sale of Sirius Group. Other revenues in 2016 includes $117 million from MediaAlpha compared to $106 million from MediaAlpha in 2015. Other revenue also includes a $20 million pre-tax gain in 2015 from the sale of Hamer LLC, a small manufacturing company that White Mountains received in 2012 in connection with the liquidation of a limited partnership fund. In addition, other revenues in 2016 included third-party investment management fee income at WM Advisors of $10 million, compared to $13 million in 2015. General and administrative expenses in 2016 included $110 million from MediaAlpha compared to $99 million from MediaAlpha in 2015. General and administrative expenses decreased in the year ended December 31, 2016 compared to the year ended December 31, 2015 as compensation expenses during 2016, driven by the rising market price of White Mountains’s common shares, were more than offset by the impact from $36 million of incentive compensation expense recorded during 2015 related to the agreements to sell Sirius Group and Symetra. WM Life Re reported losses of $3 million in 2016 compared to $6 million in 2015. WM Life Re has completed its run-off as all of its contracts matured as of June 30, 2016. See Note 9 - “Derivatives” on page for details regarding WM Life Re’s total impact on White Mountains’s statement of operations. During the year ended December 31, 2016, White Mountains wrote down its investment in the SSIE Surplus Notes, which reduced book value per share by approximately $4. White Mountains consolidates SSIE, the issuer of the SSIE Surplus Notes. As a result, the impact of the write down is eliminated in pre-tax income. However, the write down resulted in a $21 million decrease to White Mountains’s book value and a corresponding increase to non-controlling interest equity. Share repurchases. White Mountains repurchased and retired 1,106,145 of its common shares for $887 million in 2016 at an average price per share of $802.08, or approximately 101% of White Mountains’s December 31, 2016 adjusted book value per share. Other Operations Results-Year Ended December 31, 2015 versus Year Ended December 31, 2014 White Mountains’s Other Operations segment reported pre-tax income of $161 million in 2015 compared to a pre-tax loss of $50 million in 2014. White Mountains’s Other Operations segment reported net realized and unrealized investment gains of $260 million in 2015 compared to $30 million in 2014, primarily related to the $259 million unrealized investment gain from the investment in Symetra common shares. See “Summary of Investment Results” on page 50. The Other Operations segment reported net investment income of $9 million in both 2015 and 2014. Other revenues in 2015 includes $106 million from MediaAlpha compared to $65 million from MediaAlpha in 2014. Other revenue also includes a $20 million pre-tax gain in 2015 from the sale of Hamer LLC, a small manufacturing company that White Mountains received in 2012 in connection with the liquidation of a limited partnership fund. In addition, other revenues in 2015 included third-party investment management fee income at WM Advisors of $13 million, compared to $17 million in 2014. General and administrative expenses in 2015 included $99 million from MediaAlpha compared to $61 million from MediaAlpha in 2014. General and administrative expenses also included $36 million of increased incentive compensation expense recorded in connection with the agreements to sell Sirius Group and Symetra. WM Life Re reported losses of $6 million in 2015 compared to $9 million in 2014. See Note 9 - “Derivatives” on page for details regarding WM Life Re’s total impact on White Mountains’s statement of operations. White Mountains’s Other Operations segment reported a $4 million GAAP pre-tax loss relating to SSIE in 2015 compared to $12 million in 2014. As a reciprocal insurance exchange that is owned by its policyholders, SSIE’s results are attributed to non-controlling interests and do not affect White Mountains’s adjusted book value per share. Share repurchases. White Mountains repurchased and retired 387,495 of its common shares for $284 million in 2015 at an average price per share of $733.37, or approximately 105% of White Mountains’s December 31, 2015 adjusted book value per share. The average share price paid was approximately 94% of White Mountains’s December 31, 2015 adjusted book value per share including the estimated gain from the Sirius Group transaction as of December 31, 2015 of $84.02 per share. Discontinued Operations During 2016, 2015 and 2014, White Mountains entered into a number of sale transactions that have been accounted for as discontinued operations within its consolidated financial statements. See Note 22 - “Held for Sale and Discontinued Operations” on page for detailed financial information on each business sold. Sirius Group Sirius Group Results-Period Ended April 18, 2016 On April 18, 2016, White Mountains completed the sale of Sirius Group to CMI. Sirius Group’s results inured to White Mountains until the closing date of the transaction. For the 2016 period, White Mountains reported Sirius Group’s comprehensive income of $27 million and a combined ratio of 102%, which was driven by $17 million of recorded losses from the Ecuador earthquake that occurred on April 16, 2016. Sirius Group Results-Year Ended December 31, 2015 versus Year Ended December 31, 2014 Sirius Group's GAAP combined ratio was 85% for the year ended December 31, 2015 compared to 76% for 2014. Loss and expense ratios for the 2015 periods were increased by a higher frequency of non-catastrophe per risk and pro rata loss events, which primarily impacted the property, aviation, contingency, and marine lines of business, as well as continued pressure on rates and terms due to continued competitive market conditions. The 2015 results included $18 million of losses after reinstatement premiums from the Tianjin port explosion. Also, the combined ratios for the year ended December 31, 2015 were higher by 1 point due to the cost of ILW covers purchased to mitigate the potential impact of major events on Sirius Group’s balance sheet pending the close of the sale to CMI. The 2015 period included 3 points of catastrophe losses, primarily from the Chennai flood in Southern India and winter storms in the Northeastern United States, compared to 7 points in 2014. Favorable net loss reserve development was 6 points in 2015 primarily due to decreases in casualty and property loss reserves, compared to 11 points of favorable net loss reserve development in 2014. Reinsurance protection. In addition to the ILW covers, Sirius Group’s reinsurance protection primarily consists of pro-rata and excess of loss protections to cover aviation, trade credit, and certain accident and health and property exposures. Sirius Group’s proportional reinsurance programs provide protection for part of the non-proportional treaty accounts written in Europe, the Americas, Asia, the Middle East and Australia. This reinsurance is designed to increase underwriting capacity where appropriate, and to reduce exposure both to large catastrophe losses and to a frequency of smaller loss events. Attachment points and coverage limits vary by region and line of business around the world. Sirius Group’s net combined ratio was 6 points higher than the gross combined ratio for the year ended December 31, 2015 and 1 point lower than the gross combined ratio for 2014. In 2015, the net combined ratio was higher than the gross combined ratio primarily due to the cost of property retrocessional coverage, including the ILW covers, with limited or no loss recoveries. In 2014, the net combined ratio was lower than the gross combined ratio because ceded loss recoveries, primarily in the accident and health and aviation lines, mostly offset the premiums ceded under Sirius Group’s reinsurance protection programs. Tranzact On July 21, 2016, White Mountains completed the sale of Tranzact to an affiliate of Clayton, Dubilier & Rice, LLC. Tranzact's results inured to White Mountains until the closing date of the transaction. For the 2016 period, White Mountains reported Tranzact's net loss from discontinued operations of $3 million. Tranzact’s results were near break-even for the year ended December 31, 2015. OneBeacon Runoff For the year ended 2015, White Mountains recorded $0.3 million to the gain from sale of discontinued operations related to an adjustment on the estimated loss on sale of the Runoff Transaction, which included the final settlement of certain post-closing items. For year ended 2015, the net loss from discontinued operations relating to the Runoff Transaction, net of tax, was $0.5 million. During 2014, OneBeacon recorded a $19 million net loss on sale of discontinued operations on the Runoff Transaction, which included a $24 million after-tax loss from the change in the estimated value of the OneBeacon Surplus Notes issued with the Runoff Transaction, partially offset by a reduction in the loss on sale from the Runoff Transaction related to the change in the treatment of the $7 million pre-tax ($5 million after-tax) reserve charge recorded during the second quarter of 2013. Previously, OneBeacon expected that the Runoff Business Stock Purchase Agreement (“Runoff SPA”) would be amended to provide for the transfer of $7 million of additional assets to support the reserve charge. The Runoff SPA was instead revised to increase the cap on seller financing. Esurance During 2015 and 2014, White Mountains recognized $18 million and $3 million of net income from discontinued operations related to the final settlement with Allstate for favorable development on loss reserves transferred in the sale of Esurance and Answer Financial. Since the closing of the transaction through September 30, 2015, White Mountains received a net amount of $28 million from Allstate, primarily related to the favorable development on loss reserves. II. Summary of Investment Results White Mountains’s total operations investment results include continuing operations and discontinued operations. During the third quarter of 2015, White Mountains signed an agreement to sell Sirius Group, which closed on April 18, 2016. Sirius Group’s results inured to White Mountains through the closing date of the transaction. During the third quarter of 2016, White Mountains established a portfolio of high-yield fixed maturity investments. Given the risk profile of these investments, White Mountains’s management believes that the returns associated with high-yield fixed maturity investments are more appropriately included with the returns from common equity securities and other long-term investments instead of with returns associated with short-term investments and investment grade fixed maturity investments. See “NON-GAAP FINANCIAL MEASURES” on page 64. For purposes of discussing rates of return, all percentages are presented gross of management fees and trading expenses in order to produce a better comparison to benchmark returns, while all dollar amounts are presented net of management fees and trading expenses. A summary of White Mountains’s consolidated total operations’ pre-tax investment results, including the returns from discontinued operations, for the years ended December 31, 2016, 2015 and 2014 follows: Gross investment returns and benchmark returns Year Ended December 31, Short-term investments 0.8 % (0.9 )% (2.0 )% Investment grade fixed maturity investments 2.6 % 0.3 % 0.9 % High-yield fixed maturity investments 1.0 % N/A N/A Total GAAP fixed income investments(1) 2.4 % 0.2 % 0.5 % Bloomberg Barclays U.S. Intermediate Aggregate Index 2.0 % 1.2 % 4.1 % Common equity securities 6.2 % 33.2 % 7.5 % Other long-term investments 0.8 % (10.1 )% 6.5 % Total GAAP common equity securities and other long-term investments 4.3 % 19.3 % 7.2 % Total common equity securities, other long-term investments and high-yield fixed maturity investments 4.0 % 19.3 % 7.2 % S&P 500 Index (total return) 12.0 % 1.4 % 13.7 % Total consolidated portfolio 2.7 % 3.6 % 1.9 % (1) The impact of excluding high-yield fixed maturity investments from the GAAP fixed maturity investment returns was insignificant in 2016. Investment Returns-Year Ended December 31, 2016 versus Year Ended December 31, 2015 White Mountains’s GAAP pre-tax total return on invested assets was 2.7% for 2016, which included 0.2% from foreign currency gains, compared to 3.6% for 2015, which included 0.9% from foreign currency losses. The 2015 results were primarily driven by $259 million in pre-tax unrealized investment gains recognized in the fourth quarter of 2015 resulting from the Symetra transaction. Excluding the results from Symetra, the GAAP total return on invested assets was -0.2% for 2015, which included 0.9% from foreign currency losses. White Mountains’s total operations after-tax net realized and unrealized investment gains were $2 million and $203 million for 2016 and 2015. Fixed income results White Mountains maintains a high quality, short-duration fixed income portfolio, as well as the recently established high-yield portfolio, which is discussed in the next section. As of December 31, 2016, the fixed income portfolio duration, including short-term investments but excluding high-yield fixed maturity investments, was approximately 2.6 years compared to 2.2 years as of December 31, 2015. Including both short-term investments and high-yield fixed maturity investments, duration was approximately 2.8 years as of December 31, 2016. The increase in the fixed income portfolio’s duration was primarily a result of buying into the fourth-quarter bond market selloff and the establishment of a new medium duration British Pound Sterling (GBP) investment grade corporate bond mandate with Legal & General Investment Management, Ltd. (“LGIM”), a third party registered investment adviser, in October 2016. The duration of the LGIM portfolio was approximately 7.3 years as of December 31, 2016. White Mountains entered into a foreign currency forward contract to manage its GBP foreign currency exposure relating to this new mandate. As of December 31, 2016, this contract had a total gross notional value of approximately $185 million (GBP 150 million). While White Mountains actively manages its overall foreign currency position, mismatches between movements in foreign currency rates and its foreign currency forward contract may result in foreign currency positions being outside pre-defined ranges and/or foreign currency losses. The results of White Mountains’s forward foreign currency contract is included in other long-term investments. The fixed income portfolio returned 2.4% for 2016. In local currencies, the fixed income portfolio returned 2.1% for 2016, essentially in-line with the longer duration Bloomberg Barclays U.S. Intermediate Aggregate Index return of 2.0%. The fixed income portfolio returned 0.2% for 2015. In local currencies, the fixed income portfolio returned 1.1% for 2015, essentially in-line with the longer duration Bloomberg Barclays U.S. Intermediate Aggregate Index return of 1.2%. Common equity securities, other long-term investments, and high-yield fixed maturity investments results White Mountains maintains a portfolio of common equity securities, other long-term investments and high-yield fixed maturity investments. White Mountains’s management believes that prudent levels of investments in common equity securities, other long-term investments and high-yield fixed maturity investments are likely to enhance long-term after-tax total returns. White Mountains’s portfolio of common equity securities, other long-term investments and high-yield fixed maturity investments represented approximately 20% and 23% of total GAAP invested assets as of December 31, 2016 and December 31, 2015. When reflecting the close of the Symetra sale on February 1, 2016 and the close of the Sirius Group sale on April 18, 2016, White Mountains’s portfolio of common equity securities and other long-term investments represented approximately 12% of total GAAP invested assets as of December 31, 2015. White Mountains’s portfolio of common equity securities, other long-term investments and high-yield fixed maturity investments returned 4.0% for 2016, underperforming the S&P 500 Index return of 12.0%. The underperformance versus the S&P 500 Index return was primarily attributable to the overall conservative positioning of the risk asset portfolio, including the new high-yield mandate, which we do not expect to keep pace with strong up markets. The underperformance was also due to unfavorable results from publicly-traded common equity securities managed by third party investment advisers and pockets of poor performance in other long-term investments, including unfavorable results from private capital investments and private equity funds and non-controlling interests in private capital investments. White Mountains’s portfolio of common equity securities and other long-term investments returned 19.3% for 2015. Excluding the results from Symetra, the portfolio of common equity securities and other long-term investments returned -1.8% for 2015, underperforming the S&P 500 Index return of 1.4%. The underperformance versus the S&P 500 Index return was primarily attributable to unfavorable mark-to-market adjustments to the OneBeacon Surplus Notes and unfavorable results from energy exposed private equity funds and a distressed hedge fund. White Mountains’s portfolio of common equity securities returned 6.2% for 2016, underperforming the S&P 500 Index return of 12.0%. White Mountains’s portfolio of common equity securities returned 33.2% for 2015. Excluding the results from Symetra, the portfolio of common equity securities returned 2.9% for 2015, outperforming the S&P 500 Index return of 1.4%. White Mountains invests in ETFs that seek to provide investment results that, before expenses, generally correspond to the performance of broad market indices. As of December 31, 2016 and December 31, 2015, White Mountains had approximately $322 million and $356 million invested in ETFs. The following summarizes White Mountains’s investments in ETFs by exposure to each index: Index Market Value Market Value Millions December 31, 2016 December 31, 2015 S&P 500 $ 321.6 $ 297.3 Russell 1000 Value - 40.8 Russell 1000 - 17.7 Total $ 321.6 $ 355.8 In 2016 and 2015, the ETFs essentially earned the effective index return, before expenses, over the period in which White Mountains was invested in each respective fund. White Mountains has established relationships with third party registered investment advisers to actively manage publicly-traded common equity securities and convertibles. The largest of these relationships have been with Prospector Partners LLC (“Prospector”), Lateef and Silchester. During the second quarter of 2015, White Mountains instructed Prospector to liquidate its separate account portfolios and redeemed its investments in hedge funds managed by Prospector and reallocated a portion of the proceeds into ETFs. White Mountains has since terminated its investment management agreements with Prospector. White Mountains continues to have publicly-traded common equity securities actively managed by Lateef and Silchester. The Lateef separate account is a highly concentrated portfolio of mid-cap and large-cap growth companies. Lateef is a growth at a reasonable price manager focused on investing in high return businesses at reasonable valuations. Lateef uses a bottom up, fundamental research-driven investment process that is focused on absolute returns, low turnover and a long-term investment horizon. As a highly concentrated portfolio of approximately 20 positions, relative performance to the S&P 500 Index return is often driven, positively or negatively, by individual positions, especially in the short-term. The Lateef separate account returned 1.2% for 2016, underperforming the S&P 500 Index return of 12.0%. The Lateef separate account returned 3.6% for 2015, outperforming the S&P 500 Index return of 1.4%. White Mountains has an investment in the Calleva Trust, an open-ended unit trust established as an Undertaking for Collective Investment in Transferable Securities (“UCITS”) under the European Communities Regulations that is managed by Silchester. Silchester invests primarily in value-oriented non-U.S. equity securities. Silchester’s investment strategy focuses on companies with low market multiples of earnings, cash flow, asset value or dividends. In U.S. dollars, the Silchester portfolio returned 8.2% for 2016, underperforming the S&P 500 Index return of 12.0%. In local currencies, the Silchester portfolio returned 12.5% for 2016, outperforming the MCSI EAFE Index return of 5.3%. In U.S. dollars, the Silchester portfolio returned 1.2% for 2015, underperforming the S&P 500 Index return of 1.4%. In local currencies, the Silchester portfolio returned 6.5% for 2015, outperforming the MCSI EAFE Index return of 5.3%. White Mountains maintains a portfolio of other long-term investments that consists primarily of hedge funds, private equity funds, various non-controlling interests in private capital investments, the OneBeacon Surplus Notes and various other investments. As of December 31, 2016, approximately 41% of these other long-term investments were in private equity funds, with a general emphasis on narrow, sector-focused funds, and hedge funds, with a general emphasis on long-short equity funds. White Mountains’s other long-term investments portfolio returned 0.8% for 2016, underperforming the S&P 500 Index return of 12.0%. The portfolio’s underperformance versus the S&P 500 Index return was primarily attributable to write-downs in private equity funds and non-controlling interests in private capital investments partially offset by favorable mark-to-market adjustments to the OneBeacon Surplus Notes. White Mountains’s other long-term investments portfolio returned -10.1% for 2015, underperforming the S&P 500 Index return of 1.4%. The portfolio’s underperformance versus the S&P 500 Index return was primarily due to unfavorable mark-to-market adjustments to the OneBeacon Surplus Notes and write-downs in energy exposed private equity funds and a distressed hedge fund. During the third quarter of 2016, White Mountains established a new relationship with Principal Global Investors, LLC (“Principal”), a third party registered investment adviser, to manage a relatively concentrated portfolio of high-yield fixed maturity investments. The Principal portfolio is invested in issuers of U.S. dollar denominated publicly traded and 144A debt securities issued by corporations with generally at least one rating between "B-" and “BB+” inclusive by Standard and Poor's or similar ratings from other rating agencies. The fair value of the high-yield fixed maturity investments was $275.3 million as of December 31, 2016. The duration of the Principal portfolio was approximately 4.9 years as of December 31, 2016. From its inception in late July through the end of 2016, the high-yield fixed maturity investments returned 1.0%, underperforming the S&P 500 Index return of 4.3% over the comparable period. Investment Returns-Year Ended December 31, 2015 versus Year Ended December 31, 2014 White Mountains’s GAAP pre-tax total return on invested assets was 3.6% for 2015, compared to 1.9% for 2014. The 2015 results were primarily driven by $259 million in pre-tax unrealized investment gains recognized in the fourth quarter of 2015 resulting from the Symetra transaction. The 2015 and 2014 returns included 0.9% and 1.9% of foreign currency losses. Excluding the results from Symetra, the GAAP total return on invested assets was -0.2% for 2015. White Mountains’s total operations after tax realized and unrealized investment gains were $203 million and $214 million for 2015 and 2014. Fixed income results As of December 31, 2015, the fixed income portfolio duration, including short-term investments, was approximately 2.2 years compared to 2.0 years as of December 31, 2014. The fixed income portfolio returned 0.2% for 2015. In local currencies, the fixed income portfolio returned 1.1% for 2015, which was essentially in-line with the longer duration Bloomberg Barclays U.S. Intermediate Aggregate Index return of 1.2%. The fixed income portfolio returned 0.5% for 2014. In local currencies, the fixed income portfolio returned 2.7% for 2014, underperforming the longer duration Bloomberg Barclays U.S. Intermediate Aggregate Index return of 4.1%. The portfolio’s short duration positioning contributed to the underperformance versus the longer duration Bloomberg Barclays U.S. Intermediate Aggregate Index return as interest rates fell in 2014. Common equity securities and other long-term investments results White Mountains’s portfolio of common equity securities and other long-term investments represented approximately 23% and 18% of GAAP invested assets as of December 31, 2015 and December 31, 2014. The portfolio of common equity securities and other long-term investments returned 19.3% for 2015. Excluding the results from Symetra, the portfolio of common equity securities and other long-term investments returned -1.8% for 2015, underperforming the S&P 500 Index return of 1.4%. The underperformance versus the S&P 500 Index return was primarily due to unfavorable mark-to-market adjustments to the OneBeacon Surplus Notes and unfavorable results from energy exposed private equity funds and a distressed hedge fund. The portfolio of common equity securities and other long-term investments returned 7.2% for 2014, underperforming the S&P 500 Index return of 13.7%. White Mountains’s portfolio of common equity securities returned 33.2% for 2015. Excluding the results from Symetra, the portfolio of common equity securities returned 2.9% for 2015, outperforming the S&P 500 Index return of 1.4%. White Mountains’s portfolio of common equity securities returned 7.5% for 2014, underperforming the S&P 500 Index return of 13.7%. During the second quarter of 2015, White Mountains instructed Prospector to liquidate its separate account portfolios and reallocated a portion of the proceeds into ETFs. In 2015, the ETFs earned the effective market return, before expenses, over the period in which White Mountains was invested in each broad market fund. The Lateef separate account, which consists of a highly concentrated portfolio where relative performance to the S&P 500 Index return is often driven, positively or negatively, by individual positions returned 3.6% for 2015, outperforming the S&P 500 Index return of 1.4%. The Lateef separate account returned 6.5% for 2014, underperforming the S&P 500 Index return of 13.7%. White Mountains’s investment in the Calleva Trust, which is managed by Silchester and invests primarily in value-oriented non-U.S. equity securities returned 1.2% in U.S. dollars for 2015, underperforming the S&P 500 Index return of 1.4%. In local currency, the Silchester portfolio returned 6.5% for 2015, outperforming the MCSI EAFE Index return of 5.3%. The Silchester portfolio returned -1.7% in U.S. dollars for 2014, underperforming the S&P 500 Index return of 13.7%. In local currencies, the Silchester portfolio returned 8.6% for 2014, outperforming the MCSI EAFE Index return of 5.9% White Mountains’s other long-term investment portfolio returned -10.1% for 2015, underperforming the S&P 500 Index return of 1.4%. The portfolio’s underperformance versus the S&P 500 Index return was primarily due to unfavorable mark-to-market adjustments to the OneBeacon Surplus Notes and write-downs in energy exposed private equity funds and a distressed hedge fund. For 2014, the other long-term investments portfolio returned 6.5%, underperforming the S&P 500 Index return of 13.7%. Portfolio Composition The following table presents the composition of White Mountains’s total operations investment portfolio as of December 31, 2016 and 2015: As of December 31, 2016 As of December 31, 2015 $ in millions Carrying value % of total Carrying value % of total Fixed maturity investments $ 4,256.8 79.7 % $ 5,013.7 69.1 % Short-term investments 287.1 5.4 563.3 7.8 Common equity securities 474.3 8.9 1,288.3 17.8 Other long-term investments 323.3 6.0 388.0 5.3 Total investments $ 5,341.5 % $ 7,253.3 % The breakdown of White Mountains’s fixed maturity investment as of December 31, 2016 by credit class, based upon issue credit ratings provided by Standard & Poor’s, or if unrated by Standard & Poor’s, long term obligation ratings provided by Moody’s, is as follows: As of December 31, 2016 $ in millions Amortized cost % of total Carrying Value % of total U.S. government and government-sponsored entities(1) $ 938.3 22.0 % $ 930.2 21.9 % AAA/Aaa 991.3 23.2 987.7 23.2 AA/Aa 677.9 15.9 678.2 15.9 A/A 520.0 12.2 520.9 12.2 BBB/Baa 835.2 19.6 838.5 19.7 BB 219.5 5.1 217.0 5.1 B 29.9 .7 30.0 .7 Other/not rated 53.9 1.3 54.3 1.3 Total fixed maturity investments $ 4,266.0 % $ 4,256.8 % (1) Includes mortgage-backed securities, which carry the full faith and credit guaranty of the U.S. government (i.e., GNMA) or are guaranteed by a government sponsored entity (i.e., FNMA, FHLMC). The cost or amortized cost and carrying value of White Mountains’s fixed maturity investments as of December 31, 2016 is presented below by contractual maturity. Actual maturities could differ from contractual maturities because certain borrowers may call or prepay their obligations with or without call or prepayment penalties. As of December 31, 2016 Millions Amortized cost Carrying Value Due in one year or less $ 212.8 $ 213.3 Due after one year through five years 1,272.6 1,270.2 Due after five years through ten years 462.8 458.4 Due after ten years 167.8 168.0 Mortgage and asset-backed securities 2,141.7 2,132.9 Preferred stocks 8.3 14.0 Total fixed maturity investments $ 4,266.0 $ 4,256.8 Foreign Currency Translation The majority of White Mountains’s exposure to foreign currency exchange rate risk was eliminated when Sirius Group was sold to CMI on April 18, 2016. As of December 31, 2016, White Mountains’s remaining gross foreign currency exchange rate risk was approximately $291 million and relates to cash and fixed income securities denominated in GBP, common equity securities managed by Silchester, Wobi and various other consolidated and non-controlling interests in private capital investments. In 2016, White Mountains entered into a foreign currency forward contract to economically hedge the GBP foreign currency exposure in its LGIM portfolio. At December 31, 2016, the fair value of the LGIM portfolio, including cash, was approximately $184 million and White Mountains held $185 million (GBP 150 million) total gross notional value of a foreign currency forward contract, with a fair value of approximately $186 million. At December 31, 2016, White Mountains’s net foreign currency exchange rate risk was approximately $105 million. Investment in Symetra Common Shares During the third quarter of 2015, Symetra announced that it entered into a merger agreement with Sumitomo Life pursuant to which Sumitomo Life would acquire all of the outstanding shares of Symetra. Following the announcement and Symetra shareholders’ November 5, 2015 meeting to approve the transaction, White Mountains relinquished its representation on Symetra’s board of directors. As a result, White Mountains changed its accounting for Symetra common shares from the equity method to fair value. The carrying value per Symetra share used in the calculation of White Mountains’s adjusted book value per share was $31.77 at December 31, 2015. On February 1, 2016, Symetra closed its merger agreement with Sumitomo Life and White Mountains received proceeds of $658 million, or $32 per common share. White Mountains recognized $5 million in pre-tax net investment gains associated with Symetra during 2016. Symetra’s total revenues and net income through September 30, 2015 were $1.6 billion and $90 million. As of September 30, 2015, Symetra had total assets of $35.0 billion and shareholders’ equity of $3.1 billion. Symetra’s total revenues and net income for the year ended December 31, 2014 was $2.2 billion and $254 million. Since inception, White Mountains received a total of $149 million in cash dividends recorded as a reduction of White Mountains investment in Symetra under the equity method. White Mountains received a cash dividend of $2 million in the fourth quarter of 2015 recorded within net investment income. LIQUIDITY AND CAPITAL RESOURCES Operating Cash and Short-term Investments Holding company level. The primary sources of cash for the Company and certain of its intermediate holding companies are expected to be distributions and tax sharing payments received from its insurance and other operating subsidiaries, capital raising activities, net investment income, proceeds from sales and maturities of investments and, from time to time, proceeds from the sales of operating subsidiaries. The primary uses of cash are expected to be repurchases of the Company’s common shares, payments on and repurchases/retirements of its debt obligations, dividend payments to holders of the Company’s common shares and to non-controlling interest holders of OneBeacon Ltd.’s common shares, distributions to non-controlling interest holders of other consolidated subsidiaries, purchases of investments, payments to tax authorities, contributions to operating subsidiaries, operating expenses and, from time to time, purchases of operating subsidiaries. Operating subsidiary level. The primary sources of cash for White Mountains’s insurance and other operating subsidiaries are expected to be premium and fee collections, net investment income, proceeds from sales and maturities of investments, contributions from holding companies, capital raising activities and, from time to time, proceeds from the sales of operating subsidiaries. The primary uses of cash are expected to be claim payments, policy acquisition costs, purchases of investments, payments on and repurchases/retirements of its debt obligations, distributions and tax sharing payments made to holding companies, distributions to non-controlling interest holders, operating expenses and, from time to time, purchases of operating subsidiaries. Both internal and external forces influence White Mountains’s financial condition, results of operations and cash flows. Claim settlements, premium levels and investment returns may be impacted by changing rates of inflation and other economic conditions. In many cases, significant periods of time, sometimes several years or more, may lapse between the occurrence of an insured loss, the reporting of the loss to White Mountains and the settlement of the liability for that loss. The exact timing of the payment of claims and benefits cannot be predicted with certainty. White Mountains’s insurance subsidiaries maintain portfolios of invested assets with varying maturities and a substantial amount of cash and short-term investments to provide adequate liquidity for the payment of claims. Management believes that White Mountains’s cash balances, cash flows from operations, routine sales and maturities of investments and the liquidity provided by White Mountains’s revolving credit facility (the “WTM Bank Facility”), OneBeacon’s revolving credit facility (the “OneBeacon Bank Facility”) and other revolving credit facilities are adequate to meet expected cash requirements for the foreseeable future on both a holding company and insurance subsidiary level. Dividend Capacity Under the insurance laws of the states and jurisdictions that White Mountains’s insurance subsidiaries are domiciled, an insurer is restricted with respect to the timing and the amount of dividends it may pay without prior approval by regulatory authorities. Accordingly, there can be no assurance regarding the amount of such dividends that may be paid by such subsidiaries in the future. Following is a description of the dividend capacity of White Mountains’s insurance and other operating subsidiaries: OneBeacon: OneBeacon’s top-tier regulated U.S. insurance subsidiary, Atlantic Specialty Insurance Company (“ASIC”), has the ability to pay dividends to its immediate parent without the prior approval of regulatory authorities in an amount set by formula based on the lesser of (i) adjusted net investment income, as defined by statute, or (ii) 10% of statutory surplus, in both cases as most recently reported to regulatory authorities, subject to the availability of earned surplus. Based upon the formula described above, as of December 31, 2016, ASIC had the ability to pay $11 million of dividends without prior approval of regulatory authorities. When taking into consideration the rolling 12-month portion of this statutorily-defined calculation, including adjusted net investment income, and the timing of dividends paid, OneBeacon anticipates that ASIC will have the ability to pay dividends of approximately $30 million during 2017. As of December 31, 2016, ASIC had $625 million of statutory surplus and $69 million of earned surplus. During 2016, ASIC paid $27 million of dividends to its immediate parent. In 2017, Split Rock has the ability to distribute statutory capital without the prior approval of the BMA, provided it does not reduce its total statutory capital, as shown in the previous year’s statutory financial statements, by 15% or more. In addition, Split Rock has the ability to pay dividends without the prior notification of regulatory authorities of up to 25% of its previous financial year’s total statutory capital and surplus, subject to meeting all appropriate liquidity and solvency requirements as specified in the Insurance Act of 1978 and the Companies Act of 1981. As of December 31, 2016, Split Rock had $210 million of statutory capital and $60 million of statutory surplus for total statutory capital and surplus of $270 million. Based upon the limitations described above, Split Rock currently has the ability to distribute up to $32 million of statutory capital and pay up to $60 million of dividends during 2017 without the prior approval of regulatory authorities. During 2016, Split Rock paid $25 million of dividends to its immediate parent. During 2016, OneBeacon’s unregulated insurance subsidiaries paid $6 million of dividends to their immediate parent. As of December 31, 2016, OneBeacon’s unregulated insurance subsidiaries had $56 million of net unrestricted cash, short-term investments and fixed maturity investments and $72 million of other long-term investments, consisting of the OneBeacon Surplus Notes. During 2016, OneBeacon Ltd. paid $79 million of regular quarterly dividends to its common shareholders. White Mountains received $60 million of these dividends. As of December 31, 2016, OneBeacon Ltd. and its intermediate holding companies had $65 million of net unrestricted cash, short-term investments and fixed maturity investments and $12 million of common equity securities outside of its regulated and unregulated insurance subsidiaries. HG Global/BAM: As of December 31, 2016, HG Global had $619 million face value of preferred shares outstanding, of which White Mountains owned 96.9%. Holders of the HG Global preferred shares receive cumulative dividends at a fixed annual rate of 6.0% on a quarterly basis, when and if declared by HG Global. HG Global did not declare or pay any preferred dividends in 2016. As of December 31, 2016, HG Global has accrued $186 million of dividends payable to holders of its preferred shares, $180 million of which is payable to White Mountains and eliminated in consolidation. HG Re is a Special Purpose Insurer subject to regulation and supervision by the BMA, but does not require regulatory approval to pay dividends. However, HG Re’s dividend capacity is limited to amounts held outside of the collateral trusts pursuant to the FLRT with BAM. As of December 31, 2016, HG Re had statutory capital and surplus of $467 million, of which $465 million was held in the collateral trusts pursuant to the FLRT with BAM. Effective January 1, 2014, HG Global and BAM agreed to change the interest rate on the BAM Surplus Notes for the five years ending December 31, 2018 from a fixed rate of 8.0% to a variable rate equal to the one-year U.S. treasury rate plus 300 basis points, set annually, which was 3.54% for 2016 and is 3.78% for 2017. Prior to the end of 2018, BAM has the option to extend the variable rate period for an additional three years. At the end of the variable rate period, the interest rate will be fixed at the higher of the then current variable rate or 8.0%. BAM is required to seek regulatory approval to pay interest and principal on the BAM Surplus Notes only when adequate capital resources have accumulated beyond BAM’s initial capitalization and a level that continues to support its outstanding obligations, business plan and ratings. BAM did not pay any interest on the BAM Surplus Notes in 2016. Other Operations: During 2016, WM Advisors did not pay any dividends to its immediate parent. As of December 31, 2016, WM Advisors had $18 million of net unrestricted cash, short-term investments and fixed maturity investments. During 2016, White Mountains paid a $5 million common share dividend. As of December 31, 2016, the Company and its intermediate holding companies had $1,655 million of net unrestricted cash, short-term investments and fixed maturity investments, $286 million of common equity securities and $67 million of other long-term investments included in its Other Operations segment. Insurance Float Insurance float is an important aspect of White Mountains’s insurance operations. Insurance float represents funds that an insurance company holds for a limited time. In an insurance operation, float arises because premiums are collected before losses are paid. This interval can extend over many years. During that time, the insurer invests the funds. When the premiums that an insurer collects do not cover the losses and expenses it eventually must pay, the result is an underwriting loss, which can be considered as the cost of insurance float. One manner to calculate insurance float is to take insurance liabilities and subtract insurance assets. Although insurance float can be calculated using numbers determined under GAAP, insurance float is not a GAAP concept and, therefore, there is no comparable GAAP measure. Insurance float can increase in a number of ways, including through acquisitions of insurance operations, organic growth in existing insurance operations and recognition of losses that do not immediately cause a corresponding reduction in investment assets. Conversely, insurance float can decrease in a number of other ways, including sales of insurance operations, shrinking or runoff of existing insurance operations, the acquisition of operations that do not have substantial investment assets (e.g., an agency) and the recognition of gains that do not cause a corresponding increase in investment assets. It is White Mountains’s intention to generate low-cost float over time through a combination of acquisitions and organic growth in its existing insurance operations. However, White Mountains seeks to increase overall profitability, which sometimes reduces insurance float, such as in the Sirius Group transaction. Certain operational leverage metrics can be measured with ratios that are calculated using insurance float. There are many activities that do not change the amount of insurance float at an insurance company but can have a significant impact on the company’s operational leverage metrics. For example, investment gains and losses, foreign currency gains and losses, debt issuances and repurchases/retirements, common and preferred share issuances and repurchases and dividends paid to shareholders are all activities that do not change insurance float but that can meaningfully impact operational leverage metrics that are calculated using insurance float. The following table illustrates White Mountains’s consolidated insurance float position as of December 31, 2016 and 2015: December 31, $ in millions Continuing Operations Continuing Operations Sirius Group(1) Total Loss and LAE reserves $ 1,365.6 $ 1,389.8 $ 1,644.4 $ 3,034.2 Unearned insurance and reinsurance premiums 658.0 610.5 342.2 952.7 Ceded reinsurance payable 17.0 24.9 67.1 92.0 Funds held under insurance and reinsurance contracts 153.0 137.8 52.9 190.7 Deferred tax on safety reserve - - 279.2 279.2 Insurance liabilities 2,193.6 2,163.0 2,385.8 4,548.8 Cash in regulated insurance and reinsurance subsidiaries $ 13.6 $ 43.9 $ 129.2 $ 173.1 Reinsurance recoverable on paid and unpaid losses 179.5 193.5 293.3 486.8 Insurance and reinsurance premiums receivable 229.9 220.3 323.6 543.9 Funds held by ceding entities - - 90.6 90.6 Deferred acquisition costs 106.9 107.6 74.6 182.2 Ceded unearned insurance and reinsurance premiums 44.2 29.5 87.7 117.2 Insurance assets 574.1 594.8 999.0 1,593.8 Insurance float $ 1,619.5 $ 1,568.2 $ 1,386.8 $ 2,955.0 Insurance float as a multiple of total capital 0.4x 0.3x N/A 0.6x Insurance float as a multiple of White Mountains’s common shareholders’ equity 0.4x 0.4x N/A 0.8x (1) Included in Net Assets Held for Sale. See Note 22-“Held for Sale and Discontinued Operations” on page. During 2016, insurance float from continuing operations increased by $51 million, primarily due to an increase of unrestricted collateral held related to OneBeacon’s surety business. Financing The following table summarizes White Mountains’s capital structure as of December 31, 2016 and 2015: December 31, $ in millions WTM Bank Facility $ - $ 50.0 OneBeacon Bank Facility - - OBH Senior Notes, carrying value 273.2 272.9 MediaAlpha Bank Facility, carrying value 12.7 14.7 Total debt in continuing operations 285.9 337.6 Total debt in discontinued operations (1) - 506.4 Total debt 285.9 844.0 Non-controlling interest - OneBeacon Ltd. 244.6 245.6 Non-controlling interest - SIG Preference Shares - 250.0 Non-controlling interests - other, excluding mutuals and reciprocals 35.8 115.2 Total White Mountains’s common shareholders’ equity 3,603.3 3,913.2 Total capital 4,169.6 5,368.0 Total debt to total capital % % (1) See Note 22 - “Held for Sale and Discontinued Operations” on page. Management believes that White Mountains has the flexibility and capacity to obtain funds externally as needed through debt or equity financing on both a short-term and long-term basis. However, White Mountains can provide no assurance that, if needed, it would be able to obtain additional debt or equity financing on satisfactory terms, if at all. White Mountains has an unsecured revolving credit facility with a syndicate of lenders administered by Wells Fargo Bank, N.A., which has a total commitment of $425 million and a maturity date of August 14, 2018. During 2016, White Mountains borrowed $350 million and repaid $400 million under the WTM Bank Facility. As of December 31, 2016, the WTM Bank Facility was undrawn. On September 29, 2015, OneBeacon Ltd. and OBH, as co-borrowers and co-guarantors, entered into a revolving credit facility administered by U.S. Bank N.A. and also including BMO Harris Bank N.A., which has a total commitment of $65 million and has a maturity date of September 29, 2019. As of December 31, 2016 the OneBeacon Bank Facility was undrawn. The WTM and OneBeacon Bank Facilities contain various affirmative, negative and financial covenants that White Mountains considers to be customary for such borrowings, including certain minimum net worth and maximum debt to capitalization standards. These covenants can restrict White Mountains in several ways, including its ability to incur additional indebtedness. An uncured breach of these covenants could result in an event of default under the WTM or OneBeacon Bank Facilities, which would allow lenders to declare any amounts owed under the WTM or OneBeacon Bank Facilities to be immediately due and payable. In addition, a default under the WTM or OneBeacon Bank Facilities could occur if certain of White Mountains’s subsidiaries fail to pay principal and interest on a credit facility, mortgage or similar debt agreement (collectively, “covered debt”), or fail to otherwise comply with obligations in such covered debt agreements where such a default gives the holder of the covered debt the right to accelerate at least $75 million of principal amount of covered debt. On July 23, 2015, MediaAlpha entered into a credit facility with Opus Bank, which has a total commitment of $20 million and has a maturity date of July 23, 2019 (the “MediaAlpha Bank Facility”). The MediaAlpha Bank Facility consists of a $15 million term loan facility, which had a principal balance of approximately $13 million as of December 31, 2016, and a $5 million revolving credit facility, which was undrawn as of December 31, 2016. The MediaAlpha Bank Facility is secured by the intellectual property and the common stock of MediaAlpha's subsidiaries and contains various affirmative, negative and financial covenants which White Mountains considers to be customary for such borrowings, including a maximum leverage ratio. The MediaAlpha Bank Facility carries a variable interest rate, based on the U.S. dollar LIBOR rate. In November 2012, OBH issued $275 million face value of senior unsecured debt through a public offering, at an issue price of 99.9% (the “OBH Senior Notes”). The net proceeds from the issuance of the OBH Senior Notes were used to repurchase OBH’s previously issued senior notes. The OBH Senior Notes, which are fully and unconditionally guaranteed as to the payment of principal and interest by OneBeacon Ltd., bear an annual interest rate of 4.60%, payable semi-annually in arrears on May 9 and November 9, until maturity on November 9, 2022. The OBH Senior Notes were issued under indentures that contain restrictive covenants which, among other things, limit the ability of OneBeacon Ltd., OBH and their respective subsidiaries to create liens and enter into sale and leaseback transactions and limits the ability of OneBeacon Ltd. and OBH to consolidate, merge or transfer its properties and assets. The indentures do not contain any financial ratios or specified levels of net worth or liquidity to which OneBeacon Ltd. or OBH must adhere. In addition, a failure by OneBeacon Ltd. or OBH or their respective subsidiaries to pay principal and interest on covered debt, where such failure results in the acceleration of at least $75 million of principal amount of covered debt, could trigger the acceleration of the OBH Senior Notes. It is possible that, in the future, one or more of the rating agencies may lower White Mountains’s existing ratings. If one or more of its ratings were lowered, White Mountains could incur higher borrowing costs on future borrowings and its ability to access the capital markets could be impacted. Covenant Compliance At December 31, 2016, White Mountains was in compliance with all of the covenants under all of its debt instruments and expects to remain in compliance for the foreseeable future. Contractual Obligations and Commitments Below is a schedule of White Mountains’s material contractual obligations and commitments as of December 31, 2016: Millions Due in Less Than One Year Due in One to Three Years Due in Three to Five Years Due After Five Years Total Loss and LAE reserves (1)(3) $ 499.8 $ 508.0 $ 187.1 $ 170.7 $ 1,365.6 Debt 5.0 7.9 - 275.0 287.9 Interest on debt 13.2 25.7 25.3 12.6 76.8 Long-term incentive compensation 30.9 81.2 1.8 3.2 117.1 Pension and other benefit plan obligations (2) 10.7 6.5 6.2 25.9 49.3 Operating leases 10.6 17.1 11.7 22.3 61.7 Total contractual obligations and commitments $ 570.2 $ 646.4 $ 232.1 $ 509.7 $ 1,958.4 (1) Represents expected future cash outflows resulting from loss and LAE payments. The amounts presented are gross of reinsurance recoverables on unpaid losses of $173 and net of the discount on OneBeacon’s workers compensation loss and LAE reserves of $2 as of December 31, 2016. (2) Includes expected future cash outflows under OneBeacon’s non-qualified, non-contributory, defined benefit pension plan and 401(k) savings and employee stock ownership plan. OneBeacon’s pension plans were curtailed in 2002. See Note 12 - “Retirement and Postretirement Plans” on page. (3) Excludes amount related to SSIE. See Note 22 - “Held for Sale and Discontinued Operations” on page. White Mountains’s loss reserves do not have contractual maturity dates. However, based on historical payment patterns, the preceding table includes an estimate of when management expects White Mountains’s loss reserves to be paid. The timing of claim payments is subject to significant uncertainty. White Mountains maintains a portfolio of marketable investments with varying maturities and a substantial amount of short-term investments to provide adequate liquidity for the payment of claims. The balances included in the table above regarding White Mountains’s long-term incentive compensation plans include amounts payable for performance shares and units, as well as deferred compensation balances. Exact amounts to be paid for performance shares cannot be predicted with certainty, as the ultimate amounts of these liabilities are based on the future performance of White Mountains and in some cases the market price of the Company’s and OneBeacon Ltd.’s common shares at the time the payments are made. The estimated payments reflected in the table are based on current accrual factors (including performance relative to targets and common share price) and assume that all outstanding balances were 100% vested as of December 31, 2016. There are no provisions within White Mountains’s operating leasing agreements that would trigger acceleration of future lease payments. The capital lease that OneBeacon entered into in conjunction with the sale-leaseback of certain of OneBeacon’s fixed assets and capitalized software contains provisions that could trigger an event of default, including a failure to make payments when due under the capital lease. If an event of default were to occur, the lessor would have a number of remedies available including the acceleration of future lease payments or the possession of the property covered under the lease agreement. White Mountains does not finance its operations through the securitization of its trade receivables, through special purpose entities or through synthetic leases. Further, White Mountains has not entered into any material arrangements requiring it to guarantee payment of third-party debt or lease payments or to fund losses of an unconsolidated special purpose entity. White Mountains also has future binding commitments to fund certain other long-term investments. These commitments, which total approximately $138 million, do not have fixed funding dates and are therefore excluded from the table above. Share Repurchase Programs The Company: White Mountains’s board of directors has authorized the Company to repurchase its common shares, from time to time, subject to market conditions. The repurchase authorizations do not have a stated expiration date. As of February 27, 2017, White Mountains may purchase an additional 878,130 shares under the board authorizations. In addition, from time to time White Mountains has also repurchased its common shares through tender offers that were separately approved by its board of directors. The following table presents common shares repurchased by the Company, as well as the average price per share as a percent of adjusted book value per share. For 2015, the table also presents the average price per share as a percent of adjusted book value per share, including the estimated gain from the Sirius Group sale of $84 per share as of December 31, 2015 that was reported in the Company’s 2015 Form 10-K. Average price per share as % of Adjusted book Average value per share, Shares Cost price Adjusted book including estimated Dates Repurchased (millions) per share value per share gain from Sirius sale Year ended December 31, 2016 1,106,145 $ 887.2 $ 802.08 101% N/A Year ended December 31, 2015 387,495 $ 284.2 $ 733.37 105% 94% Year ended December 31, 2014 217,879 $ 134.5 $ 617.29 93% N/A OneBeacon In 2007, OneBeacon’s board authorized management to repurchase up to $200 million of OneBeacon’s Class A common shares from time to time, subject to market conditions. Shares may be repurchased on the open market or through privately negotiated transactions. This authorization does not have a stated expiration date. Since the inception of this authorization, OneBeacon has repurchased and retired 6.7 million of its Class A common shares. During 2016, OneBeacon repurchased and retired 850,349 of its common shares under the share repurchase authorization for $11 million at an average share price of $12.42. During 2015, OneBeacon repurchased and retired 166,368 of its common shares under the share repurchase authorization for $2 million at an average price of $12.62. During 2014, no shares were repurchased under the share repurchase authorization. The amount of authorization remaining is $75 million as of December 31, 2016. Cash Flows Detailed information concerning White Mountains’s cash flows during 2016, 2015 and 2014 follows: Cash flows from continuing operations for the years ended 2016, 2015 and 2014 Net cash flows (used for) provided from continuing operations was $(131) million, $120 million and $70 million for the years ended 2016, 2015 and 2014. The decrease in cash flow from continuing operations in 2016 relative to 2015 was driven by (i) a decrease at OneBeacon, due primarily to lower collateral received from its Surety business and amounts received in conjunction with exiting its Crop business, lower premium collections, higher incentive compensation payments and a large claim payment at the end of 2016 (which is expected to be mostly offset in 2017 by a recovery under reinsurance and corporate insurance policies, (ii) the settlement of certain liabilities and transaction costs in connection with the sales of Sirius Group and Tranzact, and (iii) an increase in incentive compensation payments in the Other Operations segment in 2016 relative to 2015. Cash flows from continuing operations increased $79 million in 2015 compared to 2014 primarily due to increased cash collateral received from OneBeacon’s Surety business and from higher amounts of cash provided by WTM Life Re from the sale and settlement of derivative instruments as its business ran off. White Mountains does not believe that these trends will have a meaningful impact on its future liquidity or its ability to meet its future cash requirements. Other items affecting cash flows from operations: White Mountains made long-term incentive payments totaling $50 million, $36 million and $38 million during 2016, 2015 and 2014. OneBeacon paid a total of $13 million of interest on the OBH Senior Notes during each of 2016, 2015 and 2014. Cash flows from investing and financing activities for the year ended December 31, 2016 Financing and Other Capital Activities During 2016, the Company declared and paid a $5 million cash dividend to its common shareholders. During 2016, the Company repurchased and retired 1,106,145 of its common shares for $887 million, which included 8,022 common shares repurchased under employee benefit plans. During 2016, the Company borrowed a total of $350 million and repaid a total of $400 million under the WTM Bank Facility. During 2016, OneBeacon Ltd. declared and paid $79 million of cash dividends to its common shareholders. White Mountains received a total of $60 million of these dividends. During 2016, OneBeacon Ltd. repurchased and retired 850,349 shares of its Class A common stock for $11 million. During 2016, HG Global raised $6 million of additional capital through the issuance of preferred shares, 97% of which were purchased by White Mountains. HG Global used $3 million of the proceeds to repay and cancel an internal credit facility with White Mountains. During 2016, BAM received $38 million in Member Surplus Contributions. During 2016, MediaAlpha paid $3 million of dividends, of which $2 million was paid to White Mountains. During 2016, MediaAlpha repaid $2 million of the term loan portion and borrowed $3 million and repaid $3 million under the revolving loan portion of the MediaAlpha Bank Facility. During 2016, Star & Shield borrowed a total of $4 million under an internal revolving credit facility from White Mountains. During 2016, White Mountains contributed $15 million to WM Advisors. During 2016, WM Life Re returned $73 million of capital to White Mountains. Acquisitions and Dispositions On January 7, 2016, Wobi settled its acquisition of the remaining share capital of Cashboard for NIS 16 million (approximately $4 million based upon the foreign exchange spot rate at the date of acquisition). On February 1, 2016, Symetra closed its merger agreement with Sumitomo Life and White Mountains received proceeds of $658 million, or $32.00 per Symetra common share. On February 26, 2016, White Mountains paid $8 million in settlement of the contingent purchase adjustment for its acquisition of MediaAlpha in 2014. On March 8, 2016 and August 3, 2016, White Mountains purchased additional shares in Captricity for a total of approximately $2 million. On April 18, 2016, White Mountains completed the sale of Sirius Group to CMI for approximately $2.6 billion. $162 million of this amount was used to purchase certain assets to be retained by White Mountains out of Sirius Group, including shares of OneBeacon. On various occasions during 2016, White Mountains increased its investment in Wobi through the purchase of newly-issued convertible preferred shares for a total of NIS 36 million (approximately $10 million). As of December 31, 2016, White Mountains’s ownership share of Wobi was 95% on a fully converted basis. On July 21, 2016, White Mountains completed the sale of Tranzact and received net proceeds of $221 million at closing. On October 5, White Mountains received additional proceeds of $1 million following the release of the post-closing purchase price adjustment escrow. On August 4, 2016, White Mountains purchased 110,461 common shares of Buzzmove for GBP 4 million (approximately $5 million) and 54,172 shares of newly issued convertible preferred shares of Buzzmove for GBP 2 million (approximately $3 million), representing a 70.9% ownership share of Buzzmove on a fully converted basis. On October 10, 2016, White Mountains completed the sale of Ashmere and received proceeds of $15 million. Cash flows from investing and financing activities for the year ended December 31, 2015 Financing and Other Capital Activities During 2015, the Company declared and paid a $6 million cash dividend to its common shareholders. During 2015, the Company repurchased and retired 387,495 of its common shares for $284 million, which included 12,156 common shares repurchased under employee benefit plans and 13,500 common shares from the Prospector Offshore Fund redemption. During 2015, the Company borrowed a total of $125 million and subsequently repaid a total of $75 million under the WTM Bank Facility. During 2015, OneBeacon Ltd. declared and paid $80 million of cash dividends to its common shareholders. White Mountains received a total of $60 million of these dividends. During 2015, BAM received $29 million in Member Surplus Contributions. During 2015, MediaAlpha paid $4 million of dividends, of which approximately $2 million was paid to White Mountains. During 2015, MediaAlpha borrowed $15 million under the term loan portion of the MediaAlpha Bank Facility and used the proceeds to make a $15 million return of capital payment to its unit holders, of which White Mountains received $9 million. During 2015, White Mountains provided approximately $13 million of additional growth capital to Compare.com. During 2015, White Mountains contributed $8 million to WM Life Re. During 2015, WM Life Re repaid $23 million under an internal revolving credit facility with an intermediate holding company of White Mountains. Acquisitions and Dispositions On February 23, 2015, Wobi acquired 56.2% of the outstanding share capital of Cashboard for NIS 10 million (approximately $2 million based upon the foreign exchange spot rate at the date of acquisition). During the second quarter of 2015, Wobi purchased newly issued common shares of Cashboard for NIS 10 million (approximately $3 million). During 2015, White Mountains increased its ownership interest in Wobi through (i) the purchase of common and convertible preferred shares from a non-controlling interest shareholder for NIS 35 million (approximately $9 million) and (ii) the purchase of newly-issued convertible preferred shares for NIS 56 million (approximately $15 million). As of December 31, 2015, White Mountains’s ownership share of Wobi was 96.1% on a fully converted basis. On April 2, 2015, White Mountains closed on its investment in PassportCard, a 50/50 joint venture with DavidShield and contributed $21 million of assets to a newly formed entity, PassportCard Limited (formerly PPCI Global Limited). On May 27, 2015, White Mountains sold its interest in Hamer LLC and received cash proceeds of $24 million. On December 21, 2015, White Mountains purchased a non-controlling interest in Captricity for approximately $27 million. On December 22, 2015, White Mountains closed on its investment in OneTitle for approximately $3 million. During 2015, White Mountains purchased $4 million of SSIE Surplus Notes, which increased its investment in SSIE Surplus Notes to $21 million as of December 31, 2015. Cash flows from investing and financing activities for the year ended December 31, 2014 Financing and Other Capital Activities During 2014, the Company declared and paid a $6 million cash dividend to its common shareholders. During 2014, the Company repurchased and retired 217,879 of its common shares for $134 million, which included 10,475 common shares repurchased under employee benefit plans. During 2014, the Company borrowed and repaid a total of $65 million under the WTM Bank Facility. During 2014, OneBeacon Ltd. declared and paid $80 million of cash dividends to its common shareholders. White Mountains received a total of $60 million of these dividends. During 2014, BAM received $16 million in Member Surplus Contributions. During 2014, MediaAlpha paid $2 million of dividends, of which $1 million was paid to White Mountains. During 2014, White Mountains contributed $15 million to WM Advisors. During 2014, WTM Life Re borrowed a total of $82 million and repaid a total of $89 million under an internal revolving credit facility with an intermediate holding company of White Mountains. Acquisitions and Dispositions On January 28 2014, White Mountains acquired certain assets and liabilities of Star & Shield Holdings LLC, including SSRM, the attorney-in-fact for SSIE, for a purchase price of $2 million. White Mountains also purchased $17 million of SSIE Surplus Notes during 2014. On February 19, 2014, White Mountains acquired 54% of the outstanding common shares of Wobi for NIS 14 million (approximately $4 million based upon the foreign exchange spot rate at the date of acquisition). In addition to the common shares, White Mountains also purchased NIS 32 million (approximately $9 million based upon the foreign exchange spot rates at the dates of acquisition) of newly-issued convertible preferred shares of Wobi. On March 14, 2014, White Mountains acquired 60% of the outstanding Class A common units of MediaAlpha for an initial purchase price of $28 million. On July 3, 2014, White Mountains acquired approximately 45% of the outstanding common shares of durchblicker, for EUR 9 million (approximately $12 million based upon the foreign exchange spot rate at the date of acquisition). During 2014, OneBeacon transferred $51 million of cash in connection with the sale of the Runoff Business. TRANSACTIONS WITH RELATED PERSONS See Note 20 - “Transactions with Related Persons” on page in the accompanying Consolidated Financial Statements. NON-GAAP FINANCIAL MEASURES This report includes four non-GAAP financial measures that have been reconciled to their most comparable GAAP financial measures. White Mountains believes these measures to be useful in evaluating White Mountains’s results of operations and financial condition. Adjusted comprehensive income is a non-GAAP financial measure that, for periods that White Mountains accounted for its investment in Symetra under the equity method, excludes the change in equity in net unrealized investment gains (losses) from Symetra’s fixed maturity portfolio from comprehensive income. White Mountains accounted for its investment in Symetra under the equity method until November 5, 2015, when it changed its accounting to fair value. In the calculation of comprehensive income under GAAP, fixed maturity investments are marked-to-market while the liabilities to which those assets are matched are not. Symetra attempts to earn a “spread” between what it earns on its investments and what it pays out on its products. In order to try to fix this spread, Symetra invests in a manner that tries to match the duration and cash flows of its investments with the required cash outflows associated with its life insurance and structured settlements products. As a result, Symetra typically earns the same spread on in-force business whether interest rates fall or rise. Further, at any given time, some of Symetra’s structured settlement obligations may extend 40 or 50 years into the future, which is further out than the longest maturing fixed maturity investments regularly available for purchase in the market (typically 30 years). For these long-dated products, Symetra is unable to fully match the obligation with assets until the remaining expected payout schedule comes within the duration of securities available in the market. If at that time, these fixed maturity investments have yields that are lower than the yields expected when the structured settlement product was originally priced, the spread for the product will shrink and Symetra will ultimately harvest lower returns for its shareholders. GAAP comprehensive income increases when rates decline, which would suggest an increase in the value of Symetra - the opposite of what is happening to the intrinsic value of the business. Therefore, White Mountains’s management and Board of Directors historically used adjusted comprehensive income when assessing Symetra’s quarterly financial performance. In addition, this measure is typically the predominant component of change in adjusted book value per share, which is used in calculation of White Mountains’s performance for both short-term (annual bonus) and long-term incentive plans. The reconciliation of GAAP comprehensive income to adjusted comprehensive income is included on page 37. Adjusted book value per share is a non-GAAP financial measure which is derived by expanding the calculation of GAAP book value per share to exclude equity in net unrealized investment gains (losses) from Symetra’s fixed maturity portfolio for periods that White Mountains accounted for its investment in Symetra under the equity method. White Mountains accounted for its investment in Symetra under the equity method until November 5, 2015, when it changed its accounting to fair value. Adjusted book value per share includes the dilutive effects of outstanding non-qualified options. In addition, the number of common shares outstanding used in the calculation of adjusted book value per share per White Mountains’s common share is adjusted to exclude unearned restricted common shares, the compensation cost of which, at the date of calculation, has yet to be amortized. The reconciliation of GAAP book value per share to adjusted book value per share is included on page 36. Total consolidated portfolio returns excluding Symetra and total common equity securities and other long-term investments returns excluding Symetra are non-GAAP financial measures that remove the $259 million pre-tax unrealized investment gain recognized in the fourth quarter of 2015 that was the result of the change in accounting for Symetra common shares from the equity method to fair value. White Mountains believes these measures make the returns in the current year more comparable to the prior period. A reconciliation of the GAAP returns to the returns excluding Symetra follows: For the year ended December 31, 2015 GAAP returns Remove Symetra Returns - excluding Symetra Total consolidated portfolio returns 3.6 % (3.8 )% (0.2 )% Total common equity securities and other long-term investments returns 19.3 % (21.1 )% (1.8 )% Total common equity securities 33.2 % (30.3 )% 2.9 % In the third quarter of 2016, White Mountains purchased high-yield fixed maturity investments, which are U.S. dollar denominated publicly traded and 144A debt securities issued by corporations with generally at least one rating between "B-" and “BB+” inclusive by Standard and Poor’s or similar ratings from other rating agencies. Given the risk profile of these investments, White Mountains has included returns on high-yield fixed maturity investments with returns on common equity securities and other long-term investments. A reconciliation of the GAAP return to the reported return follows: December 31, 2016 Common equity securities and other long-term investment returns GAAP return Include: Impact of return on high-yield fixed maturity investments(1) Reported return Year-to-date 4.3 % (0.3 )% 4.0 % (1) High-yield fixed maturity investments returned 1.0% for the full year of 2016. The impact of excluding high-yield fixed maturity investments from the GAAP fixed maturity investment returns was insignificant in 2016. CRITICAL ACCOUNTING ESTIMATES Management’s Discussion and Analysis of Financial Condition and Results of Operations discuss the Company’s consolidated financial statements, which have been prepared in accordance with GAAP. The financial statements presented herein include all adjustments considered necessary by management to fairly present the financial position, results of operations and cash flows of White Mountains. The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities as of the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Certain of these estimates are considered critical in that they involve a higher degree of judgment and are subject to a significant degree of variability. On an ongoing basis, management evaluates its estimates, including those related to fair value measurements of investments and other financial instruments, valuation of liabilities associated with an assumed reinsurance agreement covering benefit guarantees on variable annuities in Japan, its property-casualty loss and LAE reserves and its property-casualty reinsurance contracts. Management bases it estimates on historical experience and on various other factors that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. 1. Loss and LAE Reserves General White Mountains establishes loss and LAE reserves that are estimates of amounts needed to pay claims and related expenses in the future for insured events that have already occurred. The process of estimating reserves involves a considerable degree of judgment by management and, as of any given date, is inherently uncertain. See Note 3 - “Reserves for Unpaid Losses and Loss Adjustment Expenses” on page for a description of White Mountains’s loss and LAE reserves and actuarial methods. White Mountains performs an actuarial review of its recorded reserves each quarter. As part of that review, White Mountains’s actuaries compare the previous quarter’s projections of incurred, paid and case reserve activity, including amounts incurred but not reported, to amounts experienced in the quarter. Differences between previous estimates and actual experience evaluated to determine whether a given actuarial method for estimating loss and LAE should be relied upon to a greater or lesser extent than it had been in the past. While some variance is expected each quarter due to the inherent uncertainty in loss and LAE, persistent or large variances would indicate that prior assumptions and/or reliance on certain reserving methods may need to be revised going forward. Upon completion of each quarterly review, OneBeacon’s actuaries select indicated reserve levels based on the results of the actuarial methods described previously, which are the primary consideration in determining management’s best estimate of required reserves. However, in making its best estimate, management also considers other qualitative factors that may lead to a difference between held reserves and actuarially indicated reserve levels. Typically, these factors exist when management and OneBeacon’s actuaries conclude that there is insufficient historical incurred and paid loss information or that there is particular uncertainty about whether trends included in the historical incurred and paid loss information are unlikely to repeat in the future. Such factors include, among others, recent entry into new markets or new products, improvements in the claims department that are expected to lessen future ultimate loss costs, legal and regulatory developments, or other volatilities that may arise. OneBeacon The process of establishing loss and LAE reserves, including amounts incurred but not reported, is complex and imprecise as it must consider many variables that are subject to the outcome of future events. As a result, informed subjective estimates and judgments as to OneBeacon’s ultimate exposure to losses are an integral component of the loss and LAE reserving process. OneBeacon categorizes and tracks insurance reserves by “line of business” as either property short-tailed lines, casualty long-tailed lines, or other (accident, surety and credit) lines. OneBeacon regularly reviews the appropriateness of reserve levels at the line of business level, considering the variety of trends that impact the ultimate settlement of claims for the subsets of claims in each particular line of business. Loss and LAE Reserves by Line of Business OneBeacon’s loss and LAE reserves, net of reinsurance recoverables, as of December 31, 2016 and 2015 were as follows: December 31, 2016 December 31, 2015 Millions Case IBNR Total Case IBNR Total Property Lines: Property $ 42.4 $ 22.6 $ 65.0 $ 33.9 $ 37.6 $ 71.5 Ocean Marine 39.5 39.0 78.5 52.8 38.7 91.5 Total Property Lines 81.9 61.6 143.5 86.7 76.3 163.0 Casualty Lines: Automobile liability 52.0 65.7 117.7 49.8 57.7 107.5 General liability - occurrence 72.9 208.8 281.7 69.7 201.1 270.8 General liability - claims made 79.8 150.1 229.9 86.8 179.2 266.0 Medical malpractice 102.6 101.0 203.6 84.4 94.5 178.9 Workers compensation 57.7 65.1 122.8 54.1 62.2 116.3 Other .4 4.8 5.2 .2 4.6 4.8 Total Casualty Lines 365.4 595.5 960.9 345.0 599.3 944.3 Other Lines 22.4 65.9 88.3 23.6 72.9 96.5 Total $ 469.7 $ 723.0 $ 1,192.7 $ 455.3 $ 748.5 $ 1,203.8 For loss and allocated LAE reserves, the key assumption as of December 31, 2016 was that the impact of the various reserving factors, as described in Note 3 - “Reserves for Unpaid Losses and Loss Adjustment Expenses”, on future paid losses would be similar to the impact of those factors on the historical loss data with the exception of severity trends. Severity trends have been relatively stable over the relevant historical period. The actuarial methods used would project losses assuming continued stability in severity trends. Management has considered a range of assumptions regards future increases in loss severity trends, including the impact of inflation, in making its reserve selections. The major causes of material uncertainty (“reserving factors”) generally will vary for each line, as well as for each separately analyzed component of the line. Also, reserving factors can have offsetting or compounding effects on estimated reserves. For example, in workers compensation, the use of expensive medical procedures that result in medical cost inflation may enable workers to return to work faster, thereby lowering indemnity costs. Thus, in almost all cases, it is impossible to discretely measure the effect of a single reserving factor and construct a meaningful sensitivity expectation. Actual results will likely vary from expectations for each of these assumptions, resulting in an ultimate claim liability that is different from that being estimated currently. Additional causes of material uncertainty exist in most product lines and may impact the types of claims that could occur within a particular operating segment or book of business. Examples where reserving factors, within an underwriting unit or book of business, are subject to change include changing types of insured (e.g., type of insured vehicle, size of account, industry insured, jurisdiction, etc.), changing underwriting standards, or changing policy provisions (e.g., deductibles, policy limits, or endorsements). OneBeacon Loss and LAE Development See Note 3 - “Reserves for Unpaid Losses and Loss Adjustment Expenses” on page for prior year loss and LAE development discussions for the years ended December 31, 2016, 2015 and 2014. Range of Reserves OneBeacon’s range of loss and LAE reserve estimates was evaluated to consider the strengths and weaknesses of the various actuarial methods applied against OneBeacon’s historical claims experience data. The following table shows the recorded loss and LAE reserves and the high and low ends of OneBeacon’s range of reasonable loss reserve estimates, net of reinsurance recoverable on unpaid losses, as of December 31, 2016 and 2015. The high and low ends of the range of reserve estimates in the table below are based on the results of various actuarial methods. See Note 3 - “Reserves for Unpaid Losses and Loss Adjustment Expenses” on page for a description of White Mountains’s loss and LAE reserves and actuarial methods. December 31, 2016 December 31, 2015 Millions Low Recorded High Low Recorded High Total $ 1,011.6 $ 1,192.7 $ 1,363.4 $ 1,009.1 $ 1,203.8 $ 1,356.1 The recorded reserves represent management's best estimate of unpaid loss and LAE reserves. OneBeacon uses the results of several different actuarial methods to develop its estimate of ultimate reserves. While it has not determined the statistical probability of actual ultimate paid losses falling within the range, OneBeacon believes that it is reasonably likely that actual ultimate paid losses will fall within the ranges noted above because the ranges were developed by using several different generally accepted actuarial methods. Although OneBeacon believes its reserves are reasonably stated, ultimate losses may deviate, perhaps materially, from the recorded reserve amounts and could be above the high end of the range of actuarial projections. This is because ranges are developed based on known events as of the valuation date, whereas the ultimate disposition of losses is subject to the outcome of events and circumstances that may be unknown as of the valuation date. Sensitivity Analysis The following discussion includes disclosure of possible variations from current estimates of loss and LAE reserves due to changes in a few of the many key assumptions. Each of the impacts described below is estimated individually, without consideration for any correlation among key assumptions. Further, there is uncertainty around other assumptions not explicitly quantified in the discussion below. Therefore, it would be inappropriate to take each of the amounts described below and add them together in an attempt to estimate volatility for OneBeacon’s reserves in total. It is important to note that the volatilities and variations discussed below are not meant to be a worst-case scenarios or an all-inclusive list, and therefore it is possible that future volatilities and variations may be more than amounts discussed below. • Various sources of inflation volatility impact all of OneBeacon’s reserves in different ways. Using its internal economic capital model, OneBeacon has derived a distribution of future loss payments under the range of inflation scenarios and related claim cost trends in its economic scenario set, holding all other sources of reserve volatility constant. At the 75th percentile of modeled outcomes, the estimated impact of claim cost inflation above OneBeacon’s actuarially indicated reserves is $34 million, net of reinsurance. The following are intended to provide additional insight into the impact of inflation on key lines of business: ◦ Professional liability: Recorded loss and LAE reserves, net of reinsurance recoverables, for professional liability were $438 million as of December 31, 2016. A key assumption for professional liability is the implicit loss cost trend, particularly the severity inflation trend component of loss costs. Across the entire reserve base, a 5.0 point change in assumed annual severity trend would have changed the estimated net reserve by approximately $84 million as of December 31, 2016, in either direction. ◦ Workers compensation: Recorded workers compensation loss and LAE reserves, net of reinsurance recoverables, were $123 million as of December 31, 2016. The two most important assumptions for workers compensation reserves are loss development factors and loss cost trends, particularly medical cost inflation. Loss development patterns are dependent on medical cost inflation. Approximately half of the workers compensation net reserves are related to future medical costs. Across the entire reserve base, a 1.0 point change in calendar year medical inflation would have changed the estimated net reserve by approximately $3 million as of December 31, 2016, in either direction. • The volatility associated with the frequency and severity of large losses, defined as claims greater than or equal to $2.5 million, can have a material impact on OneBeacon’s results. The frequency and severity of large claims is driven primarily by the random nature of the insurance process but also by claim cost inflation and parameter risk. These large losses often emerge over a long time period potentially leading to a material impact on OneBeacon’s reserves. One way OneBeacon considers this sensitivity is by examining the volatility of large losses in the current accident year using its economic capital model. At the 75th percentile of modeled outcomes, OneBeacon estimates that large losses could exceed the mean by $18 million gross of reinsurance and $8 million, net of the current reinsurance structure. • As OneBeacon starts up new businesses, its initial loss estimates and development patterns are often based on industry data. As actual losses develop OneBeacon will revise its initial expectations with its actual experience. However, depending on the tail for the specific business, it can be a few years before OneBeacon has sufficient internal data to rely on. As of December 31, 2016, OneBeacon has $311 million of inception-to-date premium from its newer businesses (Programs, Environmental and Financial Institutions). A 10% error in OneBeacon’s initial loss ratio estimates could result in approximately $31 million of adverse net variance in loss reserves. 2. Fair Value Measurements General White Mountains measures certain assets and liabilities at estimated fair value in its consolidated financial statements, with changes therein recognized in current period earnings. In addition, White Mountains discloses estimated fair value for certain liabilities measured at historical or amortized cost. Fair value is defined as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants (an exit price) at a particular measurement date. Fair value measurements are categorized into a hierarchy that distinguishes between inputs based on market data from independent sources (“observable inputs”) and a reporting entity's internal assumptions based upon the best information available when external market data is limited or unavailable (“unobservable inputs”). Quoted prices in active markets for identical assets or liabilities have the highest priority (“Level 1”), followed by observable inputs other than quoted prices, including prices for similar but not identical assets or liabilities (“Level 2”) and unobservable inputs, including the reporting entity's estimates of the assumptions that market participants would use, having the lowest priority (“Level 3”). Assets and liabilities carried at fair value include substantially all of the investment portfolio; derivative instruments, both exchange traded and over the counter instruments; and reinsurance assumed liabilities associated with variable annuity benefit guarantees. Valuation of assets and liabilities measured at fair value require management to make estimates and apply judgment to matters that may carry a significant degree of uncertainty. In determining its estimates of fair value, White Mountains uses a variety of valuation approaches and inputs. Whenever possible, White Mountains estimates fair value using valuation methods that maximize the use of observable prices and other inputs. Where appropriate, assets and liabilities measured at fair value have been adjusted for the effect of counterparty credit risk. Invested Assets White Mountains used quoted market prices or other observable inputs to determine fair value for 94% of its investment portfolio as of December 31, 2016. Investments valued using Level 1 inputs include fixed maturity investments, primarily investments in U.S. Treasuries, short-term investments, which include U.S. Treasury Bills, and common equity securities. Investments valued using Level 2 inputs are primarily comprised of fixed maturity investments, which have been disaggregated into classes, including debt securities issued by corporations, municipal obligations, mortgage and asset-backed securities, foreign government, agency and provincial obligations and preferred stocks. Investments valued using Level 2 inputs also include certain ETFs that track U.S. stock indices such as the S&P 500 but are traded on foreign exchanges and that management values using the fund’s published net asset value (“NAV”) to account for the difference in market close times. Fair value estimates for investments that trade infrequently and have few or no observable market prices are classified as Level 3 measurements. Level 3 fair value estimates based upon unobservable inputs include White Mountains’s investments in surplus notes, as well as certain investments in fixed maturity investments, common equity securities and other long-term investments where quoted market prices are unavailable or are not considered reasonable. Transfers between levels are based on investments held as of the beginning of the period. White Mountains uses brokers and outside pricing services to assist in determining fair values. For investments in active markets, White Mountains uses the quoted market prices provided by outside pricing services to determine fair value. The outside pricing services White Mountains uses have indicated that they will only provide prices where observable inputs are available. In circumstances where quoted market prices are unavailable or are not considered reasonable, White Mountains estimates the fair value using industry standard pricing methodologies and observable inputs such as benchmark yields, reported trades, broker-dealer quotes, issuer spreads, benchmark securities, bids, offers, credit ratings, prepayment speeds, reference data including research publications and other relevant inputs. Given that many fixed maturity investments do not trade on a daily basis, the outside pricing services evaluate a wide range of fixed maturity investments by regularly drawing parallels from recent trades and quotes of comparable securities with similar features. The characteristics used to identify comparable fixed maturity investments vary by asset type and take into account market convention. White Mountains’s process to assess the reasonableness of the market prices obtained from the outside pricing sources covers substantially all of its fixed maturity investments and includes, but is not limited to, the evaluation of pricing methodologies, and a review of the pricing services’ quality control processes and procedures on at least an annual basis, comparison of its invested asset market prices to prices obtained from alternate independent pricing vendors on at least a semi-annual basis, monthly analytical reviews of certain prices and a review of the underlying assumptions utilized by the pricing service for selected measurements on an ad hoc basis throughout the year. White Mountains also performs back-testing of selected sales activity to determine whether there are any significant differences between the market price used to value the security prior to sale and the actual sale price on an ad-hoc basis throughout the year. Prices provided by the pricing services that vary by more than 5% and $1.0 million from the expected price based on these procedures are considered outliers. Also considered outliers are prices that have not changed from period to period and prices that have trended unusually compared to market conditions. In circumstances where the results of White Mountains’s review process does not appear to support the market price provided by the pricing services, White Mountains challenges the price. If White Mountains cannot gain satisfactory evidence to support the challenged price, it relies upon its own pricing methodologies to estimate the fair value of the security in question. The valuation process above is generally applicable to all of White Mountains’s fixed maturity investments. The techniques and inputs specific to asset classes within White Mountains’s fixed maturity investments for Level 2 securities that use observable inputs are as follow: Debt securities issued by corporations: The fair value of debt securities issued by corporations is determined from a pricing evaluation technique that uses information from market sources and integrates relative credit information, observed market movements, and sector news. Key inputs include benchmark yields, reported trades, broker-dealer quotes, issuer spreads, two-sided markets, benchmark securities, bids, offers, and reference data including sector, coupon, credit quality ratings, duration, credit enhancements, early redemption features and market research publications. Mortgage and asset-backed securities: The fair value of mortgage and asset-backed securities is determined from a pricing evaluation technique that uses information from market sources and leveraging similar securities. Key inputs include benchmark yields, reported trades, underlying tranche cash flow data, collateral performance, plus new issue data, as well as broker-dealer quotes, issuer spreads, two-sided markets, benchmark securities, bids, offers, and reference data including issuer, vintage, loan type, collateral attributes, prepayment speeds, default rates, recovery rates, cash flow stress testing, credit quality ratings and market research publications. Municipal obligations: The fair value of municipal obligations is determined from a pricing evaluation technique that uses information from market makers, brokers-dealers, buy-side firms, and analysts along with general market information. Key inputs include benchmark yields, reported trades, issuer financial statements, material event notices and new issue data, as well as broker-dealer quotes, issuer spreads, two-sided markets, benchmark securities, bids, offers, and reference data including type, coupon, credit quality ratings, duration, credit enhancements, geographic location and market research publications. Foreign government, agency and provincial obligations: The fair value of foreign government, agency and provincial obligations is determined from a pricing evaluation technique that uses feeds from data sources in each respective country, including active market makers and inter-dealer brokers. Key inputs include benchmark yields, reported trades, broker-dealer quotes, two-sided markets, benchmark securities, bids, offers, local exchange prices, foreign exchange rates and reference data including coupon, credit quality ratings, duration and market research publications. Preferred stocks: The fair value of preferred stocks is determined from a pricing evaluation technique that calculates the appropriate spread over a comparable security for each issue. Key inputs include exchange prices (underlying and common stock of same issuer), benchmark yields, reported trades, broker-dealer quotes, issuer spreads, two-sided markets, benchmark securities, bids, offers, and reference data including sector, coupon, credit quality ratings, duration, credit enhancements, early redemption features and market research publications. Level 3 valuations are generated from techniques that use assumptions not observable in the market. These unobservable assumptions reflect White Mountains’s assumptions that market participants would use in valuing the investment. Generally, certain securities may start out as Level 3 when they are originally issued but as observable inputs become available in the market, they may be reclassified to Level 2. White Mountains employs a number of procedures to assess the reasonableness of the fair value measurements for its other long-term investments, including obtaining and reviewing periodic and audited annual financial statements of hedge funds and private equity funds and discussing each fund’s pricing with the fund manager throughout the year. However, since the fund managers do not provide sufficient information to evaluate the pricing inputs and methods for each underlying investment, the inputs are considered to be unobservable. The fair value of White Mountains’s investments in hedge funds and private equity funds has generally been determined using NAV. The following table summarizes White Mountains’s fair value measurements and the percentage of Level 3 investments as of December 31, 2016. The major security types were based on the legal form of the securities. White Mountains has disaggregated its fixed maturity investments based on the issuing entity type, which impacts credit quality, with debt securities issued by U.S. government entities carrying minimal credit risk, while the credit and other risks associated with other issuers, such as debt securities issued by corporations, foreign governments, municipalities or entities issuing mortgage and asset-backed securities vary depending on the nature of the issuing entity type: December 31, 2016 $ in millions Fair value Level 3 Inputs Level 3 Inputs as a % of total fair value U.S. Government and agency obligations $ 278.3 $ - - Debt securities issued by corporations 1,509.4 - - Mortgage and asset-backed securities 2,132.9 - - Municipal obligations 309.0 - - Foreign government, agency and provincial obligations 13.2 - - Preferred stocks 14.0 - - % Fixed maturity investments(1) 4,256.8 - - % Short-term investments(1) 287.1 - - Common equity securities 474.3 - - % Other long-term investments(2)(3) 177.7 177.7 % Total investments $ 5,195.9 $ 177.7 % (1) Includes carrying value of $6.6 in fixed maturity investments and $0.1 in short-term investments that are classified as assets held for sale related to SSIE. (2) Excludes carrying value of $3.5 associated with other long-term investment limited partnerships accounted for using the equity method and $(1.2) related to foreign currency forward contracts. Excludes carrying value of $12.3 associated with a tax advantaged federal affordable housing development fund accounted for using the proportional amortization method. (3) Excludes carrying value of $131.0 associated with hedge funds and private equity funds for which fair value is generally measured at NAV using the practical expedient. White Mountains uses quoted market prices where available as the inputs to estimate fair value for its investments in active markets. Such measurements are considered to be either Level 1 or Level 2 measurements, depending on whether the quoted market price inputs are for identical securities (Level 1) or similar securities (Level 2). See Note 5 - “Investment Securities” on page for tables that summarize the changes in White Mountains’s fair value measurements by level for the years ended December 31, 2016 and 2015 and for amount of total gains (losses) included in earnings attributable to net unrealized investment gains (losses) for Level 3 investments for years ended December 31, 2016, 2015 and 2014. Other Long-Term Investments White Mountains’s other long-term investments as of December 31, 2016 include $60 million in hedge funds and $71 million in private equity funds. As of December 31, 2016, White Mountains held investments in 5 hedge funds and 23 private equity funds. The largest investment in a single fund was $37 million and $23 million as of December 31, 2016 and 2015. The fair value of White Mountains’s investments in hedge funds and private equity funds is based upon White Mountains’s proportionate interest in the underlying fund’s NAV, which is deemed to approximate fair value. White Mountains employs a number of procedures to assess the reasonableness of the fair value measurements for its other long-term investments, including obtaining and reviewing each fund’s audited financial statements and discussing each fund’s pricing with the fund manager. However, since the fund managers do not provide sufficient information to independently evaluate the pricing inputs and methods for each underlying investment, the inputs are considered to be unobservable. In circumstances where the underlying investments are publicly traded, such as the investments made by hedge funds, the fund manager uses current market prices to determine fair value. In circumstances where the underlying investments are not publicly traded, such as the investments made by private equity funds, the private equity fund managers generally consider the need for a liquidity discount on each of the underlying investments when determining the fund’s NAV. In the event White Mountains believes that its estimated NAV differs from the valuation provided by the fund manager, White Mountains will adjust the fund manager’s reported NAV to more appropriately represent the fair value of its interest in the investment. As of December 31, 2016, White Mountains determined that certain underlying investments held in six separate private equity funds required an adjustment to the fund manager's reported NAV. The total adjustment to the fund manager’s reported NAV relating to these underlying investments resulted in a $5.0 million reduction to the fair value of White Mountains’s private equity fund portfolio as of December 31, 2016. Sensitivity analysis of likely returns on other long-term investments White Mountains maintains a portfolio of other long-term investments that consists primarily of hedge funds, private equity funds, non-controlling interests in private capital investments, the OneBeacon Surplus Notes, and various other investments. The underlying investments of hedge funds and private equity funds are typically publicly traded and private common equity securities and, as such, are subject to market risks that are similar to White Mountains’s common equity securities. The following illustrates the estimated effect on December 31, 2016 fair values resulting from a 10% change and a 30% change in market value: Change in fair value Carrying Value at December 31, 2016 Millions December 31, 2016 10% decline 10% increase 30% decline 30% increase Hedge funds $ 59.8 $ (6.0 ) $ 6.0 $ (17.9 ) $ 17.9 Private equity funds 71.2 $ (7.1 ) $ 7.1 $ (21.4 ) $ 21.4 Private equity securities and limited liability companies 72.0 $ (7.2 ) $ 7.2 $ (21.6 ) $ 21.6 OneBeacon Surplus Notes 71.9 $ (7.2 ) $ 7.2 $ (21.6 ) $ 21.6 Other 48.4 $ (4.8 ) $ 4.8 $ (14.5 ) $ 14.5 Total other-long term investments $ 323.3 $ (32.3 ) $ 32.3 $ (97.0 ) $ 97.0 3. Surplus Note Valuation BAM Surplus Notes As of December 31, 2016, White Mountains owned $503 million of BAM Surplus Notes and has accrued $108 million in interest due thereon. BAM has not yet made any cash payments to White Mountains for amounts owed under the BAM Surplus Notes. Because BAM is consolidated in White Mountains’s financial statements, the BAM Surplus Notes and accrued interest are classified as intercompany notes, carried at face value and eliminated in consolidation. However, the BAM Surplus Notes and accrued interest are carried as assets at HG Global, of which White Mountains owns 97% of the preferred equity, while the BAM Surplus Notes are carried as liabilities at BAM, which White Mountains has no ownership interest in and is completely attributed to non-controlling interests. Any write-off of the carried amount of the BAM Surplus Notes and/or the accrued interest thereon would adversely impact White Mountains’s adjusted book value per share. See Item 1A., Risk Factors, “If BAM does not pay some or all of the interest and principal due on the BAM Surplus Notes, White Mountains’s adjusted book value per share, results of operations and financial condition could be materially adversely affected.” on page 23. Periodically, White Mountains’s management reviews the recoverability of amounts recorded from the BAM Surplus Notes. As of December 31, 2016, White Mountains believes such notes and interest thereon to be fully recoverable. White Mountains’s review is based on a debt service model that forecasts 20 years of operating results for BAM. The model depends on assumptions regarding future trends for the issuance of municipal bonds, interest rates, credit spreads, competitive activity in the market for bond insurance and other factors affecting the demand for and price of BAM’s bond insurance. Assumptions regarding future trends for these factors are a matter of significant judgment. The model assumes increases in insured market penetration, annual par insured volume and premium rates, which in turn lead to substantial increases in total premium written over the next six years (flattening thereafter). Under these assumptions, we project that BAM can begin making payments on the BAM Surplus Notes in 2019 and can fully repay all principal and interest due on the BAM Surplus Notes approximately 15 years prior to final maturity. The model assumptions are based on historical trends, current conditions and expected future developments. Whether actual results will follow forecast is subject to a number of risks and uncertainties. No payment of interest or principal on the BAM Surplus Notes may be made without the approval of the New York State Department of Financial Services. BAM has stated its intention to seek regulatory approval to pay interest and principal on its surplus notes only to the extent that its remaining qualified statutory capital (“QSC”) exceeds $500 million and its remaining QSC and other capital resources continue to support its outstanding obligations, business plan and its AA stable rating from S&P. Interest payments on the BAM Surplus Notes are due quarterly but are subject to deferral, without penalty or default and without compounding, for payment in the future. No principal is due on the BAM Surplus Notes prior to the stated maturity date of 2042. BAM has the right to prepay principal in whole or in part at any time. OneBeacon Runoff Transaction In the fourth quarter of 2014, in conjunction with the Runoff Transaction, OneBeacon provided financing in the form of the OneBeacon Surplus Notes with a par value of $101 million, which had a fair value of $65 million at the date of closing. As of December 31, 2016 and 2015 the OneBeacon Surplus Notes had a fair value of $72 million and $52 million. The OneBeacon Surplus Notes, issued by one of the transferred entities, OBIC, since renamed Bedivere (“Issuer”), were in the form of both seller priority and pari passu notes. Under the contractual terms of both the seller priority and pari passu notes, scheduled interest payments accrue at 6.0% until the scheduled maturity date of March 15, 2020 and at a floating interest rate thereafter, should any principal remain outstanding. As required by the Pennsylvania Insurance Department (“PID”), interest on the notes does not compound. The notes restrict the Issuer’s ability to make distributions to holders of its equity interest. All such distributions are prohibited while the seller priority note is outstanding, and while the pari passu note is outstanding, distributions are permitted only if the Issuer concurrently repays a pro rata amount of any outstanding principal on the pari passu note. Pursuant to the notes, the Issuer shall seek to redeem the notes annually each March 15 at a requested redemption amount such that the Issuer’s total adjusted capital following the proposed redemption payment would equal 200% of the Issuer’s “authorized control level RBC,” as such term is defined by the insurance laws of the Commonwealth of Pennsylvania and as prescribed by the PID. All redemptions or repayments of principal and payments of interest on the notes are subject to approval by the PID. Below is a table illustrating the valuation adjustments taken to arrive at the estimated fair value of the OneBeacon Surplus Notes as of December 31, 2016 and December 31, 2015: Type of Surplus Note Total as of December 31, 2016 Total as of December 31, 2015 Millions Seller Priority Pari Passu Par Value $ 57.9 $ 43.1 $ 101.0 $ 101.0 Fair value adjustments to reflect: Current market rates on public debt and contract-based repayments (1) 6.2 (1.1 ) 5.1 (15.1 ) Regulatory approval (2) (.2 ) (15.4 ) (15.6 ) (24.2 ) Liquidity adjustment (3) (12.8 ) (5.8 ) (18.6 ) (10.2 ) Total adjustments (6.8 ) (22.3 ) (29.1 ) (49.5 ) Fair value (4) $ 51.1 $ 20.8 $ 71.9 $ 51.5 (1) Represents the value of the surplus notes, at current market yields on comparable publicly traded debt, and assuming issuer is allowed to make principal and interest payments when its financial capacity is available, as measured by statutory capital in excess of a 250% RBC score under the NAIC’s risk-based capital standards for property and casualty companies. The favorable year-over-year change in impact is due principally to the narrowing of non-investment grade credit spreads as well as the time value of money benefit from moving one year closer to modeled cash receipts. (2) Represents anticipated delay in securing regulatory approvals of interest and principal payments to reflect graduated changes in Issuer's statutory surplus. The monetary impact of the anticipated delay is measured based on credit spreads of public securities with roughly equivalent percentages of discounted payments missed. The favorable year-over-year change in impact is driven primarily by the narrowing of non-investment grade credit spreads, which causes the anticipated delay in securing regulatory approval to be less punitive, partially offset by the change in estimates and assumptions regarding the timeline, amounts, and process necessary to obtain regulatory approval for principal and interest payments described below. (3) Represents impact of liquidity spread to account for OneBeacon’s sole ownership of the OneBeacon Surplus Notes, lack of a trading market and unique nature of the ongoing regulatory approval process. The unfavorable year-over-year change in impact is due largely to the increased fair value of the notes as well as a higher effective duration resulting from a lower overall yield to maturity; there was no change in the magnitude of the liquidity spread in 2016. (4) The increase in the fair value of the OneBeacon Surplus Notes during the year ended December 31, 2016 was driven primarily by the narrowing of non-investment grade credit spreads, partially offset by the impact of a change in estimates and assumptions regarding the timing of regulatory approval of principal and interest payments on the notes. The internal valuation model used to estimate the fair value is based on discounted expected cash flows using information as of the measurement date. The estimated fair value of the OneBeacon Surplus Notes is sensitive to changes in treasury rates and public debt credit spreads, as well as changes in estimates with respect to other variables including a discount to reflect the private nature of the notes (and the related lack of liquidity), the credit quality of the notes - based on the financial performance of the Issuer relative to expectations, and the timing, amount, and likelihood of interest and principal payments on the notes, which are subject to regulatory approval and therefore may vary from the contractual terms. Anticipating a change in the assumed timeline, amounts, and process necessary to obtain regulatory approval, OneBeacon made a change in its estimate as of December 31, 2016 with regard to the timing of regulatory approval of principal and interest payments on the notes. For the purpose of estimating fair value, OneBeacon has currently assumed that all accrued unpaid interest on the seller priority note since the date of issuance is paid in 2020, with regular annual interest payments on both the seller priority note and pari passu note beginning thereafter, all accrued but unpaid interest on the pari passu note since the date of issuance is paid in 2025, and principal repayments begin on a graduated basis in 2030 for the seller priority note and 2035 for the pari passu note. Previously, including as of December 31, 2015, OneBeacon had assumed for the purpose of estimating fair value that interest payouts, including all accrued but unpaid amounts, began in 2020 for both notes and that principal repayments began on a graduated basis in 2025 for the seller priority note and 2030 for the pari passu note. Although these variables involve considerable judgment, the Company does not currently expect any resulting changes in the estimated value of the OneBeacon Surplus Notes to be material to its financial position. Given these significant unobservable inputs, the OneBeacon Surplus Notes have been classified as Level 3 under the fair value hierarchy. See “Significant Unobservable Inputs” in Note 5 - “Investment Securities” on page. As a means to provide the degree of variability for each of the key assumptions that affect the fair value of the OneBeacon Surplus Notes, below is a table of sensitivities which measure hypothetical changes in such variables and the resulting pre-tax increase (or decrease) impact on the valuation of the OneBeacon Surplus Notes as of December 31, 2016. Estimates affecting fair value Pre-tax increase (decrease) in fair value Millions Liquidity Spread (1) -100 bp -50 bp +50 bp +100 bp Seller priority note $ 4.6 $ 2.3 $ (2.1 ) $ (4.1 ) Pari passu note 2.1 1.0 (1.0 ) (1.9 ) Total OneBeacon Surplus Notes $ 6.7 $ 3.3 $ (3.1 ) $ (6.0 ) Credit Assignment (2) +2 Notches +1 Notch -1 Notch -2 Notches Seller priority note $ 9.1 $ 4.3 $ (3.9 ) $ (7.3 ) Pari passu note 4.2 1.9 (1.7 ) (3.3 ) Total OneBeacon Surplus Notes $ 13.3 $ 6.2 $ (5.6 ) $ (10.6 ) Principal Repayments (3) -3 Years -1 Year +1 Year +3 Years Seller priority note $ .6 $ 0.2 $ (.2 ) $ (.6 ) Pari passu note .7 0.2 (.2 ) (.4 ) Total OneBeacon Surplus Notes $ 1.3 $ 0.4 $ (0.4 ) $ (1.0 ) Interest Repayments (4) -3 Years -1 Year +1 Year +3 Years Seller priority note $ 1.9 $ 0.9 $ (1.1 ) $ (3.8 ) Pari passu note 4.4 1.4 (1.5 ) (4.5 ) Total OneBeacon Surplus Notes $ 6.3 $ 2.3 $ (2.6 ) $ (8.3 ) (1) Represents the sensitivity to changes in the estimate of the liquidity spread added to account for OneBeacon’s sole ownership of the OneBeacon Surplus Notes, lack of a liquid trading market and unique nature of the ongoing regulatory approval process. (2) Represents the sensitivity to changes in the estimate of the underlying equivalent credit quality of the OneBeacon Surplus Notes. Such credit quality is approximated by comparing the expected percentage of discounted payments missed, as calculated in a proprietary Stochastic simulation, to a series of benchmarks derived from data published by Standard & Poor’s. Note that “notch” is defined as the difference between, for example a “B” and “B+” rated instrument. (3) Represents the sensitivity to changes in the estimate of timing of the first principal payment received by OneBeacon. The fair value model assumes a delay in the receipt of principal cash flows as a result of the regulatory approval required before such payments may occur; and assuming repayments are made with a graduated impact on statutory surplus. (4) Represents the sensitivity to changes in the estimate of timing of the first interest payment received by OneBeacon. The fair value model assumes a delay in the receipt of interest cash flows as a result of the regulatory approval required before such payments may occur; and assuming repayments are made with a graduated impact on statutory surplus. FORWARD-LOOKING STATEMENTS This report may contain “forward-looking statements” within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934. All statements, other than statements of historical facts, included or referenced in this report which address activities, events or developments which White Mountains expects or anticipates will or may occur in the future are forward-looking statements. The words “will”, “believe”, “intend”, “expect”, “anticipate”, “project”, “estimate”, “predict” and similar expressions are also intended to identify forward-looking statements. These forward-looking statements include, among others, statements with respect to White Mountains’: • change in adjusted book value per share or return on equity; • business strategy; • financial and operating targets or plans; • incurred loss and loss adjustment expenses and the adequacy of its loss and loss adjustment expense reserves and related reinsurance; • projections of revenues, income (or loss), earnings (or loss) per share, dividends, market share or other financial forecasts; • expansion and growth of its business and operations; and • future capital expenditures. These statements are based on certain assumptions and analyses made by White Mountains in light of its experience and perception of historical trends, current conditions and expected future developments, as well as other factors believed to be appropriate in the circumstances. However, whether actual results and developments will conform to its expectations and predictions is subject to a number of risks and uncertainties that could cause actual results to differ materially from expectations, including: • the risks associated with Item 1A of this Report on Form 10-K; • claims arising from catastrophic events, such as hurricanes, earthquakes, floods, fires, terrorist attacks or severe winter weather; • the continued availability of capital and financing; • general economic, market or business conditions; • business opportunities (or lack thereof) that may be presented to it and pursued; • competitive forces, including the conduct of other property and casualty insurers; • changes in domestic or foreign laws or regulations, or their interpretation, applicable to White Mountains, its competitors or its customers; • an economic downturn or other economic conditions adversely affecting its financial position; • recorded loss reserves subsequently proving to have been inadequate; • actions taken by ratings agencies from time to time, such as financial strength or credit ratings downgrades or placing ratings on negative watch; and • other factors, most of which are beyond White Mountains’s control. Consequently, all of the forward-looking statements made in this report are qualified by these cautionary statements, and there can be no assurance that the actual results or developments anticipated by White Mountains will be realized or, even if substantially realized, that they will have the expected consequences to, or effects on, White Mountains or its business or operations. White Mountains assumes no obligation to publicly update any such forward-looking statements, whether as a result of new information, future events or otherwise.

<s>[INST] The following discussion also includes four nonGAAP financial measures, adjusted comprehensive income, adjusted book value per share, consolidated portfolio returns excluding Symetra and common equity securities and other longterm investment returns excluding Symetra, and the return on common equity and other longterm investments including highyield fixed maturity investments that have been reconciled to their most comparable GAAP financial measures on page 64. White Mountains believes these measures to be useful in evaluating White Mountains’s financial performance and condition. RESULTS OF OPERATIONS FOR THE YEARS ENDED December 31, 2016, 2015 and 2014 OverviewYear Ended December 31, 2016 versus Year Ended December 31, 2015 White Mountains ended 2016 with book value per share of $790 and adjusted book value per share of $794, an increase of 13.6% and 13.7% for the year, including dividends. Comprehensive income attributable to common shareholders increased to $558 million in 2016 compared to $197 million in 2015. The increases in 2016 are driven by larger transaction related gains. In 2016, a gain of $477 million from the sale of Sirius Group increased book value per share and adjusted book value per share by $90, while $82 million of comprehensive income generated from the sale of Tranzact increased book value per share and adjusted book value per share by $16. In 2015, White Mountains recognized $241 million of comprehensive income that increased book value per share and adjusted book value per share by $43, which was the result of a change in accounting for the investment in Symetra from the equity method to fair value, caused by White Mountains’s relinquishment of its representation on Symetra’s board of directors subsequent to Symetra entering into a merger agreement with Sumitomo Life. See Note 2 “Significant Transactions” on page for a description of each transaction. For the year ended December 31, 2016, White Mountains repurchased and retired 1,106,145 of its common shares for $887 million at an average share price of $802.08, approximately 101% of White Mountains’s December 31, 2016 adjusted book value per share. OneBeacon’s book value per share increased 11.1% during 2016, including dividends, compared to an increase of 3.8% during 2015, including dividends. OneBeacon’s GAAP combined ratio was 97% for 2016 compared to 96% for 2015. OneBeacon’s current accident year loss ratio was 58% for the year ended December 31, 2016, compared to 60% for year ended December 31, 2015. OneBeacon had one point of net unfavorable loss reserve development in the year ended December 31, 2016 compared to insignificant loss reserve development in the year ended December 31, 2015. The decrease in the current accident year loss ratio reflects improved relative performance across most business units. The expense ratio was 38% for the year ended December 31, 2016, compared to 36% for the year ended December 31, 2015. The increase in the expense ratio was primarily due to lower earned premium volume and changing business mix. The increase in book value per share for the year ended December 31, 2016 included a $16 million tax benefit related to the settlement of IRS examinations for tax years 20072012. OneBeacon’s net written premiums were $1.1 billion for both the year ended December 31, 2016 and the year ended December 31, 2015. BAM insured municipal bonds with par value of $11.3 billion in 2016, compared to $10.6 billion in 2015. The average total premium (including both risk premiums and Member Surplus Contributions [/INST] Negative. </s>

WHITE MOUNTAINS INSURANCE GROUP LTD

2018-02-28

2017-12-31

Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations The following discussion contains “forward-looking statements”. White Mountains intends statements that are not historical in nature, which are hereby identified as forward-looking statements, to be covered by the safe harbor provisions of the Private Securities Litigation Reform Act of 1995. White Mountains cannot promise that its expectations in such forward-looking statements will turn out to be correct. White Mountains’s actual results could be materially different from and worse than its expectations. See “FORWARD-LOOKING STATEMENTS” on page 56 for specific important factors that could cause actual results to differ materially from those contained in forward-looking statements. The following discussion also includes five non-GAAP financial measures, adjusted book value per share, MediaAlpha’s earnings before interest, taxes, depreciation and amortization (“EBITDA”), adjusted total capital and consolidated portfolio returns excluding Symetra, and common equity securities and other long-term investment returns excluding Symetra, that have been reconciled to their most comparable GAAP financial measures on page 51. White Mountains believes these measures to be useful in evaluating White Mountains’s financial performance and condition. RESULTS OF OPERATIONS FOR THE YEARS ENDED DECEMBER 31, 2017, 2016 AND 2015 Overview-Year Ended December 31, 2017 versus Year Ended December 31, 2016 White Mountains ended 2017 with book value per share of $931 and adjusted book value per share of $915, an increase of 18.8% and 16.1% for the year, including dividends. The increases were primarily driven by the gain on the sale of OneBeacon. Comprehensive income attributable to common shareholders increased to $631 million in 2017 compared to $547 million in 2016. Comprehensive income attributable to common shareholders in both 2017 and 2016 was driven by large transaction gains. In 2017, OneBeacon was acquired by Intact Financial Corporation in an all-cash transaction for $18.10 per share, from which White Mountains received $1.3 billion and recorded a net gain of $555 million. In 2016, White Mountains recorded net gains of $477 million and $82 million from the sales of Sirius Group and Tranzact. See Note 2 - “Significant Transactions” on page for a description of each transaction. For the year ended December 31, 2017, White Mountains repurchased and retired 832,725 of its common shares for $724 million at an average share price of $869.29, or approximately 95% of White Mountains’s December 31, 2017 adjusted book value per share. For the year ended December 31, 2017, White Mountains returned a total of $728 million of capital to shareholders through share repurchases and dividends. Written premiums and MSC in the HG Global/BAM segment totaled $101 million in 2017, compared to $77 million in 2016, as higher pricing more than offset a decrease in issuance volume. BAM insured municipal bonds with par value of $10.4 billion in 2017, compared to $11.3 billion in 2016. Total pricing, which is written premiums plus MSC, including the present value of future installment MSC not yet collected, weighted by the par value of municipal bonds insured, was 99 basis points, up from 68 basis points in 2016. As of December 31, 2017, BAM’s total claims paying resources were $708 million on gross par outstanding of $42 billion. Total claims paying resources increased $65 million from December 31, 2016, reflecting positive cash flow building in the BAM system. During 2017, BAM paid $5 million of principal and interest in cash on the surplus notes held by HG Re. Beginning in the second quarter of 2017, White Mountains changed its calculation of adjusted book value per share (i) to include a discount for the time value of money arising from the expected timing of cash payments of principal and interest on the BAM surplus notes and (ii) to add back the unearned premium reserve, net of deferred acquisition costs, at HG Global. See “NON-GAAP FINANCIAL MEASURES” on page 51. MediaAlpha reported break-even results in 2017, compared to pre-tax loss of $4 million in 2016. MediaAlpha’s EBITDA was $11 million in 2017, compared to $7 million in 2016. The increases in pre-tax income and EBITDA were primarily driven by growth in the Health, Life and Medicare and the P&C verticals. In October 2017, MediaAlpha acquired certain assets associated with the Health, Life and Medicare insurance business of Healthplans.com. The acquired assets include domain names, advertiser and publisher relationships, traffic acquisition accounts, and owned and operated websites. During the fourth quarter of 2017, which includes the annual open enrollment period for Health and Medicare coverages, business from the acquired assets contributed $2 million of both pre-tax income and EBITDA. The pre-tax total return on invested assets was 5.6% for 2017, compared to 2.7% for 2016. White Mountains’s fixed income portfolio returned 3.5% for 2017 and 2.4% for 2016, outperforming the longer duration Bloomberg Barclays U.S. Intermediate Aggregate Index returns of 2.3% for 2017 and 2.0% for 2016. White Mountains’s portfolio of common equity securities returned 20.1% for 2017 and 6.2% for 2016, underperforming the S&P 500 Index returns of 21.8% for 2017 and 12.0% for 2016. White Mountains’s other long-term investments portfolio returned -5.8% for 2017, primarily attributable to losses from foreign currency forward contracts and private capital investments. White Mountains’s other long-term investments portfolio returned 0.8% for 2016. The results were primarily attributable to favorable mark-to-market adjustments to the surplus notes financed in conjunction with OneBeacon’s sale of its runoff business (the “OneBeacon Surplus Notes”), mostly offset by losses from private equity funds and private capital investments. Overview-Year Ended December 31, 2016 versus Year Ended December 31, 2015 White Mountains ended 2016 with book value per share of $785 and adjusted book value per share of $789, an increase of 13.2% and 13.3% for the year, including dividends. Comprehensive income attributable to common shareholders increased to $547 million in 2016 compared to $187 million in 2015. The increases in 2016 were driven by larger transaction related gains. In 2016, White Mountains recorded gains of $477 million and $82 million from the sale of Sirius Group and Tranzact. In 2015, White Mountains recognized $241 million of comprehensive income which was the result of a change in accounting for the investment in Symetra from the equity method to fair value, caused by White Mountains’s relinquishment of its representation on Symetra’s board of directors subsequent to Symetra entering into a merger agreement with Sumitomo Life. See Note 2 - “Significant Transactions” on page for a description of each transaction. For the year ended December 31, 2016, White Mountains repurchased and retired 1,106,145 of its common shares for $887 million at an average share price of $802.08, approximately 101% of White Mountains’s December 31, 2016 adjusted book value per share. For the year ended December 31, 2016, White Mountains returned a total of $892 million of capital to shareholders through share repurchases and dividends. Written premiums and MSC in the HG Global/BAM segment were $77 million in 2016, compared to $55 million in 2015, from both higher pricing and higher issuance volume. BAM insured municipal bonds with par value of $11.3 billion in 2016, compared to $10.6 billion in 2015. Total pricing, which is premiums plus MSC weighted by the par value of municipal bonds insured, was 68 basis points, up from 52 basis points in 2015. As of December 31, 2016, BAM’s total claims paying resources were $644 million on total par insured of $33 billion. Total claims paying resources increased $43 million from December 31, 2015. MediaAlpha reported pre-tax loss of $4 million in 2016, compared to $2 million in 2015. EBITDA was $7 million in both 2016 and 2015. For 2016, an increase in the pre-tax income from the Health, Life and Medicare vertical of approximately $2 million was offset by lower pre-tax income from the P&C vertical. Additionally, in 2016, amortization expense was $2 million higher than 2015, primarily from amortization related to the 2016 acquisition of certain assets in the travel vertical. The pre-tax total return on invested assets was 2.7% for 2016, compared to 3.6% for 2015. White Mountains’s fixed income portfolio returned 2.4% for 2016, outperforming the longer duration Bloomberg Barclays U.S. Intermediate Aggregate Index return of 2.0%. White Mountains’s fixed income portfolio returned 0.2% for 2015, underperforming the longer duration Bloomberg Barclays U.S. Intermediate Aggregate Index return of 1.2%. White Mountains’s portfolio of common equity securities returned 6.2% for 2016, underperforming the S&P 500 Index return of 12.0%. White Mountains’s portfolio of common equity securities returned 33.2% for 2015. Excluding the results from the Symetra transaction, White Mountains’s portfolio of common equity securities returned 2.9% for 2015, outperforming the S&P 500 Index return of 1.4%. White Mountains’s other long-term investments portfolio returned 0.8% for 2016. The results were primarily attributable to favorable mark-to-market adjustments to the OneBeacon Surplus Notes, mostly offset by losses from private equity funds and private capital investments. White Mountains’s other long-term investment portfolio returned -10.1% in 2015, primarily attributable to unfavorable mark-to-market adjustments to the OneBeacon Surplus Notes and unfavorable results from energy exposed private equity funds and a distressed debt hedge fund. Sirius Group’s results inured to White Mountains until April 18, 2016, the closing date of the sale to CMI. For the 2016 period, White Mountains reported Sirius Group’s comprehensive income of $27 million and a combined ratio of 102%, which was driven by $17 million of recorded losses from the Ecuador earthquake that occurred on April 16, 2016. Adjusted Book Value Per Share The following table presents White Mountains’s adjusted book value per share, a non-GAAP financial measure, for the years ended December 31, 2017, 2016 and 2015 and reconciles this non-GAAP measure to the most comparable GAAP measure. See “NON-GAAP FINANCIAL MEASURES” on page 51. December 31, Book value per share numerators (in millions): White Mountains’s common shareholders’ equity $ 3,492.5 $ 3,582.7 $ 3,903.2 Future proceeds from options (1) - 29.7 - Time-value of money discount on expected future payments on the BAM Surplus Notes (2) (157.0 ) N/A N/A HG Global’s unearned premium reserve (2) 103.9 N/A N/A HG Global’s net deferred acquisition costs (2) (24.3 ) N/A N/A Adjusted book value per share numerator $ 3,415.1 $ 3,612.4 $ 3,903.2 Book value per share denominators (in thousands of shares): Common shares outstanding 3,750.2 4,563.8 5,623.7 Unearned restricted shares (16.8 ) (25.9 ) (25.0 ) Options assumed issued (1) - 40.0 - Adjusted book value per share denominator 3,733.4 4,577.9 5,598.7 GAAP book value per share $ 931.30 $ 785.01 $ 694.06 Adjusted book value per share $ 914.75 $ 789.08 $ 697.16 Dividends paid per share $ 1.00 $ 1.00 $ 1.00 (1) Adjusted book value per share at December 31, 2016 includes the impact of 40,000 non-qualified stock options exercisable for $742 per common share. All non-qualified options were exercised prior to their expiration date of January 20, 2017. (2) Amounts reflects White Mountains’s preferred share ownership in HG Global of 96.9%. The following tables presents goodwill and other intangible assets that are included in White Mountains’s adjusted book value as of December 31, 2017, 2016 and 2015: December 31, Millions Goodwill: MediaAlpha $ 18.3 $ 18.3 $ 18.3 Buzzmove 7.6 7.6 - Other - - .3 Total goodwill 25.9 25.9 18.6 . Other intangible assets: MediaAlpha 35.4 18.3 24.4 Buzzmove .8 1.0 - Other - - 2.5 Total other intangible assets 36.2 19.3 26.9 Total goodwill and other intangible assets (1) 62.1 45.2 45.5 Goodwill and other intangible assets held for sale - 1.2 334.3 Goodwill and other intangible assets attributed to non-controlling interests (21.1 ) (17.1 ) (17.1 ) Goodwill and other intangible assets included in White Mountains’s common shareholders’ equity $ 41.0 $ 29.3 $ 362.7 (1) See Note 4 - “Goodwill and Other Intangible Assets” on page for details of other intangible assets. Summary of Consolidated Results The following table presents White Mountains’s consolidated financial results by industry for the years ended December 31, 2017, 2016 and 2015: Year Ended December 31, Millions Revenues Financial Guarantee revenues $ 23.3 $ 16.7 $ 10.7 Marketing Technology revenues 163.2 116.5 105.5 Other revenues 187.3 24.5 323.8 Total revenues 373.8 157.7 440.0 Expenses Financial Guarantee expenses 47.3 43.4 40.1 Marketing Technology expenses 163.6 120.6 107.5 Other expenses 155.1 141.0 163.2 Total expenses 366.0 305.0 310.8 Pre-tax income (loss) Financial Guarantee pre-tax loss (24.0 ) (26.7 ) (29.4 ) Marketing Technology pre-tax loss (.4 ) (4.1 ) (2.0 ) Other pre-tax income (loss) 32.2 (116.5 ) 160.6 Total pre-tax income (loss) 7.8 (147.3 ) 129.2 Income tax benefit (expense) 7.8 32.9 (12.7 ) Net income (loss) from continuing operations 15.6 (114.4 ) 116.5 Gain on sale of discontinued operations, net of tax 557.0 415.1 18.2 Net income from discontinued operations, net of tax 20.5 108.3 116.9 Equity in earnings of unconsolidated affiliates, net of tax - - 25.1 Net income 593.1 409.0 276.7 Net income (loss) attributable to non-controlling interests 34.1 (7.2 ) 18.5 Net income attributable to White Mountains’s common shareholders 627.2 401.8 295.2 Other comprehensive income (loss), net of tax .3 (.7 ) (42.8 ) Comprehensive income (loss) from discontinued operations, net of tax 3.2 146.3 (65.0 ) Comprehensive income 630.7 547.4 187.4 Comprehensive income attributable to non-controlling interests (.2 ) (.3 ) - Comprehensive income attributable to White Mountains’s common shareholders $ 630.5 $ 547.1 $ 187.4 I. Summary of Operations By Segment White Mountains conducts its operations through three segments: (1) HG Global/BAM, (2) MediaAlpha and (3) Other Operations. A discussion of White Mountains’s consolidated investment operations is included after the discussion of operations by segment. White Mountains’s segment information is presented in Note 13 - “Segment Information” on page to the Consolidated Financial Statements. As a result of the OneBeacon, Sirius Group and Tranzact transactions, the results of operations for OneBeacon, Sirius Group and Tranzact have been classified as discontinued operations and are now presented separately, net of related income taxes, in the statement of comprehensive income. Prior year amounts have been reclassified to conform to the current period’s presentation. See Note 19 - “Held for Sale and Discontinued Operations” on page. HG Global/BAM The following tables present the components of pre-tax income included in White Mountains’s HG Global/BAM segment related to the consolidation of HG Global, which includes HG Re and its other wholly-owned subsidiaries, and BAM for the years ended December 31, 2017, 2016 and 2015: Year Ended December 31, 2017 Millions HG Global BAM Eliminations Total Gross written premiums $ - $ 63.2 $ - $ 63.2 Assumed (ceded) written premiums 53.6 (53.6 ) - - Net written premiums $ 53.6 $ 9.6 $ - $ 63.2 Earned insurance and reinsurance premiums $ 7.1 $ 2.3 $ - $ 9.4 Net investment income 3.3 9.0 - 12.3 Net investment income - BAM Surplus Notes 19.0 - (19.0 ) - Net realized and unrealized investment (losses) gains (1.2 ) 1.8 - .6 Other revenues - 1.0 - 1.0 Total revenues 28.2 14.1 (19.0 ) 23.3 Insurance and reinsurance acquisition expenses 1.5 2.5 - 4.0 Other underwriting expenses - .4 - .4 General and administrative expenses 1.0 41.9 - 42.9 Interest expense - BAM Surplus Notes - 19.0 (19.0 ) - Total expenses 2.5 63.8 (19.0 ) 47.3 Pre-tax income (loss) $ 25.7 $ (49.7 ) $ - $ (24.0 ) Supplemental information: Member surplus contributions(1) $ - $ 37.4 $ - $ 37.4 (1) MSC are recorded directly to BAM’s equity, which is recorded as non-controlling interest on White Mountains’s balance sheet. Year Ended December 31, 2016 Millions HG Global BAM Eliminations Total Gross written premiums $ - $ 38.6 $ - $ 38.6 Assumed (ceded) written premiums 27.2 (27.2 ) - - Net written premiums $ 27.2 $ 11.4 $ - $ 38.6 Earned insurance and reinsurance premiums $ 4.4 $ 1.5 $ - $ 5.9 Net investment income 2.2 6.8 - 9.0 Net investment income - BAM Surplus Notes 17.8 - (17.8 ) - Net realized and unrealized investment gains .1 .6 - .7 Other revenues - 1.1 - 1.1 Total revenues 24.5 10.0 (17.8 ) 16.7 Insurance and reinsurance acquisition expenses .9 2.5 - 3.4 Other underwriting expenses - .4 - .4 General and administrative expenses 1.4 38.2 - 39.6 Interest expense - BAM Surplus Notes - 17.8 (17.8 ) - Total expenses 2.3 58.9 (17.8 ) 43.4 Pre-tax income (loss) $ 22.2 $ (48.9 ) $ - $ (26.7 ) Supplemental information: Member surplus contributions(1) $ - $ 38.0 $ - $ 38.0 (1) MSC are recorded directly to BAM’s equity, which is recorded as non-controlling interest on White Mountains’s balance sheet. Year Ended December 31, 2015 Millions HG Global BAM Eliminations Total Gross written premiums $ - $ 25.9 $ - $ 25.9 Assumed (ceded) written premiums 19.3 (19.3 ) - - Net written premiums $ 19.3 $ 6.6 $ - $ 25.9 Earned insurance and reinsurance premiums $ 2.5 $ .8 $ - $ 3.3 Net investment income 1.9 4.2 - 6.1 Net investment income - BAM Surplus Notes 15.8 - (15.8 ) - Net realized and unrealized investment (losses) gains (.3 ) .9 - .6 Other revenues - .7 - .7 Total revenues 19.9 6.6 (15.8 ) 10.7 Insurance and reinsurance acquisition expenses .6 2.3 - 2.9 Other underwriting expenses - .4 - .4 General and administrative expenses 1.4 35.4 - 36.8 Interest expense - BAM Surplus Notes - 15.8 (15.8 ) - Total expenses 2.0 53.9 (15.8 ) 40.1 Pre-tax income (loss) $ 17.9 $ (47.3 ) $ - $ (29.4 ) Supplemental information: Member surplus contributions(1) $ - $ 29.2 $ - $ 29.2 (1) MSC are recorded directly to BAM’s equity, which is recorded as non-controlling interest on White Mountains’s balance sheet. HG Global/BAM Results-Year Ended December 31, 2017 versus Year Ended December 31, 2016 BAM reports on a statutory accounting basis to the NYDFS and does not report stand-alone GAAP financial results. BAM is owned by its members, the municipalities that purchase BAM’s insurance for their debt issuances. BAM charges an insurance premium on each municipal bond insurance policy it writes. A portion of the premium is an MSC and the remainder is a risk premium. In the event of a municipal bond refunding, the MSC from the original issuance can be reutilized, in effect serving as a credit against the total insurance premium on the refunding of the municipal bond. Issuers of debt insured by BAM are members of BAM so long as any of their BAM-insured debt is outstanding, and as members they have certain interests in BAM, including the right to vote for BAM’s directors and to receive dividends in the future, if declared. Written premiums and MSC in the HG Global/BAM segment were $101 million in 2017, compared to $77 million in 2016, as higher pricing more than offset a decrease in issuance volume. BAM’s volume for 2017 was affected by S&P’s review of BAM’s financial strength rating. On June 6, 2017, S&P placed BAM on credit watch negative and initiated a detailed review of BAM’s financial strength rating. On June 26, 2017, S&P concluded its review and affirmed BAM’s “AA/stable” financial strength rating. During the time that BAM was under review by S&P, it voluntarily withdrew from the marketplace and did not write any municipal bond insurance policies. Total pricing, which is written premiums plus MSC, weighted by the par value of municipal bonds insured, was 99 basis points in 2017, up from 68 basis points in 2016. In 2017, BAM insured $10.4 billion of municipal bonds, $9.6 billion of which were in the primary market, down 8% from 2016. The following table presents the gross par value of primary and secondary market policies issued, the gross written premiums plus MSC and total pricing for the twelve months ended December 31, 2017 and 2016: Year Ended December 31, $ in millions Gross par value of primary market policies issued $ 9,633.5 $ 10,336.1 Gross par value of secondary market policies issued 793.2 967.2 Total gross par value of market policies issued $ 10,426.7 $ 11,303.3 Gross written premiums $ 63.2 $ 38.6 MSC collected 37.4 38.0 Total gross written premiums and MSC $ 100.6 $ 76.6 Total pricing (1) 99 bps 68 bps (1) Total pricing also includes the present value of future installment MSC not yet collected of $2.8 for the twelve months ended December 31, 2017. HG Global reported GAAP pre-tax income of $26 million and $22 million in 2017 and 2016, which was driven by $19 million and $18 million of interest income on the BAM Surplus Notes, respectively. BAM is a mutual insurance company that is owned by its members. BAM’s results are consolidated into White Mountains’s GAAP financial statements and attributed to non-controlling interests. White Mountains reported $50 million of GAAP pre-tax losses on BAM in 2017, driven by $19 million of interest expense on the BAM Surplus Notes and $42 million of operating expenses, compared to $49 million of pre-tax losses in 2016, driven by $18 million of interest expense on the BAM Surplus Notes and $38 million of operating expenses. During 2017, BAM paid $5 million of principal and interest in cash on the surplus notes held by HG Global. BAM’s “claims paying resources” represent the capital and other financial resources BAM has available to pay claims and, as such, is a key indication of BAM’s financial strength. BAM’s claims-paying resources include BAM’s qualified statutory capital, including MSC, net unearned premiums, contingency reserves, present value of future installment premiums and MSC and the first loss reinsurance protection provided by HG Re, which is collateralized and held in trusts. BAM expects MSC and HG Re’s reinsurance protection to be the primary drivers of continued growth of its claims-paying resources. BAM’s claims paying resources increased 10% to $708 million at December 31, 2017. The increase was primarily driven by $37 million of MSC and a $44 million increase in the invested assets of the HG Re collateral trusts, partially offset by BAM’s 2017 statutory net loss of $25 million. The following table presents BAM’s total claims paying resources as of December 31, 2017 and 2016: Millions December 31, 2017 December 31, 2016 Policyholders’ surplus $ 427.3 $ 431.5 Contingency reserve 34.8 22.7 Qualified statutory capital 462.1 454.2 Net unearned premiums 30.5 23.2 Present value of future installment premiums and MSC 9.0 3.3 Collateral trusts 206.8 163.0 Claims paying resources $ 708.4 $ 643.7 Beginning in 2017, White Mountains changed its calculation of adjusted book value per share (i) to include a discount for the time value of money arising from the expected timing of cash payments of principal and interest on the BAM surplus notes and (ii) to add back the unearned premium reserve, net of deferred acquisition costs, at HG Global. See “NON-GAAP FINANCIAL MEASURES” on page 51. HG Global/BAM Results-Year Ended December 31, 2016 versus Year Ended December 31, 2015 Written premiums and MSC in the HG Global/BAM segment were $77 million in 2016, compared to $55 million in 2015, from both higher pricing and higher issuance volume. Total pricing, which is written premiums plus MSC, weighted by the par value of municipal bonds insured was 68 basis points in 2016, up from 52 basis points in 2015. In 2016, BAM insured $11.3 billion of municipal bonds, $10.3 billion of which were in the primary market, up 7% from 2015. The following table presents the gross par value of primary and secondary market policies issued, the gross written premiums plus MSC and total pricing for the twelve months ended December 31, 2016 and 2015: Year Ended December 31, $ in millions Gross par value of primary market policies issued $ 10,336.1 $ 9,992.5 Gross par value of secondary market policies issued 967.2 613.5 Total gross par value of market policies issued $ 11,303.3 $ 10,606.0 Gross written premiums $ 38.6 $ 25.9 MSC collected 38.0 29.2 Total gross written premiums and MSC $ 76.6 $ 55.1 Total pricing 68 bps 52 bps HG Global reported GAAP pre-tax income of $22 million and $18 million in 2016 and 2015, which was driven by $18 million and $16 million of interest income on the BAM Surplus Notes, respectively. White Mountains reported $49 million of GAAP pre-tax losses on BAM in 2016, driven by $18 million of interest expense on the BAM Surplus Notes and $38 million of operating expenses, compared to $47 million of pre-tax losses in 2015, driven by $16 million of interest expense on the BAM Surplus Notes and $35 million of operating expenses. BAM’s claims paying resources increased 7% to $644 million at December 31, 2016. The increase was primarily driven by $38 million of MSC and a $26 million increase in the invested assets of the HG Re collateral trusts, partially offset by BAM’s 2016 statutory net loss of $33 million. The following table presents BAM’s total claims paying resources as of December 31, 2016 and 2015: Millions December 31, 2016 December 31, 2015 Policyholders’ surplus $ 431.5 $ 437.2 Contingency reserve 22.7 12.4 Qualified statutory capital 454.2 449.6 Net unearned premiums 23.2 12.5 Present value of future installment premiums and MSC 3.3 2.6 Collateral trusts 163.0 136.6 Claims paying resources $ 643.7 $ 601.3 The following table presents amounts from HG Global, which includes HG Re and its other wholly-owned subsidiaries, and BAM that are contained within White Mountains’s consolidated balance sheet as of December 31, 2017 and 2016: December 31, 2017 Millions HG Global BAM Eliminations and Segment Adjustment Total Segment Assets Fixed maturity investments $ 175.5 $ 448.1 $ - $ 623.6 Short-term investments 28.5 41.3 - 69.8 Total investments 204.0 489.4 - 693.4 Cash 1.9 23.7 - 25.6 BAM Surplus Notes 499.0 - (499.0 ) - Accrued interest receivable on BAM Surplus Notes 126.0 - (126.0 ) - Deferred acquisition costs 25.1 14.9 (25.2 ) 14.8 Insurance premiums receivable 2.7 4.7 (2.9 ) 4.5 Accounts receivable on unsettled investments sales - .1 - .1 Other assets .8 8.2 - 9.0 Total assets $ 859.5 $ 541.0 $ (653.1 ) $ 747.4 Liabilities BAM Surplus Notes (1) $ - $ 499.0 $ (499.0 ) $ - Accrued interest payable on BAM Surplus Notes (2) - 126.0 (126.0 ) - Preferred dividends payable to White Mountains's subsidiaries (3) 227.9 - - 227.9 Preferred dividends payable to non-controlling interests 7.7 - - 7.7 Unearned insurance premiums 107.2 29.6 - 136.8 Accounts payable on unsettled investment purchases - .6 - .6 Other liabilities 1.0 49.0 (28.1 ) 21.9 Total liabilities 343.8 704.2 (653.1 ) 394.9 Equity White Mountains’s common shareholders’ equity 499.8 - - 499.8 Non-controlling interests 15.9 (163.2 ) - (147.3 ) Total equity 515.7 (163.2 ) - 352.5 Total liabilities and equity $ 859.5 $ 541.0 $ (653.1 ) $ 747.4 (1) Under GAAP, the BAM Surplus Notes are classified as debt by the issuer. Under U.S. Statutory accounting, they are classified as policyholders’ surplus. (2) Under GAAP, interest accrues daily on the BAM Surplus Notes. Under U.S. Statutory accounting, interest is not accrued on the BAM Surplus Notes until it has been approved for payment by insurance regulators. (3) For segment reporting, the HG Global preferred dividend receivable at White Mountains is reclassified from the Other Operations segment to the HG Global/BAM segment. Dividends on HG Global preferred shares payable to White Mountains’s subsidiaries are eliminated in White Mountains’s consolidated financial statements. December 31, 2016 Millions HG Global BAM Eliminations and Segment Adjustment Total Segment Assets Fixed maturity investments $ 155.2 $ 430.0 $ - $ 585.2 Short-term investments 6.4 38.1 - 44.5 Total investments 161.6 468.1 - 629.7 Cash 1.9 25.1 - 27.0 BAM Surplus Notes 503.0 - (503.0 ) - Accrued interest receivable on BAM Surplus Notes 108.0 - (108.0 ) - Deferred acquisition costs 11.0 10.6 (11.0 ) 10.6 Insurance premiums receivable .9 1.7 (1.0 ) 1.6 Other assets .6 8.1 - 8.7 Total assets $ 787.0 $ 513.6 $ (623.0 ) $ 677.6 Liabilities BAM Surplus Notes (1) $ - $ 503.0 $ (503.0 ) $ - Accrued interest payable on BAM Surplus Notes (2) - 108.0 (108.0 ) - Preferred dividends payable to White Mountains's subsidiaries (3) 180.5 - - 180.5 Preferred dividends payable to non-controlling interests 5.7 - - 5.7 Unearned insurance premiums 60.7 22.2 - 82.9 Other liabilities .7 31.3 (12.0 ) 20.0 Total liabilities 247.6 664.5 (623.0 ) 289.1 Equity White Mountains’s common shareholders’ equity 522.8 - - 522.8 Non-controlling interests 16.6 (150.9 ) - (134.3 ) Total equity 539.4 (150.9 ) - 388.5 Total liabilities and equity $ 787.0 $ 513.6 $ (623.0 ) $ 677.6 (1) Under GAAP, the BAM Surplus Notes are classified as debt by the issuer. Under U.S. Statutory accounting, they are classified as policyholders’ surplus. (2) Under GAAP, interest accrues daily on the BAM Surplus Notes. Under U.S. Statutory accounting, interest is not accrued on the BAM Surplus Notes until it has been approved for payment by insurance regulators. (3) For segment reporting, the HG Global preferred dividend receivable at White Mountains is reclassified from the Other Operations segment to the HG Global/BAM segment. Dividends on HG Global preferred shares payable to White Mountains’s subsidiaries are eliminated in White Mountains’s consolidated financial statements. The following table presents the gross par value of policies priced and closed by BAM for the years ended December 31, 2017 and 2016: Year Ended December 31, Millions Gross par value of primary market policies issued $ 9,633.5 $ 10,336.1 Gross par value of secondary market policies issued 793.2 967.2 Total gross par value of policies issued 10,426.7 11,303.3 Gross par value of policies priced yet to close 114.4 353.3 Less: Gross par value of policies closed that were priced in a previous period 353.3 298.6 Total gross par value of market policies priced $ 10,187.8 $ 11,358.0 MediaAlpha The following table presents the components of GAAP net loss and EBITDA included in White Mountains’s MediaAlpha segment for the years ended 2017, 2016 and 2015: Year Ended December 31, Millions Advertising and commission revenues $ 163.2 $ 116.5 $ 105.5 Cost of sales 135.9 97.8 90.7 Gross profit 27.3 18.7 14.8 General and administrative expenses 16.2 11.8 8.3 Amortization of other intangible assets 10.5 10.1 8.1 Interest expense 1.0 .9 .4 GAAP pre-tax loss (.4 ) (4.1 ) (2.0 ) Income tax expense - - - GAAP net loss (.4 ) (4.1 ) (2.0 ) Add back: Interest expense 1.0 .9 .4 Income tax expense - - - General and administrative expenses - depreciation .2 .1 - Amortization of other intangible assets 10.5 10.1 8.1 EBITDA (1) $ 11.3 $ 7.0 $ 6.5 (1) See “NON-GAAP FINANCIAL MEASURES” on page 51. MediaAlpha Results-Year Ended December 31, 2017 versus Year Ended December 31, 2016 On October 5, 2017, MediaAlpha acquired certain assets associated with the Health, Life and Medicare insurance business of Healthplans.com for a purchase price of $28 million. The acquired assets include domain names, advertiser and publisher relationships, traffic acquisition accounts, and owned and operated websites. During the fourth quarter of 2017, which includes the annual open enrollment period for Health and Medicare coverages, business from the acquired assets contributed $15 million of revenues and $2 million of both pre-tax income and EBITDA. MediaAlpha reported break-even results in 2017, compared to a pre-tax loss of $4 million in 2016. EBITDA was $11 million in 2017, compared to $7 million in 2016. For the year ended December 31, 2017, the increase in pre-tax income and EBITDA were primarily driven by increases in gross profit of $7 million in the Health, Life and Medicare vertical and $1 million in the P&C vertical, partially offset by increased operating expenses. Advertising and commission revenues were $163 million in 2017, compared to $117 million in 2016. The increase in revenues was primarily driven by growth generated from the newly acquired assets in the Health, Life and Medicare vertical and the growth in the P&C vertical. The Health, Life and Medicare vertical revenues increased $27 million, to $56 million for the year ended December 31, 2017. The P&C vertical revenues increased $11 million, to $88 million for the year ended December 31, 2017. MediaAlpha’s cost of sales is comprised primarily of revenue share based payments to partners. Cost of sales were $136 million in 2017, compared to $98 million in 2016. The 39% increase in cost of sales was driven by the increase in revenues. MediaAlpha Results-Year Ended December 31, 2016 versus Year Ended December 31, 2015 MediaAlpha reported pre-tax losses of $4 million and $2 million in 2016 and 2015. EBITDA was $7 million in 2016 and 2015. The increase in the pre-tax loss in 2016 was primarily driven by the additional amortization expense of $2 million from amortization related to the 2016 acquisition of certain travel-related assets from Oversee.net. Additionally in 2016, gross profit from the Health, Life and Medicare vertical increased $2 million which was offset by the decline in gross profit from the P&C vertical of $2 million and increased operating expenses. Advertising and commission revenues were $117 million in 2016, compared to $106 million in 2015. The increase was driven by $18 million and $11 million of revenue growth in the Health, Life and Medicare vertical and the non-P&C verticals, partially offset by $18 million of revenue decline in the P&C vertical. MediaAlpha’s cost of sales is comprised primarily of revenue share based payments to partners. Cost of sales were $98 million in 2016, compared to $91 million in 2015. Other Operations The following table presents White Mountains’s financial results from its Other Operations segment for the years ended December 31, 2017, 2016 and 2015: Year Ended December 31, Millions Earned insurance premiums $ 1.0 $ 7.5 $ 8.7 Net investment income 43.7 23.1 4.8 Net realized and unrealized investment gains (losses) 132.7 (28.1 ) 259.9 Advertising and commission revenues 3.8 1.8 1.9 Other revenues 6.1 20.2 48.5 Total revenues 187.3 24.5 323.8 Losses and LAE 1.1 8.0 8.2 Insurance and reinsurance acquisition expenses .1 2.2 3.4 Cost of sales 3.5 4.2 2.9 General and administrative expenses - amortization of other intangible assets .2 .4 .5 General and administrative expenses - other 148.9 124.1 147.0 Interest expense on debt 1.3 2.1 1.2 Total expenses 155.1 141.0 163.2 Pre-tax income (loss) $ 32.2 $ (116.5 ) $ 160.6 Other Operations Results-Year Ended December 31, 2017 versus Year Ended December 31, 2016 White Mountains’s Other Operations segment reported pre-tax income of $32 million in 2017 compared to pre-tax loss of $117 million in 2016. The improved results were primarily driven by strong equity returns in 2017. Net realized and unrealized investment gains were $133 million in 2017, compared to net realized and unrealized investment losses of $28 million in 2016. Net investment income increased to $44 million in 2017 from $23 million in 2016. The increase was driven by a higher invested asset base resulting primarily from the proceeds received from the OneBeacon Transaction. See “Summary of Investment Results” on page 38. Other revenues were $6 million in 2017, compared to $20 million in 2016, primarily driven by lower third-party investment management fee income at WM Advisors. The Other Operations segment reported general and administrative expenses of $149 million in 2017, compared to $124 million in 2016. The increase in general and administrative expenses was driven by additional compensation expenses related to the severance of former company executives and higher incentive compensation costs resulting from the OneBeacon Transaction. Share repurchases. For the year ended December 31, 2017, White Mountains repurchased and retired 832,725 of its common shares for $724 million at an average share price of $869.29, or approximately 95% of White Mountains’s December 31, 2017 adjusted book value per share. Other Operations Results-Year Ended December 31, 2016 versus Year Ended December 31, 2015 White Mountains’s Other Operations segment reported pre-tax loss of $117 million in 2016 compared to pre-tax income of $161 million in 2015. The decrease is primarily due to the recognition of a $259 million unrealized investment gain on White Mountains’s investment in Symetra in the fourth quarter of 2015. This gain was the result of a change in accounting for the investment in Symetra from the equity method to fair value, caused by White Mountains’s relinquishment of its representation on Symetra’s board of directors subsequent to Symetra entering into a merger agreement with Sumitomo Life. White Mountains’s Other Operations segment reported net realized and unrealized investment losses of $28 million in 2016, compared to net realized and unrealized investment gains of $260 million in 2015, which included the gain from Symetra. The net realized and unrealized investment losses for the year ended December 31, 2016 included $21 million of losses in two private equity investments. The Other Operations segment reported net investment income of $23 million in 2016 compared to $5 million in 2015, driven by a higher invested asset base resulting primarily from the sale of Sirius Group. See “Summary of Investment Results” on page 38. In addition, other revenues in 2016 included third-party investment management fee income at WM Advisors of $10 million, compared to $13 million in 2015. Other revenue also included a $20 million pre-tax gain in 2015 from the sale of Hamer LLC, a small manufacturing company that White Mountains received in 2012 in connection with the liquidation of a limited partnership fund. General and administrative expenses decreased in the year ended December 31, 2016 compared to the year ended December 31, 2015 as compensation expenses during 2016, driven by the rising market price of White Mountains’s common shares, were more than offset by the impact from $36 million of incentive compensation expense recorded during 2015 related to the agreements to sell Sirius Group and Symetra. During the year ended December 31, 2016, White Mountains wrote down its investment in the SSIE Surplus Notes, which reduced book value per share by approximately $4. White Mountains consolidated SSIE, the issuer of the SSIE Surplus Notes. As a result, the impact of the write down is eliminated in pre-tax income. However, the write down resulted in a $21 million decrease to White Mountains’s book value and a corresponding increase to non-controlling interest equity. Share repurchases. White Mountains repurchased and retired 1,106,145 of its common shares for $887 million in 2016 at an average price per share of $802.08, or approximately 101% of White Mountains’s December 31, 2016 adjusted book value per share. II. Summary of Investment Results White Mountains’s total investment results include continuing operations and discontinued operations. The OneBeacon and Sirius Group investment results are included in discontinued operations for each respective period. For purposes of discussing rates of return, all percentages are presented gross of management fees and trading expenses in order to produce a better comparison to benchmark returns, while all dollar amounts are presented net of management fees and trading expenses. The following table presents White Mountains’s consolidated portfolio pre-tax investment results, including the returns from discontinued operations, for the years ended December 31, 2017, 2016 and 2015: Gross Investment Returns and Benchmark Returns Year Ended December 31, Short-term investments 1.0 % 0.8 % (0.9 )% Investment grade fixed maturity investments 3.4 % 2.6 % 0.3 % Total fixed income investments 3.5 % 2.4 % 0.2 % Bloomberg Barclays U.S. Intermediate Aggregate Index 2.3 % 2.0 % 1.2 % Common equity securities 20.1 % 6.2 % 33.2 % Other long-term investments (5.8 )% 0.8 % (10.1 )% Total common equity securities and other long-term investments 12.7 % 4.3 % 19.3 % S&P 500 Index (total return) 21.8 % 12.0 % 1.4 % Total consolidated portfolio 5.6 % 2.7 % 3.6 % Investment Returns-Year Ended December 31, 2017 versus Year Ended December 31, 2016 White Mountains’s pre-tax total return on invested assets was 5.6% for 2017 compared to 2.7% for 2016. The strong investment returns for 2017 benefited from the relatively short-duration of the fixed income portfolio and continued rally in equity markets, while returns for 2016 were driven by strong common equity returns and decent fixed income returns despite rising rates. Fixed Income Results White Mountains maintains a high quality, short-duration fixed income portfolio. As of December 31, 2017, the fixed income portfolio duration, including short-term investments, was 3.4 years compared to 2.8 years as of December 31, 2016. The increase in the duration of the fixed income portfolio over this period was primarily a result of adding modestly longer securities to the portfolio as prospective total returns became more attractive at higher interest rate levels. White Mountains’s fixed income portfolio returned 3.5% for 2017, outperforming the longer duration Bloomberg Barclays U.S. Intermediate Aggregate Index return of 2.3%, as interest rates rose in the period. White Mountains’s fixed income portfolio returned 2.4% for 2016, outperforming the longer duration Bloomberg Barclays U.S. Intermediate Aggregate Index return of 2.0%, as interest rates rose in the period. In the fourth quarter of 2017, White Mountains established a U.S. investment grade corporate bond portfolio with Principal Global Investors, LLC (“Principal”), a third party manager. As of December 31, 2017, the fair value of the Principal U.S. investment grade corporate bond investments was $250 million and the duration of the Principal investment grade corporate bond portfolio was approximately 4.7 years. In the fourth quarter of 2016, White Mountains established a medium duration GBP investment grade corporate bond mandate with Legal & General Investment Management, Ltd. (“LGIM”), a third-party manager. As of December 31, 2017, the fair value of the medium duration GBP investment grade corporate bonds was $206 million and the duration of the LGIM portfolio was approximately 7.5 years. White Mountains entered into a foreign currency forward contract, which is recorded in other long-term investments, to manage its GBP foreign currency exposure relating to this mandate. As of December 31, 2017, the contract had a total gross notional value of $206 million (GBP 152 million) and a carrying value of $(4) million. In the third quarter of 2016, White Mountains established a relatively concentrated portfolio of high-yield fixed maturity investments managed by Principal. The portfolio is invested in issuers of U.S. dollar denominated publicly traded and 144A debt securities issued by corporations with generally at least one rating between “B-” and “BB+” inclusive by Standard and Poor’s or similar ratings from other rating agencies. As of December 31, 2017, the fair value of the high-yield fixed maturity investments was $203 million and the duration of the Principal high-yield portfolio was approximately 4.6 years. Common Equity Securities and Other Long-Term Investments Results White Mountains maintains a portfolio of common equity securities and other long-term investments. White Mountains’s management believes that prudent levels of investments in common equity securities and other long-term investments are likely to enhance long-term after-tax total returns. White Mountains’s portfolio of common equity securities and other long-term investments returned 12.7% for 2017 and 4.3% for 2016. White Mountains’s portfolio of common equity securities and other long-term investments represented approximately 32% and 15% of total invested assets as of December 31, 2017 and 2016. The increase in the percentage of this portfolio is primarily attributable to management’s decision to add equity exposure during the year and a decline in the investment asset base due to the OneBeacon Transaction and share repurchase activity. White Mountains’s portfolio of common equity securities primarily consists of passive ETFs and publicly-traded common equity securities that are actively managed by third party managers. White Mountains’s portfolio of common equity securities returned 20.1% for 2017, underperforming the S&P 500 Index return of 21.8%. White Mountain’s portfolio of common equity securities returned 6.2% for 2016, underperforming the S&P 500 Index return of 12.0%. The portfolio of ETFs seeks to provide investment results that, before expenses, generally correspond to the performance of broad market indices. As of December 31, 2017 and 2016, White Mountains had approximately $570 million and $322 million invested in ETFs. In 2017 and 2016, the ETFs essentially earned the effective index return, before expenses, over the period in which White Mountains was invested in these funds. White Mountains’s third party common equity manager relationships (the “actively managed common equity portfolios”) have been with Silchester International Investors (“Silchester”), who invests in value-oriented non-U.S. equity securities through a unit trust, and Lateef Investment Management, a growth at a reasonable price adviser managing a highly concentrated portfolio of mid-cap and large-cap growth companies. During the first quarter of 2017, White Mountains established a new third-party manager relationship with Lazard Asset Management (“Lazard”), to manage a Pan-European common equity portfolio, of which the majority of the securities are denominated in Euros. In September 2017, White Mountains terminated its relationship with Lazard in order to concentrate its non-U.S. equity exposure in small to mid-cap international equities through other third-party managers. During the third quarter of 2017 and prior to terminating Lazard, White Mountains established a new third-party manager relationship with Highclere International Investors (“Highclere”), who invests in small to mid-cap equity securities listed in markets outside of the United States and Canada through a unit trust. White Mountains’s actively managed common equity portfolios returned 25.2% in 2017, outperforming the S&P 500 Index return of 21.8% for the comparable period. White Mountains’s actively managed common equity portfolios returned 4.0% in 2016, underperforming the S&P 500 Index return of 12.0% in 2016. White Mountains entered into foreign currency forward contracts, which are recorded in other long-term investments, to manage its foreign currency exposure relating to the common equity portfolio managed by Lazard and a portion of the common equity portfolios managed by Silchester and Highclere. These foreign currency forward contracts were closed as of December 31, 2017. White Mountains maintains a portfolio of other long-term investments that primarily consists of one hedge fund, private equity funds, non-controlling interests in private capital investments and foreign currency forward contracts. As of December 31, 2017, approximately 59% of these other long-term investments, excluding foreign currency forward contracts, were in one long-short hedge fund and ten private equity funds, with a general emphasis on narrow, sector-focused funds. White Mountains’s other long-term investments portfolio returned -5.8% for 2017. The results were primarily attributable to losses from foreign currency forward contracts and unfavorable results from private capital investments, including a $15 million write-down to White Mountains’s investment in Captricity. These losses were partially offset by strong private equity fund performance and favorable mark-to-market adjustments to the OneBeacon Surplus Notes. White Mountains’s other long-term investments portfolio returned 0.8% for 2016. The results were primarily attributable to favorable mark-to-market adjustments to the OneBeacon Surplus Notes, mostly offset by losses from private equity funds and private capital investments. Investment Returns-Year Ended December 31, 2016 versus Year Ended December 31, 2015 White Mountains’s pre-tax total return on invested assets was 2.7% for 2016, compared to 3.6% for 2015. The 2015 results were primarily driven by $259 million in pre-tax unrealized investment gains recognized in the fourth quarter of 2015 resulting from the Symetra transaction. Excluding the results from the Symetra transaction, the total return on invested assets was -0.2% for 2015, which included 0.9% from foreign currency losses. Fixed Income Results White Mountains’s fixed income portfolio returned 2.4% for 2016, outperforming the longer duration Bloomberg Barclays U.S. Intermediate Aggregate Index return of 2.0%, as interest rates rose in the period. White Mountains’s fixed income portfolio returned 0.2% for 2015, underperforming the longer duration Bloomberg Barclays U.S. Intermediate Aggregate Index return of 1.2%, primarily due to foreign currency losses from strengthening in the U.S. dollar. As of December 31, 2016, the fixed income portfolio duration, including short-term investments, was approximately 2.8 years, compared to 2.2 years as of December 31, 2015. The increase in the duration of the fixed income portfolio over this period was primarily a result of buying into the fourth quarter bond market selloff, the establishment of both the Principal high yield mandate in the third quarter of 2016 and the LGIM GBP investment grade corporate bond mandate in the fourth quarter of 2016. At the inception of the LGIM mandate, White Mountains entered into a foreign currency forward contract, which is recorded in other long-term investments, to manage its GBP foreign currency exposure related to this mandate. As of December 31, 2016, the contract had a total gross notional value of approximately $185 million (GBP 150 million) and a carrying value of $(1) million. Common Equity Securities and Other Long-Term Investments Results White Mountains’s portfolio of common equity securities and other long-term investments returned 4.3% for 2016. White Mountains’s portfolio of common equity securities and other long-term investments returned 19.3% for 2015. Excluding the results from the Symetra transaction, the portfolio of common equity securities and other long-term investments returned -1.8% for 2015. White Mountains’s portfolio of common equity securities and other long-term investments represented approximately 15% and 23% of total invested assets as of December 31, 2016 and 2015. When reflecting the Symetra transaction on February 1, 2016 and the Sirius Group sale on April 18, 2016, White Mountains’s portfolio of common equity securities and other long-term investments represented approximately 12% of total invested assets as of December 31, 2015. White Mountains’s common equity securities returned 6.2% for 2016, underperforming the S&P 500 Index return of 12.0% due to pockets of poor performance from the actively managed common equity portfolios managed by third party managers. White Mountains’s portfolio of common equity securities returned 33.2% for 2015. Excluding the results from the Symetra transaction, the portfolio of common equity securities returned 2.9% for 2015, outperforming the S&P 500 Index return of 1.4%. White Mountains’s other long-term investments portfolio returned 0.8% for 2016. The results were primarily attributable to favorable mark-to-market adjustments to the OneBeacon Surplus Notes, mostly offset by losses from private equity funds and private capital investments. White Mountains’s other long-term investment portfolio returned -10.1% for 2015. The results were primarily attributable to unfavorable mark-to-market adjustments to the OneBeacon Surplus Notes and poor performance from investments in energy exposed private equity funds and a distressed debt hedge fund. Portfolio Composition The following table presents the composition of White Mountains’s total operations investment portfolio as of December 31, 2017 and 2016: December 31, 2017 December 31, 2016 $ in millions Carrying value % of total Carrying value % of total Fixed maturity investments $ 2,129.7 63.0 % $ 4,256.8 79.7 % Short-term investments 176.1 5.2 287.1 5.4 Common equity securities 866.1 25.6 474.3 8.9 Other long-term investments 208.8 6.2 323.3 6.0 Total investments $ 3,380.7 100.0 % $ 5,341.5 100.0 % The following table presents the breakdown of White Mountains’s fixed maturity investments as of December 31, 2017 by credit class, based upon issuer credit ratings provided by Standard & Poor’s, or if unrated by Standard & Poor’s, long term obligation ratings provided by Moody’s: December 31, 2017 $ in millions Amortized cost % of total Carrying value % of total U.S. government and government-sponsored entities (1) $ 493.2 23.3 % $ 489.2 23.0 % AAA/Aaa 372.7 17.6 372.3 17.5 AA/Aa 335.1 15.8 338.1 15.9 A/A 246.3 11.6 251.8 11.8 BBB/Baa 471.4 22.3 479.0 22.5 BB 160.6 7.6 161.7 7.6 B 17.6 .8 17.3 .8 Other/not rated 20.3 1.0 20.3 .9 Total fixed maturity investments $ 2,117.2 100.0 % $ 2,129.7 100.0 % (1) Includes mortgage-backed securities, which carry the full faith and credit guaranty of the U.S. government (i.e., GNMA) or are guaranteed by a government sponsored entity (i.e., FNMA, FHLMC). The cost or amortized cost and carrying value of White Mountains’s fixed maturity investments as of December 31, 2017 is presented below by contractual maturity. Actual maturities could differ from contractual maturities because certain borrowers may call or prepay their obligations with or without call or prepayment penalties. December 31, 2017 Millions Amortized cost Carrying value Due in one year or less $ 109.0 $ 108.8 Due after one year through five years 663.0 660.9 Due after five years through ten years 464.9 472.0 Due after ten years 183.1 193.3 Mortgage and asset-backed securities 697.2 694.7 Total fixed maturity investments $ 2,117.2 $ 2,129.7 Foreign Currency Translation As of December 31, 2017, White Mountains had gross foreign currency exposure on approximately $444 million of net assets relating to cash and fixed maturity investments managed by LGIM, common equity securities managed by Silchester and Highclere and various other consolidated and unconsolidated private capital investments. White Mountains entered into foreign currency forward contracts to mitigate its foreign currency exposure for the invested assets managed by LGIM and a portion of the invested assets managed by Silchester and Highclere. In the fourth quarter of 2017, White Mountains closed the foreign currency forward contracts associated with the investment assets managed by Silchester and Highclere. The following table presents the fair value of White Mountains’s foreign denominated assets and the associated foreign currency forward contracts as of December 31, 2017: $ in millions Currency (1) Fair Value (Gross) % of Common Shareholders’ Equity Currency Hedge Fair Value (Net) % of Common Shareholders’ Equity GBP $ 257.5 7.4 % $ (206.3 ) $ 51.2 1.5 % JPY 68.6 2.0 - 68.6 2.0 EUR 55.3 1.6 - 55.3 1.6 All other 62.1 1.7 - 62.1 1.7 Total $ 443.5 12.7 % $ (206.3 ) $ 237.2 6.8 % (1) Includes net assets of Wobi and Buzzmove. Investment in Symetra Common Shares During the third quarter of 2015, Symetra announced that it entered into a merger agreement with Sumitomo Life pursuant to which Sumitomo Life would acquire all of the outstanding shares of Symetra. Following the announcement and Symetra shareholders’ November 5, 2015 meeting to approve the transaction, White Mountains relinquished its representation on Symetra’s board of directors. As a result, White Mountains changed its accounting for Symetra common shares from the equity method to fair value and recognized a $259 million pre-tax unrealized investment gain in the fourth quarter of 2015. The carrying value per Symetra share used in the calculation of White Mountains’s adjusted book value per share was $31.77 at December 31, 2015. On February 1, 2016, Symetra closed its merger agreement with Sumitomo Life and White Mountains received proceeds of $658 million, or $32 per common share. White Mountains recognized $5 million in pre-tax net investment gains associated with Symetra during 2016. Symetra’s total revenues and net income through September 30, 2015 were $1.6 billion and $90 million. As of September 30, 2015, Symetra had total assets of $35.0 billion and shareholders’ equity of $3.1 billion. Since inception, White Mountains received a total of $149 million in cash dividends recorded as a reduction of White Mountains investment in Symetra under the equity method. White Mountains received a cash dividend of $2 million in the fourth quarter of 2015 recorded within net investment income. Income Taxes The Company and its Bermuda-domiciled subsidiaries are not subject to Bermuda income tax under current Bermuda law. In the event there is a change in the current law such that taxes are imposed, the Company and its Bermuda-domiciled subsidiaries would be exempt from such tax until March 31, 2035, pursuant to the Bermuda Exempted Undertakings Tax Protection Act of 1966. The Company has subsidiaries and branches that operate in various other jurisdictions around the world that are subject to tax in the jurisdictions in which they operate. White Mountains reported income tax benefit of $8 million in 2017 on pre-tax income of $8 million. White Mountains’s effective tax rate related to pre-tax income from continuing operations for 2017 was different from the U.S. statutory rate of 35%, primarily due to a full valuation allowance on all U.S. operations, income generated in jurisdictions with lower tax rates than the United States, a tax benefit recorded at BAM related to its MSC, and consolidated pre-tax income being near break-even. For 2017, BAM had amounts recorded in shareholders’ equity related to its MSC that were available to partially offset its loss from continuing operations. As a result, BAM recorded a tax benefit of $10 million in net income from continuing operations, with an offsetting amount recorded in shareholders’ equity. See Note 6 - “Income Taxes” on page. White Mountains reported income tax benefit of $33 million in 2016 on pre-tax loss of $147 million. White Mountains’s effective tax rate for 2016 was different than the U.S. statutory rate of 35% due primarily to a full valuation allowance on all U.S. operations, a $21 million tax benefit generated by the sale of Tranzact recognized in continuing operations related to the reversal of a valuation allowance that resulted from income that was recognized within discontinued operations, and a tax benefit recorded at BAM related to its MSC. For 2016, BAM had amounts recorded in shareholders’ equity related to its MSC that were available to partially offset its loss from continuing operations. As a result, BAM recorded a tax benefit of $11 million in net income from continuing operations, with an offsetting amount recorded in shareholders’ equity. White Mountains reported income tax expense of $13 million in 2015 on pre-tax income of $129 million. White Mountains’s effective tax rate for 2015 was different than the U.S. statutory rate of 35% due primarily to a full valuation allowance on all U.S. operations, a tax benefit recorded at BAM related to its MSC and income generated in jurisdictions with lower tax rates than the United States. For 2015, BAM had amounts recorded in shareholders’ equity related to its MSC that were available to partially offset its loss from continuing operations. As a result, BAM recorded a tax benefit of $9 million in net income from continuing operations, with an offsetting amount recorded in shareholders’ equity. Discontinued Operations During 2017, 2016 and 2015, White Mountains entered into a number of sale transactions that have been accounted for as discontinued operations within its consolidated financial statements. See Note 19 - “Held for Sale and Discontinued Operations” on page for detailed financial information on each business sold. OneBeacon OneBeacon Results - Period Ended September 28, 2017 On September 28, 2017, White Mountains received $1.3 billion in cash proceeds from the OneBeacon Transaction and recorded a gain of $555 million, net of transaction costs. For the 2017 period, White Mountains reported net income from OneBeacon of $21 million in discontinued operations. OneBeacon’s combined ratio for the 2017 period was 105%, driven by 4 points of net unfavorable loss reserve development, primarily in the Program, Healthcare and Government Risk businesses, and 4 points of catastrophe losses, primarily due to losses from Hurricane Harvey. OneBeacon Results-Year Ended December 31, 2016 versus Year Ended December 31, 2015 For the year ended December 31, 2016, White Mountains reported net income from OneBeacon of $109 million, compared to $38 million for the year ended December 31, 2015. Solid underwriting results and investment returns drove the increase OneBeacon’s GAAP combined ratio increased to 97% for 2016 from 96% for 2015, primarily due to a higher expense ratio driven by a lower premium volume and changing business mix. Sirius Group Sirius Group Results - Period Ended April 18, 2016 On April 18, 2016, White Mountains completed the sale of Sirius Group to CMI. Sirius Group’s results inured to White Mountains until the closing date of the transaction. For the 2016 period, White Mountains reported Sirius Group’s comprehensive income of $27 million and a combined ratio of 102%, which was driven by $17 million of recorded losses from the Ecuador earthquake that occurred on April 16, 2016. Sirius Group Results-Year Ended December 31, 2015 For the 2015 period, White Mountains reported Sirius Group’s comprehensive income of $16 million and a combined ratio of 85%, which included $18 million of losses after reinstatement premiums from the Tianjin port explosion. Also, the combined ratios for the year ended December 31, 2015 were higher by 1 point due to the cost of ILW covers purchased to mitigate the potential impact of major events on Sirius Group’s balance sheet pending the close of the sale to CMI. The 2015 period included 3 points of catastrophe losses, primarily from the Chennai flood in Southern India and winter storms in the Northeastern United States. Favorable net loss reserve development was 6 points in 2015 primarily due to decreases in casualty and property loss reserves. Tranzact On July 21, 2016, White Mountains completed the sale of Tranzact to an affiliate of Clayton, Dubilier & Rice, LLC. Tranzact's results inured to White Mountains until the closing date of the transaction. For the 2016 period, White Mountains reported Tranzact's net loss from discontinued operations of $3 million. Tranzact’s results were near break-even for the year ended December 31, 2015. Esurance During 2015, White Mountains recognized $18 million of net income from discontinued operations related to the final settlement with Allstate for favorable development on loss reserves transferred in the sale of Esurance. Since the closing of the transaction through September 30, 2015, White Mountains received a net amount of $28 million from Allstate, primarily related to the favorable development on loss reserves. LIQUIDITY AND CAPITAL RESOURCES Operating Cash and Short-term Investments Holding Company Level. The primary sources of cash for the Company and certain of its intermediate holding companies are expected to be distributions and tax sharing payments received from its operating subsidiaries, capital raising activities, net investment income, proceeds from sales, repayments and maturities of investments and, from time to time, proceeds from sales of operating subsidiaries. The primary uses of cash are expected to be repurchases of the Company’s common shares, payments on and repurchases/retirements of its debt obligations, dividend payments to holders of the Company’s common shares, distributions to non-controlling interest holders of consolidated subsidiaries, purchases of investments, payments to tax authorities, contributions to operating subsidiaries, operating expenses and, from time to time, purchases of operating subsidiaries. Operating Subsidiary Level. The primary sources of cash for White Mountains’s reinsurance and other operating subsidiaries are expected to be premium and fee collections, net investment income, proceeds from sales, repayments and maturities of investments, contributions from holding companies, capital raising activities and, from time to time, proceeds from sales of operating subsidiaries. The primary uses of cash are expected to be loss payments, policy acquisition and other underwriting costs, cost of sales, purchases of investments, payments on and repurchases/retirements of its debt obligations, distributions and tax sharing payments made to holding companies, distributions to non-controlling interest holders, operating expenses and, from time to time, purchases of operating subsidiaries. Both internal and external forces influence White Mountains’s financial condition, results of operations and cash flows. Premium and fee levels, loss payments, cost of sales and investment returns may be impacted by changing rates of inflation and other economic conditions. Some time may lapse between the occurrence of an insured loss, the reporting of the loss to White Mountains and the settlement of the liability for that loss. The exact timing of the payment of losses and benefits cannot be predicted with certainty. White Mountains’s reinsurance subsidiary maintains a portfolio of invested assets with varying maturities and a substantial amount of cash and short-term investments to provide adequate liquidity for the payment of losses. Management believes that White Mountains’s cash balances, cash flows from operations and routine sales and maturities of investments are adequate to meet expected cash requirements for the foreseeable future on both a holding company and subsidiary level. Dividend Capacity Following is a description of the dividend capacity of White Mountains’s reinsurance and other operating subsidiaries: HG Global/BAM As of December 31, 2017, HG Global had $619 million face value of preferred shares outstanding, of which White Mountains owned 96.9%. Holders of the HG Global preferred shares receive cumulative dividends at a fixed annual rate of 6.0% on a quarterly basis, when and if declared by HG Global. HG Global did not declare or pay any preferred dividends in 2017. As of December 31, 2017, HG Global has accrued $236 million of dividends payable to holders of its preferred shares, $228 million of which is payable to White Mountains and eliminated in consolidation. HG Re is a Special Purpose Insurer subject to regulation and supervision by the BMA, but does not require regulatory approval to pay dividends. However, HG Re’s dividend capacity is limited to amounts held outside of the collateral trusts pursuant to the FLRT with BAM. As of December 31, 2017, HG Re had statutory capital and surplus of $677 million, $715 million of assets held in the collateral trusts pursuant to the FLRT with BAM and less than $1 million of cash and investments outside the collateral trusts. Effective January 1, 2014, HG Global and BAM agreed to change the interest rate on the BAM Surplus Notes for the five years ending December 31, 2018 from a fixed rate of 8.0% to a variable rate equal to the one-year U.S. treasury rate plus 300 basis points, set annually, which is 4.6% for 2018. Prior to the end of 2018, BAM has the option to extend the variable rate period for an additional three years. At the end of the variable rate period, the interest rate will be fixed at the higher of the then current variable rate or 8.0%. No payment of interest or principal on the BAM Surplus Notes may be made without the approval of the NYDFS. BAM has stated its intention to seek regulatory approval to pay interest and principal on its surplus notes only to the extent that its remaining qualified statutory capital and other capital resources continue to support its outstanding obligations, business plan and its AA stable rating from S&P. In order to further support BAM’s long-term capital position and business prospects, on August 14, 2017, HG Global contributed the $203 million of Series A Notes into the Supplemental Trust at HG Re, HG Global’s wholly owned reinsurance subsidiary. The Supplemental Trust already held the $300 million of Series B Surplus Notes. Assets held in the Supplemental Trust serve to collateralize HG Re’s obligations to BAM under the FLRT. HG Global and BAM also changed the payment terms of the Series B Notes, so that payments will reduce principal and accrued interest on a pro rata basis, consistent with the payment terms on the Series A Notes. The terms of the Series B Notes had previously stipulated that payments would first reduce interest owed, then reduce principal owed once all accrued interest had been paid. The Supplemental Trust target balance is equal to approximately $603 million. As the BAM Surplus Notes are repaid over time, the BAM Surplus Notes will be replaced in the Supplemental Trust by cash and fixed income securities. The collateral trust balances must be at target levels before capital can be distributed out of the Supplemental Trust. In connection with the contribution, Series A Notes were merged with the Series B Notes. During 2017, BAM repaid $4 million of principal and $1 million of accrued interest on the BAM Surplus Notes. HG Global and BAM also made certain changes to the ceding commission arrangements under the reinsurance treaty between HG Re and BAM. These changes will serve to accelerate growth in BAM’s statutory capital but do not impact the net risk premium ceded from BAM to HG Re. MediaAlpha During 2017, MediaAlpha paid $5 million of dividends, $3 million of which was paid to White Mountains. As of December 31, 2017, MediaAlpha had $9 million of net unrestricted cash. Other Operations During 2017, White Mountains paid a $5 million common share dividend. As of December 31, 2017, the Company and its intermediate holding companies had $1,683 million of net unrestricted cash, short-term investments and fixed maturity investments, $866 million of common equity securities and $62 million of other long-term investments included in its Other Operations segment. Financing The following table summarizes White Mountains’s capital structure as of December 31, 2017 and 2016: December 31, $ in millions WTM Bank Facility $ - $ - MediaAlpha Bank Facility, carrying value 23.8 - Previous MediaAlpha Bank Facility, carrying value - 12.7 Total debt in continuing operations 23.8 12.7 Debt included in discontinued operations - 273.2 Total debt 23.8 285.9 Non-controlling interest - OneBeacon - 244.6 Non-controlling interests - other, excluding mutuals and reciprocals 31.5 35.2 Total White Mountains’s common shareholders’ equity 3,492.5 3,582.7 Total capital 3,547.8 4,148.4 Time-value discount on expected future payments on the BAM Surplus Notes (1) (157.0 ) N/A HG Global’s unearned premium reserve (1) 103.9 N/A HG Global’s net deferred acquisition costs (1) (24.3 ) N/A Total adjusted capital $ 3,470.4 $ 4,148.4 Total debt to total adjusted capital 0.7 % 6.9 % (1) Amount reflects White Mountains's ownership in HG Global of 96.9%. Management believes that White Mountains has the flexibility and capacity to obtain funds externally through debt or equity financing on both a short-term and long-term basis. However, White Mountains can provide no assurance that, if needed, it would be able to obtain additional debt or equity financing on satisfactory terms, if at all. White Mountains has an unsecured revolving credit facility with a syndicate of lenders administered by Wells Fargo Bank, N.A., which has a total commitment of $425 million and a maturity date of August 14, 2018. During the third quarter of 2017, White Mountains borrowed $350 million under the WTM Bank Facility to partially fund a tender offer and subsequently repaid the $350 million after receiving the proceeds from the OneBeacon Transaction. As of December 31, 2017, the WTM Bank Facility was undrawn. The WTM Bank Facility contains various affirmative, negative and financial covenants that White Mountains considers to be customary for such borrowings, including certain minimum net worth and maximum debt to capitalization standards. These covenants can restrict White Mountains in several ways, including its ability to incur additional indebtedness. An uncured breach of these covenants could result in an event of default under the WTM Bank Facility, which would allow lenders to declare any amounts owed under the WTM Bank Facility to be immediately due and payable. In addition, a default under the WTM Bank Facility could occur if certain of White Mountains’s subsidiaries fail to pay principal and interest on a credit facility, mortgage or similar debt agreement (collectively, “covered debt”), or fail to otherwise comply with obligations in such covered debt agreements where such a default gives the holder of the covered debt the right to accelerate at least $75 million of principal amount of covered debt. It is possible that, in the future, one or more of the rating agencies may lower White Mountains’s existing ratings. If one or more of its ratings were lowered, White Mountains could incur higher borrowing costs on future borrowings and its ability to access the capital markets could be impacted. On May 12, 2017, MediaAlpha entered into a secured credit facility (the “MediaAlpha Bank Facility”) with Western Alliance Bank, which had a total commitment of $20 million and a maturity date of May 12, 2020. On October 5, 2017, MediaAlpha refinanced the MediaAlpha Bank Facility in order to fund the acquisition of certain assets associated with the Health, Life and Medicare insurance business of Healthplans.com. The total commitment of the MediaAlpha Bank Facility was increased to $28 million and the maturity date was extended to October 6, 2020. The MediaAlpha Bank Facility consists of an $18 million term loan facility, which has an outstanding balance of $18 million as of December 31, 2017, and a revolving loan facility for $10 million, which has an outstanding balance of $6 million as of December 31, 2017. The MediaAlpha Bank Facility replaced MediaAlpha’s previous credit facility (the “Previous MediaAlpha Bank Facility”) with Opus Bank, which had a total commitment of $20 million. In 2017, under the MediaAlpha Bank Facility, MediaAlpha borrowed $20 million and repaid $2 million on the term loan and borrowed $6 million on the revolving loan. In 2017, under the Previous MediaAlpha Bank Facility, MediaAlpha repaid $13 million. The MediaAlpha Bank Facility is secured by intellectual property and the common stock of MediaAlpha’s subsidiaries, and contains various affirmative, negative and financial covenants that White Mountains considers to be customary for such borrowings, including a maximum leverage ratio. Covenant Compliance At December 31, 2017, White Mountains was in compliance with all of the covenants under all of its debt instruments and expects to remain in compliance for the foreseeable future. Contractual Obligations and Commitments The following table presents White Mountains’s material contractual obligations and commitments as of December 31, 2017: Millions Due in Less Than One Year Due in One to Three Years Due in Three to Five Years Due After Five Years Total Debt $ 3.1 $ 12.1 $ 8.7 $ - $ 23.9 Interest on debt 1.6 2.1 - - 3.7 Long-term incentive compensation 23.7 44.8 - - 68.5 Operating leases (1) 3.1 5.0 8.7 .4 17.2 Total contractual obligations and commitments $ 31.5 $ 64.0 $ 17.4 $ .4 $ 113.3 (1) Amounts include BAM’s operating lease amounts of $1.8, $3.6 and $7.8 that are due in less than one year, one to three years and three to five years, are attributed to non-controlling interests. The balances included in the table above regarding White Mountains’s long-term incentive compensation plans include amounts payable for performance shares and units. Exact amounts to be paid for performance shares cannot be predicted with certainty, as the ultimate amounts of these liabilities are based on the future performance of White Mountains and the market price of the Company’s common shares at the time the payments are made. The estimated payments reflected in the table are based on current accrual factors (including performance relative to targets and common share price) and assume that all outstanding balances were 100% vested as of December 31, 2017. There are no provisions within White Mountains’s operating leasing agreements that would trigger acceleration of future lease payments. White Mountains does not finance its operations through the securitization of its trade receivables, through special purpose entities or through synthetic leases. Further, White Mountains has not entered into any material arrangements requiring it to guarantee payment of third-party debt or lease payments or to fund losses of an unconsolidated special purpose entity. White Mountains also has future binding commitments to fund certain other long-term investments. These commitments, which total approximately $109 million, do not have fixed funding dates and, are therefore, excluded from the table above. In January and February of 2018, White Mountains made additional unfunded commitments totaling $175 million to CrossHarbor and Kudu. Share Repurchase Programs White Mountains’s board of directors has authorized the Company to repurchase its common shares from time to time, subject to market conditions. The repurchase authorizations do not have a stated expiration date. As of December 31, 2017, White Mountains may repurchase an additional 643,130 shares under these board authorizations. In addition, from time to time White Mountains has also repurchased its common shares through tender offers that were separately approved by its board of directors. During the third quarter of 2017, White Mountains completed a “modified Dutch auction” tender offer, through which it repurchased 586,732 of its common shares at a purchase price of $875 per share for a total cost of approximately $515 million, including expenses. The following table presents common shares repurchased by the Company as well as the average price per share as a percent of adjusted book value per share. For 2015, the table also presents the average price per share as a percent of adjusted book value per share, including the estimated gain from the Sirius Group sale of $84 per share as of December 31, 2015 that was reported in the Company’s 2015 Form 10-K. Average price per share as % of Adjusted book Average value per share, Shares Cost price Adjusted book including estimated Dates Repurchased (millions) per share value per share gain from Sirius sale Year ended December 31, 2017 832,725 $ 723.9 $ 869.29 95% N/A Year ended December 31, 2016 1,106,145 $ 887.2 $ 802.08 101% N/A Year ended December 31, 2015 387,495 $ 284.2 $ 733.37 105% 94% Cash Flows Detailed information concerning White Mountains’s cash flows during 2017, 2016 and 2015 follows: Cash flows from continuing operations for the years ended 2017, 2016 and 2015 Net cash flows used for continuing operations was $62 million, $173 million and $66 million for the years ended 2017, 2016 and 2015. Cash used for continuing operations was lower in 2017 compared to 2016, primarily due to a $166 million use of cash in 2016 from the settlement of certain liabilities and transaction costs in connection with the Sirius Group and Tranzact sales. This decrease in cash used from operations was partially offset by an increase in incentive compensation and employee retirement payments in 2017 relative to 2016. White Mountains made long-term incentive payments totaling $22 million, $41 million and $31 million during 2017, 2016 and 2015. During 2017, White Mountains also paid $28 million in cash related to the departures of the Company’s former Chairman and CEO and former CFO. White Mountains does not believe that these trends will have a meaningful impact on its future liquidity or its ability to meet its future cash requirements as it has $1,683 million of net unrestricted cash, short-term investments and fixed maturity investments, $866 million of common equity securities and $62 million of other long-term investments as of December 31, 2017. Cash flows from investing and financing activities for the year ended December 31, 2017 Financing and Other Capital Activities During 2017, the Company declared and paid a $5 million cash dividend to its common shareholders. During 2017, the Company repurchased and retired 832,725 of its common shares for $724 million, which included 10,993 for $9 million under employee benefit plans for statutory withholding tax payments. During 2017, the Company borrowed and repaid $350 million under the WTM Bank Facility. During 2017, BAM received $37 million in MSC from its members. During 2017, BAM repaid $4 million of principal and $1 million of accrued interest on the BAM Surplus Notes. During 2017, MediaAlpha paid $5 million of dividends, of which $3 million was paid to White Mountains. During 2017, MediaAlpha borrowed $20 million on the term loan and $6 million on the revolving loan under the MediaAlpha Bank Facility. During 2017, MediaAlpha repaid $13 million under the Previous MediaAlpha Bank Facility and $2 million on the term loan under the MediaAlpha Bank Facility. During 2017, Wobi borrowed ILS 68 million (approximately $19 million) from White Mountains under an internal credit facility. During 2017, White Mountains received $45 million of dividends from OneBeacon, which is reported as discontinued operations. Acquisitions and Dispositions On August 1, 2017, White Mountains purchased 37,409 newly-issued preferred shares of Buzzmove for GBP 4 million (approximately $5 million based upon the foreign exchange spot rate at the date of acquisition) and 5,808 common shares from the company founders for GBP 0.5 million (approximately $0.7 million based upon the foreign exchange spot rate at the date of acquisition). On September 28, 2017, OneBeacon closed its definitive merger agreement with Intact and White Mountains received proceeds of $1,299 million, or $18.10 per OneBeacon common share. On October 5, 2017, White Mountains purchased 131,579 newly-issued Class A common units of MediaAlpha for $13 million. On October 5, 2017, MediaAlpha acquired certain assets associated with the Health, Life and Medicare insurance business of Healthplans.com for an aggregate purchase price of $28 million. During 2017, White Mountains made gross investments into funds managed by Enlightenment Capital totaling $13 million and received a total of $24 million of distributions from these funds. During 2017, White Mountains made gross investments into funds managed by Tuckerman Capital totaling $17 million and received a total of $2 million of distributions from these funds. Cash flows from investing and financing activities for the year ended December 31, 2016 Financing and Other Capital Activities During 2016, the Company declared and paid a $5 million cash dividend to its common shareholders. During 2016, the Company repurchased and retired 1,106,145 of its common shares for $887 million, which included 8,022 common shares repurchased under employee benefit plans. During 2016, the Company borrowed a total of $350 million and repaid a total of $400 million under the WTM Bank Facility. During 2016, HG Global raised $6 million of additional capital through the issuance of preferred shares, 97% of which were purchased by White Mountains. HG Global used $3 million of the proceeds to repay and cancel an internal credit facility with White Mountains. During 2016, BAM received $38 million in MSC from its members. During 2016, MediaAlpha paid $3 million of dividends, of which $2 million was paid to White Mountains. During 2016, MediaAlpha repaid $2 million of the term loan portion and borrowed $3 million and repaid $3 million under the revolving loan portion of the previous MediaAlpha bank facility. During 2016, Star & Shield borrowed a total of $4 million under an internal revolving credit facility from White Mountains. During 2016, White Mountains contributed $15 million to WM Advisors. During 2016, White Mountains Life Reinsurance (Bermuda) Ltd. returned $73 million of capital to White Mountains. During 2016, White Mountains received $60 million of dividends from OneBeacon, which is reported as discontinued operations. Acquisitions and Dispositions On January 7, 2016, Wobi settled its acquisition of the remaining share capital of Cashboard for NIS 16 million (approximately $4 million based upon the foreign exchange spot rate at the date of acquisition). On February 1, 2016, Symetra closed its merger agreement with Sumitomo Life and White Mountains received proceeds of $658 million, or $32.00 per Symetra common share. On February 26, 2016, White Mountains paid $8 million in settlement of the contingent purchase adjustment for its acquisition of MediaAlpha in 2014. On March 8, 2016 and August 3, 2016, White Mountains purchased additional shares in Captricity for a total of approximately $2 million. On April 18, 2016, White Mountains completed the sale of Sirius Group to CMI for approximately $2.6 billion. $162 million of this amount was used to purchase certain assets to be retained by White Mountains out of Sirius Group, including shares of OneBeacon. During 2016, White Mountains made gross investments into funds managed by Enlightenment Capital totaling $11 million and received a total of $14 million of distributions from these funds. During 2016, White Mountains made gross investments into funds managed by Tuckerman Capital totaling $10 million and received a total of $4 million of distributions from these funds. On July 21, 2016, White Mountains completed the sale of Tranzact and received net proceeds of $221 million at closing. On October 5, White Mountains received additional proceeds of $1 million following the release of the post-closing purchase price adjustment escrow. On August 4, 2016, White Mountains purchased 110,461 common shares of Buzzmove for GBP 4 million (approximately $5 million) and 54,172 shares of newly issued convertible preferred shares of Buzzmove for GBP 2 million (approximately $3 million), representing a 70.9% ownership share of Buzzmove on a fully converted basis. On October 10, 2016, White Mountains completed the sale of Ashmere and received proceeds of $15 million. During 2016, White Mountains increased its investment in Wobi through the purchase of newly-issued convertible preferred shares for a total of NIS 36 million (approximately $10 million). Cash flows from investing and financing activities for the year ended December 31, 2015 Financing and Other Capital Activities During 2015, the Company declared and paid a $6 million cash dividend to its common shareholders. During 2015, the Company repurchased and retired 387,495 of its common shares for $284 million, which included 12,156 common shares repurchased under employee benefit plans and 13,500 common shares from the Prospector Offshore Fund, Ltd. redemption. During 2015, the Company borrowed a total of $125 million and subsequently repaid a total of $75 million under the WTM Bank Facility. During 2015, BAM received $29 million in MSC from its members. During 2015, MediaAlpha paid $4 million of dividends, of which approximately $2 million was paid to White Mountains. During 2015, MediaAlpha borrowed $15 million under the term loan portion of the previous MediaAlpha bank facility and used the proceeds to make a $15 million return of capital payment to its unit holders, of which White Mountains received $9 million. During 2015, White Mountains contributed $8 million to White Mountains Life Reinsurance (Bermuda) Ltd. and its U.S.-based service provider, White Mountains Financial Services LLC (collectively, “WM Life Re”). During 2015, WM Life Re repaid $23 million under an internal revolving credit facility with an intermediate holding company of White Mountains. During 2015, White Mountains received $60 million of dividends from OneBeacon, which is reported as discontinued operations. Acquisitions and Dispositions On February 23, 2015, Wobi acquired 56.2% of the outstanding share capital of Cashboard for NIS 10 million (approximately $2 million). During the second quarter of 2015, Wobi purchased newly issued common shares of Cashboard for NIS 10 million (approximately $3 million). During 2015, White Mountains increased its ownership interest in Wobi through (i) the purchase of common and convertible preferred shares from a non-controlling interest shareholder for NIS 35 million (approximately $9 million) and (ii) the purchase of newly-issued convertible preferred shares for NIS 56 million (approximately $15 million). On April 2, 2015, White Mountains closed on its investment in PassportCard, a 50/50 joint venture with DavidShield and contributed $21 million of assets to a newly formed entity, PassportCard Limited (formerly PPCI Global Limited). On May 27, 2015, White Mountains sold its interest in Hamer LLC and received cash proceeds of $24 million. On December 21, 2015, White Mountains purchased a non-controlling interest in Captricity for approximately $27 million. On December 22, 2015, White Mountains closed on its investment in OneTitle for approximately $3 million. During 2015, White Mountains provided approximately $13 million of additional growth capital to Compare.com. During 2015, White Mountains purchased $4 million of SSIE Surplus Notes, which increased its investment in SSIE Surplus Notes to $21 million as of December 31, 2015. During 2015, White Mountains made gross investments into funds managed by Enlightenment Capital totaling $4 million and received a total of $5 million of distributions from these funds. During 2015, White Mountains made gross investments into funds managed by Tuckerman Capital totaling $5 million and received a total of $2 million of distributions from these funds. TRANSACTIONS WITH RELATED PERSONS See Note 17 - “Transactions with Related Persons” on page in the accompanying Consolidated Financial Statements. NON-GAAP FINANCIAL MEASURES This report includes five non-GAAP financial measures that have been reconciled from their most comparable GAAP financial measures. Adjusted book value per share is a non-GAAP financial measure which is derived by adjusting (i) the GAAP book value per share numerator and (ii) the common shares outstanding denominator, as described below. Beginning in 2017, the GAAP book value per share numerator has been adjusted (i) to include a discount for the time value of money arising from the expected timing of cash payments of principal and interest on the BAM surplus notes and (ii) to add back the unearned premium reserve, net of deferred acquisition costs, at HG Global. Under GAAP, White Mountains is required to carry the BAM surplus notes, including accrued interest, at nominal value with no consideration for time value of money. Based on a debt service model that forecasts operating results for BAM through maturity of the surplus notes, the present value of the BAM surplus notes, including accrued interest, was estimated to be $162 million less than the nominal GAAP carrying values as of December 31, 2017. The value of HG Global’s unearned premium reserve, net of deferred acquisition costs, was $82 million as of December 31, 2017. White Mountains believes these adjustments are useful to management and investors in analyzing the intrinsic value of HG Global, including the value of the surplus notes and the value of the in-force business at HG Re, HG Global’s reinsurance subsidiary. For 2016, the numerator used in the calculation of adjusted book value per share also includes the dilutive effects of future proceeds from the outstanding non-qualified options for periods prior to January 20, 2017, the expiration date of the non-qualified options. For 2015, the numerator used in the calculation of adjusted book value per share also excludes equity in net unrealized investment gains (losses) from Symetra’s fixed maturity portfolio for periods that White Mountains accounted for its investment in Symetra under the equity method. White Mountains accounted for its investment in Symetra under the equity method until November 5, 2015, when it changed its accounting to fair value. The denominator used in the calculation of adjusted book value per share equals the number of common shares outstanding adjusted (i) to exclude unearned restricted common shares, the compensation cost of which, at the date of calculation, has yet to be amortized and (ii) to include the dilutive effects of outstanding non-qualified options for periods prior to January 20, 2017, the expiration date of the non-qualified options. The reconciliation of GAAP book value per share to adjusted book value per share is included on page 28. In 2017, MediaAlpha became a reportable segment, and White Mountains has included MediaAlpha’s EBITDA calculation as a non-GAAP financial measure. EBITDA is defined as net income (loss) excluding interest expense on debt, income tax benefit (expense), depreciation and amortization. White Mountains believes that this non-GAAP financial measure is useful to management and investors in analyzing MediaAlpha’s economic performance without the effects of interest rates, levels of debt, effective tax rates, or depreciation and amortization primarily resulting from purchase accounting. In addition, White Mountains believes that investors use EBITDA as a supplemental measurement to evaluate the overall operating performance of companies within the same industry. The reconciliation of MediaAlpha’s GAAP net income to EBITDA is included on page 36. Total capital at White Mountains is comprised of White Mountains’s common shareholders’ equity, debt and non-controlling interests other than non-controlling interests attributable to mutuals and reciprocals. Total adjusted capital is a non-GAAP financial measure, which is derived by adjusting total capital (i) to include a discount for the time value of money arising from the expected timing of cash payments of principal and interest on the BAM Surplus Notes and (ii) to add back the unearned premium reserve, net of deferred acquisition costs, at HG Global. The reconciliation of total capital to total adjusted capital is included on page 46. For 2015, total consolidated portfolio returns excluding Symetra and total common equity securities and other long-term investments returns excluding Symetra are non-GAAP financial measures that remove the $259 million pre-tax unrealized investment gain recognized in the fourth quarter of 2015 that was the result of the change in accounting for Symetra common shares from the equity method to fair value. White Mountains believes these measures make the returns in 2016 more comparable to 2015. The following table presents a reconciliation of the GAAP returns to the returns excluding Symetra follows: For the year ended December 31, 2015 GAAP returns Remove Symetra Returns - excluding Symetra Total consolidated portfolio returns 3.6 % (3.8 )% (0.2 )% Total common equity securities and other long-term investments returns 19.3 % (21.1 )% (1.8 )% Total common equity securities 33.2 % (30.3 )% 2.9 % CRITICAL ACCOUNTING ESTIMATES Management’s Discussion and Analysis of Financial Condition and Results of Operations discuss the Company’s consolidated financial statements, which have been prepared in accordance with GAAP. The financial statements presented herein include all adjustments considered necessary by management to fairly present the financial position, results of operations and cash flows of White Mountains. The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities as of the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Certain of these estimates are considered critical in that they involve a higher degree of judgment and are subject to a significant degree of variability. On an ongoing basis, management evaluates its estimates and bases its estimates on historical experience and on various other factors that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. 1. Fair Value Measurements General White Mountains records certain assets and liabilities at fair value in its consolidated financial statements, with changes therein recognized in current period earnings. In addition, White Mountains discloses estimated fair value for certain liabilities measured at historical or amortized cost. Fair value is defined as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants (an exit price) at a particular measurement date. Fair value measurements are categorized into a hierarchy that distinguishes between inputs based on market data from independent sources (“observable inputs”) and a reporting entity’s internal assumptions based upon the best information available when external market data is limited or unavailable (“unobservable inputs”). Quoted prices in active markets for identical assets have the highest priority (“Level 1”), followed by observable inputs other than quoted prices including prices for similar but not identical assets (“Level 2”), and unobservable inputs, including the reporting entity’s estimates of the assumptions that market participants would use, having the lowest priority (“Level 3”). Assets and liabilities carried at fair value include substantially all of the investment portfolio, exchange traded and over the counter derivative instruments, and reinsurance assumed liabilities associated with variable annuity benefit guarantees. Valuation of assets and liabilities measured at fair value require management to make estimates and apply judgment to matters that may carry a significant degree of uncertainty. In determining its estimates of fair value, White Mountains uses a variety of valuation approaches and inputs. Whenever possible, White Mountains estimates fair value using valuation methods that maximize the use of observable prices and other inputs. Where appropriate, assets and liabilities measured at fair value have been adjusted for the effect of counterparty credit risk. Invested Assets As of December 31, 2017, White Mountains used quoted market prices or other observable inputs to determine fair value for approximately 94% of the investment portfolio. Investments valued using Level 1 inputs include fixed maturity investments, primarily investments in U.S. Treasuries, short-term investments, which include U.S. Treasury Bills and common equity securities. Investments valued using Level 2 inputs include fixed maturity investments, which have been disaggregated into classes, including debt securities issued by corporations, mortgage and asset-backed securities, municipal obligations, and foreign government, agency and provincial obligations. Investments valued using Level 2 inputs also include certain passive ETFs traded on foreign exchanges that track U.S. stock indices such as the S&P 500 and that management values using the fund manager’s published NAV to account for the difference in market close times. Fair value estimates for investments that trade infrequently and have few or no observable market prices are classified as Level 3 measurements. Investments valued using Level 3 fair value estimates are based upon unobservable inputs and include investments in certain fixed maturity investments, common equity securities and other long-term investments where quoted market prices are unavailable or are not considered reasonable. Transfers between levels are based on investments held as of the beginning of the period. White Mountains uses brokers and outside pricing services to assist in determining fair values. For investments in active markets, White Mountains uses the quoted market prices provided by outside pricing services to determine fair value. The outside pricing services White Mountains uses have indicated that they will only provide prices where observable inputs are available. In circumstances where quoted market prices are unavailable or are not considered reasonable, White Mountains estimates the fair value using industry standard pricing methodologies and observable inputs such as benchmark yields, reported trades, broker-dealer quotes, issuer spreads, benchmark securities, bids, offers, credit ratings, prepayment speeds, reference data including research publications and other relevant inputs. Given that many fixed maturity investments do not trade on a daily basis, the outside pricing services evaluate a wide range of fixed maturity investments by regularly drawing parallels from recent trades and quotes of comparable securities with similar features. The characteristics used to identify comparable fixed maturity investments vary by asset type and take into account market convention. White Mountains’s process to assess the reasonableness of the market prices obtained from the outside pricing services covers substantially all of its fixed maturity investments and includes, but is not limited to, a review of pricing methodologies and the pricing services’ quality control procedures on at least an annual basis, a comparison of prices provided on its invested assets by the outside pricing service to prices obtained from alternate independent pricing vendors on at least a semi-annual basis, monthly analytical reviews of certain prices and a review of the underlying assumptions utilized by the pricing services for select measurements on an ad hoc basis throughout the year. White Mountains also performs back-testing of selected sales activity to determine whether there are any significant differences between the market price used to value the security prior to sale and the actual sale price on an ad-hoc basis throughout the year. Prices provided by the pricing services that vary by more than 5% and $1 million from the expected price based on these reasonableness procedures are considered outliers. Also considered outliers are prices that have not changed from period to period and prices that have trended unusually compared to market conditions. In circumstances where the results of White Mountains’s review process does not appear to support the market price provided by the pricing services, White Mountains challenges the vendor provided price. If White Mountains cannot gain satisfactory evidence to support the challenged price, it relies upon its own pricing methodologies to estimate the fair value of the security in question. The valuation process described above is generally applicable to all of White Mountains’s fixed maturity investments. The techniques and inputs specific to asset classes within White Mountains’s fixed maturity investments for Level 2 securities that use observable inputs are as follows: Debt Securities Issued by Corporations: The fair value of debt securities issued by corporations is determined from a pricing evaluation technique that uses information from market sources and integrates relative credit information, observed market movements, and sector news. Key inputs include benchmark yields, reported trades, broker-dealer quotes, issuer spreads, two-sided markets, benchmark securities, bids, offers, and reference data including sector, coupon, credit quality ratings, duration, credit enhancements, early redemption features and market research publications. Mortgage and Asset-Backed Securities: The fair value of mortgage and asset-backed securities is determined from a pricing evaluation technique that uses information from market sources and leveraging similar securities. Key inputs include benchmark yields, reported trades, underlying tranche cash flow data, collateral performance, plus new issue data, as well as broker-dealer quotes, issuer spreads, two-sided markets, benchmark securities, bids, offers, and reference data including issuer, vintage, loan type, collateral attributes, prepayment speeds, default rates, recovery rates, cash flow stress testing, credit quality ratings and market research publications. Municipal Obligations: The fair value of municipal obligations is determined from a pricing evaluation technique that uses information from market makers, brokers-dealers, buy-side firms, and analysts along with general market information. Key inputs include benchmark yields, reported trades, issuer financial statements, material event notices and new issue data, as well as broker-dealer quotes, issuer spreads, two-sided markets, benchmark securities, bids, offers, and reference data including type, coupon, credit quality ratings, duration, credit enhancements, geographic location and market research publications. Foreign Government, Agency and Provincial Obligations: The fair value of foreign government, agency and provincial obligations is determined from a pricing evaluation technique that uses feeds from data sources in each respective country, including active market makers and inter-dealer brokers. Key inputs include benchmark yields, reported trades, broker-dealer quotes, two-sided markets, benchmark securities, bids, offers, local exchange prices, foreign exchange rates and reference data including coupon, credit quality ratings, duration and market research publications. Level 3 valuations are generated from techniques that use assumptions not observable in the market. These unobservable assumptions reflect White Mountains’s assumptions that market participants would use in valuing the investment. Generally, certain securities may start out as Level 3 when they are originally issued but as observable inputs become available in the market, they may be reclassified to Level 2. The following table presents White Mountains’s fair value measurements and the percentage of Level 3 investments as of December 31, 2017. The major security types were based on the legal form of the securities. White Mountains has disaggregated its fixed maturity investments based on the issuing entity type, which impacts credit quality, with debt securities issued by U.S. government entities carrying minimal credit risk, while the credit and other risks associated with other issuers, such as debt securities issued by corporations, foreign governments, municipalities or entities issuing mortgage and asset-backed securities vary depending on the nature of the issuing entity type. December 31, 2017 $ in millions Fair value Level 3 Inputs Level 3 Inputs as a % of total fair value U.S. Government and agency obligations $ 296.5 $ - - % Debt securities issued by corporations 880.9 - - Mortgage and asset-backed securities 694.7 - - Municipal obligations 254.9 - - Foreign government, agency and provincial obligations 2.7 - - Fixed maturity investments 2,129.7 - - Short-term investments 176.1 - - Common equity securities 866.1 - - Other long-term investments (1)(2) 87.2 87.2 % Total investments $ 3,259.1 $ 87.2 % (1) Excludes carrying value of $(3.7) related to foreign currency forward contracts. (2) Excludes carrying value of $125.3 associated with hedge funds and private equity funds for which fair value is measured at NAV using the practical expedient. White Mountains uses quoted market prices where available as the inputs to estimate fair value for its investments in active markets. Such measurements are considered to be either Level 1 or Level 2 measurements, depending on whether the quoted market price inputs are for identical securities (Level 1) or similar securities (Level 2). See Note 3 - “Investment Securities” on page for tables that summarize the changes in White Mountains’s fair value measurements by level for the years ended December 31, 2017 and 2016 and for amount of total gains (losses) included in earnings attributable to net unrealized investment gains (losses) for Level 3 investments for years ended December 31, 2017, 2016 and 2015. Other Long-Term Investments: White Mountains’s other long-term investments as of December 31, 2017 included $55 million in one hedge fund and $70 million in ten private equity funds. The largest investment in a single fund was $55 million and $22 million as of December 31, 2017 and 2016. White Mountains employs a number of procedures to assess the reasonableness of the fair value measurements for its other long-term investments, including obtaining and reviewing periodic and audited annual financial statements of hedge funds and private equity funds as well as discussing each fund’s pricing with the fund manager throughout the year. However, since the fund managers do not provide sufficient information to evaluate the pricing methods and inputs for each underlying investment, White Mountains considers the inputs to be unobservable. The fair value of White Mountains’s hedge fund and private equity fund investments has generally been determined using the fund manager’s net asset value (“NAV”). In the event that White Mountains believes the fair value of a hedge fund or private equity fund differs from the NAV reported by the fund manager due to illiquidity or other factors, White Mountains will adjust the reported NAV to more appropriately represent the fair value of its investment in the hedge fund or private equity fund. As of December 31, 2017 and 2016, White Mountains did not adjust the reported NAV of its investments in hedge funds and private equity funds. Sensitivity Analysis of Likely Returns on Other Long-Term Investments White Mountains maintains a portfolio of other long-term investments that consists primarily of one hedge fund, ten private equity funds, non-controlling interests in private capital investments and foreign currency forward contracts. The underlying investments of the hedge fund and private equity funds are typically publicly traded and private common equity securities and, as such, are subject to market risks that are similar to White Mountains’s common equity securities. The following table presents the estimated effect on fair values as of December 31, 2017 resulting from a 10% change and a 30% change in the market value of other long-term investments: Change in fair value at Carrying Value at December 31, 2017 Millions December 31, 2017 10% decline 10% increase 30% decline 30% increase Hedge fund $ 54.9 $ (5.5 ) $ 5.5 $ (16.5 ) $ 16.5 Private equity funds 70.4 (7.0 ) 7.0 (21.1 ) 21.1 Private equity securities (1) 83.2 (8.3 ) 8.3 (25.0 ) 25.0 Other .3 - - (.1 ) .1 Total other long-term investments $ 208.8 $ (20.8 ) $ 20.8 $ (62.7 ) $ 62.7 (1) Includes non-controlling interests in common equity securities, limited liability companies and private convertible preferred securities. 2. Surplus Note Valuation BAM Surplus Notes As of December 31, 2017, White Mountains owned $499 million of BAM Surplus Notes and has accrued $126 million in interest due thereon. During 2017, with approval of the NYDFS, BAM paid $5 million to White Mountains for amounts owed under the BAM Surplus Notes. Because BAM is consolidated in White Mountains’s financial statements, the BAM Surplus Notes and accrued interest are classified as intercompany notes, carried at face value and eliminated in consolidation. However, the BAM Surplus Notes and accrued interest are carried as assets at HG Global, of which White Mountains owns 97% of the preferred equity, while the BAM Surplus Notes are carried as liabilities at BAM, which White Mountains has no ownership interest in and is completely attributed to non-controlling interests. Any write-off of the carried amount of the BAM Surplus Notes and/or the accrued interest thereon would adversely impact White Mountains’s adjusted book value per share. See Item 1A., Risk Factors, “If BAM does not pay some or all of the interest and principal due on the BAM Surplus Notes, White Mountains’s adjusted book value per share, results of operations and financial condition could be materially adversely affected.” on page 18. Periodically, White Mountains’s management reviews the recoverability of amounts recorded from the BAM Surplus Notes. As of December 31, 2017, White Mountains believes such notes and interest thereon to be fully recoverable. White Mountains’s review is based on a debt service model that forecasts operating results for BAM, and related payments on the BAM Surplus Notes, through maturity of the BAM Surplus Notes in 2042. The model depends on assumptions regarding future trends for the issuance of municipal bonds, interest rates, credit spreads, insured market penetration, competitive activity in the market for municipal bond insurance and other factors affecting the demand for and price of BAM’s municipal bond insurance. Assumptions regarding future trends for these factors are a matter of significant judgment. In the updates of this model that were performed as of December 31, 2017, White Mountains has (1) reflected the impact of the changes to the terms of the BAM Surplus Notes on expected future payments and (2) made more conservative assumptions about BAM’s future operating results, specifically forecasted increases in annual par insured volume and total premiums received, which are each expected to increase over the next six years and flatten thereafter. As a result, White Mountains now projects that the BAM Surplus Notes will be fully repaid approximately nine years prior to final maturity, which is six years later than projected under the previous forecast as of December 31, 2016. The model assumptions are based on historical trends, current conditions and expected future developments. Whether actual results will follow forecast is subject to a number of risks and uncertainties. No payment of interest or principal on the BAM Surplus Notes may be made without the approval of the NYDFS. BAM has stated its intention to seek regulatory approval to pay interest and principal on its surplus notes only to the extent that its remaining qualified statutory capital and other capital resources continue to support its outstanding obligations, business plan and AA stable rating from S&P. Interest payments on the BAM Surplus Notes are due quarterly but are subject to deferral, without penalty or default and without compounding, for payment in the future. No principal is due on the BAM Surplus Notes prior to the stated maturity date of 2042. BAM has the right to prepay principal in whole or in part at any time. FORWARD-LOOKING STATEMENTS This report may contain “forward-looking statements” within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934. All statements, other than statements of historical facts, included or referenced in this report which address activities, events or developments which White Mountains expects or anticipates will or may occur in the future are forward-looking statements. The words “will”, “believe”, “intend”, “expect”, “anticipate”, “project”, “estimate”, “predict” and similar expressions are also intended to identify forward-looking statements. These forward-looking statements include, among others, statements with respect to White Mountains’: • change in adjusted book value per share or return on equity; • business strategy; • financial and operating targets or plans; • incurred loss and loss adjustment expenses and the adequacy of its loss and loss adjustment expense reserves; • projections of revenues, income (or loss), earnings (or loss) per share, dividends, market share or other financial forecasts; • expansion and growth of its business and operations; and • future capital expenditures. These statements are based on certain assumptions and analyses made by White Mountains in light of its experience and perception of historical trends, current conditions and expected future developments, as well as other factors believed to be appropriate in the circumstances. However, whether actual results and developments will conform to its expectations and predictions is subject to a number of risks and uncertainties that could cause actual results to differ materially from expectations, including: • the risks associated with Item 1A of this Report on Form 10-K; • business opportunities (or lack thereof) that may be presented to it and pursued; • actions taken by ratings agencies from time to time, such as financial strength or credit ratings downgrades or placing ratings on negative watch; and • the continued availability of capital and financing; • general economic, market or business conditions; • competitive forces, including the conduct of other insurers; • changes in domestic or foreign laws or regulations, or their interpretation, applicable to White Mountains, its competitors or its customers; • an economic downturn or other economic conditions adversely affecting its financial position; • other factors, most of which are beyond White Mountains’s control. Consequently, all of the forward-looking statements made in this report are qualified by these cautionary statements, and there can be no assurance that the actual results or developments anticipated by White Mountains will be realized or, even if substantially realized, that they will have the expected consequences to, or effects on, White Mountains or its business or operations. White Mountains assumes no obligation to publicly update any such forward-looking statements, whether as a result of new information, future events or otherwise.

<s>[INST] The following discussion also includes five nonGAAP financial measures, adjusted book value per share, MediaAlpha’s earnings before interest, taxes, depreciation and amortization (“EBITDA”), adjusted total capital and consolidated portfolio returns excluding Symetra, and common equity securities and other longterm investment returns excluding Symetra, that have been reconciled to their most comparable GAAP financial measures on page 51. White Mountains believes these measures to be useful in evaluating White Mountains’s financial performance and condition. RESULTS OF OPERATIONS FOR THE YEARS ENDED DECEMBER 31, 2017, 2016 AND 2015 OverviewYear Ended December 31, 2017 versus Year Ended December 31, 2016 White Mountains ended 2017 with book value per share of $931 and adjusted book value per share of $915, an increase of 18.8% and 16.1% for the year, including dividends. The increases were primarily driven by the gain on the sale of OneBeacon. Comprehensive income attributable to common shareholders increased to $631 million in 2017 compared to $547 million in 2016. Comprehensive income attributable to common shareholders in both 2017 and 2016 was driven by large transaction gains. In 2017, OneBeacon was acquired by Intact Financial Corporation in an allcash transaction for $18.10 per share, from which White Mountains received $1.3 billion and recorded a net gain of $555 million. In 2016, White Mountains recorded net gains of $477 million and $82 million from the sales of Sirius Group and Tranzact. See Note 2 “Significant Transactions” on page for a description of each transaction. For the year ended December 31, 2017, White Mountains repurchased and retired 832,725 of its common shares for $724 million at an average share price of $869.29, or approximately 95% of White Mountains’s December 31, 2017 adjusted book value per share. For the year ended December 31, 2017, White Mountains returned a total of $728 million of capital to shareholders through share repurchases and dividends. Written premiums and MSC in the HG Global/BAM segment totaled $101 million in 2017, compared to $77 million in 2016, as higher pricing more than offset a decrease in issuance volume. BAM insured municipal bonds with par value of $10.4 billion in 2017, compared to $11.3 billion in 2016. Total pricing, which is written premiums plus MSC, including the present value of future installment MSC not yet collected, weighted by the par value of municipal bonds insured, was 99 basis points, up from 68 basis points in 2016. As of December 31, 2017, BAM’s total claims paying resources were $708 million on gross par outstanding of $42 billion. Total claims paying resources increased $65 million from December 31, 2016, reflecting positive cash flow building in the BAM system. During 2017, BAM paid $5 million of principal and interest in cash on the surplus notes held by HG Re. Beginning in the second quarter of 2017, White Mountains changed its calculation of adjusted book value per share (i) to include a discount for the time value of money arising from the expected timing of cash payments of principal and interest on the BAM surplus notes and (ii) to add back the unearned premium reserve, net of deferred acquisition costs, at HG Global. See “NONGAAP FINANCIAL MEASURES” on page 51. MediaAlpha reported breakeven results in 2017, compared to pretax loss of $4 million in 2016. MediaAlpha’s EBITDA was $11 million in 2017, compared to $ [/INST] Positive. </s>

WHITE MOUNTAINS INSURANCE GROUP LTD

2019-02-27

2018-12-31

Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations The following discussion contains “forward-looking statements”. White Mountains intends statements that are not historical in nature, which are hereby identified as forward-looking statements, to be covered by the safe harbor provisions of the Private Securities Litigation Reform Act of 1995. White Mountains cannot promise that its expectations in such forward-looking statements will turn out to be correct. White Mountains’s actual results could be materially different from and worse than its expectations. See “FORWARD-LOOKING STATEMENTS” on page 62 for specific important factors that could cause actual results to differ materially from those contained in forward-looking statements. The following discussion also includes four non-GAAP financial measures (i) adjusted book value per share, (ii) gross written premiums and MSC from new business, (iii) adjusted capital, and (iv) adjusted earnings before interest, taxes, depreciation and amortization (“adjusted EBITDA”), that have been reconciled from their most comparable GAAP financial measures on page 55. White Mountains believes these measures to be useful in evaluating White Mountains’s financial performance and condition. RESULTS OF OPERATIONS FOR THE YEARS ENDED DECEMBER 31, 2018, 2017 AND 2016 Overview-Year Ended December 31, 2018 versus Year Ended December 31, 2017 White Mountains ended 2018 with book value per share of $896 and adjusted book value per share of $888, a decrease of 3.7% and 2.8% for the year, including dividends. Comprehensive loss attributable to common shareholders was $146 million in 2018 compared to comprehensive income attributable to common shareholders of $631 million in 2017. The decrease in book value per share and adjusted book value per share and the comprehensive loss attributable to common shareholders in 2018 was driven primarily by investment results, which were adversely impacted by the sharp decline in equity markets in the fourth quarter of 2018, while comprehensive income attributable to common shareholders in 2017 was driven primarily by the $557 million gain from the OneBeacon Transaction. On February 26, 2019, MediaAlpha completed the sale of a significant minority stake to Insignia Capital Group in connection with a recapitalization and cash distribution to existing equityholders. MediaAlpha also repurchased a portion of the holdings of existing equityholders. The transaction valued MediaAlpha at approximately $350 million. The transaction results in an estimated gain of approximately $55 to each of White Mountains’s book value per share and adjusted book value per share. Including the estimated gain of $55 per share for the MediaAlpha transaction, December 31, 2018 book value per share would have been $951 and adjusted book value per share would have been $943. See “MediaAlpha” on page 41. During 2018, White Mountains repurchased and retired 592,458 of its common shares for $519 million at an average share price of $877. The average share price paid was approximately 98% and 99%, respectively, of White Mountains’s December 31, 2018 book value per share and adjusted book value per share. The average share price paid was approximately 92% and 93%, respectively, of White Mountains’s December 31, 2018 book value per share including the estimated gain from the MediaAlpha transaction and adjusted book value per share including the estimated gain from the MediaAlpha transaction. During 2018, White Mountains also allocated roughly $300 million to new business opportunities, ending the year with approximately $1.2 billion of undeployed capital. Gross written premiums and MSC collected in the HG Global/BAM segment totaled $107 million in 2018, compared to $101 million in 2017. BAM insured municipal bonds with par value of $12.0 billion in 2018, compared to $10.4 billion in 2017. Total pricing was 93 basis points in 2018, compared to 99 basis points in 2017. BAM’s total claims paying resources were $871 million as of December 31, 2018, compared to $708 million as of December 31, 2017. The increase in claims paying resources was driven by positive cash flow from operations as well as the $100 million reinsurance agreement that BAM entered into with Fidus Re in the second quarter of 2018. During 2018, BAM paid $23 million of principal and interest on the BAM Surplus Notes held by HG Global. On May 11, 2018, White Mountains acquired a 95.0% equity interest in NSM, a full-service MGU and program administrator for specialty property & casualty insurance. NSM reported pre-tax loss of $5 million from May 11, 2018, the date of acquisition, through December 31, 2018 (“the 2018 ownership period”). NSM reported adjusted EBITDA of $16 million and revenues of $102 million in the 2018 ownership period. MediaAlpha reported pre-tax income of $9 million in 2018, compared to break-even pre-tax income in 2017. MediaAlpha’s adjusted EBITDA was $32 million in 2018, compared to $11 million in 2017. MediaAlpha reported advertising and commission revenues of $296 million in 2018, compared to $163 million in 2017. The increases in pre-tax income, adjusted EBITDA and revenues were driven primarily by growth in the P&C vertical and the HLM vertical, which includes business generated from assets acquired from Healthplans.com in the fourth quarter of 2017. White Mountains’s pre-tax total return on invested assets was -1.7% for 2018, compared to 5.6% for 2017. White Mountains’s portfolio of common equity securities and other long-term investments returned -3.6% for 2018, outperforming the S&P 500 Index return of -4.4%, driven primarily by a favorable fair value adjustment to White Mountains’s investment in PassportCard/DavidShield and strong private equity fund returns, partially offset by weak returns from the non-U.S. actively managed common equity portfolios. White Mountains’s portfolio of common equity securities and other long-term investments returned 12.7% for 2017, underperforming the S&P 500 Index returns of 21.8%, driven primarily by losses from foreign currency forward contracts and unconsolidated entities. White Mountains’s fixed income portfolio returned 1.2% for 2018, outperforming the Bloomberg Barclays U.S. Intermediate Aggregate Index return of 0.9%. White Mountains’s fixed income portfolio returned 3.5% for 2017, outperforming the Bloomberg Barclays U.S. Intermediate Aggregate Index return of 2.3%. Overview-Year Ended December 31, 2017 versus Year Ended December 31, 2016 White Mountains ended 2017 with book value per share of $931 and adjusted book value per share of $915, an increase of 18.8% and 16.1% for the year, including dividends. The increases were driven primarily by the gain from the OneBeacon Transaction. Comprehensive income attributable to common shareholders increased to $631 million in 2017, compared to $547 million in 2016. Comprehensive income attributable to common shareholders in both 2017 and 2016 was driven primarily by large transaction gains. In 2017, OneBeacon was acquired by Intact Financial Corporation in an all-cash transaction for $18.10 per share, from which White Mountains received $1.3 billion in proceeds and recorded a net gain of $557 million. In 2016, White Mountains recorded net gains of $477 million and $82 million from the sales of Sirius Group and Tranzact. See Note 2 - “Significant Transactions” on page for a description of each transaction. For the year ended December 31, 2017, White Mountains repurchased and retired 832,725 of its common shares for $724 million at an average share price of $869.29. The average share price paid was approximately 93% and 95%, respectively, of White Mountains’s December 31, 2017 book value per share and adjusted book value per share. For the year ended December 31, 2017, White Mountains returned a total of $728 million of capital to shareholders through share repurchases and dividends. Gross written premiums and MSC collected in the HG Global/BAM segment totaled $101 million in 2017, compared to $77 million in 2016, as higher pricing more than offset a decrease in issuance volume. BAM insured municipal bonds with par value of $10.4 billion in 2017, compared to $11.3 billion in 2016. Total pricing was 99 basis points, up from 68 basis points in 2016. BAM’s total claims paying resources were $708 million as of December 31, 2017, compared to $644 million as of December 31, 2016. The increase in claims paying resources was driven by positive cash flow from operations. During 2017, BAM paid $5 million of principal and interest on the surplus notes held by HG Global. Beginning in the second quarter of 2017, White Mountains changed its calculation of adjusted book value per share (i) to include a discount for the time value of money arising from the expected timing of cash payments of principal and interest on the BAM Surplus Notes and (ii) to add back the unearned premium reserve, net of deferred acquisition costs, at HG Global. See “NON-GAAP FINANCIAL MEASURES” on page 55. MediaAlpha reported break-even pre-tax income in 2017, compared to pre-tax loss of $4 million in 2016. MediaAlpha’s adjusted EBITDA was $11 million in 2017, compared to $7 million in 2016. The increases in pre-tax income and adjusted EBITDA were driven primarily by growth in the HLM vertical and the P&C vertical. In October 2017, MediaAlpha acquired certain assets associated with the Health, Life and Medicare insurance business of Healthplans.com. The acquired assets included domain names, advertiser and publisher relationships, traffic acquisition accounts, and owned and operated websites. During the fourth quarter of 2017, which includes the annual open enrollment period for health and Medicare coverages, business from the acquired assets contributed $2 million of both pre-tax income and adjusted EBITDA. White Mountains’s pre-tax total return on invested assets was 5.6% for 2017, compared to 2.7% for 2016. White Mountains’s portfolio of common equity securities and other long-term investments returned 12.7% for 2017, underperforming the S&P 500 Index return of 21.8%, driven primarily by losses from foreign currency forward contracts and unconsolidated entities. White Mountains’s portfolio of common equity securities and other long-term investments returned 4.3% for 2016, underperforming the S&P 500 Index return of 12.0%, driven primarily by losses from private equity funds and unconsolidated entities and weak returns from certain actively managed common equity portfolios. White Mountains’s fixed income portfolio returned 3.5% for 2017, outperforming the Bloomberg Barclays U.S. Intermediate Aggregate Index return of 2.3%. White Mountains’s fixed income portfolio returned 2.4% for 2016, outperforming the Bloomberg Barclays U.S. Intermediate Aggregate Index return of 2.0%. Adjusted Book Value Per Share The following table presents White Mountains’s adjusted book value per share, a non-GAAP financial measure, for the years ended December 31, 2018, 2017 and 2016 and reconciles this non-GAAP measure to book value per share, the most comparable GAAP measure. See “NON-GAAP FINANCIAL MEASURES” on page 55. December 31, Book value per share numerators (in millions): White Mountains’s common shareholders’ equity $ 2,843.1 $ 3,492.5 $ 3,582.7 Future proceeds from options (1) - - 29.7 Time-value of money discount on expected future payments on the BAM Surplus Notes (2) (141.2 ) (157.0 ) N/A HG Global’s unearned premium reserve (2) 136.9 103.9 N/A HG Global’s net deferred acquisition costs (2) (34.6 ) (24.3 ) N/A Adjusted book value per share numerator $ 2,804.2 $ 3,415.1 $ 3,612.4 Book value per share denominators (in thousands of shares): Common shares outstanding 3,173.1 3,750.2 4,563.8 Unearned restricted shares (14.6 ) (16.8 ) (25.9 ) Options assumed issued (1) - - 40.0 Adjusted book value per share denominator 3,158.5 3,733.4 4,577.9 GAAP book value per share $ 896.00 $ 931.30 $ 785.01 Adjusted book value per share $ 887.85 $ 914.75 $ 789.08 Dividends paid per share $ 1.00 $ 1.00 $ 1.00 (1) Adjusted book value per share at December 31, 2016 includes the impact of 40,000 non-qualified stock options exercisable for $742 per common share. All non-qualified options were exercised prior to their expiration date of January 20, 2017. (2) Amounts reflects White Mountains’s preferred share ownership in HG Global of 96.9%. The following tables presents goodwill and other intangible assets that are included in White Mountains’s adjusted book value as of December 31, 2018, 2017 and 2016: December 31, Millions Goodwill: NSM (1) $ 354.3 $ - $ - MediaAlpha 18.3 18.3 18.3 Buzz 7.3 7.6 7.6 Total goodwill 379.9 25.9 25.9 . Other intangible assets: NSM 131.9 - - MediaAlpha 25.1 35.4 18.3 Buzz .6 .8 1.0 Total other intangible assets 157.6 36.2 19.3 Total goodwill and other intangible assets (2) 537.5 62.1 45.2 Goodwill and other intangible assets held for sale - - 1.2 Goodwill and other intangible assets attributed to non-controlling interests (40.6 ) (21.1 ) (17.1 ) Goodwill and other intangible assets included in White Mountains’s common shareholders’ equity $ 496.9 $ 41.0 $ 29.3 (1) The relative fair values of goodwill and other intangible assets recognized in connection with the acquisition of KBK had not yet been determined at December 31, 2018. (2) See Note 4 - “Goodwill and Other Intangible Assets” on page for details of other intangible assets. Summary of Consolidated Results The following table presents White Mountains’s consolidated financial results by industry for the years ended December 31, 2018, 2017 and 2016: Year Ended December 31, Millions Revenues Financial Guarantee revenues $ 24.3 $ 23.3 $ 16.7 Specialty Insurance Distribution revenues 101.6 - - Marketing Technology revenues 297.1 163.2 116.5 Other revenues (53.9 ) 187.3 24.5 Total revenues 369.1 373.8 157.7 Expenses Financial Guarantee expenses 53.7 47.3 43.4 Specialty Insurance Distribution expenses 106.8 - - Marketing Technology expenses 288.2 163.6 120.6 Other expenses 98.6 155.1 141.0 Total expenses 547.3 366.0 305.0 Pre-tax (loss) income Financial Guarantee pre-tax loss (29.4 ) (24.0 ) (26.7 ) Specialty Insurance Distribution pre-tax loss (5.2 ) - - Marketing Technology pre-tax income (loss) 8.9 (.4 ) (4.1 ) Other pre-tax (loss) income (152.5 ) 32.2 (116.5 ) Total pre-tax (loss) income (178.2 ) 7.8 (147.3 ) Income tax benefit 4.0 7.8 32.9 Net (loss) income from continuing operations (174.2 ) 15.6 (114.4 ) (Loss) gain on sale of discontinued operations, net of tax (17.2 ) 557.0 415.1 Net income from discontinued operations, net of tax - 20.5 108.3 Net (loss) income (191.4 ) 593.1 409.0 Net loss (income) attributable to non-controlling interests 50.2 34.1 (7.2 ) Net (loss) income attributable to White Mountains’s common shareholders (141.2 ) 627.2 401.8 Other comprehensive (loss) income, net of tax (4.8 ) .3 (.7 ) Comprehensive income from discontinued operations, net of tax - 3.2 146.3 Comprehensive (loss) income (146.0 ) 630.7 547.4 Comprehensive income (loss) attributable to non-controlling interests .3 (.2 ) (.3 ) Comprehensive (loss) income attributable to White Mountains’s common shareholders $ (145.7 ) $ 630.5 $ 547.1 I. Summary of Operations By Segment White Mountains conducts its operations through four segments: (1) HG Global/BAM, (2) NSM (3) MediaAlpha and (4) Other Operations. A discussion of White Mountains’s consolidated investment operations is included after the discussion of operations by segment. White Mountains’s segment information is presented in Note 13 - “Segment Information” on page to the Consolidated Financial Statements. As a result of the OneBeacon, Sirius Group and Tranzact transactions, the results of operations for OneBeacon, Sirius Group and Tranzact have been classified as discontinued operations and are now presented separately, net of related income taxes, in the statement of comprehensive income. Prior year amounts have been reclassified to conform to the current period’s presentation. See Note 19 - “Held for Sale and Discontinued Operations” on page. HG Global/BAM The following tables present the components of pre-tax income included in White Mountains’s HG Global/BAM segment related to the consolidation of HG Global, which includes HG Re and its other wholly-owned subsidiaries, and BAM for the years ended December 31, 2018, 2017 and 2016: December 31, 2018 Millions HG Global BAM Eliminations Total Direct written premiums $ - $ 44.8 $ - $ 44.8 Assumed (ceded) written premiums 44.9 (36.8 ) - 8.1 Net written premiums $ 44.9 $ 8.0 $ - $ 52.9 Earned insurance and reinsurance premiums $ 11.0 $ 2.9 $ - $ 13.9 Net investment income 5.7 11.0 - 16.7 Net investment income - BAM Surplus Notes 22.9 - (22.9 ) - Net realized and unrealized investment losses (4.1 ) (3.4 ) - (7.5 ) Other revenues - 1.2 - 1.2 Total revenues 35.5 11.7 (22.9 ) 24.3 Insurance and reinsurance acquisition expenses 2.7 2.6 - 5.3 Other underwriting expenses - .4 - .4 General and administrative expenses 1.1 46.9 - 48.0 Interest expense - BAM Surplus Notes - 22.9 (22.9 ) - Total expenses 3.8 72.8 (22.9 ) 53.7 Pre-tax income (loss) $ 31.7 $ (61.1 ) $ - $ (29.4 ) Supplemental information: MSC collected (1) $ - $ 53.8 $ - $ 53.8 (1) MSC collected are recorded directly to BAM’s equity, which is recorded as non-controlling interest on White Mountains’s balance sheet. December 31, 2017 Millions HG Global BAM Eliminations Total Direct written premiums $ - $ 63.2 $ - $ 63.2 Assumed (ceded) written premiums 53.6 (53.6 ) - - Net written premiums $ 53.6 $ 9.6 $ - $ 63.2 Earned insurance and reinsurance premiums $ 7.1 $ 2.3 $ - $ 9.4 Net investment income 3.3 9.0 - 12.3 Net investment income - BAM Surplus Notes 19.0 - (19.0 ) - Net realized and unrealized investment (losses) gains (1.2 ) 1.8 - .6 Other revenues - 1.0 - 1.0 Total revenues 28.2 14.1 (19.0 ) 23.3 Insurance and reinsurance acquisition expenses 1.5 2.5 - 4.0 Other underwriting expenses - .4 - .4 General and administrative expenses 1.0 41.9 - 42.9 Interest expense - BAM Surplus Notes - 19.0 (19.0 ) - Total expenses 2.5 63.8 (19.0 ) 47.3 Pre-tax income (loss) $ 25.7 $ (49.7 ) $ - $ (24.0 ) Supplemental information: MSC collected (1) $ - $ 37.4 $ - $ 37.4 (1) MSC collected are recorded directly to BAM’s equity, which is recorded as non-controlling interest on White Mountains’s balance sheet. December 31, 2016 Millions HG Global BAM Eliminations Total Direct written premiums $ - $ 38.6 $ - $ 38.6 Assumed (ceded) written premiums 27.2 (27.2 ) - - Net written premiums $ 27.2 $ 11.4 $ - $ 38.6 Earned insurance and reinsurance premiums $ 4.4 $ 1.5 $ - $ 5.9 Net investment income 2.2 6.8 - 9.0 Net investment income - BAM Surplus Notes 17.8 - (17.8 ) - Net realized and unrealized investment gains .1 .6 - .7 Other revenues - 1.1 - 1.1 Total revenues 24.5 10.0 (17.8 ) 16.7 Insurance and reinsurance acquisition expenses .9 2.5 - 3.4 Other underwriting expenses - .4 - .4 General and administrative expenses 1.4 38.2 - 39.6 Interest expense - BAM Surplus Notes - 17.8 (17.8 ) - Total expenses 2.3 58.9 (17.8 ) 43.4 Pre-tax income (loss) $ 22.2 $ (48.9 ) $ - $ (26.7 ) Supplemental information: MSC collected (1) $ - $ 38.0 $ - $ 38.0 (1) MSC collected are recorded directly to BAM’s equity, which is recorded as non-controlling interest on White Mountains’s balance sheet. HG Global/BAM Results-Year Ended December 31, 2018 versus Year Ended December 31, 2017 BAM charges an insurance premium on each municipal bond insurance policy it writes. A portion of the premium is an MSC and the remainder is a risk premium. In the event of a municipal bond refunding, the MSC from the original issuance can be reutilized, in effect serving as a credit against the total insurance premium on the refunding of the municipal bond. Issuers of debt insured by BAM are members of BAM so long as any of their BAM-insured debt is outstanding, and as members they have certain interests in BAM, including the right to vote for BAM’s directors and to receive dividends, if declared. Gross written premiums and MSC collected in the HG Global/BAM segment totaled $107 million in 2018, compared to $101 million in 2017. In 2018, BAM insured $12.0 billion of municipal bonds, $11.0 billion of which were in the primary market, up 15% from 2017. During the fourth quarter of 2018, BAM completed an assumed reinsurance transaction to insure municipal bonds with a par value of $2.2 billion for gross written premiums and MSC collected of $20 million. Total pricing, which is based on gross written premiums and MSC from new business, was 93 basis points in 2018, down from 99 basis points in 2017. See “NON-GAAP FINANCIAL MEASURES” on page 55. Total pricing in the primary market, which includes assumed business, increased slightly to 75 basis points in 2018, compared to 74 basis points in 2017. The following table presents the gross par value of primary and secondary market policies issued and a reconciliation of GAAP gross written premiums to gross written premiums and MSC from new business for the twelve months ended December 31, 2018 and 2017: Year Ended December 31, $ in Millions Gross par value of primary market policies issued $ 11,015.7 $ 9,633.5 Gross par value of secondary market policies issued 959.6 793.2 Total gross par value of market policies issued $ 11,975.3 $ 10,426.7 Gross written premiums $ 52.9 $ 63.2 MSC collected 53.8 37.4 Total gross written premiums and MSC collected $ 106.7 $ 100.6 Present value of future installment MSC collections 3.1 2.8 Gross written premium adjustments on existing installment policies 1.1 - Gross written premiums and MSC from new business (1) $ 110.9 $ 103.4 Total pricing 93 bps 99 bps (1) See “NON-GAAP FINANCIAL MEASURES” on page 55. HG Global reported GAAP pre-tax income of $32 million and $26 million in 2018 and 2017, which was driven by $23 million and $19 million of interest income on the BAM Surplus Notes, respectively. BAM is a mutual insurance company that is owned by its members. BAM’s results are consolidated into White Mountains’s GAAP financial statements and attributed to non-controlling interests. White Mountains reported $61 million of GAAP pre-tax losses on BAM in 2018, driven primarily by $23 million of interest expense on the BAM Surplus Notes and $47 million of general and administrative expenses, compared to $50 million of pre-tax losses in 2017, driven primarily by $19 million of interest expense on the BAM Surplus Notes and $42 million of general and administrative expenses. The increase in general and administrative expenses was primarily due to financing expense from the reinsurance agreement with Fidus Re, which is accounted for using the deposit method under GAAP. During 2018, BAM paid $23 million of principal and interest on the BAM Surplus Notes held by HG Global. HG Global/BAM Results-Year Ended December 31, 2017 versus Year Ended December 31, 2016 Gross written premiums and MSC collected in the HG Global/BAM segment totaled $101 million in 2017, compared to $77 million in 2016, as higher pricing more than offset a decrease in issuance volume. BAM’s volume for 2017 was affected by Standard & Poor’s review of BAM’s financial strength rating. On June 6, 2017, Standard & Poor’s placed BAM on credit watch negative and initiated a detailed review of BAM’s financial strength rating. On June 26, 2017, Standard & Poor’s concluded its review and affirmed BAM’s “AA/stable” financial strength rating. During the time that BAM was under review by Standard & Poor’s, it voluntarily withdrew from the marketplace and did not write any municipal bond insurance policies. In 2017, BAM insured $10.4 billion of municipal bonds, $9.6 billion of which were in the primary market, down 8% from 2016. Total pricing was 99 basis points in 2017, up from 68 basis points in 2016. Total pricing in the primary market increased to 74 basis points in 2017, compared to 58 basis points in 2016. The following table presents the gross par value of primary and secondary market policies issued and a reconciliation of GAAP gross written premiums to gross written premiums and MSC from new business for the twelve months ended December 31, 2017 and 2016: Year Ended December 31, $ in Millions Gross par value of primary market policies issued $ 9,633.5 $ 10,336.1 Gross par value of secondary market policies issued 793.2 967.2 Total gross par value of market policies issued $ 10,426.7 $ 11,303.3 Gross written premiums $ 63.2 $ 38.6 MSC collected 37.4 38.0 Total gross written premiums and MSC collected $ 100.6 $ 76.6 Present value of future installment MSC collections 2.8 - Gross written premium adjustments on existing installment policies - - Gross written premiums and MSC from new business (1) $ 103.4 $ 76.6 Total pricing 99 bps 68 bps (1) See “NON-GAAP FINANCIAL MEASURES” on page 55. HG Global reported GAAP pre-tax income of $26 million and $22 million in 2017 and 2016, which was driven primarily by $19 million and $18 million of interest income on the BAM Surplus Notes, respectively. White Mountains reported $50 million of GAAP pre-tax losses on BAM in 2017, driven primarily by $19 million of interest expense on the BAM Surplus Notes and $42 million of operating expenses, compared to $49 million of pre-tax losses in 2016, driven primarily by $18 million of interest expense on the BAM Surplus Notes and $38 million of operating expenses. During 2017, BAM paid $5 million of principal and interest on the BAM Surplus Notes held by HG Global. Claims Paying Resources BAM’s “claims paying resources” represent the capital and other financial resources BAM has available to pay claims and, as such, is a key indication of BAM’s financial strength. In 2018, BAM expanded its claims paying resources by $100 million through the collateralized reinsurance agreement with Fidus Re, a special-purpose insurer created solely to provide collateralized reinsurance protection to BAM. The following table presents BAM’s total claims paying resources as of December 31, 2018 and 2017: Millions December 31, 2018 December 31, 2017 Policyholders’ surplus $ 413.7 $ 427.3 Contingency reserve 50.3 34.8 Qualified statutory capital 464.0 462.1 Net unearned premiums 36.2 30.5 Present value of future installment premiums and MSC 12.9 9.0 HG Re Collateral Trusts at statutory value 258.3 206.8 Fidus Re collateral trust at statutory value 100.0 - Claims paying resources $ 871.4 $ 708.4 BAM’s claims paying resources increased 23% to $871 million as of December 31, 2018. The increase was driven primarily by the $100 million reinsurance agreement with Fidus Re, $54 million of MSC collected and a $52 million increase in the invested assets of the HG Re Collateral Trusts, partially offset by BAM’s 2018 statutory net loss of $35 million. The following table presents BAM’s total claims paying resources as of December 31, 2017 and 2016: Millions December 31, 2017 December 31, 2016 Policyholders’ surplus $ 427.3 $ 431.5 Contingency reserve 34.8 22.7 Qualified statutory capital 462.1 454.2 Net unearned premiums 30.5 23.2 Present value of future installment premiums and MSC 9.0 3.3 HG Re Collateral Trusts at statutory value 206.8 163.0 Claims paying resources $ 708.4 $ 643.7 BAM’s claims paying resources increased 10% to $708 million as of December 31, 2017. The increase was driven primarily by $37 million of MSC collected and a $44 million increase in the invested assets of the HG Re Collateral Trusts, partially offset by BAM’s 2017 statutory net loss of $25 million. HG Global/BAM Balance Sheets The following table presents amounts from HG Global, which includes HG Re and its other wholly-owned subsidiaries, and BAM that are contained within White Mountains’s consolidated balance sheet as of December 31, 2018 and 2017: December 31, 2018 Millions HG Global BAM Eliminations and Segment Adjustment Total Segment Assets Fixed maturity investments $ 225.8 $ 475.6 $ - $ 701.4 Short-term investments 28.5 38.4 - 66.9 Total investments 254.3 514.0 - 768.3 Cash 6.0 6.5 - 12.5 BAM Surplus Notes 481.3 - (481.3 ) - Accrued interest receivable on BAM Surplus Notes 143.7 - (143.7 ) - Deferred acquisition costs 35.7 19.0 (35.7 ) 19.0 Insurance premiums receivable 4.0 6.4 (4.0 ) 6.4 Accounts receivable on unsettled investments sales - - - - Other assets 1.3 9.0 (.3 ) 10.0 Total assets $ 926.3 $ 554.9 $ (665.0 ) $ 816.2 Liabilities BAM Surplus Notes (1) $ - $ 481.3 $ (481.3 ) $ - Accrued interest payable on BAM Surplus Notes (2) - 143.7 (143.7 ) - Preferred dividends payable to White Mountains's subsidiaries (3) 278.5 - - 278.5 Preferred dividends payable to non-controlling interests 9.6 - - 9.6 Unearned insurance premiums 141.3 34.7 - 176.0 Accounts payable on unsettled investment purchases - 2.2 - 2.2 Other liabilities 1.1 63.6 (40.0 ) 24.7 Total liabilities 430.5 725.5 (665.0 ) 491.0 Equity White Mountains’s common shareholders’ equity (3) 481.3 - - 481.3 Non-controlling interests 14.5 (170.6 ) - (156.1 ) Total equity 495.8 (170.6 ) - 325.2 Total liabilities and equity $ 926.3 $ 554.9 $ (665.0 ) $ 816.2 (1) Under GAAP, the BAM Surplus Notes are classified as debt by the issuer. Under U.S. Statutory accounting, they are classified as policyholders’ surplus. (2) Under GAAP, interest accrues daily on the BAM Surplus Notes. Under U.S. Statutory accounting, interest is not accrued on the BAM Surplus Notes until it has been approved for payment by insurance regulators. (3) HG Global preferred dividends payable to White Mountains’s subsidiaries is eliminated in White Mountains’s consolidated financial statements. For segment reporting, the HG Global preferred dividends payable to White Mountains’s subsidiaries included within the HG Global/BAM segment are eliminated against the offsetting receivable included within the Other Operations segment, and therefore are added back to White Mountains’s common shareholders’ equity within the HG Global/BAM segment. December 31, 2017 Millions HG Global BAM Eliminations and Segment Adjustment Total Segment Assets Fixed maturity investments $ 175.5 $ 448.1 $ - $ 623.6 Short-term investments 28.5 41.3 - 69.8 Total investments 204.0 489.4 - 693.4 Cash 1.9 23.7 - 25.6 BAM Surplus Notes 499.0 - (499.0 ) - Accrued interest receivable on BAM Surplus Notes 126.0 - (126.0 ) - Deferred acquisition costs 25.1 14.9 (25.2 ) 14.8 Insurance premiums receivable 2.7 4.7 (2.9 ) 4.5 Accounts receivable on unsettled investments sales - .1 - .1 Other assets .8 8.2 - 9.0 Total assets $ 859.5 $ 541.0 $ (653.1 ) $ 747.4 Liabilities BAM Surplus Notes (1) $ - $ 499.0 $ (499.0 ) $ - Accrued interest payable on BAM Surplus Notes (2) - 126.0 (126.0 ) - Preferred dividends payable to White Mountains's subsidiaries (3) 227.9 - - 227.9 Preferred dividends payable to non-controlling interests 7.7 - - 7.7 Unearned insurance premiums 107.2 29.6 - 136.8 Accounts payable on unsettled investment purchases - .6 - .6 Other liabilities 1.0 49.0 (28.1 ) 21.9 Total liabilities 343.8 704.2 (653.1 ) 394.9 Equity White Mountains’s common shareholders’ equity (3) 499.8 - - 499.8 Non-controlling interests 15.9 (163.2 ) - (147.3 ) Total equity 515.7 (163.2 ) - 352.5 Total liabilities and equity $ 859.5 $ 541.0 $ (653.1 ) $ 747.4 (1) Under GAAP, the BAM Surplus Notes are classified as debt by the issuer. Under U.S. Statutory accounting, they are classified as policyholders’ surplus. (2) Under GAAP, interest accrues daily on the BAM Surplus Notes. Under U.S. Statutory accounting, interest is not accrued on the BAM Surplus Notes until it has been approved for payment by insurance regulators. (3) HG Global preferred dividends payable to White Mountains’s subsidiaries is eliminated in White Mountains’s consolidated financial statements. For segment reporting, the HG Global preferred dividends payable to White Mountains’s subsidiaries included within the HG Global/BAM segment are eliminated against the offsetting receivable included within the Other Operations segment, and therefore are added back to White Mountains’s common shareholders’ equity within the HG Global/BAM segment. Par Value of Policies Issued and Priced by BAM The following table presents the gross par value of policies issued and priced by BAM for the years ended December 31, 2018 and 2017: Year Ended December 31, Millions Gross par value of primary market policies issued $ 11,015.7 $ 9,633.5 Gross par value of secondary market policies issued 959.6 793.2 Total gross par value of policies issued 11,975.3 10,426.7 Gross par value of policies priced yet to close 247.3 114.4 Less: Gross par value of policies closed that were priced in a previous period 114.4 353.3 Total gross par value of market policies priced $ 12,108.2 $ 10,187.8 NSM During 2018, White Mountains acquired a 95.0% equity interest in NSM for cash consideration of $276 million. NSM is a full-service MGU and program administrator for specialty property and casualty insurance. As part of the acquisition, White Mountains assumed estimated contingent consideration earnout liabilities related to NSM’s previous acquisitions of its U.K.-based operations of $10 million. On May 18, 2018, NSM acquired 100% of Fresh Insurance, an insurance broker that focuses on non-standard personal lines products in the United Kingdom. NSM paid $50 million of upfront cash consideration for its equity interest in Fresh Insurance. The purchase price is subject to additional adjustments based upon growth in EBITDA during two earnout periods ending in February 2020 and February 2022. In connection with the acquisition, NSM recorded a contingent consideration earnout liability of $8 million. On December 3, 2018, NSM acquired all of the net assets of KBK, a specialty MGU focused on the towing and transportation space. NSM paid $60 million of upfront cash consideration for the net assets of KBK. NSM recognized $59 million of goodwill and other intangible assets, reflecting estimated acquisition date fair values. The relative fair values of goodwill and other intangible assets recognized in connection with the acquisitions of KBK had not yet been determined as of December 31, 2018. The purchase price is subject to additional adjustments based upon growth in EBITDA during three earnout periods ending in December 2019, December 2020 and December 2021. In connection with the acquisition, NSM expects to record a contingent consideration earnout liability in the first quarter of 2019. The contingent consideration earnout liabilities related to these acquisitions are subject to adjustment based upon reported EBITDA, projected EBITDA, and present value factors for the acquired entities. During the 2018 ownership period, NSM recognized pre-tax expense of $3 million for the change in the fair value of its contingent consideration earnout liabilities for Fresh Insurance and its other U.K.-based operations. Any future adjustments to contingent consideration earnout liabilities under the agreements will also be recognized through pre-tax income. As of December 31, 2018, NSM recorded contingent consideration earnout liabilities of $20 million. The following table presents the components of GAAP net loss and adjusted EBITDA included in White Mountains’s NSM segment for the 2018 ownership period: Millions Period Ended December 31, 2018 (1) Commission revenues $ 94.7 Broker commission expense 28.9 Gross profit 65.8 Other revenues 6.9 General and administrative expenses 61.6 Amortization of other intangible assets 8.3 Interest expense 8.0 GAAP pre-tax loss (5.2 ) Income tax expense - GAAP net loss (5.2 ) Add back: Change in fair value of contingent consideration earnout liabilities 2.7 Interest expense 8.0 Income tax expense - General and administrative expenses - depreciation 1.7 Amortization of other intangible assets 8.3 Adjusted EBITDA (2) $ 15.5 (1) NSM’s results are from May 11, 2018, the date of acquisition, through December 31, 2018 (“the 2018 ownership period”). (2) See “NON-GAAP FINANCIAL MEASURES” on page 55. NSM Results for the 2018 ownership period During the 2018 ownership period, NSM reported pre-tax loss of $5 million, commission revenues of $95 million, and adjusted EBITDA of $16 million. NSM’s pre-tax loss also included interest expense of $8 million and amortization of other intangible assets of $8 million. Broker commission expenses and general and administrative expenses were $29 million and $62 million in the 2018 ownership period. NSM Business Trends The following is a discussion of the trends in NSM’s business including periods prior to White Mountains’s ownership of NSM. White Mountains believes this is useful in understanding the newly acquired business. NSM’s business consists of over 15 active programs that are broadly categorized into five market verticals. The following table presents the controlled premium and commission revenues by vertical for the years ended December 31, 2018, 2017 and 2016: Year Ended December 31, $ in Millions Controlled Premium (1) Commission and Fee Revenue Controlled Premium (1) Commission and Fee Revenue Controlled Premium (1) Commission and Fee Revenue Specialty Transportation $ 136.8 $ 43.0 $ 112.6 $ 32.9 $ 112.4 $ 37.4 Real Estate 135.7 30.3 106.8 22.2 97.6 19.9 Social Services 94.0 23.8 111.6 28.8 122.3 32.3 United Kingdom 108.8 34.9 46.0 16.1 1.2 .7 Other 119.4 19.8 113.4 18.6 112.3 18.3 Total $ 594.7 $ 151.8 $ 490.4 $ 118.6 $ 445.8 $ 108.6 (1) Controlled premium are total premiums placed by NSM during the period. Year Ended December 31, 2018 versus Year Ended December 31, 2017 Specialty Transportation: NSM’s specialty transportation controlled premium and commission and fee revenue growth in 2018 was due in part to organic growth in the ACI program. In addition, profit commissions in this vertical were higher in 2018 compared to 2017, as there were no major catastrophes in 2018, while profit commissions were significantly reduced in 2017 due to hurricanes Harvey and Irma. Real Estate: NSM’s real estate controlled premium and commission and fee revenue grew in 2018 primarily due to the CHAMP program, which places coverages for coastal condominium associations and high-end hotels. CHAMP grew with greater penetration in the southeast U.S. market and coverages with existing policyholders. CHAMP also benefited from customer goodwill produced by exceptional claims handling in the wake of the hurricanes in 2017. Social Services: NSM’s social services controlled premium and commission and fee revenue experienced a decline in 2018 primarily due to the continued pull back of a key carrier partner and in response to elevated loss ratios. NSM has established relationships with two new carrier partners in the Social Services vertical for 2019. United Kingdom: NSM’s United Kingdom controlled premium and commission and fee revenue grew significantly in 2018 due to the acquisition of Fresh Insurance. Other: NSM’s other controlled premium and commission and fee revenue increased due to growth in the retail brokerage program, partially offset by a reduction in the worker’s compensation program. Year Ended December 31, 2017 versus Year Ended December 31, 2016 Specialty Transportation: The decrease in NSM’s specialty transportation commission and fee revenue in 2017 compared to 2016 was driven primarily by decreased profit commissions from the impact of hurricanes Harvey and Irma in 2017. Real Estate: NSM’s real estate controlled premium and commission and fee revenue grew in 2017 primarily due to the CHAMP program with increased penetration in the southeast U.S. market. Social Services: NSM’s social services controlled premium and commission and fee revenue experienced a decline in 2017 primarily due to pull back of a key carrier partner and the decision to non-renew certain programs within the vertical. United Kingdom: NSM acquired Vantage Holdings in the fourth quarter of 2016, which generated nearly all of the controlled premium and commission and fee revenues in the United Kingdom vertical for 2017. Other: NSM’s other controlled premium and commission and fee revenue experienced modest growth in 2017 over 2016 with the growth in the retail brokerage and architect programs offset by the shutdown of the dental program. MediaAlpha The following table presents the components of GAAP net income (loss) and adjusted EBITDA included in White Mountains’s MediaAlpha segment for the years ended 2018, 2017 and 2016: Year Ended December 31, Millions Advertising and commission revenues $ 295.5 $ 163.2 $ 116.5 Cost of sales 245.0 135.9 97.8 Gross profit 50.5 27.3 18.7 Other revenue 1.6 - - General and administrative expenses 31.7 16.2 11.8 Amortization of other intangible assets 10.3 10.5 10.1 Interest expense 1.2 1.0 .9 GAAP pre-tax income (loss) 8.9 (.4 ) (4.1 ) Income tax expense - - - GAAP net income (loss) 8.9 (.4 ) (4.1 ) Add back: Non-cash equity-based compensation expense 11.7 - - Interest expense 1.2 1.0 .9 Income tax expense - - - General and administrative expenses - depreciation .2 .2 .1 Amortization of other intangible assets 10.3 10.5 10.1 Adjusted EBITDA (1) $ 32.3 $ 11.3 $ 7.0 (1) See “NON-GAAP FINANCIAL MEASURES” on page 55. On February 26, 2019, MediaAlpha completed the sale of a significant minority stake to Insignia Capital Group in connection with a recapitalization and cash distribution to existing equityholders. MediaAlpha also repurchased a portion of the holdings of existing equityholders. The transaction valued MediaAlpha at approximately $350 million. White Mountains retained a 42% ownership interest in MediaAlpha on a fully-diluted basis, and received a net cash distribution of approximately $88 million. As a result of the transaction, White Mountains also expects that it will no longer consolidate MediaAlpha in its financial statements and will mark its interest in MediaAlpha to fair value at the transaction closing date and in subsequent periods. MediaAlpha Results-Year Ended December 31, 2018 versus Year Ended December 31, 2017 MediaAlpha reported GAAP pre-tax income of $9 million and adjusted EBITDA of $32 million in 2018, compared to break-even pre-tax income and adjusted EBITDA of $11 million in 2017. MediaAlpha reported advertising and commission revenues of $296 million in 2018, compared to $163 million in 2017. The increase in GAAP pre-tax income, adjusted EBITDA and revenues were driven primarily by growth in MediaAlpha’s P&C vertical, driven by increased demand from advertisers, and growth in the HLM vertical, driven by strong revenues generated from assets acquired from Healthplans.com in the fourth quarter of 2017. Revenues from MediaAlpha’s P&C vertical were $162 million in 2018, compared to $88 million in 2017, while revenues from the HLM vertical were $100 million in 2018 compared to $56 million in 2017. MediaAlpha’s cost of sales is comprised primarily of revenue share based payments to partners, which are correlated to and vary with revenue volume. Cost of sales were $245 million in 2018, compared to $136 million in 2017. The increase in cost of sales was driven primarily by the increase in revenues. MediaAlpha’s general and administrative expenses were $32 million in 2018, compared to $16 million in 2017. The increase in general and administrative expenses in 2018 compared to 2017 was driven primarily by the recognition of non-cash equity-based compensation expense of $12 million that relates to MediaAlpha’s Class B units held by certain employees. The units entitle the award recipient to participate in distributions from MediaAlpha once a cumulative distribution threshold has been met. Compensation expense is recognized when it is deemed probable that the distribution threshold will be met in the future. MediaAlpha Results-Year Ended December 31, 2017 versus Year Ended December 31, 2016 On October 5, 2017, MediaAlpha acquired certain assets associated with the Health, Life and Medicare insurance business of Healthplans.com for a purchase price of $28 million. The acquired assets include domain names, advertiser and publisher relationships, traffic acquisition accounts, and owned and operated websites. During the fourth quarter of 2017, which includes the annual open enrollment period for health and Medicare coverages, business from the acquired assets contributed $15 million of revenues and $2 million of both pre-tax income and adjusted EBITDA. MediaAlpha reported break-even pre-tax income in 2017, compared to a pre-tax loss of $4 million in 2016. Adjusted EBITDA was $11 million in 2017, compared to $7 million in 2016. For the year ended December 31, 2017, the increase in pre-tax income and adjusted EBITDA were driven primarily by increases in gross profit of $7 million in the HLM vertical and $1 million in the P&C vertical, partially offset by increased operating expenses. Advertising and commission revenues were $163 million in 2017, compared to $117 million in 2016. The increase in revenues was driven primarily by growth generated from the newly acquired assets in the HLM vertical and growth in the P&C vertical. The HLM vertical revenues increased $27 million, to $56 million for the year ended December 31, 2017. The P&C vertical revenues increased $11 million, to $88 million for the year ended December 31, 2017. MediaAlpha’s cost of sales is comprised primarily of revenue share based payments to partners. Cost of sales were $136 million in 2017, compared to $98 million in 2016. The increase in cost of sales was driven primarily by the increase in revenues. Other Operations The following table presents White Mountains’s financial results from its Other Operations segment for the years ended December 31, 2018, 2017 and 2016: Year Ended December 31, Millions Earned insurance premiums $ - $ 1.0 $ 7.5 Net investment income 42.3 43.7 23.1 Net realized and unrealized investment (losses) gains (100.8 ) 132.7 (28.1 ) Advertising and commission revenues 4.1 3.8 1.8 Other revenues .5 6.1 20.2 Total revenues (53.9 ) 187.3 24.5 Losses and LAE - 1.1 8.0 Insurance and reinsurance acquisition expenses - .1 2.2 Cost of sales 3.7 3.5 4.2 General and administrative and other expenses 94.4 148.9 124.1 Amortization of other intangible assets .2 .2 .4 Interest expense .3 1.3 2.1 Total expenses 98.6 155.1 141.0 Pre-tax (loss) income $ (152.5 ) $ 32.2 $ (116.5 ) Other Operations Results-Year Ended December 31, 2018 versus Year Ended December 31, 2017 White Mountains’s Other Operations segment reported pre-tax loss of $153 million in 2018, compared to pre-tax income of $32 million in 2017. The results were driven primarily by lower investment returns in 2018. Net realized and unrealized investment losses were $101 million in 2018, compared to net realized and unrealized investment gains of $133 million in 2017. See “Summary of Investment Results” on page 43. Other revenues were $1 million in 2018, compared to $6 million in 2017. In 2017, other revenues included $4 million of third-party investment management fee income at WM Advisors. The Other Operations segment reported general and administrative expenses of $94 million in 2018, compared to $149 million in 2017. General and administrative expenses in 2017 included additional compensation expenses related to the severance of former company executives and higher incentive compensation costs resulting from the OneBeacon Transaction. Share repurchases For the year ended December 31, 2018, White Mountains repurchased and retired 592,458 of its common shares for $519 million, at an average share price of $877. The average share price paid was approximately 98% and 99%, respectively, of White Mountains’s December 31, 2018 book value per share and adjusted book value per share. The average share price paid was approximately 92% and 93%, respectively, of White Mountains’s December 31, 2018 book value per share including the estimated gain from the MediaAlpha transaction and adjusted book value per share including the estimated gain from the MediaAlpha transaction. Other Operations Results-Year Ended December 31, 2017 versus Year Ended December 31, 2016 White Mountains’s Other Operations segment reported pre-tax income of $32 million in 2017 compared to pre-tax loss of $117 million in 2016. The results were driven primarily by strong equity returns in 2017. Net realized and unrealized investment gains were $133 million in 2017, compared to net realized and unrealized investment losses of $28 million in 2016. Net investment income increased to $44 million in 2017 from $23 million in 2016. The increase was driven by a higher invested asset base driven primarily from the proceeds received from the OneBeacon Transaction. See “Summary of Investment Results” on page 43. Other revenues were $6 million in 2017, compared to $20 million in 2016, driven primarily by lower third-party investment management fee income at WM Advisors. The Other Operations segment reported general and administrative expenses of $149 million in 2017, compared to $124 million in 2016. The increase in general and administrative expenses was driven primarily by additional compensation expenses related to the severance of former company executives and higher incentive compensation costs resulting from the OneBeacon Transaction. Share repurchases For the year ended December 31, 2017, White Mountains repurchased and retired 832,725 of its common shares for $724 million at an average share price of $869. The average share price paid was approximately 93% and 95%, respectively, of White Mountains’s December 31, 2017 book value per share and adjusted book value per share. II. Summary of Investment Results White Mountains’s total investment results include continuing operations and discontinued operations. The OneBeacon and Sirius Group investment results are included in discontinued operations for each respective period. For purposes of discussing rates of return, all percentages are presented gross of management fees and trading expenses in order to produce a better comparison to benchmark returns, while all dollar amounts are presented net of management fees and trading expenses. The following table presents the pre-tax investment returns for White Mountains’s consolidated portfolio, including the returns from discontinued operations, for the years ended December 31, 2018, 2017 and 2016: Gross Investment Returns and Benchmark Returns(1) Year Ended December 31, Common equity securities (7.7 )% 20.1 % 6.2 % Other long-term investments 10.0 % (5.8 )% 0.8 % Total common equity securities and other long-term investments (3.6 )% 12.7 % 4.3 % S&P 500 Index (total return) (4.4 )% 21.8 % 12.0 % Fixed income investments 1.2 % 3.5 % 2.4 % Bloomberg Barclays U.S. Intermediate Aggregate Index 0.9 % 2.3 % 2.0 % Total consolidated portfolio (1.7 )% 5.6 % 2.7 % (1) For 2018, investment returns are calculated using a daily weighted average of investments held. For periods prior to 2018, investment returns are calculated using a quarterly weighted average of investments held. Investment Returns-Year Ended December 31, 2018 versus Year Ended December 31, 2017 White Mountains’s pre-tax total return on invested assets was -1.7% for 2018, compared to 5.6% for 2017. Investment returns for 2018 were adversely impacted by the sharp decline in equity markets in the fourth quarter. Investment returns for 2017 benefited from the relatively short-duration of the fixed income portfolio and strong equity markets. Common Equity Securities and Other Long-Term Investments Results White Mountains’s portfolio of common equity securities and other long-term investments returned -3.6% for 2018 compared to 12.7% for 2017. White Mountains’s portfolio of common equity securities and other long-term investments represented approximately 49% and 32% of total invested assets as of December 31, 2018 and 2017. The increase in this percentage was driven primarily by additions to the common equity security portfolio and a decline in the investment asset base principally due to share repurchase activity during the year. White Mountains’s portfolio of common equity securities returned -7.7% for 2018, underperforming the S&P 500 Index return of -4.4%. White Mountains’s portfolio of common equity securities returned 20.1% for 2017, underperforming the S&P 500 Index return of 21.8%. White Mountains’s portfolio of common equity securities primarily consists of passive ETFs and publicly-traded common equity securities that are actively managed by third-party registered investment advisers. White Mountains’s portfolio of ETFs seeks to provide investment results that, before expenses, generally correspond to the performance of broad market indices. As of December 31, 2018 and 2017, White Mountains had approximately $675 million and $570 million invested in ETFs. In 2018 and 2017, the ETFs essentially earned the effective index return, before expenses, over the period in which White Mountains was invested in these funds. As of December 31, 2018, White Mountains’s relationships with third-party registered investment advisers (the “actively managed common equity portfolios”) were with Highclere International Investors (“Highclere”), who invests in small to mid-cap equity securities listed in markets outside of the United States and Canada through a unit trust, Silchester International Investors (“Silchester”), who invests in value-oriented non-U.S. equity securities through a unit trust and Lateef Investment Management (“Lateef”), a growth at a reasonable price adviser managing a highly concentrated separate account portfolio of U.S. mid-cap and large-cap growth companies. As of December 31, 2018 and 2017, White Mountains had approximately $250 million and $296 million of common equity securities invested with third-party registered investment advisers. White Mountains’s actively managed common equity portfolios returned -15.6% for 2018, underperforming the S&P 500 Index return of -4.4%. The underperformance was driven primarily by weak returns from the non-U.S. common equity portfolios managed by Highclere and Silchester. White Mountains’s actively managed common equity portfolios returned 25.2% for 2017, outperforming the S&P 500 Index return of 21.8%. The outperformance was driven primarily by strong returns from the common equity portfolios managed by Silchester and Lateef. During 2017, White Mountains entered into foreign currency forward contracts, which were recorded in other long-term investments, to manage its foreign currency exposure relating to a portion of the non-U.S. common equity portfolios managed by Highclere and Silchester. These foreign currency forward contracts were closed as of December 31, 2017. White Mountains maintains a portfolio of other long-term investments that primarily consists of unconsolidated entities, private equity funds and hedge funds. White Mountains’s other long-term investments portfolio returned 10.0% for 2018. The results were driven primarily by a $26 million fair value adjustment to White Mountains’s investment in PassportCard/DavidShield, which was driven by strong profitable growth in its core businesses, and strong private equity fund returns. White Mountains’s other long-term investments portfolio returned -5.8% for 2017. The results were driven primarily by losses from foreign currency forward contracts and unconsolidated entities. These losses were partially offset by strong performance from private equity funds and favorable fair value adjustments to surplus notes issued to OneBeacon in connection with the sale of its runoff business (the “OneBeacon Surplus Notes”). Fixed Income Results As of both December 31, 2018 and 2017, the fixed income portfolio duration, including short-term investments, was 3.4 years. White Mountains’s fixed income portfolio returned 1.2% for 2018, outperforming the Bloomberg Barclays U.S. Intermediate Aggregate Index return of 0.9%. These results were driven primarily by strong performance from White Mountains’s overweight exposure to municipal obligations versus the benchmark. In addition, White Mountains’s short duration positioning of the fixed income portfolio also contributed to the outperformance relative to the benchmark as rates rose during the period. However, White Mountains’s overweight exposure to debt securities issued by corporations lessened the positive relative impact of having a short duration portfolio when credit spreads widened significantly in the fourth quarter. White Mountains’s fixed income portfolio returned 3.5% for 2017, outperforming the Bloomberg Barclays U.S. Intermediate Aggregate Index return of 2.3% as short-term yields rose during the period. In the fourth quarter of 2017, White Mountains established a U.S. investment grade corporate bond mandate with Principal Global Investors, LLC (“Principal”), a third-party registered investment adviser. As of December 31, 2018, the fair value of the Principal investment grade corporate bond mandate was $247 million, with a duration of approximately 4.6 years. During 2016, White Mountains established a GBP investment grade corporate bond mandate with a third-party registered investment adviser and entered into a foreign currency forward contract, which was recorded in other long-term investments, to manage the foreign currency exposure relating to this mandate. In the first quarter of 2018, White Mountains terminated this mandate and closed the associated foreign currency forward contract. White Mountains also established a portfolio of high-yield fixed maturity investments managed by a third-party registered investment adviser during 2016. In the third quarter of 2018, White Mountains liquidated the high-yield fixed maturity portfolio and reinvested the bulk of the proceeds into U.S. government securities. Investment Returns-Year Ended December 31, 2017 versus Year Ended December 31, 2016 White Mountains’s pre-tax total return on invested assets was 5.6% for 2017, compared to 2.7% for 2016. Investment returns for 2017 benefited from the relatively short-duration of the fixed income portfolio and strong equity markets. Investment returns for 2016 were driven primarily by strong equity markets and decent fixed income returns despite rising interest rates Common Equity Securities and Other Long-Term Investments Results White Mountains’s portfolio of common equity securities and other long-term investments returned 12.7% for 2017, compared to 4.3% for 2016. White Mountains’s portfolio of common equity securities and other long-term investments represented approximately 32% and 15% of total invested assets as of December 31, 2017 and 2016. The increase in this percentage was driven primarily by additions to the common equity security portfolio and a decline in the investment asset base due to the OneBeacon Transaction and share repurchase activity during the year. White Mountains’s portfolio of common equity securities returned 20.1% for 2017, underperforming the S&P 500 Index return of 21.8%. White Mountains’s portfolio of common equity securities returned 6.2% for 2016, underperforming the S&P 500 Index return of 12.0%. As of December 31, 2017 and 2016, White Mountains had approximately $570 million and $322 million invested in ETFs. In 2017 and 2016, the portfolio of ETFs essentially earned the effective index return, before expenses, over the period in which White Mountains was invested in these funds. As of December 31, 2017 and 2016, White Mountains had approximately $296 million and $152 million of common equity securities invested with third-party registered investment advisers. White Mountains’s actively managed common equity portfolios returned 25.2% in 2017, outperforming the S&P 500 Index return of 21.8%. The outperformance was driven primarily by strong returns from the common equity portfolios managed by Silchester and Lateef. White Mountains’s actively managed common equity portfolios returned 4.0% in 2016, underperforming the S&P 500 Index return of 12.0%, driven primarily by weak returns from the common equity portfolio managed by Lateef. White Mountains’s other long-term investments portfolio returned -5.8% for 2017. The results were driven primarily by losses from foreign currency forward contracts and unconsolidated entities. These losses were partially offset by strong performance from private equity funds and favorable fair value adjustments to the OneBeacon Surplus Notes. White Mountains’s other long-term investments portfolio returned 0.8% for 2016. The results were driven primarily by favorable fair value adjustments to the OneBeacon Surplus Notes, mostly offset by losses from private equity funds and unconsolidated entities. Fixed Income Results As of December 31, 2017, the fixed income portfolio duration, including short-term investments, was 3.4 years compared to 2.8 years as of December 31, 2016. White Mountains’s fixed income portfolio returned 3.5% for 2017, outperforming the Bloomberg Barclays U.S. Intermediate Aggregate Index return of 2.3% as short-term yields rose during the period. White Mountains’s fixed income portfolio returned 2.4% for 2016, outperforming the Bloomberg Barclays U.S. Intermediate Aggregate Index return of 2.0%, as interest rates rose in the period. Portfolio Composition The following table presents the composition of White Mountains’s total operations investment portfolio as of December 31, 2018 and 2017: December 31, 2018 December 31, 2017 $ in Millions Carrying Value % of Total Carrying Value % of Total Fixed maturity investments $ 1,077.5 42.4 % $ 2,129.7 63.0 % Short-term investments 214.2 8.4 176.1 5.2 Common equity securities 925.6 36.4 866.1 25.6 Other long-term investments 325.6 12.8 208.8 6.2 Total investments $ 2,542.9 100.0 % $ 3,380.7 100.0 % The following table presents the breakdown of White Mountains’s fixed maturity investments as of December 31, 2018 by credit class, based upon issuer credit ratings provided by Standard & Poor’s, or if unrated by Standard & Poor’s, long term obligation ratings provided by Moody’s: December 31, 2018 $ in Millions Amortized Cost % of Total Carrying Value % of Total U.S. government and government-sponsored entities (1) $ 271.9 25.0 % $ 268.6 25.0 % AAA/Aaa 66.4 6.1 66.1 6.1 AA/Aa 264.2 24.3 264.4 24.6 A/A 328.2 30.1 324.8 30.1 BBB/Baa 151.8 14.0 148.0 13.7 Other/not rated 5.6 0.5 5.6 0.5 Total fixed maturity investments $ 1,088.1 100.0 % $ 1,077.5 100.0 % (1) Includes mortgage-backed securities, which carry the full faith and credit guaranty of the U.S. government (i.e., GNMA) or are guaranteed by a government sponsored entity (i.e., FNMA, FHLMC). The cost or amortized cost and carrying value of White Mountains’s fixed maturity investments as of December 31, 2018 is presented below by contractual maturity. Actual maturities could differ from contractual maturities because certain borrowers may call or prepay their obligations with or without call or prepayment penalties. December 31, 2018 Millions Amortized Cost Carrying Value Due in one year or less $ 84.8 $ 84.4 Due after one year through five years 500.8 496.2 Due after five years through ten years 222.4 218.0 Due after ten years 144.0 145.4 Mortgage and asset-backed securities 136.1 133.5 Total fixed maturity investments $ 1,088.1 $ 1,077.5 Foreign Currency Exposure As of December 31, 2018, White Mountains had foreign currency exposure on $244 million of net assets primarily relating to common equity securities managed by Silchester and Highclere, NSM’s U.K. operations, Buzz, Wobi and certain unconsolidated entities. White Mountains may enter into foreign currency forward contracts from time to time in order to mitigate its foreign currency exposure on certain invested assets. In the fourth quarter of 2017, White Mountains closed the foreign currency forward contracts associated with the investment assets managed by Silchester and Highclere. In conjunction with the liquidation of the GBP investment grade corporate bond mandate in the first quarter of 2018, White Mountains closed the associated foreign currency forward contract. The following table presents the fair value of White Mountains’s foreign denominated net assets as of December 31, 2018: $ in Millions Currency (1) Fair Value % of Common Shareholders’ Equity GBP $ 76.0 2.7 % EUR 54.0 1.9 JPY 49.9 1.8 All other 63.9 2.2 Total $ 243.8 8.6 % (1) Includes net assets of NSM’s U.K. operations, Wobi and Buzz. Income Taxes The Company and its Bermuda-domiciled subsidiaries are not subject to Bermuda income tax under current Bermuda law. In the event there is a change in the current law such that taxes are imposed, the Company and its Bermuda-domiciled subsidiaries would be exempt from such tax until March 31, 2035, pursuant to the Bermuda Exempted Undertakings Tax Protection Act of 1966. The Company has subsidiaries and branches that operate in various other jurisdictions around the world that are subject to tax in the jurisdictions in which they operate. White Mountains reported income tax benefit of $4 million in 2018 on pre-tax loss from continuing operations of $178 million. White Mountains’s effective tax rate was different from the current U.S. federal statutory rate of 21% primarily due to a full valuation allowance on most of the net deferred tax assets at U.S. operations, income generated in jurisdictions with lower tax rates than the United States, withholding taxes and a tax benefit recorded at BAM related to its MSC collected. For BAM, MSC collected and the related taxes thereon are recorded directly to non-controlling interest equity, while the valuation allowance on such taxes is recorded through the income statement. As a result, BAM recorded a tax benefit of $9 million associated with the valuation allowance on taxes related to MSC collected that is included in the effective tax rate. See Note 6 - “Income Taxes” on page. White Mountains reported income tax benefit of $8 million in 2017 on pre-tax income from continuing operations of $8 million. White Mountains’s effective tax rate was different from the 2017 U.S. federal statutory rate of 35% primarily due to a full valuation allowance on most of the net deferred tax assets at U.S. operations net of the impact of tax rate changes, income generated in jurisdictions with lower tax rates than the United States, a tax benefit recorded at BAM related to its MSC collected and consolidated pre-tax income being near break-even. For BAM, MSC collected and the related taxes thereon are recorded directly to non-controlling interest equity, while the valuation allowance on such taxes is recorded through the income statement. As a result, BAM recorded a tax benefit of $10 million associated with the valuation allowance on taxes related to MSC collected that is included in the effective tax rate. White Mountains reported income tax benefit of $33 million in 2016 on pre-tax loss from continuing operations of $147 million. White Mountains’s effective tax rate was different from the 2016 U.S. federal statutory rate of 35% primarily due to a full valuation allowance on all of the net deferred tax assets at U.S. operations including a $21 million tax benefit generated by the sale of Tranzact recognized in continuing operations related to the reversal of a valuation allowance that resulted from income that was recognized within discontinued operations, income generated in jurisdictions with lower tax rates than the United States and a tax benefit recorded at BAM related to its MSC collected. For BAM, MSC collected and the related taxes thereon are recorded directly to non-controlling interest equity, while the valuation allowance on such taxes is recorded through the income statement. As a result, BAM recorded a tax benefit of $11 million associated with the valuation allowance on taxes related to MSC collected that is included in the effective tax rate. Discontinued Operations White Mountains has entered into a number of sale transactions that have been accounted for as discontinued operations within its consolidated financial statements. See Note 19 - “Held for Sale and Discontinued Operations” on page for detailed financial information on each business sold. OneBeacon On September 28, 2017, Intact Financial Corporation completed its acquisition of OneBeacon Insurance Group, Ltd. in an all-cash transaction for $18.10 per share. OneBeacon Results - Period Ended September 28, 2017 For the 2017 period, White Mountains reported net income from OneBeacon of $21 million in discontinued operations. OneBeacon’s combined ratio for the 2017 period was 105%, driven by four points of net unfavorable loss reserve development, primarily in the Program, Healthcare and Government Risk businesses, and four points of catastrophe losses, primarily due to losses from Hurricane Harvey. OneBeacon Results-Year Ended December 31, 2016 For the year ended December 31, 2016, White Mountains reported net income from OneBeacon of $109 million in discontinued operations, driven primarily by investment results. OneBeacon’s GAAP combined ratio increased to 97% for 2016 from 96% for 2015, primarily due to a higher expense ratio driven by a lower premium volume and changing business mix. Sirius Group On April 18, 2016, White Mountains completed the sale of Sirius Group to CMI. Sirius Group’s results inured to White Mountains until the closing date of the transaction. Sirius Group Tax Contingency In October 2018, the Swedish Administrative Court ruled against Sirius Group on its appeal of the Swedish Tax Agency’s denial of certain interest deductions relating to periods prior to the sale of Sirius Group to CMI. In connection with the sale, White Mountains indemnified Sirius Group against the loss of certain tax attributes, including those related to these interest deductions. As a result, in the third quarter of 2018, White Mountains recorded a loss of $17 million within net (loss) gain on sale of discontinued operations reflecting the value of these interest deductions. Sirius Group has appealed the decision to the Swedish Administrative Court of Appeal. Sirius Group Results - Period Ended April 18, 2016 For the 2016 period, White Mountains reported Sirius Group’s comprehensive income of $27 million and a combined ratio of 102%, which was driven primarily by $17 million of recorded losses from the Ecuador earthquake that occurred on April 16, 2016. Tranzact On July 21, 2016, White Mountains completed the sale of Tranzact to an affiliate of Clayton, Dubilier & Rice, LLC. Tranzact's results inured to White Mountains until the closing date of the transaction. For the 2016 period, White Mountains reported Tranzact’s net loss from discontinued operations of $3 million. LIQUIDITY AND CAPITAL RESOURCES Operating Cash and Short-term Investments Holding Company Level The primary sources of cash for the Company and certain of its intermediate holding companies are expected to be distributions and tax sharing payments received from its operating subsidiaries, capital raising activities, net investment income, proceeds from sales, repayments and maturities of investments and, from time to time, proceeds from sales of operating subsidiaries. The primary uses of cash are expected to be repurchases of the Company’s common shares, payments on and repurchases/retirements of its debt obligations, dividend payments to holders of the Company’s common shares, distributions to non-controlling interest holders of consolidated subsidiaries, purchases of investments, payments to tax authorities, contributions to operating subsidiaries, operating expenses and, from time to time, purchases of operating subsidiaries. Operating Subsidiary Level. The primary sources of cash for White Mountains’s operating subsidiaries are expected to be premium and fee collections, net investment income, proceeds from sales, repayments and maturities of investments, contributions from holding companies, capital raising activities and, from time to time, proceeds from sales of operating subsidiaries. The primary uses of cash are expected to be loss payments, policy acquisition and other underwriting costs, cost of sales, purchases of investments, payments on and repurchases/retirements of its debt obligations, distributions and tax sharing payments made to holding companies, distributions to non-controlling interest holders, operating expenses and, from time to time, purchases of operating subsidiaries. Both internal and external forces influence White Mountains’s financial condition, results of operations and cash flows. Premium and fee levels, loss payments, cost of sales and investment returns may be impacted by changing rates of inflation and other economic conditions. Some time may lapse between the occurrence of an insured loss, the reporting of the loss to White Mountains and the settlement of the liability for that loss. The exact timing of the payment of losses and benefits cannot be predicted with certainty. Management believes that White Mountains’s cash balances, cash flows from operations and routine sales and maturities of investments are adequate to meet expected cash requirements for the foreseeable future on both a holding company and subsidiary level. Dividend Capacity Following is a description of the dividend capacity of White Mountains’s reinsurance and other operating subsidiaries: HG Global/BAM As of December 31, 2018, HG Global had $619 million face value of preferred shares outstanding, of which White Mountains owned 96.9%. Holders of the HG Global preferred shares receive cumulative dividends at a fixed annual rate of 6.0% on a quarterly basis, when and if declared by HG Global. HG Global did not declare or pay any preferred dividends in 2018. As of December 31, 2018, HG Global had accrued $288 million of dividends payable to holders of its preferred shares, $279 million of which is payable to White Mountains and eliminated in consolidation. As of December 31, 2018, HG Global and its subsidiaries had $2 million of cash outside of HG Re. HG Re is a Special Purpose Insurer subject to regulation and supervision by the BMA but does not require regulatory approval to pay dividends. However, HG Re’s dividend capacity is limited to amounts held outside of the Collateral Trusts pursuant to the FLRT with BAM. As of December 31, 2018, HG Re had statutory capital and surplus of $699 million, $757 million of assets held in the Collateral Trusts pursuant to the FLRT with BAM and $3 million of cash and investments outside the Collateral Trusts. Effective January 1, 2014, HG Global and BAM agreed to change the interest rate on the BAM Surplus Notes for the five years ending December 31, 2018 from a fixed rate of 8.0% to a variable rate equal to the one-year U.S. treasury rate plus 300 basis points, set annually. In 2018, BAM exercised its option to extend the variable rate period for an additional three years and during 2019, the interest rate will be 5.70%. At the end of the variable rate period, the interest rate will be fixed at the higher of the then current variable rate or 8.0%. BAM is required to seek regulatory approval to pay interest and principal on the BAM Surplus Notes only to the extent that its capital resources continue to support its outstanding obligations, business plan and rating. No payment of interest or principal on the BAM Surplus Notes may be made without the approval of the New York State Department of Financial Services (“NYDFS”). BAM has stated its intention to seek regulatory approval to pay interest and principal on its surplus notes to the extent that its remaining qualified statutory capital and other capital resources continue to support its outstanding obligations, its business plan and its “AA/stable” rating from Standard & Poor’s. BAM repaid $18 million of the BAM Surplus Notes and $5 million of accrued interest during 2018. BAM repaid $4 million of the BAM Surplus Notes and $1 million of accrued interest during 2017. NSM During the period from White Mountains’s acquisition of NSM through December 31, 2018, NSM did not pay any dividends to its shareholders. As of December 31, 2018, NSM had $16 million of net unrestricted cash. MediaAlpha During 2018, MediaAlpha paid $16 million of dividends, $10 million of which was paid to White Mountains. As of December 31, 2018, MediaAlpha had $6 million of net unrestricted cash. Other Operations During 2018, White Mountains paid a $4 million common share dividend. As of December 31, 2018, the Company and its intermediate holding companies had $536 million of net unrestricted cash, short-term investments and fixed maturity investments, $926 million of common equity securities and $67 million of other long-term investments included in its Other Operations segment. Financing The following table summarizes White Mountains’s capital structure as of December 31, 2018 and 2017: December 31, $ in Millions WTM Bank Facility $ - $ - NSM Bank Facility, net of unamortized issuance costs 176.6 - MediaAlpha Bank Facility, net of unamortized issuance costs 14.2 23.8 Other NSM debt 1.9 - Total debt 192.7 23.8 Non-controlling interests - other, excluding BAM 45.7 31.5 Total White Mountains’s common shareholders’ equity 2,843.1 3,492.5 Total capital 3,081.5 3,547.8 Time-value discount on expected future payments on the BAM Surplus Notes (1) (141.2 ) (157.0 ) HG Global’s unearned premium reserve (1) 136.9 103.9 HG Global’s net deferred acquisition costs (1) (34.6 ) (24.3 ) Total adjusted capital $ 3,042.6 $ 3,470.4 Total debt to total adjusted capital 6.3 % 0.7 % (1) Amount reflects White Mountains's preferred share ownership in HG Global of 96.9%. Management believes that White Mountains has the flexibility and capacity to obtain funds externally through debt or equity financing on both a short-term and long-term basis. However, White Mountains can provide no assurance that, if needed, it would be able to obtain additional debt or equity financing on satisfactory terms, if at all. It is possible that, in the future, one or more of the rating agencies may lower White Mountains’s existing ratings. If one or more of its ratings were lowered, White Mountains could incur higher borrowing costs on future borrowings and its ability to access the capital markets could be impacted. White Mountains had an unsecured revolving credit facility with a syndicate of lenders administered by Wells Fargo Bank, N.A., which had a total commitment of $425 million. White Mountains terminated the WTM Bank Facility on May 8, 2018. On May 11, 2018, NSM entered into a secured credit facility (the “NSM Bank Facility”) with Ares Capital Corporation in order to refinance NSM’s existing debt and to fund the acquisition of Fresh Insurance. The NSM Bank Facility is comprised of a term loan of $100 million, delayed-draw term loans of $51 million to fund the Fresh Insurance acquisition and $30 million to fund incremental term loans to fund the KBK acquisition and a revolving credit loan commitment of $10 million, under which NSM initially borrowed $2 million. The term loans under the NSM Bank Facility mature on May 11, 2024, and the revolving credit loan under the NSM Bank Facility matures on May 11, 2023. During the period from May 11, 2018 through December 31, 2018, NSM repaid $1 million on the term loans and $2 million on the revolving credit loan under the NSM Banking Facility. As of December 31, 2018, no revolving credit loans were outstanding under the NSM Bank Facility. Interest on the NSM Bank Facility accrues at a floating interest rate equal to the three-month LIBOR or the Prime Rate, as published by the Wall Street Journal plus, in each case, an applicable margin. The margin over LIBOR may vary between 4.25% and 4.75%, and the margin over the Prime Rate may vary between 3.25% and 3.75%, in each case, depending on the consolidated total leverage ratio of the borrower. On June 15, 2018, NSM entered into an interest rate swap agreement to hedge its exposure to interest rate risk on $151 million of its variable rate term loans. Under the terms of the swap agreement, NSM pays a fixed rate of 2.97% and receives a variable rate, which is reset monthly, based on the then-current LIBOR. As of December 31, 2018, the variable rate received by NSM under the swap agreement was 2.52%. As of December 31, 2018, the effective interest rate for the outstanding term loans of $150 million that are hedged by the swap was 7.47%. The effective interest rate on the outstanding term loans of $30 million that are unhedged was 6.85%. The effective interest rate on the total outstanding term loans under the NSM Bank Facility of $180 million was 7.42%. See Note 7 - “Derivatives - NSM Interest Rate Swap” on page. The NSM Bank Facility is secured by all property of NSM and contains various affirmative, negative and financial covenants that White Mountains considers to be customary for such borrowings, including a maximum consolidated total leverage ratio covenant. MediaAlpha has a secured credit facility (the “MediaAlpha Bank Facility”) with Western Alliance Bank, which has a total commitment of $28 million and a maturity date of October 6, 2020. The MediaAlpha Bank Facility consists of an $18 million term loan facility, which has an outstanding balance of $14 million as of December 31, 2018, and a revolving loan facility for $10 million, which was undrawn as of December 31, 2018. During 2018, MediaAlpha repaid $4 million on the term loan and borrowed $3 million and repaid $9 million on the revolving loan under the MediaAlpha Bank Facility. The MediaAlpha Bank Facility is secured by intellectual property and the common stock of MediaAlpha’s subsidiaries, and contains various affirmative, negative and financial covenants that White Mountains considers to be customary for such borrowings, including a maximum leverage ratio. Covenant Compliance At December 31, 2018, White Mountains was in compliance with all of the covenants under all of its debt instruments. NSM Bank Facility The consolidated total leverage ratio in the NSM Bank Facility is determined by dividing NSM’s debt by its EBITDA, both as defined in the NSM Bank Facility. Debt is defined to include indebtedness for borrowed money, due and payable earnouts on permitted acquisitions and various other adjustments specified in the NSM Bank Facility, less unrestricted cash and cash equivalents (“Bank Debt”). NSM’s Bank Debt was $166 million as of December 31, 2018. EBITDA is defined to include adjusted EBITDA (see NON-GAAP FINANCIAL MEASURES on page 55) plus additional adjustments to (i) exclude certain expenses, including program start up and shutdown expenses, mergers and acquisition expenses, terminations and various other adjustments specified in NSM’s Bank Facility and (ii) include/exclude historical earnings of acquired/disposed companies (“Bank EBITDA”). NSM’s Bank EBITDA was $42 million for the trailing twelve months ended December 31, 2018. The maximum consolidated total leverage ratio covenant as of December 31, 2018 was 5.5x. NSM’s actual consolidated total leverage ratio was 4.0x. Contractual Obligations and Commitments The following table presents White Mountains’s material contractual obligations and commitments as of December 31, 2018: Millions Due in Less Than One Year Due in One to Three Years Due in Three to Five Years Due After Five Years Total Debt $ 5.2 $ 10.4 $ 9.4 $ 171.9 $ 196.9 Interest on debt 14.1 26.6 12.5 - 53.2 Long-term incentive compensation 17.0 30.7 - - 47.7 Contingent consideration earnout liabilities (1) 20.2 - - - 20.2 Operating leases (2) 6.6 9.1 7.8 4.2 27.7 Total contractual obligations and commitments $ 63.1 $ 76.8 $ 29.7 $ 176.1 $ 345.7 (1) The contingent consideration earnout liabilities are related to NSM’s previous acquisitions of Fresh Insurance and its other U.K.-based operations. Any future adjustments due after one year, which are based upon EBITDA, EBITDA projections, and present value factors for acquired entities, are not included in the table. See Note 2 - “Significant Transactions” on page. (2) Amounts include BAM’s operating lease amounts of $2.2, $3.9, $3.6 and $4.2 that are due in less than one year, one to three years, three to five years, and due after five years, which are attributed to non-controlling interests. The long-term incentive compensation balances included in the table above include amounts payable for performance shares and units. Exact amounts to be paid for performance shares cannot be predicted with certainty, as the ultimate amounts of these liabilities are based on the future performance of White Mountains and the market price of the Company’s common shares at the time the payments are made. The estimated payments reflected in the table are based on current accrual factors (including performance relative to targets and common share price) and assume that all outstanding balances were 100% vested as of December 31, 2018. There are no provisions within White Mountains’s operating leasing agreements that would trigger acceleration of future lease payments. White Mountains does not finance its operations through the securitization of its trade receivables, through special purpose entities or through synthetic leases. Further, White Mountains has not entered into any material arrangements requiring it to guarantee payment of third-party debt or lease payments or to fund losses of an unconsolidated special purpose entity. White Mountains also has future binding commitments to fund certain other long-term investments. These commitments, which totaled approximately $170 million as of December 31, 2018, do not have fixed funding dates and, are therefore, excluded from the table above. Share Repurchase Programs White Mountains’s board of directors has authorized the Company to repurchase its common shares from time to time, subject to market conditions. The repurchase authorizations do not have a stated expiration date. As of December 31, 2018, White Mountains may repurchase an additional 635,705 shares under these board authorizations. In addition, from time to time White Mountains has also repurchased its common shares through tender offers that were separately approved by its board of directors. On May 11, 2018, White Mountains completed a “modified Dutch auction” tender offer, through which it repurchased 575,068 of its common shares at a purchase price of $875 per share for a total cost of approximately $505 million, including expenses. Shares repurchased under this tender offer did not impact the remaining number of shares authorized for repurchase. The following table presents common shares repurchased by the Company as well as the average price per share as a percent of adjusted book value per share. For 2018, the table also presents the average price per share as a percent of adjusted book value per share, including the estimated gain from the MediaAlpha transaction of $55 per share. Average price per share as % of Adjusted Book Value Adjusted Per Share, Including Average Book Estimated Gain From Shares Cost Price Value Adjusted Book MediaAlpha Year Ended Repurchased (Millions) Per Share Per Share Value Per Share Transaction December 31, 2018 592,458 $ 519.4 $ 876.69 $ 887.85 99% 93% December 31, 2017 832,725 $ 723.9 $ 869.29 $ 914.75 95% N/A December 31, 2016 1,106,145 $ 887.2 $ 802.08 $ 789.08 102% N/A Cash Flows Detailed information concerning White Mountains’s cash flows during 2018, 2017 and 2016 follows: Cash flows from continuing operations for the years ended 2018, 2017 and 2016 Net cash flows used for continuing operations was $31 million, $62 million and $179 million for the years ended 2018, 2017 and 2016. Cash used from continuing operations was lower in 2018 compared to 2017, primarily due to $28 million of payments made in 2017 related to the departures of the Company’s former Chairman and CEO and former CFO. Cash used in 2016 included $166 million in payments from the settlement of certain liabilities and transaction costs in connection with the Sirius Group and Tranzact sales. White Mountains does not believe that these trends will have a meaningful impact on its future liquidity or its ability to meet its future cash requirements. White Mountains has $536 million of net unrestricted cash, short-term investments and fixed maturity investments, $926 million of common equity securities and $67 million of other long-term investments as of December 31, 2018. Cash flows from investing and financing activities for the year ended December 31, 2018 Financing and Other Capital Activities During 2018, the Company declared and paid a $4 million cash dividend to its common shareholders. During 2018, the Company repurchased and retired 592,458 of its common shares for $519 million, which included 9,965 for $8 million under employee benefit plans for statutory withholding tax payments. During 2018, BAM received $54 million in MSC. During 2018, BAM repaid $18 million of principal and $5 million of accrued interest on the BAM Surplus Notes. During 2018, NSM borrowed $51 million under the NSM Bank Facility to fund the Fresh Insurance acquisition and $30 million to fund the KBK acquisition. During the period from May 11, 2018 through December 31, 2018, NSM repaid $1 million on the term loans and $2 million on the revolving credit loan under the NSM Banking Facility. During 2018, MediaAlpha paid $16 million of dividends to its shareholders, of which $10 million was paid to White Mountains. During 2018, MediaAlpha repaid $4 million on the term loan and borrowed $3 million and repaid $9 million on the revolving loan under the MediaAlpha Bank Facility. During 2018, Wobi borrowed 20 million Israeli New Shekels (“ILS”) (approximately $6 million) from White Mountains under an internal credit facility. In August 2018, White Mountains contributed ILS 91 million (approximately $25 million) to Wobi. During 2018, Wobi repaid its internal credit facility to White Mountains consisting of ILS 88 million of principal and ILS 3 million of accrued interest (totaling approximately $25 million). In October 2018, White Mountains contributed an additional ILS 10 million (approximately $3 million) to Wobi. During 2018, Buzz borrowed GBP 3 million (approximately $4 million) from White Mountains under a convertible loan note. Acquisitions and Dispositions On January 24, 2018, White Mountains paid $42 million in connection with the DavidShield transaction. On May 11, 2018, White Mountains closed its acquisition of 95% of NSM for a purchase price of $274 million. White Mountains paid a purchase price adjustment of $2 million in the fourth quarter of 2018. On May 18, 2018, NSM acquired 100% of Fresh Insurance for a purchase price of GBP 37 million (approximately $50 million). On December 3, 2018, White Mountains acquired additional newly-issued units of NSM for $29 million in connection with NSM’s acquisition of KBK. On December 3, 2018, NSM acquired all of the net assets of KBK for a purchase price of $60 million. During 2018, White Mountains made gross investments into the Enlightenment Capital Funds totaling $3 million and received a total of $1 million of distributions from these funds. During 2018, White Mountains made gross investments into the Tuckerman Capital Funds totaling $1 million and received a total of $15 million of distributions from these funds. Cash flows from investing and financing activities for the year ended December 31, 2017 Financing and Other Capital Activities During 2017, the Company declared and paid a $5 million cash dividend to its common shareholders. During 2017, the Company repurchased and retired 832,725 of its common shares for $724 million, which included 10,993 for $9 million under employee benefit plans for statutory withholding tax payments. During 2017, the Company borrowed and repaid $350 million under the WTM Bank Facility. During 2017, BAM received $37 million in MSC. During 2017, BAM repaid $4 million of principal and $1 million of accrued interest on the BAM Surplus Notes. During 2017, MediaAlpha paid $5 million of dividends, of which $3 million was paid to White Mountains. During 2017, MediaAlpha borrowed $20 million on the term loan and $6 million on the revolving loan under the MediaAlpha Bank Facility. During 2017, MediaAlpha repaid $13 million under the previous MediaAlpha Bank Facility and $2 million on the term loan under the MediaAlpha Bank Facility. During 2017, Wobi borrowed ILS 68 million (approximately $19 million) from White Mountains under an internal credit facility. During 2017, White Mountains received $45 million of dividends from OneBeacon, which is reported as discontinued operations. Acquisitions and Dispositions On August 1, 2017, White Mountains purchased 37,409 newly-issued preferred shares of Buzz for GBP 4 million (approximately $5 million) and 5,808 common shares from the company founders for GBP 0.5 million (approximately $0.7 million). On September 28, 2017, OneBeacon closed its definitive merger agreement with Intact and White Mountains received proceeds of $1,299 million, or $18.10 per OneBeacon common share. On October 5, 2017, White Mountains purchased 131,579 newly-issued Class A common units of MediaAlpha for $13 million. On October 5, 2017, MediaAlpha acquired certain assets associated with the Health, Life and Medicare insurance business of Healthplans.com for an aggregate purchase price of $28 million. During 2017, White Mountains made gross investments into the Enlightenment Capital Funds totaling $13 million and received a total of $24 million of distributions from these funds. During 2017, White Mountains made gross investments into the Tuckerman Capital Funds totaling $17 million and received a total of $2 million of distributions from these funds. Cash flows from investing and financing activities for the year ended December 31, 2016 Financing and Other Capital Activities During 2016, the Company declared and paid a $5 million cash dividend to its common shareholders. During 2016, the Company repurchased and retired 1,106,145 of its common shares for $887 million, which included 8,022 common shares repurchased under employee benefit plans. During 2016, the Company borrowed a total of $350 million and repaid a total of $400 million under the WTM Bank Facility. During 2016, HG Global raised $6 million of additional capital through the issuance of preferred shares, 97% of which were purchased by White Mountains. HG Global used $3 million of the proceeds to repay and cancel an internal credit facility with White Mountains. During 2016, BAM received $38 million in MSC. During 2016, MediaAlpha paid $3 million of dividends, of which $2 million was paid to White Mountains. During 2016, MediaAlpha repaid $2 million of the term loan portion and borrowed $3 million and repaid $3 million under the revolving loan portion of the previous MediaAlpha bank facility. During 2016, White Mountains Life Reinsurance (Bermuda) Ltd. returned $73 million of capital to White Mountains. During 2016, White Mountains received $60 million of dividends from OneBeacon, which is reported as discontinued operations. Acquisitions and Dispositions On January 7, 2016, Wobi settled its acquisition of the remaining share capital of Cashboard for NIS 16 million (approximately $4 million). On February 1, 2016, Symetra closed its merger agreement with Sumitomo Life and White Mountains received proceeds of $658 million, or $32.00 per Symetra common share. On February 26, 2016, White Mountains paid $8 million in settlement of the contingent purchase adjustment for its acquisition of MediaAlpha in 2014. On April 18, 2016, White Mountains completed the sale of Sirius Group to CMI for approximately $2.6 billion. Of this amount, $162 million of this amount was used to purchase certain assets to be retained by White Mountains out of Sirius Group, including shares of OneBeacon. On July 21, 2016, White Mountains completed the sale of Tranzact and received net proceeds of $221 million at closing. On October 5, White Mountains received additional proceeds of $1 million following the release of the post-closing purchase price adjustment escrow. On August 4, 2016, White Mountains purchased 110,461 common shares of Buzz for GBP 4 million (approximately $5 million) and 54,172 shares of newly issued convertible preferred shares of Buzz for GBP 2 million (approximately $3 million). During 2016, White Mountains increased its investment in Wobi through the purchase of newly-issued convertible preferred shares for a total of NIS 36 million (approximately $10 million). During 2016, White Mountains made gross investments into the Enlightenment Capital Funds totaling $11 million and received a total of $14 million of distributions from these funds. During 2016, White Mountains made gross investments into the Tuckerman Capital Funds totaling $10 million and received a total of $4 million of distributions from these funds. TRANSACTIONS WITH RELATED PERSONS See Note 17 - “Transactions with Related Persons” on page in the accompanying Consolidated Financial Statements. NON-GAAP FINANCIAL MEASURES This report includes four non-GAAP financial measures that have been reconciled with their most comparable GAAP financial measures. Adjusted book value per share is a non-GAAP financial measure which is derived by adjusting (i) the GAAP book value per share numerator and (ii) the common shares outstanding denominator, as described below. Beginning in 2017, the GAAP book value per share numerator has been adjusted (i) to include a discount for the time value of money arising from the expected timing of cash payments of principal and interest on the BAM Surplus Notes and (ii) to add back the unearned premium reserve, net of deferred acquisition costs, at HG Global. Under GAAP, White Mountains is required to carry the BAM Surplus Notes, including accrued interest, at nominal value with no consideration for time value of money. Based on a debt service model that forecasts operating results for BAM through maturity of the BAM Surplus Notes, the present value of the BAM Surplus Notes, including accrued interest, was estimated to be $146 million and $162 million less than the nominal GAAP carrying values as of December 31, 2018 and December 31, 2017, respectively. The value of HG Global’s unearned premium reserve, net of deferred acquisition costs, was $106 million and $82 million as of December 31, 2018 and December 31, 2017, respectively. White Mountains believes these adjustments are useful to management and investors in analyzing the intrinsic value of HG Global, including the value of the BAM Surplus Notes and the value of the in-force business at HG Re, HG Global’s reinsurance subsidiary. For 2016, the numerator used in the calculation of adjusted book value per share also includes the dilutive effects of future proceeds from the outstanding non-qualified options for periods prior to January 20, 2017, the expiration date of the non-qualified options. The denominator used in the calculation of adjusted book value per share equals the number of common shares outstanding adjusted to exclude unearned restricted common shares, the compensation cost of which, at the date of calculation, has yet to be amortized. Restricted common shares are amortized on a straight-line basis over their vesting periods. For 2016, the denominator used in the calculation of adjusted book value per share also includes the dilutive effects of outstanding non-qualified options for periods prior to January 20, 2017, the expiration date of the non-qualified options. The reconciliation of GAAP book value per share to adjusted book value per share is included on page 31. Gross written premiums and MSC from new business is a non-GAAP financial measure, which is derived by adjusting gross written premiums and MSC collected to (i) include the present value of future installment MSC not yet collected and (ii) exclude gross written premium adjustments on existing installment policies closed in prior periods. White Mountains believes these adjustments are useful to investors in evaluating the pricing of new business closed during the period. The reconciliation of GAAP gross written premiums to gross written premiums and MSC from new business is included on page 35. Adjusted EBITDA is a non-GAAP financial measure, which is defined as net income (loss) excluding interest expense on debt, income tax benefit (expense), depreciation and amortization, and certain adjustments at NSM and MediaAlpha. In the case of NSM, adjusted EBITDA also excludes the change in the fair value of NSM’s contingent consideration earnout liabilities related to prior transactions. In the case of MediaAlpha, adjusted EBITDA also excludes non-cash equity-based compensation expense. White Mountains believes that adjusted EBITDA is useful to management and investors in analyzing NSM’s and MediaAlpha’s fundamental economic performance. White Mountains believes that investors commonly use adjusted EBITDA as a supplemental measurement to evaluate the overall operating performance of companies within the same industry. See page 39 for the reconciliation of NSM’s GAAP net income (loss) to adjusted EBITDA and page 41 for the reconciliation of MediaAlpha’s GAAP net income (loss) to adjusted EBITDA. Total capital at White Mountains is comprised of White Mountains’s common shareholders’ equity, debt and non-controlling interests other than non-controlling interests attributable to BAM. Total adjusted capital is a non-GAAP financial measure, which is derived by adjusting total capital (i) to include a discount for the time value of money arising from the expected timing of cash payments of principal and interest on the BAM Surplus Notes and (ii) to add back the unearned premium reserve, net of deferred acquisition costs, at HG Global. The reconciliation of total capital to total adjusted capital is included on page 50. CRITICAL ACCOUNTING ESTIMATES Management’s Discussion and Analysis of Financial Condition and Results of Operations discuss the Company’s consolidated financial statements, which have been prepared in accordance with GAAP. The financial statements presented herein include all adjustments considered necessary by management to fairly present the financial condition, results of operations and cash flows of White Mountains. The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities as of the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Certain of these estimates are considered critical in that they involve a higher degree of judgment and are subject to a significant degree of variability. On an ongoing basis, management evaluates its estimates and bases its estimates on historical experience and on various other factors that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. 1. Fair Value Measurements General White Mountains records certain assets and liabilities at fair value in its consolidated financial statements, with changes therein recognized in current period earnings. In addition, White Mountains discloses estimated fair value for certain liabilities measured at historical or amortized cost. Fair value is defined as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants (an exit price) at a particular measurement date. Fair value measurements are categorized into a hierarchy that distinguishes between inputs based on market data from independent sources (“observable inputs”) and a reporting entity’s internal assumptions based upon the best information available when external market data is limited or unavailable (“unobservable inputs”). Quoted prices in active markets for identical assets have the highest priority (“Level 1”), followed by observable inputs other than quoted prices including prices for similar but not identical assets or liabilities (“Level 2”), and unobservable inputs, including the reporting entity’s estimates of the assumptions that market participants would use, having the lowest priority (“Level 3”). Assets and liabilities carried at fair value include substantially all of the investment portfolio, derivative instruments, both exchange traded and over the counter instruments, and reinsurance assumed liabilities associated with variable annuity benefit guarantees. Valuation of assets and liabilities measured at fair value require management to make estimates and apply judgment to matters that may carry a significant degree of uncertainty. In determining its estimates of fair value, White Mountains uses a variety of valuation approaches and inputs. Whenever possible, White Mountains estimates fair value using valuation methods that maximize the use of observable prices and other inputs. Where appropriate, assets and liabilities measured at fair value have been adjusted for the effect of counterparty credit risk. Invested Assets White Mountains uses brokers and outside pricing services to assist in determining fair values. The outside pricing services White Mountains uses have indicated that they will only provide prices where observable inputs are available. As of December 31, 2018, approximately 87% of the investment portfolio was recorded at fair value as Level 1 or Level 2 measurements. Level 1 Measurements Investments valued using Level 1 inputs include fixed maturity investments, primarily investments in U.S. Treasuries and short-term investments, which include U.S. Treasury Bills and common equity securities. For investments in active markets, White Mountains uses the quoted market prices provided by outside pricing services to determine fair value. Level 2 Measurements Investments valued using Level 2 inputs include fixed maturity investments, which have been disaggregated into classes, including debt securities issued by corporations, mortgage and asset-backed securities, municipal obligations, and foreign government, agency and provincial obligations. Investments valued using Level 2 inputs also include certain passive ETFs that track U.S. stock indices such as the S&P 500 but are traded on foreign exchanges, which management values using the fund manager’s published NAV to account for the difference in market close times. In circumstances where quoted market prices are unavailable or are not considered reasonable, White Mountains estimates the fair value using industry standard pricing methodologies and observable inputs such as benchmark yields, reported trades, broker-dealer quotes, issuer spreads, benchmark securities, bids, offers, credit ratings, prepayment speeds, reference data including research publications and other relevant inputs. Given that many fixed maturity investments do not trade on a daily basis, the outside pricing services evaluate a wide range of fixed maturity investments by regularly drawing parallels from recent trades and quotes of comparable securities with similar features. The characteristics used to identify comparable fixed maturity investments vary by asset type and take into account market convention. White Mountains’s process to assess the reasonableness of the market prices obtained from the outside pricing sources covers substantially all of its fixed maturity investments and includes, but is not limited to, the evaluation of pricing methodologies and a review of the pricing services’ quality control procedures on at least an annual basis, a comparison of its invested asset prices obtained from alternate independent pricing vendors on at least a semi-annual basis, monthly analytical reviews of certain prices and a review of the underlying assumptions utilized by the pricing services for select measurements on an ad hoc basis throughout the year. White Mountains also performs back-testing of selected sales activity to determine whether there are any significant differences between the market price used to value the security prior to sale and the actual sale price on an ad-hoc basis throughout the year. Prices provided by the pricing services that vary by more than 5% and $0.5 million from the expected price based on these assessment procedures are considered outliers, as are prices that have not changed from period to period and prices that have trended unusually compared to market conditions. In circumstances where the results of White Mountains’s review process does not appear to support the market price provided by the pricing services, White Mountains challenges the vendor provided price. If White Mountains cannot gain satisfactory evidence to support the challenged price, White Mountains will rely upon its own pricing methodologies to estimate the fair value of the security in question. The valuation process described above is generally applicable to all of White Mountains’s fixed maturity investments. The techniques and inputs specific to asset classes within White Mountains’s fixed maturity investments for Level 2 securities that use observable inputs are as follows: Debt Securities Issued by Corporations The fair value of debt securities issued by corporations is determined from a pricing evaluation technique that uses information from market sources and integrates relative credit information, observed market movements, and sector news. Key inputs include benchmark yields, reported trades, broker-dealer quotes, issuer spreads, two-sided markets, benchmark securities, bids, offers, and reference data including sector, coupon, credit quality ratings, duration, credit enhancements, early redemption features and market research publications. Mortgage and Asset-Backed Securities: The fair value of mortgage and asset-backed securities is determined from a pricing evaluation technique that uses information from market sources and leveraging similar securities. Key inputs include benchmark yields, reported trades, underlying tranche cash flow data, collateral performance, plus new issue data, as well as broker-dealer quotes, issuer spreads, two-sided markets, benchmark securities, bids, offers, and reference data including issuer, vintage, loan type, collateral attributes, prepayment speeds, default rates, recovery rates, cash flow stress testing, credit quality ratings and market research publications. Municipal Obligations: The fair value of municipal obligations is determined from a pricing evaluation technique that uses information from market makers, brokers-dealers, buy-side firms, and analysts along with general market information. Key inputs include benchmark yields, reported trades, issuer financial statements, material event notices and new issue data, as well as broker-dealer quotes, issuer spreads, two-sided markets, benchmark securities, bids, offers, and reference data including type, coupon, credit quality ratings, duration, credit enhancements, geographic location and market research publications. Foreign Government, Agency and Provincial Obligations The fair value of foreign government, agency and provincial obligations is determined from a pricing evaluation technique that uses feeds from data sources in each respective country, including active market makers and inter-dealer brokers. Key inputs include benchmark yields, reported trades, broker-dealer quotes, two-sided markets, benchmark securities, bids, offers, local exchange prices, foreign exchange rates and reference data including coupon, credit quality ratings, duration and market research publications. Level 3 Measurements Fair value estimates for investments that trade infrequently and have few or no observable market prices are classified as Level 3 measurements. Investments valued using Level 3 fair value estimates are based upon unobservable inputs and include investments in certain fixed maturity investments, equity securities and other long-term investments where quoted market prices are unavailable or are not considered reasonable. Level 3 valuations are generated from techniques that use assumptions not observable in the market. These unobservable assumptions reflect White Mountains’s assumptions that market participants would use in valuing the investment. Generally, certain securities may start out as Level 3 when they are originally issued but as observable inputs become available in the market, they may be reclassified to Level 2. Transfers between levels are based on investments held as of the beginning of the period. The following table presents White Mountains’s fair value measurements and the percentage of Level 3 investments as of December 31, 2018. The major security types were based on the legal form of the securities. White Mountains has disaggregated its fixed maturity investments based on the issuing entity type, which impacts credit quality, with debt securities issued by U.S. government entities carrying minimal credit risk, while the credit and other risks associated with other issuers, such as debt securities issued by corporations, foreign governments, municipalities or entities issuing mortgage and asset-backed securities vary depending on the nature of the issuing entity type. December 31, 2018 $ in Millions Fair Value Level 3 Inputs Level 3 Inputs as a % of Total Fair Value U.S. Government and agency obligations $ 153.2 $ - - % Debt securities issued by corporations 510.5 - - Municipal obligations 280.3 - - Mortgage and asset-backed securities 133.5 - - Fixed maturity investments 1,077.5 - - Short-term investments 214.2 - - Common equity securities 925.6 - - Other long-term investments - NAV 186.9 - - Other long-term investments - level 3 138.7 138.7 % Total investments $ 2,542.9 $ 138.7 % Other Long-Term Investments White Mountains maintains a portfolio of other long-term investments that primarily consists of unconsolidated entities, private equity funds and hedge funds. White Mountains’s portfolio of other long-term investments are generally valued at fair value, using level 3 measurements or net asset value “NAV” as a practical expedient. Investments for which fair value is measured at NAV using the practical expedient are not classified within the fair value hierarchy. Unconsolidated Entities White Mountains’s portfolio of other long-term investments includes unconsolidated entities, including non-controlling interests in certain private common equity securities, limited liability companies and convertible preferred securities. White Mountains portfolio of unconsolidated entities are generally valued using level 3 inputs. The determination of the fair value of unconsolidated entities may involve significant management judgment, the use of valuation models and assumptions that are inherently subjective. On an ongoing basis, White Mountains considers qualitative changes in facts and circumstances which may impact the valuation of unconsolidated entities, including economic changes of relevant industries and changes to the investee capital structure, business strategy and significant changes in key personnel. On an annual basis, or when facts and circumstances suggest a quantitative valuation analysis is necessary, White Mountains, with the assistance of a third-party valuation firm, completes a valuation analysis of significant unconsolidated entities. White Mountains considers the following fair value approaches: Income Approach: The income approach converts future amounts to a single current discounted amount, based on expected future cash flows that a company will generate, along with expected proceeds from disposition. The cash flows are discounted to their present value using a discount rate that incorporates the risk-free rate for the use of funds, the expected rate of inflation, and risks associated with the particular investment. Market Approach: The market approach uses prices and other relevant information generated by market transactions involving identical or comparable businesses, such as recent sales or offerings of comparable assets. Cost Approach: The cost approach reflects the amount that would be required currently to replace the service capacity of an asset, or the current replacement cost. When applied to the valuation of equity interests in businesses, value is based on the net aggregate fair market value of the entity’s underlying individual assets. Valuation of White Mountains’s investment in PassportCard/DavidShield In the fourth quarter of 2018, White Mountains completed a valuation analysis of its investment in PassportCard/DavidShield, which represents White Mountains’s most significant unconsolidated entity. White Mountains used an income approach to valuation based on discounted cash flows. The valuation model included key inputs of expected future cash flows, a discount rate, and a terminal premium and other revenue exit multiple. The expected future cash flows were based on management judgment, considering current performance along with budgets and projected future results. The discount rate reflected the weighted average cost of capital, considering comparable public company data, adjusted for risks specific to the investee and industry. The exit multiple was based on expectations of a premium and other revenue multiple for the investee in an exit year, considering comparable companies and similar transaction multiple data. Once a range of values was determined, White Mountains concluded that a discount rate of approximately 18% and a terminal exit multiple of 1 times premium and other revenue was appropriate for the valuation of its investment in PassportCard/DavidShield. A 15% liquidity discount was also applied for lack of marketability and White Mountains’s lack of control over the unconsolidated investee. As a result, the carrying value of White Mountains’s investment in PassportCard/DavidShield was $75 million as of December 31, 2018. With an income approach, small changes to inputs in a valuation model may result in significant changes to fair value. The following table presents the estimated effect on the fair value of White Mountains’s investment in PassportCard/DavidShield as of December 31, 2018, resulting from changes in key inputs to the discounted cash flow analysis, including the discount rate and terminal exit multiple: $ in Millions Discount Rate Exit Multiple 16% 17% 18% 19% 20% 1.25 $ $ $ $ $ 1.00 $ $ $ $ $ 0.75 $ $ $ $ $ Private Equity Funds and Hedge Funds White Mountains’s portfolio of other long-term investments includes investments in private equity funds and hedge funds. White Mountains employs a number of procedures to assess the reasonableness of the fair value measurements for its private equity funds and hedge funds, including obtaining and reviewing periodic and audited annual financial statements as well as discussing each fund’s pricing with the fund manager throughout the year. However, since the fund managers do not provide sufficient information to evaluate the pricing methods and inputs for each underlying investment, White Mountains considers the inputs to be unobservable. The fair value of White Mountains’s private equity fund and hedge fund investments has generally been determined using the fund manager’s NAV. In the event that White Mountains believes the fair value of a private equity fund or hedge fund differs from the NAV reported by the fund manager due to illiquidity or other factors, White Mountains will adjust the reported NAV to more appropriately represent the fair value of its investment in the private equity fund or hedge fund. As of December 31, 2018 and 2017, White Mountains did not adjust the reported NAV of its investments in private equity funds and hedge funds. Sensitivity Analysis of Likely Returns on Other Long-Term Investments The underlying investments of private equity funds and hedge funds are typically publicly-traded and private securities and, as such, are subject to market risks that are similar to White Mountains’s common equity securities. The following table presents the estimated effect on fair values as of December 31, 2018 resulting from a 10% change and a 30% change in the market value of other long-term investments: Change in Fair Value at Carrying Value at December 31, 2018 Millions December 31, 2018 10% Decline 10% Increase 30% Decline 30% Increase Unconsolidated entities - level 3 $ 124.9 $ (12.5 ) $ 12.5 $ (37.5 ) $ 37.5 Unconsolidated entities - NAV 40.8 (4.1 ) 4.1 (12.3 ) 12.3 Private equity funds - NAV 91.8 (9.2 ) 9.2 (27.5 ) 27.5 Hedge fund - NAV 54.3 (5.4 ) 5.4 (16.3 ) 16.3 Other - level 3 13.8 (1.4 ) 1.4 (4.1 ) 4.1 Total other long-term investments $ 325.6 $ (32.6 ) $ 32.6 $ (97.7 ) $ 97.7 See Note 3 - “Investment Securities” on page for tables that summarize the changes in White Mountains’s fair value measurements by level for the years ended December 31, 2018 and 2017 and for amount of total gains (losses) included in earnings attributable to net unrealized investment gains (losses) for Level 3 investments for years ended December 31, 2018, 2017 and 2016. 2. Surplus Note Valuation BAM Surplus Notes As of December 31, 2018, White Mountains owned $481 million of BAM Surplus Notes and has accrued $144 million in interest due thereon. During the year ended December 31, 2018, with approval of the NYDFS, BAM paid $23 million to White Mountains for amounts owed under the BAM Surplus Notes. During the year ended December 31, 2017, with approval of the NYDFS, BAM paid $5 million to White Mountains for amounts owed under the BAM Surplus Notes. Because BAM is consolidated in White Mountains’s financial statements, the BAM Surplus Notes and accrued interest are classified as intercompany notes, carried at face value and eliminated in consolidation. However, the BAM Surplus Notes and accrued interest are carried as assets at HG Global, of which White Mountains owns 97% of the preferred equity, while the BAM Surplus Notes are carried as liabilities at BAM, which White Mountains has no ownership interest in and is completely attributed to non-controlling interests. Any write down of the carried amount of the BAM Surplus Notes and/or the accrued interest thereon could adversely impact White Mountains’s results of operations and financial condition. See Item 1A., Risk Factors, “If BAM does not pay some or all of the principal and interest due on the BAM Surplus Notes, it could materially adversely affect our results of operations and financial condition.” on page 20. Periodically, White Mountains’s management reviews the recoverability of amounts recorded from the BAM Surplus Notes. As of December 31, 2018, White Mountains believes such notes and interest thereon to be fully recoverable. White Mountains’s review is based on a debt service model that forecasts operating results for BAM, and related payments on the BAM Surplus Notes, through maturity of the BAM Surplus Notes in 2042. The model depends on assumptions regarding future trends for the issuance of municipal bonds, interest rates, credit spreads, insured market penetration, competitive activity in the market for municipal bond insurance and other factors affecting the demand for and price of BAM’s municipal bond insurance. Assumptions regarding future trends for these factors are a matter of significant judgment. White Mountains expects both par insured and total premiums to increase gradually over the next six years and to flatten thereafter. White Mountains continues to project that the BAM Surplus Notes will be fully repaid approximately nine years prior to final maturity, which is consistent with the previous forecast as of December 31, 2017. The model assumptions are based on historical trends, current conditions and expected future developments. Whether actual results will follow forecast is subject to a number of risks and uncertainties. No payment of interest or principal on the BAM Surplus Notes may be made without the approval of the NYDFS. BAM has stated its intention to seek regulatory approval to pay interest and principal on its surplus notes to the extent that its remaining qualified statutory capital and other capital resources continue to support its outstanding obligations, its business plan and its “AA/stable” rating from Standard & Poor’s. Interest payments on the BAM Surplus Notes are due quarterly but are subject to deferral, without penalty or default and without compounding, for payment in the future. Payments made to the BAM Surplus Notes are applied pro rata between outstanding principal and interest. Deferred interest is due on the stated maturity date in 2042. 3. Goodwill and Other Intangible Assets As of December 31, 2018, goodwill and other intangible assets recognized in connection with business and asset acquisitions totaled $538 million, of which $497 million was attributable to White Mountains’s common shareholders. Goodwill and other intangible assets are recorded at their acquisition date fair values. The determination of the acquisition date fair values of goodwill and other intangible assets involves significant management judgment, the use of valuation models and assumptions that are inherently subjective. Goodwill and indefinite-lived intangible assets are not amortized but rather reviewed for potential impairment at least annually. Finite-lived intangible assets, which are amortized over their estimated economic lives, are reviewed for impairment only when events occur or there are changes in circumstances indicating that their carrying value may exceed fair value. Impairment exists when the carrying value of goodwill or other intangible assets exceeds fair value. White Mountains’s annual review for potential impairment first assesses whether qualitative factors indicate that the carrying value of goodwill or other intangible assets may be greater than fair value. If White Mountains determines based on this qualitative review that it is more likely than not that an impairment may exist, then White Mountains performs a quantitative analysis to compare the fair value of a reporting unit with its carrying value. If the carrying value exceeds the estimated fair value, then an impairment charge is recognized through current period pre-tax income. Both the annual qualitative assessment of potential impairment as well as the quantitative comparison of carrying value to estimated fair value involve management judgment, the use of discounted cash flow projections and other valuation techniques and assumptions that are inherently subjective. A significant portion of the goodwill and other identifiable intangible assets on White Mountains’s balance sheet arose from White Mountains’s acquisition of NSM in May 2018 and NSM’s subsequent acquisitions of Fresh Insurance and KBK. White Mountains believes that all of the goodwill and intangible assets recorded in respect of these acquisitions is fully recoverable. Because of the timing of these acquisitions, all of which are still within the one-year measurement period following the acquisition date, these amounts have not yet been subject to White Mountains’s annual review for potential impairment. See Item 1A., Risk Factors, “If we are required to write down goodwill and other intangible assets, it could materially adversely affect our results of operations and financial condition.” on page 20. FORWARD-LOOKING STATEMENTS This report may contain “forward-looking statements” within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934. All statements, other than statements of historical facts, included or referenced in this report which address activities, events or developments which White Mountains expects or anticipates will or may occur in the future are forward-looking statements. The words “will”, “believe”, “intend”, “expect”, “anticipate”, “project”, “estimate”, “predict” and similar expressions are also intended to identify forward-looking statements. These forward-looking statements include, among others, statements with respect to White Mountains’s: • change in adjusted book value per share or return on equity; • business strategy; • financial and operating targets or plans; • incurred loss and loss adjustment expenses and the adequacy of its loss and loss adjustment expense reserves; • projections of revenues, income (or loss), earnings (or loss) per share, dividends, market share or other financial forecasts; • expansion and growth of its business and operations; and • future capital expenditures. These statements are based on certain assumptions and analyses made by White Mountains in light of its experience and perception of historical trends, current conditions and expected future developments, as well as other factors believed to be appropriate in the circumstances. However, whether actual results and developments will conform to its expectations and predictions is subject to a number of risks and uncertainties that could cause actual results to differ materially from expectations, including: • the risks associated with Item 1A of this Report on Form 10-K; • business opportunities (or lack thereof) that may be presented to it and pursued; • actions taken by ratings agencies from time to time, such as financial strength or credit ratings downgrades or placing ratings on negative watch; • the continued availability of capital and financing; • general economic, market or business conditions; • competitive forces, including the conduct of other insurers; • changes in domestic or foreign laws or regulations, or their interpretation, applicable to White Mountains, its competitors or its customers; • an economic downturn or other economic conditions adversely affecting its financial condition; and • other factors, most of which are beyond White Mountains’s control. Consequently, all of the forward-looking statements made in this report are qualified by these cautionary statements, and there can be no assurance that the actual results or developments anticipated by White Mountains will be realized or, even if substantially realized, that they will have the expected consequences to, or effects on, White Mountains or its business or operations. White Mountains assumes no obligation to publicly update any such forward-looking statements, whether as a result of new information, future events or otherwise.

<s>[INST] The following discussion also includes four nonGAAP financial measures (i) adjusted book value per share, (ii) gross written premiums and MSC from new business, (iii) adjusted capital, and (iv) adjusted earnings before interest, taxes, depreciation and amortization (“adjusted EBITDA”), that have been reconciled from their most comparable GAAP financial measures on page 55. White Mountains believes these measures to be useful in evaluating White Mountains’s financial performance and condition. RESULTS OF OPERATIONS FOR THE YEARS ENDED DECEMBER 31, 2018, 2017 AND 2016 OverviewYear Ended December 31, 2018 versus Year Ended December 31, 2017 White Mountains ended 2018 with book value per share of $896 and adjusted book value per share of $888, a decrease of 3.7% and 2.8% for the year, including dividends. Comprehensive loss attributable to common shareholders was $146 million in 2018 compared to comprehensive income attributable to common shareholders of $631 million in 2017. The decrease in book value per share and adjusted book value per share and the comprehensive loss attributable to common shareholders in 2018 was driven primarily by investment results, which were adversely impacted by the sharp decline in equity markets in the fourth quarter of 2018, while comprehensive income attributable to common shareholders in 2017 was driven primarily by the $557 million gain from the OneBeacon Transaction. On February 26, 2019, MediaAlpha completed the sale of a significant minority stake to Insignia Capital Group in connection with a recapitalization and cash distribution to existing equityholders. MediaAlpha also repurchased a portion of the holdings of existing equityholders. The transaction valued MediaAlpha at approximately $350 million. The transaction results in an estimated gain of approximately $55 to each of White Mountains’s book value per share and adjusted book value per share. Including the estimated gain of $55 per share for the MediaAlpha transaction, December 31, 2018 book value per share would have been $951 and adjusted book value per share would have been $943. See “MediaAlpha” on page 41. During 2018, White Mountains repurchased and retired 592,458 of its common shares for $519 million at an average share price of $877. The average share price paid was approximately 98% and 99%, respectively, of White Mountains’s December 31, 2018 book value per share and adjusted book value per share. The average share price paid was approximately 92% and 93%, respectively, of White Mountains’s December 31, 2018 book value per share including the estimated gain from the MediaAlpha transaction and adjusted book value per share including the estimated gain from the MediaAlpha transaction. During 2018, White Mountains also allocated roughly $300 million to new business opportunities, ending the year with approximately $1.2 billion of undeployed capital. Gross written premiums and MSC collected in the HG Global/BAM segment totaled $107 million in 2018, compared to $101 million in 2017. BAM insured municipal bonds with par value of $12.0 billion in 2018, compared to $10.4 billion in 2017. Total pricing was 93 basis points in 2018, compared to 99 basis points in 2017. BAM’s total claims paying resources were $871 million as of December 31, 2018, compared to $708 million as of December 31, 2017. The increase in claims paying resources was driven by positive cash flow from operations as well as the $100 million reinsurance agreement that BAM entered into with Fidus Re in the second quarter of 2018. During 2018, BAM paid $23 million of principal and interest on the BAM Surplus Notes held [/INST] Positive. </s>

WHITE MOUNTAINS INSURANCE GROUP LTD

2020-03-02

2019-12-31

Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations The following discussion contains “forward-looking statements”. White Mountains intends statements that are not historical in nature, which are hereby identified as forward-looking statements, to be covered by the safe harbor provisions of the Private Securities Litigation Reform Act of 1995. White Mountains cannot promise that its expectations in such forward-looking statements will turn out to be correct. White Mountains’s actual results could be materially different from and worse than its expectations. See “FORWARD-LOOKING STATEMENTS” on page 67 for specific important factors that could cause actual results to differ materially from those contained in forward-looking statements. The following discussion also includes nine non-GAAP financial measures (i) adjusted book value per share, (ii) underlying growth in adjusted book value per share, (iii) gross written premiums and MSC from new business, (iv) adjusted capital, (v) NSM’s earnings before interest, taxes, depreciation and amortization (“EBITDA”), (vi) NSM’s adjusted EBITDA, (vii) total consolidated portfolio returns excluding the MediaAlpha Transaction, (viii) common equity securities and other long-term investments returns excluding the MediaAlpha Transaction and (ix) other long-term investments return excluding the MediaAlpha Transaction, that have been reconciled from their most comparable GAAP financial measures on page 58. White Mountains believes these measures to be useful in evaluating White Mountains’s financial performance and condition. RESULTS OF OPERATIONS FOR THE YEARS ENDED DECEMBER 31, 2019, 2018 AND 2017 Overview-Year Ended December 31, 2019 versus Year Ended December 31, 2018 White Mountains ended 2019 with book value per share of $1,024 and adjusted book value per share of $1,018, an increase of 14.4% and 14.8% for the year, including dividends. Comprehensive income attributable to common shareholders was $413 million in 2019 compared to comprehensive loss attributable to common shareholders of $146 million in 2018. The results for 2019 were driven primarily by investment results and the $182 million gain from the MediaAlpha Transaction. The results for 2018 were driven primarily by investment results, which were adversely impacted by the sharp decline in equity markets in the fourth quarter of 2018. On February 26, 2019, MediaAlpha completed the MediaAlpha Transaction. The transaction resulted in a gain of $55 to each of White Mountains’s book value per share and adjusted book value per share. See “MediaAlpha” on page 43. Including the $55 per share net gain from the MediaAlpha Transaction as if it had closed on December 31, 2018, book value per share would have been $951 and adjusted book value per share would have been $943 as of December 31, 2018. Had the MediaAlpha Transaction closed on December 31, 2018, White Mountains’s book value per share would have increased 7.8% and adjusted book value per share would have increased 8.1% in 2019, including dividends. During 2019, White Mountains repurchased and retired $5 million of its common shares. During 2019, White Mountains deployed roughly $435 million in new business opportunities, ending the year with approximately $1.0 billion of undeployed capital. Gross written premiums and MSC collected in the HG Global/BAM segment totaled $107 million in both 2019 and 2018. BAM insured municipal bonds with par value of $12.8 billion in 2019, compared to $12.0 billion in 2018. During 2019, BAM completed assumed reinsurance transactions to insure municipal bonds with a par value of $1.1 billion and, during 2018, BAM completed assumed reinsurance transactions to insure municipal bonds with a par value of $2.2 billion. Total pricing was 83 basis points in 2019, compared to 93 basis points in 2018. In December 2019, BAM made a $32 million cash payment of principal and interest on the BAM Surplus Notes held by HG Global. In January 2020, BAM made an additional $65 million special cash payment of principal and interest on the BAM Surplus Notes. During 2018, BAM made a $23 million cash payment of principal and interest on the BAM Surplus Notes. BAM’s total claims paying resources were $938 million as of December 31, 2019, compared to $871 million as of December 31, 2018. The increase in claims paying resources was driven by positive cash flow from operations. During the fourth quarter of 2019, White Mountains updated its debt service model for the BAM Surplus Notes to reflect (i) the cash payments of principal and interest on the BAM Surplus Notes made in December 2019 and January 2020, (ii) the amendments made to the terms of the BAM Surplus Notes in January 2020, including an extension of the variable interest rate period, and (iii) in light of the current interest rate environment, a more conservative forecast of future operating results for BAM. This has resulted in slower modeled future payments on the BAM Surplus Notes and, in turn, a $20 million increase to the time value of money discount on the BAM Surplus Notes as reflected in adjusted book value per share as of December 31, 2019. NSM reported pre-tax loss of $2 million, adjusted EBITDA of $48 million, and commission and other revenues of $233 million in the year ended December 31, 2019. For the period from May 11, 2018, the date White Mountains acquired NSM, to December 31, 2018, NSM reported pre-tax loss of $5 million, adjusted EBITDA of $18 million, and commission and other revenues of $102 million. Results for the year ended December 31, 2019 include the results, from the date of acquisition, of Embrace, a nationwide provider of pet health insurance for dogs and cats, which NSM acquired on April 1, 2019, and KBK, a specialized MGU focused on the towing and transportation space, which NSM acquired on December 3, 2018. On April 4, 2019, White Mountains completed the Kudu Transaction. For the twelve months ended December 31, 2019, Kudu deployed $203 million, including transaction costs, in seven asset management firms and has now deployed a total of $266 million, including transaction costs, in nine asset management firms with combined assets under management of over $33 billion, spanning a range of asset classes, including real estate, real assets, wealth management, hedge funds and alternative credit strategies. For the period from April 4, 2019, the date of the Kudu Transaction, through December 31, 2019, Kudu reported total revenues of $21 million and pretax income of $11 million. White Mountains’s pre-tax total return on invested assets was 20.4% for 2019, which included a $115 million pre-tax unrealized investment gain from the MediaAlpha Transaction. Excluding the MediaAlpha Transaction, White Mountains’s pre-tax total return on invested assets was 15.5% for 2019, compared to -1.7% for 2018. Investment returns for 2019 benefited from the decision to increase White Mountains’s equity exposure during the equity rout at the end of 2018, the strong rally in equity markets over the course of the year, and strong other long-term investments results. The strong other long-term investment results were driven primarily by a $65 million increase in the fair value of White Mountains’s investment in MediaAlpha resulting from increases in profitability metrics since the MediaAlpha Transaction. Investment returns for 2018 were adversely impacted by the sharp decline in equity markets in the fourth quarter. White Mountains’s portfolio of common equity securities and other long-term investments returned 36.9% for 2019, which included the $115 million pre-tax unrealized investment gain from the MediaAlpha Transaction. Excluding the MediaAlpha Transaction, White Mountains’s portfolio of common equity securities and other long-term investments returned 25.7% for 2019, compared to -3.6% for 2018. White Mountains’s fixed income portfolio returned 6.1% for 2019, compared to 1.2% for 2018. Overview-Year Ended December 31, 2018 versus Year Ended December 31, 2017 White Mountains ended 2018 with book value per share of $896 and adjusted book value per share of $888, a decrease of 3.7% and 2.8% for the year, including dividends. Comprehensive loss attributable to common shareholders was $146 million in 2018 compared to comprehensive income attributable to common shareholders of $631 million in 2017. The results for 2018 were driven primarily by investment results, which were adversely impacted by the sharp decline in equity markets in the fourth quarter of 2018. The results for 2017 were driven primarily by the $557 million gain from the OneBeacon Transaction. Including the estimated gain of $55 per share for the MediaAlpha Transaction, December 31, 2018 book value per share would have been $951 and adjusted book value per share would have been $943. Had the MediaAlpha Transaction closed on December 31, 2018, White Mountains’s book value per share would have increased 2.2% and adjusted book value per share would have increased 3.2% in 2018, including dividends. During 2018, White Mountains repurchased and retired 592,458 of its common shares for $519 million at an average share price of $877. The average share price paid was approximately 98% and 99%, respectively, of White Mountains’s December 31, 2018 book value per share and adjusted book value per share. The average share price paid was approximately 92% and 93%, respectively, of White Mountains’s December 31, 2018 book value per share including the estimated gain of $55 per share from the MediaAlpha Transaction and adjusted book value per share including the estimated gain from the MediaAlpha Transaction. During 2018, White Mountains deployed roughly $300 million in new business opportunities, ending the year with approximately $1.2 billion of undeployed capital. Gross written premiums and MSC collected in the HG Global/BAM segment totaled $107 million in 2018, compared to $101 million in 2017. BAM insured municipal bonds with par value of $12.0 billion in 2018, compared to $10.4 billion in 2017. During 2018, BAM completed assumed reinsurance transactions to insure municipal bonds with a par value of $2.2 billion. Total pricing was 93 basis points in 2018, compared to 99 basis points in 2017. During 2018, BAM made a $23 million cash payment of principal and interest on the BAM Surplus Notes held by HG Global. During 2017, BAM made a $5 million cash payment of principal and interest on the BAM Surplus Notes. BAM’s total claims paying resources were $871 million as of December 31, 2018, compared to $708 million as of December 31, 2017. The increase in claims paying resources was driven by positive cash flow from operations as well as the $100 million reinsurance agreement that BAM entered into with Fidus Re in the second quarter of 2018. On May 11, 2018, White Mountains acquired a 95.0% ownership interest in NSM (83.6% on a fully diluted, fully converted basis), a full-service MGU and program administrator for specialty property & casualty insurance. NSM reported pre-tax loss of $5 million from May 11, 2018, the date of acquisition, through December 31, 2018. NSM reported adjusted EBITDA of $16 million and revenues of $102 million from May 11, 2018 through December 31, 2018. MediaAlpha reported pre-tax income of $9 million in 2018, compared to break-even pre-tax income in 2017. MediaAlpha’s adjusted EBITDA was $32 million in 2018, compared to $11 million in 2017. MediaAlpha reported advertising and commission revenues of $296 million in 2018, compared to $163 million in 2017. The increases in pre-tax income, adjusted EBITDA and revenues were driven primarily by growth in the P&C vertical and the HLM vertical, which includes business generated from assets acquired from Healthplans.com in the fourth quarter of 2017. White Mountains’s pre-tax total return on invested assets was -1.7% for 2018, compared to 5.6% for 2017. Investment returns for 2018 were adversely impacted by the sharp decline in equity markets in the fourth quarter. Investment returns for 2017 benefited from the relatively short-duration of the fixed income portfolio and strong equity markets. White Mountains’s portfolio of common equity securities and other long-term investments returned -3.6% for 2018, compared to 12.7% for 2017. White Mountains’s fixed income portfolio returned 1.2% for 2018, compared to 3.5% for 2017. Adjusted Book Value Per Share The following table presents White Mountains’s adjusted book value per share, a non-GAAP financial measure, as of December 31, 2019, 2018 and 2017 and reconciles this non-GAAP measure to book value per share, the most comparable GAAP measure. See “NON-GAAP FINANCIAL MEASURES” on page 58. December 31, Book value per share numerators (in millions): White Mountains’s common shareholders’ equity $ 3,261.5 $ 2,843.1 $ 3,492.5 Time-value of money discount on expected future payments on the BAM Surplus Notes (1) (151.6 ) (141.2 ) (157.0 ) HG Global’s unearned premium reserve (1) 156.7 136.9 103.9 HG Global’s net deferred acquisition costs (1) (41.5 ) (34.6 ) (24.3 ) Adjusted book value per share numerator $ 3,225.1 $ 2,804.2 $ 3,415.1 Book value per share denominators (in thousands of shares): Common shares outstanding 3,185.4 3,173.1 3,750.2 Unearned restricted shares (18.5 ) (14.6 ) (16.8 ) Adjusted book value per share denominator 3,166.9 3,158.5 3,733.4 GAAP book value per share $ 1,023.91 $ 896.00 $ 931.30 Adjusted book value per share $ 1,018.41 $ 887.85 $ 914.75 Dividends paid per share $ 1.00 $ 1.00 $ 1.00 (1) Amounts reflects White Mountains’s preferred share ownership in HG Global of 96.9%. The following tables presents goodwill and other intangible assets that are included in White Mountains’s adjusted book value as of December 31, 2019, 2018 and 2017: December 31, Millions Goodwill: NSM (1) $ 381.6 $ 354.3 $ - Kudu 7.6 - - MediaAlpha - 18.3 18.3 Other Operations 5.5 7.3 7.6 Total goodwill 394.7 379.9 25.9 . . Other intangible assets: NSM (1) 241.4 131.9 - Kudu 2.0 - - MediaAlpha - 25.1 35.4 Other Operations 16.6 .6 .8 Total other intangible assets 260.0 157.6 36.2 Total goodwill and other intangible assets (2) 654.7 537.5 62.1 Total goodwill and other intangible assets attributed to non-controlling interests (23.4 ) (40.6 ) (21.1 ) Total goodwill and other intangible assets included in White Mountains’s common shareholders’ equity $ 631.3 $ 496.9 $ 41.0 (1) The relative fair values of goodwill and other intangible assets recognized in connection with the acquisition of KBK had not yet been finalized at December 31, 2018. (2) See Note 4 - “Goodwill and Other Intangible Assets” on page for details of other intangible assets. Summary of Consolidated Results The following table presents White Mountains’s consolidated financial results by industry for the years ended December 31, 2019, 2018 and 2017: Year Ended December 31, Millions Revenues Financial Guarantee revenues $ 66.6 $ 24.3 $ 23.3 Specialty Insurance Distribution revenues 233.1 101.6 - Asset Management revenues 21.2 - - Marketing Technology revenues 48.8 297.1 163.2 Other Operations revenues 523.7 (53.9 ) 187.3 Total revenues 893.4 369.1 373.8 Expenses Financial Guarantee expenses 56.6 53.7 47.3 Specialty Insurance Distribution expenses 235.2 106.8 - Asset Management expenses 10.4 - - Marketing Technology expenses 54.9 288.2 163.6 Other Operations expenses 131.2 98.6 155.1 Total expenses 488.3 547.3 366.0 Pre-tax income (loss) Financial Guarantee pre-tax income (loss) 10.0 (29.4 ) (24.0 ) Specialty Insurance Distribution pre-tax loss (2.1 ) (5.2 ) - Asset Management, pre-tax income 10.8 - - Marketing Technology pre-tax (loss) income (6.1 ) 8.9 (.4 ) Other Operations pre-tax income (loss) 392.5 (152.5 ) 32.2 Total pre-tax income (loss) 405.1 (178.2 ) 7.8 Income tax (expense) benefit (29.3 ) 4.0 7.8 Net income (loss) from continuing operations 375.8 (174.2 ) 15.6 Gain (loss) on sale of discontinued operations, net of tax 0.8 (17.2 ) 557.0 Net income from discontinued operations, net of tax - - 20.5 Net income (loss) 376.6 (191.4 ) 593.1 Net loss attributable to non-controlling interests 37.9 50.2 34.1 Net income (loss) attributable to White Mountains’s common shareholders 414.5 (141.2 ) 627.2 Other comprehensive (loss) income, net of tax (1.4 ) (4.8 ) .3 Comprehensive income from discontinued operations, net of tax - - 3.2 Comprehensive income (loss) 413.1 (146.0 ) 630.7 Comprehensive income (loss) attributable to non-controlling interests - .3 (.2 ) Comprehensive income (loss) attributable to White Mountains’s common shareholders $ 413.1 $ (145.7 ) $ 630.5 I. Summary of Operations By Segment As of December 31, 2019, White Mountains conducted its operations through four segments: (1) HG Global/BAM, (2) NSM, (3) Kudu and (4) Other Operations. In addition, MediaAlpha was consolidated as a reportable segment until the date of the MediaAlpha Transaction. A discussion of White Mountains’s consolidated investment operations is included after the discussion of operations by segment. White Mountains’s segment information is presented in Note 14 - “Segment Information” on page. As a result of the Kudu Transaction, White Mountains began consolidating Kudu in its financial statements in the second quarter of 2019. White Mountains’s segment disclosures for the year ended December 31, 2019 include Kudu’s results of operations for the period from April 4, 2019, the date of the Kudu Transaction, to December 31, 2019. See Note 2 - “Significant Transactions” on page. As a result of the MediaAlpha Transaction, White Mountains no longer consolidated MediaAlpha, and consequently it was no longer a reportable segment. White Mountains’s segment disclosures for the year ended December 31, 2019 include MediaAlpha’s results of operations for the period from January 1, 2019 to February 26, 2019, the date of the MediaAlpha Transaction. See Note 2 - “Significant Transactions” on page. As a result of the OneBeacon Transaction, the results of operations for OneBeacon for the year ended December 31, 2017 have been classified as discontinued operations, and are now presented separately, net of related income taxes, in the statement of comprehensive income. See Note 20 - “Held for Sale and Discontinued Operations” on page. HG Global/BAM The following tables present the components of pre-tax income included in White Mountains’s HG Global/BAM segment related to the consolidation of HG Global, which includes HG Re and its other wholly-owned subsidiaries, and BAM for the years ended December 31, 2019, 2018 and 2017: December 31, 2019 Millions HG Global BAM Eliminations Total Direct written premiums $ - $ 28.1 (2) $ - $ 28.1 Assumed written premiums 33.6 10.6 (33.6 ) 10.6 Gross written premiums 33.6 38.7 (33.6 ) 38.7 Ceded written premiums - (33.6 ) (2) 33.6 - Net written premiums $ 33.6 $ 5.1 $ - $ 38.7 Earned insurance and reinsurance premiums $ 13.1 $ 3.2 $ - $ 16.3 Net investment income 7.5 14.1 - 21.6 Net investment income - BAM Surplus Notes 27.4 - (27.4 ) - Net realized and unrealized investment gains 11.0 16.1 - 27.1 Other revenues - 1.6 - 1.6 Total revenues 59.0 35.0 (27.4 ) 66.6 Insurance and reinsurance acquisition expenses 3.3 2.4 - 5.7 Other underwriting expenses - .4 - .4 General and administrative expenses 1.6 48.9 - 50.5 Interest expense - BAM Surplus Notes - 27.4 (27.4 ) - Total expenses 4.9 79.1 (27.4 ) 56.6 Pre-tax income (loss) $ 54.1 $ (44.1 ) $ - $ 10.0 Supplemental information: MSC collected (1) (2) $ - $ 68.0 $ - $ 68.0 (1) MSC collected are recorded directly to BAM’s equity, which is recorded as non-controlling interest on White Mountains’s balance sheet. (2) During 2019, BAM issued policy endorsements for certain policies issued in periods prior to the second quarter of 2018. The impact of the policy endorsements for the year ended December 31, 2019 was a decrease to BAM’s gross written premiums of $13.4 and an increase to MSC collected of $13.4. December 31, 2018 Millions HG Global BAM Eliminations Total Direct written premiums $ - $ 44.8 $ - $ 44.8 Assumed written premiums 45.0 8.1 (45.0 ) 8.1 Gross written premiums 45.0 52.9 (45.0 ) 52.9 Ceded written premiums - (45.0 ) 45.0 - Net written premiums $ 45.0 $ 7.9 $ - $ 52.9 Earned insurance and reinsurance premiums $ 11.0 $ 2.9 $ - $ 13.9 Net investment income 5.7 11.0 - 16.7 Net investment income - BAM Surplus Notes 22.9 - (22.9 ) - Net realized and unrealized investment losses (4.1 ) (3.4 ) - (7.5 ) Other revenues - 1.2 - 1.2 Total revenues 35.5 11.7 (22.9 ) 24.3 Insurance and reinsurance acquisition expenses 2.7 2.6 - 5.3 Other underwriting expenses - .4 - .4 General and administrative expenses 1.1 46.9 - 48.0 Interest expense - BAM Surplus Notes - 22.9 (22.9 ) - Total expenses 3.8 72.8 (22.9 ) 53.7 Pre-tax income (loss) $ 31.7 $ (61.1 ) $ - $ (29.4 ) Supplemental information: MSC collected (1) $ - $ 53.8 $ - $ 53.8 (1) MSC collected are recorded directly to BAM’s equity, which is recorded as non-controlling interest on White Mountains’s balance sheet. December 31, 2017 Millions HG Global BAM Eliminations Total Direct written premiums $ - $ 63.2 $ - $ 63.2 Assumed written premiums 53.6 - (53.6 ) - Gross written premiums 53.6 63.2 (53.6 ) 63.2 Ceded written premiums - (53.6 ) 53.6 - Net written premiums $ 53.6 $ 9.6 $ - $ 63.2 Earned insurance and reinsurance premiums $ 7.1 $ 2.3 $ - $ 9.4 Net investment income 3.3 9.0 - 12.3 Net investment income - BAM Surplus Notes 19.0 - (19.0 ) - Net realized and unrealized investment (losses) gains (1.2 ) 1.8 - .6 Other revenues - 1.0 - 1.0 Total revenues 28.2 14.1 (19.0 ) 23.3 Insurance and reinsurance acquisition expenses 1.5 2.5 - 4.0 Other underwriting expenses - .4 - .4 General and administrative expenses 1.0 41.9 - 42.9 Interest expense - BAM Surplus Notes - 19.0 (19.0 ) - Total expenses 2.5 63.8 (19.0 ) 47.3 Pre-tax income (loss) $ 25.7 $ (49.7 ) $ - $ (24.0 ) Supplemental information: MSC collected (1) $ - $ 37.4 $ - $ 37.4 (1) MSC collected are recorded directly to BAM’s equity, which is recorded as non-controlling interest on White Mountains’s balance sheet. HG Global/BAM Results-Year Ended December 31, 2019 versus Year Ended December 31, 2018 BAM charges an insurance premium on each municipal bond insurance policy it writes. A portion of the premium is MSC and the remainder is a risk premium. In the event of a municipal bond refunding, a portion of the MSC from original issuance can be reutilized, in effect serving as a credit against the total insurance premium on the refunding of the municipal bond. Issuers of debt insured by BAM are members of BAM so long as any of their BAM-insured debt is outstanding, and as members they have certain interests in BAM, including the right to vote for BAM’s directors and to receive dividends, if declared. Gross written premiums and MSC collected in the HG Global/BAM segment totaled $107 million in both 2019 and 2018. BAM insured $12.8 billion of municipal bonds, $10.4 billion of which were in the primary market in 2019, compared to $12 billion of municipal bonds, $8.8 billion of which were in the primary market, in 2018. During 2019 and 2018, BAM completed assumed reinsurance transactions to insure municipal bonds with a par value of $1.1 billion and $2.2 billion, respectively. Total pricing, which reflects both gross written premiums and MSC from new business, decreased to 83 basis points in 2019, compared to 93 basis points in 2018. See “NON-GAAP FINANCIAL MEASURES” on page 58. The decrease in total pricing was driven primarily by a decrease in pricing in the primary market. Pricing in the primary market decreased to 51 basis points in 2019, compared to 71 basis points in 2018, driven primarily by lower interest rates and tighter credit spreads. Pricing in the assumed reinsurance and secondary markets, which is more transaction-specific than pricing in the primary market, increased to 219 basis points in 2019, compared to 150 basis points in 2018, partially offsetting the decline in pricing in the primary market. The following table presents the gross par value of primary and secondary market policies issued, the gross par value of assumed reinsurance, the gross written premiums and MSC collected and total pricing for the twelve months ended December 31, 2019 and 2018: Year Ended December 31, $ in Millions Gross par value of primary market policies issued $ 10,405.1 $ 8,779.9 Gross par value of assumed reinsurance 1,130.7 2,235.8 Gross par value of secondary market policies issued 1,311.8 959.6 Total gross par value of market policies issued $ 12,847.6 $ 11,975.3 Gross written premiums $ 38.7 (2) $ 52.9 MSC collected 68.0 (2) 53.8 Total gross written premiums and MSC collected $ 106.7 $ 106.7 Present value of future installment MSC collections .3 3.1 Gross written premium adjustments on existing installment policies (.1 ) 1.1 Gross written premiums and MSC from new business (1) $ 106.9 $ 110.9 Total pricing 83 bps 93 bps (1) See “NON-GAAP FINANCIAL MEASURES” on page 58. (2) During 2019, BAM issued policy endorsements for certain policies issued in periods prior to the second quarter of 2018. The impact of the policy endorsements for the year ended December 31, 2019 was a decrease to BAM’s gross written premiums of $13.4 and an increase to MSC collected of $13.4. HG Global reported GAAP pre-tax income of $54 million in 2019, compared to $32 million in 2018. The increase in pre-tax income was driven primarily by higher returns in HG Global’s investment portfolio. HG Global’s results in 2019 included $27 million of interest income on the BAM Surplus Notes, compared to $23 million in 2018. BAM is a mutual insurance company that is owned by its members. BAM’s results are consolidated into White Mountains’s GAAP financial statements and attributed to non-controlling interests. White Mountains reported GAAP pre-tax losses from BAM of $44 million in 2019, compared to $61 million in 2018. The decrease in the pre-tax loss was driven primarily by higher returns in BAM’s investment portfolio. BAM’s results included $27 million of interest expense on the BAM Surplus Notes and $49 million of general and administrative expenses in 2019, compared to $23 million of interest expense on the BAM Surplus Notes and $47 million of general and administrative expenses in 2018. In December 2019, BAM made a $32 million cash payment of principal and interest on the BAM Surplus Notes held by HG Global. Of this payment, $24 million was a repayment of principal held in the Supplemental Trust and $8 million was a payment of accrued interest held outside the Supplemental Trust. In January 2020, BAM made an additional $65 million special cash payment of principal and interest on the BAM Surplus Notes. Of this payment, $48 million was a repayment of principal held in the Supplemental Trust, $1 million was a payment of accrued interest held in the Supplemental Trust and $16 million was a payment of accrued interest held outside the Supplemental Trust. During 2018, BAM made a $23 million cash payment of principal and interest on the BAM Surplus Notes. Of this payment, $18 million was a repayment of principal held in the Supplemental Trust, $1 million was a payment of accrued interest held in the Supplemental Trust and $4 million was a payment of accrued interest held outside the Supplemental Trust. During the fourth quarter of 2019, White Mountains updated its debt service model for the BAM Surplus Notes to reflect (i) the cash payments of principal and interest on the BAM Surplus Notes made in December 2019 and January 2020, (ii) the amendments made to the terms of the BAM Surplus Notes in January 2020, including the extension of the variable interest rate period and (iii) in light of the current interest rate environment, a more conservative forecast of future operating results for BAM. This has resulted in slower modeled future payments on the BAM Surplus Notes and, in turn, a $20 million increase to the time value of money discount on the BAM Surplus Notes as reflected in adjusted book value per share as of December 31, 2019. HG Global/BAM Results-Year Ended December 31, 2018 versus Year Ended December 31, 2017 Gross written premiums and MSC collected in the HG Global/BAM segment totaled $107 million in 2018, compared to $101 million in 2017. BAM insured $12.0 billion of municipal bonds, $8.8 billion of which were in the primary market in 2018, compared to $10.4 billion, $9.6 billion of which were in the primary market, in 2017. During 2018, BAM completed an assumed reinsurance transaction to insure municipal bonds with a par value of $2.2 billion. Total pricing, which reflects both gross written premiums and MSC from new business, decreased to 93 basis points in 2018, compared to 99 basis points in 2017. See “NON-GAAP FINANCIAL MEASURES” on page 58. Pricing in the primary market decreased to 71 basis points in 2018, compared to 74 basis points in 2017. Pricing in the assumed reinsurance and secondary markets decreased to 150 basis points in 2018, compared to 410 basis points in 2017. The following table presents the gross par value of primary and secondary market policies issued, the gross par value of assumed reinsurance, the gross written premiums and MSC collected and total pricing for the twelve months ended December 31, 2018 and 2017: Year Ended December 31, $ in Millions Gross par value of primary market policies issued $ 8,779.9 $ 9,633.5 Gross par value of assumed reinsurance 2,235.8 - Gross par value of secondary market policies issued 959.6 793.2 Total gross par value of market policies issued $ 11,975.3 $ 10,426.7 Gross written premiums $ 52.9 $ 63.2 MSC collected 53.8 37.4 Total gross written premiums and MSC collected $ 106.7 $ 100.6 Present value of future installment MSC collections 3.1 2.8 Gross written premium adjustments on existing installment policies 1.1 - Gross written premiums and MSC from new business (1) $ 110.9 $ 103.4 Total pricing 93 bps 99 bps (1) See “NON-GAAP FINANCIAL MEASURES” on page 58. HG Global reported GAAP pre-tax income of $32 million in 2018, compared to $26 million in 2017. HG Global’s results in 2018 included $23 million of interest income on the BAM Surplus Notes, compared to $19 million in 2017. White Mountains reported GAAP pre-tax losses from BAM of $61 million 2018, compared to $50 million in 2017. BAM’s results included $23 million of interest expense on the BAM Surplus Notes and $47 million of general and administrative expenses in 2018, compared to $19 million of interest expense on the BAM Surplus Notes and $42 million of general and administrative expenses in 2017. The increase in general and administrative expenses was primarily due to financing expense from the reinsurance agreement with Fidus Re, which is accounted for using the deposit method under GAAP. During 2018, BAM made a $23 million cash payment of principal and interest on the BAM Surplus Notes held by HG Global. Of this payment, $18 million was a repayment of principal held in the Supplemental Trust, $1 million was a payment of accrued interest held in the Supplemental Trust and $4 million was a payment of accrued interest held outside the Supplemental Trust. During 2017, BAM made a $5 million cash payment of principal and interest on the BAM Surplus Notes. Of this payment, $4 million was a repayment of principal held in the Supplemental Trust and $1 million was a payment of accrued interest held outside the Supplemental Trust. Claims Paying Resources BAM’s claims paying resources represent the capital and other financial resources BAM has available to pay claims and, as such, is a key indication of BAM’s financial strength. The following table presents BAM’s total claims paying resources as of December 31, 2019, 2018 and 2017: Millions December 31, 2019 December 31, 2018 December 31, 2017 Policyholders’ surplus $ 402.4 $ 413.7 $ 427.3 Contingency reserve 68.2 50.3 34.8 Qualified statutory capital 470.6 464.0 462.1 Net unearned premiums 39.3 36.2 30.5 Present value of future installment premiums and MSC 13.7 12.9 9.0 HG Re Collateral Trusts at statutory value 314.0 258.3 206.8 Fidus Re collateral trust at statutory value 100.0 100.0 - Claims paying resources $ 937.6 $ 871.4 $ 708.4 BAM’s claims paying resources increased to $938 million as of December 31, 2019 from $871 million as of December 31, 2018. The increase was driven primarily by $68 million of MSC collected and a $56 million increase in the invested assets of the HG Re Collateral Trusts, partially offset by BAM’s 2019 statutory net loss of $38 million. BAM’s claims paying resources increased to $871 million as of December 31, 2018 from $708 million as of December 31, 2017. The increase was driven primarily by the $100 million reinsurance agreement with Fidus Re, $54 million of MSC collected and a $52 million increase in the invested assets of the HG Re Collateral Trusts, partially offset by BAM’s 2018 statutory net loss of $35 million. HG Global/BAM Balance Sheets The following table presents amounts from HG Global, which includes HG Re and its other wholly-owned subsidiaries, and BAM that are contained within White Mountains’s consolidated balance sheet as of December 31, 2019 and 2018: December 31, 2019 Millions HG Global BAM Eliminations and Segment Adjustment Total Segment Assets Fixed maturity investments $ 304.2 $ 495.1 $ - $ 799.3 Short-term investments 15.7 30.6 - 46.3 Total investments 319.9 525.7 - 845.6 Cash 9.8 14.4 - 24.2 BAM Surplus Notes 457.6 - (457.6 ) - Accrued interest receivable on BAM Surplus Notes 162.7 - (162.7 ) - Deferred acquisition costs 42.8 22.1 (42.8 ) 22.1 Insurance premiums receivable 4.2 6.7 (4.2 ) 6.7 Accrued investment income 1.7 3.7 - 5.4 Other assets - 20.2 (.2 ) 20.0 Total assets $ 998.7 $ 592.8 $ (667.5 ) $ 924.0 Liabilities BAM Surplus Notes (1) $ - $ 457.6 $ (457.6 ) $ - Accrued interest payable on BAM Surplus Notes (2) - 162.7 (162.7 ) - Preferred dividends payable to White Mountains's subsidiaries (3) 330.3 - - 330.3 Preferred dividends payable to non-controlling interests 11.4 - - 11.4 Unearned insurance premiums 161.7 36.7 - 198.4 Other liabilities 1.7 82.5 (47.2 ) 37.0 Total liabilities 505.1 739.5 (667.5 ) 577.1 Equity White Mountains’s common shareholders’ equity (3) 479.2 - - 479.2 Non-controlling interests 14.4 (146.7 ) - (132.3 ) Total equity 493.6 (146.7 ) - 346.9 Total liabilities and equity $ 998.7 $ 592.8 $ (667.5 ) $ 924.0 (1) Under GAAP, the BAM Surplus Notes are classified as debt by the issuer. Under U.S. Statutory accounting, they are classified as policyholders’ surplus. (2) Under GAAP, interest accrues daily on the BAM Surplus Notes. Under U.S. Statutory accounting, interest is not accrued on the BAM Surplus Notes until it has been approved for payment by insurance regulators. (3) HG Global preferred dividends payable to White Mountains’s subsidiaries is eliminated in White Mountains’s consolidated financial statements. For segment reporting, the HG Global preferred dividends payable to White Mountains’s subsidiaries included within the HG Global/BAM segment are eliminated against the offsetting receivable included within the Other Operations segment, and therefore are added back to White Mountains’s common shareholders’ equity within the HG Global/BAM segment. December 31, 2018 Millions HG Global BAM Eliminations and Segment Adjustment Total Segment Assets Fixed maturity investments $ 225.8 $ 475.6 $ - $ 701.4 Short-term investments 28.5 38.4 - 66.9 Total investments 254.3 514.0 - 768.3 Cash 6.0 6.5 - 12.5 BAM Surplus Notes 481.3 - (481.3 ) - Accrued interest receivable on BAM Surplus Notes 143.7 - (143.7 ) - Deferred acquisition costs 35.7 19.0 (35.7 ) 19.0 Insurance premiums receivable 4.0 6.4 (4.0 ) 6.4 Accounts receivable on unsettled investments sales - - - - Other assets 1.3 9.0 (.3 ) 10.0 Total assets $ 926.3 $ 554.9 $ (665.0 ) $ 816.2 Liabilities BAM Surplus Notes (1) $ - $ 481.3 $ (481.3 ) $ - Accrued interest payable on BAM Surplus Notes (2) - 143.7 (143.7 ) - Preferred dividends payable to White Mountains's subsidiaries (3) 278.5 - - 278.5 Preferred dividends payable to non-controlling interests 9.6 - - 9.6 Unearned insurance premiums 141.3 34.7 - 176.0 Accounts payable on unsettled investment purchases - 2.2 - 2.2 Other liabilities 1.1 63.6 (40.0 ) 24.7 Total liabilities 430.5 725.5 (665.0 ) 491.0 Equity White Mountains’s common shareholders’ equity (3) 481.3 - - 481.3 Non-controlling interests 14.5 (170.6 ) - (156.1 ) Total equity 495.8 (170.6 ) - 325.2 Total liabilities and equity $ 926.3 $ 554.9 $ (665.0 ) $ 816.2 (1) Under GAAP, the BAM Surplus Notes are classified as debt by the issuer. Under U.S. Statutory accounting, they are classified as policyholders’ surplus. (2) Under GAAP, interest accrues daily on the BAM Surplus Notes. Under U.S. Statutory accounting, interest is not accrued on the BAM Surplus Notes until it has been approved for payment by insurance regulators. (3) HG Global preferred dividends payable to White Mountains’s subsidiaries is eliminated in White Mountains’s consolidated financial statements. For segment reporting, the HG Global preferred dividends payable to White Mountains’s subsidiaries included within the HG Global/BAM segment are eliminated against the offsetting receivable included within the Other Operations segment, and therefore are added back to White Mountains’s common shareholders’ equity within the HG Global/BAM segment. NSM The following table presents the components of GAAP net loss and adjusted EBITDA included in White Mountains’s NSM segment for the year ended December 31, 2019 and the for the period of May 11, 2018 to December 31, 2018: Millions Year Ended December 31, 2019 May 11, 2018 to December 31, 2018 Commission revenues $ 193.4 $ 89.6 Broker commission expense 64.8 28.4 Gross profit 128.6 61.2 Other revenues 39.7 12.0 General and administrative expenses 132.2 59.4 Change in fair value of contingent consideration earnout liabilities 2.1 2.7 Amortization of other intangible assets 19.4 8.3 Interest expense 16.7 8.0 GAAP pre-tax loss (2.1 ) (5.2 ) Income tax benefit (.6 ) - GAAP net loss (1.5 ) (5.2 ) Add back: Interest expense 16.7 8.0 Income tax benefit (.6 ) - General and administrative expenses - depreciation 2.8 1.7 Amortization of other intangible assets 19.4 8.3 EBITDA (1) 36.8 12.8 Add back: Change in fair value of contingent consideration earnout liabilities 2.1 2.7 Acquisition-related transaction expenses 5.6 1.0 Fair value purchase accounting adjustment for deferred revenue .9 - Investments made in the development of new business lines .3 1.8 Restructuring expenses 2.3 .1 Adjusted EBITDA (1) $ 48.0 $ 18.4 (1) See “NON-GAAP FINANCIAL MEASURES” on page 58. NSM Results-Year ended December 31, 2019 versus the Period from May 11, 2018 to December 31, 2018 For the year ended December 31, 2019, NSM reported GAAP pre-tax loss of $2 million, adjusted EBITDA of $48 million, and commission and other revenues of $233 million. For the period from May 11, 2018, the date White Mountains acquired NSM, to December 31, 2018, NSM reported pre-tax loss of $5 million, adjusted EBITDA of $18 million, and commission and other revenues of $102 million. NSM’s pre-tax loss included interest expense of $17 million and amortization of other intangible assets of $19 million in 2019, compared to $8 million and $8 million, respectively, for the period from May 11, 2018 to December 31, 2018. Broker commission expenses and general and administrative expenses were $65 million and $132 million for 2019, compared to $28 million and $59 million, respectively, for the period from May 11, 2018 to December 31, 2018. NSM’s general and administrative expenses for 2019 included a $2 million impairment of intangible assets related to Fresh Insurance. NSM Business Trends The following is a discussion of the trends in NSM’s business including periods prior to White Mountains’s ownership of NSM. White Mountains believes this is useful in understanding the newly acquired business. NSM’s business consists of a number of active programs that are broadly categorized into six market verticals. The following table presents the controlled premium and commission and other revenues by vertical for the years ended December 31, 2019, 2018 and 2017: Year Ended December 31, 2018 (2) 2017 (2) $ in Millions Controlled Premium (1) Commission and Other Revenue Controlled Premium (1) Commission and Other Revenue Controlled Premium (1) Commission and Other Revenue Specialty Transportation $ 290.2 $ 77.6 $ 136.8 $ 43.0 $ 112.6 $ 32.9 Real Estate 157.2 34.7 135.7 30.3 106.8 22.2 Social Services 102.7 25.9 94.0 23.8 111.6 28.8 Pet 67.6 30.0 - - - - United Kingdom 155.5 45.9 108.8 34.9 46.0 16.1 Other 124.5 19.0 119.4 19.8 113.4 18.6 Total $ 897.7 $ 233.1 $ 594.7 $ 151.8 $ 490.4 $ 118.6 (1) Controlled premium are total premiums placed by NSM during the period. (2) Controlled premium and commission and other revenue includes results prior to White Mountains’s ownership of NSM. Year Ended December 31, 2019 versus Year Ended December 31, 2018 Specialty Transportation: NSM’s specialty transportation controlled premium and commission and other revenues increased significantly in 2019, compared to 2018, driven primarily by the acquisition of KBK in the fourth quarter of 2018 and an increase in contingent commissions and fees in 2019. KBK contributed $160 million of controlled premium and $32 million of commission and other revenues in 2019. Real Estate: NSM’s real estate controlled premium increased 16% in 2019, compared to 2018, driven primarily by organic growth in both rate and units. The organic growth was driven by rate increases in the CHAMP program, which offers insurance coverage for wind-exposed coastal condominium associations, combined with significant unit growth in NSM’s excess and surplus habitational program. NSM’s real estate commission and other revenues increased 15% in 2019, compared to 2018, driven primarily by the increase in controlled premium, increases in rate and an increase in associated fee revenues. Social Services: NSM’s social services controlled premium and commission and other revenues both increased 9% in 2019, compared to 2018. The increase is primarily due to increases in rate and retention. Pet: The pet program was added during the second quarter of 2019 with the acquisition of Embrace. United Kingdom: NSM’s United Kingdom controlled premium and commission and other revenues increased 43% and 32% in 2019, respectively, compared to 2018, driven primarily by the acquisition of Fresh Insurance in May 2018 and the establishment of First Underwriting in the fourth quarter of 2018. Fresh Insurance’s controlled premium and commission and other revenues contributed $62 million and $18 million in 2019, respectively, compared to $46 million and $16 million, respectively, from the date of acquisition, May 11, 2018, to the end of 2018. First Underwriting contributed $38 million of controlled premium and $3 million of commission and other revenues in 2019. Other: NSM’s other controlled premium increased 4% in 2019, compared to 2018, driven primarily by improvements in units and retention. Commissions and other revenues decreased 4% in 2019 from 2018 due to lower average commission rates resulting from a change in carrier in 2019. Year Ended December 31, 2018 versus Year Ended December 31, 2017 Specialty Transportation: NSM’s specialty transportation controlled premium and commission and other revenue growth in 2018 was due to organic growth in the collector car programs, and higher profit commissions in 2018 compared to 2017, as there were no major catastrophes in 2018, while profit commissions were significantly reduced in 2017 due to hurricanes Harvey and Irma. Real Estate: NSM’s real estate controlled premium and commission and other revenue growth in 2018 was primarily due to the CHAMP program, which increased penetration in the southeast U.S. market and benefited from customer goodwill arising from exceptional claims handling in the wake of the 2017 hurricanes. Social Services: NSM’s social services controlled premium and commission and other revenue experienced a decline in 2018 primarily due to the continued pull back of a key carrier partner. NSM established relationships with two new carrier partners in the Social Services vertical in 2019. United Kingdom: NSM’s United Kingdom controlled premium and commission and fee revenue grew significantly in 2018 due to the acquisition of Fresh Insurance. Fresh Insurance’s controlled premium and commission and other revenues contributed $46 million and $16 million, respectively, from the date of acquisition, May 11, 2018, to the end of 2018. Other: NSM’s other controlled premium and commission and fee revenue increased due to growth in the retail brokerage program, partially offset by a reduction in the worker’s compensation program. Kudu On April 4, 2019, White Mountains completed the Kudu Transaction. For the twelve months ended December 31, 2019, Kudu deployed $203 million, including transaction costs, in seven asset management firms and has now deployed a total of $266 million, including transaction costs, in nine asset management firms with combined assets under management of over $33 billion, spanning a range of asset classes, including real estate, real assets, wealth management, hedge funds and alternative credit strategies. The average cash yield to Kudu at inception for the $266 million of deployed capital was 10.6%. The following table presents a summary of White Mountains’s financial results from its Kudu segment for the period of April 4, 2019 to December 31, 2019: April 4, 2019 to December 31, 2019 Millions Net investment income $ 14.7 Net realized and unrealized investment gains 6.3 Other revenues .2 Total revenues 21.2 General and administrative expenses 10.1 Amortization of other intangible assets .2 Interest expense .1 Total expenses 10.4 Pre-tax income $ 10.8 Kudu reported pre-tax income of $11 million and revenues of $21 million for the period from April 4, 2019, the date of the Kudu Transaction, to December 31, 2019. Kudu’s pre-tax income and revenues were driven primarily by net investment income of $15 million and net realized and unrealized gains of $6 million from Kudu’s Participation Contracts. Kudu’s pre-tax income also included general and administrative expenses of $10 million, driven primarily by employee compensation costs and transaction related expenses. MediaAlpha As a result of the MediaAlpha Transaction, White Mountains’s reduced its ownership interest in MediaAlpha to 48.3% (42.0% on a fully diluted, fully converted basis). White Mountains’s remaining ownership interest in MediaAlpha no longer meets the criteria for a controlling ownership interest and, accordingly, White Mountains deconsolidated MediaAlpha as of February 26, 2019. Subsequent to the MediaAlpha Transaction, White Mountains accounts for its investment in MediaAlpha at fair value within other long-term investments. See Summary of Investment Results on page 45. The following table presents the components of GAAP pre-tax (loss) income included in White Mountains’s MediaAlpha segment for the period of January 1, 2019 to February 26, 2019, and for the years ended December 31, 2018 and 2017: Year Ended December 31, Millions January 1, 2019 to February 26, 2019 Advertising and commission revenues $ 48.8 $ 295.5 $ 163.2 Cost of sales 40.6 245.0 135.9 Gross profit 8.2 50.5 27.3 Other revenue - 1.6 - General and administrative expenses 5.7 31.7 16.2 General and administrative expenses - MediaAlpha Transaction related costs 6.8 - - Amortization of other intangible assets 1.6 10.3 10.5 Interest expense .2 1.2 1.0 GAAP pre-tax (loss) income $ (6.1 ) $ 8.9 $ (.4 ) MediaAlpha Results-For the Period from January 1, 2019 to February 26, 2019 MediaAlpha reported GAAP pre-tax loss of $6 million and revenues of $49 million from January 1, 2019 to February 26, 2019, the date of the MediaAlpha Transaction. During the period from January 1, 2019 to February 26, 2019, revenues were driven primarily by the P&C and Health, Medicare and Life verticals, which had revenues of $26 million and $17 million. During the period from January 1, 2019 to February 26, 2019, MediaAlpha recognized $7 million of costs related to the MediaAlpha Transaction in general and administrative expenses. MediaAlpha Results-Year Ended December 31, 2018 versus Year Ended December 31, 2017 MediaAlpha reported GAAP pre-tax income of $9 million, compared to GAAP break-even pre-tax income in 2017. MediaAlpha reported advertising and commission revenues of $296 million in 2018, compared to $163 million in 2017. The increase in GAAP pre-tax income and revenues were driven primarily by growth in MediaAlpha’s P&C vertical, driven by increased demand from advertisers, and growth in the Health, Medicare and Life vertical and including revenues generated from assets acquired from Healthplans.com in the fourth quarter of 2017. Revenues from MediaAlpha’s P&C vertical were $162 million in 2018, compared to $88 million in 2017, while revenues from the Health, Medicare and Life vertical were $100 million in 2018 compared to $56 million in 2017. MediaAlpha’s cost of sales is comprised primarily of revenue share-based payments to partners, which are correlated to and vary with revenue volume. Cost of sales were $245 million in 2018, compared to $136 million in 2017. The increase in cost of sales was driven primarily by the increase in revenues. MediaAlpha’s general and administrative expenses were $32 million in 2018, compared to $16 million in 2017. The increase in general and administrative expenses in 2018 compared to 2017 was driven primarily by the recognition of non-cash equity-based compensation expense of $12 million that relates to MediaAlpha’s Class B units held by certain employees. The units entitle the award recipient to participate in distributions from MediaAlpha once a cumulative distribution threshold has been met. Compensation expense is recognized when it is deemed probable that the distribution threshold will be met in the future. Other Operations The following table presents White Mountains’s financial results from its Other Operations segment for the years ended December 31, 2019, 2018 and 2017: Year Ended December 31, Millions Earned insurance premiums $ - $ - $ 1.0 Net investment income 43.4 42.3 43.7 Net realized and unrealized investment gains (losses) 285.1 (100.8 ) 132.7 Realized gain and unrealized investment gain from the MediaAlpha Transaction 182.2 - - Advertising and commission revenues 6.9 4.1 3.8 Other revenues 6.1 .5 6.1 Total revenues 523.7 (53.9 ) 187.3 Loss and loss adjustment expenses - - 1.1 Insurance acquisition expense - - .1 Cost of sales 7.5 3.7 3.5 General and administrative expenses 122.5 94.4 148.9 Amortization of other intangible assets .6 .2 .2 Interest expense .6 .3 1.3 Total expenses 131.2 98.6 155.1 Pre-tax income (loss) $ 392.5 $ (152.5 ) $ 32.2 Other Operations Results-Year Ended December 31, 2019 versus Year Ended December 31, 2018 White Mountains’s Other Operations segment reported pre-tax income of $393 million in 2019, compared to pre-tax loss of $153 million in 2018. The change was driven primarily by higher investment returns and $182 million of total gains from the MediaAlpha Transaction. White Mountains’s Other Operations segment reported net realized and unrealized investment gains, excluding the MediaAlpha Transaction, of $285 million in 2019, compared to net realized and unrealized investment losses of $101 million in 2018. See “Summary of Investment Results” on page 45. The Other Operations segment reported general and administrative expenses of $123 million in 2019, compared to $94 million in 2018. The increase was driven primarily by higher incentive compensation costs, driven primarily by an increase in both White Mountains’s share price and the assumed harvest percentage on outstanding performance shares. Share repurchases For the year ended December 31, 2019, White Mountains repurchased and retired 5,679 of its common shares for $5 million. Other Operations Results-Year Ended December 31, 2018 versus Year Ended December 31, 2017 White Mountains’s Other Operations segment reported pre-tax loss of $153 million in 2018, compared to pre-tax income of $32 million in 2017. The results were driven primarily by lower investment returns in 2018. Net realized and unrealized investment losses were $101 million in 2018, compared to net realized and unrealized investment gains of $133 million in 2017. See “Summary of Investment Results” on page 45. Other revenues were $1 million in 2018, compared to $6 million in 2017. In 2017, other revenues included $4 million of third-party investment management fee income at WM Advisors. The Other Operations segment reported general and administrative expenses of $94 million in 2018, compared to $149 million in 2017. General and administrative expenses in 2017 included additional compensation expenses related to the severance of former company executives and higher incentive compensation costs resulting from the OneBeacon Transaction Share repurchases For the year ended December 31, 2018, White Mountains repurchased and retired 592,458 of its common shares for $519 million, at an average share price of $877. The average share price paid was approximately 98% and 99%, respectively, of White Mountains’s December 31, 2018 book value per share and adjusted book value per share. The average share price paid was approximately 92% and 93%, respectively, of White Mountains’s December 31, 2018 book value per share including the $55 per share estimated gain from the MediaAlpha Transaction and adjusted book value per share including the estimated gain from the MediaAlpha Transaction. II. Summary of Investment Results White Mountains’s total investment results include results from all segments. For purposes of discussing rates of return, all percentages are presented gross of management fees and trading expenses in order to produce a better comparison to benchmark returns. The following table presents the pre-tax investment return for White Mountains’s consolidated portfolio for the years ended December 31, 2019, 2018 and 2017: Gross Investment Returns and Benchmark Returns (1) Year Ended December 31, Common equity securities 29.1 % (7.7 )% 20.1 % Other long-term investments 52.4 % 10.0 % (5.8 )% Other long-term investments - excluding MediaAlpha Transaction 15.2 % 10.0 % (5.8 )% Total common equity securities and other long-term investments 36.9 % (3.6 )% 12.7 % Total common equity securities and other long-term investments - excluding MediaAlpha Transaction 25.7 % (3.6 )% 12.7 % S&P 500 Index (total return) 31.5 % (4.4 )% 21.8 % Fixed income investments 6.1 % 1.2 % 3.5 % Bloomberg Barclays U.S. Intermediate Aggregate Index 6.7 % 0.9 % 2.3 % Total consolidated portfolio 20.4 % (1.7 )% 5.6 % Total consolidated portfolio - excluding MediaAlpha Transaction 15.5 % (1.7 )% 5.6 % (1) For 2019 and 2018, investment returns are calculated using a daily weighted average of investments held. For 2017, investment returns are calculated using a quarterly weighted average of investments held. Investment Returns-Year Ended December 31, 2019 versus Year Ended December 31, 2018 White Mountains’s pre-tax total return on invested assets was 20.4% for 2019, which included a $115 million pre-tax unrealized investment gain from the MediaAlpha Transaction. Excluding the MediaAlpha Transaction, White Mountains’s pre-tax total return on invested assets was 15.5% for of 2019, compared to -1.7% for 2018. Investment returns for 2019 benefited from the decision to increase White Mountains’s equity exposure during the equity rout at the end of 2018, the strong rally in equity markets over the course of the year, and strong other long-term investments results. The strong other long-term investment results were driven primarily by a $65 million increase in the fair value of White Mountains’s investment in MediaAlpha resulting from increases in profitability metrics since the MediaAlpha Transaction. Investment returns for 2018 were adversely impacted by the sharp decline in equity markets in the fourth quarter. Common Equity Securities and Other Long-Term Investments Results White Mountains’s portfolio of common equity securities and other long-term investments was $1.5 billion and $1.3 billion as of December 31, 2019 and 2018. See Note 3 - “Investment Securities”. White Mountains’s portfolio of common equity securities and other long-term investments represented approximately 52% and 49% of total invested assets as of December 31, 2019 and 2018. White Mountains’s portfolio of common equity securities and other long-term investments returned 36.9% for 2019, which included the $115 million pre-tax unrealized investment gain from the MediaAlpha Transaction. Excluding the MediaAlpha Transaction, White Mountains’s portfolio of common equity securities and other long-term investments returned 25.7% for 2019, compared to -3.6% for 2018. White Mountains’s portfolio of common equity securities primarily consists of passive ETFs and publicly-traded common equity securities that are actively managed by third-party registered investment advisers. White Mountains’s portfolio of common equity securities was $684 million and $926 million as of December 31, 2019 and 2018. White Mountains’s portfolio of common equity securities returned 29.1% for 2019, underperforming the S&P 500 Index return of 31.5%. White Mountains’s portfolio of common equity securities returned -7.7% for 2018, underperforming the S&P 500 Index return of -4.4%. The results in both periods were driven primarily by relative underperformance in White Mountains’s international common equity portfolios. White Mountains’s portfolio of ETFs seeks to provide investment results that generally correspond to the performance of the S&P 500 Index. White Mountains’s portfolio of ETFs was $536 million and $675 million as of December 31, 2019 and 2018. In 2019 and 2018, the ETF portfolio essentially earned the effective index return, before expenses, over the period in which White Mountains was invested in these funds. White Mountains has maintained long-standing relationships with a small number of third-party registered investment advisers (the “actively managed common equity portfolio”), including Highclere International Investors (“Highclere”), who invests in small- and mid-cap equity securities listed in markets outside of the United States and Canada through a unit trust, and Silchester International Investors (“Silchester”), who invests in value-oriented non-U.S. equity securities through a unit trust. In the third quarter of 2019, White Mountains redeemed $82 million from its Highclere and Silchester accounts in order to reduce its international exposure in the context of the size of its overall portfolio of common equity securities. White Mountains’s actively managed common equity portfolio was $147 million and $250 million as of December 31, 2019 and 2018. White Mountains’s actively managed common equity portfolio returned 24.2% for 2019, underperforming the S&P 500 Index return of 31.5%. White Mountains’s actively managed common equity portfolio returned -15.6% for 2018, underperforming the S&P 500 Index return of -4.4%. The results in both periods were driven primarily by relative underperformance in the international common equity portfolios managed by Highclere and Silchester. White Mountains maintains a portfolio of other long-term investments that primarily consists of unconsolidated entities, Kudu’s Participation Contracts, private equity funds, hedge funds, ILS funds and private debt instruments. White Mountains’s portfolio of other long-term investments was $856 million and $326 million as of December 31, 2019 and 2018. White Mountains’s other long-term investments portfolio returned 52.4% for 2019, which included the $115 million pre-tax unrealized investment gain from the MediaAlpha Transaction. Excluding the MediaAlpha Transaction, White Mountains’s other long-term investments portfolio returned 15.2% for 2019, compared to 10.0% for 2018. Investment returns for 2019 were driven primarily by a $65 million increase in the fair value of White Mountains’s investment in MediaAlpha resulting from increases in profitability metrics since the MediaAlpha Transaction. In addition, the investment returns were also driven by net investment income from Kudu’s Participation Contracts and a $15 million increase in the fair value of White Mountains’s investment in PassportCard/DavidShield resulting from increases in profitability metrics in its core businesses, partially offset by losses from certain unconsolidated entities. Investment results for 2018 were driven primarily by a $26 million increase in the fair value of White Mountains’s investment in PassportCard/DavidShield resulting from increases in profitability metrics in its core businesses, as well as strong private equity fund returns. In the second quarter of 2019, White Mountains made an investment in three multi-investor ILS funds managed by Elementum, a third-party registered investment adviser specializing in natural catastrophe ILS. Elementum manages separate accounts and pooled investment vehicles across various ILS sectors, including catastrophe bonds, collateralized reinsurance investments and industry loss warranties, on behalf of third-party clients. As of December 31, 2019, White Mountains had approximately $41 million invested in these three ILS funds and has committed an additional $10 million to a fourth fund. Fixed Income Results White Mountains’s fixed income portfolio, including short-term investments, was $1.4 billion and $1.3 billion as of December 31, 2019 and 2018. The duration of White Mountains’s fixed income portfolio, including short-term investments, was 2.8 years and 3.4 years as of December 31, 2019 and 2018. White Mountains’s fixed income portfolio includes fixed maturity investments and short-term investments in the Collateral Trusts of $320 million and $254 million as of December 31, 2019 and 2018. White Mountains’s fixed income portfolio returned 6.1% for 2019, underperforming the Bloomberg Barclays U.S. Intermediate Aggregate Index returns of 6.7%. The short duration and high liquidity positioning of White Mountains’s fixed income portfolio contributed to the underperformance relative to the benchmark as interest rates declined significantly during the period. White Mountains’s fixed income portfolio returned 1.2% for 2018, outperforming the Bloomberg Barclays U.S. Intermediate Aggregate Index returns of 0.9%. The short duration and high liquidity positioning of White Mountains’s fixed income portfolio contributed to the outperformance relative to the benchmark as interest rates rose during the period. Investment Returns-Year Ended December 31, 2018 versus Year Ended December 31, 2017 White Mountains’s pre-tax total return on invested assets was -1.7% for 2018, compared to 5.6% for 2017. Investment returns for 2018 were adversely impacted by the sharp decline in equity markets in the fourth quarter. Investment returns for 2017 benefited from the relatively short-duration of the fixed income portfolio and strong equity markets. Investment returns for 2017 include discontinued operations returns through the close of the OneBeacon Transaction. Common Equity Securities and Other Long-Term Investments Results White Mountains’s portfolio of common equity securities and other long-term investments was $1.3 billion and $1.1 billion as of December 31, 2018 and 2017. See Note 3 - “Investment Securities”. White Mountains’s portfolio of common equity securities and other long-term investments represented approximately 49% and 32% of total invested assets as of December 31, 2018 and 2017. White Mountains’s portfolio of common equity securities and other long-term investments returned -3.6% for 2018 compared to 12.7% for 2017. White Mountains’s portfolio of common equity securities was $926 million and $866 million as of December 31, 2018 and 2017. White Mountains’s portfolio of common equity securities returned -7.7% for 2018, underperforming the S&P 500 Index return of -4.4%, driven primarily by relative underperformance in White Mountains’s international common equity portfolios. White Mountains’s portfolio of common equity securities returned 20.1% for 2017, underperforming the S&P 500 Index return of 21.8%. White Mountains’s portfolio of ETFs was $675 million and $570 million as of December 31, 2018 and 2017. In 2018 and 2017, White Mountains’s portfolio of ETFs essentially earned the effective S&P 500 index return, before expenses, over the period in which White Mountains was invested in these funds. As of December 31, 2018 and 2017, White Mountains had approximately $250 million and $296 million of common equity securities invested with third-party registered investment advisers. White Mountains’s actively managed common equity portfolios returned -15.6% for 2018, underperforming the S&P 500 Index return of -4.4%, driven primarily by relative underperformance in the international common equity portfolios managed by Highclere and Silchester. White Mountains’s actively managed common equity portfolios returned 25.2% for 2017, outperforming the S&P 500 Index return of 21.8%. The outperformance was driven primarily by strong returns from the common equity portfolios managed by Silchester and Lateef. White Mountains’s other long-term investments portfolio returned 10.0% for 2018. The results were driven primarily by a $26 million increase in the fair value of White Mountains’s investment in PassportCard/DavidShield resulting from increases in profitability metrics in its core businesses, as well as strong private equity fund returns. White Mountains’s other long-term investments portfolio returned -5.8% for 2017. The results were driven primarily by losses from foreign currency forward contracts and White Mountains’s unconsolidated entities, partially offset by strong performance from private equity funds and favorable fair value adjustments to surplus notes issued to OneBeacon in connection with the sale of its runoff business. Fixed Income Results White Mountains’s fixed income portfolio, including short-term investments, was $1.3 billion and $2.3 billion as of December 31, 2018 and 2017. The duration of White Mountains’s fixed income portfolio, including short-term investments, was 3.4 years as of both December 31, 2018 and 2017. White Mountains’s fixed income portfolio includes fixed maturity investments and short-term investments in the Collateral Trusts of $254 million and $204 million as of December 31, 2018 and 2017. White Mountains’s fixed income portfolio returned 1.2% for 2018, outperforming the Bloomberg Barclays U.S. Intermediate Aggregate Index return of 0.9%. The short duration and high liquidity positioning of White Mountains’s fixed income portfolio contributed to the outperformance relative to the benchmark as interest rates rose during the period. White Mountains’s fixed income portfolio returned 3.5% for 2017, outperforming the Bloomberg Barclays U.S. Intermediate Aggregate Index return of 2.3% as short-term yields rose during the period. Portfolio Composition The following table presents the composition of White Mountains’s total operations investment portfolio as of December 31, 2019 and 2018: December 31, 2019 December 31, 2018 $ in Millions Carrying Value % of Total Carrying Value % of Total Fixed maturity investments $ 1,205.8 40.9 % $ 1,077.5 42.4 % Short-term investments 201.2 6.8 214.2 8.4 Common equity securities 683.9 23.2 925.6 36.4 Other long-term investments 856.3 29.1 325.6 12.8 Total investments $ 2,947.2 100.0 % $ 2,542.9 100.0 % The following table presents the breakdown of White Mountains’s fixed maturity investments as of December 31, 2019 by credit class, based upon issuer credit ratings provided by Standard & Poor’s, or if unrated by Standard & Poor’s, long-term obligation ratings provided by Moody’s: December 31, 2019 $ in Millions Amortized Cost % of Total Carrying Value % of Total U.S. government and government-sponsored entities (1) $ 409.3 34.7 % $ 412.4 34.1 % AAA/Aaa 67.9 5.8 69.5 5.8 AA/Aa 265.2 22.5 275.7 22.9 A/A 335.7 28.5 345.6 28.7 BBB/Baa 97.8 8.3 100.6 8.3 Other/not rated 2.0 0.2 2.0 0.2 Total fixed maturity investments $ 1,177.9 100.0 % $ 1,205.8 100.0 % (1) Includes mortgage-backed securities, which carry the full faith and credit guaranty of the U.S. government (i.e., GNMA) or are guaranteed by a government sponsored entity (i.e., FNMA, FHLMC). The cost or amortized cost and carrying value of White Mountains’s fixed maturity investments as of December 31, 2019 is presented below by contractual maturity. Actual maturities could differ from contractual maturities because certain borrowers may call or prepay their obligations with or without call or prepayment penalties. December 31, 2019 Millions Amortized Cost Carrying Value Due in one year or less $ 190.0 $ 190.8 Due after one year through five years 481.6 489.3 Due after five years through ten years 165.3 173.2 Due after ten years 134.4 143.5 Mortgage and asset-backed securities 206.6 209.0 Total fixed maturity investments $ 1,177.9 $ 1,205.8 Foreign Currency Exposure As of December 31, 2019, White Mountains had foreign currency exposure on $191 million of net assets primarily related to common equity securities managed by Silchester and Highclere, NSM’s U.K. operations and certain foreign consolidated and unconsolidated entities. From time to time, White Mountains may enter into foreign currency forward contracts in order to mitigate its foreign currency exposure on certain invested assets. As of December 31, 2019, White Mountains does not have any open foreign currency forward contracts. The following table presents the fair value of White Mountains’s foreign denominated net assets as of December 31, 2019: $ in Millions Currency Fair Value % of Common Shareholders’ Equity GBP $ 70.4 2.2 % EUR 40.0 1.2 JPY 39.0 1.2 All other 41.2 1.2 Total $ 190.6 5.8 % Income Taxes The Company and its Bermuda domiciled subsidiaries are not subject to Bermuda income tax under current Bermuda law. In the event there is a change in the current law and taxes are imposed, the Company and its Bermuda domiciled subsidiaries would be exempt from such tax until March 31, 2035 pursuant to the Bermuda Exempted Undertakings Tax Protection Act of 1966. The Company has subsidiaries and branches that operate in various other jurisdictions around the world and are subject to tax in the jurisdictions in which they operate. White Mountains reported income tax expense of $29 million in 2019 on pre-tax income from continuing operations of $405 million. White Mountains’s effective tax rate was different from the current U.S. federal statutory rate of 21% primarily due to income generated in jurisdictions with lower tax rates than the United States, state income taxes and a tax benefit recorded at BAM related to its MSC collected. Also, the effective tax rate for 2019 was different from the current U.S. federal statutory rate of 21% due to the release of a valuation allowance on the net deferred tax assets of the U.S. consolidated group Guilford Holdings, Inc. and subsidiaries (“Guilford”), which includes Kudu, White Mountains’s investment in MediaAlpha, WM Capital, WM Advisors and certain other entities and investments that are included in the Other Operations segment. For BAM, MSC collected and the related taxes thereon, are recorded directly to non-controlling interest equity, while the valuation allowance on such taxes is recorded through the income statement. As a result, BAM recorded a tax benefit of $10 million associated with the valuation allowance on taxes related to MSC collected that is included in the effective tax rate. See Note 6 - “Income Taxes” on page. White Mountains reported income tax benefit of $4 million in 2018 on pre-tax loss from continuing operations of $178 million. White Mountains’s effective tax rate was different from the current U.S. federal statutory rate of 21% primarily due to a full valuation allowance on the net deferred tax assets of Guilford, income generated in jurisdictions with lower tax rates than the United States, withholding taxes and a tax benefit recorded at BAM related to its MSC collected. For BAM, MSC collected and the related taxes thereon are recorded directly to non-controlling interest equity, while the valuation allowance on such taxes is recorded through the income statement. As a result, BAM recorded a tax benefit of $9 million associated with the valuation allowance on taxes related to MSC collected that is included in the effective tax rate. White Mountains reported income tax benefit of $8 million in 2017 on pre-tax income from continuing operations of $8 million. White Mountains’s effective tax rate was different from the 2017 U.S. federal statutory rate of 35% primarily due to a full valuation allowance on the net deferred tax assets of Guilford net of the impact of tax rate changes, income generated in jurisdictions with lower tax rates than the United States, a tax benefit recorded at BAM related to its MSC collected and consolidated pre-tax income being near break-even. For BAM, MSC collected and the related taxes thereon are recorded directly to non-controlling interest equity, while the valuation allowance on such taxes is recorded through the income statement. As a result, BAM recorded a tax benefit of $10 million associated with the valuation allowance on taxes related to MSC collected that is included in the effective tax rate. Discontinued Operations White Mountains has entered into a number of sale transactions that have been accounted for as discontinued operations within its consolidated financial statements. See Note 20 - “Held for Sale and Discontinued Operations” on page for detailed financial information on each business sold. OneBeacon On September 28, 2017, Intact Financial Corporation completed its acquisition of OneBeacon Insurance Group, Ltd. in an all-cash transaction for $18.10 per share. OneBeacon Results - Period Ended September 28, 2017 For the 2017 period, White Mountains reported net income from OneBeacon of $21 million in discontinued operations. OneBeacon’s combined ratio for the 2017 period was 105%, driven by four points of net unfavorable loss reserve development, primarily in the Program, Healthcare and Government Risk businesses, and four points of catastrophe losses, primarily due to losses from Hurricane Harvey. Sirius Group On April 18, 2016, White Mountains completed the sale of Sirius Group to CMI. Sirius Group’s results inured to White Mountains until the closing date of the transaction. Sirius Group Tax Contingency In late October 2018, the Swedish Administrative Court ruled against Sirius Group on its appeal of the Swedish Tax Agency’s denial of certain interest deductions relating to periods prior to the sale of Sirius Group to CMI in 2016. In connection with the sale, White Mountains indemnified Sirius Group against the loss of these interest deductions. As a result, in the third quarter of 2018, White Mountains recorded a loss of $17 million within net (loss) gain on sale of discontinued operations reflecting the value of these interest deductions. For the year ended December 31, 2019, White Mountains recognized a net foreign currency translation gain of $1 million that is included within net gain from sale of Sirius Group in discontinued operations. LIQUIDITY AND CAPITAL RESOURCES Operating Cash and Short-term Investments Holding Company Level The primary sources of cash for the Company and certain of its intermediate holding companies are expected to be distributions from its operating subsidiaries, net investment income, proceeds from sales, repayments and maturities of investments, capital raising activities and, from time to time, proceeds from sales of operating subsidiaries. The primary uses of cash are expected to be general and administrative expenses, purchases of investments, payments to tax authorities, payments on and repurchases/retirements of its debt obligations, dividend payments to holders of the Company’s common shares, distributions to non-controlling interest holders of consolidated subsidiaries, contributions to operating subsidiaries and, from time to time, purchases of operating subsidiaries and repurchases of the Company’s common shares. Operating Subsidiary Level The primary sources of cash for White Mountains’s operating subsidiaries are expected to be commissions, fees and premium collections, net investment income, proceeds from sales, repayments and maturities of investments, contributions from holding companies and capital raising activities. The primary uses of cash are expected to be general and administrative expenses, broker commission expenses, cost of sales, insurance acquisition expenses, loss payments, purchases of investments, payments to tax authorities, payments on and repurchases/retirements of its debt obligations, distributions made to holding companies, distributions to non-controlling interest holders and, from time to time, purchases of operating subsidiaries. Both internal and external forces influence White Mountains’s financial condition, results of operations and cash flows. Premium and fee levels, loss payments, cost of sales and investment returns may be impacted by changing rates of inflation and other economic conditions. Some time may lapse between the occurrence of an insured loss, the reporting of the loss to White Mountains’s operating subsidiaries and the settlement of the liability for that loss. The exact timing of the payment of losses and benefits cannot be predicted with certainty. Management believes that White Mountains’s cash balances, cash flows from operations and routine sales and maturities of investments are adequate to meet expected cash requirements for the foreseeable future on both a holding company and operating subsidiary level. Dividend Capacity Following is a description of the dividend capacity of White Mountains’s reinsurance and other operating subsidiaries: HG Global/BAM As of December 31, 2019, HG Global had $619 million face value of preferred shares outstanding, of which White Mountains owned 96.9%. Holders of the HG Global preferred shares receive cumulative dividends at a fixed annual rate of 6.0% on a quarterly basis, when and if declared by HG Global. HG Global declared and paid preferred dividends of $2 million in 2019. As of December 31, 2019, HG Global had accrued $342 million of dividends payable to holders of its preferred shares, $330 million of which is payable to White Mountains and eliminated in consolidation. As of December 31, 2019, HG Global and its subsidiaries had $3 million of cash outside of HG Re. HG Re is a Special Purpose Insurer subject to regulation and supervision by the BMA but does not require regulatory approval to pay dividends. However, HG Re’s dividend capacity is limited to amounts held outside of the Collateral Trusts pursuant to the FLRT with BAM. As of December 31, 2019, HG Re had $745 million of statutory capital and surplus and $787 million of assets held in the Collateral Trusts pursuant to the FLRT with BAM. On a monthly basis, BAM deposits cash equal to ceded premiums, net of ceding commissions, due to HG Re under the FLRT directly into the Regulation 114 Trust. The Regulation 114 Trust target balance is equal to gross ceded unearned premiums and unpaid ceded loss and LAE expenses, if any. If, at the end of any quarter, the Regulation 114 Trust balance is below the target balance, funds will be withdrawn from the Supplemental Trust and deposited into the Regulation 114 Trust in an amount equal to the shortfall. If, at the end of any quarter, the Regulation 114 Trust balance is above 102% of the target balance, funds will be withdrawn from the Regulation 114 Trust and deposited into the Supplemental Trust. The Supplemental Trust Target Balance is $603 million, less the amount of cash and securities in the Regulation 114 Trust in excess of its target balance. If, at the end of any quarter, the Supplemental Trust balance exceeds the Supplemental Trust Target Balance, such excess may be distributed to HG Re. The distribution will be made first as an assignment of accrued interest on the BAM Surplus Notes and second in cash and/or fixed income securities. As the BAM Surplus Notes are repaid over time, the BAM Surplus Notes will be replaced in the Supplemental Trust by cash and fixed income securities. As of December 31, 2019, HG Re had $6 million of cash and investments and $111 million of accrued interest on the BAM Surplus Notes held outside the Collateral Trusts. Effective January 1, 2014, HG Global and BAM agreed to change the interest rate on the BAM Surplus Notes for the five years ending December 31, 2018 from a fixed rate of 8.0% to a variable rate equal to the one-year U.S. Treasury rate plus 300 basis points, set annually. In 2018, BAM exercised its option to extend the variable rate period for an additional three years and, during 2020, the interest rate will be 4.6%. In January 2020, HG Global and BAM agreed to amend the BAM Surplus Notes to extend the end of the variable interest rate period until December 31, 2024. At the end of the variable rate period, the interest rate will be fixed at the higher of the then current variable rate or 8.0%. BAM is required to seek regulatory approval to pay interest and principal on the BAM Surplus Notes only to the extent that its remaining qualified statutory capital and other capital resources continue to support its outstanding obligations, its business plan and its “AA/stable” rating from Standard & Poor’s. No payment of principal or interest on the BAM Surplus Notes may be made without the approval of the NYDFS. In December 2019, BAM made a $32 million cash payment of principal and interest on the BAM Surplus Notes held by HG Global. Of this payment, $24 million was a repayment of principal held in the Supplemental Trust and $8 million was a payment of accrued interest held outside the Supplemental Trust. In January 2020, BAM made an additional $65 million special cash payment of principal and interest on the BAM Surplus Notes. Of this payment, $48 million was a repayment of principal held in the Supplemental Trust, $1 million was a payment accrued interest held in the Supplemental Trust and $16 million was a payment of accrued interest held outside the Supplemental Trust. NSM During 2019, NSM did not make any distributions to unitholders. As of December 31, 2019, NSM had $33 million of net unrestricted cash. Kudu In December 2019, Kudu entered into a secured credit facility to provide funding for distributions to unitholders and fund new investments and related transaction expenses. At closing, Kudu drew an initial term loan of $57 million to pay transaction expenses and to distribute $54 million to unitholders, of which $53 million was paid to White Mountains. As of December 31, 2019, Kudu had $6 million of net unrestricted cash and short-term investments. Other Operations During 2019, White Mountains paid a $3 million common share dividend. As of December 31, 2019, the Company and its intermediate holding companies had $603 million of net unrestricted cash, short-term investments and fixed maturity investments, $684 million of common equity securities and $202 million of private equity funds, hedge funds and ILS funds. Financing The following table summarizes White Mountains’s capital structure as of December 31, 2019 and 2018: December 31, $ in Millions NSM Bank Facility, net of unamortized issuance costs $ 217.4 $ 176.6 Other NSM debt 1.8 1.9 Kudu Bank Facility, net of unamortized issuance costs 53.6 - MediaAlpha Bank Facility, net of unamortized issuance costs - 14.2 Other Operations debt 10.7 - Total debt 283.5 192.7 Non-controlling interests - other, excluding BAM 29.9 45.7 Total White Mountains’s common shareholders’ equity 3,261.5 2,843.1 Total capital 3,574.9 3,081.5 Time-value discount on expected future payments on the BAM Surplus Notes (1) (151.6 ) (141.2 ) HG Global’s unearned premium reserve (1) 156.7 136.9 HG Global’s net deferred acquisition costs (1) (41.5 ) (34.6 ) Total adjusted capital $ 3,538.5 $ 3,042.6 Total debt to total adjusted capital 8.0 % 6.3 % (1) Amount reflects White Mountains's preferred share ownership in HG Global of 96.9%. Management believes that White Mountains has the flexibility and capacity to obtain funds externally through debt or equity financing on both a short-term and long-term basis. However, White Mountains can provide no assurance that, if needed, it would be able to obtain additional debt or equity financing on satisfactory terms, if at all. It is possible that, in the future, one or more of the rating agencies may lower White Mountains’s existing ratings. If one or more of its ratings were lowered, White Mountains could incur higher borrowing costs on future borrowings and its ability to access the capital markets could be impacted. On May 11, 2018, NSM entered into a secured credit facility (the “NSM Bank Facility”) with Ares Capital Corporation in order to refinance NSM’s existing debt and to fund the acquisitions of subsidiaries. The NSM Bank Facility has a total commitment of $234 million, which is comprised of term loans of $224 million and a revolving credit loan of $10 million. The term loans under the NSM Bank Facility mature on May 11, 2024, and the revolving loan under the NSM Bank Facility matures on May 11, 2023. During 2019, NSM borrowed $43 million of incremental term loans, which included $20 million and $23 million for the funding of the acquisitions of Embrace and the Renewal Rights from AIG, respectively, and repaid $2 million of the term loans. Additionally, during 2019, NSM borrowed and repaid $7 million of revolving credit loans under the NSM Bank Facility. As of December 31, 2019, the term loans had an outstanding balance of $221 million and the revolving credit loans were undrawn. Interest on the NSM Bank Facility accrues at a floating interest rate equal to the three-month LIBOR or the Prime Rate, as published by the Wall Street Journal plus, in each case, an applicable margin. The margin over LIBOR may vary between 4.25% and 4.75%, and the margin over the Prime Rate may vary between 3.25% and 3.75%, in each case, depending on the consolidated total leverage ratio of the borrower. On June 15, 2018, NSM entered into an interest rate swap agreement to hedge its exposure to interest rate risk on $151 million of its variable rate term loans. Under the terms of the swap agreement, NSM pays a fixed rate of 2.97% and receives a variable rate, which is reset monthly, based on then-current LIBOR. As of December 31, 2019, the variable rate received by NSM under the swap agreement was 1.71%. As of December 31, 2019, the interest rate, including the effect of the swap, for the outstanding term loans of $149 million that are hedged by the swap was 7.47%. The effective interest on the outstanding term loans of $73 million that are unhedged was 6.21%. The effective interest rate on the total outstanding term loans under the NSM Bank Facility of $221 million was 7.06%, excluding the effect of debt issuance costs. The NSM Bank Facility is secured by all property of the loan parties and contains various affirmative, negative and financial covenants that White Mountains considers to be customary for such borrowings, including a maximum consolidated total leverage ratio covenant. NSM also has a secured term loan related to its U.K.-based operations. As of December 31, 2019, the secured term loan had an outstanding balance of $2 million and a maturity date of May 11, 2024. On December 23, 2019, Kudu entered into a secured credit facility (the “Kudu Bank Facility”) with Monroe Capital Management Advisors, LLC to provide funding for distributions to unitholders and fund new investments and related transaction expenses. The Kudu Bank Facility has a maximum borrowing capacity of $125 million, which is comprised of an initial term loan of $57 million, a delayed-draw term loan of $63 million and a revolving credit loan of $5 million. The term loans and the revolving credit loans under the Kudu Bank Facility mature in 2025. During 2019, Kudu borrowed $57 million in term loans under the Kudu Bank Facility and had no repayments. As of December 31, 2019, the term loans had an outstanding balance of $57 million and the revolving loan was undrawn. Interest on the Kudu Bank Facility accrues at a floating interest rate equal to the one-month LIBOR plus 1% or the Prime Rate plus, in each case, an applicable margin. The margin over LIBOR may vary between 5.50% and 6.25% and the margin over the Prime Rate may vary between 4.50% and 5.25%, depending on the consolidated total leverage ratio of the borrower. The Kudu Bank Facility is secured by all property of the loan parties and contains various affirmative, negative and financial covenants that White Mountains considers to be customary for such borrowings, including a maximum consolidated total leverage ratio covenant. As of December 31, 2019, debt in White Mountains’s Other Operations segment consisted of a secured credit facility that had a term loan of $11 million, a delayed-draw term loan of $3 million and a revolving credit loan commitment of $2 million, all with a maturity date of March 12, 2024. Covenant Compliance As of December 31, 2019, White Mountains was in compliance with all of the covenants under all of its debt instruments. NSM Bank Facility The consolidated total leverage ratio in the NSM Bank Facility is determined by dividing NSM’s debt by its EBITDA, both as defined in the NSM Bank Facility. Debt is defined to include indebtedness for borrowed money, due and payable earnouts on permitted acquisitions and various other adjustments specified in the NSM Bank Facility, less unrestricted cash and cash equivalents (“Bank Debt”). NSM’s Bank Debt was $190 million as of December 31, 2019. EBITDA is defined to include adjusted EBITDA (see NON-GAAP FINANCIAL MEASURES on page 58) plus additional adjustments (i) to exclude certain expenses not already excluded from adjusted EBITDA as specified in NSM’s Bank Facility and (ii) to include/exclude historical earnings of acquired/disposed companies (“Bank EBITDA”). NSM’s Bank EBITDA was $53 million for the trailing twelve months ended December 31, 2019. The maximum consolidated total leverage ratio covenant was 5.5x. NSM’s actual consolidated total leverage ratio as of December 31, 2019 was 3.6x. Contractual Obligations and Commitments The following table presents White Mountains’s material contractual obligations and commitments as of December 31, 2019: Millions Due in Less Than One Year Due in One to Three Years Due in Three to Five Years Due After Five Years Total Debt $ 2.8 $ 7.0 $ 226.2 $ 55.2 $ 291.2 Interest on debt 15.7 30.6 73.0 - 119.3 Long-term incentive compensation 29.6 37.0 - - 66.6 Contingent consideration earnout liabilities (1) 20.6 - - - 20.6 Operating leases (2) 7.1 11.8 9.6 8.8 37.3 Total contractual obligations and commitments $ 75.8 $ 86.4 $ 308.8 $ 64.0 $ 535.0 (1) The contingent consideration earnout liabilities are related to NSM’s previous acquisitions of Fresh Insurance, KBK and its other U.K.-based operations. Any future adjustments due after one year, which are based upon EBITDA, EBITDA projections, and present value factors for acquired entities, are not included in the table. See Note 2 - “Significant Transactions” on page. (2) Amounts include BAM’s operating lease amounts of $2.1, $3.6, $3.6 and $2.4 that are due in less than one year, one to three years, three to five years, and due after five years, which are attributed to non-controlling interests. The long-term incentive compensation balances included in the table above include amounts payable for performance shares. Exact amounts to be paid for performance shares cannot be predicted with certainty, as the ultimate amounts of these liabilities are based on the future performance of White Mountains and the market price of the Company’s common shares at the time the payments are made. The estimated payments reflected in the table are based on current accrual factors (including performance relative to targets and common share price) and assume that all outstanding balances were 100% vested as of December 31, 2019. There are no provisions within White Mountains’s operating leasing agreements that would trigger acceleration of future lease payments. White Mountains does not finance its operations through the securitization of its trade receivables, through special purpose entities or through synthetic leases. Further, White Mountains has not entered into any material arrangements requiring it to guarantee payment of third-party debt or lease payments or to fund losses of an unconsolidated special purpose entity. White Mountains also has future binding commitments to fund certain other long-term investments. These commitments, which totaled approximately $183 million as of December 31, 2019, do not have fixed funding dates and, are therefore, excluded from the table above. Share Repurchase Programs White Mountains’s board of directors has authorized the Company to repurchase its common shares from time to time, subject to market conditions. The repurchase authorizations do not have a stated expiration date. As of December 31, 2019, White Mountains may repurchase an additional 635,705 shares under these board authorizations. In addition, from time to time White Mountains has also repurchased its common shares through tender offers that were separately approved by its board of directors. On May 11, 2018, White Mountains completed a “modified Dutch auction” tender offer, through which it repurchased 575,068 of its common shares at a purchase price of $875 per share for a total cost of approximately $505 million, including expenses. Shares repurchased under this tender offer did not impact the remaining number of shares authorized for repurchase. The following table presents common shares repurchased by the Company as well as the average price per share as a percent of adjusted book value per share. For 2018, the table also presents the average price per share as a percent of adjusted book value per share, including the estimated gain from the MediaAlpha Transaction of $55 per share. Average Price Per Share as % of Adjusted Book Value Adjusted Per Share, Including Average Book Estimated Gain From Shares Cost Price Value Adjusted Book MediaAlpha Year Ended Repurchased (Millions) Per Share Per Share Value Per Share Transaction December 31, 2019 5,679 $ 4.9 $ 857.69 $ 1,018.41 84% N/A December 31, 2018 592,458 $ 519.4 $ 876.69 $ 887.85 99% 93% December 31, 2017 832,725 $ 723.9 $ 869.29 $ 914.75 95% N/A Cash Flows Detailed information concerning White Mountains’s cash flows during 2019, 2018 and 2017 follows: Cash flows from continuing operations for the years ended 2019, 2018 and 2017 Net cash flows used for continuing operations was $121 million, $31 million and $62 million for the years ended 2019, 2018 and 2017. Cash used from continuing operations was higher in 2019 compared to 2018, driven primarily by Kudu’s deployments in asset management firms. Cash used from continuing operations was lower in 2018 compared to 2017, primarily due to $28 million of payments made in 2017 related to the departures of the Company’s former Chairman and CEO and former CFO. White Mountains does not believe that these trends will have a meaningful impact on its future liquidity or its ability to meet its future cash requirements. The Company and its intermediate holding companies had $603 million of net unrestricted cash, short-term investments and fixed maturity investments, $684 million of common equity securities and $202 million of private equity funds, hedge funds and ILS funds as of December 31, 2019. Cash flows from investing and financing activities for the year ended December 31, 2019 Financing and Other Capital Activities During 2019, the Company declared and paid a $3 million cash dividend to its common shareholders. During 2019, White Mountains repurchased and retired 5,679 of its common shares for $5 million, all of which were repurchased under employee benefit plans for statutory withholding tax payments. During 2019, BAM received $55 million in MSC. During 2019, BAM repaid $24 million of principal and paid $8 million of accrued interest on the BAM Surplus Notes. During 2019, NSM borrowed $43 million of term loans under the NSM Bank Facility, which included $20 million and $23 million for the funding of the acquisitions of Embrace and the Renewal Rights from AIG, and $7 million of revolving credit loans. Additionally, during 2019 NSM repaid $2 million of term loans and $7 million of revolving credit loans under the NSM Bank Facility. During 2019, Kudu borrowed $57 million in term loans under the Kudu Bank Facility and distributed $54 million to unitholders, of which $53 million was paid to White Mountains. As of December 31, 2019, Kudu has not made any payment on the Kudu Bank Facility. Acquisitions and Dispositions On February 26, 2019, White Mountains received net cash proceeds of $89 million from the MediaAlpha Transaction. On April 1, 2019, White Mountains acquired additional newly-issued units of NSM for $58 million in connection with NSM’s acquisition of Embrace. On April 1, 2019, NSM acquired 100% of Embrace for $72 million, net of cash acquired. On April 4, 2019, White Mountains completed the Kudu Transaction for $81 million. In addition, White Mountains assumed all of Oaktree’s unfunded capital commitments to Kudu, increasing White Mountains’s total capital commitment to $250 million. During the fourth quarter of 2019, White Mountains increased its total capital commitment to Kudu by an additional $100 million to $350 million, of which $129 million is undrawn as of December 31, 2019. Also during the fourth quarter of 2019, Kudu obtained a committed $125 million credit facility, of which $68 million was undrawn as of December 31, 2019. During 2019, Kudu deployed $203 million, including transaction costs, in seven asset management firms and has now deployed a total of $266 million, including transaction costs, in nine asset management firms. On May 31, 2019, White Mountains completed the Elementum Transaction for $55 million. As part of the Elementum Transaction, White Mountains also committed to invest $50 million in ILS funds managed by Elementum. As of December 31, 2019, White Mountains had invested $40 million into Elementum-managed ILS funds. On June 28, 2019, White Mountains acquired additional newly-issued units of NSM for $59 million in connection with NSM’s acquisition of the Renewal Rights from AIG. On June 28, 2019, NSM acquired the Renewal Rights from AIG for $83 million. Cash flows from investing and financing activities for the year ended December 31, 2018 Financing and Other Capital Activities During 2018, the Company declared and paid a $4 million cash dividend to its common shareholders. During 2018, the Company repurchased and retired 592,458 of its common shares for $519 million, which included 9,965 of common shares for $8 million under employee benefit plans for statutory withholding tax payments. During 2018, BAM received $54 million in MSC. During 2018, BAM repaid $18 million of principal and paid $5 million of accrued interest on the BAM Surplus Notes. During 2018, NSM borrowed $51 million of term loans under the NSM Bank Facility to fund the Fresh Insurance acquisition and $30 million of term loans to fund the KBK acquisition. Additionally, during 2018, NSM repaid $1 million on the term loans and $2 million on the revolving credit loan under the NSM Bank Facility. During 2018, MediaAlpha distributed $16 million to unitholders, of which $10 million was paid to White Mountains. During 2018, MediaAlpha repaid $4 million on the term loan and borrowed $3 million and repaid $9 million on the revolving loan under the MediaAlpha Bank Facility. Acquisitions and Dispositions On January 24, 2018, White Mountains paid $42 million in connection with the DavidShield transaction. On May 11, 2018, White Mountains closed its acquisition of 95.0% of NSM (83.6% on a fully diluted, fully converted basis) for a purchase price of $274 million. White Mountains paid a purchase price adjustment of $2 million in the fourth quarter of 2018. On May 18, 2018, NSM acquired 100% of Fresh Insurance for a purchase price of GBP 37 million (approximately $50 million). On December 3, 2018, White Mountains acquired additional newly-issued units of NSM for $29 million in connection with NSM’s acquisition of KBK. On December 3, 2018, NSM acquired all of the net assets of KBK for a purchase price of $60 million. Cash flows from investing and financing activities for the year ended December 31, 2017 Financing and Other Capital Activities During 2017, the Company declared and paid a $5 million cash dividend to its common shareholders. During 2017, the Company repurchased and retired 832,725 of its common shares for $724 million, which included 10,993 of common shares for $9 million under employee benefit plans for statutory withholding tax payments. During 2017, the Company borrowed and repaid $350 million under the WTM Bank Facility. During 2017, BAM received $37 million in MSC. During 2017, BAM repaid $4 million of principal and paid $1 million of accrued interest on the BAM Surplus Notes. During 2017, MediaAlpha distributed $5 million to unitholders, of which $3 million was paid to White Mountains. During 2017, MediaAlpha borrowed $20 million on the term loan and $6 million on the revolving loan under the MediaAlpha Bank Facility. During 2017, MediaAlpha repaid $13 million under the previous MediaAlpha Bank Facility and $2 million on the term loan under the MediaAlpha Bank Facility. During 2017, White Mountains received $45 million of dividends from OneBeacon, which is reported as discontinued operations. Acquisitions and Dispositions On September 28, 2017, OneBeacon closed its definitive merger agreement with Intact and White Mountains received proceeds of $1,299 million, or $18.10 per OneBeacon common share. On October 5, 2017, White Mountains purchased additional newly-issued units of MediaAlpha for $13 million. On October 5, 2017, MediaAlpha acquired certain assets associated with the Health, Life and Medicare insurance business of Healthplans.com for an aggregate purchase price of $28 million. TRANSACTIONS WITH RELATED PERSONS See Note 18 - “Transactions with Related Persons” on page in the accompanying Consolidated Financial Statements. NON-GAAP FINANCIAL MEASURES This report includes nine non-GAAP financial measures that have been reconciled with their most comparable GAAP financial measures. Adjusted book value per share is a non-GAAP financial measure which is derived by adjusting (i) the GAAP book value per share numerator and (ii) the common shares outstanding denominator, as described below. The GAAP book value per share numerator is adjusted (i) to include a discount for the time value of money arising from the modeled timing of cash payments of principal and interest on the BAM Surplus Notes and (ii) to add back the unearned premium reserve, net of deferred acquisition costs, at HG Global. Under GAAP, White Mountains is required to carry the BAM Surplus Notes, including accrued interest, at nominal value with no consideration for time value of money. Based on a debt service model that forecasts operating results for BAM through maturity of the BAM Surplus Notes, the present value of the BAM Surplus Notes, including accrued interest and using an 8.0% discount rate, was estimated to be $157 million, $146 million and $162 million less than the nominal GAAP carrying values as of December 31, 2019, 2018 and 2017, respectively. The value of HG Global’s unearned premium reserve, net of deferred acquisition costs, was $119 million, $106 million and $82 million as of December 31, 2019, 2018 and 2017, respectively. White Mountains believes these adjustments are useful to management and investors in analyzing the intrinsic value of HG Global, including the value of the BAM Surplus Notes and the value of the in-force business at HG Re, HG Global’s reinsurance subsidiary. The denominator used in the calculation of adjusted book value per share equals the number of common shares outstanding adjusted to exclude unearned restricted common shares, the compensation cost of which, at the date of calculation, has yet to be amortized. Restricted common shares are earned on a straight-line basis over their vesting periods. The reconciliation of GAAP book value per share to adjusted book value per share is included on page 30. The underlying growth in adjusted book value per share on page 30 reflects the estimated gain from the MediaAlpha Transaction as if it had closed as of December 31, 2018. A reconciliation from GAAP to the reported percentage is as follows: As of December 31, 2019 As of December 31, 2018 Growth % (1) GAAP book value per share $ 1,023.91 $ 896.00 14.4 % Estimated gain from the MediaAlpha Transaction as of December 31, 2018 - 55.07 GAAP book value per share including the estimated gain from the MediaAlpha Transaction as of December 31, 2018 1,023.91 951.07 7.8 % Adjustments to book value per share (see reconciliation on page 30) (5.50 ) (8.15 ) Adjusted book value per share including the estimated gain from the MediaAlpha Transaction as of December 31, 2018 $ 1,018.41 $ 942.92 8.1 % (1) Growth includes $1.00 per share dividend paid during the first quarter of 2019. As of December 31, 2018 As of December 31, 2017 Growth % (1) GAAP book value per share $ 896.00 $ 931.30 (3.7 )% Estimated gain from the MediaAlpha Transaction as of December 31, 2018 55.07 - GAAP book value per share including the estimated gain from the MediaAlpha Transaction as of December 31, 2018 951.07 931.30 2.2 % Adjustments to book value per share (see reconciliation on page 30) (8.15 ) (16.55 ) Adjusted book value per share including the estimated gain from the MediaAlpha Transaction as of December 31, 2018 $ 942.92 $ 914.75 3.2 % (1) Growth includes $1.00 per share dividend paid during the first quarter of 2018. Gross written premiums and MSC from new business is a non-GAAP financial measure, which is derived by adjusting gross written premiums and MSC collected (i) to include the present value of future installment MSC not yet collected and (ii) to exclude the impact of gross written premium adjustments related to policies closed in prior periods. White Mountains believes these adjustments are useful to management and investors in evaluating the volume and pricing of new business closed during the period. The reconciliation from GAAP gross written premiums to gross written premiums and MSC from new business is included on page 35. Total capital at White Mountains is comprised of White Mountains’s common shareholders’ equity, debt and non-controlling interests other than non-controlling interests attributable to BAM. Total adjusted capital is a non-GAAP financial measure, which is derived by adjusting total capital (i) to include a discount for the time value of money arising from the expected timing of cash payments of principal and interest on the BAM Surplus Notes and (ii) to add back the unearned premium reserve, net of deferred acquisition costs, at HG Global. The reconciliation of total capital to total adjusted capital is included on page 53. NSM’s EBITDA and adjusted EBITDA are non-GAAP financial measures. EBITDA is a non-GAAP financial measure that excludes interest expense on debt, income tax benefit (expense), depreciation and amortization from GAAP net income (loss). Adjusted EBITDA is a non-GAAP financial measure that excludes certain other items in GAAP net income (loss) in addition to those excluded from EBITDA. The adjustments relate to (i) change in fair value of contingent consideration earnout liabilities, (ii) acquisition-related transaction expenses, (iii) fair value purchase accounting adjustment for deferred revenue, (iv) investments made in the development of new business lines and (v) restructuring expenses. A description of each follows: • Change in fair value of contingent consideration earnout liabilities - Earnout liabilities are amounts payable to the sellers of businesses purchased by NSM that are contingent on the earnings of such businesses in periods subsequent to their acquisition. Under GAAP, earnout liabilities are not capitalized as part of the purchase price. Earnout liabilities are recorded at fair value, with the periodic change in the fair value of these liabilities recorded as income or an expense. • Acquisition-related transaction expenses - Represents costs directly related to NSM’s transactions to acquire businesses, such as transaction-related compensation, impairments of intangible assets, banking, accounting and external lawyer fees, which are not capitalized and are expensed under GAAP. • Fair value purchase accounting adjustment for deferred revenue - Represents the amount of deferred revenue that had already been collected but subsequently written down in connection with establishing the fair value of deferred revenue as part of NSM’s purchase accounting for Embrace. • Investments made in the development of new business lines - Represents the net loss related to the start-up of newly established lines of business, which NSM views as investments. For the periods presented, this adjustment relates primarily to NSM’s investment expenditures, net of revenues generated, in the organic development of (i) its pet insurance line and (ii) its MGA in the United Kingdom. NSM recently decided to cease investment in the organic development of its pet insurance line and, instead, to acquire Embrace, which closed in April 2019. • Restructuring expenses - Represents expenses associated with eliminating redundant work force and facilities that often arise as a result of NSM’s post-acquisition integration strategies. White Mountains believes that these non-GAAP financial measures are useful to management and investors in evaluating NSM’s performance. See page 40 for the reconciliation of NSM’s GAAP net income (loss) to EBITDA and adjusted EBITDA. Total consolidated portfolio returns excluding the MediaAlpha Transaction, common equity securities and other long-term investment returns excluding the MediaAlpha Transaction and other long-term investments returns excluding the MediaAlpha Transaction are non-GAAP financial measures that remove the $115 million pre-tax unrealized investment gain resulting from the MediaAlpha Transaction recognized in the first quarter of 2019. Subsequent to the MediaAlpha Transaction, White Mountains no longer consolidates MediaAlpha and accounts for its remaining investment in MediaAlpha at fair value. White Mountains believes these measures to be useful to management and investors by making the returns in the current period comparable to the prior periods. A reconciliation from GAAP to the reported percentages is as follows: For the Twelve Months Ended December 31, 2019 GAAP Returns Remove MediaAlpha Transaction Returns - Excluding MediaAlpha Transaction Total consolidated portfolio returns 20.4 % (4.9 ) % 15.5 % Common equity securities and other long-term investments returns 36.9 % (11.2 ) % 25.7 % Other long-term investments returns 52.4 % (37.2 ) % 15.2 % CRITICAL ACCOUNTING ESTIMATES Management’s Discussion and Analysis of Financial Condition and Results of Operations discuss the Company’s consolidated financial statements, which have been prepared in accordance with GAAP. The financial statements presented herein include all adjustments considered necessary by management to fairly present the financial condition, results of operations and cash flows of White Mountains. The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities as of the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Certain of these estimates are considered critical in that they involve a higher degree of judgment and are subject to a significant degree of variability. On an ongoing basis, management evaluates its estimates and bases its estimates on historical experience and on various other factors that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. 1. Fair Value Measurements General White Mountains records certain assets and liabilities at fair value in its consolidated financial statements, with changes therein recognized in current period earnings. In addition, White Mountains discloses estimated fair value for certain liabilities measured at historical or amortized cost. Fair value is defined as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants (an exit price) at a particular measurement date. Fair value measurements are categorized into a hierarchy that distinguishes between inputs based on market data from independent sources (“observable inputs”) and a reporting entity’s internal assumptions based upon the best information available when external market data is limited or unavailable (“unobservable inputs”). Quoted prices in active markets for identical assets have the highest priority (“Level 1”), followed by observable inputs other than quoted prices including prices for similar but not identical assets or liabilities (“Level 2”), and unobservable inputs, including the reporting entity’s estimates of the assumptions that market participants would use, having the lowest priority (“Level 3”). Assets and liabilities carried at fair value include substantially all of the investment portfolio, and derivative instruments, both exchange traded and over the counter instruments. Valuation of assets and liabilities measured at fair value require management to make estimates and apply judgment to matters that may carry a significant degree of uncertainty. In determining its estimates of fair value, White Mountains uses a variety of valuation approaches and inputs. Whenever possible, White Mountains estimates fair value using valuation methods that maximize the use of quoted market prices or other observable inputs. Where appropriate, assets and liabilities measured at fair value have been adjusted for the effect of counterparty credit risk. Invested Assets White Mountains uses outside pricing services and brokers to assist in determining fair values. The outside pricing services White Mountains uses have indicated that they will only provide prices where observable inputs are available. As of December 31, 2019, approximately 71% of the investment portfolio recorded at fair value was priced based upon quoted market prices or other observable inputs. Level 1 Measurements Investments valued using Level 1 inputs include fixed maturity investments, primarily investments in U.S. Treasuries and short-term investments, which include U.S. Treasury Bills, and common equity securities. For investments in active markets, White Mountains uses the quoted market prices provided by outside pricing services to determine fair value. Level 2 Measurements Investments valued using Level 2 inputs include fixed maturity investments which have been disaggregated into classes, including debt securities issued by corporations, municipal obligations and mortgage and asset-backed securities. Investments valued using Level 2 inputs also include certain passive ETFs that track U.S. stock indices such as the S&P 500 Index, but are traded on foreign exchanges, which White Mountains values using the fund manager’s published net asset value per share (“NAV”) to account for the difference in market close times. In circumstances where quoted market prices are unavailable or are not considered reasonable, White Mountains estimates the fair value using industry standard pricing methodologies and observable inputs such as benchmark yields, reported trades, broker-dealer quotes, issuer spreads, benchmark securities, bids, offers, credit ratings, prepayment speeds, reference data including research publications and other relevant inputs. Given that many fixed maturity investments do not trade on a daily basis, the outside pricing services evaluate a wide range of fixed maturity investments by regularly drawing parallels from recent trades and quotes of comparable securities with similar features. The characteristics used to identify comparable fixed maturity investments vary by asset type and take into account market convention. White Mountains’s process to assess the reasonableness of the market prices obtained from the outside pricing sources covers substantially all of its fixed maturity investments and includes, but is not limited to, the evaluation of pricing methodologies and a review of the pricing services’ quality control procedures on at least an annual basis, a comparison of its invested asset prices obtained from alternate independent pricing vendors on at least a semi-annual basis, monthly analytical reviews of certain prices and a review of the underlying assumptions utilized by the pricing services for select measurements on an ad hoc basis throughout the year. White Mountains also performs back-testing of selected investment sales activity to determine whether there are any significant differences between the market price used to value the security prior to sale and the actual sale price of the security on an ad-hoc basis throughout the year. Prices provided by the pricing services that vary by more than $0.5 million and 5% from the expected price based on these assessment procedures are considered outliers, as are prices that have not changed from period to period and prices that have trended unusually compared to market conditions. In circumstances where the results of White Mountains’s review process does not appear to support the market price provided by the pricing services, White Mountains challenges the vendor provided price. If White Mountains cannot gain satisfactory evidence to support the challenged price, White Mountains will rely upon its own internal pricing methodologies to estimate the fair value of the security in question. The valuation process described above is generally applicable to all of White Mountains’s fixed maturity investments. The techniques and inputs specific to asset classes within White Mountains’s fixed maturity investments for Level 2 securities that use observable inputs are as follows: Debt Securities Issued by Corporations: The fair value of debt securities issued by corporations is determined from a pricing evaluation technique that uses information from market sources and integrates relative credit information, observed market movements, and sector news. Key inputs include benchmark yields, reported trades, broker-dealer quotes, issuer spreads, two-sided markets, benchmark securities, bids, offers, and reference data including sector, coupon, credit quality ratings, duration, credit enhancements, early redemption features and market research publications. Municipal Obligations: The fair value of municipal obligations is determined from a pricing evaluation technique that uses information from market makers, brokers-dealers, buy-side firms, and analysts along with general market information. Key inputs include benchmark yields, reported trades, issuer financial statements, material event notices and new issue data, as well as broker-dealer quotes, issuer spreads, two-sided markets, benchmark securities, bids, offers, and reference data including type, coupon, credit quality ratings, duration, credit enhancements, geographic location and market research publications. Mortgage and Asset-Backed Securities: The fair value of mortgage and asset-backed securities is determined from a pricing evaluation technique that uses information from market sources and leveraging similar securities. Key inputs include benchmark yields, reported trades, underlying tranche cash flow data, collateral performance, plus new issue data, as well as broker-dealer quotes, issuer spreads, two-sided markets, benchmark securities, bids, offers, and reference data including issuer, vintage, loan type, collateral attributes, prepayment speeds, default rates, recovery rates, cash flow stress testing, credit quality ratings and market research publications. Level 3 Measurements Fair value estimates for investments that trade infrequently and have few or no quoted market prices or other observable inputs are classified as Level 3 measurements. Investments valued using Level 3 fair value estimates are based upon unobservable inputs and include investments in certain fixed maturity investments, common equity securities and other long-term investments where quoted market prices or other observable inputs are unavailable or are not considered reliable or reasonable. Level 3 valuations are generated from techniques that use assumptions not observable in the market. These unobservable inputs reflect White Mountains’s assumptions of what market participants would use in valuing the investment. In certain circumstances, investment securities may start out as Level 3 when they are originally issued, but as observable inputs become available in the market, they may be reclassified to Level 2. Transfers of securities between levels are based on investments held as of the beginning of the period. Other Long-Term Investments As of December 31, 2019, White Mountains owned a portfolio of other long-term investments valued at $856 million, including unconsolidated entities, Kudu’s Participation Contracts, private equity funds, hedge funds, ILS funds and private debt instruments. As of December 31, 2019, $654 million of White Mountains’s other long-term investments, including unconsolidated entities, Kudu’s Participation Contracts and private debt instruments were classified as Level 3 investments in the GAAP fair value hierarchy, were not actively traded in public markets and did not have readily observable market prices. The determination of the fair value of these securities involves significant management judgment, and the use of valuation models and assumptions that are inherently subjective and uncertain. See Item 1A. Risk Factors, “Our investment portfolio includes securities that do not have readily observable market prices. We use valuation methodologies that are inherently subjective and uncertain to value these securities. The values of securities established using these methodologies may never be realized, which could materially adversely affect our results of operations and financial condition.” on page 17. As of December 31, 2019, $202 million of White Mountains’s other long-term investments, including private equity funds, hedge funds and ILS funds, were valued at fair value using NAV as a practical expedient. Investments for which fair value is measured at NAV using the practical expedient are not classified within the fair value hierarchy. White Mountains may use a variety of valuation techniques to determine fair value depending on the nature of the investment, including a discounted cash flow analysis, market multiple approach, cost approach and/or liquidation analysis. On an ongoing basis, White Mountains also considers qualitative changes in facts and circumstances, which may impact the valuation of unconsolidated entities, including economic and market changes in relevant industries, changes to the entity’s capital structure, business strategy and key personnel, and any recent transactions relating to the unconsolidated entity. On a quarterly basis, White Mountains evaluates the most recent qualitative and quantitative information of the business and completes a fair valuation analysis for all Level 3 other long-term investments. Periodically, and at least on an annual basis, White Mountains uses a third-party valuation firm to complete an independent valuation analysis of significant unconsolidated entities. As of December 31, 2019, White Mountains’s most significant other long-term investments that are valued using Level 3 measurements include Kudu’s Participation Contracts, MediaAlpha and PassportCard/DavidShield. Valuation of Kudu’s Participation Contracts Kudu’s Participation Contracts comprise non-controlling equity interests in the form of revenue and earnings participation contracts. On a quarterly basis, White Mountains values each of Kudu’s Participation Contracts using discounted cash flow models. The valuation models include key inputs such as projections of future revenues and earnings of Kudu’s clients, a discount rate and a terminal cash flow exit multiple. The expected future cash flows are based on management judgment, considering current performance, budgets and projected future results. The discount rates reflect the weighted average cost of capital, considering comparable public company data, adjusted for risks specific to the business and industry. The terminal exit multiple is generally based on expectations of annual cash flow to Kudu from each of its clients in the terminal year of the cash flow model. In determining fair value, White Mountains considers factors such as performance of underlying products and vehicles, expected client growth rates, new fund launches, fee rates by products, capacity constraints, operating cash flow of underlying manager and other qualitative factors, including the assessment of key personnel. As of December 31, 2019, the combined fair value of Kudu’s Participation Contracts was $267 million. The inputs to each discounted cash flow analysis vary depending on the nature of each client. As of December 31, 2019, White Mountains concluded that discount rates in the range of 15% to 22%, and terminal cash flow exit multiples in the range of 6 to 12 times were appropriate for the valuations of Kudu’s Participation Contracts. With a discounted cash flow analysis, small changes to inputs in a valuation model may result in significant changes to fair value. The following table presents the estimated effect on the fair value of Kudu’s Participation Contracts as of December 31, 2019, resulting from increases and decreases to the discount rates and terminal cash flow exit multiples used in the discounted cash flow analysis: $ in Millions Discount Rate Terminal Exit Multiple -2% -1% 15% - 22% +1% +2% +2 $ $ $ $ $ +1 $ $ $ $ $ 6x to 12x $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ Valuation of MediaAlpha and PassportCard/DavidShield On a quarterly basis, White Mountains values its investments in MediaAlpha and PassportCard/DavidShield using discounted cash flow models. The discounted cash flow valuation models include key inputs such as projections of future revenues and earnings, a discount rate and a terminal revenue growth rate. The expected future cash flows are based on management judgment, considering current performance, budgets and projected future results. The discount rates reflect the weighted average cost of capital, considering comparable public company data, adjusted for risks specific to the business and industry. The terminal revenue growth rate is based on company, industry and macroeconomic expectations of perpetual revenue growth subsequent to the end of the discrete period in the discounted cash flow analysis. When making its fair value selection, White Mountains considers all available information, including market multiples and multiples implied by recent transactions, facts and circumstances specific to MediaAlpha’s and PassportCard/DavidShield’s businesses and industries, and any infrequent or unusual results for the period. MediaAlpha. White Mountains concluded that a discount rate of 15% and a terminal revenue growth rate of 4% was appropriate for the valuation of its investment in MediaAlpha as of December 31, 2019. Utilizing these assumptions, White Mountains determined that the fair value of its investment in MediaAlpha was $180 million as of December 31, 2019. With a discounted cash flow analysis, small changes to inputs in a valuation model may result in significant changes to fair value. The following table presents the estimated effect on the fair value of White Mountains’s investment in MediaAlpha as of December 31, 2019 resulting from changes in the discount rate and terminal revenue growth rate, two key inputs to the discounted cash flow analysis: $ in Millions Discount Rate Terminal Revenue Growth Rate 13% 14% 15% 16% 17% 4.5% $ $ $ $ $ 4.0% $ $ $ $ $ 3.5% $ $ $ $ $ PassportCard/DavidShield. White Mountains concluded that a discount rate of 22% and a terminal revenue growth rate of 4% was appropriate for the valuation of its investment in PassportCard/DavidShield as of December 31, 2019. Utilizing these assumptions, White Mountains determined that the fair value of its investment in PassportCard/DavidShield was $90 million as of December 31, 2019. With a discounted cash flow analysis, small changes to inputs in a valuation model may result in significant changes to fair value. The following table presents the estimated effect on the fair value of White Mountains’s investment in PassportCard/DavidShield as of December 31, 2019, resulting from changes in key inputs to the discounted cash flow analysis, including the discount rate and terminal revenue growth rate: $ in Millions Discount Rate Terminal Revenue Growth Rate 20% 21% 22% 23% 24% 4.5% $ $ $ $ $ 4.0% $ $ $ $ $ 3.5% $ $ $ $ $ Other Long-term Investments - NAV White Mountains’s portfolio of other long-term investments includes investments in private equity funds, hedge funds and ILS funds. White Mountains employs a number of procedures to assess the reasonableness of the fair value measurements for its private equity funds, hedge funds and ILS funds, including obtaining and reviewing periodic and audited annual financial statements as well as discussing each fund’s pricing with the fund manager throughout the year. However, since the fund managers do not provide sufficient information to evaluate the pricing methods and inputs for each underlying investment, White Mountains considers the inputs to be unobservable. The fair value of White Mountains’s private equity fund, hedge fund and ILS fund investments are generally determined using the fund manager’s NAV. In the event that White Mountains believes the fair value of a private equity fund, hedge fund or ILS fund differs from the NAV reported by the fund manager due to illiquidity or other factors, White Mountains will adjust the reported NAV to more appropriately represent the fair value of its investment in the private equity fund, hedge fund or ILS fund. Sensitivity Analysis of Likely Returns on Other Long-term Investments - NAV The underlying investments of White Mountains’s private equity funds and hedge funds are typically publicly-traded and private securities and, as such, are subject to market risks that are similar to White Mountains’s common equity securities. The following table presents the estimated effect on fair values as of December 31, 2019 resulting from a 10% change and a 30% change in the market value of private equity fund and hedge fund investments: Change in Fair Value at Carrying Value at December 31, 2019 Millions December 31, 2019 10% Decline 10% Increase 30% Decline 30% Increase Private equity funds and hedge funds - NAV $ 161.1 $ (16.1 ) $ 16.1 $ (48.3 ) $ 48.3 The underlying investments of White Mountains’s multi-investor ILS funds consist primarily of catastrophe bonds, collateralized reinsurance investments and industry loss warranties. In addition to catastrophe event risk, the underlying investments are also subject to a variety of other risks including modeling, liquidity, market, collateral credit quality, counterparty financial strength, interest rate and currency risks. See Note 3 - “Investment Securities” on page for tables that summarize the changes in White Mountains’s fair value measurements by level for the years ended December 31, 2019 and 2018 and for amount of total gains (losses) included in earnings attributable to net unrealized investment gains (losses) for Level 3 investments for years ended December 31, 2019, 2018 and 2017. 2. Surplus Note Valuation BAM Surplus Notes As of December 31, 2019, White Mountains owned $458 million of BAM Surplus Notes and has accrued $163 million in interest due thereon. In December 2019, BAM made a $32 million cash payment of principal and interest on the BAM Surplus Notes held by HG Global. In January 2020, BAM made an additional $65 million special cash payment of principal and interest on the BAM Surplus Notes. During 2018, BAM made a $23 million cash payment of note principal and interest on the BAM Surplus Notes. Because BAM is consolidated in White Mountains’s financial statements, the BAM Surplus Notes and accrued interest are classified as intercompany notes, carried at face value and eliminated in consolidation. However, the BAM Surplus Notes and accrued interest are carried as assets at HG Global, of which White Mountains owns 97% of the preferred equity, while the BAM Surplus Notes are carried as liabilities at BAM, which White Mountains has no ownership interest in and is completely attributed to non-controlling interests. Any write-down of the carried amount of the BAM Surplus Notes and/or the accrued interest thereon could adversely impact White Mountains’s results of operations and financial condition. See Item 1A., Risk Factors, “If BAM does not pay some or all of the principal and interest due on the BAM Surplus Notes, it could materially adversely affect our results of operations and financial condition.” on page 18. Periodically, White Mountains’s management reviews the recoverability of amounts recorded from the BAM Surplus Notes. As of December 31, 2019, White Mountains believes such notes and interest thereon to be fully recoverable. White Mountains’s review is based on a debt service model that forecasts operating results for BAM, and related payments on the BAM Surplus Notes, through maturity of the BAM Surplus Notes in 2042. The model depends on assumptions regarding future trends for the issuance of municipal bonds, interest rates, credit spreads, insured market penetration, competitive activity in the market for municipal bond insurance and other factors affecting the demand for and price of BAM’s municipal bond insurance. During the fourth quarter of 2019, White Mountains updated its debt service model to reflect (i) the cash payments of principal and interest on the BAM Surplus Notes made in December 2019 and January 2020, (ii) the amendments made to the terms of the BAM Surplus Notes in January 2020, including an extension of the variable interest rate period, and (iii) in light of the current interest rate environment, a more conservative forecast of future operating results for BAM. The debt service model assumes both par insured and total pricing gradually increase over the next five years, and flatten thereafter. White Mountains models that the BAM Surplus Notes will be fully repaid approximately seven years prior to final maturity, which is two years later than previously modeled as of December 31, 2018. The changes to the debt service model resulted in a $20 million increase to the time value of money discount on the BAM Surplus Notes as reflected in adjusted book value per share at December 31, 2019. Assumptions regarding future trends for these factors are a matter of significant judgment, and whether actual results will follow the model is subject to a number of risks and uncertainties. BAM is required to seek regulatory approval to pay interest and principal on the BAM Surplus Notes to the extent that its remaining qualified statutory capital and other capital resources continue to support its outstanding obligations, its business plan and its “AA/stable” rating from Standard & Poor’s. No payment of principal or interest on the BAM Surplus Notes may be made without the approval of the NYDFS. Interest payments on the BAM Surplus Notes are due quarterly but are subject to deferral, without penalty or default and without compounding, for payment in the future. Payments made to the BAM Surplus Notes are applied pro rata between outstanding principal and interest. Deferred interest is due on the stated maturity date in 2042. 3. Goodwill and Other Intangible Assets As of December 31, 2019, goodwill and other intangible assets recognized in connection with business and asset acquisitions totaled $655 million, of which $631 million was attributable to White Mountains’s common shareholders. Goodwill and other intangible assets are recorded at their acquisition date fair values. The determination of the acquisition date fair values of goodwill and other intangible assets involves significant management judgment, the use of valuation models and assumptions that are inherently subjective. Goodwill and indefinite-lived intangible assets are not amortized but rather reviewed for potential impairment on an annual basis, or whenever indications of potential impairment exist. In the absence of any indications of potential impairment, the evaluation of goodwill and indefinite-lived intangible assets is performed no later than the interim period in which the anniversary of the acquisition date falls. Finite-lived intangible assets, which are amortized over their estimated economic lives, are reviewed for impairment only when events occur or there are changes in circumstances indicating that their carrying value may exceed fair value. Impairment exists when the carrying value of goodwill or other intangible assets exceeds fair value. White Mountains’s annual review first assesses whether qualitative factors indicate that the carrying value of goodwill or other intangible assets may be impaired. If White Mountains determines based on this qualitative review that it is more likely than not that an impairment may exist, then White Mountains performs a quantitative analysis to compare the fair value of a reporting unit with its carrying value. If the carrying value exceeds the estimated fair value, then an impairment charge is recognized through current period pre-tax income. Both the annual qualitative assessment of potential impairment as well as the quantitative comparison of carrying value to estimated fair value involve management judgment, the use of discounted cash flow models, market comparisons and other valuation techniques and assumptions, including customer retention rates and revenue growth rates, that are inherently subjective. Most of White Mountains’s total goodwill and other intangible assets of $655 million relates to the acquisition of NSM and NSM’s subsequent acquisitions of Fresh Insurance, KBK, Embrace and the Renewal Rights from AIG. As of December 31, 2019, goodwill and other intangible assets related to NSM were $623 million. During the second quarter of 2019, White Mountains performed its periodic reviews for potential impairment, including a quantitative review of the goodwill associated with NSM. White Mountains concluded that there was no impairment of the goodwill associated with NSM. White Mountains recognized an impairment of other intangible assets of $2 million related to Fresh Insurance and impairments of goodwill and other intangible assets of $8 million and $1 million, respectively, related to its Other Operations. There were no impairments to goodwill and other intangible assets during 2018 or 2017. See Item 1A., Risk Factors, “If we are required to write down goodwill and other intangible assets, it could materially adversely affect our results of operations and financial condition.” on page 19. FORWARD-LOOKING STATEMENTS This report may contain “forward-looking statements” within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934. All statements, other than statements of historical facts, included or referenced in this report which address activities, events or developments which White Mountains expects or anticipates will or may occur in the future are forward-looking statements. The words “will”, “believe”, “intend”, “expect”, “anticipate”, “project”, “estimate”, “predict” and similar expressions are also intended to identify forward-looking statements. These forward-looking statements include, among others, statements with respect to White Mountains’s: • change in adjusted book value per share or return on equity; • business strategy; • financial and operating targets or plans; • projections of revenues, income (or loss), earnings (or loss) per share, dividends, market share or other financial forecasts; • expansion and growth of its business and operations; and • future capital expenditures. These statements are based on certain assumptions and analyses made by White Mountains in light of its experience and perception of historical trends, current conditions and expected future developments, as well as other factors believed to be appropriate in the circumstances. However, whether actual results and developments will conform to its expectations and predictions is subject to a number of risks and uncertainties that could cause actual results to differ materially from expectations, including: • the risks associated with Item 1A of this Report on Form 10-K; • business opportunities (or lack thereof) that may be presented to it and pursued; • actions taken by ratings agencies from time to time, such as financial strength or credit ratings downgrades or placing ratings on negative watch; • the continued availability of capital and financing; • deterioration of general economic, market or business conditions, including due to outbreaks of contagious disease (including COVID-19); • competitive forces, including the conduct of other insurers; • changes in domestic or foreign laws or regulations, or their interpretation, applicable to White Mountains, its competitors or its customers; • an economic downturn or other economic conditions adversely affecting its financial condition; and • other factors, most of which are beyond White Mountains’s control. Consequently, all of the forward-looking statements made in this report are qualified by these cautionary statements, and there can be no assurance that the actual results or developments anticipated by White Mountains will be realized or, even if substantially realized, that they will have the expected consequences to, or effects on, White Mountains or its business or operations. White Mountains assumes no obligation to publicly update any such forward-looking statements, whether as a result of new information, future events or otherwise.

<s>[INST] The following discussion also includes nine nonGAAP financial measures (i) adjusted book value per share, (ii) underlying growth in adjusted book value per share, (iii) gross written premiums and MSC from new business, (iv) adjusted capital, (v) NSM’s earnings before interest, taxes, depreciation and amortization (“EBITDA”), (vi) NSM’s adjusted EBITDA, (vii) total consolidated portfolio returns excluding the MediaAlpha Transaction, (viii) common equity securities and other longterm investments returns excluding the MediaAlpha Transaction and (ix) other longterm investments return excluding the MediaAlpha Transaction, that have been reconciled from their most comparable GAAP financial measures on page 58. White Mountains believes these measures to be useful in evaluating White Mountains’s financial performance and condition. RESULTS OF OPERATIONS FOR THE YEARS ENDED DECEMBER 31, 2019, 2018 AND 2017 OverviewYear Ended December 31, 2019 versus Year Ended December 31, 2018 White Mountains ended 2019 with book value per share of $1,024 and adjusted book value per share of $1,018, an increase of 14.4% and 14.8% for the year, including dividends. Comprehensive income attributable to common shareholders was $413 million in 2019 compared to comprehensive loss attributable to common shareholders of $146 million in 2018. The results for 2019 were driven primarily by investment results and the $182 million gain from the MediaAlpha Transaction. The results for 2018 were driven primarily by investment results, which were adversely impacted by the sharp decline in equity markets in the fourth quarter of 2018. On February 26, 2019, MediaAlpha completed the MediaAlpha Transaction. The transaction resulted in a gain of $55 to each of White Mountains’s book value per share and adjusted book value per share. See “MediaAlpha” on page 43. Including the $55 per share net gain from the MediaAlpha Transaction as if it had closed on December 31, 2018, book value per share would have been $951 and adjusted book value per share would have been $943 as of December 31, 2018. Had the MediaAlpha Transaction closed on December 31, 2018, White Mountains’s book value per share would have increased 7.8% and adjusted book value per share would have increased 8.1% in 2019, including dividends. During 2019, White Mountains repurchased and retired $5 million of its common shares. During 2019, White Mountains deployed roughly $435 million in new business opportunities, ending the year with approximately $1.0 billion of undeployed capital. Gross written premiums and MSC collected in the HG Global/BAM segment totaled $107 million in both 2019 and 2018. BAM insured municipal bonds with par value of $12.8 billion in 2019, compared to $12.0 billion in 2018. During 2019, BAM completed assumed reinsurance transactions to insure municipal bonds with a par value of $1.1 billion and, during 2018, BAM completed assumed reinsurance transactions to insure municipal bonds with a par value of $2.2 billion. Total pricing was 83 basis points in 2019, compared to 93 basis points in 2018. In December 2019, BAM made a $32 million cash payment of principal and interest on the BAM Surplus Notes held by HG Global. In January 2020, BAM made an additional $65 million special cash payment of principal and interest on the BAM Surplus Notes. During 2018, BAM made a $23 million cash payment of principal and interest on the BAM Surplus Notes. BAM’s total claims paying resources were $938 million as of December 3 [/INST] Negative. </s>

UNIT CORP

2015-02-24

2014-12-31

Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations Please read the following discussion of our financial condition and results of operations in conjunction with the consolidated financial statements and related notes included in Item 8 of this report. General We operate, manage, and analyze our results of operations through our three principal business segments: • Oil and Natural Gas - carried out by our subsidiary Unit Petroleum Company. This segment explores, develops, acquires, and produces oil and natural gas properties for our own account. • Contract Drilling - carried out by our subsidiary Unit Drilling Company and its subsidiaries. This segment contracts to drill onshore oil and natural gas wells for others and for our own account. • Mid-Stream - carried out by our subsidiary Superior Pipeline Company, L.L.C. and its subsidiaries. This segment buys, sells, gathers, processes, and treats natural gas for third parties and for our own account. Business Outlook As discussed in other parts of this report, the success of our business and each of our three main operating segments depend, on a large part, on the prices we receive for our oil and natural gas production and the demand for oil and natural gas as well as for our drilling rigs which, in turn, influences the amounts we can charge for the use of those drilling rigs. While our operations are located within the United States, events outside the United States can also impact us and our industry. During recent months, both within the United States and the world, deteriorating commodity prices have brought about significant and immediate changes affecting our industry and us. The recent decline in commodity prices is causing us (and other oil and gas companies) to reduce our level of drilling activity and spending. When drilling activity and spending decline for any sustained period of time the rates for and the number of our drilling rigs working also tend to decline. In addition, lower commodity prices for any sustained period of time could impact the liquidity condition of some of our industry partners and customers, which, in turn, might limit their ability to meet their financial obligations to us. How long the current depressed prices for oil and natural gas products continues is uncertain at this time. As noted elsewhere in this report, commodity prices are subject to a number of factors most of which are beyond our control. The impact on our business and financial results as a consequence of the recent reduction in oil and NGLs (and to a lesser extent natural gas) prices is uncertain in the long term, but in the short term, it has had a number of consequences for us, including the following: • In December 2014, we determined the value of certain unproved oil and gas properties were diminished (in part or in whole) based on an impairment evaluation and our anticipated future exploration plans. That determination resulted in $73.7 million of costs associated with the unproved properties being added to the capitalized costs to be amortized. We incurred a non-cash ceiling test write-down of our oil and natural gas properties of $76.7 million pre-tax ($47.7 million net of tax). Subsequent to December 31, 2014, commodity prices have continued to decrease below December 31, 2014 levels. We anticipate that these reduced prices will require an additional write-down of the carrying value of our oil and natural gas properties for the quarter ending March 31, 2015 and potentially for subsequent quarters. • We have reduced the number of gross wells we plan to drill in 2015 by approximately 62% from the number of gross wells drilled in 2014. This reduction is driven not only by reduced commodity prices but also because the costs to drill the wells have tended to remain relatively high in comparison to current commodity prices. • In December 2014, we removed from service 31 drilling rigs, some older top drives, and certain drill pipe no longer marketable in the current environment. We estimated the fair value of the rigs and other assets based on the estimate market value from third-party assessments (Level 3 fair value measurement). Based on these estimates, we recorded a write-down of approximately $74.3 million pre-tax. • Several of our drilling rig customers have significantly reduced their drilling budgets for 2015, resulting in a significant reduction in the average utilization of our drilling rig fleet. At December 31, 2014, we had 75 rigs operating, at February 13, 2015, this number was 50. We currently expect further reductions into 2015. • In December 2014, our mid-stream segment had a $7.1 million pre-tax write-down of three of its systems, Weatherford, Billy Rose, and Spring Creek due to anticipated future cash flow and future development around these systems supporting their carrying value. The estimated future cash flows were less than the carrying value on these systems (Level 3 fair value measurement). • Due to the decline in NGLs prices during 2014, in the second half of the year we operated our processing facilities in full ethane rejection mode which reduced the amount of liquids sold during this time period. As long as NGLs prices continue to be at or below these levels, we expect to continue operating in full ethane rejection mode. Our mid-stream segment did not experience a significant reduction in processed volumes in 2014, but as the low prices continue we expect further reductions in drilling activity around our systems which will eventually effect our ability to connect new wells and resulting in lower processed volumes in the future. We have reduced our total 2015 capital budget for all three of our business segments by approximately 52% as compared to 2014, excluding acquisitions and ARO liability. Our budget is designed to keep our capital expenditures substantially within our anticipated cash flow. Our 2015 current capital expenditures budget is based on realized prices for the year of $53.73 per barrel of oil, $17.03 per barrel of NGLs, and $3.18 per Mcf of natural gas. Our budget is subject to possible periodic adjustments for various reasons including changes in commodity prices and industry conditions. Funding for the budget will come primarily from our cash flow and, if necessary, borrowings under our credit agreement. Executive Summary Oil and Natural Gas Fourth quarter 2014 production from our oil and natural gas segment was 4,868,000 barrels of oil equivalent (Boe), a 6% increase over the third quarter of 2014 and a 10% increase over the fourth quarter of 2013. These increases came mostly from production associated with new wells. Oil and NGLs production during the fourth quarter of 2014 was 47% of our total production compared to 46% of our total production during the fourth quarter of 2013. Fourth quarter 2014 oil and natural gas revenues decreased 13% from the third quarter of 2014 and decreased 5% from the fourth quarter of 2013. These deceases were primarily due to lower oil and NGLs prices. Our NGLs and oil prices for the fourth quarter of 2014 decreased 16% and 11%, respectively, compared to the third quarter of 2014 while our natural gas prices increased 1%. Our NGLs and oil prices decreased 26% and 14%, respectively compared to the fourth quarter of 2013 while natural gas prices increased 16%. Direct profit (oil and natural gas revenues less oil and natural gas operating expense) decreased 21% from the third quarter of 2014 and 13% from the fourth quarter of 2013. The decreases were primarily attributable to decreased oil and NGLs prices and from higher saltwater disposal expense. Operating cost per Boe produced for the fourth quarter of 2014 increased 5% and 7% over the third quarter of 2014 and the fourth quarter of 2013, respectively. The increases were primarily due to higher saltwater disposal expenses and higher lease operating expenses (LOE). The increase in LOE was mitigated in part by lower gross production tax resulting from lower oil and NGLs prices (not under derivative contracts) and from credits received. For 2014, we had derivative contracts on approximately 69% of our average daily oil production and approximately 56% of our average natural gas production. These derivatives were intended to help manage our cash flow and capital expenditure requirements. We have a derivative contract on 1,000 Bbls per day of oil production for 2015. We have derivative contracts on 70,000 Mmbtu per day of natural gas production in the first quarter 2015, 100,000 Mmbtu per day of natural gas production in the second quarter 2015, 70,000 Mmbtu per day of natural gas production, and 40,000 Mmbtu per day of natural gas production in the third and fourth quarters 2015, respectively. The contract for the oil production is a swap contract for 1,000 Bbls per day. The swap transaction was done at a comparable average NYMEX price of $95.00. The contracts for the natural gas production in the first quarter are swaps covering 40,000 Mmbtu per day and collars for 30,000 Mmbtu per day. The first quarter swap transactions were done at a comparable average NYMEX price of $3.98. The first quarter collar transactions were done at a comparable average NYMEX floor price of $4.20 and ceiling price of $5.03. The contracts for the natural gas production in the second quarter are swaps for 70,000 Mmbtu per day and collars for 30,000 Mmbtu per day. The second quarter swap transactions were done at a comparable average NYMEX price of $3.60. The second quarter collar transactions were done at a comparable average NYMEX floor price of $2.92 and ceiling price of $3.26. The contracts for the natural gas production in the third quarter are swaps for 40,000 Mmbtu per day and collars for 30,000 Mmbtu per day. The third quarter swap transactions were done at a comparable average NYMEX price of $3.98. The third quarter collar transactions were done at a comparable average NYMEX floor price of $2.58 and ceiling price of $3.04. The contracts for the natural gas production in the fourth quarter are swaps for 40,000 Mmbtu per day. The fourth quarter swap transactions were done at a comparable average NYMEX price of $3.98. During 2014, we participated in the drilling of 186 wells (121.00 net wells). For 2015, we plan to participate in the drilling of approximately 70 wells. Our 2015 production guidance is approximately 18.6 to 19.0 MMBoe, an increase of 2% to 4% over 2014, although actual results will continue to be subject to many factors. This segment’s capital budget for 2015 is $308.5 million, a 60% decrease from 2014, excluding acquisitions and ARO liability. Contract Drilling The average number of drilling rigs we operated for 2014 was 75.4 compared to 65.0 in 2013. Late in the fourth quarter of 2014, the number of our drilling rigs operating started to decline and has continued to decline and at February 13, 2015, we had 50 drilling rigs operating. We anticipate further reductions through the first quarter of 2015 and potentially for subsequent quarters. Dayrates for the fourth quarter of 2014 averaged $20,488, a 2% and 4% increase over the third quarter of 2014 and the fourth quarter of 2013, respectively. The increases were primarily due to the higher rates for the new BOSS rigs that went into service. Direct profit (contract drilling revenue less contract drilling operating expense) for the fourth quarter of 2014 increased 6% and 33% over the third quarter of 2014 and the fourth quarter of 2013, respectively. For both comparative periods, we had more drilling rigs operating with higher dayrates. Operating cost per day for the fourth quarter of 2014 increased 14% over the third quarter of 2014 and 7% over the fourth quarter of 2013. The increases were primarily due to increases in direct expense for both comparative periods and indirect rig expenses and workers' compensation related costs in the fourth quarter of 2014 versus the third quarter of 2013. Almost all of our working drilling rigs in 2014 have been drilling horizontal or directional wells. With the recent low commodity prices, our customers have drastically reduced their drilling budgets. As a result, we are experiencing reduced rig utilization. Commodity prices in the various basins in which we operate ultimately affect the demand and mix of the type of drilling rigs used by our customers. Unit’s rig fleet is comprised of rigs capable to meet our customers’ demands whether it be for oil, natural gas, or NGLs and whether it be for shallow, deep, vertical, or horizontal type drilling. Current and future demand for drilling rigs will have an impact on dayrates. The future demand for and the availability of drilling rigs to meet that demand will have an impact on our future dayrates. As of December 31, 2014, we had 30 term drilling contracts with original terms ranging from six months to three years. Twenty-six of these contracts are up for renewal in 2015, (ten in the first quarter, eight in the second quarter, seven in the third quarter, and one in the fourth quarter) and four are up for renewal in 2016. Term contracts may contain a fixed rate for the duration of the contract or provide for rate adjustments within a specific range from the existing rate. As of February 13, 2015, four expired and were not renewed and two of these term drilling contracts have been terminated early. During the first quarter of 2014, four idle 3,000 horsepower drilling rigs were sold to an unaffiliated third party. The proceeds from the sale were used in our construction program for our new proprietary 1,500 horsepower, AC electric drilling rig, called the BOSS drilling rig. This new drilling rig design is positioning us to more effectively meet the demands of our existing customers as well as allowing us to compete for the work of new customers. During 2014, three BOSS drilling rigs were constructed and placed into service for third-party operators. In December 2014, we removed from service 31 drilling rigs, some older top drives, and certain drill pipe no longer marketable under the current environment. We estimated the fair value of the rigs and other assets based on the estimate market value from third-party assessments (Level 3 fair value measurement). Based on these estimates, we recorded a write-down of approximately $74.3 million pre-tax. This reduction to our fleet brought our total number of drilling rigs at year end to 89. Five additional BOSS drilling rigs have been contracted to be built for third-party operators and will be placed into service in 2015, the first of which began operating in January 2015. Some of the long lead time components for three additional BOSS drilling rigs have also been ordered. Our anticipated 2015 capital expenditures for this segment are $99.7 million, a 44% decrease from 2014. Mid-Stream Fourth quarter 2014 liquids sold per day decreased 11% from the third quarter of 2014 and increased 5% over the fourth quarter of 2013. The decrease in liquids sold from the third quarter was due to operating in ethane rejection mode. The increase over prior year was due to increased purchased volume from connecting new wells to our systems. For the fourth quarter of 2014, gas processed per day decreased 3% from the third quarter of 2014 and increased 10% over the fourth quarter of 2013. The decrease from the third quarter was due to declining volumes on several systems. The increase over prior year was due to upgrading several of our existing processing facilities and adding processing plants along with connecting new wells. For the fourth quarter of 2014, gas gathered per day increased 2% over the third quarter of 2014 and increased 5% over the fourth quarter of 2013. These increases were primarily from well connects throughout 2014. NGLs prices in the fourth quarter of 2014 decreased 24% and 36% from the prices received in the third quarter of 2014 and the fourth quarter of 2013, respectively. Because certain of the contracts used by our mid-stream segment for NGLs transactions are percent of proceeds (POP) contracts - under which we receive a share of the proceeds from the sale of the NGLs - our revenues from those POP contracts fluctuate based on NGLs prices. Direct profit (mid-stream revenues less mid-stream operating expense) for the fourth quarter of 2014 decreased 25% from the third quarter of 2014 and decreased 18% from the fourth quarter of 2013. The decreases were primarily due to lower NGLs and condensate prices. Total operating cost for our this segment for the fourth quarter of 2014 decreased 13% from the third quarter of 2014 and decreased 4% from the fourth quarter of 2013 due primarily to the lower cost of gas purchased. At our Hemphill County, Texas facility, we operate four processing plants with a total processing capacity of 135 MMcf per day. During the year we completed the construction of a nine-mile trunkline and related compression facilities allowing us to connect our Buffalo Wallow gathering system to our Hemphill processing facility. At our Cashion facility located in central Oklahoma, our total processing capacity is currently 45 MMcf per day. During December 2014, we connected 33 new wells to this system. At our Perkins facility, our total processing capacity has increased from 20 MMcf per day to 27 MMcf per day due to several projects that are being completed. These projects consist of processing plant upgrades along with projects to improve recoveries at this facility. We connected 33 new wells to this system in 2014. In the Mississippian play in north central Oklahoma, we continue to add wells and increase volumes on our Bellmon facility. Sixty new wells were connected to this system during 2014. Our current processing capacity is approximately 90 MMcf per day. In the Appalachian region, we continue to expand our Pittsburgh Mills gathering system. We are completing the construction of a project which extends our gathering system into Butler County, Pennsylvania. This project consists of a seven-mile trunkline along with related compressor station and provides us an additional outlet for our gas. This project is expected to be completed in the first quarter of 2015. Also in the Appalachian area, we recently began construction of our Snow Show Gathering System, a new fee-based gathering system in Centre County, Pennsylvania. This system will consist of approximately seven miles of 16” and 24” pipeline and a related compressor station. All environmental and regulatory activities have been completed and we are in the process of clearing right of way. Construction of the pipeline and compressor station will begin in the second quarter of 2015 with an expected completion date in the third quarter of 2015. Anticipated 2015 capital expenditures for this segment are $68.4 million, a 34% increase over 2014, excluding acquisitions and capital leases. Critical Accounting Policies and Estimates Summary In this section, we identify those critical accounting policies we follow in preparing our financial statements and related disclosures. Many of these policies require us to make difficult, subjective, and complex judgments in the course of making estimates of matters that are inherently imprecise. Some accounting policies involve judgments and uncertainties to such an extent that there is reasonable likelihood that materially different amounts could have been reported under different conditions, or if different assumptions had been used. We evaluate our estimates and assumptions on a regular basis. We base our estimates on historical experience and various other assumptions that we believe are reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates and assumptions used in preparation of our financial statements. In the following discussion we will attempt to explain the nature of these estimates, assumptions and judgments, as well as the likelihood that materially different amounts would be reported in our financial statements under different conditions or using different assumptions. The following table lists the critical accounting policies, identifies the estimates and assumptions that can have a significant impact on the application of these accounting policies, and the financial statement accounts that are affected by these estimates and assumptions. Accounting Policies Estimates or Assumptions Accounts Affected Full cost method of accounting for oil, NGLs, and natural gas properties • Oil, NGLs, and natural gas reserves, estimates, and related present value of future net revenues • Valuation of unproved properties • Estimates of future development costs • Oil and natural gas properties • Accumulated depletion, depreciation and amortization • Provision for depletion, depreciation and amortization • Impairment of oil and natural gas properties • Long-term debt and interest expense Accounting for ARO for oil, NGLs, and natural gas properties • Cost estimates related to the plugging and abandonment of wells • Timing of cost incurred • Oil and natural gas properties • Accumulated depletion, depreciation and amortization • Provision for depletion, depreciation and amortization • Current and non-current liabilities • Operating expense Accounting for impairment of long-lived assets • Forecast of undiscounted estimated future net operating cash flows • Drilling and mid-stream property and equipment • Accumulated depletion, depreciation and amortization • Provision for depletion, depreciation and amortization • Other intangible assets Goodwill • Forecast of discounted estimated future net operating cash flows • Terminal value • Weighted average cost of capital • Goodwill Accounting for value of stock compensation awards • Estimates of stock volatility • Estimates of expected life of awards granted • Estimates of rates of forfeitures • Oil and natural gas properties • Shareholder’s equity • Operating expenses • General and administrative expenses Accounting for derivative instruments and hedging • Hedges measured for effectiveness and ineffectiveness • Non-qualifying and qualifying derivatives measured at fair value • Current and non-current derivative assets and liabilities • Other comprehensive income as a component of equity • Oil and natural gas revenue • Gain (loss) on derivatives not designated as hedges and hedge ineffectiveness, net Significant Estimates and Assumptions Full Cost Method of Accounting for Oil, NGLs, and Natural Gas Properties. The determination of our oil, NGLs, and natural gas reserves is a subjective process. It entails estimating underground accumulations of oil, NGLs, and natural gas that cannot be measured in an exact manner. The degree of accuracy of these estimates depends on a number of factors, including, the quality and availability of geological and engineering data, the precision of the interpretations of that data, and individual judgments. Each year, we hire an independent petroleum engineering firm to audit our internal evaluation of our reserves. The audit of our reserve wells or locations as of December 31, 2014 covered those that we projected to comprise 85% of the total proved developed discounted future net income and 83% of the total proved undeveloped discounted future net income based on the unescalated pricing policy of the SEC. Included in Part I, Item 1 of this report are the qualifications of our independent petroleum engineering firm and our employees responsible for the preparation of our reserve reports. As a general rule, the accuracy of estimating oil, NGLs, and natural gas reserves varies with the reserve classification and the related accumulation of available data, as shown in the following table: Type of Reserves Nature of Available Data Degree of Accuracy Proved undeveloped Data from offsetting wells, seismic data Less accurate Proved developed non-producing The above as well as logs, core samples, well tests, pressure data More accurate Proved developed producing The above as well as production history, pressure data over time Most accurate Assumptions of future oil, NGLs, and natural gas prices and operating and capital costs also play a significant role in estimating these reserves as well as the estimated present value of the cash flows to be received from the future production of those reserves. Volumes of recoverable reserves are influenced by the assumed prices and costs due to the economic limit (that point when the projected costs and expenses of producing recoverable oil, NGLs, and natural gas reserves is greater than the projected revenues from the oil, NGLs, and natural gas reserves). But more significantly, the estimated present value of the future cash flows from our oil, NGLs, and natural gas reserves is sensitive to prices and costs, and may vary materially based on different assumptions. Companies, like ours, using full cost accounting use the unweighted arithmetic average of the commodity prices existing on the first day of each of the 12 months before the end of the reporting period to calculate discounted future revenues, unless prices were otherwise determined under contractual arrangements. We compute DD&A on a units-of-production method. Each quarter, we use the following formulas to compute the provision for DD&A for our producing properties: • DD&A Rate = Unamortized Cost / End of Period Reserves Adjusted for Current Period Production • Provision for DD&A = DD&A Rate x Current Period Production Oil, NGLs, and natural gas reserve estimates have a significant impact on our DD&A rate. If future reserve estimates for a property or group of properties are revised downward, the DD&A rate will increase as a result of the revision. Alternatively, if reserve estimates are revised upward, the DD&A rate will decrease. Based on our 2014 production level of 18.3 MMBoe, a decrease in the amount of our 2014 oil, NGLs, and natural gas reserves by 5% would increase our DD&A rate by $0.78 per Boe and would decrease pre-tax income by $14.3 million annually. Conversely, an increase in our 2014 oil, NGLs, and natural gas reserves by 5% would decrease our DD&A rate by $0.72 per Boe and would increase pre-tax income by $13.2 million annually. The DD&A expense on our oil and natural gas properties is calculated each quarter using period end reserve quantities adjusted for current period production. We account for our oil and natural gas exploration and development activities using the full cost method of accounting. Under this method, we capitalize all costs incurred in the acquisition, exploration, and development of oil and natural gas properties. At the end of each quarter, the net capitalized costs of our oil and natural gas properties are limited to that amount which is the lower of unamortized costs or a ceiling. The ceiling is defined as the sum of the present value (using a 10% discount rate) of the estimated future net revenues from our proved reserves (based on the unescalated 12-month average price on our oil, NGLs, and natural gas adjusted for any cash flow hedges), plus the cost of properties not being amortized, plus the lower of the cost or estimated fair value of unproved properties included in the costs being amortized, less related income taxes. If the net capitalized costs of our oil and natural gas properties exceed the ceiling, we are required to write-down the excess amount. A ceiling test write-down is a non-cash charge to earnings. If required, it reduces earnings and impacts shareholders’ equity in the period of occurrence and results in lower DD&A expense in future periods. Once incurred, a write-down cannot be reversed. The risk that we will be required to write-down the carrying value of our oil and natural gas properties increases when the prices for oil, NGLs, and natural gas are depressed or if we have large downward revisions in our estimated proved oil, NGLs, and natural gas reserves. Application of these rules during periods of relatively low prices, even if temporary, increases the chance of a ceiling test write-down. Based on applying 12-month 2014 average unescalated prices of $94.99 per barrel of oil, $45.25 per barrel of NGLs, and $4.36 per Mcf of natural gas (then adjusted for price differentials) over the estimated life of each of our oil and natural gas properties, the unamortized cost of our oil and natural gas properties exceeded the ceiling of our proved oil, NGLs, and natural gas reserves in the fourth quarter of 2014. We incurred a non-cash ceiling test write-down of our oil and natural gas properties of $76.7 million pre-tax ($47.7 million net of tax) due to the inclusion of the impaired value of certain unproved properties and a reduction of the 12-month average commodity prices during the quarter. Subsequent to December 31, 2014, commodity prices have continued to decrease below December 31, 2014 levels. We anticipate that these reduced prices will require an additional write-down of the carrying value of our oil and natural gas properties for the quarter ending March 31, 2015 and potentially for subsequent quarters. Derivative instruments qualifying as cash flow hedges are included in the computation of limitation on capitalized costs. All of our cash flow hedges expired as of December 31, 2013 and no longer effect this computation. Our oil and natural gas derivatives are discussed in Note 13 of the Notes to our Consolidated Financial Statements. We use the sales method for recording natural gas sales. This method allows for the recognition of revenue, which may be more or less than our share of pro-rata production from certain wells. Our policy is to expense our pro-rata share of lease operating costs from all wells as incurred. The expenses relating to the wells in which we have a production imbalance are not material. Costs Withheld from Amortization. Costs associated with unproved properties are excluded from our amortization base until we have evaluated the properties. The costs associated with unevaluated leasehold acreage and related seismic data, wells currently drilling and capitalized interest are initially excluded from our amortization base. Leasehold costs are either transferred to our amortization base with the costs of drilling a well on the lease or are assessed at least annually for possible impairment or reduction in value. Leasehold costs are transferred to our amortization base to the extent a reduction in value has occurred. Our decision to withhold costs from amortization and the timing of the transfer of those costs into the amortization base involve a significant amount of judgment and may be subject to changes over time based on several factors, including our drilling plans, availability of capital, project economics and results of drilling on adjacent acreage. In December 2014, we determined the value of certain unproved oil and gas properties were diminished (in part or in whole) based on an impairment evaluation and our anticipated future exploration plans. That determination resulted in $73.7 million of costs associated with the unproved properties being added to the capitalized costs to be amortized. We incurred a non-cash ceiling test write-down. At December 31, 2014, we had a total of approximately $485.6 million of costs excluded from the amortization base of our full cost pool. Accounting for ARO for Oil, NGLs, and Natural Gas Properties. We record the fair value of liabilities associated with the retirement of assets having a long life. In our case, when the reserves in each of our oil or gas wells deplete or otherwise become uneconomical, we are required to incur costs to plug and abandon the wells. These costs are recorded in the period in which the liability is incurred (at the time the wells are drilled or acquired). We do not have any assets restricted for the purpose of settling these ARO liabilities. Our engineering staff uses historical experience to determine the estimated plugging costs taking into account the type of well (either oil or natural gas), the depth of the well and physical location of the well to determine the estimated plugging costs. Accounting for Impairment of Long-Lived Assets. Drilling equipment, transportation equipment, gas gathering and processing systems, and other property and equipment are carried at cost less accumulated depreciation. Renewals and enhancements are capitalized while repairs and maintenance are expensed. We review the carrying amounts of long-lived assets for potential impairment annually, typically during the fourth quarter, or when events occur or changes in circumstances suggest that these carrying amounts may not be recoverable. Changes that could prompt such an assessment may include equipment obsolescence, changes in the market demand for a specific asset, changes in commodity prices, periods of relatively low rig utilization, declining revenue per day, declining cash margin per day, or overall changes in general market conditions. Assets are determined to be impaired if a forecast of undiscounted estimated future net operating cash flows directly related to the asset, including disposal value if any, is less than the carrying amount of the asset. If any asset is determined to be impaired, the loss is measured as the amount by which the carrying amount of the asset exceeds its fair value. The estimate of fair value is based on the best information available, including prices for similar assets. Changes in these estimates could cause us to reduce the carrying value of property and equipment. Asset impairment evaluations are, by nature, highly subjective. They involve expectations about future cash flows generated by our assets and reflect management’s assumptions and judgments regarding future industry conditions and their effect on future utilization levels, dayrates, and costs. The use of different estimates and assumptions could result in materially different carrying values of our assets. On a periodic basis, we evaluate our fleet of drilling rigs for marketability based on the condition of inactive rigs, expenditures that would be necessary to bring them to working condition and the expected demand for drilling services by rig type. The components comprising inactive rigs are evaluated, and those components with continuing utility to the Company’s other marketed rigs are transferred to other rigs or to its yards to be used as spare equipment. The remaining components of these rigs are retired. In December 2014, we removed from service 31 drilling rigs, some older top drives, and certain drill pipe no longer marketable in the current environment. We estimated the fair value of the rigs and other assets based on the estimate market value from third-party assessments (Level 3 fair value measurement). Based on these estimates, we recorded a write-down of approximately $74.3 million pre-tax. In December 2014, our mid-stream segment had a $7.1 million pre-tax write-down of three of its systems, Weatherford, Billy Rose, and Spring Creek due to anticipated future cash flow and future development around these systems supporting their carrying value. The estimated future cash flows were less than the carrying value on these systems (Level 3 fair value measurement). In December 2012, our mid-stream segment had a $1.2 million write-down of its Erick system. There was no volume from the wells connected to this system, the compressor and related surface equipment have been removed from this location and there is no future activity anticipated from this gathering system. No significant impairment was recorded at December 31, 2013. Goodwill. Goodwill represents the excess of the cost of acquisitions over the fair value of the net assets acquired. Goodwill is not amortized, but an impairment test is performed at least annually to determine whether the fair value has decreased and is performed additionally when events indicate an impairment may have occurred. For purposes of impairment testing, goodwill is evaluated at the reporting unit level. Our goodwill is all related to our contract drilling segment, and accordingly, the impairment test is generally based on the estimated discounted future net cash flows of our drilling segment, utilizing discount rates and other factors in determining the fair value of our drilling segment. Inputs in our estimated discounted future net cash flows include rig utilization, day rates, gross margin percentages, and terminal value (these are all considered level 3 inputs). No goodwill impairment was recorded at December 31, 2014, 2013, or 2012. Turnkey and Footage Drilling Contracts. Because our contract drilling operations do not bear the risk of completion of a well being drilled under a “daywork” contract, we recognize revenues and expense generated under “daywork” contracts as the services are performed. Under “footage” and “turnkey” contracts we bear the risk of completion of the well, so revenues and expenses are recognized when the well is substantially completed. Substantial completion is determined when the well bore reaches the depth specified in the contract. The entire amount of a loss, if any, is recorded when the loss can be reasonably determined, however, any profit is recorded only at the time the well is finished. The costs of drilling contracts uncompleted at the end of the reporting period (which includes expenses incurred to date on “footage” or “turnkey” contracts) are included in other current assets. We did not drill any wells under turnkey or footage contracts in 2014, 2013, or 2012. Accounting for Value of Stock Compensation Awards. To account for stock-based compensation, compensation cost is measured at the grant date based on the fair value of an award and is recognized over the service period, which is usually the vesting period. We elected to use the modified prospective method, which requires compensation expense to be recorded for all unvested stock options and other equity-based compensation beginning in the first quarter of adoption. The determination of the fair value of an award requires significant estimates and subjective judgments regarding, among other things, the appropriate option pricing model, the expected life of the award and performance vesting criteria assumptions. As there are inherent uncertainties related to these factors and our judgment in applying them to the fair value determinations, there is risk that the recorded stock compensation may not accurately reflect the amount ultimately earned by the employee. Accounting for Derivative Instruments and Hedging. For our economic hedges that we did not apply cash flow accounting to, any changes in their fair value occurring before their maturity (i.e., temporary fluctuations in value) are reported in gain (loss) on derivatives not designated as hedges and hedge ineffectiveness, net in our Consolidated Statements of Income. The commodity derivative instruments we had under cash flow accounting expired as of December 2013. Previous changes in the fair value of derivatives designated as cash flow hedges, to the extent they were effective in offsetting cash flows attributable to the hedged risk, were recorded in OCI until the hedged item was recognized into earnings. When the hedged item was recognized into earnings, it was reported in oil and natural gas revenues. Any change in fair value resulting from ineffectiveness was recognized in gain (loss) on derivatives not designated as hedges and hedge ineffectiveness, net. New Accounting Standards Presentation of Financial Statements-Going Concern: Disclosure of Uncertainties about an Entity's Ability to Continue as a Going Concern. The FASB has issued ASU 2014-15. This is intended to define management's responsibility to evaluate whether there is substantial doubt about an organization's ability to continue as a going concern and to provide related footnote disclosures. For each reporting period, management will be required to evaluate whether there are conditions or events that raise substantial doubt about a company's ability to continue as a going concern within one year from the date financial statements are issued. The amendments are effective for annual periods ending after December 15, 2016, and interim periods within annual periods beginning after December 15, 2016. Early application is permitted for annual or interim reporting periods for which the financial statements have not previously been issued. Compensation - Stock Compensation: Accounting for Share-Based Payments When the Terms of an Award Provide that a Performance Target Could Be Achieved after the Requisite Service Period. The FASB has issued ASU 2014-12, the amendments in the ASU require that a performance target that affects vesting and that could be achieved after the requisite service period be treated as a performance condition. A reporting entity should apply existing guidance in Topic 718, Compensation - Stock Compensation, as it relates to awards with performance conditions that affect vesting to account for such awards. The performance target should not be reflected in estimating the grant-date fair value of the award. Compensation cost should be recognized in the period in which it becomes probable that the performance target will be achieved and should represent the compensation cost attributable to the period(s) for which the requisite service has already been rendered. If the performance target becomes probable of being achieved before the end of the requisite service period, the remaining unrecognized compensation cost should be recognized prospectively over the remaining requisite service period. The total amount of compensation cost recognized during and after the requisite service period should reflect the number of awards that are expected to vest and should be adjusted to reflect those awards that ultimately vest. The requisite service period ends when the employee can cease rendering service and still be eligible to vest in the award if the performance target is achieved.The amendments in this ASU are effective for annual periods and interim periods within those annual periods beginning after December 15, 2015. Earlier adoption is permitted. We do not have any stock compensation awards with these conditions at this time. Revenue from Contracts with Customers. The FASB has issued ASU 2014-09. This affects any entity using U.S. GAAP that either enters into contracts with customers to transfer goods or services or enters into contracts for the transfer of nonfinancial assets unless those contracts are within the scope of other standards (e.g., insurance contracts or lease contracts). The core principle of the guidance is that an entity should recognize revenue to depict the transfer of promised goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services. The amendments in this ASU are effective for annual reporting periods beginning after December 15, 2016, including interim periods within that reporting period. Early application is not permitted. We are in the process of evaluating the impact it will have on our financial statements. Presentation of Financial Statements and Property, Plant, and Equipment: Reporting Discontinued Operations and Disclosures of Disposals of Components of an Entity. The FASB has issued ASU 2014-08, the amendments in this update change the criteria for reporting discontinued operations while enhancing disclosures in this area. It also addresses sources of confusion and inconsistent application related to financial reporting of discontinued operations guidance in U.S. GAAP. Under the new guidance, only disposals representing a strategic shift that would have a major effect on the organization's operations and financial results should be presented as discontinued operations. In addition, it requires expanded disclosures about discontinued operations that will provide financial statement users with more information about the assets, liabilities, income, and expenses of discontinued operations. It also requires disclosure of pre-tax income attributable to a disposal of a significant part of an organization that does not qualify for discontinued operations reporting. The updates are effective for fiscal years, and interim periods within those years, beginning after December 15, 2014. Early adoption is permitted. We currently do not have any discontinued operations or disposals of components of an entity. Financial Condition and Liquidity Summary. Our financial condition and liquidity primarily depends on the cash flow from our operations and borrowings under our credit agreement. The principal factors determining the amount of our cash flow are: • the quantity of natural gas, oil, and NGLs we produce; • the prices we receive for our natural gas, oil, and NGLs production; • the demand for and the dayrates we receive for our drilling rigs; and • the fees and margins we obtain from our natural gas gathering and processing contracts. We currently believe we have sufficient cash flow and liquidity to meet our obligations for the next twelve months. Our ability to meet our debt covenants (under our credit agreement as well as our Indenture) and our capacity to incur additional indebtedness will depend on our future performance, which in turn will be affected by financial, business, economic, regulatory, and other factors. For example, lower oil, natural gas, and NGLs prices could result in a redetermination of the borrowing base under our credit agreement to a lower level and therefore reduce or limit our ability to incur indebtedness. As a result, we monitor our liquidity and capital resources, endeavor to anticipate potential covenant compliance issues and work with the lenders under our credit agreement to address those issues, if any, ahead of time. As part of our plan to manage liquidity risks, we have lowered our capital expenditures budget, focused our drilling program on our highest return plays, and continue to explore opportunities to divest non-core assets and properties. The following is a summary of certain financial information for the years ended December 31: Cash flows from Operating Activities Our operating cash flow is primarily influenced by the prices we receive for our oil, NGLs, and natural gas production, the quantity of oil, NGL, and natural gas we produce, settlements of derivative contracts, third-party demand for our drilling rigs and mid-stream services, and the rates we are able to charge for those services. Our cash flows from operating activities are also impacted by changes in working capital. Net cash provided by operating activities during 2014 increased by $34.7 million over 2013 due primarily to adjustments for depreciation and impairment and to a lesser extent from changes in operating assets and liabilities related to the timing of cash receipts and disbursements offset partially by lower net income and adjustments for gains on derivatives. Cash flows from Investing Activities We dedicate and expect to continue to dedicate a substantial portion of our capital expenditure program toward the exploration for and production of oil, NGLs, and natural gas. Theses capital expenditures are necessary to offset inherent declines in production, which is typical in the capital-intensive oil and natural gas industry. Cash flows used in investing activities increased by $341.4 million in 2014 compared to 2013. The change was due primarily to an increase in capital expenditures partially offset by the proceeds received from the disposition of assets. See additional information on capital expenditures below under Capital Requirements. Cash Flows from Financing Activities Cash flows provided by financing activities increased by $271.6 million in 2014 compared to 2013. This increase was primarily due to our borrowings under our credit agreement as well as an increase in our book overdrafts (which are checks that have been issued but not presented to our bank for payment before the end of the period). At December 31, 2014, we had unrestricted cash totaling $1.0 million and had borrowed $166.0 million of the $500.0 million we currently have available under our credit agreement. Our credit agreement is used primarily for working capital and capital expenditures. The following is a summary of certain financial information as of December 31, and for the years ended December 31: _________________________ (1) Long-term debt is net of unamortized discount. (2) In 2014 and 2012, we incurred non-cash ceiling test write-downs of our oil and natural gas properties of $76.7 million and $283.6 million pre-tax ($47.7 million and $176.5 million, net of tax), respectively. Also in December 2014, we incurred a non-cash write-down associated with the removal of 31 drilling rigs from our fleet along with certain other equipment and drill pipe of $74.3 million pre-tax ($46.3 million net of tax) and a non-cash write-down associated with a reduction in the carrying value of three midstream segment systems of $7.1 million pre-tax ($4.4 million net of tax). The write-downs impacted our shareholders’ equity, ratio of long-term debt to total capitalization, and net income for years 2014 and 2012. There was no impact on our compliance with the covenants contained in our credit agreement. The following table summarizes certain operating information for the years ended December 31: Working Capital Typically, our working capital balance fluctuates, in part, because of the timing of our trade accounts receivable and accounts payable and the fluctuation in current assets and liabilities associated with the mark to market value of our derivative activity. We had negative working capital of $51.7 million, $31.5 million, and $11.5 million as of December 31, 2014, 2013, and 2012, respectively. This is primarily from the timing of our accounts payable associated with our capital expenditures. Our credit agreement is used primarily for working capital and capital expenditures. At December 31, 2014, we had borrowed $166.0 million of the $500.0 million currently available to us under our credit agreement. The effect of our derivatives increased working capital by $31.1 million as of December 31, 2014, and decreased working capital by $5.0 million as of December 31, 2013, and increased working capital by $9.6 million as of December 31, 2012. Oil and Natural Gas Operations Any significant change in oil, NGLs, or natural gas prices has a material effect on our revenues, cash flow, and the value of our oil, NGLs, and natural gas reserves. Generally, prices and demand for domestic natural gas are influenced by weather conditions, supply imbalances, and by worldwide oil price levels. Domestic oil prices are primarily influenced by world oil market developments. All of these factors are beyond our control and we cannot predict nor measure their future influence on the prices we will receive. Based on our 2014 production, a $0.10 per Mcf change in what we are paid for our natural gas production, without the effect of derivatives, would result in a corresponding $466,000 per month ($5.6 million annualized) change in our pre-tax operating cash flow. Our 2014 average natural gas price was $3.92 compared to an average natural gas price of $3.32 for 2013 and $3.37 for 2012. A $1.00 per barrel change in our oil price, without the effect of derivatives, would have a $308,000 per month ($3.7 million annualized) change in our pre-tax operating cash flow and a $1.00 per barrel change in our NGLs prices, without the effect of derivatives, would have a $368,000 per month ($4.4 million annualized) change in our pre-tax operating cash flow based on our production in 2014. Our 2014 average oil price per barrel was $89.43 compared with an average oil price of $95.06 in 2013 and $92.60 in 2012, and our 2014 average NGLs price per barrel was $30.95 compared with an average NGLs price of $31.79 in 2013 and $31.58 in 2012. Because commodity prices have an effect on the value of our oil, NGLs, and natural gas reserves, declines in those prices can result in a decline in the carrying value of our oil and natural gas properties. Price declines can also adversely affect the semi-annual determination of the amount available for us to borrow under our credit agreement since that determination is based mainly on the value of our oil, NGLs, and natural gas reserves. A reduction could limit our ability to carry out our planned capital projects. Subsequent to December 31, 2014, commodity prices have continued to decrease and should commodity prices remain below December 31, 2014 levels, we anticipate an additional write-down of the carrying value of our oil and natural gas properties will be required for the quarter ending March 31, 2015 and potentially for subsequent quarters. Our natural gas production is sold to intrastate and interstate pipelines, to independent marketing firms and gatherers under contracts with terms generally ranging anywhere from one month to five years. Our oil production is sold to independent marketing firms generally under six month contracts. Contract Drilling Operations Many factors influence the number of drilling rigs we are working at any given time as well as the costs and revenues associated with that work. These factors include the demand for drilling rigs in our areas of operation, competition from other drilling contractors, the prevailing prices for oil, NGLs, and natural gas, availability and cost of labor to run our drilling rigs, and our ability to supply the equipment needed. Several of our drilling rig customers have significantly reduced their drilling budgets for 2015, resulting in a significant reduction in the utilization of our drilling rig fleet. At December 31, 2014, we had 75 rigs operating, and at February 13, 2015, this number has been reduced to 50 rigs operating. We currently expect further reductions into 2015. We increased compensation for rig personnel in our Oklahoma, Texas, Louisiana, and Kansas operations during the third quarter of 2014 to remain competitive in attracting and retaining rig crew personnel in a growing drilling market. Now that the market conditions have changed and our rig utilization has decreased dramatically, we do not anticipate any further increases. Almost all of our working drilling rigs in 2014 have been drilling horizontal or directional wells. With the recent low commodity prices, our customers have drastically reduced their drilling budgets. As a result, we are experiencing reduced rig utilization. Commodity prices in the various basins in which we operate ultimately affect the demand and mix of the type of drilling rigs used by our customers. Unit’s rig fleet is comprised of rigs capable to meet our customers’ demands whether it be for oil, natural gas, or NGLs and whether it be for shallow, deep, vertical, or horizontal type drilling. Current and future demand for drilling rigs will have an impact on dayrates. The future demand for and the availability of drilling rigs to meet that demand will have an impact on our future dayrates. For 2014, our average dayrate was $20,043 per day compared to $19,646 and $19,949 per day for 2013 and 2012, respectively. Our average number of drilling rigs used in 2014 was 75.4 (63%) compared with 65.0 (52%) and 73.9 (58%) in 2013 and 2012, respectively. Based on the average utilization of our drilling rigs during 2014, a $100 per day change in dayrates has a $7,500 per day ($2.8 million annualized) change in our pre-tax operating cash flow. Our contract drilling segment provides drilling services for our exploration and production segment. Some of the drilling services we perform on our properties are, depending on the timing of those services, deemed to be associated with the acquisition of an ownership interest in the property. In those cases, revenues and expenses for those services are eliminated in our income statement, with any profit recognized as a reduction in our investment in our oil and natural gas properties. The contracts for these services are issued under the same conditions and rates as the contracts entered into with unrelated third parties. We eliminated revenue of $89.5 million, $64.3 million, and $49.6 million for 2014, 2013, and 2012, respectively, from our contract drilling segment and eliminated the associated operating expense of $62.4 million, $46.9 million, and $34.1 million during 2014, 2013, and 2012, respectively, yielding $27.1 million, $17.4 million, and $15.5 million during 2014, 2013, and 2012, respectively, as a reduction to the carrying value of our oil and natural gas properties. Mid-Stream Operations This segment is engaged primarily in the buying, selling, gathering, processing, and treating of natural gas. It operates three natural gas treatment plants, 14 processing plants, 38 gathering systems, and approximately 1,525 miles of pipeline. Its operations are located in Oklahoma, Texas, Kansas, Pennsylvania, and West Virginia. This segment enhances our ability to gather and market not only our own natural gas and NGLs but also that owned by third parties and serves as a mechanism through which we can construct or acquire existing natural gas gathering and processing facilities. During 2014, 2013, and 2012 this segment purchased $80.9 million, $83.0 million, and $68.2 million, respectively, of our oil and natural gas segment's natural gas and NGLs production, and provided gathering and transportation services of $8.7 million, $8.0 million, and $5.1 million, respectively. Intercompany revenue from services and purchases of production between this business segment and our oil and natural gas segment has been eliminated in our consolidated financial statements. Our mid-stream segment gathered an average of 319,348 Mcf per day in 2014 compared to 309,554 Mcf per day in 2013 and 250,290 Mcf per day in 2012. It processed an average of 161,282 Mcf per day in 2014 compared to 140,584 Mcf per day in 2013 and 133,987 Mcf per day in 2012, and sold NGLs of 733,406 gallons per day in 2014 compared to 543,602 gallons per day in 2013 and 542,578 gallons per day in 2012. Gas gathering volumes per day in 2014 increased primarily from new wells connected to our systems throughout 2014 along with the addition of new systems and the expansion of existing systems. Volumes processed and NGLs sold both increased primarily due to the addition of new wells connected, recent upgrades to several existing processing facilities, and the addition of new processing facilities. Due to the decline in NGLs prices during 2014, in the second half of the year we operated our processing facilities in full ethane rejection mode which reduced the amount of liquids sold during this time period. As long as NGLs prices continue at or below these levels,we expect to continue operating in full ethane rejection mode. Our mid-stream segment did not experience a significant reduction in processed volumes in 2014 but as low prices continue we expect further reductions in drilling activity around our systems which will eventually effect our ability to connect new wells resulting in lower processed volumes in the future. Our Credit Agreement and Senior Subordinated Notes Credit Agreement. Under our Senior Credit Agreement (credit agreement), the amount we can borrow is the lesser of the amount we elect (from time to time) as the commitment amount or the value of the borrowing base as determined by the lenders, but in either event not to exceed the maximum credit agreement amount of $900.0 million. Our current commitment amount is $500.0 million. Our current borrowing base is $900.0 million. We are charged a commitment fee ranging from 0.375 to 0.50 of 1% on the amount available but not borrowed. The fee varies based on the amount borrowed as a percentage of the amount of the total borrowing base. The credit agreement matures as of September 13, 2016. In connection with the most recent amendment of the credit agreement, we paid $1.5 million in origination, agency, syndication, and other related fees. We are amortizing these fees over the life of the credit agreement. The current lenders under our credit agreement and their respective participation interests are as follows: The amount of the borrowing base-which is subject to redetermination by the lenders on April 1st and October 1st of each year, is based primarily on a percentage of the discounted future value of our oil and natural gas reserves. There was no change to the borrowing base with the October 2014 redetermination. With the recent decline in commodity prices, we anticipate our lenders may reduce our borrowing base at the next scheduled redetermination. We do not anticipate any reduction at the next borrowing base redetermination will result in the borrowing base being below our current elected commitment amount of $500.0 million. We or the lenders may request a onetime special redetermination of the borrowing base between each scheduled redetermination. In addition, we may request a redetermination following the completion of an acquisition that meets the requirements set forth in the credit agreement. At our election, any part of the outstanding debt under the credit agreement may be fixed at a London Interbank Offered Rate (LIBOR). LIBOR interest is computed as the sum of the LIBOR base for the applicable term plus 1.75% to 2.50% depending on the level of debt as a percentage of the borrowing base and is payable at the end of each term, or every 90 days, whichever is less. Borrowings not under LIBOR bear interest at the prime rate specified in the credit agreement that in any event cannot be less than LIBOR plus 1.00%. Interest is payable at the end of each month and the principal may be repaid in whole or in part at anytime, without a premium or penalty. At December 31, 2014 and February 13, 2015, we had $166.0 million and $201.5 million, respectively, outstanding borrowings under our credit agreement. We can use borrowings for financing general working capital requirements for (a) exploration, development, production and acquisition of oil and gas properties, (b) acquisitions and operation of mid-stream assets, (c) issuance of standby letters of credit, (d) contract drilling services, and (e) general corporate purposes. The credit agreement prohibits, among other things: • the payment of dividends (other than stock dividends) during any fiscal year in excess of 30% of our consolidated net income for the preceding fiscal year; • the incurrence of additional debt with certain limited exceptions; and • the creation or existence of mortgages or liens, other than those in the ordinary course of business, on any of our properties, except in favor of our lenders. The credit agreement also requires that we have at the end of each quarter: • a current ratio (as defined in the credit agreement) of not less than 1 to 1; and • a leverage ratio of funded debt to consolidated EBITDA (as defined in the credit agreement) for the most recently ended rolling four fiscal quarters of no greater than 4 to 1. As of December 31, 2014, we were in compliance with the covenants contained in the credit agreement. 6.625% Senior Subordinated Notes. We have issued and outstanding an aggregate principal amount of $650.0 million, 6.625% senior subordinated notes (the Notes). The interest is payable semi-annually (in arrears) on May 15 and November 15 of each year, and the Notes will mature on May 15, 2021. In connection with the issuance of the Notes, we incurred $14.7 million of fees that are being amortized as debt issuance cost over the life of the Notes. The Notes are subject to an Indenture dated as of May 18, 2011, between us and Wilmington Trust, National Association (successor to Wilmington Trust FSB), as Trustee (the Trustee), as supplemented by the First Supplemental Indenture dated as of May 18, 2011, between us, the Guarantors, and the Trustee, and as further supplemented by that the Second Supplemental Indenture dated as of January 7, 2013, between us, the Guarantors and the Trustee (as supplemented, the 2011 Indenture), establishing the terms and providing for the issuance of the Notes. The Guarantors are all of our direct and indirect subsidiaries. The discussion of the Notes in this report is qualified by and subject to the actual terms of the 2011 Indenture. Unit, as the parent company, has no independent assets or operations. The guarantees by the Guarantors of the Notes (registered under registration statements) are full and unconditional, joint and several, subject to certain automatic customary releases, are subject to certain restrictions on the sale, disposition, or transfer of the capital stock or substantially all of the assets of a subsidiary guarantor, and other conditions and terms set out in the Indenture. Any of our subsidiaries that are not Guarantors are minor. There are no significant restrictions on our ability to receive funds from our subsidiaries through dividends, loans, advances or otherwise. At any time before May 15, 2016, we may redeem the Notes, in whole or in part, at a redemption price equal to 100% of the principal amount plus a “make whole” premium, plus accrued and unpaid interest, if any, to the redemption date. On and after May 15, 2016, we may redeem all or, from time to time, a part of the Notes at certain redemption prices, plus accrued and unpaid interest. If a “change of control” occurs, subject to certain conditions, we must offer to repurchase from each holder all or any part of that holder’s Notes at a purchase price in cash equal to 101% of the principal amount of the Notes plus accrued and unpaid interest, if any, to the date of purchase. The 2011 Indenture contains customary events of default. The 2011 Indenture also contains covenants that, among other things, limit our ability and the ability of certain of our subsidiaries to incur or guarantee additional indebtedness; pay dividends on our capital stock or redeem capital stock or subordinated indebtedness; transfer or sell assets; make investments; incur liens; enter into transactions with our affiliates; and merge or consolidate with other companies. We were in compliance with all covenants of the Notes as of December 31, 2014. Capital Requirements Oil and Natural Gas Dispositions, Acquisitions, and Capital Expenditures. Most of our capital expenditures for this segment are discretionary and directed toward future growth. Any decision to increase our oil, NGLs, and natural gas reserves through acquisitions or through drilling depends on the prevailing or expected market conditions, potential return on investment, future drilling potential, and opportunities to obtain financing under the circumstances involved, all of which provide us with a large degree of flexibility in deciding when and if to incur these costs. We completed drilling 186 gross wells (121.0 net wells) in 2014 compared to 149 gross wells (91.14 net wells) in 2013, and 171 gross wells (80.08 net wells) in 2012. Our 2014 total capital expenditures for our oil and natural gas segment, excluding a $37.7 million reduction in the ARO liability and $5.7 million in acquisitions, totaled $772.2 million compared to 2013 capital expenditures of $549.2 million (excluding a $18.0 million ARO liability), and 2012 capital expenditures of $521.2 million (excluding a $45.1 million ARO liability and $579.0 million for acquisitions). For all of 2015, we plan to participate in drilling approximately 70 wells and estimate our total capital expenditures (excluding any possible acquisitions) for our oil and natural gas segment will be approximately $308.5 million. Whether we are able to drill all of those wells is dependent on a number of factors, many of which are beyond our control and include the availability of drilling rigs, availability of pressure pumping services, prices for oil, NGLs, and natural gas, demand for oil, NGLs, and natural gas, the cost to drill wells, the weather, and the efforts of outside industry partners. On September 17, 2012, we closed on the acquisition of certain oil and natural gas assets from Noble Energy, Inc. (Noble). After final closing adjustments, the acquisition included approximately 83,000 net acres primarily in the Granite Wash, Cleveland, and various other plays in western Oklahoma and the Texas Panhandle. The adjusted amount paid was $592.6 million. Also in September 2012, we sold our interest in certain Bakken properties. The proceeds, net of related expenses were $226.6 million. In addition, we sold certain oil and natural gas assets located in Brazos and Madison Counties, Texas, for approximately $44.1 million. In August 2013, we sold additional Bakken property interests. The proceeds, net of related expenses, were $57.1 million. In addition, we had other non-core asset sales with proceeds, net of related expenses, of $21.7 million for 2013. Proceeds from these dispositions reduced the net book value of the full cost pool with no gain or loss recognized. We sold non-core oil and natural gas assets, net of related expenses, for $33.1 million during 2014. Proceeds from those dispositions reduced the net book value of our full cost pool with no gain or loss recognized. Contract Drilling Dispositions, Acquisitions, and Capital Expenditures. During 2012, we placed two new build 1,500 horsepower, diesel-electric drilling rigs into service, one in Wyoming and one in North Dakota. Also during 2012, we sold an idle 600 horsepower mechanical drilling rig to an unaffiliated third party and had a fire on one of our drilling rigs located in the mid-continent region. The net book value of the damaged equipment was $3.2 million. All of the net book value of the damaged equipment was recovered from insurance proceeds. No personnel were injured in this incident. During 2013, we sold four of our 2,000 horsepower electric drilling rigs and one 3,000 horsepower electric drilling rigs. All of these sales were to unaffiliated third parties. During the first quarter of 2014. we sold four additional idle 3,000 horsepower drilling rigs to an unaffiliated third party. The proceeds from that sale were used in our construction program for our new proprietary 1,500 horsepower, AC electric drilling rig, called the BOSS drilling rig. During 2014, three BOSS drilling rigs were constructed and placed into service for third-party operators. In December 2014, we removed from service 31 drilling rigs, some older top drives, and certain drill pipe no longer marketable in the current environment. We estimated the fair value of the rigs and other assets based on the estimate market value from third-party assessments (Level 3 fair value measurement). Based on these estimates, we recorded a write-down of approximately $74.3 million, pre-tax. This reduction to our fleet brought our total number of drilling rigs at year end to 89. Five additional BOSS drilling rigs have been contracted to be built for third-party operators and will be placed into service in 2015, the first of which began operating in January 2015. The long lead time components for three additional BOSS drilling rigs have also been ordered. Our anticipated 2015 capital expenditures for this segment are $99.7 million. We have spent $176.7 million for capital expenditures during 2014 compared to $64.3 million in 2013, and $77.5 million in 2012. Mid-Stream Dispositions, Acquisitions, and Capital Expenditures. At our Hemphill County, Texas facility, we operate four processing plants with a total processing capacity of 135 MMcf per day. During the year we completed the construction of a nine-mile trunkline and related compression facilities allowing us to connect our Buffalo Wallow gathering system to our Hemphill processing facility. At our Cashion facility located in central Oklahoma, our total processing capacity is currently 45 MMcf per day. During December 2014, we connected 33 new wells to this system. At our Perkins facility, our total processing capacity has increased from 20 MMcf per day to 27 MMcf per day due to several projects that are being completed. These projects consist of processing plant upgrades along with projects to improve recoveries at this facility. We connected 33 new wells to this system in 2014. In the Mississippian play in north central Oklahoma, we continue to add wells and increase volumes on our Bellmon facility. Sixty new wells were connected to this system during 2014. Our current processing capacity is approximately 90 MMcf per day. In the Appalachian region, we continue to expand our Pittsburgh Mills gathering system. We are completing the construction of a project which extends our gathering system into Butler County, Pennsylvania. This project consists of a seven-mile trunkline along with related compressor station and provides us an additional outlet for our gas. This project is expected to be completed in the first quarter of 2015. Also in the Appalachian area, we recently began construction of our Snow Show Gathering System, a new fee-based gathering system in Centre County, Pennsylvania. This system will consist of approximately seven miles of 16” and 24” pipeline and a related compressor station. All environmental and regulatory activities have been completed and we are in the process of clearing right of way. Construction of the pipeline and compressor station will begin in the second quarter of 2015 with an expected completion date in the third quarter of 2015. During 2014, our mid-stream segment incurred $51.1 million in capital expenditures, excluding $28.2 million for capital leases, as compared to $96.1 million in 2013, and $183.2 million ($18.7 million on four gathering systems acquired in the Noble acquisition) in 2012, including acquisitions. For 2015, our estimated capital expenditures (excluding acquisitions) are $68.4 million. At December 31, 2014, we had committed to purchase a gas accounting system for $0.2 million within the next twelve months. Contractual Commitments At December 31, 2014, we had the following contractual obligations: _________________________ (1) See previous discussion in MD&A regarding our long-term debt. This obligation is presented in accordance with the terms of the Notes and credit agreement and includes interest calculated using our December 31, 2014 interest rates of 6.625% for the Notes and 2.9% for the credit agreement. (2) We lease office space or yards in Edmond, Oklahoma City, and Tulsa, Oklahoma; Houston, Texas; Englewood, Colorado; Pinedale, Wyoming; and Pittsburgh, Pennsylvania under the terms of operating leases expiring through July 2019. Additionally, we have several equipment leases and lease space on short-term commitments to stack excess drilling rig equipment and production inventory. (3) Maintenance and interest payments are included in our capital lease agreements. The capital leases are discounted using annual rates of 4.0%. Total maintenance and interest remaining are $11.4 million and $3.7 million, respectively. (4) We have committed to purchase approximately $26.1 million of new drilling rig components, drill pipe, and related equipment over the next two years. (5) We have committed to pay $1.4 million for Enterprise Resource Planning software and $0.5 million for maintenance for one year following implementation. (6) We have committed to pay $0.2 million for a gas accounting system over the next twelve months. At December 31, 2014, we also had the following commitments and contingencies that could create, increase or accelerate our liabilities: _________________________ (1) We provide a salary deferral plan which allows participants to defer the recognition of salary for income tax purposes until actual distribution of benefits, which occurs at either termination of employment, death or certain defined unforeseeable emergency hardships. We recognize payroll expense and record a liability, included in other long-term liabilities in our Consolidated Balance Sheets, at the time of deferral. (2) Effective January 1, 1997, we adopted a separation benefit plan (“Separation Plan”). The Separation Plan allows eligible employees whose employment with us is involuntarily terminated or, in the case of an employee who has completed 20 years of service, voluntarily or involuntarily terminated, to receive benefits equivalent to four weeks salary for every whole year of service completed with the company up to a maximum of 104 weeks. To receive payments the recipient must waive certain claims against us in exchange for receiving the separation benefits. On October 28, 1997, we adopted a Separation Benefit Plan for Senior Management (“Senior Plan”). The Senior Plan provides certain officers and key executives of the company with benefits generally equivalent to the Separation Plan. The Compensation Committee of the Board of Directors has absolute discretion in the selection of the individuals covered in this plan. On May 5, 2004 we also adopted the Special Separation Benefit Plan (“Special Plan”). This plan is identical to the Separation Benefit Plan with the exception that the benefits under the plan vest on the earliest of a participant’s reaching the age of 65 or serving 20 years with the company. On December 31, 2008, all these plans were amended to bring the plans into compliance with Section 409A of the Internal Revenue Code of 1986, as amended. (3) When a well is drilled or acquired, under ASC 410 “Accounting for Asset Retirement Obligations,” we record the fair value of liabilities associated with the retirement of long-lived assets (mainly plugging and abandonment costs for our depleted wells). (4) We have recorded a liability for those properties we believe do not have sufficient oil, NGLs, and natural gas reserves to allow the under-produced owners to recover their under-production from future production volumes. (5) We formed The Unit 1984 Oil and Gas Limited Partnership and the 1986 Energy Income Limited Partnership along with private limited partnerships (the “Partnerships”) with certain qualified employees, officers and directors from 1984 through 2011, with a subsidiary of ours serving as general partner. Effective December 31, 2014, The Unit 1984 Oil and Gas Limited Partnership dissolved. The Partnerships were formed for the purpose of conducting oil and natural gas acquisition, drilling and development operations and serving as co-general partner with us in any additional limited partnerships formed during that year. The Partnerships participated on a proportionate basis with us in most drilling operations and most producing property acquisitions commenced by us for our own account during the period from the formation of the Partnership through December 31 of that year. These partnership agreements require, on the election of a limited partner, that we repurchase the limited partner’s interest at amounts to be determined by appraisal in the future. Repurchases in any one year are limited to 20% of the units outstanding. We made repurchases of $45,000, $16,000, and $56,000 in 2014, 2013, and 2012, respectively. (6) We have recorded a liability for future estimated payments related to workers’ compensation claims primarily associated with our contract drilling segment. (7) This amount includes commitments under capital lease arrangements for compressors in our mid-stream segment. Derivative Activities Periodically we enter into derivative transactions locking in the prices to be received for a portion of our oil, NGLs, and natural gas production. In August 2012, we determined-on a prospective basis-that we would no longer elect to use cash flow hedge accounting for our economic hedges. All of our previous cash flow hedges expired as of December 31, 2013. Any change in fair value on all commodity derivatives we have entered into are now reflected in the income statement and not in accumulated other comprehensive income. Commodity Derivatives. Our commodity derivatives is intended to reduce our exposure to price volatility and manage price risks. Our decision on the type and quantity of our production and the price(s) of our derivative(s) is based, in part, on our view of current and future market conditions. As of December 31, 2014, based on our fourth quarter 2014 average daily production, the approximated percentages of our production under derivative contracts are as follows: With respect to the commodities subject to derivative contracts, those contracts serve to limit the risk of adverse downward price movements. However, they also limit increases in future revenues that would otherwise result from price movements above the contracted prices. The use of derivative transactions carries with it the risk that the counterparties may not be able to meet their financial obligations under the transactions. Based on our evaluation at December 31, 2014, we believe the risk of non-performance by our counterparties is not material. At December 31, 2014, the fair values of the net assets we had with each of the counterparties to our commodity derivative transactions are as follows: If a legal right of set-off exists, we net the value of the derivative arrangements we have with the same counterparty in our Consolidated Balance Sheets. At December 31, 2014, we recorded the fair value of our commodity derivatives on our balance sheet as current derivative assets of $31.1 million. At December 31, 2013, we recorded the fair value of our commodity derivatives on our balance sheet as current derivative assets of $0.5 million and current derivative liabilities of $5.6 million. For our economic hedges that we did not apply cash flow accounting to, any changes in their fair value occurring before their maturity (i.e., temporary fluctuations in value) are reported in gain (loss) on derivatives not designated as hedges and hedge ineffectiveness, net in our Consolidated Statements of Income. The commodity derivative instruments we had under cash flow accounting expired as of December 2013. Previous changes in the fair value of derivatives designated as cash flow hedges, to the extent they were effective in offsetting cash flows attributable to the hedged risk, were recorded in OCI until the hedged item was recognized into earnings. When the hedged item was recognized into earnings, it was reported in oil and natural gas revenues. Any change in fair value resulting from ineffectiveness was recognized in gain (loss) on derivatives not designated as hedges and hedge ineffectiveness, net. These gains (losses) are as follows at December 31: Stock and Incentive Compensation During 2014, we granted awards covering 468,890 shares of restricted stock. These awards were granted as retention incentive awards. These stock awards had an estimated fair value as of the grant date of $24.1 million. Compensation expense will be recognized over the awards' three year vesting period. During 2014, we recognized $9.1 million in additional compensation expense and capitalized $1.9 million for these awards. During 2013, we granted awards covering 474,677 shares of restricted stock. These awards were granted as retention incentive awards and are being recognized over the awards' three year vesting period. During 2012, we granted awards covering 401,051 shares of restricted stock. These awards were granted as retention incentive awards and are being recognized over their two and three year vesting periods. No SAR awards were made during 2014, 2013, or 2012. During 2014, we recognized compensation expense of $17.4 million for our restricted stock grants and capitalized $3.7 million of compensation cost for oil and natural gas properties. Insurance We are self-insured for certain losses relating to workers’ compensation, control of well, and employee medical benefits. Insured policies for other coverages contain deductibles or retentions per occurrence that range from zero to $1.5 million. We have purchased stop-loss coverage in order to limit, to the extent feasible, per occurrence and aggregate exposure to certain types of claims. However, there is no assurance that the insurance coverages we have will adequately protect us against liability from all potential consequences. We have elected to use an ERISA governed occupational injury benefit plan to cover our drilling segment employees in Texas in lieu of covering them under Texas Workers’ Compensation. If insurance coverage becomes more expensive, we may choose to self-insure, decrease our limits, raise our deductibles or any combination of these rather than pay higher premiums. Oil and Natural Gas Limited Partnerships and Other Entity Relationships. We are the general partner of 15 oil and natural gas partnerships which were formed privately or publicly. Each partnership’s revenues and costs are shared under formulas set out in that partnership’s agreement. The partnerships repay us for contract drilling, well supervision and general and administrative expense. Related party transactions for contract drilling and well supervision fees are the related party’s share of such costs. These costs are billed on the same basis as billings to unrelated third parties for similar services. General and administrative reimbursements consist of direct general and administrative expense incurred on the related party’s behalf as well as indirect expenses assigned to the related parties. Allocations are based on the related party’s level of activity and are considered by us to be reasonable. During 2014, 2013, and 2012, the total we received for all of these fees was $0.5 million, $0.5 million, and $0.7 million, respectively. Our proportionate share of assets, liabilities, and net income relating to the oil and natural gas partnerships is included in our consolidated financial statements. Effects of Inflation The effect of inflation in the oil and natural gas industry is primarily driven by the prices for oil, NGLs, and natural gas. Increases in these prices increase the demand for our contract drilling rigs and services. This increase in demand in turn affects the dayrates we can obtain for our contract drilling services. During periods of higher demand for our drilling rigs we have experienced increases in labor costs as well as the costs of services to support our drilling rigs. Historically, during this same period, when oil, NGLs, and natural gas prices did decline, labor rates did not come back down to the levels existing before the increases. If commodity prices increase substantially for a long period, shortages in support equipment (such as drill pipe, third party services, and qualified labor) can result in additional increases in our material and labor costs. Increases in dayrates for drilling rigs also increase the cost of our oil and natural gas properties. How inflation will affect us in the future will depend on increases, if any, realized in our drilling rig rates, the prices we receive for our oil, NGLs, and natural gas, and the rates we receive for gathering and processing natural gas. Off-Balance Sheet Arrangements We do not currently utilize any off-balance sheet arrangements with unconsolidated entities to enhance liquidity and capital resource positions, or for any other purpose. However, as is customary in the oil and gas industry, we are subject to various contractual commitments. Results of Operations 2014 versus 2013 _________________________ (1) NM - A percentage calculation is not meaningful due to a zero-value denominator or a percentage change greater than 200. Oil and Natural Gas Oil and natural gas revenues increased $90.4 million or 14% in 2014 as compared to 2013 primarily due to a 9% increase in equivalent production volumes. Oil production increased 14%, NGLs production increased 18%, and natural gas production increased 4%. Average oil prices between the comparative years decreased 6% to $89.43 per barrel and NGLs prices decreased 3% to $30.95 per barrel while prices for natural gas increased 18% to $3.92 per Mcf. Oil and natural gas operating costs increased $3.9 million or 2% between the comparative years of 2014 and 2013 due to increased lease operating costs, higher saltwater disposal expenses, and increased general and administrative expense partially offset by lower gross production tax due to tax credits. Depreciation, depletion, and amortization (“DD&A”) increased $49.6 million or 22% primarily due to an 9% increase in equivalent production and an 11% increase in our DD&A rate. The increase in our DD&A rate in 2014 compared to 2013 resulted primarily from increased capitalized cost on new wells drilled between periods. Our DD&A expense on our oil and natural gas properties is calculated each quarter utilizing period end reserve quantities adjusted for current period production. In December 2014, we determined the value of certain unproved oil and gas properties were diminished (in part or in whole) based on an impairment evaluation and our anticipated future exploration plans. That determination resulted in $73.7 million of costs associated with the unproved properties being added to the capitalized costs to be amortized. We incurred a non-cash ceiling test write-down of our oil and natural gas properties of $76.7 million pre-tax ($47.7 million net of tax). Subsequent to December 31, 2014, commodity prices have continued to decrease below December 31, 2014 levels. We anticipate that these reduced prices will require an additional write-down of the carrying value of our oil and natural gas properties for the quarter ending March 31, 2015 and potentially for subsequent quarters. We did not have any ceiling test write-downs during 2013. Contract Drilling Drilling revenues increased $61.7 million or 15% in 2014 as compared to 2013. The increase was due primarily to a 16% increase in the average number of drilling rigs in use and a 2% increase in the average dayrate. Average drilling rig utilization increased from 65.0 drilling rigs in 2013 to 75.4 drilling rigs in 2014. Drilling operating costs increased $27.7 million or 11% in 2014 compared to 2013. The increase was due primarily to higher direct and indirect expenses due to higher utilization. Contract drilling depreciation and impairment increased $88.5 million or 124% due primarily to the write-down of 31 drilling rigs and other assets and to a lesser extent the increase in utilization. In December 2014, we removed from service 31 drilling rigs, some older top drives, and certain drill pipe no longer marketable in the current environment. We estimated the fair value of the rigs and other assets based on the estimate market value from third-party assessments (Level 3 fair value measurement). Based on these estimates, we recorded a write-down of approximately $74.3 million pre-tax. Several of our drilling rig customers have significantly reduced their drilling budgets for 2015, resulting in a significant reduction in the average utilization of our drilling fleet mix. At December 31, 2014, we had 75 rigs operating, at February 13, 2015, this number has been reduced to 50 rigs operating. We currently expect further reductions into 2015. Mid-Stream Our mid-stream revenues increased $69.0 million or 24% in 2014 as compared to 2013. The average price for natural gas sold increased 15%. Gas processing volumes per day increased 15% between the comparative years and NGLs sold per day increased 35% between the comparative periods. The increase in volumes processed per day is primarily attributable to the volumes added from new wells connected to existing systems and increased capacity of processing facilities. Gas gathering volumes per day increased 3% primarily from new well connections. Operating costs increased $63.4 million or 26% in 2014 compared to 2013 primarily due to an 8% increase in prices paid for natural gas purchased. Depreciation, amortization, and impairment increased $14.3 million or 43% primarily due to the write-down of three systems and additional assets placed into service throughout 2013. In December 2014, our mid-stream segment had a $7.1 million pre-tax write-down of three of its systems, Weatherford, Billy Rose, and Spring Creek due to anticipated future cash flow and future development around these systems supporting their carrying value. The estimated future cash flows were less than the carrying value on these systems (Level 3 fair value measurement). Due to the decline in NGLs prices during 2014, in the second half of the year we operated our processing facilities in full ethane rejection mode which reduced the amount of liquids sold during this time period. As long as NGLs prices continue at or below these levels,we expect to continue operating in full ethane rejection mode. Our mid-stream segment did not experience a significant reduction in processed volumes in 2014 but as low prices continue we expect further reductions in drilling activity around our systems which will eventually effect our ability to connect new wells resulting in lower processed volumes in the future. General and Administrative General and administrative expenses increased $3.7 million or 10% in 2014 compared to 2013. The increase was primarily due to increases in employee costs. Gain on Disposition of Assets Gain on disposition of assets decreased $8.1 million in 2014 compared to 2013 primarily due to the sale of fewer rigs. Other Income (Expense) Interest expense, net of capitalized interest, increased $2.4 million between the comparative years of 2014 and 2013. We capitalized interest based on the net book value associated with unproved properties not being amortized, the construction of additional drilling rigs, and the construction of gas gathering systems. Capitalized interest for 2014 was $32.2 million compared to $33.7 million in 2013, and was netted against our gross interest of $49.6 million and $48.7 million for 2014 and 2013, respectively. Our average interest rate increased from 6.4% to 6.5% and our average debt outstanding was $11.8 million lower in 2014 as compared to 2013 primarily due to the reduction of outstanding borrowings under our credit agreement over the comparative periods. Gain (loss) on derivatives not designated as hedges and hedge ineffectiveness, net increased from a loss of $8.4 million in 2013 to a gain of $30.1 million in 2014 primarily due to fluctuations in forward prices used to estimate the fair value in mark-to-market accounting. Income Tax Expense Income tax expense decreased $30.1 million in 2014 compared to 2013 primarily due to decreased income due to the impairments in all three segments during 2014. Our effective tax rate was 38.9% for 2014 and 38.7% for 2013. This increase is primarily due to the effect of permanent differences as they relate to the decline in pre-tax income. Current income tax expense was $9.4 million in 2014 compared to a current income tax expense of $16.0 million for 2013. This decrease is also primarily due to decreased income. We paid $15.9 million in income taxes during 2014. 2013 versus 2012 _________________________ (1) NM - A percentage calculation is not meaningful due to a zero-value denominator or a percentage change greater than 200. Oil and Natural Gas Oil and natural gas revenues increased $81.8 million or 14% in 2013 as compared to 2012 primarily due to an 18% increase in equivalent production volumes. This production increase was the result of 2012 acquisitions and new wells completed in oil and NGLs rich prospects that were brought online. Oil production increased 2%, NGLs production increased 40%, and natural gas production increased 16%. Average oil prices between the comparative years increased 3% to $95.06 per barrel and NGLs prices increased 1% to $31.79 per barrel while prices for natural gas decreased 1% to $3.32 per Mcf, respectively. Oil and natural gas operating costs increased $33.8 million or 22% between the comparative years of 2013 and 2012 due to increased well servicing costs, higher saltwater disposal expenses, and increased general and administrative expense. DD&A increased $15.2 million or 7% primarily due to an 18% increase in equivalent production offset by a 9% decrease in our DD&A rate. The decrease in our DD&A rate resulted primarily from a reduction to the full cost pool from proceeds associated with the divestitures completed during 2013 and the non-cash ceiling test write-down of $167.7 million pre-tax ($104.4 million, net of tax) that occurred during the fourth quarter of 2012. Our DD&A expense on our oil and natural gas properties is calculated each quarter using period end reserve quantities adjusted for current period production. We did not have any ceiling test write-downs during 2013. During the second quarter of 2012, we recorded a non-cash ceiling test write-down of $115.9 million pre-tax ($72.1 million, net of tax). During the fourth quarter of 2012, we recorded a non-cash ceiling test write-down of $167.7 million pre-tax ($104.4 million, net of tax). Contract Drilling Drilling revenues decreased $114.9 million or 22% in 2013 as compared to 2012. The decrease was due primarily to a 12% decrease in the average number of drilling rigs in use and a 2% decrease in the average dayrate. Average drilling rig utilization decreased from 73.9 drilling rigs in 2012 to 65.0 drilling rigs in 2013. During 2012, we had eight drilling contracts that were terminated early by the operator. The early termination fees associated with these contracts included in revenues was approximately $22.6 million compared to $1.9 million for the termination of one long-term drilling contract in 2013. Drilling operating costs decreased $42.2 million or 15% in 2013 compared to 2013. The decrease was due primarily to operating fewer rigs as per day direct cost increased $79 and indirect cost increased $0.6 million due to increased ad valorem tax. Contract drilling depreciation decreased $9.8 million or 12% also due primarily to the decrease in utilization. Mid-Stream Our mid-stream revenues increased $69.9 million or 32% in 2013 as compared to 2012. The average price for natural gas sold increased 37%. Gas processing volumes per day increased 5% between the comparative years and NGLs sold per day essentially unchanged between the comparative periods. The increase in volumes processed per day is primarily attributable to the volumes added from new wells connected to existing systems and increased capacity of processing facilities. NGLs sold volumes per day remained constant as an increase in volumes processed and upgrades to several of our processing facilities was offset from decreases due to one of our customers completing construction of their own processing plant and moving their volumes off our system during the second half of 2012. Gas gathering volumes per day increased 24% primarily from new well connections. Operating costs increased $56.1 million or 30% in 2013 compared to 2012 primarily due to a 25% increase in prices paid for natural gas purchased. Depreciation, amortization, and impairment increased $8.8 million or 36% primarily due to additional assets placed into service throughout 2013. General and Administrative General and administrative expenses increased $5.2 million or 16% in 2013 compared to 2012. The increase was primarily due to increases in employee costs. Gain on Disposition of Assets Gain on disposition of assets increased $16.8 million in 2013 compared to 2012 primarily due to the sale of five drilling rigs. Other Income (Expense) Interest expense, net of capitalized interest, increased $0.9 million between the comparative years of 2013 and 2012. We capitalized interest based on the net book value associated with unproved properties not being amortized, the construction of additional drilling rigs, and the construction of gas gathering systems. Capitalized interest for 2013 was $33.7 million compared to $18.9 million in 2012, and was netted against our gross interest of $48.7 million and $33.0 million for 2013 and 2012, respectively. Our average interest rate increased from 6.1% to 6.4% and our average debt outstanding was $190.8 million higher in 2013 as compared to 2012 due to the issuance of $400.0 million of senior subordinated notes during the third quarter of 2012 to partially fund the Noble acquisition in the oil and natural gas segment. Loss on derivatives not designated as hedges and hedge ineffectiveness, net increased from $1.2 million in 2012 to $8.4 million in 2013 primarily due to fluctuations in forward prices used to estimate the fair value in mark-to-market accounting. Income Tax Expense Income tax expense increased $100.5 million in 2013 compared to 2012 primarily due to decreased income. Our effective tax rate was 38.7% for 2013 and 41.2% for 2012. This decrease is primarily due to the effect of permanent differences as they relate to the rise in pre-tax income. Current income tax expense was $16.0 million in 2013 compared to a current income tax expense of $0.7 million for 2012. This increase is also primarily due to increased income. We paid $9.1 million in income taxes during 2013.

<s>[INST] General We operate, manage, and analyze our results of operations through our three principal business segments: Oil and Natural Gas carried out by our subsidiary Unit Petroleum Company. This segment explores, develops, acquires, and produces oil and natural gas properties for our own account. Contract Drilling carried out by our subsidiary Unit Drilling Company and its subsidiaries. This segment contracts to drill onshore oil and natural gas wells for others and for our own account. MidStream carried out by our subsidiary Superior Pipeline Company, L.L.C. and its subsidiaries. This segment buys, sells, gathers, processes, and treats natural gas for third parties and for our own account. Business Outlook As discussed in other parts of this report, the success of our business and each of our three main operating segments depend, on a large part, on the prices we receive for our oil and natural gas production and the demand for oil and natural gas as well as for our drilling rigs which, in turn, influences the amounts we can charge for the use of those drilling rigs. While our operations are located within the United States, events outside the United States can also impact us and our industry. During recent months, both within the United States and the world, deteriorating commodity prices have brought about significant and immediate changes affecting our industry and us. The recent decline in commodity prices is causing us (and other oil and gas companies) to reduce our level of drilling activity and spending. When drilling activity and spending decline for any sustained period of time the rates for and the number of our drilling rigs working also tend to decline. In addition, lower commodity prices for any sustained period of time could impact the liquidity condition of some of our industry partners and customers, which, in turn, might limit their ability to meet their financial obligations to us. How long the current depressed prices for oil and natural gas products continues is uncertain at this time. As noted elsewhere in this report, commodity prices are subject to a number of factors most of which are beyond our control. The impact on our business and financial results as a consequence of the recent reduction in oil and NGLs (and to a lesser extent natural gas) prices is uncertain in the long term, but in the short term, it has had a number of consequences for us, including the following: In December 2014, we determined the value of certain unproved oil and gas properties were diminished (in part or in whole) based on an impairment evaluation and our anticipated future exploration plans. That determination resulted in $73.7 million of costs associated with the unproved properties being added to the capitalized costs to be amortized. We incurred a noncash ceiling test writedown of our oil and natural gas properties of $76.7 million pretax ($47.7 million net of tax). Subsequent to December 31, 2014, commodity prices have continued to decrease below December 31, 2014 levels. We anticipate that these reduced prices will require an additional writedown of the carrying value of our oil and natural gas properties for the quarter ending March 31, 2015 and potentially for subsequent quarters. We have reduced the number of gross wells we plan to drill in 2015 by approximately 62% from the number of gross wells drilled in 2014. This reduction is driven not only by reduced commodity prices but also because the costs to drill the wells have tended to remain relatively high in comparison to current commodity prices. In December 2014, we removed from service 31 drilling rigs, some older top drives, and certain drill pipe no longer marketable in the current environment. We estimated the fair value of the rigs and other assets based on the estimate market value from thirdparty assessments (Level 3 fair value measurement). Based on these estimates, we recorded a writedown of approximately $74.3 million pretax. Several of our drilling rig customers have significantly reduced their drilling budgets for 2015, resulting in a significant reduction in the average utilization of our drilling rig fleet. At December 31, 2014, we had 75 rigs operating, at February 13, 2015, this number was 50. We currently expect further reductions into 2015. [/INST] Negative. </s>

UNIT CORP

2016-02-25

2015-12-31

Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations Please read the following discussion of our financial condition and results of operations in conjunction with the consolidated financial statements and related notes included in Item 8 of this report. General We operate, manage, and analyze our results of operations through our three principal business segments: • Oil and Natural Gas - carried out by our subsidiary Unit Petroleum Company. This segment explores, develops, acquires, and produces oil and natural gas properties for our own account. • Contract Drilling - carried out by our subsidiary Unit Drilling Company. This segment contracts to drill onshore oil and natural gas wells for others and for our own account. • Mid-Stream - carried out by our subsidiary Superior Pipeline Company, L.L.C. and its subsidiaries. This segment buys, sells, gathers, processes, and treats natural gas for third parties and for our own account. Business Outlook As discussed in other parts of this report, the success of our business and each of our three main operating segments depend, on a large part, on the prices we receive for our oil and natural gas production and the demand for oil and natural gas as well as for our drilling rigs which, in turn, influences the amounts we can charge for the use of those drilling rigs. While our operations are located within the United States, events outside the United States can also impact us and our industry. Both within the United States and the world, deteriorating commodity prices have brought about significant changes affecting our industry and us. The decline in commodity prices has caused us (and other oil and gas companies) to reduce our level of drilling activity and spending. When drilling activity and spending decline for any sustained period of time the rates for and the number of our drilling rigs working also tend to decline. In addition, lower commodity prices for any sustained period of time could impact the liquidity condition of some of our industry partners and customers, which, in turn, might limit their ability to meet their financial obligations to us. It is uncertain how long the current depressed prices for oil and natural gas products will continue. As noted elsewhere in this report, commodity prices are subject to a number of factors most of which are beyond our control. The impact on our business and financial results as a consequence of the reduction in oil and NGLs (and to a lesser extent natural gas) prices has had a number of consequences for us, including the following: • In December 2015, we determined the value of certain unproved oil and gas properties were diminished (in part or in whole) based on an impairment evaluation and our anticipated future exploration plans. That determination resulted in $114.4 million of costs associated with the unproved properties being added to the capitalized costs to be amortized. For the full year of 2015, we incurred a cumulative non-cash ceiling test write-down of our oil and natural gas properties of $1.6 billion pre-tax ($1.0 billion net of tax). We expect to incur a non-cash ceiling test write-down in the first quarter of 2016. It is difficult to predict with reasonable certainty the amount of expected future impairments given the many factors impacting the ceiling test calculation including, but not limited to, future pricing, operating costs, drilling and completion costs, upward or downward reserve revisions, reserve additions, and tax attributes. Subject to these numerous factors and inherent limitations, holding these factors constant and only adjusting the 12-month average price to an estimated first quarter ending average (holding February 2016 prices constant for the remaining one month of 2016), we currently anticipate that we could recognize an impairment in the first quarter of 2016 of approximately $60 million pre-tax. The impact of the significantly higher commodity prices used in the ceiling test 12-month average price calculation will lessen as those higher prices will roll off from the calculation. • We have reduced the number of gross wells we plan to drill in 2016 by approximately 57-74% from the number of gross wells drilled in 2015 due to reduced cash flow from lower commodity prices. • In December 2014, we removed from service 31 drilling rigs, some older top drives, and certain drill pipe no longer marketable in the current environment and sold most of these items at auction during 2015. • Several of our drilling rig customers significantly reduced their drilling budgets, resulting in a significant reduction in the average utilization of our drilling rig fleet. At December 31, 2014, we had 75 drilling rigs operating, during 2015, we averaged 34.7 drilling rigs operating, and at February 12, 2016, this number was 20. We currently expect further reductions in 2016. • In December 2015, our mid-stream segment incurred a $27.0 million pre-tax write-down of three of its systems due to anticipated future cash flow and future development around these systems not being sufficient to support their carrying value. The estimated future cash flows were less than the carrying value on these systems. • Due to the low NGLs prices, we are operating our processing facilities in full ethane rejection mode which reduces the amount of liquids sold. As long as NGLs prices continue to be depressed, we expect to continue operating in full ethane rejection mode. As low commodity prices continue, we expect the reductions in drilling activity around our systems will reduce the number of new wells available to connect to our systems and result in lower processed volumes as production from wells previously connected naturally decline. • Effective with the October 2015 redetermination, the lenders of our credit agreement decreased our borrowing base from $725.0 million to $550.0 million. This new amount is above the $500.0 million commitment we have elected under the credit agreement. While it is anticipated deteriorating commodity prices may result in a further reduction to our current borrowing base, we believe our liquidity will be adequate to carry out our 2016 capital plans. We have reduced our total 2016 capital budget by a range of approximately 59-65% as compared to 2015, excluding acquisitions and ARO liability. Our budget is designed to keep our capital expenditures below our anticipated cash flow and proceeds from non-core asset sales. Our 2016 current capital expenditures budget is based on realized prices for the year of $34.57 per barrel of oil, $8.01 per barrel of NGLs, and $2.24 per Mcf of natural gas. Our budget is subject to possible periodic adjustments for various reasons including changes in commodity prices and industry conditions. Funding for the budget will come primarily from our cash flow, non-core asset sales, and, if necessary, borrowings under our credit agreement. In response to the adverse impacts that the lower commodity prices had on us in 2015 as well as our industry we carried out the following during 2015 and early 2016: • We are in the process of consolidating from five to two the number of divisions within our drilling segment allowing for us to further reduce the costs associated with operating the divisions. • The higher end of our 2016 capital expenditure budget for exploration and production segment is designed with the intent to incur the majority of those expenditures in the latter part of the year thus allowing us to take into account future commodity price movement before we incur those expenditures. • We have implemented certain reduction in our office and field workforces to account for the reduction in our operating activities. • As of February 12, 2016, we have sold approximately $37.4 million of non-core oil and gas properties in 2016 using the majority of the proceeds to pay down our borrowings under our bank credit agreement. Executive Summary Oil and Natural Gas Fourth quarter 2015 production from our oil and natural gas segment was 4,757,000 barrels of oil equivalent (Boe), a 6% decrease from the third quarter of 2015 and a 2% decrease from the fourth quarter of 2014. These decreases came mostly from lower production due to reduced drilling activity and the replacement of reserves as a result of lower oil and NGLs prices. Oil and NGLs production during the fourth quarter of 2015 was 44% of our total production compared to 47% of our total production during the fourth quarter of 2014. Fourth quarter 2015 oil and natural gas revenues decreased 22% from the third quarter of 2015 and decreased 54% from the fourth quarter of 2014. These deceases were primarily due to lower oil, natural gas, and NGLs prices and to a lesser extent from reduced production volumes. Our natural gas and oil prices for the fourth quarter of 2015 decreased 16% and 5%, respectively, compared to the third quarter of 2015 while our NGLs prices increased 26%. Our NGLs, oil, and natural gas prices decreased 56%, 41%, and 40%, respectively compared to the fourth quarter of 2014. Direct profit (oil and natural gas revenues less oil and natural gas operating expense) decreased 32% from the third quarter of 2015 and 64% from the fourth quarter of 2014. The decreases were primarily attributable to decreased oil, natural gas, and NGLs prices. Operating cost per Boe produced for the fourth quarter of 2015 decreased 1% from the third quarter of 2015 and decreased 31% from the fourth quarter of 2014. The decrease from the third quarter of 2015 was primarily due to lower lease operating expenses (LOE ) partially offset by higher gross production taxes. The decrease from the fourth quarter of 2014 was primarily due to lower salt water disposal expense, lower LOE, lower gross production tax from lower sales revenue, and lower general and administrative expenses. For 2016, we have derivative contracts covering approximately 2,850 Bbls per day of oil production. For the month of January, we have hedged approximately 90,500 MMBtu per day of natural gas production and for the remainder of 2016, we have hedged approximately 100,500 MMBtu per day of natural gas production. For 2017, we have hedged approximately 750 Bbls per day of oil production and 25,000 MMBtu per day of natural gas production. At December 31, 2015, the following non-designated hedges were outstanding: _________________________ (1) We pay our counterparty a premium, which can be and is being deferred until settlement. Subsequent to December 31, 2015, the following non-designated hedges were entered into: During 2015, we participated in the drilling of 58 wells (34.99 net wells). For 2016, we plan to participate in the drilling of approximately 15 to 25 gross wells. Our 2016 production guidance is approximately 16.9 to 17.4 MMBoe, a decrease of 13-16% from 2015, actual results will be subject to many factors. This segment’s capital budget for 2016 is a range from $109.0 to $131.0 million, a 52-60% decrease from 2015, excluding acquisitions and ARO liability. As of February 12, 2016, we have sold approximately $37.4 million of non-core oil and gas properties in 2016. Contract Drilling The average number of drilling rigs we operated for 2015 was 34.7 compared to 75.4 in 2014. Late in the fourth quarter of 2014, the number of our drilling rigs operating started to decline and has continued to decline throughout 2015 due to lower commodity prices and operators reducing their drilling budgets. As of December 31, 2015, 26 drilling rigs were operating. Revenue for the fourth quarter of 2015 decreased 22% and 63% from the third quarter of 2015 and fourth quarter of 2014, respectively. The decreases were primarily due to fewer drilling rigs operating and lower dayrates. Dayrates for the fourth quarter of 2015 averaged $18,604, a 1% and 9% decrease from the third quarter of 2015 and the fourth quarter of 2014, respectively. The decreases were primarily due to downward pressure on dayrates with lower demand. Operating costs for the fourth quarter of 2015 decreased 8% and 58% from the third quarter of 2015 and the fourth quarter of 2014, respectively. The decreases were due primarily to fewer drilling rigs operating. Direct profit (contract drilling revenue less contract drilling operating expense) for the fourth quarter of 2015 decreased 39% and 69% from the third quarter of 2015 and the fourth quarter of 2014, respectively. For both comparative periods, we had fewer drilling rigs operating with lower dayrates. Operating cost per day for the fourth quarter of 2015 increased 6% and 25% over the third quarter of 2015 and the fourth quarter of 2014, respectively. The increases were primarily due to less revenue days partially offset by lower direct rig expense due to fewer drilling rigs operating for both comparative periods. During 2015, almost all of our working drilling rigs were drilling horizontal or directional wells for oil and NGLs. Today, the drastic reduction in commodity prices for oil and natural gas has changed demand for drilling rigs. All of these factors ultimately affect the demand and mix of the type of drilling rigs used by our customers. The future demand for and the availability of drilling rigs to meet that demand will have an impact on our future dayrates. As of December 31, 2015, we had nine term drilling contracts with original terms ranging from six months to three years. Five of these contracts are up for renewal in 2016, (two in the first quarter, two in the third quarter, and one in the fourth quarter) and four are up for renewal in 2017. Term contracts may contain a fixed rate for the duration of the contract or provide for rate adjustments within a specific range from the existing rate. Some operators who had signed term contracts have opted to release the drilling rig and pay an early termination penalty for the remaining term of the contract. During 2015, we recorded $29.0 million in early termination fees. In December 2014, we removed from service 31 drilling rigs, some older top drives, and certain drill pipe no longer marketable in the current environment and based on the estimated market value from third-party assessments, we recorded a write-down of approximately $74.3 million, pre-tax. During the first quarter of 2015, we sold one of these drilling rigs to an unaffiliated third party. The proceeds of this sale, less costs to sell, exceeded the $0.3 million net book value of the drilling rig resulting in a gain of $7,900. During the second quarter, we recorded an additional write-down on the remaining drilling rigs and other equipment of approximately $8.3 million pre-tax based on the estimated market value from similar auctions. During the third quarter, we sold the remaining 30 drilling rigs and most of the equipment in an auction. The proceeds from the sale of those assets, less costs to sell, was less than the $11.0 million net book value resulting in a loss of $7.3 million pre-tax. Some of the equipment that was not sold at the auction will be sold within the next twelve months and remain classified as assets held for sale. The net book value of those assets is $0.6 million. We have completed our current new BOSS drilling rig program for 2015. Eight new BOSS drilling rigs have been placed into service. Some of the long lead time components for three additional BOSS drilling rigs were ordered during 2014 in anticipation for future demand of the BOSS drilling rigs. With the decline in the drilling market, many of these long lead time components were either postponed for later delivery or canceled altogether. Currently, we do not have any contracts to build new BOSS drilling rigs. Our anticipated 2016 capital expenditures for this segment range from $9.0 million to $11.0 million, an 87-89% decrease from 2015. Mid-Stream Fourth quarter 2015 liquids sold per day decreased 3% and 18% from the third quarter of 2015 and the fourth quarter of 2014, respectively. The decrease from third quarter of 2015 was due to more effectively operating our processing facilities in full ethane rejection mode. The decrease from the prior year was due to operating in ethane rejection mode in 2015. For the fourth quarter of 2015, gas processed per day decreased 8% from the third quarter of 2015 and increased 4% over the fourth quarter of 2014. The decrease from the third quarter was due to general declines in wells. The increase over prior year was due to connecting new wells to both existing and newly constructed systems to replace production declines from wells already connected. For the fourth quarter of 2015, gas gathered per day increased 1% and 10% over the third quarter of 2015 and the fourth quarter of 2014, respectively. These increases were primarily from well connects throughout 2015. NGLs prices in the fourth quarter of 2015 were essentially unchanged from the prices received in the third quarter of 2015 and decreased 38% from the prices received in the fourth quarter of 2014. Because certain of the contracts used by our mid-stream segment for NGLs transactions are commodity-based contracts - under which we receive a share of the proceeds from the sale of the NGLs - our revenues from those commodity-based contracts fluctuate based on NGLs prices. Direct profit (mid-stream revenues less mid-stream operating expense) for the fourth quarter of 2015 decreased 10% from the third quarter of 2015 and decreased 6% from the fourth quarter of 2014. These decreases were primarily due to lower NGLs, natural gas, and condensate prices reducing revenues. Total operating cost for this segment for the fourth quarter of 2015 decreased 10% and 47% from the third quarter of 2015 and the fourth quarter of 2014, respectively due primarily to the lower cost of gas purchased. At our Hemphill Texas system with the completion of the nine-mile pipeline that connects our Buffalo Wallow gathering system to our Hemphill processing facility, we began transporting Buffalo Wallow gathered gas to our Hemphill facility for processing. At our Hemphill processing facility, we have three operational processing skids that provide approximately 135 MMcf per day of processing capacity. In central Oklahoma at our Perkins processing facility, we completed the upgrade of our processing facility which increased our total processing capacity from 20 MMcf per day to 27 MMcf per day. These improvements consist of processing plant upgrades along with projects to improve recoveries at this facility. During 2015, we connected 11 new wells to this system from several producers. Also in central Oklahoma, at our Minco processing facility, we completed upgrades to this facility which improved our processing capacity and allowed us to gather and process additional liquid rich gas from third-party producers. With this upgrade the total processing capacity of this system was increased to approximately 15 MMcf per day. In the Mississippian play in north central Oklahoma, we completed the upgrade of our Bellmon gathering system along with the installation of additional compressors. This will allow us to receive additional volume from third-party producers in the area. We connected 40 new wells to this system from several producers during 2015. At this processing facility we have two operational processing skids that provide total processing capacity of approximately 90 MMcf per day. In the Appalachian region, we completed the northern expansion of the Pittsburgh Mills gathering system into Butler County, Pennsylvania. This project includes a seven-mile trunkline along with a related compressor station. With the completion of this project we also gain an additional outlet for our gas into NiSource pipeline. The Clinton compressor station located in Butler County, Pennsylvania was completed and became operational in the fourth quarter of 2015. With the completion of this expansion project, we now have the ability to connect additional wells that are scheduled to be drilled in this area in 2016. Also in the Appalachian area, we completed the construction of our new fee-based gathering system, Snow Shoe Gathering System, in Centre County, Pennsylvania. This system consists of approximately 12 miles of gathering pipeline. The pipeline has been installed and is now operational. We began flowing gas on this pipeline in January 2016. Anticipated 2016 capital expenditures for this segment range from $22.0 million to $24.0 million, a 62-65% decrease from 2015. Critical Accounting Policies and Estimates Summary In this section, we identify those critical accounting policies we follow in preparing our financial statements and related disclosures. Many of these policies require us to make difficult, subjective, and complex judgments in the course of making estimates of matters that are inherently imprecise. Some accounting policies involve judgments and uncertainties to such an extent that there is reasonable likelihood that materially different amounts could have been reported under different conditions, or if different assumptions had been used. We evaluate our estimates and assumptions on a regular basis. We base our estimates on historical experience and various other assumptions that we believe are reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates and assumptions used in preparation of our financial statements. In the following discussion we will attempt to explain the nature of these estimates, assumptions and judgments, as well as the likelihood that materially different amounts would be reported in our financial statements under different conditions or using different assumptions. The following table lists the critical accounting policies, identifies the estimates and assumptions that can have a significant impact on the application of these accounting policies, and the financial statement accounts that are affected by these estimates and assumptions. Accounting Policies Estimates or Assumptions Accounts Affected Full cost method of accounting for oil, NGLs, and natural gas properties • Oil, NGLs, and natural gas reserves, estimates, and related present value of future net revenues • Valuation of unproved properties • Estimates of future development costs • Oil and natural gas properties • Accumulated depletion, depreciation and amortization • Provision for depletion, depreciation and amortization • Impairment of oil and natural gas properties • Long-term debt and interest expense Accounting for ARO for oil, NGLs, and natural gas properties • Cost estimates related to the plugging and abandonment of wells • Timing of cost incurred • Oil and natural gas properties • Accumulated depletion, depreciation and amortization • Provision for depletion, depreciation and amortization • Current and non-current liabilities • Operating expense Accounting for impairment of long-lived assets • Forecast of undiscounted estimated future net operating cash flows • Drilling and mid-stream property and equipment • Accumulated depletion, depreciation and amortization • Provision for depletion, depreciation and amortization • Other intangible assets Goodwill • Forecast of discounted estimated future net operating cash flows • Terminal value • Weighted average cost of capital • Goodwill Accounting for value of stock compensation awards • Estimates of stock volatility • Estimates of expected life of awards granted • Estimates of rates of forfeitures • Oil and natural gas properties • Shareholder’s equity • Operating expenses • General and administrative expenses Accounting for derivative instruments and hedging • Hedges measured for effectiveness and ineffectiveness (2013) • Non-qualifying and qualifying derivatives measured at fair value • Current and non-current derivative assets and liabilities • Other comprehensive income as a component of equity (2013) • Oil and natural gas revenue (2013) • Gain (loss) on derivatives not designated as hedges and hedge ineffectiveness, net Significant Estimates and Assumptions Full Cost Method of Accounting for Oil, NGLs, and Natural Gas Properties. The determination of our oil, NGLs, and natural gas reserves is a subjective process. It entails estimating underground accumulations of oil, NGLs, and natural gas that cannot be measured in an exact manner. The degree of accuracy of these estimates depends on a number of factors, including, the quality and availability of geological and engineering data, the precision of the interpretations of that data, and individual judgments. Each year, we hire an independent petroleum engineering firm to audit our internal evaluation of our reserves. The audit of our reserve wells or locations as of December 31, 2015 covered those that we projected to comprise 79% of the total proved developed discounted future net income and 81% of the total proved discounted future net income based on the unescalated pricing policy of the SEC. Included in Part I, Item 1 of this report are the qualifications of our independent petroleum engineering firm and our employees responsible for the preparation of our reserve reports. As a general rule, the accuracy of estimating oil, NGLs, and natural gas reserves varies with the reserve classification and the related accumulation of available data, as shown in the following table: Type of Reserves Nature of Available Data Degree of Accuracy Proved undeveloped Data from offsetting wells, seismic data Less accurate Proved developed non-producing The above as well as logs, core samples, well tests, pressure data More accurate Proved developed producing The above as well as production history, pressure data over time Most accurate Assumptions of future oil, NGLs, and natural gas prices and operating and capital costs also play a significant role in estimating these reserves as well as the estimated present value of the cash flows to be received from the future production of those reserves. Volumes of recoverable reserves are influenced by the assumed prices and costs due to the economic limit (that point when the projected costs and expenses of producing recoverable oil, NGLs, and natural gas reserves is greater than the projected revenues from the oil, NGLs, and natural gas reserves). But more significantly, the estimated present value of the future cash flows from our oil, NGLs, and natural gas reserves is sensitive to prices and costs, and may vary materially based on different assumptions. Companies, like ours, using full cost accounting use the unweighted arithmetic average of the commodity prices existing on the first day of each of the 12 months before the end of the reporting period to calculate discounted future revenues, unless prices were otherwise determined under contractual arrangements. We compute DD&A on a units-of-production method. Each quarter, we use the following formulas to compute the provision for DD&A for our producing properties: • DD&A Rate = Unamortized Cost / End of Period Reserves Adjusted for Current Period Production • Provision for DD&A = DD&A Rate x Current Period Production Oil, NGLs, and natural gas reserve estimates have a significant impact on our DD&A rate. If future reserve estimates for a property or group of properties are revised downward, the DD&A rate will increase as a result of the revision. Alternatively, if reserve estimates are revised upward, the DD&A rate will decrease. Based on our 2015 production level of 20.0 MMBoe, a decrease in the amount of our 2015 oil, NGLs, and natural gas reserves by 5% would increase our DD&A rate by $0.48 per Boe and would decrease pre-tax income by $9.6 million annually. Conversely, an increase in our 2015 oil, NGLs, and natural gas reserves by 5% would decrease our DD&A rate by $0.48 per Boe and would increase pre-tax income by $9.6 million annually. The DD&A expense on our oil and natural gas properties is calculated each quarter using period end reserve quantities adjusted for current period production. We account for our oil and natural gas exploration and development activities using the full cost method of accounting. Under this method, we capitalize all costs incurred in the acquisition, exploration, and development of oil and natural gas properties. At the end of each quarter, the net capitalized costs of our oil and natural gas properties are limited to that amount which is the lower of unamortized costs or a ceiling. The ceiling is defined as the sum of the present value (using a 10% discount rate) of the estimated future net revenues from our proved reserves (based on the unescalated 12-month average price on our oil, NGLs, and natural gas adjusted for any cash flow hedges), plus the cost of properties not being amortized, plus the lower of the cost or estimated fair value of unproved properties included in the costs being amortized, less related income taxes. If the net capitalized costs of our oil and natural gas properties exceed the ceiling, we are required to write-down the excess amount. A ceiling test write-down is a non-cash charge to earnings. If required, it reduces earnings and impacts shareholders’ equity in the period of occurrence and results in lower DD&A expense in future periods. Once incurred, a write-down cannot be reversed. The risk that we will be required to write-down the carrying value of our oil and natural gas properties increases when the prices for oil, NGLs, and natural gas are depressed or if we have large downward revisions in our estimated proved oil, NGLs, and natural gas reserves. Application of these rules during periods of relatively low prices, even if temporary, increases the chance of a ceiling test write-down. At December 31, 2015, our reserves were calculated based on applying 12-month 2015 average unescalated prices of $50.28 per barrel of oil, $19.47 per barrel of NGLs, and $2.59 per Mcf of natural gas (then adjusted for price differentials) over the estimated life of each of our oil and natural gas properties. In total for 2015, we incurred non-cash ceiling test write-downs of our oil and natural gas properties of $1.6 billion pre-tax ($1.0 billion net of tax) due to the inclusion of the impaired value of certain unproved properties and a reduction of the 12-month average commodity prices during the year. We expect to incur a non-cash ceiling test write-down in the first quarter of 2016. It is difficult to predict with reasonable certainty the amount of expected future impairments given the many factors impacting the ceiling test calculation including, but not limited to, future pricing, operating costs, drilling and completion costs, upward or downward reserve revisions, reserve additions, and tax attributes. Subject to these numerous factors and inherent limitations, holding these factors constant and only adjusting the 12-month average price to an estimated first quarter ending average (holding February 2016 prices constant for the remaining one month of 2016), we currently anticipate that we could recognize an impairment in the first quarter of 2016 of approximately $60 million pre-tax. The estimated first quarter 2016 impairment is partially the result of a decrease in our proved undeveloped reserves of approximately 26%. These anticipated decreases are primarily due to certain locations no longer being economical under the adjusted 12-month average price for the first quarter. Based on this estimated 12-month average price, we would eliminate those locations from our future development plan. The impact of the significantly higher commodity prices used in the ceiling test 12-month average price calculation will lessen as those higher prices will roll off from the calculation. Given the uncertainty associated with the factors used in calculating our estimate of both our future period ceiling test write-down and the decrease in our undeveloped reserves, these estimates should not necessarily be construed as indicative of our future development plans or financial results. Derivative instruments qualifying as cash flow hedges are included in the computation of limitation on capitalized costs. All of our cash flow hedges expired as of December 31, 2013 and no longer effect this computation. Our oil and natural gas derivatives are discussed in Note 12 of the Notes to our Consolidated Financial Statements. We use the sales method for recording natural gas sales. This method allows for the recognition of revenue, which may be more or less than our share of pro-rata production from certain wells. Our policy is to expense our pro-rata share of lease operating costs from all wells as incurred. The expenses relating to the wells in which we have a production imbalance are not material. Costs Withheld from Amortization. Costs associated with unproved properties are excluded from our amortization base until we have evaluated the properties. The costs associated with unevaluated leasehold acreage and related seismic data, wells currently drilling and capitalized interest are initially excluded from our amortization base. Leasehold costs are either transferred to our amortization base with the costs of drilling a well on the lease or are assessed at least annually for possible impairment or reduction in value. Leasehold costs are transferred to our amortization base to the extent a reduction in value has occurred. Our decision to withhold costs from amortization and the timing of the transfer of those costs into the amortization base involve a significant amount of judgment and may be subject to changes over time based on several factors, including our drilling plans, availability of capital, project economics and results of drilling on adjacent acreage. In December 2014 and December 2015, we determined the value of certain unproved oil and gas properties were diminished (in part or in whole) based on an impairment evaluation and our anticipated future exploration plans. That determination resulted in $73.7 million in 2014 and $114.4 million in 2015 of costs associated with the unproved properties being added to the capitalized costs to be amortized. At December 31, 2015, we had a total of approximately $337.1 million of costs excluded from the amortization base of our full cost pool. Accounting for ARO for Oil, NGLs, and Natural Gas Properties. We record the fair value of liabilities associated with the retirement of assets having a long life. In our case, when the reserves in each of our oil or gas wells deplete or otherwise become uneconomical, we are required to incur costs to plug and abandon the wells. These costs are recorded in the period in which the liability is incurred (at the time the wells are drilled or acquired). We do not have any assets restricted for the purpose of settling these ARO liabilities. Our engineering staff uses historical experience to determine the estimated plugging costs taking into account the type of well (either oil or natural gas), the depth of the well and physical location of the well to determine the estimated plugging costs. Accounting for Impairment of Long-Lived Assets. Drilling equipment, transportation equipment, gas gathering and processing systems, and other property and equipment are carried at cost less accumulated depreciation. Renewals and enhancements are capitalized while repairs and maintenance are expensed. We review the carrying amounts of long-lived assets for potential impairment annually, typically during the fourth quarter, or when events occur or changes in circumstances suggest that these carrying amounts may not be recoverable. Changes that could prompt such an assessment may include equipment obsolescence, changes in the market demand for a specific asset, changes in commodity prices, periods of relatively low drilling rig utilization, declining revenue per day, declining cash margin per day, or overall changes in general market conditions. Assets are determined to be impaired if a forecast of undiscounted estimated future net operating cash flows directly related to the asset, including disposal value if any, is less than the carrying amount of the asset. If any asset is determined to be impaired, the loss is measured as the amount by which the carrying amount of the asset exceeds its fair value. The estimate of fair value is based on the best information available, including prices for similar assets. Changes in these estimates could cause us to reduce the carrying value of property and equipment. Asset impairment evaluations are, by nature, highly subjective. They involve expectations about future cash flows generated by our assets and reflect management’s assumptions and judgments regarding future industry conditions and their effect on future utilization levels, dayrates, and costs. The use of different estimates and assumptions could result in materially different carrying values of our assets. As of December 31, 2015, with continuing declines to commodity prices and an outlook that commodity prices may be lower for longer, we lowered our expectations about future utilization of our drilling rigs and associated cash flows. We performed a Step 1 analysis as required by ASC 360-10-35 to assess the recoverability of long-lived assets within our contract drilling segment. With respect to these assets, future cash flows were estimated over the expected remaining life of the assets. Management determined that, on an undiscounted basis, expected cash flows exceeded the carrying value of the long-lived assets within our contract drilling segment by 99%, and there was no impairment at December 31, 2015. On a periodic basis, we evaluate our fleet of drilling rigs for marketability based on the condition of inactive rigs, expenditures that would be necessary to bring them to working condition and the expected demand for drilling services by rig type. The components comprising inactive rigs are evaluated, and those components with continuing utility to the Company’s other marketed rigs are transferred to other rigs or to its yards to be used as spare equipment. The remaining components of these rigs are retired. In December 2014, we removed from service 31 drilling rigs, some older top drives, and certain drill pipe no longer marketable in the current environment. We estimated the fair value of the drilling rigs and other assets based on the estimate market value from third-party assessments. Based on these estimates, we recorded a write-down of approximately $74.3 million pre-tax. In June 2015, we recorded an additional write-down on the remaining drilling rigs and other equipment of approximately $8.3 million pre-taxed based on the estimated market value from similar auctions. In 2014, our mid-stream segment incurred a $7.1 million pre-tax write-down of three of its systems, Weatherford, Billy Rose, and Spring Creek and in 2015, incurred a $27.0 million pre-tax write-down of its systems, Bruceton Mills, Spring Creek, and Midwell due to anticipated future cash flow and future development around these systems not being sufficient to support their carrying value. The estimated future cash flows were less than the carrying value on these systems. No significant impairment was recorded at December 31, 2013. Goodwill. Goodwill represents the excess of the cost of acquisitions over the fair value of the net assets acquired. Goodwill is not amortized, but an impairment test is performed at least annually to determine whether the fair value has decreased and is performed additionally when events indicate an impairment may have occurred. For purposes of impairment testing, goodwill is evaluated at the reporting unit level. Our goodwill is all related to our contract drilling segment, and accordingly, the impairment test is generally based on the estimated discounted future net cash flows of our drilling segment, utilizing discount rates and other factors in determining the fair value of our drilling segment. Inputs in our estimated discounted future net cash flows include drilling rig utilization, day rates, gross margin percentages, and terminal value. No goodwill impairment was recorded at December 31, 2015, 2014, or 2013. Based on our impairment test performed as of December 31, 2015, the fair value of our drilling segment exceeded its carrying value by 19%. A period of sustained reduced commodity prices resulting in further reductions in the number of our drilling rigs working and the rates we charge for them could result in a non-cash goodwill impairment in future periods. Turnkey and Footage Drilling Contracts. Because our contract drilling operations do not bear the risk of completion of a well being drilled under a “daywork” contract, we recognize revenues and expense generated under “daywork” contracts as the services are performed. Under “footage” and “turnkey” contracts we bear the risk of completion of the well, so revenues and expenses are recognized when the well is substantially completed. Substantial completion is determined when the well bore reaches the depth specified in the contract. The entire amount of a loss, if any, is recorded when the loss can be reasonably determined, however, any profit is recorded only at the time the well is finished. The costs of drilling contracts uncompleted at the end of the reporting period (which includes expenses incurred to date on “footage” or “turnkey” contracts) are included in other current assets. We did not drill any wells under turnkey or footage contracts in 2015, 2014, or 2013. Accounting for Value of Stock Compensation Awards. To account for stock-based compensation, compensation cost is measured at the grant date based on the fair value of an award and is recognized over the service period, which is usually the vesting period. We elected to use the modified prospective method, which requires compensation expense to be recorded for all unvested stock options and other equity-based compensation beginning in the first quarter of adoption. The determination of the fair value of an award requires significant estimates and subjective judgments regarding, among other things, the appropriate option pricing model, the expected life of the award and performance vesting criteria assumptions. As there are inherent uncertainties related to these factors and our judgment in applying them to the fair value determinations, there is risk that the recorded stock compensation may not accurately reflect the amount ultimately earned by the employee. Accounting for Derivative Instruments and Hedging. For our economic hedges that we did not apply cash flow accounting to, any changes in their fair value occurring before their maturity (i.e., temporary fluctuations in value) are reported in gain (loss) on derivatives not designated as hedges and hedge ineffectiveness, net in our Consolidated Statements of Operations. The commodity derivative instruments we had under cash flow accounting expired as of December 2013. Previous changes in the fair value of derivatives designated as cash flow hedges, to the extent they were effective in offsetting cash flows attributable to the hedged risk, were recorded in OCI until the hedged item was recognized into earnings. When the hedged item was recognized into earnings, it was reported in oil and natural gas revenues. Any change in fair value resulting from ineffectiveness was recognized in gain (loss) on derivatives not designated as hedges and hedge ineffectiveness, net. New Accounting Standards Income Taxes: Balance Sheet Classification of Deferred Taxes. The FASB has issued ASU 2015-17. This changes how deferred taxes are classified on organizations' balance sheets. Organizations will be required to classify all deferred tax assets and liabilities as noncurrent. The amendments apply to all organizations that present a classified balance sheet. For public companies, the amendments are effective for financial statements issued for annual periods beginning after December 15, 2016, and interim periods within those annual periods. Early adoption of the amendments is permitted. We are in the process of evaluating the impact it will have on our financial statements. Interest-Imputation of Interest: Simplifying the Presentation of Debt Issuance Costs. The FASB has issued ASU 2015-03. The amendments in this ASU require that debt issuance costs related to a recognized debt liability be presented in the balance sheet as a direct deduction from the carrying amount of that debt liability, consistent with debt discounts. The FASB has also issued ASU 2015-15. The amendments in this ASU allow an entity to defer and present debt issuance cost as an asset and subsequently amortize the deferred debt issuance costs ratably over the term of the line-of-credit arrangement, regardless of whether there are any outstanding borrowings on the line-of-credit arrangement. For public business entities, the amendments are effective for financial statements issued for fiscal years beginning after December 15, 2015, and interim periods within those fiscal years. Early adoption of the amendments is permitted for financial statements that have not been previously issued. The amendments should be applied on a retrospective basis, wherein the balance sheet of each individual period presented should be adjusted to reflect the period-specific effects of applying the new guidance. We do not expect the adoption of this guidance will have a material impact on our financial statements. Revenue from Contracts with Customers. The FASB has issued ASU 2014-09. This affects any entity using U.S. GAAP that either enters into contracts with customers to transfer goods or services or enters into contracts for the transfer of nonfinancial assets unless those contracts are within the scope of other standards (e.g., insurance contracts or lease contracts). The core principle of the guidance is that an entity should recognize revenue to depict the transfer of promised goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services. The FASB has issued 2015-14, which defers the effective date to annual reporting periods beginning after December 15, 2017, including interim reporting periods within that reporting period. We are in the process of evaluating the impact it will have on our financial statements. Financial Condition and Liquidity Summary. Our financial condition and liquidity primarily depends on the cash flow from our operations and borrowings under our credit agreement. The principal factors determining the amount of our cash flow are: • the quantity of natural gas, oil, and NGLs we produce; • the prices we receive for our natural gas, oil, and NGLs production; • the demand for and the dayrates we receive for our drilling rigs; and • the fees and margins we obtain from our natural gas gathering and processing contracts. We currently believe we have sufficient cash flow and liquidity to meet our obligations and remain in compliance with our debt covenants for the next twelve months. Our ability to meet our debt covenants (under our credit agreement as well as our Indenture) and our capacity to incur additional indebtedness will depend on our future performance, which in turn will be affected by financial, business, economic, regulatory, and other factors. For example, lower oil, natural gas, and NGLs prices since the last redetermination could result in a redetermination of the borrowing base under our credit agreement to a lower level and therefore reduce or limit our ability to incur indebtedness. As a result, we monitor our liquidity and capital resources, endeavor to anticipate potential covenant compliance issues and work with the lenders under our credit agreement to address those issues, if any, ahead of time. As part of our plan to manage liquidity risks, we have lowered our capital expenditures budget, focused our drilling program on our highest return plays, and continue to explore opportunities to divest non-core assets and properties. As of February 12, 2016, we have sold approximately $37.4 million of non-core oil and gas properties in 2016 using the majority of the proceeds to pay down our borrowings under our bank credit agreement. If necessary, we could sell other non-core assets and use the proceeds to further reduce our outstanding borrowings. The following is a summary of certain financial information for the years ended December 31: Cash flows from Operating Activities Our operating cash flow is primarily influenced by the prices we receive for our oil, NGLs, and natural gas production, the quantity of oil, NGL, and natural gas we produce, settlements of derivative contracts, third-party demand for our drilling rigs and mid-stream services, and the rates we are able to charge for those services. Our cash flows from operating activities are also impacted by changes in working capital. Net cash provided by operating activities during 2015 decreased by $262.0 million from 2014 due primarily to lower revenues due to lower commodity prices and lower drilling rig utilization partially offset by $29.0 million we recorded in early termination fees and by changes in operating assets and liabilities related to the timing of cash receipts and disbursements. Cash flows from Investing Activities We dedicate and expect to continue to dedicate a substantial portion of our capital expenditure program toward the exploration for and production of oil, NGLs, and natural gas. These capital expenditures are necessary to offset inherent declines in production, which is typical in the capital-intensive oil and natural gas industry. Cash flows used in investing activities decreased by $370.8 million in 2015 compared to 2014. The change was due primarily to a decrease in capital expenditures partially offset by the proceeds received from the disposition of assets. See additional information on capital expenditures below under Capital Requirements. Cash Flows from Financing Activities Cash flows provided by financing activities decreased by $91.4 million in 2015 compared to 2014. This decrease was primarily due to our borrowings under our credit agreement as well as a decrease in our book overdrafts (which are checks that have been issued but not presented to our bank for payment before the end of the period). At December 31, 2015, we had unrestricted cash totaling $0.8 million and had borrowed $281.0 million of the $500.0 million we currently have available under our credit agreement. Our credit agreement is used primarily for working capital and capital expenditures. The following is a summary of certain financial information as of December 31, and for the years ended December 31: _________________________ (1) Long-term debt is net of unamortized discount. (2) In 2015 and 2014, we incurred non-cash ceiling test write-downs of our oil and natural gas properties of $1.6 billion and $76.7 million pre-tax ($1.0 billion and $47.7 million, net of tax), respectively. In December 2014, we incurred a non-cash write-down associated with the removal of 31 drilling rigs from our fleet along with certain other equipment and drill pipe of $74.3 million pre-tax ($46.3 million net of tax) and then an additional non-cash write-down in 2015 of $8.3 million pre-tax ($5.1 million, net of tax). Also in December 2014, we incurred a non-cash write-down associated with a reduction in the carrying value of three midstream segment systems of $7.1 million pre-tax ($4.4 million net of tax). Then in December 2015, we incurred a non-cash write-down associated with the reduction in the carrying value of three midstream segment gathering systems of $27.0 million pre-tax ($16.8 million, net of tax). The write-downs impacted our shareholders’ equity, ratio of long-term debt to total capitalization, and net income (loss) for years 2015 and 2014. There was no impact on our compliance with the covenants contained in our credit agreement. Working Capital Typically, our working capital balance fluctuates, in part, because of the timing of our trade accounts receivable and accounts payable and the fluctuation in current assets and liabilities associated with the mark to market value of our derivative activity. We had negative working capital of $10.6 million, $51.7 million, and $31.5 million as of December 31, 2015, 2014, and 2013, respectively. This is primarily from the timing of our accounts payable associated with our capital expenditures partially offset by lower accounts receivable due to lower revenues. Our credit agreement is used primarily for working capital and capital expenditures. At December 31, 2015, we had borrowed $281.0 million of the $500.0 million currently available to us under our credit agreement. The effect of our derivatives increased working capital by $10.2 million and $31.1 million as of December 31, 2015 and 2014, respectively, and decreased working capital by $5.0 million as of December 31, 2013. The following table summarizes certain operating information for the years ended December 31: _________________________ (1) In 2015, our mid-stream segment transferred 11 natural gas gathering systems to our oil and natural gas segment. Oil and Natural Gas Operations Any significant change in oil, NGLs, or natural gas prices has a material effect on our revenues, cash flow, and the value of our oil, NGLs, and natural gas reserves. Generally, prices and demand for domestic natural gas are influenced by weather conditions, supply imbalances, and by worldwide oil price levels. Domestic oil prices are primarily influenced by world oil market developments. All of these factors are beyond our control and we cannot predict nor measure their future influence on the prices we will receive. Based on our 2015 production, a $0.10 per Mcf change in what we are paid for our natural gas production, without the effect of derivatives, would result in a corresponding $520,000 per month ($6.2 million annualized) change in our pre-tax operating cash flow. Our 2015 average natural gas price was $2.63 compared to an average natural gas price of $3.92 for 2014 and $3.32 for 2013. A $1.00 per barrel change in our oil price, without the effect of derivatives, would have a $303,000 per month ($3.6 million annualized) change in our pre-tax operating cash flow and a $1.00 per barrel change in our NGLs prices, without the effect of derivatives, would have a $419,000 per month ($5.0 million annualized) change in our pre-tax operating cash flow based on our production in 2015. Our 2015 average oil price per barrel was $50.79 compared with an average oil price of $89.43 in 2014 and $95.06 in 2013, and our 2015 average NGLs price per barrel was $10.12 compared with an average NGLs price of $30.95 in 2014 and $31.79 in 2013. Because commodity prices have an effect on the value of our oil, NGLs, and natural gas reserves, declines in those prices can result in a decline in the carrying value of our oil and natural gas properties. Price declines can also adversely affect the semi-annual determination of the amount available for us to borrow under our credit agreement since that determination is based mainly on the value of our oil, NGLs, and natural gas reserves. A reduction could limit our ability to carry out our planned capital projects. We expect to incur a non-cash ceiling test write-down in the first quarter of 2016. It is difficult to predict with reasonable certainty the amount of expected future impairments given the many factors impacting the ceiling test calculation including, but not limited to, future pricing, operating costs, drilling and completion costs, upward or downward reserve revisions, reserve additions, and tax attributes. Subject to these numerous factors and inherent limitations, holding these factors constant and only adjusting the 12-month average price to an estimated first quarter ending average (holding February 2016 prices constant for the remaining one month of 2016), we currently anticipate that we could recognize an impairment in the first quarter of 2016 of approximately $60 million pre-tax. The impact of the significantly higher commodity prices used in the ceiling test 12-month average price calculation will lessen as those higher prices will roll off from the calculation. Our natural gas production is sold to intrastate and interstate pipelines, to independent marketing firms and gatherers under contracts with terms generally ranging anywhere from one month to five years. Our oil production is sold to independent marketing firms generally under six month contracts. Contract Drilling Operations Many factors influence the number of drilling rigs we are working at any given time as well as the costs and revenues associated with that work. These factors include the demand for drilling rigs in our areas of operation, competition from other drilling contractors, the prevailing prices for oil, NGLs, and natural gas, availability and cost of labor to run our drilling rigs, and our ability to supply the equipment needed. Although our drilling rig personnel are a key component to the overall success of our drilling services, with the present conditions existing in the drilling industry, we do not anticipate increases in the compensation paid to those personnel in the near term. During 2015, almost all of our working drilling rigs were drilling horizontal or directional wells for oil and NGLs. Today, the drastic reduction in commodity prices for oil and natural gas has changed demand for drilling rigs. All of these factors ultimately affect the demand and mix of the type of drilling rigs used by our customers. The future demand for and the availability of drilling rigs to meet that demand will have an impact on our future dayrates. For 2015, our average dayrate was $19,455 per day compared to $20,043 and $19,646 per day for 2014 and 2013, respectively. Our average number of drilling rigs used in 2015 was 34.7 (38%) compared with 75.4 (63%) and 65.0 (52%) in 2014 and 2013, respectively. Based on the average utilization of our drilling rigs during 2015, a $100 per day change in dayrates has a $3,470 per day ($1.3 million annualized) change in our pre-tax operating cash flow. Our contract drilling segment provides drilling services for our exploration and production segment. Some of the drilling services we perform on our properties are, depending on the timing of those services, deemed to be associated with the acquisition of an ownership interest in the property. In those cases, revenues and expenses for those services are eliminated in our statement of operations, with any profit recognized as a reduction in our investment in our oil and natural gas properties. The contracts for these services are issued under the same conditions and rates as the contracts entered into with unrelated third parties. We eliminated revenue of $22.1 million, $89.5 million, and $64.3 million for 2015, 2014, and 2013, respectively, from our contract drilling segment and eliminated the associated operating expense of $18.3 million, $62.4 million, and $46.9 million during 2015, 2014, and 2013, respectively, yielding $3.8 million, $27.1 million, and $17.4 million during 2015, 2014, and 2013, respectively, as a reduction to the carrying value of our oil and natural gas properties. In December 2014, we removed from service 31 drilling rigs, some older top drives, and certain drill pipe no longer marketable in the current environment and based on the estimated market value from third-party assessments, we recorded a write-down of approximately $74.3 million, pre-tax. During the first quarter of 2015, we sold one of these drilling rigs to an unaffiliated third party. The proceeds of this sale, less costs to sell, exceeded the $0.3 million net book value of the drilling rig resulting in a gain of $7,900. During the second quarter, we recorded an additional write-down on the remaining drilling rigs and other equipment of approximately $8.3 million pre-tax based on the estimated market value from similar auctions. During the third quarter, we sold the remaining 30 drilling rigs and most of the equipment in an auction. The proceeds from the sale of those assets, less costs to sell, was less than the $11.0 million net book value resulting in a loss of $7.3 million pre-tax. Some of the equipment that was not sold at the auction will be sold within the next twelve months and remain classified as assets held for sale. The net book value of those assets is $0.6 million. Mid-Stream Operations This segment is engaged primarily in the buying, selling, gathering, processing, and treating of natural gas. It operates three natural gas treatment plants, 13 processing plants, 25 gathering systems, and approximately 1,464 miles of pipeline. Its operations are located in Oklahoma, Texas, Kansas, Pennsylvania, and West Virginia. This segment enhances our ability to gather and market not only our own natural gas and NGLs but also that owned by third parties and serves as a mechanism through which we can construct or acquire existing natural gas gathering and processing facilities. During 2015, 2014, and 2013 this segment purchased $57.6 million, $80.9 million, and $83.0 million, respectively, of our oil and natural gas segment's natural gas and NGLs production, and provided gathering and transportation services of $7.6 million, $8.7 million, and $8.0 million, respectively. Intercompany revenue from services and purchases of production between this business segment and our oil and natural gas segment has been eliminated in our consolidated financial statements. Our mid-stream segment gathered an average of 353,771 Mcf per day in 2015 compared to 319,348 Mcf per day in 2014 and 309,554 Mcf per day in 2013. It processed an average of 182,684 Mcf per day in 2015 compared to 161,282 Mcf per day in 2014 and 140,584 Mcf per day in 2013, and sold NGLs of 577,513 gallons per day in 2015 compared to 733,406 gallons per day in 2014 and 543,602 gallons per day in 2013. Gas gathering volumes per day in 2015 increased primarily from new wells connected to our systems between the comparative periods. Volumes processed increased primarily due to new wells connected. NGLs sold decreased primarily from being in ethane rejection mode. Our Credit Agreement and Senior Subordinated Notes Credit Agreement. On April 10, 2015, we amended our Senior Credit Agreement (credit agreement) to extend the maturity date from September 13, 2016 to April 10, 2020.The amount we can borrow is the lesser of the amount we elect (from time to time) as the commitment amount or the value of the borrowing base as determined by the lenders, but in either event not to exceed the maximum credit agreement amount of $900.0 million. Our current commitment amount is $500.0 million. Our current borrowing base is $550.0 million. We are charged a commitment fee ranging from 0.375% to 0.50% on the amount available but not borrowed. The fee varies based on the amount borrowed as a percentage of the amount of the total borrowing base. To date, for this new amendment, we paid $2.6 million in origination, agency, syndication, and other related fees. We are amortizing these fees over the life of the credit agreement. The current lenders under our credit agreement and their respective participation interests are as follows: The amount of the borrowing base-which is subject to redetermination by the lenders on April 1st and October 1st of each year, is based primarily on a percentage of the discounted future value of our oil and natural gas reserves. Effective with the October 2015 redetermination, the lenders under our credit agreement decreased our borrowing base from $725.0 million to $550.0 million. We or the lenders may request a onetime special redetermination of the borrowing base between each scheduled redetermination. In addition, we may request a redetermination following the completion of an acquisition that meets the requirements set forth in the credit agreement. While it is anticipated deteriorating commodity prices may result in a reduction to our current borrowing base, we believe our liquidity will be adequate to carry out our 2016 capital plans. At our election, any part of the outstanding debt under the credit agreement may be fixed at a London Interbank Offered Rate (LIBOR). LIBOR interest is computed as the sum of the LIBOR base for the applicable term plus 1.75% to 2.50% depending on the level of debt as a percentage of the borrowing base and is payable at the end of each term, or every 90 days, whichever is less. Borrowings not under LIBOR bear interest at the prime rate specified in the credit agreement that in any event cannot be less than LIBOR plus 1.00%. Interest is payable at the end of each month and the principal may be repaid in whole or in part at anytime, without a premium or penalty. At December 31, 2015 and February 12, 2016, we had $281.0 million and $262.9 million, respectively, outstanding borrowings under our credit agreement. We can use borrowings for financing general working capital requirements for (a) exploration, development, production and acquisition of oil and gas properties, (b) acquisitions and operation of mid-stream assets, (c) issuance of standby letters of credit, (d) contract drilling services, and (e) general corporate purposes. The credit agreement prohibits, among other things: • the payment of dividends (other than stock dividends) during any fiscal year in excess of 30% of our consolidated net income for the preceding fiscal year; • the incurrence of additional debt with certain limited exceptions; and • the creation or existence of mortgages or liens, other than those in the ordinary course of business, on any of our properties, except in favor of our lenders. The credit agreement also requires that we have at the end of each quarter: • a current ratio (as defined in the credit agreement) of not less than 1 to 1; and • a leverage ratio of funded debt to consolidated EBITDA (as defined in the credit agreement) for the most recently ended rolling four fiscal quarters of no greater than 4 to 1. As of December 31, 2015, we were in compliance with the covenants contained in the credit agreement. 6.625% Senior Subordinated Notes. We have an aggregate principal amount of $650.0 million, 6.625% senior subordinated notes (the Notes). Interest on the Notes is payable semi-annually (in arrears) on May 15 and November 15 of each year. The Notes will mature on May 15, 2021. In connection with the issuance of the Notes, we incurred $14.7 million of fees that are being amortized as debt issuance cost over the life of the Notes. The Notes are subject to an Indenture dated as of May 18, 2011, between us and Wilmington Trust, National Association (successor to Wilmington Trust FSB), as Trustee (the Trustee), as supplemented by the First Supplemental Indenture dated as of May 18, 2011, between us, the Guarantors, and the Trustee, and as further supplemented by the Second Supplemental Indenture dated as of January 7, 2013, between us, the Guarantors and the Trustee (as supplemented, the 2011 Indenture), establishing the terms and providing for the issuance of the Notes. The Guarantors are all of our direct and indirect subsidiaries. The discussion of the Notes in this report is qualified by and subject to the actual terms of the 2011 Indenture. Unit, as the parent company, has no independent assets or operations. The guarantees by the Guarantors of the Notes (registered under registration statements) are full and unconditional, joint and several, subject to certain automatic customary releases, are subject to certain restrictions on the sale, disposition, or transfer of the capital stock or substantially all of the assets of a subsidiary guarantor, and other conditions and terms set out in the Indenture. Any of our subsidiaries that are not Guarantors are minor. There are no significant restrictions on our ability to receive funds from our subsidiaries through dividends, loans, advances or otherwise. At any time before May 15, 2016, we may redeem the Notes, in whole or in part, at a redemption price equal to 100% of the principal amount plus a “make whole” premium, plus accrued and unpaid interest, if any, to the redemption date. On and after May 15, 2016, we may redeem all or, from time to time, a part of the Notes at certain redemption prices, plus accrued and unpaid interest. If a “change of control” occurs, subject to certain conditions, we must offer to repurchase from each holder all or any part of that holder’s Notes at a purchase price in cash equal to 101% of the principal amount of the Notes plus accrued and unpaid interest, if any, to the date of purchase. The 2011 Indenture contains customary events of default. The 2011 Indenture also contains covenants that, among other things, limit our ability and the ability of certain of our subsidiaries to incur or guarantee additional indebtedness; pay dividends on our capital stock or redeem capital stock or subordinated indebtedness; transfer or sell assets; make investments; incur liens; enter into transactions with our affiliates; and merge or consolidate with other companies. We were in compliance with all covenants of the Notes as of December 31, 2015. Capital Requirements Oil and Natural Gas Dispositions, Acquisitions, and Capital Expenditures. Most of our capital expenditures for this segment are discretionary and directed toward future growth. Any decision to increase our oil, NGLs, and natural gas reserves through acquisitions or through drilling depends on the prevailing or expected market conditions, potential return on investment, future drilling potential, and opportunities to obtain financing under the circumstances involved, all of which provide us with a large degree of flexibility in deciding when and if to incur these costs. We completed drilling 58 gross wells (34.99 net wells) in 2015 compared to 186 gross wells (121.00 net wells) in 2014, and 149 gross wells (91.14 net wells) in 2013. Our 2015 total capital expenditures for our oil and natural gas segment, excluding a $5.7 million reduction in the ARO liability and $0.2 million in acquisitions, totaled $273.5 million compared to 2014 capital expenditures of $772.2 million (excluding a $37.7 million reduction in the ARO liability and $5.7 million in acquisitions), and 2013 capital expenditures of $549.2 million (excluding an $18.0 million reduction in the ARO liability). For all of 2016, we plan to participate in drilling approximately 15 to 25 gross wells and estimate our total capital expenditures (excluding any possible acquisitions) for our oil and natural gas segment will be a range of approximately $109.0 million to $131.0 million. Whether we are able to drill all of those wells is dependent on a number of factors, many of which are beyond our control and include the availability of drilling rigs, availability of pressure pumping services, prices for oil, NGLs, and natural gas, demand for oil, NGLs, and natural gas, the cost to drill wells, the weather, and the efforts of outside industry partners. In August 2013, we sold some Bakken property interests. The proceeds, net of related expenses, were $57.1 million. In addition, we had other non-core asset sales with proceeds, net of related expenses, of $21.7 million for 2013. Proceeds from these dispositions reduced the net book value of the full cost pool with no gain or loss recognized. We sold non-core oil and natural gas assets, net of related expenses, for $1.9 million and $33.1 million during 2015 and 2014, respectively. Proceeds from those dispositions reduced the net book value of our full cost pool with no gain or loss recognized. As of February 12, 2016, we have sold approximately $37.4 million of non-core oil and gas properties in 2016 using the majority of the proceeds to pay down our borrowings under our bank credit agreement. Contract Drilling Dispositions, Acquisitions, and Capital Expenditures. During 2013, we sold four of our 2,000 horsepower electric drilling rigs and one 3,000 horsepower electric drilling rigs. All of these sales were to unaffiliated third-parties. During the first quarter of 2014. we sold four additional idle 3,000 horsepower drilling rigs to an unaffiliated third party. The proceeds from that sale were used in our construction program for our new proprietary 1,500 horsepower, AC electric drilling rig, called the BOSS drilling rig. During 2014, three BOSS drilling rigs were constructed and placed into service for third-party operators. In December 2014, we removed from service 31 drilling rigs, some older top drives, and certain drill pipe no longer marketable in the current environment and based on the estimated market value from third-party assessments, we recorded a write-down of approximately $74.3 million, pre-tax. During the first quarter of 2015, we sold one of these drilling rigs to an unaffiliated third party. The proceeds of this sale, less costs to sell, exceeded the $0.3 million net book value of the drilling rig resulting in a gain of $7,900. During the second quarter, we recorded an additional write-down on the remaining drilling rigs and other equipment of approximately $8.3 million pre-tax based on the estimated market value from similar auctions. During the third quarter, we sold the remaining 30 drilling rigs and most of the equipment in an auction. The proceeds from the sale of those assets, less costs to sell, was less than the $11.0 million net book value resulting in a loss of $7.3 million pre-tax. Some of the equipment that was not sold at the auction will be sold within the next twelve months and remain classified as assets held for sale. The net book value of those assets is $0.6 million. During the first half of 2015, five BOSS drilling rigs were constructed and placed into service for third-party operators. The long lead time components for three additional BOSS drilling rigs were ordered in 2014 in anticipation for future demand of the BOSS drilling rigs. However, with the decline in the drilling market, many of these long lead time components were either postponed for later delivery or canceled altogether. Currently, we do not have any contracts to build new BOSS drilling rigs. Our anticipated 2016 capital expenditures for this segment range from $9.0 million to $11.0 million. We have spent $84.8 million for capital expenditures during 2015 compared to $176.7 million in 2014, and $64.3 million in 2013. Mid-Stream Dispositions, Acquisitions, and Capital Expenditures. At our Hemphill Texas system with the completion of the nine-mile pipeline that connects our Buffalo Wallow gathering system to our Hemphill processing facility, we began transporting Buffalo Wallow gathered gas to our Hemphill facility for processing. At our Hemphill processing facility, we have three operational processing skids that provide approximately 135 MMcf per day of processing capacity. In central Oklahoma at our Perkins processing facility, we completed the upgrade of our processing facility which increased our total processing capacity from 20 MMcf per day to 27 MMcf per day. These improvements consist of processing plant upgrades along with projects to improve recoveries at this facility. During 2015, we connected 11 new wells to this system from several producers. Also in central Oklahoma, at our Minco processing facility, we completed upgrades to this facility which improved our processing capacity and allowed us to gather and process additional liquid rich gas from third-party producers. With this upgrade the total processing capacity of this system was increased to approximately 15 MMcf per day. In the Mississippian play in north central Oklahoma, we completed the upgrade of our Bellmon gathering system along with the installation of additional compressors. This will allow us to receive additional volume from third-party producers in the area. We connected 40 new wells to this system from several producers during 2015. At this processing facility we have two operational processing skids that provide total processing capacity of approximately 90 MMcf per day. In the Appalachian region, we completed the northern expansion of the Pittsburgh Mills gathering system into Butler County, Pennsylvania. This project includes a seven-mile trunkline along with a related compressor station. With the completion of this project we also gain an additional outlet for our gas into NiSource pipeline. The Clinton compressor station located in Butler County, Pennsylvania was completed and became operational in the fourth quarter of 2015. With the completion of this expansion project, we now have the ability to connect additional wells that are scheduled to be drilled in this area in 2016. Also in the Appalachian area, we completed the construction of our new fee-based gathering system, Snow Shoe Gathering System, in Centre County, Pennsylvania. This system consists of approximately 12 miles of gathering pipeline. The pipeline has been installed and is now operational. We began flowing gas on this pipeline in January 2016. During 2015, our mid-stream segment incurred $63.5 million in capital expenditures as compared to $51.1 million, excluding $28.2 million for capital leases, in 2014, and $96.1 million in 2013. For 2016, our estimated capital expenditures range from $22.0 million to $24.0 million. Contractual Commitments At December 31, 2015, we had the following contractual obligations: _________________________ (1) See previous discussion in MD&A regarding our long-term debt. This obligation is presented in accordance with the terms of the Notes and credit agreement and includes interest calculated using our December 31, 2015 interest rates of 6.625% for the Notes and 2.6% for the credit agreement. (2) We lease office space or yards in Edmond, Oklahoma City, and Tulsa, Oklahoma; Houston, Texas; Englewood, Colorado; Pinedale, Wyoming; and Pittsburgh, Pennsylvania under the terms of operating leases expiring through December 2021. Additionally, we have several equipment leases and lease space on short-term commitments to stack excess drilling rig equipment and production inventory. (3) Maintenance and interest payments are included in our capital lease agreements. The capital leases are discounted using annual rates of 4.0%. Total maintenance and interest remaining are $9.4 million and $2.7 million, respectively. (4) We have committed to purchase approximately $6.7 million of new drilling rig components, drill pipe, and related equipment over the next twelve months. (5) We have committed to pay $1.4 million for Enterprise Resource Planning software and $0.5 million for maintenance for one year following implementation. At December 31, 2015, we also had the following commitments and contingencies that could create, increase or accelerate our liabilities: _________________________ (1) We provide a salary deferral plan which allows participants to defer the recognition of salary for income tax purposes until actual distribution of benefits, which occurs at either termination of employment, death or certain defined unforeseeable emergency hardships. We recognize payroll expense and record a liability, included in other long-term liabilities in our Consolidated Balance Sheets, at the time of deferral. (2) Effective January 1, 1997, we adopted a separation benefit plan (Separation Plan). The Separation Plan allows eligible employees whose employment with us is involuntarily terminated or, in the case of an employee who has completed 20 years of service, voluntarily or involuntarily terminated, to receive benefits equivalent to four weeks salary for every whole year of service completed with the company up to a maximum of 104 weeks. To receive payments the recipient must waive certain claims against us in exchange for receiving the separation benefits. On October 28, 1997, we adopted a Separation Benefit Plan for Senior Management (Senior Plan). The Senior Plan provides certain officers and key executives of the company with benefits generally equivalent to the Separation Plan. The Compensation Committee of the Board of Directors has absolute discretion in the selection of the individuals covered in this plan. On May 5, 2004 we also adopted the Special Separation Benefit Plan (Special Plan). This plan is identical to the Separation Benefit Plan with the exception that the benefits under the plan vest on the earliest of a participant’s reaching the age of 65 or serving 20 years with the company. On December 31, 2008, all these plans were amended to bring the plans into compliance with Section 409A of the Internal Revenue Code of 1986, as amended. On December 8, 2015, we amended the Plans to change the calculation for determining the payouts at the time of a Separation of Service under the Plans. (3) When a well is drilled or acquired, under ASC 410 “Accounting for Asset Retirement Obligations,” we record the fair value of liabilities associated with the retirement of long-lived assets (mainly plugging and abandonment costs for our depleted wells). (4) We have recorded a liability for those properties we believe do not have sufficient oil, NGLs, and natural gas reserves to allow the under-produced owners to recover their under-production from future production volumes. (5) We formed The Unit 1984 Oil and Gas Limited Partnership and the 1986 Energy Income Limited Partnership along with private limited partnerships (the Partnerships) with certain qualified employees, officers and directors from 1984 through 2011, with a subsidiary of ours serving as general partner. Effective December 31, 2014, The Unit 1984 Oil and Gas Limited Partnership dissolved. The Partnerships were formed for the purpose of conducting oil and natural gas acquisition, drilling and development operations and serving as co-general partner with us in any additional limited partnerships formed during that year. The Partnerships participated on a proportionate basis with us in most drilling operations and most producing property acquisitions commenced by us for our own account during the period from the formation of the Partnership through December 31 of that year. These partnership agreements require, on the election of a limited partner, that we repurchase the limited partner’s interest at amounts to be determined by appraisal in the future. Repurchases in any one year are limited to 20% of the units outstanding. We made repurchases of $118,000, $45,000, and $16,000 in 2015, 2014, and 2013, respectively. (6) We have recorded a liability for future estimated payments related to workers’ compensation claims primarily associated with our contract drilling segment. (7) This amount includes commitments under capital lease arrangements for compressors in our mid-stream segment. Derivative Activities Periodically we enter into derivative transactions locking in the prices to be received for a portion of our oil, NGLs, and natural gas production. In August 2012, we determined-on a prospective basis-that we would no longer elect to use cash flow hedge accounting for our economic hedges. All of our previous cash flow hedges expired as of December 31, 2013. Any change in fair value on all commodity derivatives we have entered into are reflected in the statement of operations and not in accumulated other comprehensive income. Commodity Derivatives. Our commodity derivatives is intended to reduce our exposure to price volatility and manage price risks. Our decision on the type and quantity of our production and the price(s) of our derivative(s) is based, in part, on our view of current and future market conditions. As of December 31, 2015, based on our fourth quarter 2015 average daily production, the approximated percentages of our production under derivative contracts are as follows: With respect to the commodities subject to derivative contracts, those contracts serve to limit the risk of adverse downward price movements. However, they also limit increases in future revenues that would otherwise result from price movements above the contracted prices. The use of derivative transactions carries with it the risk that the counterparties may not be able to meet their financial obligations under the transactions. Based on our evaluation at December 31, 2015, we believe the risk of non-performance by our counterparties is not material. At December 31, 2015, the fair values of the net assets we had with each of the counterparties to our commodity derivative transactions are as follows: If a legal right of set-off exists, we net the value of the derivative arrangements we have with the same counterparty in our Consolidated Balance Sheets. At December 31, 2015, we recorded the fair value of our commodity derivatives on our balance sheet as current and non-current derivative assets of $10.2 million and $1.0 million, respectively, and non-current derivative liabilities of $0.3 million. At December 31, 2014, we recorded the fair value of our commodity derivatives on our balance sheet as current derivative assets of $31.1 million. For our economic hedges that we did not apply cash flow accounting to, any changes in their fair value occurring before their maturity (i.e., temporary fluctuations in value) are reported in gain (loss) on derivatives not designated as hedges and hedge ineffectiveness, net in our Consolidated Statements of Operations. The commodity derivative instruments we had under cash flow accounting expired as of December 2013. Previous changes in the fair value of derivatives designated as cash flow hedges, to the extent they were effective in offsetting cash flows attributable to the hedged risk, were recorded in OCI until the hedged item was recognized into earnings. When the hedged item was recognized into earnings, it was reported in oil and natural gas revenues. Any change in fair value resulting from ineffectiveness was recognized in gain (loss) on derivatives not designated as hedges and hedge ineffectiveness, net. These gains (losses) are as follows at December 31: Stock and Incentive Compensation During 2015, we granted awards covering 750,290 shares of restricted stock. These awards were granted as retention incentive awards. These stock awards had an estimated fair value as of the grant date of $24.5 million. Compensation expense will be recognized over the awards' three year vesting period. During 2015, we recognized $7.9 million in additional compensation expense and capitalized $1.9 million for these awards. During 2014, we granted awards covering 468,890 shares of restricted stock. These awards were granted as retention incentive awards and are being recognized over the awards' three year vesting period. During 2013, we granted awards covering 474,677 shares of restricted stock. These awards were granted as retention incentive awards and are being recognized over their two and three year vesting periods. No SAR awards were made during 2015, 2014, or 2013. During 2015, we recognized compensation expense of $15.3 million for our restricted stock grants and capitalized $3.5 million of compensation cost for oil and natural gas properties. Recognized compensation expense and capitalized stock compensation cost for oil and natural gas properties were reduced $3.2 million and $0.2 million, respectively, for adjustments made related to the performance shares. Insurance We are self-insured for certain losses relating to workers’ compensation, control of well, and employee medical benefits. Insured policies for other coverages contain deductibles or retentions per occurrence that range from zero to $1.0 million. We have purchased stop-loss coverage in order to limit, to the extent feasible, per occurrence and aggregate exposure to certain types of claims. However, there is no assurance that the insurance coverages we have will adequately protect us against liability from all potential consequences. Unit Texas Drilling, L.L.C. was merged into its parent company, Unit Drilling Company, effective October 31, 2015, at which time the ERISA governed occupational injury benefit program was closed. All new claims after this date are processed under an existing insured workers’ compensation program. If insurance coverage becomes more expensive, we may choose to self-insure, decrease our limits, raise our deductibles, or any combination of these rather than pay higher premiums. Oil and Natural Gas Limited Partnerships and Other Entity Relationships. We are the general partner of 15 oil and natural gas partnerships which were formed privately or publicly. Each partnership’s revenues and costs are shared under formulas set out in that partnership’s agreement. The partnerships repay us for contract drilling, well supervision and general and administrative expense. Related party transactions for contract drilling and well supervision fees are the related party’s share of such costs. These costs are billed on the same basis as billings to unrelated third parties for similar services. General and administrative reimbursements consist of direct general and administrative expense incurred on the related party’s behalf as well as indirect expenses assigned to the related parties. Allocations are based on the related party’s level of activity and are considered by us to be reasonable. During 2015, 2014, and 2013, the total we received for all of these fees was $0.4 million, $0.5 million, and $0.5 million, respectively. Our proportionate share of assets, liabilities, and net income relating to the oil and natural gas partnerships is included in our consolidated financial statements. Effects of Inflation The effect of inflation in the oil and natural gas industry is primarily driven by the prices for oil, NGLs, and natural gas. Increases in these prices increase the demand for our contract drilling rigs and services. This increase in demand in turn affects the dayrates we can obtain for our contract drilling services. During periods of higher demand for our drilling rigs we have experienced increases in labor costs as well as the costs of services to support our drilling rigs. Historically, during this same period, when oil, NGLs, and natural gas prices did decline, labor rates did not come back down to the levels existing before the increases. If commodity prices increase substantially for a long period, shortages in support equipment (such as drill pipe, third party services, and qualified labor) can result in additional increases in our material and labor costs. Increases in dayrates for drilling rigs also increase the cost of our oil and natural gas properties. How inflation will affect us in the future will depend on increases, if any, realized in our drilling rig rates, the prices we receive for our oil, NGLs, and natural gas, and the rates we receive for gathering and processing natural gas. Off-Balance Sheet Arrangements We do not currently utilize any off-balance sheet arrangements with unconsolidated entities to enhance liquidity and capital resource positions, or for any other purpose. However, as is customary in the oil and gas industry, we are subject to various contractual commitments. Results of Operations 2015 versus 2014 _________________________ (1) NM - A percentage calculation is not meaningful due to a zero-value denominator or a percentage change greater than 200. Oil and Natural Gas Oil and natural gas revenues decreased $354.3 million or 48% in 2015 as compared to 2014 due primarily to lower oil, natural gas, and NGLs prices partially offset by an increase in production. Oil production decreased 2%, NGLs production increased 14%, and natural gas production increased 11%. Average oil prices between the comparative years decreased 43% to $50.79 per barrel, NGLs prices decreased 67% to $10.12 per barrel, and natural gas prices decreased 33% to $2.63 per Mcf. Oil and natural gas operating costs decreased $21.9 million or 12% between the comparative years of 2015 and 2014 due to lower gross production taxes due to lower sales revenue and lower general and administrative expense. Depreciation, depletion, and amortization (DD&A) decreased $24.1 million or 9% primarily due to a 17% decrease in our DD&A rate partially offset by the effect of a 9% increase in equivalent production. The decrease in our DD&A rate in 2015 compared to 2014 resulted primarily from the effect of the ceiling test write-downs during 2015. Our DD&A expense on our oil and natural properties is calculated each quarter utilizing period end reserve quantities adjusted for current period production. During 2015, we recorded non-cash ceiling test write-downs of our oil and natural gas properties totaling $1.6 billion pre-tax ($1.0 billion, net of tax) compared to a non-cash ceiling test write-down of our oil and natural gas properties of $76.7 million pre-tax ($47.7 million net of tax) in December of 2014. These write-downs were due to the inclusion of the impaired value of the unproved properties of $114.4 million and $73.7 million in 2015 and 2014, respectively and a reduction of the 12-month average commodity prices during each year. Contract Drilling Drilling revenues decreased $210.8 million or 44% in 2015 as compared to 2014. The decrease was due primarily to a 54% decrease in the average number of drilling rigs in use and a 3% decrease in the average dayrate partially offset by $29.0 million for fees on contracts terminated early in 2015. Average drilling rig utilization decreased from 75.4 drilling rigs in 2014 to 34.7 drilling rigs in 2015. Drilling operating costs decreased $118.5 million or 43% in 2015 compared to 2014. The decrease was due primarily to fewer drilling rigs operating. Contract drilling depreciation decreased $29.2 million or 34% also due primarily to fewer drilling rigs operating. In December 2014, 31 drilling rigs and other drilling equipment were written down to their estimated market value. This impairment was approximately $74.3 million pre-tax. During the second quarter of 2015, we recorded an additional impairment of approximately $8.3 million on the drilling rigs and other equipment that was sold at auction during the third quarter. Several of our drilling rig customers have continued to significantly reduce their drilling budgets for 2016, resulting in a significant reduction in the average utilization of our drilling fleet mix. At December 31, 2015, we had 26 drilling rigs operating, at February 12, 2016, this number has been reduced to 20 drilling rigs operating. Mid-Stream Our mid-stream revenues decreased $153.6 million or 43% in 2015 as compared to 2014 due primarily from the average price for NGLs sold decreasing 47%, the average price for natural gas sold decreasing 39%, and NGLs volumes sold per day decreasing 21% primarily from being in ethane rejection mode. Gas processing volumes per day increased 13% between the comparative years primarily from new well connections. Gas gathering volumes per day increased 11% primarily from new well connections. Operating costs decreased $145.3 million or 47% in 2015 compared to 2014 primarily due to an 54% decrease in prices paid for natural gas purchased partially offset by a 12% increase in purchase volumes. Depreciation and amortization increased $3.2 million or 8% primarily due to capital expenditures for upgrades and well connects. In December 2014, our mid-stream segment had a $7.1 million pre-tax write-down of three of its systems, Weatherford, Billy Rose, and Spring Creek due to anticipated future cash flow and future development around these systems supporting their carrying value. The estimated future cash flows were less than the carrying value on these systems. In December 2015, our mid-stream segment had another $27.0 million pre-tax write-down of three of its systems, Bruceton Mills, Midwell, and Spring Creek due to anticipated future cash flow and future development around these systems not being sufficient to support their carrying value. The estimated future cash flows were less than the carrying value on these systems. Due to the decline in NGLs prices beginning in 2014, we operated our processing facilities in full ethane rejection mode which reduced the amount of liquids sold throughout 2015. As long as NGLs prices continue at or below these levels,we expect to continue operating in full ethane rejection mode. Our mid-stream segment did not experience a reduction in processed volumes in 2015 but as low prices continue we expect further reductions in drilling activity around our systems which will eventually effect our ability to connect new wells resulting in lower processed volumes in the future. General and Administrative General and administrative expenses decreased $6.7 million or 16% in 2015 compared to 2014 primarily due to lower employee costs and a $1.8 million decrease in the stock-based compensation accrual due to an evaluation of the performance based shares component of previous grants. Gain (loss) on Disposition of Assets Gain (loss) on disposition of assets decreased $16.2 million in 2015 compared to 2014 primarily due to the loss of $7.3 million pre-tax on the sale of 30 drilling rigs and other drilling equipment in an auction somewhat offset by the gains on the sale of one gathering system, various drilling rig components, vehicles, and a drilling rig during 2015, compared to a gain of $9.0 million primarily for the sale of four idle 3,000 horsepower drilling rigs to an unaffiliated third-party during 2014. Other Income (Expense) Interest expense, net of capitalized interest, increased $14.6 million between the comparative years of 2015 and 2014. We capitalized interest based on the net book value associated with unproved properties not being amortized, the construction of additional drilling rigs, and the construction of gas gathering systems. Capitalized interest for 2015 was $21.7 million compared to $32.2 million in 2014, and was netted against our gross interest of $53.7 million and $49.6 million for 2015 and 2014, respectively. Our average interest rate decreased from 6.5% to 5.4% and our average debt outstanding was $222.6 million higher in 2015 as compared to 2014 primarily due to the increase in our outstanding borrowings under our credit agreement over the comparative periods. Gain on derivatives not designated as hedges decreased from a gain of $30.1 million in 2014 to a gain of $26.3 million in 2015 primarily due to fluctuations in forward prices used to estimate the fair value in mark-to-market accounting. Income Tax Expense Income tax expense decreased $713.6 million in 2015 compared to 2014 primarily due to decreased income due to the impairments in all three segments during 2015. Our effective tax rate was 37.7% for 2015 and 38.9% for 2014. This decrease is primarily due to the effect of permanent differences as they relate to negative pre-tax income. Current income tax benefit was $20.6 million in 2015 compared to a current income tax expense of $9.4 million for 2014. The $20.6 million current income tax benefit is due to an anticipated alternative minimum tax (AMT) net operating loss (NOL) refund. We paid $3.5 million in income taxes during 2015. 2014 versus 2013 _________________________ (1) NM - A percentage calculation is not meaningful due to a zero-value denominator or a percentage change greater than 200. Oil and Natural Gas Oil and natural gas revenues increased $90.4 million or 14% in 2014 as compared to 2013 primarily due to a 9% increase in equivalent production volumes. Oil production increased 14%, NGLs production increased 18%, and natural gas production increased 4%. Average oil prices between the comparative years decreased 6% to $89.43 per barrel and NGLs prices decreased 3% to $30.95 per barrel while prices for natural gas increased 18% to $3.92 per Mcf. Oil and natural gas operating costs increased $3.9 million or 2% between the comparative years of 2014 and 2013 due to increased lease operating costs, higher saltwater disposal expenses, and increased general and administrative expense partially offset by lower gross production tax due to tax credits. DD&A increased $49.6 million or 22% primarily due to an 9% increase in equivalent production and an 11% increase in our DD&A rate. The increase in our DD&A rate in 2014 compared to 2013 resulted primarily from increased capitalized cost on new wells drilled between periods. Our DD&A expense on our oil and natural gas properties is calculated each quarter utilizing period end reserve quantities adjusted for current period production. In December 2014, we determined the value of certain unproved oil and gas properties were diminished (in part or in whole) based on an impairment evaluation and our anticipated future exploration plans. That determination resulted in $73.7 million of costs associated with the unproved properties being added to the capitalized costs to be amortized. We incurred a non-cash ceiling test write-down of our oil and natural gas properties of $76.7 million pre-tax ($47.7 million net of tax). We did not have any ceiling test write-downs during 2013. Contract Drilling Drilling revenues increased $61.7 million or 15% in 2014 as compared to 2013. The increase was due primarily to a 16% increase in the average number of drilling rigs in use and a 2% increase in the average dayrate. Average drilling rig utilization increased from 65.0 drilling rigs in 2013 to 75.4 drilling rigs in 2014. Drilling operating costs increased $27.7 million or 11% in 2014 compared to 2013. The increase was due primarily to higher direct and indirect expenses due to higher utilization. Contract drilling depreciation and impairment increased $88.5 million or 124% due primarily to the write-down of 31 drilling rigs and other assets and to a lesser extent the increase in utilization. In December 2014, we removed from service 31 drilling rigs, some older top drives, and certain drill pipe no longer marketable in the current environment. We estimated the fair value of the drilling rigs and other assets based on the estimate market value from third-party assessments. Based on these estimates, we recorded a write-down of approximately $74.3 million pre-tax. Mid-Stream Our mid-stream revenues increased $69.0 million or 24% in 2014 as compared to 2013. The average price for natural gas sold increased 15%. Gas processing volumes per day increased 15% between the comparative years and NGLs sold per day increased 35% between the comparative periods. The increase in volumes processed per day is primarily attributable to the volumes added from new wells connected to existing systems and increased capacity of processing facilities. Gas gathering volumes per day increased 3% primarily from new well connections. Operating costs increased $63.4 million or 26% in 2014 compared to 2013 primarily due to an 8% increase in prices paid for natural gas purchased. Depreciation, amortization, and impairment increased $14.3 million or 43% primarily due to the write-down of three systems and additional assets placed into service throughout 2013. In December 2014, our mid-stream segment had a $7.1 million pre-tax write-down of three of its systems, Weatherford, Billy Rose, and Spring Creek due to anticipated future cash flow and future development around these systems not being sufficient to support their carrying value. The estimated future cash flows were less than the carrying value on these systems. Due to the decline in NGLs prices during 2014, in the second half of the year we operated our processing facilities in full ethane rejection mode which reduced the amount of liquids sold during this time period. As long as NGLs prices continue at or below these levels,we expect to continue operating in full ethane rejection mode. Our mid-stream segment did not experience a significant reduction in processed volumes in 2014 but as low prices continue we expect further reductions in drilling activity around our systems which will eventually effect our ability to connect new wells resulting in lower processed volumes in the future. General and Administrative General and administrative expenses increased $3.7 million or 10% in 2014 compared to 2013. The increase was primarily due to increases in employee costs. Gain on Disposition of Assets Gain on disposition of assets decreased $8.1 million in 2014 compared to 2013 primarily due to the sale of fewer drilling rigs. Other Income (Expense) Interest expense, net of capitalized interest, increased $2.4 million between the comparative years of 2014 and 2013. We capitalized interest based on the net book value associated with unproved properties not being amortized, the construction of additional drilling rigs, and the construction of gas gathering systems. Capitalized interest for 2014 was $32.2 million compared to $33.7 million in 2013, and was netted against our gross interest of $49.6 million and $48.7 million for 2014 and 2013, respectively. Our average interest rate increased from 6.4% to 6.5% and our average debt outstanding was $11.8 million lower in 2014 as compared to 2013 primarily due to the reduction of outstanding borrowings under our credit agreement over the comparative periods. Gain (loss) on derivatives not designated as hedges and hedge ineffectiveness, net increased from a loss of $8.4 million in 2013 to a gain of $30.1 million in 2014 primarily due to fluctuations in forward prices used to estimate the fair value in mark-to-market accounting. Income Tax Expense Income tax expense decreased $30.1 million in 2014 compared to 2013 primarily due to decreased income due to the impairments in all three segments during 2014. Our effective tax rate was 38.9% for 2014 and 38.7% for 2013. This increase is primarily due to the effect of permanent differences as they relate to the decline in pre-tax income. Current income tax expense was $9.4 million in 2014 compared to a current income tax expense of $16.0 million for 2013. This decrease is also primarily due to decreased income. We paid $15.9 million in income taxes during 2014.

<s>[INST] General We operate, manage, and analyze our results of operations through our three principal business segments: Oil and Natural Gas carried out by our subsidiary Unit Petroleum Company. This segment explores, develops, acquires, and produces oil and natural gas properties for our own account. Contract Drilling carried out by our subsidiary Unit Drilling Company. This segment contracts to drill onshore oil and natural gas wells for others and for our own account. MidStream carried out by our subsidiary Superior Pipeline Company, L.L.C. and its subsidiaries. This segment buys, sells, gathers, processes, and treats natural gas for third parties and for our own account. Business Outlook As discussed in other parts of this report, the success of our business and each of our three main operating segments depend, on a large part, on the prices we receive for our oil and natural gas production and the demand for oil and natural gas as well as for our drilling rigs which, in turn, influences the amounts we can charge for the use of those drilling rigs. While our operations are located within the United States, events outside the United States can also impact us and our industry. Both within the United States and the world, deteriorating commodity prices have brought about significant changes affecting our industry and us. The decline in commodity prices has caused us (and other oil and gas companies) to reduce our level of drilling activity and spending. When drilling activity and spending decline for any sustained period of time the rates for and the number of our drilling rigs working also tend to decline. In addition, lower commodity prices for any sustained period of time could impact the liquidity condition of some of our industry partners and customers, which, in turn, might limit their ability to meet their financial obligations to us. It is uncertain how long the current depressed prices for oil and natural gas products will continue. As noted elsewhere in this report, commodity prices are subject to a number of factors most of which are beyond our control. The impact on our business and financial results as a consequence of the reduction in oil and NGLs (and to a lesser extent natural gas) prices has had a number of consequences for us, including the following: In December 2015, we determined the value of certain unproved oil and gas properties were diminished (in part or in whole) based on an impairment evaluation and our anticipated future exploration plans. That determination resulted in $114.4 million of costs associated with the unproved properties being added to the capitalized costs to be amortized. For the full year of 2015, we incurred a cumulative noncash ceiling test writedown of our oil and natural gas properties of $1.6 billion pretax ($1.0 billion net of tax). We expect to incur a noncash ceiling test writedown in the first quarter of 2016. It is difficult to predict with reasonable certainty the amount of expected future impairments given the many factors impacting the ceiling test calculation including, but not limited to, future pricing, operating costs, drilling and completion costs, upward or downward reserve revisions, reserve additions, and tax attributes. Subject to these numerous factors and inherent limitations, holding these factors constant and only adjusting the 12month average price to an estimated first quarter ending average (holding February 2016 prices constant for the remaining one month of 2016), we currently anticipate that we could recognize an impairment in the first quarter of 2016 of approximately $60 million pretax. The impact of the significantly higher commodity prices used in the ceiling test 12month average price calculation will lessen as those higher prices will roll off from the calculation. We have reduced the number of gross wells we plan to drill in 2016 by approximately 5774% from the number of gross wells drilled in 2015 due to reduced cash flow from lower commodity prices. In December 2014, we removed from service 31 drilling rigs, some older top drives, and certain drill pipe no longer marketable in the current environment and sold most of these items at auction during 2015. Several of our drilling rig customers significantly reduced their drilling budgets, resulting in a significant reduction in the average utilization of our drilling rig fleet. At December 31, [/INST] Negative. </s>

UNIT CORP

2017-02-28

2016-12-31

Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations Please read the following discussion of our financial condition and results of operations in conjunction with the consolidated financial statements and related notes included in Item 8 of this report. General We operate, manage, and analyze our results of operations through our three principal business segments: • Oil and Natural Gas - carried out by our subsidiary Unit Petroleum Company. This segment explores, develops, acquires, and produces oil and natural gas properties for our own account. • Contract Drilling - carried out by our subsidiary Unit Drilling Company. This segment contracts to drill onshore oil and natural gas wells for others and for our own account. • Mid-Stream - carried out by our subsidiary Superior Pipeline Company, L.L.C. and its subsidiaries. This segment buys, sells, gathers, processes, and treats natural gas for third parties and for our own account. Business Outlook As discussed in other parts of this report, our success depends, to a large degree, on the prices we receive for our oil and natural gas production, the demand for oil and natural gas, as well as, the demand for our drilling rigs which, in turn, influences the amounts we can charge for those drilling rigs. While our operations are located within the United States, events outside the United States affect us and our industry. Deteriorating commodity prices worldwide during the past two years or so brought about significant adverse changes affecting our industry and us. These lower commodity prices caused us (and other oil and gas companies) to reduce and ultimately stop drilling activity and spending. When drilling activity and spending decline for extended periods of time the rates for and the number of our drilling rigs working also tend to decline. In addition, sustained lower commodity prices impact the liquidity condition of some of our industry partners and customers, which, in turn, could limit their ability to meet their financial obligations to us. Commodity prices are volatile and subject to a number of factors most of which we cannot control. With the recent improvements in commodity prices, we are slowly starting to see signs of improvement in both industry and our activity. Our oil and natural gas segment began using two drilling rigs in the fourth quarter of 2016 and continued to do so in January 2017. Our contract drilling segment completed the construction and contracted the ninth BOSS drilling rig in the fourth quarter of 2016. In addition, we have seen indications that other operators are picking up their activity as well, but the extent and duration of this increase remains uncertain. The impact on our business and financial results from the reduction in oil, NGLs, and natural gas prices has had a number of consequences for us, including: • We incurred non-cash ceiling test write-downs in the first nine months of 2016 of $161.6 million ($100.6 million net of tax). We did not have a write-down in the fourth quarter of 2016. It is hard to predict with any reasonable certainty the need for or amount of any future impairments given the many factors that go into the ceiling test calculation including, but not limited to, future pricing, operating costs, drilling and completion costs, upward or downward oil and gas reserve revisions, oil and gas reserve additions, and tax attributes. Subject to these inherent uncertainties, if we hold these same factors constant as they existed at December 31, 2016 and only adjust the 12-month average price to an estimated first quarter ending average (holding February 2017 prices constant for the remaining one month of the first quarter of 2017), our forward looking expectation is that we will not recognize an impairment in the first quarter of 2017. But commodity prices (and other factors) remain volatile and they could negatively impact the 12-month average price resulting in the potential for an impairment in the first quarter. • We reduced the number of gross wells our oil and natural gas segment drilled in 2016 by approximately 64% from the number drilled in 2015 due to reduced cash flow. For 2017, we plan to increase the number of gross wells drilled by approximately 67-90% from the number of wells drilled in 2016. • The decline in drilling by our customers reduced the average utilization of our drilling rig fleet. At December 31, 2015, we had 26 drilling rigs operating. In 2016, utilization continued downward bottoming out in May at 13 operating drilling rigs. After May commodity prices began improving for the remainder of the year and we exited 2016 with 21 active rigs. As of February 10, 2017, we had 25 drilling rigs operating. Operators have been increasing drilling, but the extent of further increases remain uncertain. As of December 31 2016, all nine of our BOSS drilling rigs were under contract. • Due to low NGLs prices, we continue to operate most of our mid-stream processing facilities in full ethane rejection mode which reduces the amount of liquids sold. As long as NGLs prices remain depressed, we expect to continue operating in full ethane rejection mode. Low prices have reduced drilling activity around our processing systems thus reducing the number of new wells available to connect to these systems which has resulted in lower processed volumes as production from connected wells naturally decline. • Under the third amendment to our credit agreement entered into on April 8, 2016, the lenders decreased our borrowing base from $550.0 million to $475.0 million. Our commitment under the credit agreement also decreased from $500.0 million to $475.0 million. The October 2016 redetermination did not result in any changes to our borrowing base, and we currently do not anticipate any reduction to our borrowing base for the April 2017 redetermination. At February 10, 2017, we had $163.0 million outstanding borrowings under our credit agreement. In response to lower commodity prices we did the following during 2016: • Consolidated from five to two the number of divisions within our drilling segment further reducing the costs associated with operating the divisions. • Designed the higher end of our 2016 exploration and production segment budget so the majority of those proposed expenditures were in the latter part of the year allowing us to take into account future commodity price movement before we actually incured those expenditures. • Implemented certain reductions in our office and field workforces to account for the reduction in our operating activities as well as reducing the compensation paid to drilling personnel. • Sold non-core oil and gas properties for approximately $67.2 million with most of the proceeds being used to pay down borrowings under our bank credit agreement. Executive Summary Oil and Natural Gas Fourth quarter 2016 production from our oil and natural gas segment was 4,209,000 Boe which was essentially unchanged from the third quarter of 2016 and decreased 12% from the fourth quarter of 2015. The decrease came mostly from lower production due to reduced drilling activity resulting in decreased replacement of reserves. Oil and NGLs production during the fourth quarter of 2016 was 47% of our total production compared to 44% of our total production during the fourth quarter of 2015. Fourth quarter 2016 oil and natural gas revenues increased 11% over the third quarter of 2016 and increased 16% over the fourth quarter of 2015. These increases were primarily due to rising oil, natural gas, and NGLs prices partially offset by reduced production volumes compared to the fourth quarter of 2015. Our NGLs, oil, and natural gas prices for the fourth quarter of 2016 increased 15%, 8%, and 3%, respectively, compared to the third quarter of 2016. Our NGLs and natural gas prices increased 32% and 6%, respectively, compared to the fourth quarter of 2015, while our oil prices decreased 4%. Direct profit (oil and natural gas revenues less oil and natural gas operating expense) increased 14% over the third quarter of 2016 and 52% over the fourth quarter of 2015. The increase over the third quarter of 2016 was primarily due to higher revenues due to rising commodity prices. The increase over the fourth quarter of 2015 was primarily due to higher revenues and lower lease operating expenses (LOE). Operating cost per Boe produced for the fourth quarter of 2016 increased 5% over the third quarter of 2016 and decreased 14% from the fourth quarter of 2015. The increase over the third quarter of 2016 was primarily due to higher lease operating expenses, gross production taxes, and bad debt expense. The decrease from the fourth quarter of 2015 was primarily due to lower LOE, general and administrative expenses, salt water disposal expense, and lower production. For 2017, we have derivative contracts covering approximately 3,750 Bbls per day of oil production. For the first quarter, second and third quarters, we have hedged approximately 105,000 MMBtu per day of natural gas production, and for the fourth quarter, we have hedged approximately 92,000 MMBtu per day of natural gas production. For the first quarter of 2018, we have hedged approximately 60,000 MMBtu per day of natural gas production. For the remainder of 2018, we have to date hedged approximately 20,000 MMBtu per day of natural gas production. At December 31, 2016, the following non-designated hedges were outstanding: _________________________ (1) After December 31, 2016, the basis swaps for February through October 2017 and April through October 2018 were liquidated for $0.6 million and $0.5 million, respectively. After December 31, 2016, the following non-designated hedges were entered into: During 2016, we participated in the drilling of 21 wells (9.67 net wells). For 2017, we plan to participate in the drilling of approximately 35 to 40 gross wells. Our 2017 production guidance is approximately 15.9 to 16.4 MMBoe, an decrease of 5-8% from 2016, actual results will be subject to many factors. This segment’s capital budget for 2017 is approximately $188.0 million, a 57% increase from 2016, excluding acquisitions and ARO liability. Contract Drilling The average number of drilling rigs we operated for 2016 was 17.4 compared to 34.7 in 2015. At December 31, 2015, we had 26 drilling rigs operating. In 2016, utilization continued downward bottoming out in May at 13 operating drilling rigs. After May commodity prices began improving for the remainder of the year and we exited 2016 with 21 active rigs. Revenue for the fourth quarter of 2016 increased 29% over the third quarter of 2016 and decreased 34% from the fourth quarter of 2015. The increase over the third quarter of 2016 was primarily due to more drilling rigs operating offset slightly by lower dayrates. The decrease from the fourth quarter of 2015 was primarily due to less drilling rigs operating and lower dayrates. Dayrates for the fourth quarter of 2016 averaged $16,866, a 4% and 9% decrease from the third quarter of 2016 and the fourth quarter of 2015, respectively. The decreases were primarily due to downward pressure on dayrates with lower demand. Operating costs for the fourth quarter of 2016 increased 13% over the third quarter of 2016 and decreased 34% from the fourth quarter of 2015, respectively. The increase over the third quarter of 2016 was primarily due to more drilling rigs operating while the decrease from the fourth quarter of 2015 was primarily due to fewer drilling rigs operating. Direct profit (contract drilling revenue less contract drilling operating expense) for the fourth quarter of 2016 increased 74% over the third quarter of 2016 and decreased 35% from the fourth quarter of 2015. The increase over the third quarter of 2016 was primarily due to more drilling rigs operating while the decrease from the fourth quarter of 2015 was primarily due to fewer drilling rigs operating. Operating cost per day for the fourth quarter of 2016 decreased 7% and 8% from the third quarter of 2016 and the fourth quarter of 2015, respectively. The decrease from the third quarter of 2016 was primarily due to an increase in drilling rigs operating. The decrease from the fourth quarter of 2015 was primarily due to fewer drilling rigs operating. During 2016, almost all of our working drilling rigs were drilling horizontal or directional wells for oil and NGLs. The future demand for and the availability of drilling rigs to meet that demand will have an impact on our future dayrates. As of December 31, 2016, we had eight term drilling contracts with original terms ranging from six months to two years. Seven of these contracts are up for renewal in 2017, (two in the first quarter, three in the second quarter, and two in the third quarter) and one is up for renewal in 2018. Term contracts may contain a fixed rate for the duration of the contract or provide for rate adjustments within a specific range from the existing rate. Some operators who had signed term contracts have opted to release the drilling rig and pay an early termination penalty for the remaining term of the contract. We recorded $3.1 million and $29.0 million in early termination fees in 2016 and 2015, respectively. During December 2016, we sold an idle 1,500 horsepower SCR drilling rig to an unaffiliated third party. We also fabricated and placed into service our ninth new BOSS drilling rig for a third party operator. This new BOSS rig was constructed using the long lead time components purchased in prior years. Our anticipated 2017 capital expenditures for this segment are approximately $24.0 million, a 25% increase from 2016. Mid-Stream Fourth quarter 2016 liquids sold per day decreased 4% and 5% from the third quarter of 2016 and the fourth quarter of 2015, respectively. The decrease from third quarter of 2016 was due primarily to less processed volume due to connecting fewer wells to our system and continuing to operate our processing facilities in full ethane rejection. The decrease from the fourth quarter of 2015 was also due to connecting fewer wells to our systems. For the fourth quarter of 2016, gas processed per day decreased 8% and 17% from the third quarter of 2016 and the fourth quarter of 2015, respectively. The decrease from the third quarter of 2016 was due to connecting fewer wells to our processing systems and general declines in wells. The decrease from prior year was also due to connecting fewer wells to our processing systems. For the fourth quarter of 2016, gas gathered per day decreased 1% from the third quarter of 2016 and increased 18% over the fourth quarter of 2015. The decrease from the third quarter of 2016 is primarily due to connecting fewer wells to our systems. The increase over the fourth quarter of 2015 were primarily from well connects in the Appalachian region throughout 2016 and the addition of the Snow Shoe system. NGLs prices in the fourth quarter of 2016 increased 25% and 29% over the prices received in the third quarter of 2016 and the fourth quarter of 2015, respectively. Because certain of the contracts used by our mid-stream segment for NGLs transactions are commodity-based contracts - under which we receive a share of the proceeds from the sale of the NGLs - our revenues from those commodity-based contracts fluctuate based on NGLs prices. Direct profit (mid-stream revenues less mid-stream operating expense) for the fourth quarter of 2016 increased 13% and 55% over the third quarter of 2016 and fourth quarter of 2015, respectively. The increase over the third quarter was primarily due to an increase in the price of gas liquids and condensate sold. The increase over the fourth quarter of 2015 was primarily due to an increase in the price of gas liquids and condensate sold as well as an increase in gas transported. Total operating cost for this segment for the fourth quarter of 2016 increased 8% and 5% over the third quarter of 2016 and the fourth quarter of 2015, respectively due primarily to the higher cost of gas purchased. At our Cashion processing facility located in central Oklahoma, our total throughput volume for the fourth quarter of 2016 averaged approximately 33.1 MMcf per day and our total production of natural gas liquids increased to approximately 182,400 gallons per day. The total processing capacity at this facility is approximately 45 MMcf per day. In the fourth quarter of 2016, we completed a construction project that allows us to bring additional gas to the Cashion processing plant. Beginning on January 1, 2017, the producer will deliver 10 MMcf per day for five years on a fee-basis to the Cashion processing facility or pay a shortfall fee which is settled on an annual basis. During 2016, we connected a total of seven new wells to this system. At our Bellmon processing facility located in the Mississippian play in North Central Oklahoma, our total throughput volume averaged approximately 28.7 MMcf per day during the fourth quarter of 2016 and our total natural gas liquids averaged approximately 148,400 gallons per day while operating in ethane recovery mode during the quarter. In 2016, after we installed additional compression to be able to handle new third-party volumes, we were able to consolidate two producer-owned gathering systems into our system. During 2016, we connected 15 new wells to this facility. We currently have two processing skids available for processing that provide total processing capacity of 90 MMcf per day. At our Segno gathering facility located in Southeast Texas, our average gathered volume for the fourth quarter of 2016 increased to approximately 91.3 MMcf per day. During 2016 we completed construction projects that improved the facility and increased our gathering and dehydration capacity to approximately 120 MMcf per day. Also during 2016, we connected three new wells to this gathering system and there is active drilling and recompletion activity in the area around our system. In the Appalachian region, at our Pittsburgh Mills gathering system, we continue to connect new well pads to this system. During 2016, we connected four new well pads with a total of 18 new wells to this gathering system. With the addition of these new wells our average gathered volume for the fourth quarter increased to approximately 153 MMcf per day. In the fourth quarter of 2016, we started preliminary construction activities to connect the next well pad. This well pad will have five wells drilled and we anticipate connecting it in the second quarter of 2017. This well pad is located on the north end of our system close to our Clinton compressor station. Also in the Appalachian area, we began operating our Snow Shoe gathering system in January of 2016. During 2016, we connected three well pads to this system that have a total of six wells. Our average total gathered volume for this new system in 2016 was approximately 10.2 MMcf per day. Preliminary construction continues on the Snow Shoe compressor station but we do not intend to complete construction and put this compressor station into service until compression services are required on this system. Anticipated 2017 capital expenditures for this segment are approximately $13.0 million, a 23% decrease from 2016. Critical Accounting Policies and Estimates Summary In this section, we identify those critical accounting policies we follow in preparing our financial statements and related disclosures. Many of these policies require us to make difficult, subjective, and complex judgments in the course of making estimates of matters that are inherently imprecise. Some accounting policies involve judgments and uncertainties to such an extent that there is reasonable likelihood that materially different amounts could have been reported under different conditions, or if different assumptions had been used. We evaluate our estimates and assumptions on a regular basis. We base our estimates on historical experience and various other assumptions that we believe are reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates and assumptions used in preparation of our financial statements. In the following discussion we will attempt to explain the nature of these estimates, assumptions and judgments, as well as the likelihood that materially different amounts would be reported in our financial statements under different conditions or using different assumptions. The following table lists the critical accounting policies, identifies the estimates and assumptions that can have a significant impact on the application of these accounting policies, and the financial statement accounts that are affected by these estimates and assumptions. Accounting Policies Estimates or Assumptions Accounts Affected Full cost method of accounting for oil, NGLs, and natural gas properties • Oil, NGLs, and natural gas reserves, estimates, and related present value of future net revenues • Valuation of unproved properties • Estimates of future development costs • Oil and natural gas properties • Accumulated depletion, depreciation and amortization • Provision for depletion, depreciation and amortization • Impairment of oil and natural gas properties • Long-term debt and interest expense Accounting for ARO for oil, NGLs, and natural gas properties • Cost estimates related to the plugging and abandonment of wells • Timing of cost incurred • Credit adjusted risk free rate • Oil and natural gas properties • Accumulated depletion, depreciation and amortization • Provision for depletion, depreciation and amortization • Current and non-current liabilities • Operating expense Accounting for impairment of long-lived assets • Forecast of undiscounted estimated future net operating cash flows • Drilling and mid-stream property and equipment • Accumulated depletion, depreciation and amortization • Provision for depletion, depreciation and amortization Goodwill • Forecast of discounted estimated future net operating cash flows • Terminal value • Weighted average cost of capital • Goodwill Accounting for value of stock compensation awards • Estimates of stock volatility • Estimates of expected life of awards granted • Estimates of rates of forfeitures • Oil and natural gas properties • Shareholder’s equity • Operating expenses • General and administrative expenses Accounting for derivative instruments • Derivatives measured at fair value • Current and non-current derivative assets and liabilities • Gain (loss) on derivatives Significant Estimates and Assumptions Full Cost Method of Accounting for Oil, NGLs, and Natural Gas Properties. The determination of our oil, NGLs, and natural gas reserves is a subjective process. It entails estimating underground accumulations of oil, NGLs, and natural gas that cannot be measured in an exact manner. The degree of accuracy of these estimates depends on a number of factors, including, the quality and availability of geological and engineering data, the precision of the interpretations of that data, and individual judgments. Each year, we hire an independent petroleum engineering firm to audit our internal evaluation of our reserves. The audit of our reserve wells or locations as of December 31, 2016 covered those that we projected to comprise 82% of the total proved developed future net income discounted at 10% and 83% of the total proved discounted future net income (based on the SEC's unescalated pricing policy). Included in Part I, Item 1 of this report are the qualifications of our independent petroleum engineering firm and our employees responsible for the preparation of our reserve reports. As a general rule, the accuracy of estimating oil, NGLs, and natural gas reserves varies with the reserve classification and the related accumulation of available data, as shown in the following table: Type of Reserves Nature of Available Data Degree of Accuracy Proved undeveloped Data from offsetting wells, seismic data Less accurate Proved developed non-producing The above as well as logs, core samples, well tests, pressure data More accurate Proved developed producing The above as well as production history, pressure data over time Most accurate Assumptions of future oil, NGLs, and natural gas prices and operating and capital costs also play a significant role in estimating these reserves as well as the estimated present value of the cash flows to be received from the future production of those reserves. Volumes of recoverable reserves are influenced by the assumed prices and costs due to the economic limit (that point when the projected costs and expenses of producing recoverable oil, NGLs, and natural gas reserves is greater than the projected revenues from the oil, NGLs, and natural gas reserves). But more significantly, the estimated present value of the future cash flows from our oil, NGLs, and natural gas reserves is sensitive to prices and costs, and may vary materially based on different assumptions. Companies, like ours, using full cost accounting use the unweighted arithmetic average of the commodity prices existing on the first day of each of the 12 months before the end of the reporting period to calculate discounted future revenues, unless prices were otherwise determined under contractual arrangements. We compute DD&A on a units-of-production method. Each quarter, we use the following formulas to compute the provision for DD&A for our producing properties: • DD&A Rate = Unamortized Cost / End of Period Reserves Adjusted for Current Period Production • Provision for DD&A = DD&A Rate x Current Period Production Oil, NGLs, and natural gas reserve estimates have a significant impact on our DD&A rate. If future reserve estimates for a property or group of properties are revised downward, the DD&A rate will increase as a result of the revision. Alternatively, if reserve estimates are revised upward, the DD&A rate will decrease. Based on our 2016 production level of 17.3 MMBoe, a decrease in the amount of our 2016 oil, NGLs, and natural gas reserves by 5% would increase our DD&A rate by $0.30 per Boe and would decrease pre-tax income by $5.2 million annually. Conversely, an increase in our 2016 oil, NGLs, and natural gas reserves by 5% would decrease our DD&A rate by $0.24 per Boe and would increase pre-tax income by $4.1 million annually. The DD&A expense on our oil and natural gas properties is calculated each quarter using period end reserve quantities adjusted for current period production. We account for our oil and natural gas exploration and development activities using the full cost method of accounting. Under this method, we capitalize all costs incurred in the acquisition, exploration, and development of oil and natural gas properties. At the end of each quarter, the net capitalized costs of our oil and natural gas properties are limited to that amount which is the lower of unamortized costs or a ceiling. The ceiling is defined as the sum of the present value (using a 10% discount rate) of the estimated future net revenues from our proved reserves (based on the unescalated 12-month average price on our oil, NGLs, and natural gas adjusted for any cash flow hedges), plus the cost of properties not being amortized, plus the lower of the cost or estimated fair value of unproved properties included in the costs being amortized, less related income taxes. If the net capitalized costs of our oil and natural gas properties exceed the ceiling, we are required to write-down the excess amount. A ceiling test write-down is a non-cash charge to earnings. If required, it reduces earnings and impacts shareholders’ equity in the period of occurrence and results in lower DD&A expense in future periods. Once incurred, a write-down cannot be reversed. The risk that we will be required to write-down the carrying value of our oil and natural gas properties increases when the prices for oil, NGLs, and natural gas are depressed or if we have large downward revisions in our estimated proved oil, NGLs, and natural gas reserves. Application of these rules during periods of relatively low prices, even if temporary, increases the chance of a ceiling test write-down. At December 31, 2016 , our reserves were calculated based on applying 12-month 2016 average unescalated prices of $42.75 per barrel of oil, $19.74 per barrel of NGLs, and $2.48 per Mcf of natural gas (then adjusted for price differentials) over the estimated life of each of our oil and natural gas properties. In total for 2016 , we incurred non-cash ceiling test write-downs of our oil and natural gas properties of $161.6 million pre-tax ($100.6 million net of tax) due to the reduction of the 12-month average commodity prices during the first three quarters of the year. We did not have a ceiling test write-down for the fourth quarter of 2016. It is hard to predict with any reasonable certainty the need for or amount of any future impairments given the many factors that go into the ceiling test calculation including, but not limited to, future pricing, operating costs, drilling and completion costs, upward or downward oil and gas reserve revisions, oil and gas reserve additions, and tax attributes. Subject to these inherent uncertainties, if we hold these same factors constant as they existed at December 31, 2016 and only adjust the 12-month average price to an estimated first quarter ending average (holding February 2017 prices constant for the remaining one month of the first quarter of 2017), our forward looking expectation is that we will not recognize an impairment in the first quarter of 2017. But commodity prices (and other factors) remain volatile and they could negatively impact the 12-month average price resulting in the potential for an impairment in the first quarter. We use the sales method for recording natural gas sales. This method allows for the recognition of revenue, which may be more or less than our share of pro-rata production from certain wells. Our policy is to expense our pro-rata share of lease operating costs from all wells as incurred. The expenses relating to the wells in which we have a production imbalance are not material. Costs Withheld from Amortization. Costs associated with unproved properties are excluded from our amortization base until we have evaluated the properties. The costs associated with unevaluated leasehold acreage and related seismic data, wells currently drilling and capitalized interest are initially excluded from our amortization base. Leasehold costs are either transferred to our amortization base with the costs of drilling a well on the lease or are assessed at least annually for possible impairment or reduction in value. Leasehold costs are transferred to our amortization base to the extent a reduction in value has occurred. Our decision to withhold costs from amortization and the timing of the transfer of those costs into the amortization base involve a significant amount of judgment and may be subject to changes over time based on several factors, including our drilling plans, availability of capital, project economics and results of drilling on adjacent acreage. In December 2014, December 2015, and December 2016, we determined the value of certain unproved oil and gas properties were diminished (in part or in whole) based on an impairment evaluation and our anticipated future exploration plans. That determination resulted in $73.7 million in 2014, $114.4 million in 2015, and $7.6 million in 2016 of costs associated with the unproved properties being added to the capitalized costs to be amortized. At December 31, 2016, we had a total of approximately $314.9 million of costs excluded from the amortization base of our full cost pool. Accounting for ARO for Oil, NGLs, and Natural Gas Properties. We record the fair value of liabilities associated with the retirement of assets having a long life. In our case, when the reserves in each of our oil or gas wells deplete or otherwise become uneconomical, we are required to incur costs to plug and abandon the wells. These costs are recorded in the period in which the liability is incurred (at the time the wells are drilled or acquired). We do not have any assets restricted for the purpose of settling these ARO liabilities. Our engineering staff uses historical experience to determine the estimated plugging costs taking into account the type of well (either oil or natural gas), the depth of the well and physical location of the well to determine the estimated plugging costs. Accounting for Impairment of Long-Lived Assets. Drilling equipment, transportation equipment, gas gathering and processing systems, and other property and equipment are carried at cost less accumulated depreciation. Renewals and enhancements are capitalized while repairs and maintenance are expensed. We review the carrying amounts of long-lived assets for potential impairment annually, typically during the fourth quarter, or when events occur or changes in circumstances suggest that these carrying amounts may not be recoverable. Changes that could prompt such an assessment may include equipment obsolescence, changes in the market demand for a specific asset, changes in commodity prices, periods of relatively low drilling rig utilization, declining revenue per day, declining cash margin per day, or overall changes in general market conditions. Assets are determined to be impaired if a forecast of undiscounted estimated future net operating cash flows directly related to the asset, including disposal value if any, is less than the carrying amount of the asset. If any asset is determined to be impaired, the loss is measured as the amount by which the carrying amount of the asset exceeds its fair value. The estimate of fair value is based on the best information available, including prices for similar assets. Changes in these estimates could cause us to reduce the carrying value of property and equipment. Asset impairment evaluations are, by nature, highly subjective. They involve expectations about future cash flows generated by our assets and reflect management’s assumptions and judgments regarding future industry conditions and their effect on future utilization levels, dayrates, and costs. The use of different estimates and assumptions could result in materially different carrying values of our assets. On a periodic basis, we evaluate our fleet of drilling rigs for marketability based on the condition of inactive rigs, expenditures that would be necessary to bring them to working condition and the expected demand for drilling services by rig type. The components comprising inactive rigs are evaluated, and those components with continuing utility to the Company’s other marketed rigs are transferred to other rigs or to its yards to be used as spare equipment. The remaining components of these rigs are retired. In December 2014, we removed from service 31 drilling rigs, some older top drives, and certain drill pipe no longer marketable in the current environment. We estimated the fair value of the drilling rigs and other assets based on the estimate market value from third-party assessments. Based on these estimates, we recorded a write-down of approximately $74.3 million pre-tax. In June 2015, we recorded an additional write-down on the remaining drilling rigs and other equipment of approximately $8.3 million pre-taxed based on the estimated market value from similar auctions. In 2014, our mid-stream segment incurred a $7.1 million pre-tax write-down of three of its systems, Weatherford, Billy Rose, and Spring Creek and in 2015, incurred a $27.0 million pre-tax write-down of its systems, Bruceton Mills, Spring Creek, and Midwell due to anticipated future cash flow and future development around these systems not being sufficient to support their carrying value. The estimated future cash flows were less than the carrying value on these systems. No impairment was recorded at December 31, 2016. Goodwill. Goodwill represents the excess of the cost of acquisitions over the fair value of the net assets acquired. Goodwill is not amortized, but an impairment test is performed at least annually to determine whether the fair value has decreased and is performed additionally when events indicate an impairment may have occurred. For purposes of impairment testing, goodwill is evaluated at the reporting unit level. Our goodwill is all related to our contract drilling segment, and accordingly, the impairment test is generally based on the estimated discounted future net cash flows of our drilling segment, utilizing discount rates and other factors in determining the fair value of our drilling segment. Inputs in our estimated discounted future net cash flows include drilling rig utilization, day rates, gross margin percentages, and terminal value. No goodwill impairment was recorded at December 31, 2016, 2015, or 2014. Based on our impairment test performed as of December 31, 2016, the fair value of our drilling segment exceeded its carrying value by 16%. A period of sustained reduced commodity prices resulting in further reductions in the number of our drilling rigs working and the rates we charge for them could result in a non-cash goodwill impairment in future periods. Turnkey and Footage Drilling Contracts. Because our contract drilling operations do not bear the risk of completion of a well being drilled under a “daywork” contract, we recognize revenues and expense generated under “daywork” contracts as the services are performed. Under “footage” and “turnkey” contracts we bear the risk of completion of the well, so revenues and expenses are recognized when the well is substantially completed. Substantial completion is determined when the well bore reaches the depth specified in the contract. The entire amount of a loss, if any, is recorded when the loss can be reasonably determined, however, any profit is recorded only at the time the well is finished. The costs of drilling contracts uncompleted at the end of the reporting period (which includes expenses incurred to date on “footage” or “turnkey” contracts) are included in other current assets. We did not drill any wells under turnkey or footage contracts in 2016, 2015, or 2014. Accounting for Value of Stock Compensation Awards. To account for stock-based compensation, compensation cost is measured at the grant date based on the fair value of an award and is recognized over the service period, which is usually the vesting period. We elected to use the modified prospective method, which requires compensation expense to be recorded for all unvested stock options and other equity-based compensation beginning in the first quarter of adoption. The determination of the fair value of an award requires significant estimates and subjective judgments regarding, among other things, the appropriate option pricing model, the expected life of the award and performance vesting criteria assumptions. As there are inherent uncertainties related to these factors and our judgment in applying them to the fair value determinations, there is risk that the recorded stock compensation may not accurately reflect the amount ultimately earned by the employee. Accounting for Derivative Instruments and Hedging. All derivatives are recognized on the balance sheet and measured at fair value. Any changes in our derivatives' fair value occurring before their maturity (i.e., temporary fluctuations in value) along with any derivatives settled are reported in gain (loss) on derivatives in our Consolidated Statements of Operations. New Accounting Standards Intangibles-Goodwill and Other: Simplifying the Test for Goodwill Impairment. The FASB issued ASU 2017-04, to simplify the subsequent measurement of goodwill. The amendment eliminates Step 2 from the goodwill impairment test. This amendment will be effective prospectively for reporting periods beginning after December 31, 2019, and early adoption is permitted. We do not believe this ASU will have a material impact on our financial statements. Business Combinations; Clarifying the Definition of a Business. The FASB issued ASU 2017-01, clarifying the definition of a business. The amendments are intended to help companies and other organizations evaluate whether transactions should be accounted for as acquisitions (or disposals) of assets or businesses. For public companies, the amendments are effective for annual periods beginning after December 15, 2017. We are in the process of evaluating the impact these amendments will have on our financial statements. Statement of Cash Flows: Classification of Certain Cash Receipts and Cash Payments. The FASB issued ASU 2016-15, to address diversity in how certain transactions are presented and classified in the statement of cash flows. This amendment will be effective retrospectively for reporting periods beginning after December 31, 2017, and early adoption is permitted. We do not believe this ASU will have a material impact on our financial statements. Compensation-Stock Compensation: Improvements to Employee Share-Based Payment Accounting. The FASB has issued ASU 2016-09. The amendments are intended to improve the accounting for employee share-based payments and affect all organizations that issue share-based payment awards to their employees. Several aspects of the accounting for share-based payment award transactions are simplified, including: (a) income tax consequences; (b) classification of awards as either equity or liabilities; and (c) classification on the statement of cash flows. For public companies, the amendments are effective for annual periods beginning after December 15, 2016, and interim periods within those annual periods. Early adoption of the amendments is permitted. The amendments primarily impact classification within the statement of cash flows between financial and operating activities. This will not have a material impact on our financial statements. Leases. The FASB has issued ASU 2016-02. Under the new guidance, lessees will be required to recognize at the commencement date a lease liability, which is a lessee's obligation to make lease payments arising from a lease, measured on a discounted basis; and a right-of-use asset, which is an asset that represents the lessee's right to use a specified asset for the lease term. Lessor accounting is largely unchanged. For public companies, the amendments are effective for annual periods beginning after December 15, 2018, and interim periods within those annual periods. Early adoption of the amendments is permitted. We are in the process of evaluating the impact these amendments will have on our financial statements. Income Taxes: Balance Sheet Classification of Deferred Taxes. The FASB has issued ASU 2015-17. This changes how deferred taxes are classified on organizations' balance sheets. Organizations will be required to classify all deferred tax assets and liabilities as noncurrent. The amendments apply to all organizations that present a classified balance sheet. For public companies, the amendments are effective for financial statements issued for annual periods beginning after December 15, 2016, and interim periods within those annual periods. Early adoption of the amendments is permitted. The amendments will require current deferred tax assets to be combined with noncurrent deferred tax assets. The amendments will not have a material impact on our financial statements. Revenue from Contracts with Customers. The FASB has issued ASU 2014-09. This guidance affects any entity using U.S. GAAP that either enters into contracts with customers to transfer goods or services or enters into contracts for the transfer of nonfinancial assets unless those contracts are within the scope of other standards (e.g., insurance contracts or lease contracts). The core principle of the guidance is that an entity should recognize revenue to depict the transfer of promised goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services. In May 2016, the FASB issued ASU 2016-12, "Narrow-Scope Improvements and Practical Expedients," which provides clarifying guidance in certain areas and adds some practical expedients. Also in May 2016, the FASB issued ASU 2016-11, "Rescission of SEC Guidance Because of Accounting Standards Updates 2014-09 and 2014-16 Pursuant to Staff Announcements at the March 3, 2016 EITF Meeting." This ASU rescinds SEC Staff Observer comments that are codified in Topic 605, Revenue Recognition, and Topic 932, Extractive Activities- Oil and Gas, effective upon the adoption of Topic 606, Revenue from Contracts with Customers. In April 2016, the FASB issued ASU 2016-10, "Identifying Performance Obligations and Licensing," which amends the revenue guidance on identifying performance obligations and accounting for licenses of intellectual property. The FASB has issued 2015-14, which defers the effective date to annual reporting periods beginning after December 15, 2017, including interim reporting periods within that reporting period. We will adopt these amendments effective January 1, 2018. We have begun the identification of revenue within the scope of the guidance. Our evaluation of the impact of the new guidance on our financial statements is on-going. Topic 606 provides for adoption either retrospectively to each prior reporting period presented or as a cumulative effect adjustment to retained earnings at the date of adoption . We currently believe we will adopt the cumulative effect method. Adopted Standards Interest-Imputation of Interest: Simplifying the Presentation of Debt Issuance Costs. The FASB has issued ASU 2015-03. The amendments in this ASU require that debt issuance costs related to a recognized debt liability be presented in the balance sheet as a direct deduction from the carrying amount of that debt liability, consistent with debt discounts. The FASB has also issued ASU 2015-15. The amendments in this ASU allow an entity to defer and present debt issuance cost as an asset and subsequently amortize the deferred debt issuance costs ratably over the term of the line-of-credit arrangement, regardless of whether there are any outstanding borrowings on the line-of-credit arrangement. We have maintained debt issuance costs associated with our credit agreement as an asset and amortize these fees over the life of the credit agreement. For public business entities, the amendments are effective for financial statements issued for fiscal years beginning after December 15, 2015, and interim periods within those fiscal years. The amendments should be applied on a retrospective basis, wherein the balance sheet of each individual period presented should be adjusted to reflect the period-specific effects of applying the new guidance. We have adopted these amendments during the first quarter of 2016. Previously, debt issuance costs associated with the Notes was classified as a long-term asset on the balance sheet, but with ASU 2015-03, it is presented as a direct deduction from the carrying amount of the recognized debt liability. This is also reflected in Note 6 - Long-Term Debt and Other Long-term Liabilities. Presentation of Financial Statements-Going Concern: Disclosure of Uncertainties about an Entity's Ability to Continue as a Going Concern. The FASB has issued ASU 2014-15. This is intended to define management's responsibility to evaluate whether there is substantial doubt about an organization's ability to continue as a going concern and to provide related footnote disclosures. For each reporting period, management will be required to evaluate whether there are conditions or events that raise substantial doubt about a company's ability to continue as a going concern within one year from the date financial statements are issued. The amendments are effective for annual periods ending after December 15, 2016, and interim periods within annual periods beginning after December 15, 2016. We have adopted these amendments and began performing the management assessment beginning with the fiscal year end of December 31, 2016. There are no considerations or events that raise substantial doubt about our ability to continue as a going concern. Financial Condition and Liquidity Summary. Our financial condition and liquidity primarily depends on the cash flow from our operations and borrowings under our credit agreement. The principal factors determining the amount of our cash flow are: • the amount of natural gas, oil, and NGLs we produce; • the prices we receive for our natural gas, oil, and NGLs production; • the demand for and the dayrates we receive for our drilling rigs; and • the fees and margins we obtain from our natural gas gathering and processing contracts. We currently believe we have sufficient cash flow and liquidity to meet our obligations and remain in compliance with our debt covenants for the next twelve months. Our ability to meet our debt covenants (under our credit agreement as well as our Indenture) and our capacity to incur additional indebtedness will depend on our future performance, which in turn will be affected by financial, business, economic, regulatory, and other factors. For example, lower oil, natural gas, and NGLs prices since the last redetermination under our credit agreement could result in a redetermination of the borrowing base to a lower level and therefore reduce or limit our ability to borrow funds. As a result, we monitor our liquidity and capital resources, endeavor to anticipate potential covenant compliance issues and work with the lenders under our credit agreement to address those issues, if any, ahead of time. The following is a summary of certain financial information for the years ended December 31: Cash flows from Operating Activities Our operating cash flow is primarily influenced by the prices we receive for our oil, NGLs, and natural gas production, the quantity of oil, NGL, and natural gas we produce, settlements of derivative contracts, third-party demand for our drilling rigs and mid-stream services, and the rates we are able to charge for those services. Our cash flows from operating activities are also impacted by changes in working capital. Net cash provided by operating activities during 2016 decreased by $206.8 million from 2015 due primarily to lower revenues due to lower commodity prices and lower drilling rig utilization and dayrates and $25.9 million less in early termination fees and by changes in operating assets and liabilities related to the timing of cash receipts and disbursements. Cash flows from Investing Activities We dedicate and expect to continue to dedicate a substantial portion of our capital expenditure program toward the exploration for and production of oil, NGLs, and natural gas. These capital expenditures are necessary to offset inherent declines in production, which is typical in the capital-intensive oil and natural gas industry. Cash flows used in investing activities decreased by $438.8 million in 2016 compared to 2015. The change was due primarily to a decrease in capital expenditures partially offset by the proceeds received from the disposition of assets. See additional information on capital expenditures below under Capital Requirements. Cash Flows from Financing Activities Cash flows used in financing activities decreased by $231.7 million in 2016 compared to 2015. This decrease was primarily due to paying down borrowings during 2016 combined with increased borrowing during 2015 under our credit agreement. At December 31, 2016, we had unrestricted cash totaling $0.9 million and had borrowed $160.8 million of the $475.0 million we currently have available under our credit agreement. The following is a summary of certain financial information as of December 31, and for the years ended December 31: _________________________ (1) Long-term debt is net of unamortized discount and debt issuance costs. (2) In 2016, 2015, and 2014, we incurred non-cash ceiling test write-downs of our oil and natural gas properties of $161.6 million, $1.6 billion, and $76.7 million pre-tax ($100.6 million, $1.0 billion and $47.7 million, net of tax), respectively. In December 2014, we incurred a non-cash write-down associated with the removal of 31 drilling rigs from our fleet along with certain other equipment and drill pipe of $74.3 million pre-tax ($46.3 million net of tax) and then an additional non-cash write-down in 2015 of $8.3 million pre-tax ($5.1 million, net of tax). Also in December 2014, we incurred a non-cash write-down associated with a reduction in the carrying value of three midstream segment systems of $7.1 million pre-tax ($4.4 million net of tax). Then in December 2015, we incurred a non-cash write-down associated with the reduction in the carrying value of three midstream segment gathering systems of $27.0 million pre-tax ($16.8 million, net of tax). The write-downs impacted our shareholders’ equity, ratio of long-term debt to total capitalization, and net income (loss) for years 2015 and 2014. There was no impact on our compliance with the covenants contained in our credit agreement. Working Capital Typically, our working capital balance fluctuates, in part, because of the timing of our trade accounts receivable and accounts payable and the fluctuation in current assets and liabilities associated with the mark to market value of our derivative activity. We had negative working capital of $43.7 million, $10.6 million, and $51.7 million as of December 31, 2016, 2015, and 2014, respectively. This is primarily from the timing of our accounts payable associated with our capital expenditures partially offset by lower accounts receivable due to lower revenues. Our credit agreement is used primarily for working capital and capital expenditures. At December 31, 2016, we had borrowed $160.8 million of the $475.0 million currently available to us under our credit agreement. The effect of our derivatives decreased working capital by $21.6 million as of December 31, 2016, and increased working capital by $10.2 million and $31.1 million as of December 31, 2015 and 2014, respectively. The following table summarizes certain operating information for the years ended December 31: _________________________ (1) In 2015, our mid-stream segment transferred 11 natural gas gathering systems to our oil and natural gas segment. Oil and Natural Gas Operations Any significant change in oil, NGLs, or natural gas prices has a material effect on our revenues, cash flow, and the value of our oil, NGLs, and natural gas reserves. Generally, prices and demand for domestic natural gas are influenced by weather conditions, supply imbalances, and by worldwide oil price levels. Domestic oil prices are primarily influenced by world oil market developments. All of these factors are beyond our control and we cannot predict nor measure their future influence on the prices we will receive. Based on our 2016 production, a $0.10 per Mcf change in what we are paid for our natural gas production, without the effect of derivatives, would result in a corresponding $442,000 per month ($5.3 million annualized) change in our pre-tax operating cash flow. Our 2016 average natural gas price was $2.07 compared to an average natural gas price of $2.63 for 2015 and $3.92 for 2014. A $1.00 per barrel change in our oil price, without the effect of derivatives, would have a $238,000 per month ($2.9 million annualized) change in our pre-tax operating cash flow and a $1.00 per barrel change in our NGLs prices, without the effect of derivatives, would have a $398,000 per month ($4.8 million annualized) change in our pre-tax operating cash flow based on our production in 2016. Our 2016 average oil price per barrel was $40.50 compared with an average oil price of $50.79 in 2015 and $89.43 in 2014, and our 2016 average NGLs price per barrel was $11.26 compared with an average NGLs price of $10.12 in 2015 and $30.95 in 2014. It is hard to predict with any reasonable certainty the need for or amount of any future impairments given the many factors that go into the ceiling test calculation including, but not limited to, future pricing, operating costs, drilling and completion costs, upward or downward oil and gas reserve revisions, oil and gas reserve additions, and tax attributes. Subject to these inherent uncertainties, if we hold these same factors constant as they existed at December 31, 2016 and only adjust the 12-month average price to an estimated first quarter ending average (holding February 2017 prices constant for the remaining one month of the first quarter of 2017), our forward looking expectation is that we will not recognize an impairment in the first quarter of 2017. Commodity prices remain volatile and they could negatively impact the 12-month average price and the potential for an impairment in the first quarter. Our natural gas production is sold to intrastate and interstate pipelines, to independent marketing firms and gatherers under contracts with terms generally ranging anywhere from one month to five years. Our oil production is sold to independent marketing firms generally under six month contracts. Contract Drilling Operations Many factors influence the number of drilling rigs we are working at any given time as well as the costs and revenues associated with that work. These factors include the demand for drilling rigs in our areas of operation, competition from other drilling contractors, the prevailing prices for oil, NGLs, and natural gas, availability and cost of labor to run our drilling rigs, and our ability to supply the equipment needed. Although our drilling rig personnel are a key component to the overall success of our drilling services, with the present conditions existing in the drilling industry, we do not anticipate increases in the compensation paid to those personnel in the near term. During 2016, almost all of our working drilling rigs were drilling horizontal or directional wells for oil and NGLs. The drastic reduction in commodity prices from two years ago for oil and natural gas has changed demand for drilling rigs. All of these factors ultimately affect the demand and mix of the type of drilling rigs used by our customers. The future demand for and the availability of drilling rigs to meet that demand will have an impact on our future dayrates. For 2016, our average dayrate was $17,784 per day compared to $19,455 and $20,043 per day for 2015 and 2014, respectively. Our average number of drilling rigs used in 2016 was 17.4 (19%) compared with 34.7 (38%) and 75.4 (63%) in 2015 and 2014, respectively. Based on the average utilization of our drilling rigs during 2016, a $100 per day change in dayrates has a $1,740 per day ($0.6 million annualized) change in our pre-tax operating cash flow. Our contract drilling segment provides drilling services for our exploration and production segment. Some of the drilling services we perform on our properties are, depending on the timing of those services, deemed to be associated with the acquisition of an ownership interest in the property. In those cases, revenues and expenses for those services are eliminated in our statement of operations, with any profit recognized as a reduction in our investment in our oil and natural gas properties. The contracts for these services are issued under the same conditions and rates as the contracts entered into with unrelated third parties. We did not eliminate any revenue or expenses in our contract drilling segment during 2016. By providing drilling services for the oil and natural gas segment, we eliminated revenue of $22.1 million and $89.5 million during 2015 and 2014, respectively, from our contract drilling segment and eliminated the associated operating expense of $18.3 million and $62.4 million during 2015 and 2014, respectively, yielding $3.8 million and $27.1 million during 2015 and 2014, respectively, as a reduction to the carrying value of our oil and natural gas properties. Mid-Stream Operations This segment is engaged primarily in the buying, selling, gathering, processing, and treating of natural gas. It operates three natural gas treatment plants, 13 processing plants, 25 gathering systems, and approximately 1,465 miles of pipeline. Its operations are located in Oklahoma, Texas, Kansas, Pennsylvania, and West Virginia. This segment enhances our ability to gather and market not only our own natural gas and NGLs but also that owned by third parties and serves as a mechanism through which we can construct or acquire existing natural gas gathering and processing facilities. During 2016, 2015, and 2014 this segment purchased $42.7 million, $57.6 million, and $80.9 million, respectively, of our oil and natural gas segment's natural gas and NGLs production, and provided gathering and transportation services of $9.2 million, $7.6 million, and $8.7 million, respectively. Intercompany revenue from services and purchases of production between this business segment and our oil and natural gas segment has been eliminated in our consolidated financial statements. Our mid-stream segment gathered an average of 419,217 Mcf per day in 2016 compared to 353,771 Mcf per day in 2015 and 319,348 Mcf per day in 2014. It processed an average of 155,461 Mcf per day in 2016 compared to 182,684 Mcf per day in 2015 and 161,282 Mcf per day in 2014, and sold NGLs of 536,494 gallons per day in 2016 compared to 577,513 gallons per day in 2015 and 733,406 gallons per day in 2014. Gas gathering volumes per day in 2016 increased primarily from new wells connected to our systems between the comparative periods particularly at our fee-based Appalachian systems and the addition of the Snow Shoe system. Volumes processed decreased primarily due to fewer wells connected to our processing systems. NGLs sold decreased primarily due to lower processed volume and operating in ethane rejection mode. Our Credit Agreement and Senior Subordinated Notes Credit Agreement. On April 8, 2016, we amended our Senior Credit Agreement (credit agreement) scheduled to mature on April 10, 2020. The amount we can borrow is the lesser of the amount we elect (from time to time) as the commitment amount or the value of the borrowing base as determined by the lenders, but in either event not to exceed the maximum credit agreement amount of $875.0 million. Our elected commitment amount is $475.0 million. Our borrowing base is $475.0 million. We are charged a commitment fee of 0.50% on the amount available but not borrowed. The fee varies based on the amount borrowed as a percentage of the amount of the total borrowing base. We paid $1.0 million in origination, agency, syndication, and other related fees. We are amortizing these fees over the life of the credit agreement. With the new amendment, we pledged the following collateral: (a) 85% of the proved developed producing (discounted as present worth at 8%) total value of our oil and gas properties and (b) 100% of our ownership interest in our midstream affiliate, Superior Pipeline Company, L.L.C. The current lenders under our credit agreement and their respective participation interests are as follows: The borrowing base amount-which is subject to redetermination by the lenders on April 1st and October 1st of each year, is based primarily on a percentage of the discounted future value of our oil and natural gas reserves. The October 2016 redetermination did not result in any changes. We or the lenders may request a onetime special redetermination of the borrowing base between each scheduled redetermination. In addition, we may request a redetermination following the completion of an acquisition that meets the requirements set forth in the credit agreement. At our election, any part of the outstanding debt under the credit agreement may be fixed at a London Interbank Offered Rate (LIBOR). LIBOR interest is computed as the sum of the LIBOR base for the applicable term plus 2.00% to 3.00% depending on the level of debt as a percentage of the borrowing base and is payable at the end of each term, or every 90 days, whichever is less. Borrowings not under LIBOR bear interest at the prime rate specified in the credit agreement that in any event cannot be less than LIBOR plus 1.00%. Interest is payable at the end of each month and the principal may be repaid in whole or in part at anytime, without a premium or penalty. At December 31, 2016 and February 10, 2017, we had $160.8 million and $163.0 million, respectively, outstanding borrowings under our credit agreement. We can use borrowings for financing general working capital requirements for (a) exploration, development, production and acquisition of oil and gas properties, (b) acquisitions and operation of mid-stream assets, (c) issuance of standby letters of credit, (d) contract drilling services, and (e) general corporate purposes. The credit agreement prohibits, among other things: • the payment of dividends (other than stock dividends) during any fiscal year in excess of 30% of our consolidated net income for the preceding fiscal year; • the incurrence of additional debt with certain limited exceptions; and • the creation or existence of mortgages or liens, other than those in the ordinary course of business, on any of our properties, except in favor of our lenders. The credit agreement also requires that we have at the end of each quarter: • a current ratio (as defined in the credit agreement) of not less than 1 to 1. Through the quarter ending March 31, 2019, the credit agreement also requires that we have at the end of each quarter: • a senior indebtedness ratio of senior indebtedness to consolidated EBITDA (as defined in the credit agreement) for the most recently ended rolling four quarter of no greater than 2.75 to 1. Beginning with the quarter ending June 30, 2019, and for each quarter ending thereafter, the credit agreement requires: • a leverage ratio of funded debt to consolidated EBITDA (as defined in the credit agreement) for the most recently ended rolling four fiscal quarters of no greater than 4 to 1. As of December 31, 2016, we were in compliance with the covenants contained in the credit agreement. 6.625% Senior Subordinated Notes. We have an aggregate principal amount of $650.0 million, 6.625% senior subordinated notes (the Notes). Interest on the Notes is payable semi-annually (in arrears) on May 15 and November 15 of each year. The Notes will mature on May 15, 2021. In connection with the issuance of the Notes, we incurred $14.7 million of fees that are being amortized as debt issuance cost over the life of the Notes. The Notes are subject to an Indenture dated as of May 18, 2011, between us and Wilmington Trust, National Association (successor to Wilmington Trust FSB), as Trustee (the Trustee), as supplemented by the First Supplemental Indenture dated as of May 18, 2011, between us, the Guarantors, and the Trustee, and as further supplemented by the Second Supplemental Indenture dated as of January 7, 2013, between us, the Guarantors and the Trustee (as supplemented, the 2011 Indenture), establishing the terms and providing for the issuance of the Notes. The Guarantors are all of our direct and indirect subsidiaries. The discussion of the Notes in this report is qualified by and subject to the actual terms of the 2011 Indenture. Unit, as the parent company, has no independent assets or operations. The guarantees by the Guarantors of the Notes (registered under registration statements) are full and unconditional, joint and several, subject to certain automatic customary releases, are subject to certain restrictions on the sale, disposition, or transfer of the capital stock or substantially all of the assets of a subsidiary guarantor, and other conditions and terms set out in the Indenture. Any of our subsidiaries that are not Guarantors are minor. There are no significant restrictions on our ability to receive funds from our subsidiaries through dividends, loans, advances or otherwise. On and after May 15, 2016, we may redeem all or, from time to time, a part of the Notes at certain redemption prices, plus accrued and unpaid interest. If a “change of control” occurs, subject to certain conditions, we must offer to repurchase from each holder all or any part of that holder’s Notes at a purchase price in cash equal to 101% of the principal amount of the Notes plus accrued and unpaid interest, if any, to the date of purchase. The 2011 Indenture contains customary events of default. The 2011 Indenture also contains covenants that, among other things, limit our ability and the ability of certain of our subsidiaries to incur or guarantee additional indebtedness; pay dividends on our capital stock or redeem capital stock or subordinated indebtedness; transfer or sell assets; make investments; incur liens; enter into transactions with our affiliates; and merge or consolidate with other companies. We were in compliance with all covenants of the Notes as of December 31, 2016. Capital Requirements Oil and Natural Gas Dispositions, Acquisitions, and Capital Expenditures. Most of our capital expenditures for this segment are discretionary and directed toward future growth. Any decision to increase our oil, NGLs, and natural gas reserves through acquisitions or through drilling depends on the prevailing or expected market conditions, potential return on investment, future drilling potential, and opportunities to obtain financing under the circumstances involved, all of which provide us with a large degree of flexibility in deciding when and if to incur these costs. We completed drilling 21 gross wells(9.67 net wells) in 2016 compared to 58 gross wells (34.99 net wells) in 2015, and 186 gross wells (121.00 net wells) in 2014. Our 2016 total capital expenditures for our oil and natural gas segment, excluding a $30.9 million reduction in the ARO liability and $0.6 million in acquisitions, totaled $119.9 million compared to 2015 capital expenditures of $273.5 million (excluding a $5.7 million reduction in the ARO liability and $0.2 million in acquisitions), and 2014 capital expenditures of $772.2 million (excluding an $37.7 million reduction in the ARO liability and $5.7 million in acquisitions). For all of 2017, we plan to participate in drilling approximately 35 to 40 gross wells and estimate our total capital expenditures (excluding any possible acquisitions) for our oil and natural gas segment will be approximately $188.0 million. Whether we are able to drill all of those wells is dependent on a number of factors, many of which are beyond our control and include the availability of drilling rigs, availability of pressure pumping services, prices for oil, NGLs, and natural gas, demand for oil, NGLs, and natural gas, the cost to drill wells, the weather, and the efforts of outside industry partners. We sold non-core oil and natural gas assets, net of related expenses, for $67.2 million, $1.9 million, and $33.1 million during 2016, 2015, and 2014, respectively. Proceeds from those dispositions reduced the net book value of our full cost pool with no gain or loss recognized. Contract Drilling Dispositions, Acquisitions, and Capital Expenditures. During the first quarter of 2014. we sold four idle 3,000 horsepower drilling rigs to an unaffiliated third party. The proceeds from that sale were used in our construction program for our new proprietary 1,500 horsepower, AC electric drilling rig, called the BOSS drilling rig. During 2014, three BOSS drilling rigs were constructed and placed into service for third-party operators. In December 2014, we removed from service 31 drilling rigs, some older top drives, and certain drill pipe no longer marketable in the current environment and based on the estimated market value from third-party assessments, we recorded a write-down of approximately $74.3 million, pre-tax. During 2015, we recorded an additional write-down on the drilling rigs and other equipment of approximately $8.3 million pre-tax based on the estimated market value from similar auctions. We sold all 31 of these drilling rigs and some other drilling equipment to unaffiliated third parties. The proceeds from the sale of those assets, less costs to sell, was less than the $11.3 million net book value resulting in a loss of $7.3 million pre-tax. During 2015, five BOSS drilling rigs were constructed and placed into service for third-party operators. During December 2016, we sold an idle 1500 HP SCR drilling rig to an unaffiliated third party. We also fabricated and placed into service our ninth new BOSS drilling rig for a third party operator. This new BOSS rig was constructed using the long lead time components purchased in prior years. Our anticipated 2017 capital expenditures for this segment is approximately $24.0 million. We spent $19.1 million for capital expenditures during 2016 compared to $84.8 million in 2015, and $176.7 million in 2014. Mid-Stream Dispositions, Acquisitions, and Capital Expenditures. At our Cashion processing facility located in central Oklahoma, our total throughput volume for the fourth quarter of 2016 averaged approximately 33.1 MMcf per day and our total production of natural gas liquids increased to approximately 182,400 gallons per day. The total processing capacity at this facility is approximately 45 MMcf per day. In the fourth quarter of 2016, we completed a construction project that allows us to bring additional gas to the Cashion processing plant. Beginning on January 1, 2017, the producer will deliver 10 MMcf per day for five years on a fee-basis to the Cashion processing facility or pay a shortfall fee which is settled on an annual basis. During 2016, we connected a total of seven new wells to this system. At our Bellmon processing facility located in the Mississippian play in North Central Oklahoma, our total throughput volume averaged approximately 28.7 MMcf per day during the fourth quarter of 2016 and our total natural gas liquids averaged approximately 148,400 gallons per day while operating in ethane recovery mode during the quarter. In 2016, after we installed additional compression to be able to handle new third-party volumes, we were able to consolidate two producer-owned gathering systems into our system. During 2016, we connected 15 new wells to this facility. We currently have two processing skids available for processing that provide total processing capacity of 90 MMcf per day. At our Segno gathering facility located in Southeast Texas, our average gathered volume for the fourth quarter of 2016 increased to approximately 91.3 MMcf per day. During 2016 we completed construction projects that improved the facility and increased our gathering and dehydration capacity to approximately 120 MMcf per day. Also during 2016, we connected three new wells to this gathering system and there is active drilling and recompletion activity in the area around our system. In the Appalachian region, at our Pittsburgh Mills gathering system, we continue to connect new well pads to this system. During 2016, we connected four new well pads with a total of 18 new wells to this gathering system. With the addition of these new wells our average gathered volume for the fourth quarter increased to approximately 153 MMcf per day. In the fourth quarter of 2016, we started preliminary construction activities to connect the next well pad. This well pad will have five wells drilled and we anticipate connecting it in the second quarter of 2017. This well pad is located on the north end of our system close to our Clinton compressor station. Also in the Appalachian area, we began operating our Snow Shoe gathering system in January of 2016. During 2016, we connected three well pads to this system that have a total of six wells. Our average total gathered volume for this new system in 2016 was approximately 10.2 MMcf per day. Preliminary construction continues on the Snow Shoe compressor station but we do not intend to complete construction and put this compressor station into service until compression services are required on this system. During 2016, our mid-stream segment incurred $16.8 million in capital expenditures as compared to $63.5 million in 2015, and $51.1 million, excluding $28.2 million for capital leases, in 2014. For 2017, our estimated capital expenditures is approximately $13.0 million. Contractual Commitments At December 31, 2016, we had the following contractual obligations: _________________________ (1) See previous discussion in MD&A regarding our long-term debt. This obligation is presented in accordance with the terms of the Notes and credit agreement and includes interest calculated using our December 31, 2016 interest rates of 6.625% for the Notes and 2.8% for the credit agreement. (2) We lease office space or yards in Edmond and Oklahoma City, Oklahoma; Houston, Texas; Englewood, Colorado; Pinedale, Wyoming; and Pittsburgh, Pennsylvania under the terms of operating leases expiring through December 2021. Additionally, we have several equipment leases and lease space on short-term commitments to stack excess drilling rig equipment and production inventory. (3) Maintenance and interest payments are included in our capital lease agreements. The capital leases are discounted using annual rates of 4.0%. Total maintenance and interest remaining are $7.7 million and $1.9 million, respectively. (4) We have committed to purchase approximately $4.2 million of new drilling rig components over the next two years. (5) We have committed to pay $0.9 million for Enterprise Resource Planning software and $0.5 million for maintenance for one year following implementation. At December 31, 2016, we also had the following commitments and contingencies that could create, increase or accelerate our liabilities: _________________________ (1) We provide a salary deferral plan which allows participants to defer the recognition of salary for income tax purposes until actual distribution of benefits, which occurs at either termination of employment, death or certain defined unforeseeable emergency hardships. We recognize payroll expense and record a liability, included in other long-term liabilities in our Consolidated Balance Sheets, at the time of deferral. (2) Effective January 1, 1997, we adopted a separation benefit plan (Separation Plan). The Separation Plan allows eligible employees whose employment with us is involuntarily terminated or, in the case of an employee who has completed 20 years of service, voluntarily or involuntarily terminated, to receive benefits equivalent to four weeks salary for every whole year of service completed with the company up to a maximum of 104 weeks. To receive payments the recipient must waive certain claims against us in exchange for receiving the separation benefits. On October 28, 1997, we adopted a Separation Benefit Plan for Senior Management (Senior Plan). The Senior Plan provides certain officers and key executives of the company with benefits generally equivalent to the Separation Plan. The Compensation Committee of the Board of Directors has absolute discretion in the selection of the individuals covered in this plan. On May 5, 2004 we also adopted the Special Separation Benefit Plan (Special Plan). This plan is identical to the Separation Benefit Plan with the exception that the benefits under the plan vest on the earliest of a participant’s reaching the age of 65 or serving 20 years with the company. On December 31, 2008, all these plans were amended to bring the plans into compliance with Section 409A of the Internal Revenue Code of 1986, as amended. On December 8, 2015, we amended the Plans to change the calculation for determining the payouts at the time of a Separation of Service under the Plans. (3) When a well is drilled or acquired, under ASC 410 “Accounting for Asset Retirement Obligations,” we record the fair value of liabilities associated with the retirement of long-lived assets (mainly plugging and abandonment costs for our depleted wells). (4) We have recorded a liability for those properties we believe do not have sufficient oil, NGLs, and natural gas reserves to allow the under-produced owners to recover their under-production from future production volumes. (5) We formed The Unit 1984 Oil and Gas Limited Partnership and the 1986 Energy Income Limited Partnership along with private limited partnerships (the Partnerships) with certain qualified employees, officers and directors from 1984 through 2011, with a subsidiary of ours serving as general partner. Effective December 31, 2014, the 1984 partnership was dissolved and effective December 31, 2016, the two 1986 partnerships were also dissolved. The Partnerships were formed for the purpose of conducting oil and natural gas acquisition, drilling and development operations and serving as co-general partner with us in any additional limited partnerships formed during that year. The Partnerships participated on a proportionate basis with us in most drilling operations and most producing property acquisitions commenced by us for our own account during the period from the formation of the Partnership through December 31 of that year. These partnership agreements require, on the election of a limited partner, that we repurchase the limited partner’s interest at amounts to be determined by appraisal in the future. Repurchases in any one year are limited to 20% of the units outstanding. We made repurchases of approximately $5,000, $118,000, and $45,000 in 2016, 2015, and 2014, respectively. (6) We have recorded a liability for future estimated payments related to workers’ compensation claims primarily associated with our contract drilling segment. (7) This amount includes commitments under capital lease arrangements for compressors in our mid-stream segment. Derivative Activities Periodically we enter into derivative transactions locking in the prices to be received for a portion of our oil, NGLs, and natural gas production. Any change in fair value on all commodity derivatives we have entered into are reflected in the statement of operations. Commodity Derivatives. Our commodity derivatives is intended to reduce our exposure to price volatility and manage price risks. Our decision on the type and quantity of our production and the price(s) of our derivative(s) is based, in part, on our view of current and future market conditions. As of December 31, 2016, based on our fourth quarter 2016 average daily production, the approximated percentages of our production under derivative contracts are as follows: With respect to the commodities subject to derivative contracts, those contracts serve to limit the risk of adverse downward price movements. However, they also limit increases in future revenues that would otherwise result from price movements above the contracted prices. The use of derivative transactions carries with it the risk that the counterparties may not be able to meet their financial obligations under the transactions. Based on our evaluation at December 31, 2016, we believe the risk of non-performance by our counterparties is not material. At December 31, 2016, the fair values of the net liabilities we had with each of the counterparties to our commodity derivative transactions are as follows: If a legal right of set-off exists, we net the value of the derivative arrangements we have with the same counterparty in our Consolidated Balance Sheets. At December 31, 2016, we recorded the fair value of our commodity derivatives on our balance sheet as non-current derivative assets of $0.4 million and current and non-current derivative liabilities of $21.6 million and $0.4 million, respectively. At December 31, 2015, we recorded the fair value of our commodity derivatives on our balance sheet as current and non-current derivative assets of $10.2 million and $1.0 million, respectively, and non-current derivative liabilities of $0.3 million. All derivatives are recognized on the balance sheet and measured at fair value. Any changes in our derivatives' fair value occurring before their maturity (i.e., temporary fluctuations in value) are reported in gain (loss) on derivatives in our Consolidated Statements of Operations. These gains (losses) are as follows at December 31: Stock and Incentive Compensation During 2016, we granted awards covering 736,451 shares of restricted stock. These awards were granted as retention incentive awards. These stock awards had an estimated fair value as of the grant date of $4.5 million. Compensation expense will be recognized over the awards' three year vesting period. During 2016, we recognized $1.9 million in additional compensation expense and capitalized $0.2 million for these awards. During 2015, we granted awards covering 750,290 shares of restricted stock. These awards were granted as retention incentive awards and are being recognized over the awards' three year vesting period. During 2014, we granted awards covering 468,890 shares of restricted stock. These awards were granted as retention incentive awards and are being recognized over their two and three year vesting periods. No SAR awards were made during 2016, 2015, or 2014. During 2016, we recognized compensation expense of $9.6 million for our restricted stock grants and capitalized $2.1 million of compensation cost for oil and natural gas properties. Insurance We are self-insured for certain losses relating to workers’ compensation, general liability, control of well, and employee medical benefits. Insured policies for other coverage contain deductibles or retentions per occurrence that range from zero to $1.0 million. We have purchased stop-loss coverage in order to limit, to the extent feasible, per occurrence and aggregate exposure to certain types of claims. There is no assurance that the insurance coverage we have will protect us against liability from all potential consequences. If insurance coverage becomes more expensive, we may choose to self-insure, decrease our limits, raise our deductibles, or any combination of these rather than pay higher premiums. Oil and Natural Gas Limited Partnerships and Other Entity Relationships. We are the general partner of 13 oil and natural gas partnerships which were formed privately or publicly. Each partnership’s revenues and costs are shared under formulas set out in that partnership’s agreement. The partnerships repay us for contract drilling, well supervision and general and administrative expense. Related party transactions for contract drilling and well supervision fees are the related party’s share of such costs. These costs are billed on the same basis as billings to unrelated third parties for similar services. General and administrative reimbursements consist of direct general and administrative expense incurred on the related party’s behalf as well as indirect expenses assigned to the related parties. Allocations are based on the related party’s level of activity and are considered by us to be reasonable. During 2016, 2015, and 2014, the total we received for all of these fees was $0.3 million, $0.4 million, and $0.5 million, respectively. Our proportionate share of assets, liabilities, and net income relating to the oil and natural gas partnerships is included in our consolidated financial statements. Effects of Inflation The effect of inflation in the oil and natural gas industry is primarily driven by the prices for oil, NGLs, and natural gas. Increases in these prices increase the demand for our contract drilling rigs and services. This increase in demand in turn affects the dayrates we can obtain for our contract drilling services. During periods of higher demand for our drilling rigs we have experienced increases in labor costs as well as the costs of services to support our drilling rigs. Historically, during this same period, when oil, NGLs, and natural gas prices did decline, labor rates did not come back down to the levels existing before the increases. If commodity prices increase substantially for a long period, shortages in support equipment (such as drill pipe, third party services, and qualified labor) can result in additional increases in our material and labor costs. Increases in dayrates for drilling rigs also increase the cost of our oil and natural gas properties. How inflation will affect us in the future will depend on increases, if any, realized in our drilling rig rates, the prices we receive for our oil, NGLs, and natural gas, and the rates we receive for gathering and processing natural gas. Off-Balance Sheet Arrangements We do not currently utilize any off-balance sheet arrangements with unconsolidated entities to enhance liquidity and capital resource positions, or for any other purpose. However, as is customary in the oil and gas industry, we are subject to various contractual commitments. Results of Operations 2016 versus 2015 _________________________ (1) NM - A percentage calculation is not meaningful due to a zero-value denominator or a percentage change greater than 200. Oil and Natural Gas Oil and natural gas revenues decreased $91.6 million or 24% in 2016 as compared to 2015 due primarily to lower oil and natural gas prices as well as a decrease in production. Oil production decreased 21%, NGLs production decreased 5%, and natural gas production decreased 15%. Average oil prices between the comparative years decreased 20% to $40.50 per barrel, NGLs prices increased 11% to $11.26 per barrel, and natural gas prices decreased 21% to $2.07 per Mcf. Oil and natural gas operating costs decreased $45.9 million or 28% between the comparative years of 2016 and 2015 due to lower LOE, saltwater disposal, and general and administrative expense. Depreciation, depletion, and amortization (DD&A) decreased $138.1 million or 55% primarily due to a 49% decrease in our DD&A rate and by the effect of a 14% decrease in equivalent production. The decrease in our DD&A rate in 2016 compared to 2015 resulted primarily from the effect of the ceiling test write-downs during 2015 and 2016. Our DD&A expense on our oil and natural properties is calculated each quarter utilizing period end reserve quantities adjusted for current period production. During 2016, we recorded non-cash ceiling test write-downs of our oil and natural gas properties totaling $161.6 million pre-tax ($100.6 million, net of tax) compared to a non-cash ceiling test write-down of our oil and natural gas properties of $1.6 billion pre-tax ($1.0 billion net of tax) in 2015. These write-downs were due primarily from the reduction of the 12-month average commodity prices during each year. Contract Drilling Drilling revenues decreased $143.6 million or 54% in 2016 as compared to 2015. The decrease was due primarily to a 50% decrease in the average number of drilling rigs in use, a 9% decrease in the average dayrate, and $25.9 million less received for fees on contracts terminated early in 2016 compared to 2015. Average drilling rig utilization decreased from 34.7 drilling rigs in 2015 to 17.4 drilling rigs in 2016. Drilling operating costs decreased $68.3 million or 44% in 2016 compared to 2015. The decrease was due primarily to fewer drilling rigs operating. Contract drilling depreciation decreased $9.1 million or 16% also due primarily to fewer drilling rigs operating. During the second quarter of 2015, we recorded an impairment of approximately $8.3 million on 31 drilling rigs and other equipment that was sold at auction during the third quarter. Mid-Stream Our mid-stream revenues decreased $16.9 million or 8% in 2016 as compared to 2015 due primarily to gas sold per day decreasing 16% and NGLs sold per day decreasing 7%. Gas processing volumes per day decreased 15% between the comparative years primarily from fewer well connections near our processing systems. Gas gathering volumes per day increased 18% primarily from new well connections in the Appalachian region. Operating costs decreased $23.9 million or 15% in 2016 compared to 2015 primarily due to a 6% decrease in prices paid for natural gas purchased and a 15% decrease in purchase volumes. Depreciation and amortization increased $2.0 million or 5% primarily due to capital expenditures for upgrades and well connects. In December 2015, our mid-stream segment had a $27.0 million pre-tax write-down of three of its systems, Bruceton Mills, Midwell, and Spring Creek due to anticipated future cash flow and future development around these systems not being sufficient to support their carrying value. The estimated future cash flows were less than the carrying value on these systems. Due to continued depressed NGLs prices, we are operating most of our processing facilities in full ethane rejection mode which reduced the amount of liquids sold throughout 2016. As long as NGLs prices continue at or below these levels, we expect to continue operating most facilities in full ethane rejection mode. Our mid-stream segment also experience a reduction in processed volumes in 2016 due to the low pricing environment and reduced drilling activity around our systems. General and Administrative General and administrative expenses decreased $1.0 million or 3% in 2016 compared to 2015 primarily due to lower employee costs. Other Depreciation Other depreciation increased $0.8 million or 86% in 2016 compared to 2015 primarily due to the depreciation on the corporate office facility. Gain (loss) on Disposition of Assets Gain (loss) on disposition of assets increased $9.8 million in 2016 compared to 2015 primarily due to the gain of $3.2 million pre-tax on the sale of one drilling rig, various drilling rig components, vehicles, and other equipment somewhat offset by losses from our oil and natural gas and mid-stream segments, compared to a loss of $7.3 million pre-tax on the sale of 31 drilling rigs and other drilling equipment somewhat offset by the gains on the sale of one gathering system, various drilling rig components, vehicles, and a drilling rig during 2015. Other Income (Expense) Interest expense, net of capitalized interest, increased $7.9 million between the comparative years of 2016 and 2015. We capitalized interest based on the net book value associated with unproved properties not being amortized, the construction of additional drilling rigs, and the construction of gas gathering systems. Capitalized interest for 2016 was $15.3 million compared to $21.7 million in 2015, and was netted against our gross interest of $55.1 million and $53.7 million for 2016 and 2015, respectively. Our average interest rate increased from 5.4% to 5.7% and our average debt outstanding was $29.1 million lower in 2016 as compared to 2015 primarily due to the decrease in our outstanding borrowings under our credit agreement over the comparative periods. Gain (loss) on derivatives decreased from a gain of $26.3 million in 2015 to a loss of $22.8 million in 2016 primarily due to fluctuations in forward prices used to estimate the fair value in mark-to-market accounting. Income Tax Benefit Income tax benefit decreased $555.8 million in 2016 compared to 2015 primarily due to a lower pre-tax loss from a reduction in non-cash ceiling test write-downs in 2016 compared to 2015. Our effective tax rate was 34.4% for 2016 and 37.7% for 2015. This decrease is primarily due to increased deferred tax expense in 2016 related to our restricted stock vestings in 2016 after the exhaustion of our remaining accumulated excess tax benefits. The current income tax benefit was minimal in 2016 compared to a current income tax benefit of $20.6 million for 2015. The $20.6 million current income tax benefit in 2015 was primarily due to an anticipated alternative minimum tax (AMT) net operating loss (NOL) carryback refund claim. We paid $42,000 in income taxes during 2016. 2015 versus 2014 _________________________ (1) NM - A percentage calculation is not meaningful due to a zero-value denominator or a percentage change greater than 200. Oil and Natural Gas Oil and natural gas revenues decreased $354.3 million or 48% in 2015 as compared to 2014 due primarily to lower oil, natural gas, and NGLs prices partially offset by an increase in production. Oil production decreased 2%, NGLs production increased 14%, and natural gas production increased 11%. Average oil prices between the comparative years decreased 43% to $50.79 per barrel, NGLs prices decreased 67% to $10.12 per barrel, and natural gas prices decreased 33% to $2.63 per Mcf. Oil and natural gas operating costs decreased $21.9 million or 12% between the comparative years of 2015 and 2014 due to lower gross production taxes due to lower sales revenue and lower general and administrative expense. DD&A decreased $24.1 million or 9% primarily due to a 17% decrease in our DD&A rate partially offset by the effect of a 9% increase in equivalent production. The decrease in our DD&A rate in 2015 compared to 2014 resulted primarily from the effect of the ceiling test write-downs during 2015. Our DD&A expense on our oil and natural properties is calculated each quarter utilizing period end reserve quantities adjusted for current period production. During 2015, we recorded non-cash ceiling test write-downs of our oil and natural gas properties totaling $1.6 billion pre-tax ($1.0 billion, net of tax) compared to a non-cash ceiling test write-down of our oil and natural gas properties of $76.7 million pre-tax ($47.7 million net of tax) in December of 2014. These write-downs were due to the inclusion of the impaired value of the unproved properties of $114.4 million and $73.7 million in 2015 and 2014, respectively and a reduction of the 12-month average commodity prices during each year. Contract Drilling Drilling revenues decreased $210.8 million or 44% in 2015 as compared to 2014. The decrease was due primarily to a 54% decrease in the average number of drilling rigs in use and a 3% decrease in the average dayrate partially offset by $29.0 million for fees on contracts terminated early in 2015. Average drilling rig utilization decreased from 75.4 drilling rigs in 2014 to 34.7 drilling rigs in 2015. Drilling operating costs decreased $118.5 million or 43% in 2015 compared to 2014. The decrease was due primarily to fewer drilling rigs operating. Contract drilling depreciation decreased $29.2 million or 34% also due primarily to fewer drilling rigs operating. In December 2014, 31 drilling rigs and other drilling equipment were written down to their estimated market value. This impairment was approximately $74.3 million pre-tax. During the second quarter of 2015, we recorded an additional impairment of approximately $8.3 million on the drilling rigs and other equipment that was sold at auction during the third quarter. Mid-Stream Our mid-stream revenues decreased $153.6 million or 43% in 2015 as compared to 2014 due primarily from the average price for NGLs sold decreasing 47%, the average price for natural gas sold decreasing 39%, and NGLs volumes sold per day decreasing 21% primarily from being in ethane rejection mode. Gas processing volumes per day increased 13% between the comparative years primarily from new well connections. Gas gathering volumes per day increased 11% primarily from new well connections. Operating costs decreased $145.3 million or 47% in 2015 compared to 2014 primarily due to an 54% decrease in prices paid for natural gas purchased partially offset by a 12% increase in purchase volumes. Depreciation and amortization increased $3.2 million or 8% primarily due to capital expenditures for upgrades and well connects. In December 2014, our mid-stream segment had a $7.1 million pre-tax write-down of three of its systems, Weatherford, Billy Rose, and Spring Creek due to anticipated future cash flow and future development around these systems supporting their carrying value. The estimated future cash flows were less than the carrying value on these systems. In December 2015, our mid-stream segment had another $27.0 million pre-tax write-down of three of its systems, Bruceton Mills, Midwell, and Spring Creek due to anticipated future cash flow and future development around these systems not being sufficient to support their carrying value. The estimated future cash flows were less than the carrying value on these systems. Due to the decline in NGLs prices beginning in 2014, we operated our processing facilities in full ethane rejection mode which reduced the amount of liquids sold throughout 2015. As long as NGLs prices continue at or below these levels,we expect to continue operating in full ethane rejection mode. Our mid-stream segment did not experience a reduction in processed volumes in 2015 but as low prices continue we expect further reductions in drilling activity around our systems which will eventually effect our ability to connect new wells resulting in lower processed volumes in the future. General and Administrative General and administrative expenses decreased $6.7 million or 16% in 2015 compared to 2014 primarily due to lower employee costs and a $1.8 million decrease in the stock-based compensation accrual due to an evaluation of the performance based shares component of previous grants. Gain (loss) on Disposition of Assets Gain (loss) on disposition of assets decreased $16.2 million in 2015 compared to 2014 primarily due to the loss of $7.3 million pre-tax on the sale of 30 drilling rigs and other drilling equipment in an auction somewhat offset by the gains on the sale of one gathering system, various drilling rig components, vehicles, and a drilling rig during 2015, compared to a gain of $9.0 million primarily for the sale of four idle 3,000 horsepower drilling rigs to an unaffiliated third-party during 2014. Other Income (Expense) Interest expense, net of capitalized interest, increased $14.6 million between the comparative years of 2015 and 2014. We capitalized interest based on the net book value associated with unproved properties not being amortized, the construction of additional drilling rigs, and the construction of gas gathering systems. Capitalized interest for 2015 was $21.7 million compared to $32.2 million in 2014, and was netted against our gross interest of $53.7 million and $49.6 million for 2015 and 2014, respectively. Our average interest rate decreased from 6.5% to 5.4% and our average debt outstanding was $222.6 million higher in 2015 as compared to 2014 primarily due to the increase in our outstanding borrowings under our credit agreement over the comparative periods. Gain on derivatives decreased from a gain of $30.1 million in 2014 to a gain of $26.3 million in 2015 primarily due to fluctuations in forward prices used to estimate the fair value in mark-to-market accounting. Income Tax Expense Income tax expense decreased $713.6 million in 2015 compared to 2014 primarily due to decreased income due to the impairments in all three segments during 2015. Our effective tax rate was 37.7% for 2015 and 38.9% for 2014. This decrease is primarily due to the effect of permanent differences as they relate to negative pre-tax income. Current income tax benefit was $20.6 million in 2015 compared to a current income tax expense of $9.4 million for 2014. The $20.6 million current income tax benefit is due to an anticipated alternative minimum tax (AMT) net operating loss (NOL) refund. We paid $3.5 million in income taxes during 2015.

<s>[INST] General We operate, manage, and analyze our results of operations through our three principal business segments: Oil and Natural Gas carried out by our subsidiary Unit Petroleum Company. This segment explores, develops, acquires, and produces oil and natural gas properties for our own account. Contract Drilling carried out by our subsidiary Unit Drilling Company. This segment contracts to drill onshore oil and natural gas wells for others and for our own account. MidStream carried out by our subsidiary Superior Pipeline Company, L.L.C. and its subsidiaries. This segment buys, sells, gathers, processes, and treats natural gas for third parties and for our own account. Business Outlook As discussed in other parts of this report, our success depends, to a large degree, on the prices we receive for our oil and natural gas production, the demand for oil and natural gas, as well as, the demand for our drilling rigs which, in turn, influences the amounts we can charge for those drilling rigs. While our operations are located within the United States, events outside the United States affect us and our industry. Deteriorating commodity prices worldwide during the past two years or so brought about significant adverse changes affecting our industry and us. These lower commodity prices caused us (and other oil and gas companies) to reduce and ultimately stop drilling activity and spending. When drilling activity and spending decline for extended periods of time the rates for and the number of our drilling rigs working also tend to decline. In addition, sustained lower commodity prices impact the liquidity condition of some of our industry partners and customers, which, in turn, could limit their ability to meet their financial obligations to us. Commodity prices are volatile and subject to a number of factors most of which we cannot control. With the recent improvements in commodity prices, we are slowly starting to see signs of improvement in both industry and our activity. Our oil and natural gas segment began using two drilling rigs in the fourth quarter of 2016 and continued to do so in January 2017. Our contract drilling segment completed the construction and contracted the ninth BOSS drilling rig in the fourth quarter of 2016. In addition, we have seen indications that other operators are picking up their activity as well, but the extent and duration of this increase remains uncertain. The impact on our business and financial results from the reduction in oil, NGLs, and natural gas prices has had a number of consequences for us, including: We incurred noncash ceiling test writedowns in the first nine months of 2016 of $161.6 million ($100.6 million net of tax). We did not have a writedown in the fourth quarter of 2016. It is hard to predict with any reasonable certainty the need for or amount of any future impairments given the many factors that go into the ceiling test calculation including, but not limited to, future pricing, operating costs, drilling and completion costs, upward or downward oil and gas reserve revisions, oil and gas reserve additions, and tax attributes. Subject to these inherent uncertainties, if we hold these same factors constant as they existed at December 31, 2016 and only adjust the 12month average price to an estimated first quarter ending average (holding February 2017 prices constant for the remaining one month of the first quarter of 2017), our forward looking expectation is that we will not recognize an impairment in the first quarter of 2017. But commodity prices (and other factors) remain volatile and they could negatively impact the 12month average price resulting in the potential for an impairment in the first quarter. We reduced the number of gross wells our oil and natural gas segment drilled in 2016 by approximately 64% from the number drilled in 2015 due to reduced cash flow. For 2017, we plan to increase the number of gross wells drilled by approximately 6790% from the number of wells drilled in 2016. The decline in drilling by our customers reduced the average utilization of our drilling rig fleet. At December 31, 2015, we had 26 drilling rigs operating. In 2016, utilization continued downward bottoming out in May at [/INST] Positive. </s>

UNIT CORP

2018-02-27

2017-12-31

Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations Please read this discussion of our financial condition and results of operations with the consolidated financial statements and related notes in Item 8 of this report. General We operate, manage, and analyze our results of operations through our three principal business segments: • Oil and Natural Gas - carried out by our subsidiary Unit Petroleum Company. This segment explores, develops, acquires, and produces oil and natural gas properties for our own account. • Contract Drilling - carried out by our subsidiary Unit Drilling Company. This segment contracts to drill onshore oil and natural gas wells for others and for our own account. • Mid-Stream - carried out by our subsidiary Superior Pipeline Company, L.L.C. and its subsidiaries. This segment buys, sells, gathers, processes, and treats natural gas for third parties and for our own account. Business Outlook As discussed in other parts of this report, our success depends, to a large degree, on the prices we receive for our oil and natural gas production, the demand for oil, natural gas, and NGLs, and the demand for our drilling rigs which influences the amounts we can charge for those drilling rigs. While our operations are within the United States, events outside the United States affect us and our industry. Deteriorating commodity prices worldwide during the past several years brought about significant and adverse changes to our industry and us. As a result we reduced or stopped, for a time, our oil and natural gas segment's drilling activity. Industry wide reductions in drilling activity and spending for extended periods also reduces the rates for and the number of our drilling rigs we can work. In addition, sustained lower commodity prices impact the liquidity condition of some of our industry partners and customers, which could limit their ability to meet their financial obligations to us. During 2016, commodity prices improved. In the fourth quarter of 2016, our oil and natural gas segment began using two of our drilling rigs and has been using two to three drilling rigs throughout 2017. Our contract drilling segment completed the construction and contracted the ninth and tenth BOSS drilling rigs in the fourth quarter of 2016 and the second quarter of 2017, respectively. Our drilling rig segment's rig utilization increased from 16 drilling rigs working as of June 30, 2016, to 31 drilling rigs working as of December 31, 2017. The extent and duration of this improvement remains uncertain. The reduction in oil, NGLs, and natural gas prices had several consequences for us (although, as noted, we are seeing improvements). Below are some of those consequences: • We incurred non-cash ceiling test write-downs in the first nine months of 2016 of $161.6 million ($100.6 million net of tax). We had no write-downs during 2017. It is hard to predict with any reasonable certainty the need for or amount of any future impairments given the many factors that go into the ceiling test calculation including, future pricing, operating costs, drilling and completion costs, upward or downward oil and gas reserve revisions, oil and gas reserve additions, and tax attributes. Subject to these inherent uncertainties, if we hold these same factors constant as they existed at December 31, 2017, and only adjust the 12-month average price to an estimated first quarter ending average (holding February 2018 prices constant for the remaining one month of the first quarter of 2018), our forward looking expectation is that we will not recognize an impairment in the first quarter of 2018. But commodity prices (and other factors) remain volatile and they could negatively affect the 12-month average price resulting in the potential for a future impairment. • The number of gross wells our oil and gas segment drilled in 2017 verses 2016 increased from 21 wells to 70 wells due to increased cash flow. For 2018, we plan to increase the number of gross wells drilled to 75-85 wells (depending on future commodity prices). • The decline in drilling by our customers reduced the average use of our drilling rig fleet. At December 31, 2015, we had 26 drilling rigs operating. In 2016, utilization continued downward bottoming out in May at 13 operating drilling rigs. After May commodity prices improved for the remainder of the year and we exited 2016 with 21 active rigs. As of December 31, 2017, we had 31 drilling rigs operating. Operators have been increasing drilling, but the extent of further increases remains uncertain. As of December 31 2017, all ten of our BOSS drilling rigs were under contract. • Due to low ethane price, we continue to operate some of our mid-stream processing facilities in ethane rejection mode which reduces the liquids sold. If ethane price relative to natural gas price remains depressed, we expect to continue operating in ethane rejection mode at some of our processing facilities. Also, as noted elsewhere, beginning on April 4, 2017, we began an at-the-market offering for the sale of shares of our common stock. The offering allows us to sell shares, from time to time, up to an aggregate of $100.0 million in gross proceeds. As of December 31, 2017, we sold 787,547 shares for $18.6 million, net of offering costs of $0.4 million. Approximately $81.0 million remain available for sale under the program. Net proceeds from the offering will fund (or offset costs of) acquisitions, future capital expenditures, repay amounts outstanding under our revolving credit facility, and general corporate purposes. On April 3, 2017, we closed an acquisition of certain oil and natural gas assets from an unrelated third party. The acquisition included approximately 47 proved developed producing wells and 8,300 net acres primarily in Grady and Caddo Counties in western Oklahoma. The final adjusted value of consideration given was $54.3 million. The effective date of this acquisition was January 1, 2017. Executive Summary Oil and Natural Gas Fourth quarter 2017 production from our oil and natural gas segment was 4,310 MBoe, an increase of 6% over the third quarter of 2017 and an increase of 2% over the fourth quarter of 2016. The increases mostly came from acquired wells and new wells drilled in 2017. Oil and NGLs production during the fourth quarter of 2017 was 46% of our total production compared to 47% of our total production during the fourth quarter of 2016. Fourth quarter 2017 oil and natural gas revenues increased 19% over the third quarter of 2017 and increased 15% over the fourth quarter of 2016. These increases were primarily due to higher oil and NGLs prices and higher oil and natural gas production volumes. Our NGLs, oil, and natural gas prices for the fourth quarter of 2017 increased 19%, 15%, and 1%, respectively, compared to the third quarter of 2017. Our NGLs and oil prices increased 50% and 18%, respectively, compared to the fourth quarter of 2016, while our natural gas prices were essentially unchanged. Direct profit (oil and natural gas revenues less oil and natural gas operating expense) increased 29% over the third quarter of 2017 and 10% over the fourth quarter of 2016. The increases were primarily due to higher revenues due to rising commodity prices and production volumes. Operating cost per Boe produced for the fourth quarter of 2017 decreased 3% from the third quarter of 2017 and increased 24% over the fourth quarter of 2016. The decrease from the third quarter of 2017 was primarily due to higher production volumes. The increase over the fourth quarter of 2016 was primarily due to higher lease operating expenses (LOE), gross production taxes, general and administrative expenses offset partially by higher production. At December 31, 2017, these non-designated hedges were outstanding: After December 31, 2017, these non-designated hedges were entered into: During 2017, we participated in the drilling of 70 wells (25.71 net wells). For 2018, we plan to participate in the drilling of approximately 75 to 85 gross wells. Our 2018 production guidance is approximately 17.1 to 17.4 MMBoe, an increase of 7-9% over 2017, actual results will be subject to many factors. This segment’s capital budget for 2018 is approximately $272.0 million, a 26% increase over 2017, excluding acquisitions and ARO liability. Contract Drilling The average number of drilling rigs we operated in the fourth quarter was 31.2 compared to 34.6 and 19.5 in the third quarter of 2017 and fourth quarter of 2016, respectively. As of December 31, 2017, 31 of our drilling rigs were operating. Revenue for the fourth quarter of 2017 decreased 10% from the third quarter of 2017 and increased 40% over the fourth quarter of 2016. The decrease from the third quarter of 2017 was primarily due to fewer drilling rigs operating offset slightly by higher dayrates. The increase over the fourth quarter of 2016 was primarily due to more drilling rigs operating partially offset by lower dayrates. Dayrates for the fourth quarter of 2017 averaged $16,645, a 1% increase over the third quarter of 2017 and a 1% decrease from the fourth quarter of 2016. The increase over the third quarter of 2017 was primarily due to a labor increase that was passed through to contracted rigs. The decrease from the fourth quarter of 2016 was primarily due to downward pressure on dayrates due to lower demand as higher rate contracts were expiring. Operating costs for the fourth quarter of 2017 decreased 10% from the third quarter of 2017 and increased 45% over the fourth quarter of 2016. The decrease from the third quarter of 2017 was primarily due to fewer drilling rigs operating while the increase over the fourth quarter of 2016 was primarily due to more drilling rigs operating. Direct profit (contract drilling revenue less contract drilling operating expense) for the fourth quarter of 2017 decreased 9% from the third quarter of 2017 and increased 31% over the fourth quarter of 2016. The decrease from the third quarter of 2017 was primarily due to fewer drilling rigs operating while the increase over the fourth quarter of 2016 was primarily due to more drilling rigs operating. Operating cost per day for the fourth quarter of 2017 was essentially unchanged from the third quarter of 2017 and decreased 9% from the fourth quarter of 2016. The decrease from the fourth quarter of 2016 was primarily due to an increase in drilling rigs operating. During 2017, almost all of our working drilling rigs were drilling horizontal or directional wells for oil and NGLs. The future demand for and the availability of drilling rigs to meet that demand will affect our future dayrates. As of December 31, 2017, we had nine term drilling contracts with original terms ranging from six months to two years. Eight of these contracts are up for renewal in 2018, (four in the first quarter, three in the second quarter, and one in the fourth quarter) and one is up for renewal in 2019. Term contracts may contain a fixed rate during the contract or provide for rate adjustments within a specific range from the existing rate. Some operators who had signed term contracts have opted to release the drilling rig and pay an early termination penalty for the remaining term of the contract. We recorded $0.8 million, $3.1 million, and $29.0 million in early termination fees in 2017, 2016, and 2015, respectively. All ten of our existing BOSS drilling rigs are under contract. Our anticipated 2018 capital expenditures for this segment are approximately $47.0 million, a 30% increase over 2017. Mid-Stream Fourth quarter 2017 liquids sold per day increased 10% and 9% over the third quarter of 2017 and the fourth quarter of 2016, respectively. The increases were due primarily to more processed volume due to connecting additional wells to our systems. For the fourth quarter of 2017, gas processed per day increased 6% and 5% over the third quarter of 2017 and the fourth quarter of 2016, respectively. The increases were due to connecting additional wells to our processing systems. For the fourth quarter of 2017, gas gathered per day was essentially unchanged from the third quarter of 2017 and decreased 10% from the fourth quarter of 2016. The decrease from the fourth quarter of 2016 was primarily due to declining volumes from the Appalachian region. NGLs prices in the fourth quarter of 2017 increased 17% and 44% over the prices received in the third quarter of 2017 and the fourth quarter of 2016, respectively. Because certain of the contracts used by our mid-stream segment for NGLs transactions are commodity-based contracts - under which we receive a share of the proceeds from the sale of the NGLs - our revenues from those commodity-based contracts fluctuate based on NGLs prices. Direct profit (mid-stream revenues less mid-stream operating expense) for the fourth quarter of 2017 decreased 2% and 11% from the third quarter of 2017 and fourth quarter of 2016, respectively. The decrease from the third quarter was primarily due to a demand fee expiring in the fourth quarter of 2017 at our Pittsburgh Mills facility. The decrease from the fourth quarter of 2016 was also primarily due to the expiring demand fee at our Pittsburgh Mills facility in the fourth quarter of 2017 along with a short-fall fee that was recognized in the fourth quarter of 2016. Total operating cost for this segment for the fourth quarter of 2017 increased 14% over both the third quarter of 2017 and the fourth quarter of 2016, respectively due primarily to the combination of the higher cost of gas purchased and increased purchase volumes. At our Cashion processing facility in central Oklahoma, our total throughput volume for the fourth quarter of 2017 averaged approximately 37.3 MMcf per day and our total production of natural gas liquids increased to approximately 198,600 gallons per day. The total processing capacity at this facility is approximately 45 MMcf per day. During 2017, we connected 12 new wells to this system from three producers. We are continuing a pipeline extension project for a producer scheduled to actively drill in the Cashion area in 2018. We have already connected four new wells from this producer and anticipate connecting several more wells throughout 2018. As volume increases on this system, we will evaluate the need to add additional processing capacity. If volume continues to increase, we may need to add an additional processing plant in the Cashion area. At our Hemphill processing facility in the Texas panhandle, our average gathered volume for the fourth quarter of 2017 was approximately 68.5 MMcf per day and our total production of natural gas liquids increased to 188,600 gallons per day. During 2017, we connected six new wells to this processing system with several more wells scheduled to be connected in the first part of 2018. We have completed construction of the pipeline to connect the next well pad and we are upgrading our compression facilities to handles the expected additional volume. At our Bellmon processing facility in the Mississippian play in north central Oklahoma, during 2017 we connected 14 new wells to this system. Our total throughput volume for the fourth quarter of 2017 averaged approximately 27 MMcf per day. We have two processing skids available that provide total processing capacity of 90 MMcf per day. At our Segno gathering facility in Southeast Texas, our average gathered volume for the fourth quarter of 2017 was approximately 86.4 MMcf per day. The gathering and dehydration capacity for this facility is approximately 120 MMcf per day. During 2017, we connected three new wells to this gathering system along with additional volume from recompletion activity in the area around our system. In the Appalachian region, at our Pittsburgh Mills gathering system, we continue to connect new well pads to this system. During 2017, we connected one new well pad with five new wells to this gathering system. By adding these new wells our average gathered volume for the fourth quarter was approximately 117.2 MMcf per day. We are constructing a new pipeline to connect the next well pad to this system. Most of the preliminary environmental and permitting activities have been completed and right of way has been obtained. In the first quarter of 2018, we will start the construction of the pipeline with an expected completion date in the third quarter of 2018. This new well pad is expected to have seven wells drilled and we anticipate receiving gas from this pad at the end of 2018. This well pad is on the south end of our system and will be connected to our Kissick compressor station. And we have been notified by the producer they will drill seven infill wells on already existing pads in 2018. Anticipated 2018 capital expenditures for this segment are approximately $32.0 million, a 44% increase over 2017. Critical Accounting Policies and Estimates Summary In this section, we identify those critical accounting policies we follow in preparing our financial statements and related disclosures. Many policies require us to make difficult, subjective, and complex judgments while making estimates of matters inherently imprecise. Some accounting policies involve judgments and uncertainties to such an extent there is reasonable likelihood that materially different amounts could have been reported under different conditions, or had different assumption been used. We evaluate our estimates and assumptions regularly. We base our estimates on historical experience and various other assumptions we believe are reasonable under the circumstances, the results of which support making judgments about the carrying values of assets and liabilities not readily apparent from other sources. Actual results may differ from these estimates and assumptions used in preparation of our financial statements. In this discussion we attempt to explain the nature of these estimates, assumptions and judgments, and the likelihood that materially different amounts would be reported in our financial statements under different conditions or using different assumptions. This table lists the critical accounting policies, identifies the estimates and assumptions that can have a significant impact on applying of these accounting policies, and the financial statement accounts affected by these estimates and assumptions. Accounting Policies Estimates or Assumptions Accounts Affected Full cost method of accounting for oil, NGLs, and natural gas properties • Oil, NGLs, and natural gas reserves, estimates, and related present value of future net revenues • Valuation of unproved properties • Estimates of future development costs • Oil and natural gas properties • Accumulated depletion, depreciation and amortization • Provision for depletion, depreciation and amortization • Impairment of oil and natural gas properties • Long-term debt and interest expense Accounting for ARO for oil, NGLs, and natural gas properties • Cost estimates related to the plugging and abandonment of wells • Timing of cost incurred • Credit adjusted risk free rate • Oil and natural gas properties • Accumulated depletion, depreciation and amortization • Provision for depletion, depreciation and amortization • Current and non-current liabilities • Operating expense Accounting for impairment of long-lived assets • Forecast of undiscounted estimated future net operating cash flows • Drilling and mid-stream property and equipment • Accumulated depletion, depreciation and amortization • Provision for depletion, depreciation and amortization Goodwill • Forecast of discounted estimated future net operating cash flows • Terminal value • Weighted average cost of capital • Goodwill Accounting for value of stock compensation awards • Estimates of stock volatility • Estimates of expected life of awards granted • Estimates of rates of forfeitures • Estimates of performance shares granted • Oil and natural gas properties • Shareholder’s equity • Operating expenses • General and administrative expenses Accounting for derivative instruments • Derivatives measured at fair value • Current and non-current derivative assets and liabilities • Gain (loss) on derivatives Significant Estimates and Assumptions Full Cost Method of Accounting for Oil, NGLs, and Natural Gas Properties. Determining our oil, NGLs, and natural gas reserves is a subjective process. It entails estimating underground accumulations of oil, NGLs, and natural gas that cannot be measured in an exact manner. Accuracy of these estimates depends on several factors, including, the quality and availability of geological and engineering data, the precision of the interpretations of that data, and individual judgments. Each year, we hire an independent petroleum engineering firm to audit our internal evaluation of our reserves. The audit of our reserve wells or locations as of December 31, 2017 covered those that we projected to comprise 83% of the total proved developed future net income discounted at 10% and 86% of the total proved discounted future net income (based on the SEC's unescalated pricing policy). Included in Part I, Item 1 of this report are the qualifications of our independent petroleum engineering firm and our employees responsible for preparing our reserve reports. As a rule, the accuracy of estimating oil, NGLs, and natural gas reserves varies with the reserve classification and the related accumulation of available data, as shown in this table: Type of Reserves Nature of Available Data Degree of Accuracy Proved undeveloped Data from offsetting wells, seismic data Less accurate Proved developed non-producing The above and logs, core samples, well tests, pressure data More accurate Proved developed producing The above and production history, pressure data over time Most accurate Assumptions of future oil, NGLs, and natural gas prices and operating and capital costs also play a significant role in estimating these reserves and the estimated present value of the cash flows to be received from the future production of those reserves. Volumes of recoverable reserves are influenced by the assumed prices and costs due to the economic limit (that point when the projected costs and expenses of producing recoverable oil, NGLs, and natural gas reserves is greater than the projected revenues from the oil, NGLs, and natural gas reserves). But more significantly, the estimated present value of the future cash flows from our oil, NGLs, and natural gas reserves is sensitive to prices and costs and may vary materially based on different assumptions. Companies, like ours, using full cost accounting use the unweighted arithmetic average of the commodity prices existing on the first day of each of the 12 months before the end of the reporting period to calculate discounted future revenues, unless prices were otherwise determined under contractual arrangements. We compute DD&A on a units-of-production method. Each quarter, we use these formulas to compute the provision for DD&A for our producing properties: • DD&A Rate = Unamortized Cost / End of Period Reserves Adjusted for Current Period Production • Provision for DD&A = DD&A Rate x Current Period Production Unamortized cost includes all capitalized costs, estimated future expenditures to be incurred in developing proved reserves and estimated dismantlement and abandonment costs, net of estimated salvage values less accumulated amortization, unproved properties, and equipment not placed in service. Oil, NGLs, and natural gas reserve estimates have a significant impact on our DD&A rate. If future reserve estimates for a property or group of properties are revised downward, the DD&A rate will increase because of the revision. If reserve estimates are revised upward, the DD&A rate will decrease. Based on our 2017 production level of 16.0 MMBoe, a decrease in our 2017 oil, NGLs, and natural gas reserves by 5% would increase our DD&A rate by $0.36 per Boe and would decrease pre-tax income by $5.8 million annually. Conversely, an increase in our 2017 oil, NGLs, and natural gas reserves by 5% would decrease our DD&A rate by $0.30 per Boe and would increase pre-tax income by $4.8 million annually. The DD&A expense on our oil and natural gas properties is calculated each quarter using period end reserve quantities adjusted for period production. We account for our oil and natural gas exploration and development activities using the full cost method of accounting. Under this method, we capitalize all costs incurred in the acquisition, exploration, and development of oil and natural gas properties. At the end of each quarter, the net capitalized costs of our oil and natural gas properties are limited to that amount which is the lower of unamortized costs or a ceiling. The ceiling is defined as the sum of the present value (using a 10% discount rate) of the estimated future net revenues from our proved reserves (based on the unescalated 12-month average price on our oil, NGLs, and natural gas adjusted for any cash flow hedges), plus the cost of properties not being amortized, plus the lower of the cost or estimated fair value of unproved properties included in the costs being amortized, less related income taxes. If the net capitalized costs of our oil and natural gas properties exceed the ceiling, we are required to write-down the excess amount. A ceiling test write-down is a non-cash charge to earnings. If required, it reduces earnings and impacts shareholders’ equity in the period of occurrence and results in lower DD&A expense in future periods. Once incurred, a write-down cannot be reversed. The risk we will be required to write-down the carrying value of our oil and natural gas properties increases when the prices for oil, NGLs, and natural gas are depressed or if we have large downward revisions in our estimated proved oil, NGLs, and natural gas reserves. Application of these rules during periods of relatively low prices, even if temporary, increases the chance of a ceiling test write-down. At December 31, 2017, our reserves were calculated based on applying 12-month 2017 average unescalated prices of $51.34 per barrel of oil, $31.83 per barrel of NGLs, and $2.98 per Mcf of natural gas (then adjusted for price differentials) over the estimated life of each of our oil and natural gas properties. We had no ceiling test write-down for 2017. It is hard to predict with any reasonable certainty the need for or amount of any future impairments given the many factors that go into the ceiling test calculation including, but not limited to, future pricing, operating costs, drilling and completion costs, upward or downward oil and gas reserve revisions, oil and gas reserve additions, and tax attributes. Subject to these inherent uncertainties, if we hold these same factors constant as they existed at December 31, 2017 and only adjust the 12-month average price to an estimated first quarter ending average (holding February 2018 prices constant for the remaining one month of the first quarter of 2018), our forward looking expectation is that we will not recognize an impairment in the first quarter of 2018. But commodity prices (and other factors) remain volatile and they could negatively affect the 12-month average price resulting in the potential for an impairment in the first quarter. We use the sales method for recording natural gas sales. This method allows for the recognition of revenue, which may be more or less than our share of pro-rata production from certain wells. Our policy is to expense our pro-rata share of lease operating costs from all wells as incurred. The expenses relating to the wells in which we have a production imbalance are not material. Costs Withheld from Amortization. Costs associated with unproved properties are excluded from our amortization base until we have evaluated the properties. The costs associated with unevaluated leasehold acreage and related seismic data, wells drilling and capitalized interest are initially excluded from our amortization base. Leasehold costs are transferred to our amortization base with the costs of drilling a well on the lease or are assessed at least annually for possible impairment or reduction in value. Leasehold costs are transferred to our amortization base to the extent a reduction in value has occurred. Our decision to withhold costs from amortization and the timing of transferring those costs into the amortization base involve significant judgment and may be subject to changes over time based on several factors, including our drilling plans, availability of capital, project economics and results of drilling on adjacent acreage. In December 2015, December 2016, and December 2017, we determined the value of certain unproved oil and gas properties were diminished (in part or in whole) based on an impairment evaluation and our anticipated future exploration plans. Those determinations resulted in $114.4 million, $7.6 million, and $10.5 million in 2015, 2016, and 2017, respectively of costs being added to the total of our capitalized costs being amortized. At December 31, 2017, we had approximately $296.8 million of costs excluded from the amortization base of our full cost pool. Accounting for ARO for Oil, NGLs, and Natural Gas Properties. We record the fair value of liabilities associated with the future plugging and abandonment of wells. In our case, when the reserves in each of our oil or gas wells deplete or otherwise become uneconomical, we must incur costs to plug and abandon the wells. These costs are recorded in the period in which the liability is incurred (at the time the wells are drilled or acquired). We have no assets restricted to settle these ARO liabilities. Our engineering staff uses historical experience to determine the estimated plugging costs considering the type of well (either oil or natural gas), the depth of the well, the physical location of the well, and the ultimate productive life to determine the estimated plugging costs. A risk-adjusted discount rate and an inflation factor are used on these estimated costs to determine the current present value of this obligation. To the extent any change in these assumptions affect future revisions and impact the present value of the existing ARO, a corresponding adjustment is made to the full cost pool. Accounting for Impairment of Long-Lived Assets. Drilling equipment, transportation equipment, gas gathering and processing systems, and other property and equipment are carried at cost less accumulated depreciation. Renewals and enhancements are capitalized while repairs and maintenance are expensed. We review the carrying amounts of long-lived assets for potential impairment annually, typically during the fourth quarter, or when events occur or changes in circumstances suggest these carrying amounts may not be recoverable. Changes that could prompt such an assessment may include equipment obsolescence, changes in the market demand for a specific asset, changes in commodity prices, periods of relatively low drilling rig utilization, declining revenue per day, declining cash margin per day, or overall changes in market conditions. Assets are determined to be impaired if a forecast of undiscounted estimated future net operating cash flows directly related to the asset, including disposal value if any, is less than the carrying amount of the asset. If any asset is determined to be impaired, the loss is measured as the amount by which the carrying amount of the asset exceeds its fair value. The estimate of fair value is based on the best information available, including prices for similar assets. Changes in these estimates could cause us to reduce the carrying value of property and equipment. Asset impairment evaluations are, by nature, highly subjective. They involve expectations about future cash flows generated by our assets and reflect management’s assumptions and judgments regarding future industry conditions and their effect on future utilization levels, dayrates, and costs. Using different estimates and assumptions could cause materially different carrying values of our assets. On a periodic basis, we evaluate our fleet of drilling rigs for marketability based on the condition of inactive rigs, expenditures that would be necessary to bring them to working condition and the expected demand for drilling services by rig type. The components comprising inactive rigs are evaluated, and those components with continuing utility to the Company’s other marketed rigs are transferred to other rigs or to its yards to be spare equipment. The remaining components of these rigs are retired. During 2015, we recorded a write-down on 31 of our drilling rigs and related equipment of approximately $8.3 million pre-tax based on the estimated market value for similar equipment from auctions sales. We then sold all 31 of these drilling rigs and some other drilling equipment to unaffiliated third parties. The proceeds from the sale of those assets, less costs to sell, was less than the $11.3 million net book value resulting in a loss of $7.3 million pre-tax. No impairments were recorded in 2016 or 2017. In 2015, our mid-stream segment incurred a $27.0 million pre-tax write-down of its systems, Bruceton Mills, Spring Creek, and Midwell due to anticipated future cash flow and future development around these systems not being sufficient to support their carrying value. The estimated future cash flows were less than the carrying value on these systems. No impairments were recorded in 2016 or 2017. Goodwill. Goodwill represents the excess of the cost of acquisitions over the fair value of the net assets acquired. Goodwill is not amortized, but an impairment test is performed at least annually to determine whether the fair value has decreased and is performed additionally when events indicate an impairment may have occurred. For impairment testing, goodwill is evaluated at the reporting unit level. Our goodwill is all related to our contract drilling segment, and, the impairment test is generally based on the estimated discounted future net cash flows of our drilling segment, utilizing discount rates and other factors in determining the fair value of our drilling segment. Inputs in our estimated discounted future net cash flows include drilling rig utilization, day rates, gross margin percentages, and terminal value. No goodwill impairment was recorded at December 31, 2017, 2016, or 2015. Based on our impairment test performed as of December 31, 2017, the fair value of our drilling segment exceeded its carrying value by 41%. A period of sustained reduced commodity prices resulting in further reductions in the number of our drilling rigs working and the rates we charge for them could cause a non-cash goodwill impairment in future periods. Turnkey and Footage Drilling Contracts. Because our contract drilling operations do not bear the risk of completion of a well being drilled under a “daywork” contract, we recognize revenues and expense generated under “daywork” contracts as the services are performed. Under “footage” and “turnkey” contracts we bear the risk of completion of the well, so revenues and expenses are recognized when the well is substantially completed. Substantial completion is determined when the well bore reaches the depth specified in the contract. The entire amount of any loss is recorded when the loss can be reasonably determined, however, any profit is recorded only at the time the well is finished. The costs of drilling contracts uncompleted at the end of the reporting period (which includes expenses incurred on “footage” or “turnkey” contracts) are included in other current assets. We drilled no wells under turnkey or footage contracts in 2017, 2016, or 2015. Accounting for Value of Stock Compensation Awards. To account for stock-based compensation, compensation cost is measured at the grant date based on the fair value of an award and is recognized over the service period, which is usually the vesting period. We elected to use the modified prospective method, which requires compensation expense to be recorded for all unvested stock options and other equity-based compensation beginning in the first quarter of adoption. Determining the fair value of an award requires significant estimates and subjective judgments regarding, among other things, the appropriate option pricing model, the expected life of the award and performance vesting criteria assumptions. As there are inherent uncertainties related to these factors and our judgment in applying them to the fair value determinations, there is risk that the recorded stock compensation may not accurately reflect the amount ultimately earned by the employee. Accounting for Derivative Instruments and Hedging. All derivatives are recognized on the balance sheet and measured at fair value. Any changes in our derivatives' fair value before their maturity (i.e., temporary fluctuations in value) along with any derivatives settled are reported in gain (loss) on derivatives in our Consolidated Statements of Operations. New Accounting Standards Compensation-Stock Compensation. The FASB issued ASU 2017-09, to clarify and reduce both (i) diversity in practice and (ii) cost and complexity when applying its guidance to changes in the terms of a share-based payment award. The amendment is effective for reporting periods beginning after December 15, 2017. This amendment will not have a material impact on our financial statements. Intangibles-Goodwill and Other: Simplifying the Test for Goodwill Impairment. The FASB issued ASU 2017-04, to simplify the measurement of goodwill. The amendment eliminates Step 2 from the goodwill impairment test. The amendment will be effective prospectively for reporting periods beginning after December 15, 2019, and early adoption is permitted. This amendment will not have a material impact on our financial statements. Business Combinations; Clarifying the Definition of a Business. The FASB issued ASU 2017-01, clarifying the definition of a business. The amendment should help companies and other organizations evaluate whether transactions should be accounted for as acquisitions (or disposals) of assets or businesses. For public companies, the amendment is effective for annual periods beginning after December 15, 2017. This amendment will not have a material impact on our financial statements. Statement of Cash Flows: Classification of Certain Cash Receipts and Cash Payments. The FASB issued ASU 2016-15, to address diversity in how certain transactions are presented and classified in the statement of cash flows. The amendment will be effective retrospectively for reporting periods beginning after December 31, 2017, and early adoption is permitted. This amendment will not have a material impact on our financial statements. Leases. The FASB has issued ASU 2016-02. The amendment will require lessees to recognize at the commencement date a lease liability, which is a lessee's obligation to make lease payments arising from a lease, measured on a discounted basis; and a right-of-use asset, which is an asset that represents the lessee's right to use a specified asset for the lease term. Lessor accounting is largely unchanged. For public companies, the amendment is effective for annual periods beginning after December 15, 2018, and interim periods within those annual periods. The standard will not apply to leases of mineral rights. We are evaluating the impact this amendment will have on our financial statements and currently evaluating a plan for implementation. Revenue from Contracts with Customers. The FASB has issued ASU 2014-09. This standard affects any entity using U.S. GAAP that either contracts with customers to transfer goods or services or enters into contracts for transferring nonfinancial assets unless those contracts are within the scope of other standards (e.g., insurance contracts or lease contracts). The core principle of the amendments is that an entity should recognize revenue to depict the transfer of promised goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services. ASU 2014-09 has been amended several times pre-issuance, which is codified in the new Topic 606, effective January 1, 2018. The guidance in this update supersedes the revenue recognition requirements in Topic 605, Revenue Recognition, and most industry-specific guidance throughout the Industry Topics of the Codification. We adopted this standard January 1, 2018 using the modified retrospective approach, which resulted in a cumulative effect adjustment upon adoption for our mid-stream segment. This adjustment related to the timing of revenue on certain demand fees which was not material to the company. Both our oil and natural gas and contract drilling segments had no retained earnings adjustment. The application of Topic 606 will not have a material effect on our statement of operations or our balance sheet, as the timing of revenue recognized will not be materially modified, but additional footnote disclosures are required with respect to revenue. In our oil and natural gas segment, the classification of certain costs as either a deduction from revenue or an expense will be determined based on when control of the commodity transfers to the customer, which would impact total revenue recognized, but will not affect gross profit. Part of our review included evaluation of these issues: • Based on an analysis of whether the transportation of gas is a performance obligation that occurs at a point in time or over time, the timing of when we recognize certain revenue elements will change. Specifically related to our mid-stream segment, certain fees collectible during a contract will be recognized over the life of the contract because these fees are part of the single performance obligation associated with the contract. • Certain of our contracts include promises to deliver a minimum volume of commodity to the customer over a defined period. If we do not meet this commitment, a deficiency fee is payable to the customer. Topic 606 requires these arrangements represent variable consideration related to the sale of the commodity, and requires that we include an estimate of any deficiency fees expected within revenue, rather than as operating costs. In addition, we will also be required to analyze fees that are billable for deficiencies in minimum volume commitments from customers for our mid-stream segment. In these instances, we will assess the likelihood of earning these fees each reporting period based on the customer’s performance and recognize variable revenue when it is not expected to be subject to a significant reversal. Our internal control framework did not materially change, but the existing internal controls have been modified to consider our new revenue recognition policy effective January 1, 2018. As we implement the new standard, we have added internal controls to ensure that we adequately evaluate new contracts under the five-step model under ASU 2014-09. Adopted Standards Income Taxes: Balance Sheet Classification of Deferred Taxes. The FASB has issued ASU 2015-17. This changes how deferred taxes are classified on organizations' balance sheets. Organizations must classify all deferred tax assets and liabilities as noncurrent. The amendments apply to all organizations that present a classified balance sheet. For public companies, the amendments were effective for financial statements issued for annual periods beginning after December 15, 2016, and interim periods within those annual periods. The amendment requires current deferred tax assets to be combined with noncurrent deferred tax assets. We have adopted this ASU during the first quarter of 2017 on a prospective basis. Previously, we had a net current deferred tax asset now netted with our noncurrent deferred tax liability. Prior periods were not retrospectively adjusted. Compensation-Stock Compensation: Improvements to Employee Share-Based Payment Accounting. The FASB has issued ASU 2016-09. The amendment should improve the accounting for employee share-based payments and affect all organizations that issue share-based payment awards to their employees. Several aspects of the accounting for share-based payment award transactions are simplified, including: (a) income tax consequences; (b) classification of awards as either equity or liabilities; and (c) classification on the statement of cash flows. For public companies, the amendment was effective for annual periods beginning after December 15, 2016, and interim periods within those annual periods. The amendment primarily affects classification within the statement of cash flows between financial and operating activities. This did not have a material impact on our financial statements. Financial Condition and Liquidity Summary. Our financial condition and liquidity primarily depends on the cash flow from our operations and borrowings under our credit agreement. The principal factors determining our cash flow are: • the amount of natural gas, oil, and NGLs we produce; • the prices we receive for our natural gas, oil, and NGLs production; • the demand for and the dayrates we receive for our drilling rigs; and • the fees and margins we obtain from our natural gas gathering and processing contracts. We believe we have sufficient cash flow and liquidity to meet our obligations and remain in compliance with our debt covenants for the next twelve months. Our ability to meet our debt covenants (under our credit agreement and our Indenture) and our capacity to incur additional indebtedness will depend on our future performance, which in turn will be affected by financial, business, economic, regulatory, and other factors. For example, lower oil, natural gas, and NGLs prices since the last redetermination under our credit agreement could cause a redetermination of the borrowing base to a lower level and therefore reduce or limit our ability to borrow funds. We monitor our liquidity and capital resources, endeavor to anticipate potential covenant compliance issues and work with the lenders under our credit agreement to address any of those issues ahead of time. Below is a summary of certain financial information for the years ended December 31: Cash flows from Operating Activities Our operating cash flow is primarily influenced by the prices we receive for our oil, NGLs, and natural gas production, the quantity of oil, NGL, and natural gas we produce, settlements of derivative contracts, third-party demand for our drilling rigs and mid-stream services, and the rates we can charge for those services. Our cash flows from operating activities are also affected by changes in working capital. Net cash provided by operating activities during 2017 increased by $39.5 million from 2016 due primarily to higher revenues due to higher commodity prices and higher drilling rig utilization partially offset by changes in operating assets and liabilities related to the timing of cash receipts and disbursements. Cash flows from Investing Activities We dedicate and expect to continue to dedicate a substantial portion of our capital budget to the exploration for and production of oil, NGLs, and natural gas. These expenditures are necessary to off-set the inherent production declines typically experienced in oil and gas wells. Cash flows used in investing activities increased by $196.0 million in 2017 compared to 2016. The change was due primarily to an increase in capital expenditures due to an oil and gas property acquisition, the restarting of our drilling program in 2017, the construction of a new BOSS drilling rig, and a decrease in the proceeds received from the disposition of assets. See additional information on capital expenditures below under Capital Requirements. Cash Flows from Financing Activities Cash flows provided by (used in) financing activities increased by $156.3 million in 2017 compared to 2016. The increase was primarily due to proceeds from the ATM common stock program coupled with an increase in net borrowing after paying down long-term debt in 2016. At December 31, 2017, we had unrestricted cash totaling $0.7 million and had borrowed $178.0 million of the $475.0 million we have available under our credit agreement. Below is a summary of certain financial information as of December 31, and for the years ended December 31: _________________________ (1) Long-term debt is net of unamortized discount and debt issuance costs. (2) In 2016 and 2015, we incurred non-cash ceiling test write-downs of our oil and natural gas properties of $161.6 million, and $1.6 billion pre-tax ($100.6 million and $1.0 billion, net of tax), respectively. In 2015, we incurred a non-cash write-down associated with the removal of 31 drilling rigs from our fleet along with certain other equipment and drill pipe of $8.3 million pre-tax ($5.1 million, net of tax). In December 2015, we incurred a non-cash write-down associated with the reduction in the carrying value of three mid-stream segment gathering systems of $27.0 million pre-tax ($16.8 million, net of tax). The write-downs affected our shareholders’ equity, ratio of long-term debt to total capitalization, and net income (loss) for 2015. There was no impact on our compliance with the covenants in our credit agreement. Working Capital Typically, our working capital balance fluctuates, in part, because of the timing of our trade accounts receivable and accounts payable and the fluctuation in current assets and liabilities associated with the mark to market value of our derivative activity. We had negative working capital of $62.3 million, $43.7 million, and $10.6 million as of December 31, 2017, 2016, and 2015, respectively. This is primarily due to increased accounts payable due to increased activity in our drilling program and increased drilling rig utilization and the reclassification of the current deferred tax asset to long-term asset per ASU 2015-17 partially offset by increased accounts receivable from increased revenues and the change in the value of outstanding derivatives. Our credit agreement is used primarily for working capital and capital expenditures. At December 31, 2017, we had borrowed $178.0 million of the $475.0 million available to us under our credit agreement. The effect of our derivatives decreased working capital by $7.1 million as of December 31, 2017, and increased working capital by $21.6 million and $10.2 million as of December 31, 2016 and 2015, respectively. This table summarizes certain operating information for the years ended December 31: _________________________ (1) In 2015, our mid-stream segment transferred 11 natural gas gathering systems to our oil and natural gas segment. Oil and Natural Gas Operations Any significant change in oil, NGLs, or natural gas prices has a material effect on our revenues, cash flow, and the value of our oil, NGLs, and natural gas reserves. Generally, prices and demand for domestic natural gas are influenced by weather conditions, supply imbalances, and by worldwide oil price levels. Domestic oil prices are primarily influenced by world oil market developments. These factors are beyond our control and we cannot predict nor measure their future influence on the prices we will receive. Based on our 2017 production, a $0.10 per Mcf change in what we are paid for our natural gas production, without the effect of derivatives, would cause a corresponding $410,000 per month ($4.9 million annualized) change in our pre-tax operating cash flow. Our 2017 average natural gas price was $2.46 compared to an average natural gas price of $2.07 for 2016 and $2.63 for 2015. A $1.00 per barrel change in our oil price, without the effect of derivatives, would have a $217,000 per month ($2.6 million annualized) change in our pre-tax operating cash flow and a $1.00 per barrel change in our NGLs prices, without the effect of derivatives, would have a $380,000 per month ($4.6 million annualized) change in our pre-tax operating cash flow based on our production in 2017. Our 2017 average oil price per barrel was $49.44 compared with an average oil price of $40.50 in 2016 and $50.79 in 2015, and our 2017 average NGLs price per barrel was $18.35 compared with an average NGLs price of $11.26 in 2016 and $10.12 in 2015. Because commodity prices affect the value of our oil, NGLs, and natural gas reserves, declines in those prices can cause a decline in the carrying value of our oil and natural gas properties. At December 31, 2017, the 12-month average unescalated prices were $51.34 per barrel of oil, $31.83 per barrel of NGLs, and $2.98 per Mcf of natural gas, and then are adjusted for price differentials. We did not have to take a write down in 2017. It is hard to predict with any reasonable certainty the need for or amount of any future impairments given the many factors that go into the ceiling test calculation including, but not limited to, future pricing, operating costs, drilling and completion costs, upward or downward oil and gas reserve revisions, oil and gas reserve additions, and tax attributes. Subject to these inherent uncertainties, if we hold these same factors constant as they existed at December 31, 2017 and only adjust the 12-month average price to an estimated first quarter ending average (holding February 2018 prices constant for the remaining one month of the first quarter of 2018), our forward looking expectation is that we will not recognize an impairment in the first quarter of 2018. Commodity prices remain volatile and they could negatively affect the 12-month average price and the potential for an impairment in the first quarter. Our natural gas production is sold to intrastate and interstate pipelines, to independent marketing firms and gatherers under contracts with terms generally ranging from one month to five years. Our oil production is sold to independent marketing firms generally under six-month contracts. Contract Drilling Operations Many factors influence the number of drilling rigs we have working and the costs and revenues associated with that work. These factors include the demand for drilling rigs in our areas of operation, competition from other drilling contractors, the prevailing prices for oil, NGLs, and natural gas, availability and cost of labor to run our drilling rigs, and our ability to supply the equipment needed. Competition to keep qualified labor continues. We increased compensation for some rig personnel in the third quarter of 2017 and again during the first quarter of 2018. During 2017, almost all of our working drilling rigs were drilling horizontal or directional wells for oil and NGLs. The continuous fluctuations in commodity prices for oil and natural gas changes demand for drilling rigs. These factors ultimately affect the demand and mix of the type of drilling rigs used by our customers. The future demand for and the availability of drilling rigs to meet that demand will affect our future dayrates. For 2017, our average dayrate was $16,256 per day compared to $17,784 and $19,455 per day for 2016 and 2015, respectively. Our average number of drilling rigs used (utilization %) in 2017 was 30.0 (32%) compared with 17.4 (19%) and 34.7 (38%) in 2016 and 2015, respectively. Based on the average utilization of our drilling rigs during 2017, a $100 per day change in dayrates has a $3,000 per day ($1.1 million annualized) change in our pre-tax operating cash flow. Our contract drilling segment provides drilling services for our exploration and production segment. Some of the drilling services we perform on our properties are, depending on the timing of those services, deemed associated with acquiring an ownership interest in the property. In those cases, revenues and expenses for those services are eliminated in our statement of operations, with any profit recognized as a reduction in our investment in our oil and natural gas properties. The contracts for these services are issued under the same conditions and rates as the contracts entered into with unrelated third parties. By providing drilling services for the oil and natural gas segment, we eliminated revenue of $13.4 million and $22.1 million during 2017 and 2015, respectively, from our contract drilling segment and eliminated the associated operating expense of $11.8 million and $18.3 million during 2017 and 2015, respectively, yielding $1.6 million and $3.8 million during 2017 and 2015, respectively, as a reduction to the carrying value of our oil and natural gas properties. We eliminated no revenue or expenses in our contract drilling segment during 2016. Mid-Stream Operations This segment is engaged primarily in the buying, selling, gathering, processing, and treating of natural gas. It operates three natural gas treatment plants, 13 processing plants, 24 gathering systems, and approximately 1,455 miles of pipeline. Its operations are in Oklahoma, Texas, Kansas, Pennsylvania, and West Virginia. This segment enhances our ability to gather and market not only our own natural gas and NGLs but also that owned by third parties and serves as a mechanism through which we can construct or acquire existing natural gas gathering and processing facilities. During 2017, 2016, and 2015 this segment purchased $63.2 million, $42.7 million, and $57.6 million, respectively, of our oil and natural gas segment's natural gas and NGLs production, and provided gathering and transportation services of $6.7 million, $9.2 million, and $7.6 million, respectively. Intercompany revenue from services and purchases of production between this business segment and our oil and natural gas segment has been eliminated in our consolidated financial statements. Our mid-stream segment gathered an average of 385,209 Mcf per day in 2017 compared to 419,217 Mcf per day in 2016 and 353,771 Mcf per day in 2015. It processed an average of 137,625 Mcf per day in 2017 compared to 155,461 Mcf per day in 2016 and 182,684 Mcf per day in 2015, and sold NGLs of 534,140 gallons per day in 2017 compared to 536,494 gallons per day in 2016 and 577,513 gallons per day in 2015. Gas gathering volumes per day in 2017 decreased primarily due to lower volumes from our fee-based Appalachian systems. Volumes processed decreased primarily due to lower purchased volumes and fewer new wells connected to our processing systems in 2017. NGLs sold decreased primarily due to lower purchased volumes and continuing to operate most of our systems in ethane rejection mode. At-the-Market (ATM) Common Stock Program On April 4, 2017, we entered into a Distribution Agreement (the Agreement) with a sales agent, under which we may offer and sell, from time to time, through the sales agent shares of our common stock, par value $0.20 per share (the Shares), up to an aggregate offering price of $100.0 million. We intend to use the net proceeds from these sales to fund (or offset costs of) acquisitions, future capital expenditures, repay amounts outstanding under our revolving credit facility, and general corporate purposes. Under the Agreement, the sales agent may sell the Shares by methods deemed to be an “at-the-market” offering as defined in Rule 415 promulgated under the Securities Act of 1933, as amended, including sales made directly on the NYSE, on any other existing trading market for the Shares or to or through a market maker. In addition, under the Agreement, the sales agent may sell the Shares by any other method permitted by law, including in privately negotiated transactions. Subject to the terms of the Agreement, the sales agent will use commercially reasonable efforts, consistent with its normal trading and sales practices and applicable state and federal law, rules and regulations and the rules of the NYSE, to sell the Shares from time to time, based on our instructions (including any price, time or size limits or other customary parameters or conditions we may impose). We do not have to make any sales of the Shares under the Agreement. The offering of Shares under the Agreement will terminate on the earlier of (1) the sale of all of the Shares subject to the Agreement or (2) the termination of the Agreement by the sales agent or us. We will pay the sales agent a commission of 2.0% of the gross sales price per share sold and have agreed to provide the sales agent with customary indemnification and contribution rights. Since entering into the Agreement through February 13, 2018, we have sold 787,547 shares of our common stock resulting in net proceeds of approximately $18.6 million. No shares were sold in the fourth quarter of 2017. Approximately $81.0 million remain available for sale under the program. Our Credit Agreement and Senior Subordinated Notes Credit Agreement. On April 8, 2016, we amended our Senior Credit Agreement (credit agreement) scheduled to mature on April 10, 2020. The amount we can borrow is the lesser of the amount we elect (from time to time) as the commitment amount or the value of the borrowing base as determined by the lenders, but in either event not to exceed the maximum credit agreement amount of $875.0 million. Our elected commitment amount is $475.0 million. Our borrowing base is $475.0 million. We are charged a commitment fee of 0.50% on the amount available but not borrowed. The fee varies based on the amount borrowed as a percentage of the total borrowing base. We paid $1.0 million in origination, agency, syndication, and other related fees. We are amortizing these fees over the life of the credit agreement. With the new amendment, we pledged the following collateral: (a) 85% of the proved developed producing (discounted as present worth at 8%) total value of our oil and gas properties and (b) 100% of our ownership interest in our mid-stream affiliate, Superior Pipeline Company, L.L.C. The lenders under our credit agreement and their respective participation interests are: The borrowing base amount-which is subject to redetermination by the lenders on April 1st and October 1st of each year, is based primarily on a percentage of the discounted future value of our oil and natural gas reserves and on our cash flows from our mid-stream segment. The October 2017 redetermination did not result in any changes. We or the lenders may request a onetime special redetermination of the borrowing base between each scheduled redetermination. In addition, we may request a redetermination following the completion of an acquisition that meets the requirements in the credit agreement. At our election, any part of the outstanding debt under the credit agreement may be fixed at a London Interbank Offered Rate (LIBOR). LIBOR interest is computed as the sum of the LIBOR base for the applicable term plus 2.00% to 3.00% depending on the level of debt as a percentage of the borrowing base and is payable at the end of each term, or every 90 days, whichever is less. Borrowings not under LIBOR bear interest at the prime rate specified in the credit agreement that cannot be less than LIBOR plus 1.00% plus a margin. Interest is payable at the end of each month and the principal may be repaid in whole or in part at any time, without a premium or penalty. At December 31, 2017 and February 13, 2018, we had $178.0 million and $173.8 million, respectively, outstanding borrowings under our credit agreement. We can use borrowings for financing general working capital requirements for (a) exploration, development, production and acquisition of oil and gas properties, (b) acquisitions and operation of mid-stream assets, (c) issuance of standby letters of credit, (d) contract drilling services, and (e) general corporate purposes. The credit agreement prohibits, among other things: • the payment of dividends (other than stock dividends) during any fiscal year over 30% of our consolidated net income for the preceding fiscal year; • the incurrence of additional debt with certain limited exceptions; and • the creation or existence of mortgages or liens, other than those in the ordinary course of business, on any of our properties, except for our lenders. The credit agreement also requires that we have at the end of each quarter: • a current ratio (as defined in the credit agreement) of not less than 1 to 1. Through the quarter ending March 31, 2019, the credit agreement also requires that we have at the end of each quarter: • a senior indebtedness ratio of senior indebtedness to consolidated EBITDA (as defined in the credit agreement) for the most recently ended rolling four quarters of no greater than 2.75 to 1. Beginning with the quarter ending June 30, 2019, and for each quarter ending thereafter, the credit agreement requires: • a leverage ratio of funded debt to consolidated EBITDA (as defined in the credit agreement) for the most recently ended rolling four fiscal quarters of no greater than 4 to 1. As of December 31, 2017, we were in compliance with the covenants in the credit agreement. 6.625% Senior Subordinated Notes. We have an aggregate principal amount of $650.0 million, 6.625% senior subordinated notes (the Notes). Interest on the Notes is payable semi-annually (in arrears) on May 15 and November 15 of each year. The Notes will mature on May 15, 2021. In issuing the Notes, we incurred $14.7 million of fees that are being amortized as debt issuance cost over the life of the Notes. The Notes are subject to an Indenture dated as of May 18, 2011, between us and Wilmington Trust, National Association (successor to Wilmington Trust FSB), as Trustee (the Trustee), as supplemented by the First Supplemental Indenture dated as of May 18, 2011, between us, the Guarantors, and the Trustee, and as further supplemented by the Second Supplemental Indenture dated as of January 7, 2013, between us, the Guarantors and the Trustee (as supplemented, the 2011 Indenture), establishing the terms and providing for issuing the Notes. The Guarantors are our direct and indirect subsidiaries. The discussion of the Notes in this report is qualified by and subject to the actual terms of the 2011 Indenture. Unit, as the parent company, has no independent assets or operations. The guarantees by the Guarantors of the Notes (registered under registration statements) are full and unconditional, joint and several, subject to certain automatic customary releases, are subject to certain restrictions on the sale, disposition, or transfer of the capital stock or substantially all of the assets of a subsidiary guarantor, and other conditions and terms set out in the Indenture. Any of our subsidiaries that are not Guarantors are minor. There are no significant restrictions on our ability to receive funds from our subsidiaries through dividends, loans, advances or otherwise. We may redeem all or, from time to time, a part of the Notes at certain redemption prices, plus accrued and unpaid interest. If a “change of control” occurs, subject to certain conditions, we must offer to repurchase from each holder all or any part of that holder’s Notes at a purchase price in cash equal to 101% of the principal amount of the Notes plus accrued and unpaid interest, if any, to the date of purchase. The 2011 Indenture contains customary events of default. The 2011 Indenture also contains covenants that, among other things, limit our ability and the ability of certain of our subsidiaries to incur or guarantee additional indebtedness; pay dividends on our capital stock or redeem capital stock or subordinated indebtedness; transfer or sell assets; make investments; incur liens; enter into transactions with our affiliates; and merge or consolidate with other companies. We were in compliance with all covenants of the Notes as of December 31, 2017. Capital Requirements Oil and Natural Gas Dispositions, Acquisitions, and Capital Expenditures. Most of our capital expenditures for this segment are discretionary and directed toward growth. Any decision to increase our oil, NGLs, and natural gas reserves through acquisitions or through drilling depends on the prevailing or expected market conditions, potential return on investment, future drilling potential, and opportunities to obtain financing, which provide us flexibility in deciding when and if to incur these costs. We completed drilling 70 gross wells (25.71 net wells) in 2017 compared to 21 gross wells (9.67 net wells) in 2016, and 58 gross wells (34.99 net wells) in 2015. On April 3, 2017, we closed an acquisition of certain oil and natural gas assets located primarily in Grady and Caddo Counties in western Oklahoma. The final adjusted value of consideration given was $54.3 million. As of January 1, 2017, the effective date of the acquisition, the estimated proved oil and gas reserves of the acquired properties were 3.2 million barrels of oil equivalent (MMBoe). The acquisition added approximately 8,300 net oil and gas leasehold acres to our core Hoxbar area in southwestern Oklahoma including approximately 47 proved developed producing wells. This acquisition included 13 potential horizontal drilling locations not otherwise included in our existing acreage. Of the acreage acquired, approximately 71% was held by production. We also received one gathering system as part of the transaction. Capital expenditures for oil and gas properties on the full cost method for 2017 by this segment, excluding a $4.0 million reduction in the ARO liability and $59.0 million in acquisitions (including associated ARO), totaled $215.4 million compared to 2016 capital expenditures of $119.9 million (excluding a $30.9 million reduction in the ARO liability and $0.6 million in acquisitions), and 2015 capital expenditures of $273.5 million (excluding an $5.7 million reduction in the ARO liability and $0.2 million in acquisitions). For 2018, we plan to participate in drilling approximately 75 to 85 gross wells and estimate our total capital expenditures (excluding any possible acquisitions) for our oil and natural gas segment will be approximately $272.0 million. Whether we drill all of those wells depends on several factors, many of which are beyond our control and include the availability of drilling rigs, availability of pressure pumping services, prices for oil, NGLs, and natural gas, demand for oil, NGLs, and natural gas, the cost to drill wells, the weather, and the efforts of outside industry partners. We sold non-core oil and natural gas assets, net of related expenses, for $18.6 million, $67.2 million, and $1.9 million during 2017, 2016, and 2015, respectively. Proceeds from those dispositions reduced the net book value of our full cost pool with no gain or loss recognized. Contract Drilling Dispositions, Acquisitions, and Capital Expenditures. During 2015, we recorded a write-down on 31 of our drilling rigs and related equipment of approximately $8.3 million pre-tax based on the estimated market value for similar equipment from auctions sales. We then sold all 31 of these drilling rigs and some other drilling equipment to unaffiliated third parties. The proceeds from the sale of those assets, less costs to sell, was less than the $11.3 million net book value resulting in a loss of $7.3 million pre-tax. During 2015, five BOSS drilling rigs were constructed and placed into service for third-party operators. During December 2016, we sold an idle 1500 HP SCR drilling rig to an unaffiliated third party. We also fabricated and placed into service our ninth new BOSS drilling rig for a third party operator. This new BOSS rig was constructed using the long lead time components purchased in prior years. During 2017, we built our tenth BOSS drilling rig and placed it into service for a third party operator under a long term contract. We also returned to service 14 SCR drilling rigs that had been previously stacked. Our anticipated 2018 capital expenditures for this segment is approximately $47.0 million. We spent $36.1 million for capital expenditures during 2017 compared to $19.1 million in 2016, and $84.8 million in 2015. Mid-Stream Dispositions, Acquisitions, and Capital Expenditures. At our Cashion processing facility in central Oklahoma, our total throughput volume for the fourth quarter of 2017 averaged approximately 37.3 MMcf per day and our total production of natural gas liquids increased to approximately 198,600 gallons per day. The total processing capacity at this facility is approximately 45 MMcf per day. During 2017, we connected 12 new wells to this system from three producers. We are continuing a pipeline extension project for a producer scheduled to actively drill in the Cashion area in 2018. We have already connected four new wells from this producer and anticipate connecting several more wells throughout 2018. As volume increases on this system, we will evaluate the need to add additional processing capacity. If volume continues to increase, we may need to add an additional processing plant in the Cashion area. At our Hemphill processing facility in the Texas panhandle, our average gathered volume for the fourth quarter of 2017 was approximately 68.5 MMcf per day and our total production of natural gas liquids increased to 188,600 gallons per day. During 2017, we connected six new wells to this processing system with several more wells scheduled to be connected in the first part of 2018. We have completed construction of the pipeline to connect the next well pad and we are upgrading our compression facilities to handles the expected additional volume. At our Bellmon processing facility in the Mississippian play in north central Oklahoma, during 2017 we connected 14 new wells to this system. Our total throughput volume for the fourth quarter of 2017 averaged approximately 27 MMcf per day. We have two processing skids available that provide total processing capacity of 90 MMcf per day. At our Segno gathering facility in Southeast Texas, our average gathered volume for the fourth quarter of 2017 was approximately 86.4 MMcf per day. The gathering and dehydration capacity for this facility is approximately 120 MMcf per day. During 2017, we connected three new wells to this gathering system along with additional volume from recompletion activity in the area around our system. In the Appalachian region, at our Pittsburgh Mills gathering system, we continue to connect new well pads to this system. During 2017, we connected one new well pad with five new wells to this gathering system. By adding these new wells our average gathered volume for the fourth quarter was approximately 117.2 MMcf per day. We are constructing a new pipeline to connect the next well pad to this system. Most of the preliminary environmental and permitting activities have been completed and right of way has been obtained. In the first quarter of 2018, we will start the construction of the pipeline with an expected completion date in the third quarter of 2018. This new well pad is expected to have seven wells drilled and we anticipate receiving gas from this pad at the end of 2018. This well pad is on the south end of our system and will be connected to our Kissick compressor station. And we have been notified by the producer they will drill seven infill wells on already existing pads in 2018. During 2017, our mid-stream segment incurred $22.2 million in capital expenditures as compared to $16.8 million in 2016, and $63.5 million, in 2015. For 2018, our estimated capital expenditures is approximately $32.0 million. Contractual Commitments At December 31, 2017, we had these contractual obligations: _________________________ (1) See previous discussion in MD&A regarding our long-term debt. This obligation is presented under the Notes and credit agreement and includes interest calculated using our December 31, 2017 interest rates of 6.625% for the Notes and 3.4% for the credit agreement. (2) We lease office space or yards in Edmond and Oklahoma City, Oklahoma; Houston, Texas; Englewood, Colorado; Pinedale, Wyoming; and Canonsburg, Pennsylvania under the terms of operating leases expiring through December 2021. And, we have several equipment leases and lease space on short-term commitments to stack excess drilling rig equipment and production inventory. (3) Maintenance and interest payments are included in our capital lease agreements. The capital leases are discounted using annual rates of 4.0%. Total maintenance and interest remaining are $5.9 million and $1.2 million, respectively. (4) We have committed to purchase approximately $3.9 million of new drilling rig components over the next year. At December 31, 2017, we also had these commitments and contingencies that could create, increase or accelerate our liabilities: _________________________ (1) We provide a salary deferral plan which allows participants to defer the recognition of salary for income tax purposes until actual distribution of benefits, which occurs at either termination of employment, death or certain defined unforeseeable emergency hardships. We recognize payroll expense and record a liability, included in other long-term liabilities in our Consolidated Balance Sheets, at the time of deferral. (2) Effective January 1, 1997, we adopted a separation benefit plan (Separation Plan). The Separation Plan allows eligible employees whose employment with us is involuntarily terminated or with an employee who has completed 20 years of service, voluntarily or involuntarily terminated, to receive benefits equivalent to four weeks salary for every whole year of service completed with the company up to a maximum of 104 weeks. To receive payments the recipient must waive certain claims against us in exchange for receiving the separation benefits. On October 28, 1997, we adopted a Separation Benefit Plan for Senior Management (Senior Plan). The Senior Plan provides certain officers and key executives of the company with benefits generally equivalent to the Separation Plan. The Compensation Committee of the Board of Directors has absolute discretion in the selection of the individuals covered in this plan. On May 5, 2004 we also adopted the Special Separation Benefit Plan (Special Plan). This plan is identical to the Separation Benefit Plan with the exception that the benefits under the plan vest on the earliest of a participant’s reaching the age of 65 or serving 20 years with the company. (3) When a well is drilled or acquired, under ASC 410 “Accounting for Asset Retirement Obligations,” we record the fair value of liabilities associated with the retirement of long-lived assets (mainly plugging and abandonment costs for our depleted wells). (4) We have recorded a liability for those properties we believe do not have sufficient oil, NGLs, and natural gas reserves to allow the under-produced owners to recover their under-production from future production volumes. (5) We formed The Unit 1984 Oil and Gas Limited Partnership and the 1986 Energy Income Limited Partnership along with private limited partnerships (the Partnerships) with certain qualified employees, officers and directors from 1984 through 2011. One of our subsidiaries serves as the general partner of each of these programs. Effective December 31, 2014, the 1984 partnership was dissolved and effective December 31, 2016, the two 1986 partnerships were also dissolved. The Partnerships were formed to conduct oil and natural gas acquisition, drilling and development operations and serving as co-general partner with us in any additional limited partnerships formed during that year. The Partnerships participated on a proportionate basis with us in most drilling operations and most producing property acquisitions commenced by us for our own account during the period from the formation of the Partnership through December 31 of that year. These partnership agreements require, on the election of a limited partner, that we repurchase the limited partner’s interest at amounts to be determined by appraisal in the future. Repurchases in any one year are limited to 20% of the units outstanding. We made repurchases of approximately $2,900, $5,000, and $118,000 in 2017, 2016, and 2015, respectively. (6) We have recorded a liability for future estimated payments related to workers’ compensation claims primarily associated with our contract drilling segment. (7) This amount includes commitments under capital lease arrangements for compressors in our mid-stream segment. Derivative Activities Periodically we enter into derivative transactions locking in the prices to be received for a portion of our oil, NGLs, and natural gas production. Any change in the fair value of all our derivatives are reflected in the statement of operations. Commodity Derivatives. Our commodity derivatives should reduce our exposure to price volatility and manage price risks. Our decision on the type and quantity of our production and the price(s) of our derivative(s) is based, in part, on our view of current and future market conditions. As of December 31, 2017, based on our fourth quarter 2017 average daily production, the approximated percentages of our production under derivative contracts are as follows: Regarding the commodities subject to derivative contracts, those contracts limit the risk of adverse downward price movements. However, they also limit increases in future revenues that would otherwise result from price movements above the contracted prices. Using derivative transactions has the risk that the counterparties may not meet their financial obligations under the transactions. Based on our evaluation at December 31, 2017, we believe the risk of non-performance by our counterparties is not material. At December 31, 2017, the fair values of the net assets (liabilities) we had with each of the counterparties to our commodity derivative transactions are: If a legal right of set-off exists, we net the value of the derivative arrangements we have with the same counterparty in our Consolidated Balance Sheets. At December 31, 2017, we recorded the fair value of our commodity derivatives on our balance sheet as current derivative assets of $0.7 million and current derivative liabilities of $7.8 million. At December 31, 2016, we recorded the fair value of our commodity derivatives on our balance sheet as non-current derivative assets of $0.4 million and current and non-current derivative liabilities of $21.6 million and $0.4 million, respectively. All derivatives are recognized on the balance sheet and measured at fair value. Any changes in our derivatives' fair value before their maturity (i.e., temporary fluctuations in value) are reported in gain (loss) on derivatives in our Consolidated Statements of Operations. These gains (losses) are as follows at December 31: Stock and Incentive Compensation During 2017, we granted awards covering 708,276 shares of restricted stock. These awards were granted as retention incentive awards. These stock awards had an estimated fair value as of the grant date of $17.4 million. Compensation expense will be recognized over the awards' three year vesting period. During 2017, we recognized $7.0 million in additional compensation expense and capitalized $1.1 million for these awards. During 2016, we granted awards covering 736,451 shares of restricted stock. These awards were granted as retention incentive awards and are being recognized over the awards' three year vesting period. During 2015, we granted awards covering 750,290 shares of restricted stock. These awards were granted as retention incentive awards and are being recognized over their two and three year vesting periods. No SAR awards were made during 2017, 2016, or 2015. During 2017, we recognized compensation expense of $13.3 million for our restricted stock grants and capitalized $1.8 million of compensation cost for oil and natural gas properties. Insurance We are self-insured for certain losses relating to workers’ compensation, general liability, control of well, and employee medical benefits. Insured policies for other coverage contain deductibles or retentions per occurrence that range from zero to $1.0 million. We have purchased stop-loss coverage to limit, to the extent feasible, per occurrence and aggregate exposure to certain types of claims. There is no assurance that the insurance coverage we have will protect us against liability from all potential consequences. If insurance coverage becomes more expensive, we may choose to self-insure, decrease our limits, raise our deductibles, or any combination of these rather than pay higher premiums. Oil and Natural Gas Limited Partnerships and Other Entity Relationships. We are the general partner of 13 oil and natural gas partnerships formed privately or publicly. Each partnership’s revenues and costs are shared under formulas set out in that partnership’s agreement. The partnerships repay us for contract drilling, well supervision and general and administrative expense. Related party transactions for contract drilling and well supervision fees are the related party’s share of such costs. These costs are billed the same as billings to unrelated third parties for similar services. General and administrative reimbursements consist of direct general and administrative expense incurred on the related party’s behalf and indirect expenses assigned to the related parties. Allocations are based on the related party’s level of activity and are considered by us to be reasonable. During 2017, 2016, and 2015, the total we received for these fees was $0.2 million, $0.3 million, and $0.4 million, respectively. Our proportionate share of assets, liabilities, and net income relating to the oil and natural gas partnerships is included in our consolidated financial statements. Effects of Inflation The effect of inflation in the oil and natural gas industry is primarily driven by the prices for oil, NGLs, and natural gas. Increases in these prices increase the demand for our contract drilling rigs and services. This increase in demand affects the dayrates we can obtain for our contract drilling services. During periods of higher demand for our drilling rigs we have experienced increases in labor costs and the costs of services to support our drilling rigs. Historically, during this same period, when oil, NGLs, and natural gas prices declined, labor rates did not come back down to the levels existing before the increases. If commodity prices increase substantially for a long period, shortages in support equipment (like drill pipe, third party services, and qualified labor) can cause additional increases in our material and labor costs. Increases in dayrates for drilling rigs also increase the cost of our oil and natural gas properties. Commodity prices also can affect our fracking and completion costs. How inflation will affect us in the future will depend on increases, if any, realized in our drilling rig rates, the prices we receive for our oil, NGLs, and natural gas, and the rates we receive for gathering and processing natural gas. Due to increased demand for drilling rigs and the need to maintain qualified labor, we increased pay for some of our drilling personnel in the fourth quarter of 2017 and again in the first quarter of 2018. Off-Balance Sheet Arrangements We do not currently utilize any off-balance sheet arrangements with unconsolidated entities to enhance liquidity and capital resource positions, or for any other purpose. However, as is customary in the oil and gas industry, we are subject to various contractual commitments. Results of Operations 2017 versus 2016 _________________________ (1) NM - A percentage calculation is not meaningful due to a zero-value denominator or a percentage change greater than 200. Oil and Natural Gas Oil and natural gas revenues increased $63.5 million or 22% in 2017 as compared to 2016 due primarily to higher commodity prices partially offset by a decrease in production. Oil production decreased 9%, NGLs production decreased 6%, and natural gas production decreased 8%. Average oil prices between the comparative years increased 22% to $49.44 per barrel, NGLs prices increased 63% to $18.35 per barrel, and natural gas prices increased 19% to $2.46 per Mcf. Oil and natural gas operating costs increased $10.6 million or 9% between the comparative years of 2017 and 2016 primarily due to higher LOE and gross production taxes partially offset by lower saltwater disposal expense. DD&A decreased $11.9 million or 10% primarily due to a 4% decrease in our DD&A rate and by the effect of a 7% decrease in equivalent production. The decrease in our DD&A rate in 2017 compared to 2016 resulted primarily from the effect of the ceiling test write-downs throughout 2016. Our DD&A expense on our oil and natural properties is calculated each quarter using period end reserve quantities adjusted for period production. During 2016, we recorded non-cash ceiling test write-downs of our oil and natural gas properties totaling $161.6 million pre-tax ($100.6 million net of tax). We did not have a non-cash ceiling test write-down in 2017. The write-downs were due primarily from the reduction of the 12-month average commodity prices during 2016. Contract Drilling Drilling revenues increased $52.6 million or 43% in 2017 as compared to 2016. The increase was due primarily to a 72% increase in the average number of drilling rigs in use partially offset by a 9% decrease in the average dayrate compared to 2016. Average drilling rig utilization increased from 17.4 drilling rigs in 2016 to 30.0 drilling rigs in 2017. Drilling operating costs increased $34.4 million or 39% in 2017 compared to 2016. The increase was due primarily to more drilling rigs operating. Contract drilling depreciation increased $9.4 million or 20% also due primarily to more drilling rigs operating. Mid-Stream Our mid-stream revenues increased $21.3 million or 11% in 2017 as compared to 2016 primarily due to increased NGLs and condensate sales. Gas processing volumes per day decreased 11% between the comparative years primarily due to fewer new well connections to our processing systems. Gas gathering volumes per day decreased 8% primarily due to declining volumes in the Appalachian region. Operating costs increased $17.9 million or 13% in 2017 compared to 2016 primarily due to increased natural gas, NGLs, and condensate prices. Depreciation and amortization decreased $2.2 million or 5% primarily due to less capital expenditures this year while older assets became fully depreciated. General and Administrative General and administrative expenses increased $4.8 million or 14% in 2017 compared to 2016 primarily due to higher employee costs. Other Depreciation Other depreciation increased $5.6 million in 2017 compared to 2016 primarily due to the depreciation on the new ERP system and the corporate office facility. Gain on Disposition of Assets Gain on disposition of assets decreased $2.2 million in 2017 compared to 2016. The gain in 2017 was primarily for the sale of a corporate aircraft and vehicles, while the pre-tax gain of $3.2 million in 2016 was primarily for the sale of one drilling rig, various drilling rig components, vehicles, and other equipment somewhat offset by losses from our oil and natural gas and mid-stream segments in 2016. Other Income (Expense) Interest expense, net of capitalized interest, decreased $1.5 million between the comparative years of 2017 and 2016. We capitalized interest based on the net book value associated with unproved properties not being amortized, the construction of additional drilling rigs, and the construction of gas gathering systems. Capitalized interest for 2017 was $15.9 million compared to $15.3 million in 2016, and was netted against our gross interest of $54.2 million and $55.1 million for 2017 and 2016, respectively. Our average interest rate increased from 5.7% to 6.0% and our average debt outstanding was $57.6 million lower in 2017 as compared to 2016 primarily due to the decrease in our outstanding borrowings under our credit agreement over the comparative periods. Gain (loss) on derivatives increased from a loss of $22.8 million in 2016 to a gain of $14.7 million in 2017 primarily due to fluctuations in forward prices used to estimate the fair value in mark-to-market accounting. Income Tax Benefit Income tax benefit decreased $13.5 million in 2017 compared to 2016 primarily. During the fourth quarter of 2017, the U.S. government enacted the Tax Cuts and Jobs Act (the Tax Act). Among other provisions, the Tax Act reduces the federal corporate tax rate from the existing maximum rate of 35% to 21%, effective January 1, 2018. As a result of the Tax Act, the Company recorded a tax benefit of $81.3 million due to a revaluation of our net deferred tax liability. Without this income tax benefit charge, income tax expense would have been $23.6 million in 2017 compared to an income tax benefit of $71.2 million in 2016 or an increase of $94.8 million which is commensurate with the increase in pre-tax income for 2017 compared to 2016. Our effective tax rate was (95.9%) for 2017 compared to 34.4% for 2016. The effective tax rate for the current year was dramatically lower due to the Tax Act and revaluation of our net deferred tax liability. Without the $81.3 million income tax benefit, our effective tax rate for 2017 would have been 39.3% The rate change without consideration of deferred tax liability revaluation was primarily due to increased deferred income tax expense related to our restricted stock vestings in both years whereby the increase in 2017 increased our deferred income tax expense and the increase in 2016 decreased our income tax benefit. We did not pay any income taxes during 2017. 2016 versus 2015 _________________________ (1) NM - A percentage calculation is not meaningful due to a zero-value denominator or a percentage change greater than 200. Oil and Natural Gas Oil and natural gas revenues decreased $91.6 million or 24% in 2016 as compared to 2015 due primarily to lower oil and natural gas prices and a decrease in production. Oil production decreased 21%, NGLs production decreased 5%, and natural gas production decreased 15%. Average oil prices between the comparative years decreased 20% to $40.50 per barrel, NGLs prices increased 11% to $11.26 per barrel, and natural gas prices decreased 21% to $2.07 per Mcf. Oil and natural gas operating costs decreased $45.9 million or 28% between the comparative years of 2016 and 2015 due to lower LOE, saltwater disposal, and general and administrative expense. DD&A decreased $138.1 million or 55% primarily due to a 49% decrease in our DD&A rate and by the effect of a 14% decrease in equivalent production. The decrease in our DD&A rate in 2016 compared to 2015 resulted primarily from the effect of the ceiling test write-downs during 2015 and 2016. Our DD&A expense on our oil and natural properties is calculated each quarter using period end reserve quantities adjusted for period production. During 2016, we recorded non-cash ceiling test write-downs of our oil and natural gas properties totaling $161.6 million pre-tax ($100.6 million, net of tax) compared to a non-cash ceiling test write-down of our oil and natural gas properties of $1.6 billion pre-tax ($1.0 billion net of tax) in 2015. These write-downs were due primarily from the reduction of the 12-month average commodity prices during each year. Contract Drilling Drilling revenues decreased $143.6 million or 54% in 2016 as compared to 2015. The decrease was due primarily to a 50% decrease in the average number of drilling rigs in use, a 9% decrease in the average dayrate, and $25.9 million less received for fees on contracts terminated early in 2016 compared to 2015. Average drilling rig utilization decreased from 34.7 drilling rigs in 2015 to 17.4 drilling rigs in 2016. Drilling operating costs decreased $68.3 million or 44% in 2016 compared to 2015. The decrease was due primarily to fewer drilling rigs operating. Contract drilling depreciation decreased $9.1 million or 16% also due primarily to fewer drilling rigs operating. During the second quarter of 2015, we recorded an impairment of approximately $8.3 million on 31 drilling rigs and other equipment sold at auction during the third quarter. Mid-Stream Our mid-stream revenues decreased $16.9 million or 8% in 2016 as compared to 2015 due primarily to gas sold per day decreasing 16% and NGLs sold per day decreasing 7%. Gas processing volumes per day decreased 15% between the comparative years primarily from fewer well connections near our processing systems. Gas gathering volumes per day increased 18% primarily from new well connections in the Appalachian region. Operating costs decreased $23.9 million or 15% in 2016 compared to 2015 primarily due to a 6% decrease in prices paid for natural gas purchased and a 15% decrease in purchase volumes. Depreciation and amortization increased $2.0 million or 5% primarily due to capital expenditures for upgrades and well connects. In December 2015, our mid-stream segment had a $27.0 million pre-tax write-down of three of its systems, Bruceton Mills, Midwell, and Spring Creek due to anticipated future cash flow and future development around these systems not being sufficient to support their carrying value. The estimated future cash flows were less than the carrying value on these systems. Due to continued depressed NGLs prices, we were operating most of our processing facilities in full ethane rejection mode which reduced the liquids sold throughout 2016. Our mid-stream segment also experienced a reduction in processed volumes in 2016 due to the low pricing environment and reduced drilling activity around our systems. General and Administrative General and administrative expenses decreased $1.0 million or 3% in 2016 compared to 2015 primarily due to lower employee costs. Other Depreciation Other depreciation increased $0.8 million or 86% in 2016 compared to 2015 primarily due to the depreciation on the corporate office facility. Gain (loss) on Disposition of Assets Gain (loss) on disposition of assets increased $9.8 million in 2016 compared to 2015 primarily due to the gain of $3.2 million pre-tax on the sale of one drilling rig, various drilling rig components, vehicles, and other equipment somewhat offset by losses from our oil and natural gas and mid-stream segments, compared to a loss of $7.3 million pre-tax on the sale of 31 drilling rigs and other drilling equipment somewhat offset by the gains on the sale of one gathering system, various drilling rig components, vehicles, and a drilling rig during 2015. Other Income (Expense) Interest expense, net of capitalized interest, increased $7.9 million between the comparative years of 2016 and 2015. We capitalized interest based on the net book value associated with unproved properties not being amortized, the construction of additional drilling rigs, and the construction of gas gathering systems. Capitalized interest for 2016 was $15.3 million compared to $21.7 million in 2015, and was netted against our gross interest of $55.1 million and $53.7 million for 2016 and 2015, respectively. Our average interest rate increased from 5.4% to 5.7% and our average debt outstanding was $29.1 million lower in 2016 as compared to 2015 primarily due to the decrease in our outstanding borrowings under our credit agreement over the comparative periods. Gain (loss) on derivatives decreased from a gain of $26.3 million in 2015 to a loss of $22.8 million in 2016 primarily due to fluctuations in forward prices used to estimate the fair value in mark-to-market accounting. Income Tax Benefit Income tax benefit decreased $555.8 million in 2016 compared to 2015 primarily due to a lower pre-tax loss from a reduction in non-cash ceiling test write-downs in 2016 compared to 2015. Our effective tax rate was 34.4% for 2016 and 37.7% for 2015. This decrease was primarily due to increased deferred tax expense in 2016 related to our restricted stock vestings in 2016 after the exhaustion of our remaining accumulated excess tax benefits. The current income tax benefit was minimal in 2016 compared to a current income tax benefit of $20.6 million for 2015. The $20.6 million current income tax benefit in 2015 was primarily due to an anticipated alternative minimum tax (AMT) net operating loss (NOL) carryback refund claim. We paid $42,000 in income taxes during 2016.

<s>[INST] General We operate, manage, and analyze our results of operations through our three principal business segments: Oil and Natural Gas carried out by our subsidiary Unit Petroleum Company. This segment explores, develops, acquires, and produces oil and natural gas properties for our own account. Contract Drilling carried out by our subsidiary Unit Drilling Company. This segment contracts to drill onshore oil and natural gas wells for others and for our own account. MidStream carried out by our subsidiary Superior Pipeline Company, L.L.C. and its subsidiaries. This segment buys, sells, gathers, processes, and treats natural gas for third parties and for our own account. Business Outlook As discussed in other parts of this report, our success depends, to a large degree, on the prices we receive for our oil and natural gas production, the demand for oil, natural gas, and NGLs, and the demand for our drilling rigs which influences the amounts we can charge for those drilling rigs. While our operations are within the United States, events outside the United States affect us and our industry. Deteriorating commodity prices worldwide during the past several years brought about significant and adverse changes to our industry and us. As a result we reduced or stopped, for a time, our oil and natural gas segment's drilling activity. Industry wide reductions in drilling activity and spending for extended periods also reduces the rates for and the number of our drilling rigs we can work. In addition, sustained lower commodity prices impact the liquidity condition of some of our industry partners and customers, which could limit their ability to meet their financial obligations to us. During 2016, commodity prices improved. In the fourth quarter of 2016, our oil and natural gas segment began using two of our drilling rigs and has been using two to three drilling rigs throughout 2017. Our contract drilling segment completed the construction and contracted the ninth and tenth BOSS drilling rigs in the fourth quarter of 2016 and the second quarter of 2017, respectively. Our drilling rig segment's rig utilization increased from 16 drilling rigs working as of June 30, 2016, to 31 drilling rigs working as of December 31, 2017. The extent and duration of this improvement remains uncertain. The reduction in oil, NGLs, and natural gas prices had several consequences for us (although, as noted, we are seeing improvements). Below are some of those consequences: We incurred noncash ceiling test writedowns in the first nine months of 2016 of $161.6 million ($100.6 million net of tax). We had no writedowns during 2017. It is hard to predict with any reasonable certainty the need for or amount of any future impairments given the many factors that go into the ceiling test calculation including, future pricing, operating costs, drilling and completion costs, upward or downward oil and gas reserve revisions, oil and gas reserve additions, and tax attributes. Subject to these inherent uncertainties, if we hold these same factors constant as they existed at December 31, 2017, and only adjust the 12month average price to an estimated first quarter ending average (holding February 2018 prices constant for the remaining one month of the first quarter of 2018), our forward looking expectation is that we will not recognize an impairment in the first quarter of 2018. But commodity prices (and other factors) remain volatile and they could negatively affect the 12month average price resulting in the potential for a future impairment. The number of gross wells our oil and gas segment drilled in 2017 verses 2016 increased from 21 wells to 70 wells due to increased cash flow. For 2018, we plan to increase the number of gross wells drilled to 7585 wells (depending on future commodity prices). The decline in drilling by our customers reduced the average use of our drilling rig fleet. At December 31, 2015, we had 26 drilling rigs operating. In 2016, utilization continued downward bottoming out in May at 13 operating drilling [/INST] Negative. </s>

UNIT CORP

2019-02-26

2018-12-31

Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations Please read this discussion of our financial condition and results of operations with the consolidated financial statements and related notes in Item 8 of this report. General We were founded in 1963 as a contract drilling company. Today, we operate, manage, and analyze our results of operations through our three principal business segments: •Oil and Natural Gas - carried out by our subsidiary Unit Petroleum Company. This segment explores, develops, acquires, and produces oil and natural gas properties for our own account. •Contract Drilling - carried out by our subsidiary Unit Drilling Company. This segment contracts to drill onshore oil and natural gas wells for others and for our own account. •Mid-Stream - carried out by our subsidiary Superior Pipeline Company, L.L.C. and its subsidiaries. This segment buys, sells, gathers, processes, and treats natural gas for third parties and for our own account. We own 50% of this subsidiary. Business Outlook As discussed in other parts of this report, our success depends, to a large degree, on the prices we receive for our oil and natural gas production, the demand for oil, natural gas, and NGLs, and the demand for our drilling rigs which influences the amounts we can charge for those drilling rigs. While our operations are all within the United States, events outside the United States affect us and our industry. Fluctuating commodity prices can result in significant changes to our industry and us. Depressed commodity prices, particularly for the extended time, can result in industry wide reductions in drilling activity and spending which reduce the rates for and the number of our drilling rigs we were able to put to work. Such industry wide reductions in drilling activity and spending for extended periods also reduces the rates for and the number of our drilling rigs we can work. In addition, sustained lower commodity prices impact the liquidity condition of some of our industry partners and customers, which could limit their ability to meet their financial obligations to us. During the last three years, commodity prices have been volatile. Late in 2016, commodity prices improved over 2015. In the fourth quarter of 2016, our oil and natural gas segment began using two of our drilling rigs and used two to three drilling rigs throughout 2017. With improved commodity prices during the first quarter of 2018, our oil and natural gas segment put four of our drilling rigs to work and increased the number to six drilling rigs for a brief period during the third quarter of 2018. We have subsequently reduced our operated rig count. The following chart reflects the significant fluctuations in the prices for oil and natural gas: We incurred non-cash ceiling test write-downs in the first nine months of 2016 totaling $161.6 million ($100.6 million, net of tax). We had no write-downs in 2017 or 2018. It is hard to predict with any reasonable certainty the need for or amount of any future impairments given the many factors that go into the ceiling test calculation including, future pricing, operating costs, drilling and completion costs, upward or downward oil and gas reserve revisions, oil and gas reserve additions, and tax attributes. Subject to these inherent uncertainties, if we hold these same factors constant as they existed at December 31, 2018, and only adjust the 12-month average price to an estimated first quarter ending average (holding February 2019 prices constant for the remaining one month of the first quarter of 2019), our forward looking expectation is that we will not recognize an impairment in the first quarter of 2019. But commodity prices (and other factors) remain volatile and they could negatively affect the 12-month average price resulting in the potential for a future impairment. The number of gross wells our oil and gas segment drilled in 2018 verses 2017 increased from 70 wells to 117 wells due to increased cash flow. For 2019, we plan to decrease the number of gross wells drilled to 90-100 wells (depending on future commodity prices). Our contract drilling segment completed the construction of three additional BOSS drilling rigs between the fourth quarter of 2016 and the third quarter of 2018. During the second quarter and third quarter of 2018, we were awarded term contracts to build our 12th and 13th BOSS drilling rigs. Construction was completed for one of these in January and it was placed into service for a third-party operator. Recently the other contract was terminated but we were able to find another third-party operator and it was placed into service in February. Rig utilization fluctuated over the past year due to commodity prices changing and budget constraints on operators. We expect commodity prices and budget constraints on operators to continue to affect rig utilization throughout 2019. In 2016, utilization bottomed out in May at 13 operating drilling rigs. As commodity prices began improving for the remainder of 2016, we exited the year with 21 active rigs. As of December 31, 2017, we had 31 drilling rigs operating. During 2018, utilization increased from 31 to a high of 36 drilling rigs and with a decline in commodity prices during the fourth quarter, declined to 32 drilling rigs as of December 31, 2018. As of December 31, 2018, all 11 of our BOSS drilling rigs were operating. In December 2018, we removed from service 41 drilling rigs, some older top drives, and certain drill pipe that has been reclassed to 'Assets held for sale.' As of February 12, our drilling rig fleet totaled 56 drilling rigs. During 2018, due to low ethane and residue prices, we operated some of our mid-stream processing facilities in ethane rejection mode which reduces the liquids sold. At the end of 2018 and into the first part of 2019, as NGLs and gas prices improved, we began operating some of our mid-stream processing facilities in ethane recovery mode. We are continuing to monitor commodity prices to determine the most economical method in which to operate our processing facilities. On April 3, 2018, we completed the sale of 50% of the ownership interests in Superior to SP Investor Holdings, LLC, a holding company jointly owned by OPTrust and funds managed and/or advised by Partners Group, a global private markets investment manager, for $300.0 million. Part of the proceeds from the sale were used to pay down our bank debt and the balance was used to accelerate the drilling program of our upstream subsidiary, Unit Petroleum Company and build additional BOSS drilling rigs. In December 2018, we closed on an acquisition of certain oil and natural gas assets located primarily in Custer County, Oklahoma. The total preliminary adjusted value of consideration given was $29.6 million. As of November 1, 2018, the effective date of the acquisition, the estimated proved oil and gas reserves for the acquired properties was 2.6 MMBoe net to Unit. The acquisition added approximately 8,667 net oil and gas leasehold acres to our Penn Sands area in Oklahoma including approximately 44 wells. The acquisitions included approximately 30 potential horizontal drilling locations which are anticipated to have a high percentage of oil relative to the total production stream. Of the acreage acquired, approximately 82% was held by production. Executive Summary Oil and Natural Gas Fourth quarter 2018 production from our oil and natural gas segment was 4,318 MBoe, a decrease of 1% from the third quarter of 2018 and was essentially unchanged from the fourth quarter of 2017. The decrease from the third quarter came from fewer net wells being completed in the fourth quarter. Oil and NGLs production was 46% of our total production during both the fourth quarter of 2018 and the fourth quarter of 2017. Fourth quarter 2018 oil and natural gas revenues decreased 5% from the third quarter of 2018 and increased 4% over the fourth quarter of 2017. The decrease from the third quarter was primarily due to a decrease in production and decrease in oil and NGL prices partially offset by an increase in natural gas prices. The increase over the fourth quarter 2017 was primarily due to higher unhedged natural gas prices and higher oil and natural gas production volumes. Our hedged natural gas prices for the fourth quarter of 2018 increased 22% and 16% over third quarter of 2018 and fourth quarter of 2017, respectively. Our hedged oil prices for the fourth quarter of 2018 decreased 6% and 1% from the third quarter of 2018 and the fourth quarter of 2017, respectively. Our hedged NGLs prices for the fourth quarter of 2018 decreased 24% and 10% from the third quarter of 2018 and fourth quarter of 2017, respectively. Direct profit (oil and natural gas revenues less oil and natural gas operating expense) decreased 6% from the third quarter of 2018 and increased 12% over the fourth quarter of 2017. The decrease from the third quarter of 2018 was primarily due to a decrease in production, a decrease in oil and NGLs prices, and an increase in lease operating expenses (LOE) partially offset by an increase in natural gas prices. The increase over the fourth quarter of 2017 was primarily due to higher revenues due to rising unhedged oil and natural gas prices and increased oil and natural gas production volumes. Operating cost per Boe produced for the fourth quarter of 2018 decreased 2% from the third quarter of 2018 and decreased 11% from the fourth quarter of 2017. The decrease from the the third quarter of 2018 was primarily due to lower gross production taxes due to tax credits received and decrease tax from lower revenues and lower saltwater disposal expense partially offset by higher LOE and general and administrative (G&A) expenses net of geological and geophysical capitalized. The decrease from the fourth quarter of 2017 was primarily due to the reclass of deduction to revenues under ASC 606 offset partially by production that was essentially unchanged. At December 31, 2018, these non-designated hedges were outstanding: After December 31, 2018, these non-designated hedges were entered into: In our Wilcox play, located primarily in Polk, Tyler, Hardin, and Goliad Counties, Texas, we completed seven vertical and one horizontal well (average working interest 100%) in 2018, all of which were completed as gas/condensate producers. Annual production from our Wilcox play averaged 89 MMcfe per day (9% oil, 27% NGLs, 64% natural gas) which is a decrease of 2% compared to 2017. We averaged approximately 0.7 Unit drilling rigs operating during 2018 and we plan to use one Unit drilling rig during 2019. We anticipate completing approximately 13 vertical wells during 2019. In addition, we plan to complete approximately ten behind pipe gas and liquids zones. In our Southern Oklahoma Hoxbar Oil Trend (SOHOT) play, in western Oklahoma primarily in Grady County, we completed seven horizontal oil wells (average working interest 77.6%) in the Marchand zone of the Hoxbar interval. In our Western STACK area, we completed two horizontal wells (average working interest 94.8%), and in our Thomas Field (Red Fork), we completed two horizontal wells (average working interest 79.2%). Annual production from western Oklahoma averaged 76.4 MMcfe per day (33% oil, 21% NGLs, 46% natural gas) which is an increase of approximately 26% compared to 2017. During 2018, we averaged approximately 1.4 Unit drilling rigs operating, and we currently plan to use approximately three Unit drilling rigs for the first half of 2019. We anticipate completing approximately eight horizontal Marchand wells in our SOHOT play and eight horizontal wells in our Red Fork play in Thomas Field during 2019. During 2018, we participated in 61 non-operated wells in the mid-continent region, with most of those occurring in the STACK play. Unit’s average working interest in these wells is 3.7%. In our Texas Panhandle Granite Wash play, we completed 12 extended lateral horizontal gas/condensate wells (average working interest 99.7%) in our Buffalo Wallow field. Annual production from the Texas Panhandle averaged 96.3 MMcfe per day (10% oil, 39% NGLs, 51% natural gas) which is an increase of approximately 11% compared to 2017. We used 1.3 Unit drilling rigs during 2018 and ww plan to operate one Unit drilling rig for the first four months of the year in 2019. We anticipate completing approximately four extended lateral Granite Wash horizontal wells in our Buffalo Wallow field during 2019. In 2018, we performed two recompletions on existing wells in our Panola Field. Both recompletions were upper zones in the Lower Atoka formation. We also drilled one vertical well that targeted the Middle Atoka. We plan on drilling one vertical well in early 2019 that will target the Middle Atoka. During 2018, we participated in the drilling of 117 wells (33.16 net wells). For 2019, we plan to participate in the drilling of approximately 90 to 100 gross wells. Our 2019 production guidance is approximately 17.4 to 17.9 MMBoe, an increase of 2-5% over 2018, actual results which will be subject to many factors. This segment’s capital budget for 2019 ranges from approximately $271.0 million to $315.0 million, a decrease of 21% to 9% from 2018, excluding acquisitions and ARO liability. Contract Drilling The average number of drilling rigs we operated in the fourth quarter was 33.1 compared to 34.2 and 31.2 in the third quarter of 2018 and fourth quarter of 2017, respectively. As of December 31, 2018, 32 of our drilling rigs were operating. Revenue for the fourth quarter of 2018 increased 5% over the third quarter of 2018 and increased 14% over the fourth quarter of 2017. The increase over the third quarter of 2018 was primarily due to higher dayrates partially offset by fewer drilling rigs operating. The increase over the fourth quarter of 2017 was primarily due to more drilling rigs operating and higher dayrates. Dayrates for the fourth quarter of 2018 averaged $18,047, a 3% increase over the third quarter of 2018 and an 8% increase over the fourth quarter of 2017. The increase over the third quarter of 2018 was primarily due to general increases with the improving market and the addition of a BOSS drilling rig. The increase over the fourth quarter of 2017 was primarily due to two labor increases passed through to contracted rig rates and improving market dayrates. Operating costs for the fourth quarter of 2018 increased 12% over the third quarter of 2018 and increased 14% over the fourth quarter of 2017. The increase over the third quarter of 2018 was primarily due to a decrease in eliminations with a lower percentage of our drilling rig usage coming from our oil and gas segment and increased indirect and G&A expenses, partially offset by decreased direct cost with decrease utilization. The increase over the fourth quarter of 2017 was primarily due to more drilling rigs operating and increased per day cost. Direct profit (contract drilling revenue less contract drilling operating expense) for the fourth quarter of 2018 decreased 8% from the third quarter of 2018 and increased 12% over the fourth quarter of 2017. The decrease from the third quarter of 2018 was primarily due to fewer drilling rigs operating and increased indirect and drilling G&A expenses while the increase over the fourth quarter of 2017 was primarily due to more drilling rigs operating. Operating cost per day for the fourth quarter of 2018 increased 15% over the third quarter of 2018 and increased 8% over the fourth quarter of 2017. The increase over the third quarter of 2018 was primarily due to decreased eliminations with a lower percentage of our drilling rig usage coming from our oil and gas segment and higher per day indirect and G&A costs. The increase over the fourth quarter of 2017 was primarily due to more rigs operating. In December 2018, our Board of Directors approved a plan to sell 41 drilling rigs (29 mechanical drilling rigs and 12 SCR diesel-electric drilling rigs) and other equipment. This plan satisfies the criteria of assets held for sale under ASC 360-10-45-9. Over the last five years, only six of our drilling rigs in the fleet have not been utilized. We made a strategic decision to focus on our new BOSS drilling rigs and specific SCR drilling rigs (good candidates for modification) and sell the other drilling rigs that we now choose not to market. We estimated the fair value of the 41 drilling rigs we will no longer market based on the estimated market value from third-party assessments (Level 3 fair value measurement) less cost to sell. Based on these estimates, we recorded a non-cash write-down of approximately $147.9 million, pre-tax ($111.7 million, net of tax). The contract drilling segment has operations in Oklahoma, Texas, Louisiana, Kansas, Colorado, Utah, Wyoming, Montana and North Dakota. As of December 31, 2018, 18 rigs were working in Oklahoma and the Texas Panhandle, one in East Texas, and six in the Permian Basin of West Texas, two drilling rigs in Wyoming and five drilling rigs in the Bakken Shale of North Dakota. During 2018, almost all of our working drilling rigs were drilling horizontal or directional wells for oil and NGLs. The future demand for and the availability of drilling rigs to meet that demand will affect our future dayrates. As of December 31, 2018, we had 24 term drilling contracts with original terms ranging from six months to three years. Seventeen of these contracts are up for renewal in 2019, (seven in the first quarter, seven in the second quarter, one in the third quarter, and two in the fourth quarter) and seven are up for renewal in 2020 and beyond. Term contracts may contain a fixed rate during the contract or provide for rate adjustments within a specific range from the existing rate. Some operators who had signed term contracts have opted to release the drilling rig and pay an early termination penalty for the remaining term of the contract. We recorded $0.1 million, $0.8 million, and $3.1 million in early termination fees in 2018, 2017, and 2016, respectively. In the first quarter of 2019, we recorded $4.6 million in early termination fees. All 13 of our existing BOSS drilling rigs are under contract. All of our contracts are daywork contracts. Our anticipated 2019 capital expenditures for this segment ranges from approximately $30.0 million to $65.0 million, a 60% to 14% decrease from 2018. Mid-Stream Fourth quarter 2018 liquids sold per day was essentially unchanged from the third quarter of 2018 and increased 20% over the fourth quarter of 2017. The increase over the fourth quarter of 2017 was due primarily to more processed volume from connecting additional wells to our systems. For the fourth quarter of 2018, gas processed per day was essentially unchanged from the third quarter of 2018 and increased 8% over the fourth quarter of 2017. The increase over the fourth quarter of 2017 was due to connecting additional wells to our processing systems. For the fourth quarter of 2018, gas gathered per day decreased 5% from the third quarter of 2018 and increased 3% over the fourth quarter of 2017. The decrease from the third quarter of 2018 was primarily due to declining volumes from the Appalachian region and the increase over the fourth quarter of 2017 was mainly due to connecting the infill wells on the Pittsburgh Mills gathering system. NGLs prices in the fourth quarter of 2018 decreased 20% and 23% from the prices received in the third quarter of 2018 and the fourth quarter of 2017, respectively. Because certain of the contracts used by our mid-stream segment for NGLs transactions are commodity-based contracts - under which we receive a share of the proceeds from the sale of the NGLs - our revenues from those commodity-based contracts fluctuate based on NGLs prices. Direct profit (mid-stream revenues less mid-stream operating expense) for the fourth quarter of 2018 decreased 16% and 5% from the third quarter of 2018 and fourth quarter of 2017, respectively. The decrease from the third quarter of 2018 was primarily due to lower NGLs and condensate prices. The decrease from the fourth quarter of 2017 was primarily due to the increased revenues from the timing of demand fees recognition under ASC 606 along with a decrease in NGLs prices. Total operating cost for this segment for the fourth quarter of 2018 increased 1% over the third quarter of 2018 and decreased 1% from the fourth quarter of 2017. The increase over the third quarter of 2018 was primarily due to a decrease from the third quarter of 2018 in purchases made from our oil and gas segment that was eliminated and the increase over the fourth quarter of 2017 was due primarily to higher field direct operating expenses. In the Appalachian region at the Pittsburgh Mills gathering system, average gathered volume for the fourth quarter of 2018 was approximately 129.7 MMcf per day and the annual average gathered volume was 123.9 MMcf per day. In 2018, we added seven new infill wells late in the second quarter and all the new infill wells are currently online and flowing gas. We have completed construction of the new pipeline to connect the next scheduled well pad to our system. We have also completed the upgrade of the compressor station and dehydration facilities. Production from this new pad started online during January 2019. At the Hemphill Texas system, average total throughput volume for the fourth quarter of 2018 increased to 75.3 MMcf per day and total production of natural gas liquids was approximately 301,500 gallons per day during this same period. The annual average throughput volume was 72.6 MMcf per day while the annual total production of natural gas liquids averaged 264,971 gallons per day. During the fourth quarter, we connected five new wells in the Buffalo Wallow area. These new wells along with increased production from recently drilled wells in this area contributed to the increased throughput volume. Our oil and gas segment continues to operate a rig in the Buffalo Wallow area and we anticipate connecting additional wells to this system in 2019. At the Cashion processing facility in central Oklahoma, total throughput volume for the fourth quarter of 2018 averaged approximately 49.2 MMcf per day and total production of natural gas liquids increased to 246,873 gallons per day. The annual average throughput volume was 46.0 MMcf per day and the annual average natural gas liquids production was 234,316 gallons per day. This system is currently operating at full processing capacity and we are adding additional capacity to this system. We are relocating a 60 MMcf per day processing plant from our Bellmon facility to the Cashion area. This processing plant will be installed at the Reeding site on the Cashion system. This plant is expected to be operational by the end of the first quarter of 2019 and it will increase our total processing capacity on the Cashion system to approximately 105 MMcf per day. We connected eight new wells to this system during the fourth quarter of 2018 and we are continuing to connect additional wells from a third party producer who continues to be active in this area. At the Minco processing facility in central Oklahoma, total throughput volume for the fourth quarter of 2018 was approximately 8.0 MMcf per day and the average annual total throughput volume was 9.5 MMcf per day. During the fourth quarter of 2018 we completed a new interconnect with a producer who is currently delivering gas to our system. Additionally, we are completing construction of a new well connect for a third party producer who is expected to deliver gas to our system in 2019. The current processing capacity of the Minco facility is approximately 12 MMcf per day. Anticipated 2019 capital expenditures for this segment range from approximately $35.0 million to $42.0 million, a 22% to 6% decrease from 2018. Critical Accounting Policies and Estimates Summary In this section, we identify those critical accounting policies we follow in preparing our financial statements and related disclosures. Many policies require us to make difficult, subjective, and complex judgments while making estimates of matters inherently imprecise. Some accounting policies involve judgments and uncertainties to such an extent there is reasonable likelihood that materially different amounts could have been reported under different conditions, or had different assumption been used. We evaluate our estimates and assumptions regularly. We base our estimates on historical experience and various other assumptions we believe are reasonable under the circumstances, the results of which support making judgments about the carrying values of assets and liabilities not readily apparent from other sources. Actual results may differ from these estimates and assumptions used in preparation of our financial statements. In this discussion we attempt to explain the nature of these estimates, assumptions and judgments, and the likelihood that materially different amounts would be reported in our financial statements under different conditions or using different assumptions. This table lists the critical accounting policies, identifies the estimates and assumptions that can have a significant impact on applying these accounting policies, and the financial statement accounts affected by these estimates and assumptions. Accounting Policies Estimates or Assumptions Accounts Affected Full cost method of accounting for oil, NGLs, and natural gas properties • Oil, NGLs, and natural gas reserves, estimates, and related present value of future net revenues • Valuation of unproved properties • Estimates of future development costs • Oil and natural gas properties • Accumulated depletion, depreciation and amortization • Provision for depletion, depreciation and amortization • Impairment of oil and natural gas properties • Long-term debt and interest expense Accounting for ARO for oil, NGLs, and natural gas properties • Cost estimates related to the plugging and abandonment of wells • Timing of cost incurred • Credit adjusted risk free rate • Oil and natural gas properties • Accumulated depletion, depreciation and amortization • Provision for depletion, depreciation and amortization • Current and non-current liabilities • Operating expense Accounting for material producing property and undeveloped acreage acquisitions •Value the reserves with the income approach using cash flow projections •Value the undeveloped acreage with the market approach using comparable sales data •Value equipment with the market approach using comparable sales data and CEPS pricing • Oil and natural gas properties • Non-current liabilities Accounting for impairment of long-lived assets • Forecast of undiscounted estimated future net operating cash flows • Drilling and mid-stream property and equipment • Accumulated depletion, depreciation and amortization • Provision for depletion, depreciation and amortization Goodwill • Forecast of discounted estimated future net operating cash flows • Terminal value • Weighted average cost of capital • Goodwill Accounting for value of stock compensation awards • Estimates of stock volatility • Estimates of expected life of awards granted • Estimates of rates of forfeitures • Estimates of performance shares granted • Oil and natural gas properties • Shareholder’s equity • Operating expenses • General and administrative expenses Accounting for derivative instruments • Derivatives measured at fair value • Current and non-current derivative assets and liabilities • Gain (loss) on derivatives Significant Estimates and Assumptions Full Cost Method of Accounting for Oil, NGLs, and Natural Gas Properties. Determining our oil, NGLs, and natural gas reserves is a subjective process. It entails estimating underground accumulations of oil, NGLs, and natural gas that cannot be measured in an exact manner. Accuracy of these estimates depends on several factors, including, the quality and availability of geological and engineering data, the precision of the interpretations of that data, and individual judgments. Each year, we hire an independent petroleum engineering firm to audit our internal evaluation of our reserves. The audit of our reserve wells or locations as of December 31, 2018 covered those that we projected to comprise 83% of the total proved developed future net income discounted at 10% and 82% of the total proved discounted future net income (based on the SEC's unescalated pricing policy). Included in Part I, Item 1 of this report are the qualifications of our independent petroleum engineering firm and our employees responsible for preparing our reserve reports. As a rule, the accuracy of estimating oil, NGLs, and natural gas reserves varies with the reserve classification and the related accumulation of available data, as shown in this table: Type of Reserves Nature of Available Data Degree of Accuracy Proved undeveloped Data from offsetting wells, seismic data Less accurate Proved developed non-producing The above and logs, core samples, well tests, pressure data More accurate Proved developed producing The above and production history, pressure data over time Most accurate Assumptions of future oil, NGLs, and natural gas prices and operating and capital costs also play a significant role in estimating these reserves and the estimated present value of the cash flows to be received from the future production of those reserves. Volumes of recoverable reserves are influenced by the assumed prices and costs due to the economic limit (that point when the projected costs and expenses of producing recoverable oil, NGLs, and natural gas reserves are greater than the projected revenues from the oil, NGLs, and natural gas reserves). But more significantly, the estimated present value of the future cash flows from our oil, NGLs, and natural gas reserves is sensitive to prices and costs and may vary materially based on different assumptions. Companies, like ours, using full cost accounting use the unweighted arithmetic average of the commodity prices existing on the first day of each of the 12 months before the end of the reporting period to calculate discounted future revenues, unless prices were otherwise determined under contractual arrangements. We compute DD&A on a units-of-production method. Each quarter, we use these formulas to compute the provision for DD&A for our producing properties: •DD&A Rate = Unamortized Cost / End of Period Reserves Adjusted for Current Period Production •Provision for DD&A = DD&A Rate x Current Period Production Unamortized cost includes all capitalized costs, estimated future expenditures to be incurred in developing proved reserves and estimated dismantlement and abandonment costs, net of estimated salvage values less accumulated amortization, unproved properties, and equipment not placed in service. Oil, NGLs, and natural gas reserve estimates have a significant impact on our DD&A rate. If future reserve estimates for a property or group of properties are revised downward, the DD&A rate will increase because of the revision. If reserve estimates are revised upward, the DD&A rate will decrease. Based on our 2018 production level of 17.1 MMBoe, a decrease in our 2018 oil, NGLs, and natural gas reserves by 5% would increase our DD&A rate by $0.42 per Boe and would decrease pre-tax income by $7.2 million annually. Conversely, an increase in our 2018 oil, NGLs, and natural gas reserves by 5% would decrease our DD&A rate by $0.36 per Boe and would increase pre-tax income by $6.1 million annually. The DD&A expense on our oil and natural gas properties is calculated each quarter using period end reserve quantities adjusted for period production. We account for our oil and natural gas exploration and development activities using the full cost method of accounting. Under this method, we capitalize all costs incurred in the acquisition, exploration, and development of oil and natural gas properties. At the end of each quarter, the net capitalized costs of our oil and natural gas properties are limited to that amount which is the lower of unamortized costs or a ceiling. The ceiling is defined as the sum of the present value (using a 10% discount rate) of the estimated future net revenues from our proved reserves (based on the unescalated 12-month average price on our oil, NGLs, and natural gas adjusted for any cash flow hedges), plus the cost of properties not being amortized, plus the lower of the cost or estimated fair value of unproved properties included in the costs being amortized, less related income taxes. If the net capitalized costs of our oil and natural gas properties exceed the ceiling, we are required to write-down the excess amount. A ceiling test write-down is a non-cash charge to earnings. If required, it reduces earnings and impacts shareholders’ equity in the period of occurrence and results in lower DD&A expense in future periods. Once incurred, a write-down cannot be reversed. The risk we will be required to write-down the carrying value of our oil and natural gas properties increases when the prices for oil, NGLs, and natural gas are depressed or if we have large downward revisions in our estimated proved oil, NGLs, and natural gas reserves. Application of these rules during periods of relatively low prices, even if temporary, increases the chance of a ceiling test write-down. At December 31, 2018, our reserves were calculated based on applying 12-month 2018 average unescalated prices of $65.56 per barrel of oil, $37.68 per barrel of NGLs, and $3.10 per Mcf of natural gas (then adjusted for price differentials) over the estimated life of each of our oil and natural gas properties. We had no ceiling test write-down for 2018. It is hard to predict with any reasonable certainty the need for or amount of any future impairments given the many factors that go into the ceiling test calculation including future pricing, operating costs, drilling and completion costs, upward or downward oil and gas reserve revisions, oil and gas reserve additions, and tax attributes. Subject to these inherent uncertainties, if we hold these same factors constant as they existed at December 31, 2018 and only adjust the 12-month average price to an estimated first quarter ending average (holding February 2019 prices constant for the remaining one month of the first quarter of 2019), our forward looking expectation is that we will not recognize an impairment in the first quarter of 2019. But commodity prices (and other factors) remain volatile and they could negatively affect the 12-month average price resulting in the potential for an impairment in the first quarter. We account for revenue transactions under ASC 606 for recording natural gas sales, which may be more or less than our share of pro-rata production from certain wells. Our policy is to expense our pro-rata share of lease operating costs from all wells as incurred. The expenses relating to the wells in which we have a production imbalance are not material. Costs Withheld from Amortization. Costs associated with unproved properties are excluded from our amortization base until we have evaluated the properties. The costs associated with unevaluated leasehold acreage and related seismic data, the drilling of wells, and capitalized interest are initially excluded from our amortization base. Leasehold costs are transferred to our amortization base with the costs of drilling a well on the lease or are assessed at least annually for possible impairment or reduction in value. Leasehold costs are transferred to our amortization base to the extent a reduction in value has occurred. Our decision to withhold costs from amortization and the timing of transferring those costs into the amortization base involve significant judgment and may be subject to changes over time based on several factors, including our drilling plans, availability of capital, project economics and results of drilling on adjacent acreage. In December 2016 and December 2017, we determined the value of certain unproved oil and gas properties were diminished (in part or in whole) based on an impairment evaluation and our anticipated future exploration plans. Those determinations resulted in $7.6 million and $10.5 million in 2016 and 2017, respectively of costs being added to the total of our capitalized costs being amortized. We did not have any in 2018. At December 31, 2018, we had approximately $330.2 million of costs excluded from the amortization base of our full cost pool. Accounting for ARO for Oil, NGLs, and Natural Gas Properties. We record the fair value of liabilities associated with the future plugging and abandonment of wells. In our case, when the reserves in each of our oil or gas wells deplete or otherwise become uneconomical, we must incur costs to plug and abandon the wells. These costs are recorded in the period in which the liability is incurred (at the time the wells are drilled or acquired). We have no assets restricted to settle these ARO liabilities. Our engineering staff uses historical experience to determine the estimated plugging costs considering the type of well (either oil or natural gas), the depth of the well, the physical location of the well, and the ultimate productive life to determine the estimated plugging costs. A risk-adjusted discount rate and an inflation factor are used on these estimated costs to determine the current present value of this obligation. To the extent any change in these assumptions affect future revisions and impact the present value of the existing ARO, a corresponding adjustment is made to the full cost pool. Accounting for Impairment of Long-Lived Assets. Drilling equipment, transportation equipment, gas gathering and processing systems, and other property and equipment are carried at cost less accumulated depreciation. Renewals and enhancements are capitalized while repairs and maintenance are expensed. We review the carrying amounts of long-lived assets for potential impairment annually, typically during the fourth quarter, or when events occur or changes in circumstances suggest these carrying amounts may not be recoverable. Changes that could prompt such an assessment may include equipment obsolescence, changes in the market demand for a specific asset, changes in commodity prices, periods of relatively low drilling rig utilization, declining revenue per day, declining cash margin per day, or overall changes in market conditions. Assets are determined to be impaired if a forecast of undiscounted estimated future net operating cash flows directly related to the asset, including disposal value if any, is less than the carrying amount of the asset. If any asset is determined to be impaired, the loss is measured as the amount by which the carrying amount of the asset exceeds its fair value. The estimate of fair value is based on the best information available, including prices for similar assets. Changes in these estimates could cause us to reduce the carrying value of property and equipment. Asset impairment evaluations are, by nature, highly subjective. They involve expectations about future cash flows generated by our assets and reflect management’s assumptions and judgments regarding future industry conditions and their effect on future utilization levels, dayrates, and costs. Using different estimates and assumptions could cause materially different carrying values of our assets. On a periodic basis, we evaluate our fleet of drilling rigs for marketability based on the condition of inactive rigs, expenditures that would be necessary to bring them to working condition and the expected demand for drilling services by rig type. The components comprising inactive rigs are evaluated, and those components with continuing utility to the Company’s other marketed rigs are transferred to other rigs or to its yards to be spare equipment. The remaining components of these rigs are retired. No impairments were recorded in 2016 or 2017. In December 2018, our Board of Directors approved a plan to sell 41 drilling rigs (29 mechanical drilling rigs and 12 SCR diesel-electric drilling rigs) and other equipment. This plan satisfies the criteria of assets held for sale under ASC 360-10-45-9. Over the last five years, only six of our drilling rigs in the fleet have not been utilized. We made a strategic decision to focus on our new BOSS drilling rigs and specific SCR drilling rigs (good candidates for modification) and sell the other drilling rigs that we now choose not to market. We estimated the fair value of the 41 drilling rigs we will no longer market based on the estimated market value from third-party assessments (Level 3 fair value measurement) less cost to sell. Based on these estimates, we recorded a non-cash write-down of approximately $147.9 million, pre-tax ($111.7 million, net of tax). Goodwill. Goodwill represents the excess of the cost of acquisitions over the fair value of the net assets acquired. Goodwill is not amortized, but an impairment test is performed at least annually to determine whether the fair value has decreased and is performed additionally when events indicate an impairment may have occurred. For impairment testing, goodwill is evaluated at the reporting unit level. Our goodwill is all related to our contract drilling segment, and, the impairment test is generally based on the estimated discounted future net cash flows of our drilling segment, utilizing discount rates and other factors in determining the fair value of our drilling segment. Inputs in our estimated discounted future net cash flows include drilling rig utilization, day rates, gross margin percentages, and terminal value. No goodwill impairment was recorded at December 31, 2018, 2017, or 2016. Based on our impairment test performed as of December 31, 2018, the fair value of our drilling segment exceeded its carrying value by 37%. While the goodwill of this reporting unit is not currently impaired, there could be an impairment in the future as a result of changes in certain assumptions. For example, the fair value could be adversely affected and result in an impairment of goodwill if we do not realize the anticipated drilling rig utilization of the anticipated drilling rig dayrates, or if the estimated cash flows are discounted at a higher risk-adjusted rate or market multiples decrease. Drilling Contracts.The type of contract used determines our compensation. All of our contracts in 2018, 2017, and 2016 were daywork contracts. Under a daywork contract, we provide the drilling rig with the required personnel and the operator supervises the drilling of the well. Our compensation is based on a negotiated rate to be paid for each day the drilling rig is used. Accounting for Value of Stock Compensation Awards. To account for stock-based compensation, compensation cost is measured at the grant date based on the fair value of an award and is recognized over the service period, which is usually the vesting period. We elected to use the modified prospective method, which requires compensation expense to be recorded for all unvested stock options and other equity-based compensation beginning in the first quarter of adoption. Determining the fair value of an award requires significant estimates and subjective judgments regarding, among other things, the appropriate option pricing model, the expected life of the award and performance vesting criteria assumptions. As there are inherent uncertainties related to these factors and our judgment in applying them to the fair value determinations, there is risk that the recorded stock compensation may not accurately reflect the amount ultimately earned by the employee. Accounting for Derivative Instruments and Hedging. All derivatives are recognized on the balance sheet and measured at fair value. Any changes in our derivatives' fair value before their maturity (i.e., temporary fluctuations in value) along with any derivatives settled are reported in gain (loss) on derivatives in our Consolidated Statements of Operations. New Accounting Standards Fair Value Measurement (Topic 820): Disclosure Framework-Changes to the Disclosure Requirements for Fair Value Measurement. The FASB issued ASU 2018-13 to modify the disclosure requirements in Topic 820. Part of the disclosures were removed or modified and other disclosures were added. The amendment will be effective for reporting periods beginning after December 15, 2019. Early adoption is permitted. Also it is permitted to early adopt any removed or modified disclosure and delay adoption of the additional disclosures until their effective date. This amendment will not have a material impact on our financial statements. Compensation-Stock Compensation: Improvements to Nonemployee Share-Based Payment Accounting. The FASB issued ASU 2018-07, to improve financial reporting for nonemployee share-based payments. The amendment expands Topic 718, Compensation-Stock Compensation to include share-based payments issued to nonemployees for goods or services. The amendment will be effective for years beginning after December 15, 2019, and interim periods within those years. This amendment will not have a material impact on our financial statements. Intangibles-Goodwill and Other: Simplifying the Test for Goodwill Impairment. The FASB issued ASU 2017-04, to simplify the measurement of goodwill. The amendment eliminates Step 2 from the goodwill impairment test. The amendment will be effective prospectively for reporting periods beginning after December 15, 2019, and early adoption is permitted. This amendment will not have a material impact on our financial statements. Leases. The FASB has issued several accounting standards updates and amendments related to leases in the past two years, which are codified within Topic 842. For public companies, these are effective for annual periods beginning after December 15, 2018, and interim periods within those annual periods. The standard requires lessees to recognize at the commencement date of a lease a lease liability, which represents the lessee's obligation to make lease payments arising from the lease, measured on a discounted basis; and a right-of-use asset, which represents the lessee's right to use a specified asset for the lease term. Other recently issued amendments to Topic 842 have provided clarifying guidance regarding land easements, an additional modified retrospective transition method, and added several practical expedients to apply Topic 842 for both lessees and lessors. The standard will not apply to leases of mineral rights. We have an implementation team working through the provisions of the new guidance including a review of different types of contracts to document our lease portfolio and assess the impact on our accounting, disclosures, processes, internal control over financial reporting, and the election of certain practical expedients. Our evaluation of the impact of the new guidance is substantially complete. We have made certain accounting policy decisions including that we plan to adopt the short-term lease recognition exemption, accounting for certain asset classes at a portfolio level, and establishing a balance sheet recognition capitalization threshold. Our transition will utilize the modified retrospective approach to adopting the new standard, and will be applied at the beginning of the period adopted (January 1, 2019) in accordance with ASU 2018-11. We have elected the transition practical expedient, which allows us to not evaluate land easements that existed prior to January 1, 2019, and the optional transition method to record the our immaterial adoption impact through a cumulative adjustment to equity. We expect for certain lessee asset classes to elect the practical expedient and not separate lease and nonlease components. For these asset classes, we will account for the agreements as a single lease component. We have determined that Unit Drilling Company lessor drilling rig contracts will be accounted for under ASC 606 as the service has been deemed the predominate component of the contract. For both lessee and lessor practical expedients, we considered quantitative and qualitative factors when determining if an asset class qualified for the application of the practical expedient. The adoption of this guidance will result in the addition of right-of-use assets and corresponding lease obligations to the consolidated balance sheet and will not have a material impact on the Company’s results of operations or cash flows. Upon adoption, the Company expects to record operating lease right-of-use assets and the corresponding operating lease liabilities in the range of approximately $3.0 million to $4.5 million, representing the present value of future lease payments under operating leases. The Company is in the process of finalizing its catalog of existing lease contracts and implementing changes to its processes. There would be no impact to the Superior credit agreement debt covenants and an immaterial impact to the Unit credit agreement debt covenants as a result of adopting this standard. Adopted Standards As of January 1, 2018, we adopted ASU 2018-02 Reclassification of Certain Tax Effects from Accumulated Other Comprehensive Income. This standard is explained further in Note 8 - New Accounting Pronouncements. We adopted this amendment early and it had no material effect to our financial statements. We previously used 37.75% to calculate the tax effect on AOCI and we now use 24.5%. This change is reflected in our Consolidated Statements of Comprehensive Income and in Note 17 - Equity. Also, as of January 1, 2018, we adopted ASU 2014-09 Revenue from Contracts with Customers - Topic 606 (ASC 606) and all later amendments that modified ASC 606. This new revenue standard is explained further in Note 8 - New Accounting Pronouncements. We elected to apply this standard on the modified retrospective approach method to contracts not completed as of January 1, 2018, where the cumulative effect on adoption, which only affected our mid-stream segment, is recognized as an adjustment to opening retained earnings at January 1, 2018. This adjustment related to the timing of revenue recognition for certain demand fees. Our oil and natural gas and contract drilling segments had no retained earnings adjustment. Comparative prior periods have not been adjusted and continue to be reported under ASC 605. The additional disclosures required by ASC 606 have been included in Note 3 - Revenue from Contracts with Customers. Our internal control framework did not materially change because of this standard, but the existing internal controls have been modified to consider our new revenue recognition policy effective January 1, 2018. As we implement the new standard, we have added internal controls to ensure that we adequately evaluate new contracts under the five-step model under ASU 2014-09. Financial Condition and Liquidity Summary. Our financial condition and liquidity primarily depends on the cash flow from our operations and borrowings under our credit agreements. The principal factors determining our cash flow are: •the amount of natural gas, oil, and NGLs we produce; •the prices we receive for our natural gas, oil, and NGLs production; •the demand for and the dayrates we receive for our drilling rigs; and •the fees and margins we obtain from our natural gas gathering and processing contracts. We believe we have sufficient cash flow and liquidity to meet our obligations and remain in compliance with our debt covenants for the next twelve months. Our ability to meet our debt covenants (under our credit agreements and our Indenture) and our capacity to incur additional indebtedness will depend on our future performance, which in turn will be affected by financial, business, economic, regulatory, and other factors. For example, lower oil, natural gas, and NGLs prices since the last redetermination under the Unit credit agreement could cause a redetermination of the borrowing base to a lower level and therefore reduce or limit our ability to borrow funds. We monitor our liquidity and capital resources, endeavor to anticipate potential covenant compliance issues and work with our lenders to address any of those issues ahead of time. Below is a summary of certain financial information for the years ended December 31: Cash Flows from Operating Activities Our operating cash flow is primarily influenced by the prices we receive for our oil, NGLs, and natural gas production, the quantity of oil, NGL, and natural gas we produce, settlements of derivative contracts, third-party demand for our drilling rigs and mid-stream services, and the rates we can charge for those services. Our cash flows from operating activities are also affected by changes in working capital. Net cash provided by operating activities increased by $81.8 million in 2018 compared to 2017 due primarily from higher revenues due to higher commodity prices and higher drilling rig utilization partially offset by changes in operating assets and liabilities related to the timing of cash receipts and disbursements. Cash Flows from Investing Activities We dedicate and expect to continue to dedicate a substantial portion of our capital budget to the exploration for and production of oil, NGLs, and natural gas. These expenditures are necessary to off-set the inherent production declines typically experienced in oil and gas wells. Cash flows used in investing activities increased by $157.0 million in 2018 compared to 2017. The change was due primarily to an increase in capital expenditures due to an increase in wells drilled, oil and gas property acquisitions, and the construction of new BOSS drilling rigs partially offset by an increase in the proceeds received from the disposition of assets. See additional information on capital expenditures below under Capital Requirements. Cash Flows from Financing Activities Cash flows provided by financing activities increased by $81.1 million in 2018 compared to 2017. The increase was primarily due to the proceeds from the sale of 50% interest in our mid-stream segment partially offset by the pay down of our outstanding debt under the Unit credit agreement. At December 31, 2018, we had unrestricted cash totaling $6.5 million and had borrowed none of the amounts available under either of the Unit or Superior credit agreements. Below is a summary of certain financial information as of December 31, and for the years ended December 31: _________________________ 1.Long-term debt is net of unamortized discount and debt issuance costs. 2.In December 2018, we incurred a non-cash write-down associated with the removal of 41 drilling rigs from our fleet of $147.9 million pre-tax ($111.7 million, net of tax). In 2016, we incurred non-cash ceiling test write-downs of our oil and natural gas properties of $161.6 million pre-tax ($100.6 million, net of tax). Working Capital Typically, our working capital balance fluctuates, in part, because of the timing of our trade accounts receivable and accounts payable and the fluctuation in current assets and liabilities associated with the mark to market value of our derivative activity. We had negative working capital of $38.7 million, $62.3 million, and $43.7 million as of December 31, 2018, 2017, and 2016, respectively. The increase in working capital from 2017 is primarily due to increased cash and cash equivalents from the sale of 50% interest in our mid-stream segment and increased accounts receivable due to increased revenues, the change in the value of the derivatives outstanding and the fair value of drilling assets held for sale partially offset by increased accounts payable due to increased activity in our drilling program. The Unit and Superior credit agreements are used primarily for working capital and capital expenditures. At December 31, 2018, we had borrowed none of the $425.0 million available to us under the Unit credit agreement and none of the $200.0 million available to us under the Superior credit agreement. The effect of our derivatives increased working capital by $12.9 million as of December 31, 2018, decreased working capital by $7.1 million as of December 31, 2017, and increased working capital by $21.6 million as of December 31, 2016. This table summarizes certain operating information for the years ended December 31: ________________________ 1.In 2018, our mid-stream segment transferred two natural gas gathering systems to our oil and natural gas segment. Oil and Natural Gas Operations Any significant change in oil, NGLs, or natural gas prices has a material effect on our revenues, cash flow, and the value of our oil, NGLs, and natural gas reserves. Generally, prices and demand for domestic natural gas are influenced by weather conditions, supply imbalances, and by worldwide oil price levels. Domestic oil prices are primarily influenced by world oil market developments. These factors are beyond our control and we cannot predict nor measure their future influence on the prices we will receive. Based on our 2018 production, a $0.10 per Mcf change in what we are paid for our natural gas production, without the effect of derivatives, would cause a corresponding $439,000 per month ($5.3 million annualized) change in our pre-tax operating cash flow. Our 2018 average natural gas price was $2.46 compared to an average natural gas price of $2.46 for 2017 and $2.07 for 2016. A $1.00 per barrel change in our oil price, without the effect of derivatives, would have a $228,000 per month ($2.7 million annualized) change in our pre-tax operating cash flow and a $1.00 per barrel change in our NGLs prices, without the effect of derivatives, would have a $393,000 per month ($4.7 million annualized) change in our pre-tax operating cash flow based on our production in 2018. Our 2018 average oil price per barrel was $55.78 compared with an average oil price of $49.44 in 2017 and $40.50 in 2016, and our 2018 average NGLs price per barrel was $22.18 compared with an average NGLs price of $18.35 in 2017 and $11.26 in 2016. Because commodity prices affect the value of our oil, NGLs, and natural gas reserves, declines in those prices can cause a decline in the carrying value of our oil and natural gas properties. At December 31, 2018, the 12-month average unescalated prices were $65.56 per barrel of oil, $37.68 per barrel of NGLs, and $3.10 per Mcf of natural gas, and then are adjusted for price differentials. We did not have to take a write down in 2018. It is hard to predict with any reasonable certainty the need for or amount of any future impairments given the many factors that go into the ceiling test calculation including, but not limited to, future pricing, operating costs, drilling and completion costs, upward or downward oil and gas reserve revisions, oil and gas reserve additions, and tax attributes. Subject to these inherent uncertainties, if we hold these same factors constant as they existed at December 31, 2018 and only adjust the 12-month average price to an estimated first quarter ending average (holding February 2019 prices constant for the remaining one month of the first quarter of 2019), our forward-looking expectation is that we will not recognize an impairment in the first quarter of 2019. Commodity prices remain volatile and they could negatively affect the 12-month average price and the potential for an impairment in the first quarter. Our natural gas production is sold to intrastate and interstate pipelines, to independent marketing firms and gatherers under contracts with terms generally ranging from one month to five years. Our oil production is sold to independent marketing firms generally under six-month contracts. Contract Drilling Operations Many factors influence the number of drilling rigs we have working and the costs and revenues associated with that work. These factors include the demand for drilling rigs in our areas of operation, competition from other drilling contractors, the prevailing prices for oil, NGLs, and natural gas, availability and cost of labor to run our drilling rigs, and our ability to supply the equipment needed. Competition to keep qualified labor continues. We increased compensation for some rig personnel during the first quarter of 2018. Our drilling rig personnel are a key component to the overall success of our drilling services. With the present conditions in the drilling industry, we do not anticipate increases in the compensation paid to those personnel in the near term. During 2018, almost all of our working drilling rigs were drilling horizontal or directional wells for oil and NGLs. The continuous fluctuations in commodity prices for oil and natural gas changes demand for drilling rigs. These factors ultimately affect the demand and mix of the type of drilling rigs used by our customers. The future demand for and the availability of drilling rigs to meet that demand will affect our future dayrates. For 2018, our average dayrate was $17,510 per day compared to $16,256 and $17,784 per day for 2017 and 2016, respectively. Our average number of drilling rigs used (utilization %) in 2018 was 32.8 (34%) compared with 30.0 (32%) and 17.4 (19%) in 2017 and 2016, respectively. Based on the average utilization of our drilling rigs during 2018, a $100 per day change in dayrates has a $3,280 per day ($1.2 million annualized) change in our pre-tax operating cash flow. Our contract drilling segment provides drilling services for our exploration and production segment. Some of the drilling services we perform on our properties are, depending on the timing of those services, deemed associated with acquiring an ownership interest in the property. In those cases, revenues and expenses for those services are eliminated in our statement of operations, with any profit recognized as a reduction in our investment in our oil and natural gas properties. The contracts for these services are issued under the same conditions and rates as the contracts entered into with unrelated third parties. By providing drilling services for the oil and natural gas segment, we eliminated revenue of $22.5 million and $13.4 million during 2018 and 2017, respectively, from our contract drilling segment and eliminated the associated operating expense of $19.5 million and $11.8 million during 2018 and 2017, respectively, yielding $3.0 million and $1.6 million during 2018 and 2017, respectively, as a reduction to the carrying value of our oil and natural gas properties. We eliminated no revenue or expenses in our contract drilling segment during 2016. Mid-Stream Operations This segment is engaged primarily in the buying, selling, gathering, processing, and treating of natural gas. It operates three natural gas treatment plants, 14 processing plants, 22 gathering systems, and approximately 1,475 miles of pipeline. Its operations are in Oklahoma, Texas, Kansas, Pennsylvania, and West Virginia. This segment enhances our ability to gather and market not only our own natural gas and NGLs but also that owned by third parties and serves as a mechanism through which we can construct or acquire existing natural gas gathering and processing facilities. During 2018, 2017, and 2016 this segment purchased $81.4 million, $63.2 million, and $42.7 million, respectively, of our oil and natural gas segment's natural gas and NGLs production, and provided gathering and transportation services of $7.3 million, $6.7 million, and $9.2 million, respectively. Intercompany revenue from services and purchases of production between this business segment and our oil and natural gas segment has been eliminated in our consolidated financial statements. Our mid-stream segment gathered an average of 393,613 Mcf per day in 2018 compared to 385,209 Mcf per day in 2017 and 419,217 Mcf per day in 2016. It processed an average of 158,189 Mcf per day in 2018 compared to 137,625 Mcf per day in 2017 and 155,461 Mcf per day in 2016, and sold NGLs of 663,367 gallons per day in 2018 compared to 534,140 gallons per day in 2017 and 536,494 gallons per day in 2016. Gas gathering volumes per day in 2018 increased primarily due to higher volumes at our Cashion and Hemphill facilities. Volumes processed increased primarily due to connecting new wells to our processing systems in 2018. NGLs sold increased primarily due to higher purchased volumes and better recoveries at our processing facilities. At-the-Market (ATM) Common Stock Program On April 4, 2017, we entered into a Distribution Agreement (the Agreement) with a sales agent, under which we may offer and sell, from time to time, through the sales agent shares of our common stock, par value $0.20 per share (the Shares), up to an aggregate offering price of $100.0 million. We intended to use the net proceeds from these sales to fund (or offset costs of) acquisitions, future capital expenditures, repay amounts outstanding under our revolving credit facility, and general corporate purposes. On May 2, 2018, we terminated the Distribution Agreement. The Distribution Agreement was terminable at will on written notification by us with no penalty. As of the date of termination, we had sold 787,547 shares of our common stock under the Distribution Agreement resulting in net proceeds of approximately$18.6 million. We paid the sales agent a commission of 2.0% of the gross sales price per share sold. As a result of the termination, there will be no more sales of our common stock under the Distribution Agreement. Our Credit Agreements and Senior Subordinated Notes Unit Credit Agreement. On October 18, 2018, we signed a Fifth Amendment to our Senior Credit Agreement (Unit credit agreement) amending our existing credit agreement entered into between the Company and certain lenders on September 13, 2011, as amended September 5, 2012, as further amended April 10, 2015, as further amended on April 8, 2016, as further amended on April 2, 2018, attached as Exhibit 10.1 to the Company’s Current Report on Form 8-K filed on September 15, 2011, September 11, 2012, April 13, 2015, April 8, 2016, and April 6, 2018, respectively, and the Company’s Current Report on Form 8-K/A filed on April 13, 2016, and each incorporated by reference herein. The Fifth Amendment, among other things, (i) extends the term of the Unit credit agreement to October 18, 2023, subject to certain conditions; (ii) reduces the pricing for borrowing and non-use fees; and (iii) eliminates the requirement that the company maintain a senior indebtedness to consolidated EBITDA ratio. The total commitment of credit and the borrowing base both remain unchanged at $425.0 million. Under the Unit credit agreement, the amount we can borrow is the lesser of the amount we elect as the commitment amount or the value of the borrowing base as determined by the lenders, but in either event not to exceed the maximum credit agreement. We are charged a commitment fee of 0.375% on the amount available but not borrowed. That fee varies based on the amount borrowed as a percentage of the total borrowing base. Total amendment fees of $3.3 million in origination, agency, syndication, and other related fees are being amortized over the life of the Unit credit agreement. Under the Unit credit agreement, we have pledged as collateral 80% of the proved developed producing (discounted as present worth at 8%) total value of our oil and gas properties. On April 2, 2018, we signed the fourth amendment to the Unit credit agreement. The Fourth Amendment provided, among other things, for a reduction of the maximum credit amount from $875.0 million to $425.0 million, a reduction in the borrowing base from $475.0 million to $425.0 million, a reduction in the total commitment amount from $475.0 million to $425.0 million; and the full release of Superior and its subsidiaries as a borrower and co-obligor under the Unit credit agreement. Under the amendment once the sale of the interest in Superior was completed, we were required to us part of the proceeds to pay down the Unit credit agreement. The Superior sale closed on April 3, 2018 and the pay down was made that day. On May 2, 2018, as contemplated under the Fourth Amendment, we entered into a Pledge Agreement with BOKF, NA (dba Bank of Oklahoma), as administrative agent for the benefit of the secured parties, under which we granted a security interest in the limited liability membership interests and other equity interests we own in Superior (which as of the date of this report is 50% of the aggregate outstanding equity interests of Superior) as additional collateral for our obligations under the Unit credit agreement. The lenders under our Unit credit agreement and their respective participation interests are: The borrowing base amount-which is subject to redetermination by the lenders on April 1st and October 1st of each year-is based primarily on a percentage of the discounted future value of our oil and natural gas reserves. We or the lenders may request a one time special redetermination of the borrowing base between each scheduled redetermination. In addition, we may request a redetermination following the completion of an acquisition that meets the requirements in the Unit credit agreement. At our election, any part of the outstanding debt under the Unit credit agreement may be fixed at a London Interbank Offered Rate (LIBOR). LIBOR interest is computed as the sum of the LIBOR base for the applicable term plus 1.50% to 2.50% depending on the level of debt as a percentage of the borrowing base and is payable at the end of each term, or every 90 days, whichever is less. Borrowings not under LIBOR bear interest at the prime rate specified in the Unit credit agreement that cannot be less than LIBOR plus 1.00% plus a margin. Interest is payable at the end of each month and the principal may be repaid in whole or in part at any time, without a premium or penalty. At December 31, 2018, we had no outstanding borrowings. We can use borrowings for financing general working capital requirements for (a) exploration, development, production and acquisition of oil and gas properties, (b) acquisitions and operation of mid-stream assets, (c) issuance of standby letters of credit, (d) contract drilling services, and (e) general corporate purposes. The Unit credit agreement prohibits, among other things: •the payment of dividends (other than stock dividends) during any fiscal year over 30% of our consolidated net income for the preceding fiscal year; •the incurrence of additional debt with certain limited exceptions; •the creation or existence of mortgages or liens, other than those in the ordinary course of business, on any of our properties, except for our lenders; and •investments in Unrestricted Subsidiaries (as defined in the Unit credit agreement) over $200.0 million. The Unit credit agreement also requires that we have at the end of each quarter: •a current ratio (as defined in the Unit credit agreement) of not less than 1 to 1. •a leverage ratio of funded debt to consolidated EBITDA (as defined in the Unit credit agreement) for the most recently ended rolling four fiscal quarters of no greater than 4 to 1. As of December 31, 2018, we were in compliance with the covenants in the Unit credit agreement. Superior Credit Agreement. On May 10, 2018, Superior, a limited liability company equally owned between us and SP Investor Holdings, LLC, entered into a five-year, $200.0 million senior secured revolving credit facility with an option to increase the credit amount up to $250.0 million, subject to certain conditions. The amounts borrowed under the Superior credit agreement bear annual interest at a rate, at Superior’s option, equal to (a) LIBOR plus the applicable margin of 2.00% to 3.25% or (b) the alternate base rate (greater of (i) the federal funds rate plus 0.5%, (ii) the prime rate, and (iii) third day LIBOR plus 1.00%) plus the applicable margin of 1.00% to 2.25%. The obligations under the Superior credit agreement are secured by, among other things, mortgage liens on certain of Superior’s processing plants and gathering systems. Superior is charged a commitment fee of 0.375% on the amount available but not borrowed which varies based on the amount borrowed as a percentage of the total borrowing base. Superior paid $1.7 million in origination, agency, syndication, and other related fees. These fees are being amortized over the life of the Superior credit agreement. The Superior credit agreement requires that Superior maintain a Consolidated EBITDA to interest expense ratio for the most-recently ended rolling four quarters of at least 2.50 to 1.00, and a funded debt to Consolidated EBITDA ratio of not greater than 4.00 to 1.00. Additionally, the Superior credit agreement contains a number of customary covenants that, among other things, restrict (subject to certain exceptions) Superior’s ability to incur additional indebtedness, create additional liens on its assets, make investments, pay distributions, enter into sale and leaseback transactions, engage in certain transactions with affiliates, engage in mergers or consolidations, enter into hedging arrangements, and acquire or dispose of assets. As of December 31, 2018, Superior was in compliance with the Superior credit agreement covenants. The borrowings the Superior credit agreement will be used to fund capital expenditures and acquisitions, provide general working capital, and for letters of credit for Superior. On June 27, 2018, Superior and the lenders amended the Superior credit agreement to revise certain definitions in the agreement. Superior's credit agreement is not guaranteed by Unit. The current lenders under the Superior credit agreement and their respective participation interests are: 6.625% Senior Subordinated Notes. We have an aggregate principal amount of $650.0 million, 6.625% senior subordinated notes (the Notes). Interest on the Notes is payable semi-annually (in arrears) on May 15 and November 15 of each year. The Notes will mature on May 15, 2021. In issuing the Notes, we incurred $14.7 million of fees that are being amortized as debt issuance cost over the life of the Notes. The Notes are subject to an Indenture dated as of May 18, 2011, between us and Wilmington Trust, National Association (successor to Wilmington Trust FSB), as Trustee (the Trustee), as supplemented by the First Supplemental Indenture dated as of May 18, 2011, between us, the Guarantors, and the Trustee, and as further supplemented by the Second Supplemental Indenture dated as of January 7, 2013, between us, the Guarantors and the Trustee (as supplemented, the 2011 Indenture), establishing the terms and providing for issuing the Notes. The Guarantors are our direct and indirect subsidiaries. The discussion of the Notes in this report is qualified by and subject to the actual terms of the 2011 Indenture. Unit, as the parent company, has no independent assets or operations. The guarantees by the Guarantors of the Notes (registered under registration statements) are full and unconditional, joint and several, subject to certain automatic customary releases, are subject to certain restrictions on the sale, disposition, or transfer of the capital stock or substantially all of the assets of a subsidiary guarantor, and other conditions and terms set out in the Indenture. Any of our subsidiaries that are not Guarantors are minor. There are no significant restrictions on our ability to receive funds from our subsidiaries through dividends, loans, advances or otherwise. We may redeem all or, from time to time, a part of the Notes at certain redemption prices, plus accrued and unpaid interest. If a “change of control” occurs, subject to certain conditions, we must offer to repurchase from each holder all or any part of that holder’s Notes at a purchase price in cash equal to 101% of the principal amount of the Notes plus accrued and unpaid interest, if any, to the date of purchase. The 2011 Indenture contains customary events of default. The 2011 Indenture also contains covenants that, among other things, limit our ability and the ability of certain of our subsidiaries to incur or guarantee additional indebtedness; pay dividends on our capital stock or redeem capital stock or subordinated indebtedness; transfer or sell assets; make investments; incur liens; enter into transactions with our affiliates; and merge or consolidate with other companies. We were in compliance with all covenants of the Notes as of December 31, 2018. Capital Requirements Oil and Natural Gas Dispositions, Acquisitions, and Capital Expenditures. Most of our capital expenditures for this segment are discretionary and directed toward growth. Any decision to increase our oil, NGLs, and natural gas reserves through acquisitions or through drilling depends on the prevailing or expected market conditions, potential return on investment, future drilling potential, and opportunities to obtain financing, which provide us flexibility in deciding when and if to incur these costs. We completed drilling 117 gross wells (33.16 net wells) in 2018 compared to 70 gross wells (25.71 net wells) in 2017, and 21 gross wells (9.67 net wells) in 2016. On April 3, 2017, we closed an acquisition of certain oil and natural gas assets located primarily in Grady and Caddo Counties in western Oklahoma. The final adjusted value of consideration given was $54.3 million. As of January 1, 2017, the effective date of the acquisition, the estimated proved oil and gas reserves of the acquired properties were 3.2 million barrels of oil equivalent (MMBoe). The acquisition added approximately 8,300 net oil and gas leasehold acres to our core Hoxbar area in southwestern Oklahoma including approximately 47 proved developed producing wells. This acquisition included 13 potential horizontal drilling locations not otherwise included in our existing acreage. Of the acreage acquired, approximately 71% was held by production. We also received one gathering system as part of the transaction. In December 2018, we closed on an acquisition of certain oil and natural gas assets located primarily in Custer County, Oklahoma. The total preliminary adjusted value of consideration given was $29.6 million. As of November 1, 2018, the effective date of the acquisition, the estimated proved oil and gas reserves for the acquired properties was 2.6 MMBoe net to Unit. The acquisition added approximately 8,667 net oil and gas leasehold acres to our Penn Sands area in Oklahoma including approximately 44 wells. The acquisitions included approximately 30 potential horizontal drilling locations which are anticipated to have a high percentage of oil relative to the total production stream. Of the acreage acquired, approximately 82% was held by production. Capital expenditures for oil and gas properties on the full cost method for 2018 by this segment, excluding a $7.6 million reduction in the ARO liability and $30.7 million in acquisitions (including associated ARO), totaled $344.3 million compared to 2017 capital expenditures of $215.4 million (excluding a $4.0 million reduction in the ARO liability and $59.0 million in acquisitions), and 2016 capital expenditures of $119.9 million (excluding an $30.9 million reduction in the ARO liability and $0.6 million in acquisitions). For 2019, we plan to participate in drilling approximately 90 to 100 gross wells and estimate our total capital expenditures (excluding any possible acquisitions) for our oil and natural gas segment will range from approximately $271.0 million to $315.0 million. Whether we drill all of those wells depends on several factors, many of which are beyond our control and include the availability of drilling rigs, availability of pressure pumping services, prices for oil, NGLs, and natural gas, demand for oil, NGLs, and natural gas, the cost to drill wells, the weather, and the efforts of outside industry partners. We sold non-core oil and natural gas assets, net of related expenses, for $22.5 million, $18.6 million, and $67.2 million during 2018, 2017, and 2016, respectively. Proceeds from those dispositions reduced the net book value of our full cost pool with no gain or loss recognized. Contract Drilling Dispositions, Acquisitions, and Capital Expenditures. During December 2016, we sold an idle 1500 HP SCR drilling rig to an unaffiliated third party. We also fabricated and placed into service our ninth new BOSS drilling rig for a third party operator. This new BOSS rig was constructed using the long lead time components purchased in prior years. During 2017, we built our tenth BOSS drilling rig and placed it into service for a third party operator under a long term contract. We also returned to service 14 SCR drilling rigs that had been previously stacked. During 2018, we built our 11th BOSS drilling and placed it into service for a third party operator under a long term contract. We also made modifications to nine SCR rigs to meet customer requirements. In December 2018, our Board of Directors approved a plan to sell 41 drilling rigs (29 mechanical drilling rigs and 12 SCR diesel-electric drilling rigs) and other equipment. This plan satisfies the criteria of assets held for sale under ASC 360-10-45-9. Over the last five years, only six of our drilling rigs in the fleet have not been utilized. We made a strategic decision to focus on our new BOSS drilling rigs and specific SCR drilling rigs (good candidates for modification) and sell the other drilling rigs that we now choose not to market. We estimated the fair value of the 41 drilling rigs we will no longer market based on the estimated market value from third-party assessments (Level 3 fair value measurement) less cost to sell. Based on these estimates, we recorded a non-cash write-down of approximately $147.9 million, pre-tax ($111.7 million, net of tax). Our anticipated 2019 capital expenditures for this segment range from approximately $30.0 million to $65.0 million. We spent $75.5 million for capital expenditures during 2018 compared to $36.1 million in 2017, and $19.1 million in 2016. Mid-Stream Dispositions, Acquisitions, and Capital Expenditures. In the Appalachian region at the Pittsburgh Mills gathering system, average gathered volume for the fourth quarter of 2018 was approximately 129.7 MMcf per day and the annual average gathered volume was 123.9 MMcf per day. In 2018, we added seven new infill wells late in the second quarter and all the new infill wells are currently online and flowing gas. We have completed construction of the new pipeline to connect the next scheduled well pad to our system. We have also completed the upgrade of the compressor station and dehydration facilities. Production from this new pad started online during January 2019. At the Hemphill Texas system, average total throughput volume for the fourth quarter of 2018 increased to 75.3 MMcf per day and total production of natural gas liquids was approximately 301,500 gallons per day during this same period. The annual average throughput volume was 72.6 MMcf per day while the annual total production of natural gas liquids averaged 264,971 gallons per day. During the fourth quarter, we connected five new wells in the Buffalo Wallow area. These new wells along with increased production from recently drilled wells in this area contributed to the increased throughput volume. Our oil and gas segment continues to operate a rig in the Buffalo Wallow area and we anticipate connecting additional wells to this system in 2019. At the Cashion processing facility in central Oklahoma, total throughput volume for the fourth quarter of 2018 averaged approximately 49.2 MMcf per day and total production of natural gas liquids increased to 246,873 gallons per day. The annual average throughput volume was 46.0 MMcf per day and the annual average natural gas liquids production was 234,316 gallons per day. This system is currently operating at full processing capacity and we are adding additional capacity to this system. We are relocating a 60 MMcf per day processing plant from our Bellmon facility to the Cashion area. This processing plant will be installed at the Reeding site on the Cashion system. This plant is expected to be operational by the end of the first quarter of 2019 and it will increase our total processing capacity on the Cashion system to approximately 105 MMcf per day. We connected eight new wells to this system during the fourth quarter of 2018 and we are continuing to connect additional wells from a third party producer who continues to be active in this area. At the Minco processing facility in central Oklahoma, total throughput volume for the fourth quarter of 2018 was approximately 8.0 MMcf per day and the average annual total throughput volume was 9.5 MMcf per day. During the fourth quarter of 2018 we completed a new interconnect with a producer who is currently delivering gas to our system. Additionally, we are completing construction of a new well connect for a third party producer who is expected to deliver gas to our system in 2019. The current processing capacity of the Minco facility is approximately 12 MMcf per day. During 2018, our mid-stream segment incurred $44.8 million in capital expenditures as compared to $22.2 million in 2017, and $16.8 million, in 2016. For 2019, our estimated capital expenditures range from approximately $35.0 million to $42.0 million. Contractual Commitments At December 31, 2018, we had these contractual obligations: _________________________ 1.See previous discussion in MD&A regarding our long-term debt. This obligation is presented under the Notes and the Unit and Superior credit agreements and includes interest calculated using our December 31, 2018 interest rates of 6.625% for the Notes. The outstanding Unit credit facility balance was paid down on April 3, 2018, and as of December 31, 2018, we did not have any outstanding borrowings. 2.We lease office space or yards in Edmond and Oklahoma City, Oklahoma; Houston, Texas; Englewood, Colorado; Pinedale, Wyoming; and Canonsburg, Pennsylvania under the terms of operating leases expiring through December 2021. And, we have several equipment leases and lease space on short-term commitments to stack excess drilling rig equipment and production inventory. 3.Maintenance and interest payments are included in our capital lease agreements. The capital leases are discounted using annual rates of 4.0%. Total maintenance and interest remaining are $4.1 million and $0.6 million, respectively. 4.We have committed to purchase approximately $9.2 million of new drilling rig components over the next year. During the second quarter of 2018, we entered into a contractual obligation that commits us to spend $150.0 million for drilling wells in the Granite Wash/Buffalo Wallow area over the next three years starting January 1, 2019. This amount is already included in our drilling plan. For each dollar of the $150.0 million that we do not spend (over the three year period), we would forgo receiving $0.58 of future distributions from our 50% ownership interest in our consolidated mid-stream subsidiary. If we elected not to drill or spend any money in the designated area over the three year period, the maximum amount we could forgo from distributions would be $87.0 million. At December 31, 2018, we also had these commitments and contingencies that could create, increase or accelerate our liabilities: _________________________ 1.We provide a salary deferral plan which allows participants to defer the recognition of salary for income tax purposes until actual distribution of benefits, which occurs at either termination of employment, death or certain defined unforeseeable emergency hardships. We recognize payroll expense and record a liability, included in other long-term liabilities in our Consolidated Balance Sheets, at the time of deferral. 2.Effective January 1, 1997, we adopted a separation benefit plan (Separation Plan). The Separation Plan allows eligible employees whose employment with us is involuntarily terminated or with an employee who has completed 20 years of service, voluntarily or involuntarily terminated, to receive benefits equivalent to four weeks salary for every whole year of service completed with the company up to a maximum of 104 weeks. To receive payments the recipient must waive certain claims against us in exchange for receiving the separation benefits. On October 28, 1997, we adopted a Separation Benefit Plan for Senior Management (Senior Plan). The Senior Plan provides certain officers and key executives of the company with benefits generally equivalent to the Separation Plan. The Compensation Committee of the Board of Directors has absolute discretion in the selection of the individuals covered in this plan. On May 5, 2004 we also adopted the Special Separation Benefit Plan (Special Plan). This plan is identical to the Separation Benefit Plan with the exception that the benefits under the plan vest on the earliest of a participant’s reaching the age of 65 or serving 20 years with the company. 3.When a well is drilled or acquired, under ASC 410 “Accounting for Asset Retirement Obligations,” we record the fair value of liabilities associated with the retirement of long-lived assets (mainly plugging and abandonment costs for our depleted wells). 4.We have recorded a liability for those properties we believe do not have sufficient oil, NGLs, and natural gas reserves to allow the under-produced owners to recover their under-production from future production volumes. 5.We formed The Unit 1984 Oil and Gas Limited Partnership and the 1986 Energy Income Limited Partnership along with private limited partnerships (the Partnerships) with certain qualified employees, officers and directors from 1984 through 2011. One of our subsidiaries serves as the general partner of each of these programs. Effective December 31, 2014, the 1984 partnership was dissolved and effective December 31, 2016, the two 1986 partnerships were also dissolved. The Partnerships were formed to conduct oil and natural gas acquisition, drilling and development operations and serving as co-general partner with us in any additional limited partnerships formed during that year. The Partnerships participated on a proportionate basis with us in most drilling operations and most producing property acquisitions commenced by us for our own account during the period from the formation of the Partnership through December 31 of that year. These partnership agreements require, on the election of a limited partner, that we repurchase the limited partner’s interest at amounts to be determined by appraisal in the future. Repurchases in any one year are limited to 20% of the units outstanding. We made repurchases of approximately $1,700, $2,900, and $5,000 in 2018, 2017, and 2016, respectively. Effective January 1, 2019, we elected to terminate and wind down all of the remaining employee limited partnerships. In accordance with the partnership agreements, we, as the liquidating trustees will value the interests of the limited partners using the formula provided in each partnership agreement and purchase those interests. Presently, we expect the total purchase price for all of the limited partners interests will be approximately $0.6 million. We have no plans to sponsor additional employee limited partnerships. 6.We have recorded a liability for future estimated payments related to workers’ compensation claims primarily associated with our contract drilling segment. 7.This amount includes commitments under capital lease arrangements for compressors in our mid-stream segment. 8.We have recorded a liability related to the timing of the revenue recognized on certain demand fees for Superior. Derivative Activities Periodically we enter into derivative transactions locking in the prices to be received for a portion of our oil, NGLs, and natural gas production. Any change in the fair value of all our derivatives are reflected in the statement of operations. Commodity Derivatives. Our commodity derivatives should reduce our exposure to price volatility and manage price risks. Our decision on the type and quantity of our production and the price(s) of our derivative(s) is based, in part, on our view of current and future market conditions. As of December 31, 2018, based on our fourth quarter 2018 average daily production, the approximated percentages of our production under derivative contracts are as follows: Regarding the commodities subject to derivative contracts, those contracts limit the risk of adverse downward price movements. However, they also limit increases in future revenues that would otherwise result from price movements above the contracted prices. Using derivative transactions has the risk that the counterparties may not meet their financial obligations under the transactions. Based on our evaluation at December 31, 2018, we believe the risk of non-performance by our counterparties is not material. At December 31, 2018, the fair values of the net assets we had with each of the counterparties to our commodity derivative transactions are: If a legal right of set-off exists, we net the value of the derivative arrangements we have with the same counterparty in our Consolidated Balance Sheets. At December 31, 2018, we recorded the fair value of our commodity derivatives on our balance sheet as current derivative assets of $12.9 million and long-term derivative liabilities of $0.3 million. At December 31, 2017, we recorded the fair value of our commodity derivatives on our balance sheet as current derivative assets of $0.7 million and current derivative liabilities of $7.8 million. All derivatives are recognized on the balance sheet and measured at fair value. Any changes in our derivatives' fair value before their maturity (i.e., temporary fluctuations in value) are reported in gain (loss) on derivatives in our Consolidated Statements of Operations. These gains (losses) are as follows at December 31: Stock and Incentive Compensation During 2018, we granted awards covering 1,279,255 shares of restricted stock. These awards were granted as retention incentive awards. These stock awards had an estimated fair value as of the grant date of $24.7 million. Compensation expense will be recognized over the awards' three year vesting period. During 2018, we recognized $9.4 million in additional compensation expense and capitalized $1.4 million for these awards. During 2017, we granted awards covering 708,276 shares of restricted stock. These awards were granted as retention incentive awards and are being recognized over the awards' three year vesting period. During 2016, we granted awards covering 736,451 shares of restricted stock. These awards were granted as retention incentive awards and are being recognized over their two and three year vesting periods. No SAR awards were made during 2018, 2017, or 2016. During 2018, we recognized compensation expense of $17.8 million for our restricted stock grants and capitalized $2.1 million of compensation cost for oil and natural gas properties. Insurance We are self-insured for certain losses relating to workers’ compensation, general liability, control of well, and employee medical benefits. Insured policies for other coverage contain deductibles or retentions per occurrence that range from zero to $1.0 million. We have purchased stop-loss coverage to limit, to the extent feasible, per occurrence and aggregate exposure to certain types of claims. There is no assurance that the insurance coverage we have will protect us against liability from all potential consequences. If insurance coverage becomes more expensive, we may choose to self-insure, decrease our limits, raise our deductibles, or any combination of these rather than pay higher premiums. Oil and Natural Gas Limited Partnerships and Other Entity Relationships. We are the general partner of 13 oil and natural gas partnerships formed privately or publicly. Each partnership’s revenues and costs are shared under formulas set out in that partnership’s agreement. The partnerships repay us for contract drilling, well supervision and general and administrative expense. Related party transactions for contract drilling and well supervision fees are the related party’s share of such costs. These costs are billed the same as billings to unrelated third parties for similar services. General and administrative reimbursements consist of direct general and administrative expense incurred on the related party’s behalf and indirect expenses assigned to the related parties. Allocations are based on the related party’s level of activity and are considered by us to be reasonable. During 2018, 2017, and 2016, the total we received for these fees was $0.2 million, $0.2 million, and $0.3 million, respectively. Our proportionate share of assets, liabilities, and net income relating to the oil and natural gas partnerships is included in our consolidated financial statements. These partnerships will be terminated in 2019. Effects of Inflation The effect of inflation in the oil and natural gas industry is primarily driven by the prices for oil, NGLs, and natural gas. Increases in these prices increase the demand for our contract drilling rigs and services. This increase in demand affects the dayrates we can obtain for our contract drilling services. During periods of higher demand for our drilling rigs we have experienced increases in labor costs and the costs of services to support our drilling rigs. Historically, during this same period, when oil, NGLs, and natural gas prices declined, labor rates did not come back down to the levels existing before the increases. If commodity prices increase substantially for a long period, shortages in support equipment (like drill pipe, third party services, and qualified labor) can cause additional increases in our material and labor costs. Increases in dayrates for drilling rigs also increase the cost of our oil and natural gas properties. Commodity prices also can affect our fracking and completion costs. How inflation will affect us in the future will depend on increases, if any, realized in our drilling rig rates, the prices we receive for our oil, NGLs, and natural gas, and the rates we receive for gathering and processing natural gas. Due to increased demand for drilling rigs and the need to maintain qualified labor, we increased pay for some of our drilling personnel in the first quarter of 2018. Off-Balance Sheet Arrangements We do not currently utilize any off-balance sheet arrangements with unconsolidated entities to enhance liquidity and capital resource positions, or for any other purpose. However, as is customary in the oil and gas industry, we are subject to various contractual commitments. Results of Operations 2018 versus 2017 Oil and Natural Gas Oil and natural gas revenues increased $65.3 million or 18% in 2018 as compared to 2017 due primarily to higher oil and NGLs prices and higher production. Oil production increased 6%, NGLs production increased 4%, and natural gas production increased 9%. Average oil prices between the comparative years increased 13% to $55.78 per barrel, NGLs prices increased 21% to $22.18 per barrel, and natural gas prices remained at $2.46 per Mcf. Oil and natural gas operating costs increased $0.9 million or 1% between the comparative years of 2018 and 2017 primarily due to higher LOE, gross production taxes, general and administrative expenses, and saltwater disposal expense, partially offset by less expenses due to certain deductions being netted in revenues after ASC 606 implementation in 2018. DD&A increased $31.7 million or 31% primarily due to a 25% increase in our DD&A rate and by the effect of a 7% increase in equivalent production. The increase in our DD&A rate in 2018 compared to 2017 resulted primarily from the cost of wells drilled in 2018. Contract Drilling Drilling revenues increased $21.8 million or 12% in 2018 as compared to 2017. The increase was due primarily to a 9% increase in the average number of drilling rigs in use and an 8% increase in the average dayrate compared to 2017. Average drilling rig utilization increased from 30.0 drilling rigs in 2017 to 32.8 drilling rigs in 2018. Drilling operating costs increased $8.8 million or 7% in 2018 compared to 2017. The increase was due primarily to more drilling rigs operating and to a less extent from increased per day direct cost. Contract drilling depreciation increased $1.1 million or 2% also due primarily to more drilling rigs operating and the acceleration of depreciation on drilling rigs stacked for more than 48 months. In December 2018, our Board of Directors approved a plan to sell 41 drilling rigs (29 mechanical drilling rigs and 12 SCR diesel-electric drilling rigs) and other equipment. This plan satisfies the criteria of assets held for sale under ASC 360-10-45-9. Over the last five years, only six of our drilling rigs in the fleet have not been utilized. We made a strategic decision to focus on our new BOSS drilling rigs and specific SCR drilling rigs (good candidates for modification) and sell the other drilling rigs that we now choose not to market. We estimated the fair value of the 41 drilling rigs we will no longer market based on the estimated market value from third-party assessments (Level 3 fair value measurement) less cost to sell. Based on these estimates, we recorded a non-cash write-down of approximately $147.9 million, pre-tax ($111.7 million, net of tax). Mid-Stream Our mid-stream revenues increased $16.6 million or 8% in 2018 as compared to 2017 primarily due to increased NGLs and condensate sales partially offset by lower gas sales, transportation revenue, and increased intercompany eliminations. Gas processing volumes per day increased 15% between the comparative years primarily due to connecting new wells to our processing systems. Gas gathering volumes per day increased 2% primarily due to connecting new wells at several of our gathering and processing systems. Operating costs increased $12.4 million or 8% in 2018 compared to 2017 primarily due to an increase in purchased volume along with an increase in purchase prices combined with increased mid-stream direct G&A and field direct expenses partially offset by increased intercompany eliminations. Depreciation and amortization increased $1.3 million or 3% primarily due to placing additional capital assets into service in 2018. General and Administrative General and administrative expenses increased $0.6 million or 2% in 2018 compared to 2017 primarily due to higher employee costs. Other Depreciation Other depreciation increased $0.2 million in 2018 compared to 2017 primarily due to the depreciation on the new ERP system. Gain on Disposition of Assets Gain on disposition of assets increased $0.4 million in 2018 compared to 2017. The gain in 2018 was primarily for the sale of drilling equipment and vehicles, while gain in 2017 was primarily for the sale of a corporate aircraft and vehicles. Other Income (Expense) Interest expense, net of capitalized interest, decreased $3.9 million between the comparative years of 2018 and 2017. We capitalized interest based on the net book value associated with unproved properties not being amortized, the construction of additional drilling rigs, and the construction of gas gathering systems. Capitalized interest for 2018 was $16.5 million compared to $15.9 million in 2017, and was netted against our gross interest of $51.0 million and $54.2 million for 2018 and 2017, respectively. Our average interest rate increased from 6.0% to 6.5% and our average debt outstanding was $125.4 million lower in 2018 as compared to 2017 primarily due to the pay down of our Unit credit agreement in the second quarter of 2018. We had interest earned of $1.0 million from the excess cash in our investment accounts from the sale of 50% of Superior. Gain (loss) on derivatives decreased from a gain of $14.7 million in 2017 to a loss of $3.2 million in 2018 primarily due to fluctuations in forward prices used to estimate the fair value in mark-to-market accounting. Income Tax Benefit Income tax benefit decreased $43.7 million in 2018 compared to 2017. We recognized an income tax benefit of $14.0 million in 2018 compared to an income tax benefit of $57.7 million in 2017. The 2017 benefit was due to the revaluation of our net deferred tax liability in connection with the enactment of the Tax Cuts and Jobs Act (the Tax Act) in December 2017 which resulted in an $81.3 million reduction in our deferred liability. Taxable income before the impairment was higher in 2018 resulting in higher tax netted against the $111.7 tax benefit from the impairment. Our effective tax rate was 26.0% for 2018 compared to 95.9% for 2017. The effective tax rate for the current year was more normalized as compared to 2017 because of the negative rate resulting from enactment of the Tax Act and revaluation of our net deferred tax liability during 2017. We paid $3.6 million in state income taxes during 2018 due to the sale of 50% interest in our mid-stream segment. 2017 versus 2016 _________________________ 1.NM - A percentage calculation is not meaningful due to a zero-value denominator or a percentage change greater than 200. Oil and Natural Gas Oil and natural gas revenues increased $63.5 million or 22% in 2017 as compared to 2016 due primarily to higher commodity prices partially offset by a decrease in production. Oil production decreased 9%, NGLs production decreased 6%, and natural gas production decreased 8%. Average oil prices between the comparative years increased 22% to $49.44 per barrel, NGLs prices increased 63% to $18.35 per barrel, and natural gas prices increased 19% to $2.46 per Mcf. Oil and natural gas operating costs increased $10.6 million or 9% between the comparative years of 2017 and 2016 primarily due to higher LOE and gross production taxes partially offset by lower saltwater disposal expense. DD&A decreased $11.9 million or 10% primarily due to a 4% decrease in our DD&A rate and by the effect of a 7% decrease in equivalent production. The decrease in our DD&A rate in 2017 compared to 2016 resulted primarily from the effect of the ceiling test write-downs throughout 2016. Our DD&A expense on our oil and natural properties is calculated each quarter using period end reserve quantities adjusted for period production. During 2016, we recorded non-cash ceiling test write-downs of our oil and natural gas properties totaling $161.6 million pre-tax ($100.6 million net of tax). We did not have a non-cash ceiling test write-down in 2017. The write-downs were due primarily from the reduction of the 12-month average commodity prices during 2016. Contract Drilling Drilling revenues increased $52.6 million or 43% in 2017 as compared to 2016. The increase was due primarily to a 72% increase in the average number of drilling rigs in use partially offset by a 9% decrease in the average dayrate compared to 2016. Average drilling rig utilization increased from 17.4 drilling rigs in 2016 to 30.0 drilling rigs in 2017. Drilling operating costs increased $34.4 million or 39% in 2017 compared to 2016. The increase was due primarily to more drilling rigs operating. Contract drilling depreciation increased $9.4 million or 20% also due primarily to more drilling rigs operating. Mid-Stream Our mid-stream revenues increased $21.3 million or 11% in 2017 as compared to 2016 primarily due to increased NGLs and condensate sales. Gas processing volumes per day decreased 11% between the comparative years primarily due to fewer new well connections to our processing systems. Gas gathering volumes per day decreased 8% primarily due to declining volumes in the Appalachian region. Operating costs increased $17.9 million or 13% in 2017 compared to 2016 primarily due to increased natural gas, NGLs, and condensate prices. Depreciation and amortization decreased $2.2 million or 5% primarily due to less capital expenditures this year while older assets became fully depreciated. General and Administrative General and administrative expenses increased $4.8 million or 14% in 2017 compared to 2016 primarily due to higher employee costs. Other Depreciation Other depreciation increased $5.6 million in 2017 compared to 2016 primarily due to the depreciation on the new ERP system and the corporate office facility. Gain on Disposition of Assets Gain on disposition of assets decreased $2.2 million in 2017 compared to 2016. The gain in 2017 was primarily for the sale of a corporate aircraft and vehicles, while the pre-tax gain of $3.2 million in 2016 was primarily for the sale of one drilling rig, various drilling rig components, vehicles, and other equipment somewhat offset by losses from our oil and natural gas and mid-stream segments in 2016. Other Income (Expense) Interest expense, net of capitalized interest, decreased $1.5 million between the comparative years of 2017 and 2016. We capitalized interest based on the net book value associated with unproved properties not being amortized, the construction of additional drilling rigs, and the construction of gas gathering systems. Capitalized interest for 2017 was $15.9 million compared to $15.3 million in 2016, and was netted against our gross interest of $54.2 million and $55.1 million for 2017 and 2016, respectively. Our average interest rate increased from 5.7% to 6.0% and our average debt outstanding was $57.6 million lower in 2017 as compared to 2016 primarily due to the decrease in our outstanding borrowings under the Unit credit agreement over the comparative periods. Gain (loss) on derivatives increased from a loss of $22.8 million in 2016 to a gain of $14.7 million in 2017 primarily due to fluctuations in forward prices used to estimate the fair value in mark-to-market accounting. Income Tax Benefit Income tax benefit decreased $13.5 million in 2017 compared to 2016. During the fourth quarter of 2017, the U.S. government enacted the Tax Cuts and Jobs Act (the Tax Act). Among other provisions, the Tax Act reduces the federal corporate tax rate from the existing maximum rate of 35% to 21%, effective January 1, 2018. As a result of the Tax Act, the Company recorded a tax benefit of $81.3 million due to a revaluation of our net deferred tax liability. Without this income tax benefit charge, income tax expense would have been $23.6 million in 2017 compared to an income tax benefit of $71.2 million in 2016 or an increase of $94.8 million which is commensurate with the increase in pre-tax income for 2017 compared to 2016. Our effective tax rate was (95.9%) for 2017 compared to 34.4% for 2016. The effective tax rate for the current year was dramatically lower due to the Tax Act and revaluation of our net deferred tax liability. Without the $81.3 million income tax benefit, our effective tax rate for 2017 would have been 39.3%. The rate change without consideration of deferred tax liability revaluation was primarily due to increased deferred income tax expense related to our restricted stock vestings in both years whereby the increase in 2017 increased our deferred income tax expense and the increase in 2016 decreased our income tax benefit. We did not pay any income taxes during 2017.

<s>[INST] General We were founded in 1963 as a contract drilling company. Today, we operate, manage, and analyze our results of operations through our three principal business segments: Oil and Natural Gas carried out by our subsidiary Unit Petroleum Company. This segment explores, develops, acquires, and produces oil and natural gas properties for our own account. Contract Drilling carried out by our subsidiary Unit Drilling Company. This segment contracts to drill onshore oil and natural gas wells for others and for our own account. MidStream carried out by our subsidiary Superior Pipeline Company, L.L.C. and its subsidiaries. This segment buys, sells, gathers, processes, and treats natural gas for third parties and for our own account. We own 50% of this subsidiary. Business Outlook As discussed in other parts of this report, our success depends, to a large degree, on the prices we receive for our oil and natural gas production, the demand for oil, natural gas, and NGLs, and the demand for our drilling rigs which influences the amounts we can charge for those drilling rigs. While our operations are all within the United States, events outside the United States affect us and our industry. Fluctuating commodity prices can result in significant changes to our industry and us. Depressed commodity prices, particularly for the extended time, can result in industry wide reductions in drilling activity and spending which reduce the rates for and the number of our drilling rigs we were able to put to work. Such industry wide reductions in drilling activity and spending for extended periods also reduces the rates for and the number of our drilling rigs we can work. In addition, sustained lower commodity prices impact the liquidity condition of some of our industry partners and customers, which could limit their ability to meet their financial obligations to us. During the last three years, commodity prices have been volatile. Late in 2016, commodity prices improved over 2015. In the fourth quarter of 2016, our oil and natural gas segment began using two of our drilling rigs and used two to three drilling rigs throughout 2017. With improved commodity prices during the first quarter of 2018, our oil and natural gas segment put four of our drilling rigs to work and increased the number to six drilling rigs for a brief period during the third quarter of 2018. We have subsequently reduced our operated rig count. The following chart reflects the significant fluctuations in the prices for oil and natural gas: We incurred noncash ceiling test writedowns in the first nine months of 2016 totaling $161.6 million ($100.6 million, net of tax). We had no writedowns in 2017 or 2018. It is hard to predict with any reasonable certainty the need for or amount of any future impairments given the many factors that go into the ceiling test calculation including, future pricing, operating costs, drilling and completion costs, upward or downward oil and gas reserve revisions, oil and gas reserve additions, and tax attributes. Subject to these inherent uncertainties, if we hold these same factors constant as they existed at December 31, 2018, and only adjust the 12month average price to an estimated first quarter ending average (holding February 2019 prices constant for the remaining one month of the first quarter of 2019), our forward looking expectation is that we will not recognize an impairment in the first quarter of 2019. But commodity prices (and other factors) remain volatile and they could negatively affect the 12month average price resulting in the potential for a future impairment. The number of gross wells our oil and gas segment drilled in 2018 verses 2017 increased from 70 wells to 117 wells due to increased cash flow. For 2019, we plan to decrease the number of gross wells drilled to 90100 wells (depending on future commodity prices). Our contract drilling segment completed the construction of three additional BOSS drilling rigs between the fourth quarter of 2016 and the third quarter of 2018. During the second quarter and third quarter of 20 [/INST] Negative. </s>

UNIT CORP

2020-03-16

2019-12-31

Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations Please read this discussion of our financial condition and results of operations with the consolidated financial statements and related notes in Item 8 of this report. For discussion related to changes in financial condition and results of operations for 2018 as compared with 2017, refer to Part II, Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations in our 2018 Form 10-K, which was filed with the SEC on February 26, 2019. General We were founded in 1963 as a contract drilling company. Today, we operate, manage, and analyze our results of operations through our three principal business segments: •Oil and Natural Gas - carried out by our subsidiary Unit Petroleum Company. This segment explores, develops, acquires, and produces oil and natural gas properties for our own account. •Contract Drilling - carried out by our subsidiary Unit Drilling Company. This segment contracts to drill onshore oil and natural gas wells for others and for our own account. •Mid-Stream - carried out by our subsidiary Superior Pipeline Company, L.L.C. and its subsidiaries. This segment buys, sells, gathers, processes, and treats natural gas for third parties and for our own account. We own 50% of this subsidiary. Business Outlook As discussed in other parts of this report, among other things, our success depends, to a large degree, on the prices we receive for our oil and natural gas production, the demand for oil, natural gas, and NGLs, and the demand for our drilling rigs which influences the amounts we can charge for those drilling rigs. While our operations are all within the United States, events outside the United States affect us and our industry. On March 9, 2020, the price of oil fell approximately 20% due to a dispute over production levels between Russia and Saudi Arabia, as a result of which Saudi Arabia increased its production to record levels. We cannot anticipate whether or when this dispute will be resolved and production returned to normalized levels. In the absence of a resolution, oil prices could remain at current levels, or decline further, for an extended period of time. As a result of record commodity price declines and our substantial debt burden, we do not believe that forecasted cash and available credit capacity will be sufficient to meet commitments as they come due over the next twelve months. Our ability to continue as a going concern is dependent on our ability to refinance our debt liability that is coming due. These factors, among others, raise substantial doubt about our ability to continue as a going concern. Our consolidated financial statements do not include any adjustments that might result from the outcome of this uncertainty. We cannot assure you that we will be successful in our efforts to generate revenues, become profitable, raise additional outside capital or to continue as a going concern. If we are not successful in our efforts to raise additional capital or to restructure our capital structure sufficient to support our operations, we would be unlikely to be able to raise capital in the near term and may be forced to seek protection under Chapter 11. In an effort to address these circumstances, we sought to extend the maturity profile of our debt through the Exchange Offer. However, we have been advised by certain holders of a large percentage of our outstanding senior subordinated notes that they do not intend to participate in the Exchange Offer, which raises doubts regarding our ability to complete the Exchange Offer and increases the likelihood we may need to seek protection under Chapter 11. Fluctuating commodity prices can result in significant changes to our industry and us. Depressed commodity prices, particularly for the extended time, can result in industry wide reductions in drilling activity and spending which reduce the rates for and the number of our drilling rigs we were able to put to work. Such industry wide reductions in drilling activity and spending for extended periods also reduces the rates for and the number of our drilling rigs we can work. In addition, sustained lower commodity prices impact the liquidity condition of some of our industry partners and customers, which could limit their ability to meet their financial obligations to us. During the last three years, commodity prices have been volatile. Our oil and natural gas segment used two to three drilling rigs throughout 2017. With improved commodity prices during the first quarter of 2018, our oil and natural gas segment put four of our drilling rigs to work and increased the number to six drilling rigs for a brief period during the third quarter of 2018. We have subsequently reduced our operated rig count in the fourth quarter of 2018 and the first quarter of 2019 before getting as high as six drilling rigs again in the second quarter of 2019. Due to declining prices we shut down our drilling program in July and did not use any drilling rigs the remainder of the year. The following chart reflects the significant fluctuations in the prices for oil and natural gas: The following chart reflects the significant fluctuations in the prices for NGLs: _________________________ 1.NGLs prices reflect a weighted-average, based on production, of Mont Belvieu and Conway prices. Commodity prices have continued to decline into the first quarter of 2020. As of March 11, 2020, crude oil WTI was $32.98 per BBl, natural gas Henry Hub was $1.88 per MMBtu, ethane was $5.87 per Bbl, propane was $13.05 per Bbl, and condensate was $14.50 per Bbl. In 2019, we incurred non-cash ceiling test write-downs of our oil and natural gas properties of $559.4 million pre-tax ($422.4 million net of tax). We anticipate a non-cash ceiling test write-down in the first quarter of 2020 and future quarters. It is hard to predict with any reasonable certainty the need for or amount of any future impairments given the many factors that go into the ceiling test calculation including, future pricing, operating costs, drilling and completion costs, upward or downward oil and gas reserve revisions, oil and gas reserve additions, and tax attributes. Subject to these inherent uncertainties, if we hold these same factors constant as they existed at December 31, 2019, and only adjust the 12-month average price to a first quarter ending average, our forward looking expectation is that we would recognize an impairment of $62 million pre-tax in the first quarter of 2020. The actual amount of any write-down may vary significantly from this estimate depending on the final future determination. The number of gross wells our oil and gas segment drilled in 2019 verses 2018 decreased from 117 wells to 115 wells. For 2020, we do not currently have any plans to drill wells pending our ability to refinance our debt. Our contract drilling segment completed the construction of three additional BOSS drilling rigs between the fourth quarter of 2016 and the third quarter of 2018. During the second quarter and third quarter of 2018, we were awarded term contracts to build our 12th and 13th BOSS drilling rigs. Construction was completed for one of these in January of 2019 and it was placed into service for a third-party operator. The other contract was terminated but we were able to find another third-party operator and the 13th BOSS drilling rig was placed into service in February of 2019. In the second half of 2019, we constructed the 14th BOSS drilling rig and it was placed into service in December 2019. Rig utilization fluctuated over the past year due to commodity prices changing and budget constraints on operators. We expect commodity prices and budget constraints on operators to continue to affect rig utilization throughout 2020. As of December 31, 2017, we had 31 drilling rigs operating. During 2018, utilization increased from 31 to a high of 36 drilling rigs and with a decline in commodity prices during the fourth quarter, declined to 32 drilling rigs as of December 31, 2018 and continued to decline to 20 drilling rigs as of December 31, 2019. As of December 31, 2019, all fourteen of our BOSS drilling rigs were operating. During 2019, due to low ethane and residue prices, we operated some of our mid-stream processing facilities in ethane rejection mode which reduces the liquids sold. We are continuing to monitor commodity prices to determine the most economical method in which to operate our processing facilities. Going Concern As a result of the sustained commodity price decline and our substantial debt burden, we do not believe that we will be able to satisfy our commitments and debt repayments over the next twelve months. This conclusion is based on the following principal conditions which are explained in further detail below. •Inability to meet anticipated commitments due to recurring losses, negative working capital and limited access to liquidity. •A forecasted covenant violation of the Unit credit agreement for the quarter ending June 30, 2020. •The expected acceleration of the amounts outstanding under the Unit credit agreement from October 18, 2023 to November 16, 2020. The company has incurred significant losses and is in a negative working capital position at December 31, 2019. Additionally, our cash balance as of December 31, 2019 was $0.6 million and, effective January 17, 2020, the company’s borrowing base under the Unit credit facility was reduced to $200.0 million of which $108.2 million has been borrowed. On March 11, 2020, the Company entered into a Standstill agreement with regards to the Unit credit facility which delays the scheduled borrowing base redetermination date for the facility from April 1, 2020 to April 15, 2020. Once the borrowing base is redetermined, the company anticipates that the borrowing base will be further reduced, potentially below the current amount outstanding under the credit facility. Such a reduction would prevent the company from further accessing the facility. Additionally, under the Standstill agreement, the company is prevented from withdrawing more than an additional $15.0 million between March 11, 2020 and the expiration of the agreement on April 15, 2020, which further reduces the company’s ability to access liquidity during the term of the agreement. Due to our further anticipated losses, negative working capital position and lack of access to liquidity under the credit agreement, we do not anticipate that forecasted cash and available credit capacity will be sufficient to meet our commitments as they come due over the next twelve months. Additionally, once the amounts outstanding on our 2021 Senior Notes are classified as current on our June 30, 2020 balance sheet, we will be in violation of the current ratio covenant in our credit agreement. If we are unable to cure the covenant violation, renegotiate the terms of the credit agreement or obtain a waiver, the covenant violation would result in all amounts outstanding under the Unit credit agreement becoming due and payable during the third quarter of 2020 (after we file our second quarter Form 10-Q). The covenant violation would also cause a cross-default of the indenture on our 2021 Senior Notes, which would make those notes immediately due and payable. The amounts outstanding as of December 31, 2019 on our Unit credit agreement and 2021 Senior Notes are $108.2 million and $650.0 million, respectively. If we are unable to avoid the anticipated credit violation or otherwise obtain a waiver, we will be unable to pay these amounts when due. In addition, the October 18, 2023 scheduled maturity date of the loans under the Unit credit agreement will accelerate to November 16, 2020 to the extent that, on or before that date, all the 2021 Senior Notes are not repurchased, redeemed, or refinanced with indebtedness having a maturity date at least six months following October 18, 2023 (the “Credit Agreement Extension Condition”). On November 5, 2019, the company filed with the SEC a registration statement on Form S-4 (the Registration Statement) to commence an offer to exchange (the Exchange Offer) any and all of the existing 2021 Senior Notes for new notes with terms and conditions that would satisfy the Credit Agreement Extension Condition. However, there can be no assurance that the company will be able to complete the Exchange Offer as contemplated, if at all. Due to the Credit Agreement Extension Condition, the company's debt associated with the Unit credit agreement is reflected as a current liability in its consolidated balance sheet as of December 31, 2019. The classification as a current liability is based on the uncertainty regarding the company's ability to repay or refinance the 2021 Senior Notes before November 16, 2020. Based on our current forecasted cash flows and cash on hand, we will not be able to pay the outstanding amount of the Unit credit agreement if the maturity is accelerated. Inability to pay the amount outstanding under the credit agreement would cause a covenant violation and also create cross-default with the indenture of the 2021 Senior Notes, which would also become due and payable. If we are unable to pay the balance of the Unit credit agreement upon acceleration, we would be required to file for protection under Chapter 11 of the U.S. Bankruptcy Code (Chapter 11). Based on our evaluation of the conditions described above, substantial doubt exists about our ability to continue as a going concern. The consolidated financial statements do not reflect any adjustments that might result if we are unable to continue as a going concern. In order to alleviate the conditions that give rise to substantial doubt about our ability to continue as a going concern, the company is currently undertaking a number of actions, including (i) minimizing capital expenditures, (ii) aggressively managing working capital, (iii) further reducing recurring operating expenses, (iv) exploring potential business transactions, and (v) negotiating with existing debt holders to restructure existing debts. We believe that even after taking these actions, we will not have sufficient liquidity to satisfy our debt service obligations, meet other financial obligations, and comply with our debt covenants. We have engaged financial and legal advisors to, among other things, assist with analyzing various strategic alternatives, to include a potential reorganization under Chapter 11, to address our liquidity and capital structure. However, there can be no assurance that we will be able to restructure our financial obligations on terms acceptable to the company and our creditors, and there can be no assurance that we will generate the necessary liquidity to satisfy these obligations when they come due. Executive Summary Oil and Natural Gas Fourth quarter 2019 production from our oil and natural gas segment was 4,157 MBoe, a decrease of 5% and 4% from the third quarter of 2019 and the fourth quarter of 2018, respectively. The decreases came from fewer net wells being completed in the fourth quarter to replace declines in previously drilled wells. Oil and NGLs production during the fourth quarter of 2019 was 48% of our total production compared to 46% of our total production during the fourth quarter of 2018. Fourth quarter 2019 oil and natural gas revenues increased 7% over the third quarter of 2019 and decreased 21% from the fourth quarter of 2018. The increase over the third quarter of 2019 was primarily due an increase in commodity prices partially offset by a decrease in equivalent production. The decrease from the fourth quarter of 2018 was primarily due to a decrease in commodity prices and equivalent production. Our hedged natural gas prices for the fourth quarter of 2019 increased 8% over third quarter of 2019 and decreased 29% from fourth quarter of 2018. Our hedged oil prices for the fourth quarter of 2019 increased 1% and 6% over the third quarter of 2019 and the fourth quarter of 2018, respectively. Our hedged NGLs prices for the fourth quarter of 2019 increased 54% over the third quarter of 2019 and decreased 33% from fourth quarter of 2018. Direct profit (oil and natural gas revenues less oil and natural gas operating expense) increased 24% over the third quarter of 2019 and decreased 29% from the fourth quarter of 2018. The increase over the third quarter of 2019 was primarily due to an increase in commodity prices and a reduction in lease operating expenses (LOE) and general and administrative (G&A) expenses partially offset by a decrease in equivalent production. The decrease from the fourth quarter of 2018 was primarily due to lower revenues due to lower commodity prices and volumes and higher salt water disposal expenses and gross production taxes. Operating cost per Boe produced for the fourth quarter of 2019 decreased 8% from the third quarter of 2019 and increased 3% over the fourth quarter of 2018. The decrease from the third quarter of 2019 was primarily due to lower G&A and LOE. The increase over the fourth quarter of 2018 was primarily due to increased saltwater and production taxes along with lower equivalent production. At December 31, 2019, these non-designated hedges were outstanding: In our Wilcox play, located primarily in Polk, Tyler, Hardin, and Goliad Counties, Texas, we completed seven vertical gas/condensate wells (average working interest 100%) in 2019. Annual production from our Wilcox play averaged 76 MMcfe per day (7% oil, 21% NGLs, 72% natural gas) which is a decrease of 15% compared to 2018. We averaged approximately 0.75 Unit drilling rigs operating during 2019. In our Southern Oklahoma Hoxbar Oil Trend (SOHOT) play in western Oklahoma, primarily in Grady County, we completed seven horizontal oil wells in the Marchand zone of the Hoxbar interval and, in our Red Fork play, we completed seven horizontal wells. Average working interest for these wells was 85.3%. Annual production from western Oklahoma averaged 95.7 MMcfe per day (35% oil, 22% NGLs, 43% natural gas) which is an increase of approximately 25% compared to 2018. During 2019, we averaged approximately 1.5 Unit drilling rigs operating and we participated in 61 non-operated wells in the mid-continent region, with most of those occurring in the STACK play. Unit’s average working interest in these non-operated wells is 3.7%. In our Texas Panhandle Granite Wash play, we completed two extended lateral horizontal gas/condensate wells (average working interest 98.5%) in our Buffalo Wallow field. Annual production from the Texas Panhandle averaged 91.9 MMcfe per day (9% oil, 37% NGLs, 55% natural gas) which is a decrease of approximately 5% compared to 2018. We used 0.25 Unit drilling rigs during 2019. In December of 2019, we sold our Panola Field in eastern Oklahoma for $17.9 million. During 2019, we participated in the drilling of 115 wells (29.15 net wells). For 2020, we do not currently have any plans to drill wells pending our ability to refinance our debt. Contract Drilling The average number of drilling rigs we operated in the fourth quarter was 18.3 compared to 20.4 and 33.1 in the third quarter of 2019 and fourth quarter of 2018, respectively. As of December 31, 2019, 20 of our drilling rigs were operating. Revenue for the fourth quarter of 2019 decreased 3% from the third quarter of 2019 and decreased 31% from the fourth quarter of 2018. The decreases were primarily due to less drilling rigs operating. Dayrates for the fourth quarter of 2019 averaged $19,311, which was essentially unchanged from the third quarter of 2019 and a 7% increase over the fourth quarter of 2018. The increase over the fourth quarter of 2018 was primarily due to a labor increase passed through to contracted drilling rig rates and improving market dayrates and additional BOSS drilling rigs which receive higher dayrates. Operating costs for the fourth quarter of 2019 decreased 8% from the third quarter of 2019 and decreased 26% from the fourth quarter of 2018. The decreases were both primarily due to less drilling rigs operating and from decreased employee cost in G&A expenses. Direct profit (contract drilling revenue less contract drilling operating expense) for the fourth quarter of 2019 increased 15% over the third quarter of 2019 and decreased 41% from the fourth quarter of 2018. The increase over the third quarter of 2019 was primarily due to lower G&A expenses. The decrease from the fourth quarter of 2018 was primarily due to less drilling rigs operating. Operating cost per day for the fourth quarter of 2019 increased 3% over the third quarter of 2019 and increased 34% over the fourth quarter of 2018. The increase over the third quarter of 2019 was primarily due to decreased eliminations with a lower percentage of our drilling rig usage coming from our oil and gas segment and higher third party expense. The increase over the fourth quarter of 2018 was primarily due to increased per day direct cost and total indirect and G&A expense spread over fewer operating days. In December 2018, our Board of Directors approved a plan to sell 41 drilling rigs (29 mechanical drilling rigs and 12 SCR diesel-electric drilling rigs) and other equipment. This plan satisfies the criteria of assets held for sale under ASC 360-10-45-9. Over the years 2014 through 2018, only six of our drilling rigs in the fleet had not been utilized. The plan included a strategic decision to focus on our new BOSS drilling rigs and specific SCR drilling rigs and sell the other drilling rigs that we now choose not to market. We estimated the fair value of the 41 drilling rigs we will no longer market based on the estimated market value from third-party assessments (Level 3 fair value measurement) less cost to sell. Based on these estimates, in December 2018, we recorded a non-cash write-down of approximately $147.9 million, pre-tax ($111.7 million, net of tax). During 2019, we sold six of these drilling rigs and some of the other equipment to unaffiliated third parties. As of December 31, 2019, we determined that $10.8 million of the assets held for sale would not be sold in the next twelve months and were moved back to long-lived assets. Seven drilling rigs and equipment will be marketed for sale throughout the next twelve months and remain classified as assets held for sale. The net book value of those assets is $5.9 million. The contract drilling segment has operations in Oklahoma, Texas, New Mexico, Wyoming, North Dakota, and to a lesser extent in Colorado. As of December 31, 2019, four drilling rigs were working in Oklahoma and the Texas Panhandle, seven in the Permian Basin of West Texas, one in New Mexico, two in Wyoming and six drilling rigs in the Bakken Shale of North Dakota. During 2019, almost all of our working drilling rigs were drilling horizontal or directional wells for oil and NGLs. The future demand for and the availability of drilling rigs to meet that demand will affect our future dayrates. As of December 31, 2019, we had 14 term drilling contracts with original terms ranging from two months to three years. Ten of these contracts are up for renewal in 2020, (three in the first quarter, three in the second quarter, one in the third quarter, and three in the fourth quarter) and four are up for renewal in 2021 and beyond. Term contracts may contain a fixed rate during the contract or provide for rate adjustments within a specific range from the existing rate. Some operators who had signed term contracts have opted to release the drilling rig and pay an early termination penalty for the remaining term of the contract. We recorded $4.8 million, $0.1 million, and $0.8 million in early termination fees in 2019, 2018, and 2017, respectively. All 14 of our existing BOSS drilling rigs are under contract. All of our contracts are daywork contracts. For 2020, we do not currently have an approved capital plan for this segment. Capital expenditures incurred would be within anticipated cash flows. Mid-Stream Fourth quarter 2019 liquids sold per day was essentially unchanged from the third quarter of 2019 and decreased 18% from the fourth quarter of 2018. The decrease from the fourth quarter of 2018 was due primarily to less processed volume from our processing systems along with operating in full ethane rejection. For the fourth quarter of 2019, gas processed per day decreased 3% from the third quarter of 2019 and increased 1% over the fourth quarter of 2018. The decrease from the third quarter of 2019 was primarily due to lower volume from the Hemphill Buffalo Wallow area. The increase over the fourth quarter of 2018 was due to connecting additional wells to our processing systems. For the fourth quarter of 2019, gas gathered per day decreased 7% from the third quarter of 2019 and increased 1% over the fourth quarter of 2018. The decrease from the third quarter of 2019 was primarily due to declining volumes from the Appalachian region and the increase over the fourth quarter of 2018 was primarily due to connecting the seven new wells on the Pittsburgh Mills gathering system. NGLs prices in the fourth quarter of 2019 increased 19% over the prices received in the third quarter of 2019 and decreased 26% from the prices received in the fourth quarter of 2018. Because certain of the contracts used by our mid-stream segment for NGLs transactions are commodity-based contracts - under which we receive a share of the proceeds from the sale of the NGLs - our revenues from those commodity-based contracts fluctuate based on NGLs prices. Direct profit (mid-stream revenues less mid-stream operating expense) for the fourth quarter of 2019 decreased 6% from the third quarter of 2019 and decreased 14% from the fourth quarter of 2018, respectively. The decrease from the third quarter of 2019 was primarily due to higher purchase prices partially offset by higher condensate volume. The decrease from the fourth quarter of 2018 was primarily due to lower NGL, gas and condensate prices along with lower NGLs and condensate volume. Total operating cost for this segment for the fourth quarter of 2019 increased 17% over the third quarter of 2019 and decreased 23% from the fourth quarter of 2018. The increase over the third quarter of 2019 was primarily due to an increase in gas purchase cost due to higher purchase prices. The decrease over the fourth quarter of 2018 was primarily due to lower gas purchase prices along with lower field direct operating expenses. At the Cashion processing facility in central Oklahoma, total throughput volume for the fourth quarter of 2019 averaged approximately 67.7 MMcf per day and total production of natural gas liquids increased to 326,337 gallons per day. We are continuing to connect new wells to this system from third party producers. Since the beginning of 2019, we have connected 35 new wells to this system from producers who continue to drill in the area. Construction of the 60 MMcf per day Reeding processing facility is complete and is fully operational. The total processing capacity on the Cashion system is 105 MMcf per day. With the assets from the recent acquisition in December, we will process the additional volume from these assets at the Reeding facility which is expected to begin April 1, 2020. In the Appalachian region at the Pittsburgh Mills gathering system, average gathered volume for December 2019 was 148.4 MMcf per day while the average gathered volume for the fourth quarter of 2019 was approximately 150.3 MMcf per day. During 2019, we added seven new wells to this system which accounted for a significant increase in gathered volume. Since these wells have been in production since the beginning of the year, we are seeing less of a decline than was expected from these wells. We are currently preparing to connect four new infill wells to this system which are expected to begin production in the second quarter of 2020. At the Hemphill processing facility located in the Texas panhandle, average total throughput volume for the fourth quarter of 2019 was 62.2 MMcf per day and total production of natural gas liquids declined to 141,137 gallons per day due to lower wellhead volume and operating in full ethane rejection. Since the first of this year, we connected eight new wells to the Hemphill system. At this time there are no active rigs in the area and we have not budgeted any new well connects for this system. At the Segno gathering system located in East Texas, the average throughput volume for the fourth quarter of 2019 was 59.9 MMcf per day. During 2019, we connected two new Unit Petroleum wells to this system. Unit Petroleum continues to rework and recomplete wells in the area around this system. During the fourth quarter of 2019, we disposed of three small gathering systems. We sold the Scipio gathering system, which is located in Southeast Oklahoma, to the producer. There was no net book value and resulted in a small gain less than $0.1 million. We discontinued the operations and abandoned the Ford and Briscoe gathering systems and recorded an impairment on those assets of $0.8 million. Also in December of 2019, we closed on an acquisition for $16.1 million that included approximately 572 miles of pipeline and related compressor stations. The transaction closed on December 30, 2019 and the effective date of the purchase was December 1, 2019. Anticipated 2020 capital expenditures for this segment will be approximately $28.0 million, a 57% decrease from 2019. Critical Accounting Policies and Estimates Summary In this section, we identify those critical accounting policies we follow in preparing our financial statements and related disclosures. Many policies require us to make difficult, subjective, and complex judgments while making estimates of matters inherently imprecise. Some accounting policies involve judgments and uncertainties to such an extent there is reasonable likelihood that materially different amounts could have been reported under different conditions, or had different assumption been used. We evaluate our estimates and assumptions regularly. We base our estimates on historical experience and various other assumptions we believe are reasonable under the circumstances, the results of which support making judgments about the carrying values of assets and liabilities not readily apparent from other sources. Actual results may differ from these estimates and assumptions used in preparation of our financial statements. In this discussion we attempt to explain the nature of these estimates, assumptions and judgments, and the likelihood that materially different amounts would be reported in our financial statements under different conditions or using different assumptions. This table lists the critical accounting policies, identifies the estimates and assumptions that can have a significant impact on applying these accounting policies, and the financial statement accounts affected by these estimates and assumptions. Accounting Policies Estimates or Assumptions Accounts Affected Full cost method of accounting for oil, NGLs, and natural gas properties • Oil, NGLs, and natural gas reserves, estimates, and related present value of future net revenues • Valuation of unproved properties • Estimates of future development costs • Oil and natural gas properties • Accumulated depletion, depreciation and amortization • Provision for depletion, depreciation and amortization • Impairment of oil and natural gas properties • Interest expense Accounting for ARO for oil, NGLs, and natural gas properties • Cost estimates related to the plugging and abandonment of wells • Timing of cost incurred • Credit adjusted risk free rate • Oil and natural gas properties • Accumulated depletion, depreciation and amortization • Provision for depletion, depreciation and amortization • Current and non-current liabilities • Operating expense Accounting for material producing property and undeveloped acreage acquisitions •Value the reserves with the income approach using cash flow projections •Value the undeveloped acreage with the market approach using comparable sales data •Value equipment with the market approach using comparable sales data and CEPS pricing • Oil and natural gas properties • Non-current liabilities Accounting for impairment of long-lived assets • Forecast of undiscounted estimated future net operating cash flows • Oil and natural gas, drilling, and mid-stream property and equipment • Accumulated depletion, depreciation and amortization • Provision for depletion, depreciation and amortization Goodwill • Forecast of discounted estimated future net operating cash flows • Terminal value • Weighted average cost of capital • Goodwill Accounting for value of stock compensation awards • Estimates of stock volatility • Estimates of expected life of awards granted • Estimates of rates of forfeitures • Estimates of performance shares granted • Oil and natural gas properties • Shareholder’s equity • Operating expenses • General and administrative expenses Accounting for derivative instruments • Derivatives measured at fair value • Current and non-current derivative assets and liabilities • Gain (loss) on derivatives Significant Estimates and Assumptions Full Cost Method of Accounting for Oil, NGLs, and Natural Gas Properties. Determining our oil, NGLs, and natural gas reserves is a subjective process. It entails estimating underground accumulations of oil, NGLs, and natural gas that cannot be measured in an exact manner. Accuracy of these estimates depends on several factors, including, the quality and availability of geological and engineering data, the precision of the interpretations of that data, and individual judgments. Each year, we hire an independent petroleum engineering firm to audit our internal evaluation of our reserves. The audit of our reserve wells or locations as of December 31, 2019 covered those that we projected to comprise 86% of the total proved developed future net income discounted at 10% (based on the SEC's unescalated pricing policy). Included in Part I, Item 1 of this report are the qualifications of our independent petroleum engineering firm and our employees responsible for preparing our reserve reports. As a rule, the accuracy of estimating oil, NGLs, and natural gas reserves varies with the reserve classification and the related accumulation of available data, as shown in this table: Type of Reserves Nature of Available Data Degree of Accuracy Proved undeveloped Data from offsetting wells, seismic data Less accurate Proved developed non-producing The above and logs, core samples, well tests, pressure data More accurate Proved developed producing The above and production history, pressure data over time Most accurate Assumptions of future oil, NGLs, and natural gas prices and operating and capital costs also play a significant role in estimating these reserves and the estimated present value of the cash flows to be received from the future production of those reserves. Volumes of recoverable reserves are influenced by the assumed prices and costs due to the economic limit (that point when the projected costs and expenses of producing recoverable oil, NGLs, and natural gas reserves are greater than the projected revenues from the oil, NGLs, and natural gas reserves). But more significantly, the estimated present value of the future cash flows from our oil, NGLs, and natural gas reserves is sensitive to prices and costs and may vary materially based on different assumptions. Companies, like ours, using full cost accounting use the unweighted arithmetic average of the commodity prices existing on the first day of each of the 12 months before the end of the reporting period to calculate discounted future revenues, unless prices were otherwise determined under contractual arrangements. We compute DD&A on a units-of-production method. Each quarter, we use these formulas to compute the provision for DD&A for our producing properties: •DD&A Rate = Unamortized Cost / End of Period Reserves Adjusted for Current Period Production •Provision for DD&A = DD&A Rate x Current Period Production Unamortized cost includes all capitalized costs, estimated future expenditures to be incurred in developing proved reserves and estimated dismantlement and abandonment costs, net of estimated salvage values less accumulated amortization, unproved properties, and equipment not placed in service. Oil, NGLs, and natural gas reserve estimates have a significant impact on our DD&A rate. If future reserve estimates for a property or group of properties are revised downward, the DD&A rate will increase because of the revision. If reserve estimates are revised upward, the DD&A rate will decrease. Based on our 2019 production level of 16.8 MMBoe, a decrease in our 2019 oil, NGLs, and natural gas reserves by 5% would increase our DD&A rate by $0.54 per Boe and would decrease pre-tax income by $9.1 million annually. Conversely, an increase in our 2019 oil, NGLs, and natural gas reserves by 5% would decrease our DD&A rate by $0.48 per Boe and would increase pre-tax income by $8.1 million annually. The DD&A expense on our oil and natural gas properties is calculated each quarter using period end reserve quantities adjusted for period production. We account for our oil and natural gas exploration and development activities using the full cost method of accounting. Under this method, we capitalize all costs incurred in the acquisition, exploration, and development of oil and natural gas properties. At the end of each quarter, the net capitalized costs of our oil and natural gas properties are limited to that amount which is the lower of unamortized costs or a ceiling. The ceiling is defined as the sum of the present value (using a 10% discount rate) of the estimated future net revenues from our proved reserves (based on the unescalated 12-month average price on our oil, NGLs, and natural gas adjusted for any cash flow hedges), plus the cost of properties not being amortized, plus the lower of the cost or estimated fair value of unproved properties included in the costs being amortized, less related income taxes. If the net capitalized costs of our oil and natural gas properties exceed the ceiling, we are required to write-down the excess amount. A ceiling test write-down is a non-cash charge to earnings. If required, it reduces earnings and impacts shareholders’ equity in the period of occurrence and results in lower DD&A expense in future periods. Once incurred, a write-down cannot be reversed. The risk we will be required to write-down the carrying value of our oil and natural gas properties increases when the prices for oil, NGLs, and natural gas are depressed or if we have large downward revisions in our estimated proved oil, NGLs, and natural gas reserves. Application of these rules during periods of relatively low prices, even if temporary, increases the chance of a ceiling test write-down. At December 31, 2019, our reserves were calculated based on applying 12-month 2019 average unescalated prices of $55.69 per barrel of oil, $23.19 per barrel of NGLs, and $2.58 per Mcf of natural gas (then adjusted for price differentials) over the estimated life of each of our oil and natural gas properties. In 2019, we incurred non-cash ceiling test write-downs of our oil and natural gas properties of $559.4 million pre-tax ($422.4 million net of tax) due to the reduction of the 12-month average commodity prices and the removal of proved undeveloped reserves due to the uncertainty regarding our ability to finance future capital expenditures. We anticipate a non-cash ceiling test write-down in the first quarter of 2020 and future quarters. It is hard to predict with any reasonable certainty the need for or amount of any future impairments given the many factors that go into the ceiling test calculation including, but not limited to, future pricing, operating costs, drilling and completion costs, upward or downward oil and gas reserve revisions, oil and gas reserve additions, and tax attributes. Subject to these inherent uncertainties, if we hold these same factors constant as they existed at December 31, 2019 and only adjust the 12-month average price to a first quarter ending average, our forward looking expectation is that we would recognize an impairment of $62 million pre-tax in the first quarter of 2020. Given the uncertainty associated with the factors used in calculating our estimate of both our future period ceiling test write-down and the removal of our undeveloped reserves, these estimates should not necessarily be construed as indicative of our future development plans or financial results and the actual amount of any write-down may vary significantly from this estimate depending on the final determination. We account for revenue transactions under ASC 606 for recording natural gas sales, which may be more or less than our share of pro-rata production from certain wells. Our policy is to expense our pro-rata share of lease operating costs from all wells as incurred. The expenses relating to the wells in which we have a production imbalance are not material. Costs Withheld from Amortization. Costs associated with unproved properties are excluded from our amortization base until we have evaluated the properties. The costs associated with unevaluated leasehold acreage and related seismic data, the drilling of wells, and capitalized interest are initially excluded from our amortization base. Leasehold costs are transferred to our amortization base with the costs of drilling a well on the lease or are assessed at least annually for possible impairment or reduction in value. Leasehold costs are transferred to our amortization base to the extent a reduction in value has occurred. Our decision to withhold costs from amortization and the timing of transferring those costs into the amortization base involve significant judgment and may be subject to changes over time based on several factors, including our drilling plans, availability of capital, project economics and results of drilling on adjacent acreage. In 2017 and 2019, we determined the value of certain unproved oil and gas properties were diminished (in part or in whole) based on an impairment evaluation and our anticipated future exploration plans. Those determinations resulted in $73.9 million and $10.5 million in 2019 and 2017, respectively of costs being added to the total of our capitalized costs being amortized. We did not have any in 2018. At December 31, 2019, we had approximately $252.9 million of costs excluded from the amortization base of our full cost pool. Accounting for ARO for Oil, NGLs, and Natural Gas Properties. We record the fair value of liabilities associated with the future plugging and abandonment of wells. In our case, when the reserves in each of our oil or gas wells deplete or otherwise become uneconomical, we must incur costs to plug and abandon the wells. These costs are recorded in the period in which the liability is incurred (at the time the wells are drilled or acquired). We have no assets restricted to settle these ARO liabilities. Our engineering staff uses historical experience to determine the estimated plugging costs considering the type of well (either oil or natural gas), the depth of the well, the physical location of the well, and the ultimate productive life to determine the estimated plugging costs. A risk-adjusted discount rate and an inflation factor are used on these estimated costs to determine the current present value of this obligation. To the extent any change in these assumptions affect future revisions and impact the present value of the existing ARO, a corresponding adjustment is made to the full cost pool. Accounting for Impairment of Long-Lived Assets. Drilling equipment, transportation equipment, gas gathering and processing systems, and other property and equipment are carried at cost less accumulated depreciation. Renewals and enhancements are capitalized while repairs and maintenance are expensed. We review the carrying amounts of long-lived assets for potential impairment when events occur or changes in circumstances suggest these carrying amounts may not be recoverable. Changes that could prompt such an assessment may include equipment obsolescence, changes in the market demand for a specific asset, changes in commodity prices, periods of relatively low drilling rig utilization, declining revenue per day, declining cash margin per day, or overall changes in market conditions. Assets are determined to be impaired if a forecast of undiscounted estimated future net operating cash flows directly related to the asset, including disposal value if any, is less than the carrying amount of the asset. If any asset is determined to be impaired, the loss is measured as the amount by which the carrying amount of the asset exceeds its fair value. The estimate of fair value is based on the best information available, including prices for similar assets. Changes in these estimates could cause us to reduce the carrying value of property and equipment. Asset impairment evaluations are, by nature, highly subjective. They involve expectations about future cash flows generated by our assets and reflect management’s assumptions and judgments regarding future industry conditions and their effect on future utilization levels, dayrates, and costs. Using different estimates and assumptions could cause materially different carrying values of our assets. On a periodic basis, we evaluate our fleet of drilling rigs for marketability based on the condition of inactive rigs, expenditures that would be necessary to bring them to working condition and the expected demand for drilling services by rig type. The components comprising inactive rigs are evaluated, and those components with continuing utility to the Company’s other marketed rigs are transferred to other rigs or to its yards to be spare equipment. The remaining components of these rigs are retired. No impairments were recorded in 2019 or 2017. In December 2018, our Board of Directors approved a plan to sell 41 drilling rigs (29 mechanical drilling rigs and 12 SCR diesel-electric drilling rigs) and other equipment. This plan satisfies the criteria of assets held for sale under ASC 360-10-45-9. The plan included a strategic decision to focus on our new BOSS drilling rigs and specific SCR drilling rigs and sell the other drilling rigs that we now choose not to market. We estimated the fair value of the 41 drilling rigs we will no longer use based on the estimated market value from third-party assessments (Level 3 fair value measurement) less cost to sell. Based on these estimates, in December 2018, we recorded a non-cash write-down of approximately $147.9 million, pre-tax ($111.7 million, net of tax). During 2019, we sold six of these drilling rigs and some of the other equipment to unaffiliated third parties. As of December 31, 2019, we determined that $10.8 million of the assets held for sale would not be sold in the next twelve months and were moved back to long-lived assets. Seven drilling rigs and equipment will be marketed for sale throughout the next twelve months and remain classified as assets held for sale. The net book value of those assets is $5.9 million. During the third quarter of 2019, we determined a triggering event had occurred within our contract drilling reporting unit due to a decline in the number of drilling rigs being used and the overall market performance of the contract drilling industry. As a result, we performed a recoverability test on long-lived assets within the segment. Based on the results of the undiscounted future cash flows of the asset group, the undiscounted projected future cash flows of the asset group exceeded the group's carrying value as of September 30, 2019 and therefore no long-lived asset impairment was recorded for the group. Goodwill. Goodwill represents the excess of the cost of acquisitions over the fair value of the net assets acquired. Goodwill is not amortized, but an impairment test is performed at least annually to determine whether the fair value has decreased and is performed additionally when events indicate an impairment may have occurred. For impairment testing, goodwill is evaluated at the reporting unit level. Our goodwill is all related to our contract drilling segment, and, the impairment test is generally based on the estimated discounted future net cash flows of our drilling segment, utilizing discount rates and other factors in determining the fair value of our drilling segment. Inputs in our estimated discounted future net cash flows include drilling rig utilization, day rates, gross margin percentages, and terminal value. Due to the triggering event within the contract drilling reporting unit, we performed an interim goodwill impairment test as of September 30, 2019. Based on the projected discounted cash flows, we recognized a goodwill impairment charge of $62.8 million, pre-tax ($59.8 million, net of tax) which represented the total goodwill previously reported on our consolidated balance sheets. No goodwill impairment was recorded for the years ended December 31, 2018, or 2017. Drilling Contracts. The type of contract used determines our compensation. All of our contracts in 2019, 2018, and 2017 were daywork contracts. Under a daywork contract, we provide the drilling rig with the required personnel and the operator supervises the drilling of the well. Our compensation is based on a negotiated rate to be paid for each day the drilling rig is used. Accounting for Value of Stock Compensation Awards. To account for stock-based compensation, compensation cost is measured at the grant date based on the fair value of an award and is recognized over the service period, which is usually the vesting period. We elected to use the modified prospective method, which requires compensation expense to be recorded for all unvested stock options and other equity-based compensation beginning in the first quarter of adoption. Determining the fair value of an award requires significant estimates and subjective judgments regarding, among other things, the appropriate option pricing model, the expected life of the award and performance vesting criteria assumptions. As there are inherent uncertainties related to these factors and our judgment in applying them to the fair value determinations, there is risk that the recorded stock compensation may not accurately reflect the amount ultimately earned by the employee. Accounting for Derivative Instruments and Hedging. All derivatives are recognized on the balance sheet and measured at fair value. Any changes in our derivatives' fair value before their maturity (i.e., temporary fluctuations in value) along with any derivatives settled are reported in gain (loss) on derivatives in our Consolidated Statements of Operations. New Accounting Standards Measurement of Credit Losses on Financial Instruments (Topic 326). The FASB issued ASU 2016-13 which replaces current methods for evaluating impairment of financial instruments not measured at fair value, including trade accounts receivable and certain debt securities, with a current expected credit loss model. The amendment will be effective for reporting periods after December 15, 2019. We have evaluated the impact this will have on our consolidated financial statements by reviewing our accounts receivable accounts and our historic credit losses. This standard will not have a material impact on our financial statements. Fair Value Measurement (Topic 820): Disclosure Framework-Changes to the Disclosure Requirements for Fair Value Measurement. The FASB issued ASU 2018-13 to modify the disclosure requirements in Topic 820. Part of the disclosures were removed or modified, and other disclosures were added. The amendment will be effective for reporting periods beginning after December 15, 2019. Early adoption is permitted. Also, it is permitted to early adopt any removed or modified disclosure and delay adoption of the additional disclosures until their effective date. This amendment will not have a material impact on our financial statements. Income Taxes (Topic 740)-Simplifying the Accounting for Income Taxes. The FASB issued ASU 2019-12 to reduce the cost and complexity related to the accounting for income taxes. The amendment will be effective for reporting periods beginning after December 15, 2020. Early adoption is permitted. We are evaluating what impact this standard will have on our consolidated financial statements. Adopted Standards Compensation-Stock Compensation: Improvements to Nonemployee Share-Based Payment Accounting. The FASB issued ASU 2018-07, to improve financial reporting for nonemployee share-based payments. The amendment expands Topic 718, Compensation-Stock Compensation to include share-based payments issued to nonemployees for goods or services. The amendment is effective for years beginning after December 15, 2018, and interim periods within those years. This amendment did not have an impact on our financial statements. We adopted ASC 842 on January 1, 2019, using the modified retrospective method and the optional transition method to record the adoption impact through a cumulative adjustment to equity. Results for reporting periods beginning after January 1, 2019, are presented under Topic 842, while prior periods are not adjusted and continue to be reported under the accounting standards in effect for those periods. The additional disclosures required by ASC 842 have been included in Note 16 - Leases. Intangibles-Goodwill and Other: Simplifying the Test for Goodwill Impairment. The FASB issued ASU 2017-04, to simplify the measurement of goodwill. The amendment eliminates Step 2 from the goodwill impairment test. The amendment will be effective prospectively for reporting periods beginning after December 15, 2019. We have early adopted this amendment in the third quarter of 2019. We performed our goodwill assessment and booked the impairment for the difference between fair value and book value. Financial Condition and Liquidity Summary Our financial condition and liquidity primarily depends on the cash flow from our operations and borrowings under our credit agreements. The principal factors determining our cash flow are: •the amount of natural gas, oil, and NGLs we produce; •the prices we receive for our natural gas, oil, and NGLs production; •the demand for and the dayrates we receive for our drilling rigs; and •the fees and margins we obtain from our natural gas gathering and processing contracts. Our financial statements have been prepared assuming we will continue as a going concern. As a result of the sustained commodity price decline and our substantial debt burden, we do not believe that forecasted cash and available credit capacity will be sufficient to meet commitments as they come due over the next twelve months. These conditions raise substantial doubt about our ability to continue as a going concern. Our ability to meet our debt covenants (under our credit agreements and our Indenture) and our capacity to incur additional indebtedness will depend on our future performance, which in turn will be affected by financial, business, economic, regulatory, and other factors. Below is a summary of certain financial information for the years ended December 31: Cash Flows from Operating Activities Our operating cash flow is primarily influenced by the prices we receive for our oil, NGLs, and natural gas production, the quantity of oil, NGL, and natural gas we produce, settlements of derivative contracts, third-party demand for our drilling rigs and mid-stream services, and the rates we can charge for those services. Our cash flows from operating activities are also affected by changes in working capital. Net cash provided by operating activities decreased by $83.4 million in 2019 compared to 2018 due primarily from lower revenues due to lower commodity prices and lower drilling rig utilization and by changes in operating assets and liabilities related to the timing of cash receipts and disbursements. Cash Flows from Investing Activities We dedicate and expect to continue to dedicate a substantial portion of our capital budget to the exploration for and production of oil, NGLs, and natural gas. These expenditures are necessary to off-set the inherent production declines typically experienced in oil and gas wells. Cash flows used in investing activities decreased by $55.8 million in 2019 compared to 2018. The change was due primarily to a decrease in capital expenditures due to a decrease in wells drilled and oil and gas property acquisitions partially offset by the construction of new BOSS drilling rigs, acquisition of mid-stream assets, and an increase in the proceeds received from the disposition of assets. See additional information on capital expenditures below under Capital Requirements. Cash Flows from Financing Activities Cash flows provided by financing activities increased by $15.9 million in 2019 compared to 2018. The increase was primarily due to an increase in the net borrowing under our credit agreements partially offset by the sale of 50% interest in our mid-stream segment in 2018. At December 31, 2019, we had unrestricted cash totaling $0.6 million and had borrowed $108.2 million and $16.5 million of the amounts available under the Unit and Superior credit agreements, respectively. Below is a summary of certain financial information as of December 31, and for the years ended December 31: _________________________ 1.Long-term debt is net of unamortized discount and debt issuance costs. 2.In 2019, we incurred a non-cash ceiling test write-downs of our oil and natural gas properties of $559.4 million pre-tax ($422.4 million, net of tax). We also recognized goodwill impairment charges of $62.8 million pre-tax ($59.8 million, net of tax). In 2018, we incurred a non-cash write-down associated with the removal of 41 drilling rigs from our fleet of $147.9 million pre-tax ($111.7 million, net of tax). Working Capital Typically, our working capital balance fluctuates, in part, because of the timing of our trade accounts receivable and accounts payable and the fluctuation in current assets and liabilities associated with the mark to market value of our derivative activity. We had negative working capital of $155.0 million, $38.7 million, and $62.3 million as of December 31, 2019, 2018, and 2017, respectively. The decrease in working capital from 2018 is primarily due to the springing maturity of the Unit credit agreement, decreased cash and cash equivalents from the sale of 50% interest in our mid-stream segment in 2018, decreased accounts receivable due to decreased revenues, the change in the value of the derivatives outstanding, and the fair value of drilling assets held for sale partially offset by decreased accounts payable due to decreased activity in our drilling program. The Unit and Superior credit agreements are used primarily for working capital and capital expenditures. At December 31, 2019, we had borrowed $108.2 million of the $200.0 million available to us under the Unit credit agreement and $16.5 million of the $200.0 million available to us under the Superior credit agreement. The effect of our derivatives increased working capital by $0.6 million as of December 31, 2019, increased working capital by $12.9 million as of December 31, 2018, and decreased working capital by $7.1 million as of December 31, 2017. This table summarizes certain operating information for the years ended December 31: Oil and Natural Gas Operations Any significant change in oil, NGLs, or natural gas prices has a material effect on our revenues, cash flow, and the value of our oil, NGLs, and natural gas reserves. Generally, prices and demand for domestic natural gas are influenced by weather conditions, supply imbalances, by worldwide oil price levels, and recently by the worldwide economic impact from the coronavirus. Domestic oil prices are primarily influenced by world oil market developments. These factors are beyond our control and we cannot predict nor measure their future influence on the prices we will receive. Based on our 2019 production, a $0.10 per Mcf change in what we are paid for our natural gas production, without the effect of derivatives, would cause a corresponding $423,000 per month ($5.1 million annualized) change in our pre-tax operating cash flow. Our 2019 average natural gas price was $2.04 compared to an average natural gas price of $2.46 for 2018 and $2.46 for 2017. A $1.00 per barrel change in our oil price, without the effect of derivatives, would have a $252,000 per month ($3.0 million annualized) change in our pre-tax operating cash flow and a $1.00 per barrel change in our NGLs prices, without the effect of derivatives, would have a $371,000 per month ($4.5 million annualized) change in our pre-tax operating cash flow based on our production in 2019. Our 2019 average oil price per barrel was $57.49 compared with an average oil price of $55.78 in 2018 and $49.44 in 2017, and our 2019 average NGLs price per barrel was $12.42 compared with an average NGLs price of $22.18 in 2018 and $18.35 in 2017. Because commodity prices affect the value of our oil, NGLs, and natural gas reserves, declines in those prices can cause a decline in the carrying value of our oil and natural gas properties. At December 31, 2019, the 12-month average unescalated prices were $55.69 per barrel of oil, $23.19 per barrel of NGLs, and $2.58 per Mcf of natural gas, and then are adjusted for price differentials. In 2019, we incurred non-cash ceiling test write-downs of our oil and natural gas properties of $559.4 million pre-tax ($422.4 million net of tax) due to the reduction of the 12-month average commodity prices and the removal of proved undeveloped reserves due to the uncertainty regarding our ability to finance future capital expenditures. We anticipate a non-cash ceiling test write-down in the first quarter of 2020 and future quarters. It is hard to predict with any reasonable certainty the need for or amount of any future impairments given the many factors that go into the ceiling test calculation including, but not limited to, future pricing, operating costs, drilling and completion costs, upward or downward oil and gas reserve revisions, oil and gas reserve additions, and tax attributes. Subject to these inherent uncertainties, if we hold these same factors constant as they existed at December 31, 2019 and only adjust the 12-month average price to a first quarter ending average, our forward looking expectation is that we would recognize an impairment of $62 million pre-tax in the first quarter of 2020. Given the uncertainty associated with the factors used in calculating our estimate of both our future period ceiling test write-down and the removal of our undeveloped reserves, these estimates should not necessarily be construed as indicative of our future development plans or financial results and the actual amount of any write-down may vary significantly from this estimate depending on the final determination. Our natural gas production is sold to intrastate and interstate pipelines, to independent marketing firms and gatherers under contracts with terms generally ranging from one month to five years. Our oil production is sold to independent marketing firms generally under six-month contracts. Contract Drilling Operations Many factors influence the number of drilling rigs we have working and the costs and revenues associated with that work. These factors include the demand for drilling rigs in our areas of operation, competition from other drilling contractors, the prevailing prices for oil, NGLs, and natural gas, availability and cost of labor to run our drilling rigs, and our ability to supply the equipment needed. Competition to keep qualified labor continues. We increased compensation for some rig personnel during the first quarter of 2018. Our drilling rig personnel are a key component to the overall success of our drilling services. With the present conditions in the drilling industry, we do not anticipate increases in the compensation paid to those personnel in the near term. During 2019, almost all of our working drilling rigs were drilling horizontal or directional wells for oil and NGLs. The continuous fluctuations in commodity prices for oil and natural gas changes demand for drilling rigs. These factors ultimately affect the demand and mix of the type of drilling rigs used by our customers. The future demand for and the availability of drilling rigs to meet that demand will affect our future dayrates. For 2019, our average dayrate was $18,762 per day compared to $17,510 and $16,256 per day for 2018 and 2017, respectively. Our average number of drilling rigs used (utilization %) in 2019 was 24.6 (43%) compared with 32.8 (34%) and 30.0 (32%) in 2018 and 2017, respectively. Based on the average utilization of our drilling rigs during 2019, a $100 per day change in dayrates has a $2,460 per day ($0.9 million annualized) change in our pre-tax operating cash flow. Our contract drilling segment provides drilling services for our exploration and production segment. Some of the drilling services we perform on our properties are, depending on the timing of those services, deemed associated with acquiring an ownership interest in the property. In those cases, revenues and expenses for those services are eliminated in our statement of operations, with any profit recognized as a reduction in our investment in our oil and natural gas properties. The contracts for these services are issued under the same conditions and rates as the contracts entered into with unrelated third parties. By providing drilling services for the oil and natural gas segment, we eliminated revenue of $15.8 million, $22.5 million, and $13.4 million during 2019, 2018, and 2017, respectively, from our contract drilling segment and eliminated the associated operating expense of $14.2 million, $19.5 million, and $11.8 million during 2019, 2018, and 2017, respectively, yielding $1.6 million, $3.0 million, and$1.6 million during 2019, 2018, and 2017, respectively, as a reduction to the carrying value of our oil and natural gas properties. Mid-Stream Operations This segment is engaged primarily in the buying, selling, gathering, processing, and treating of natural gas. It operates three natural gas treatment plants, 11 processing plants, 19 gathering systems, and approximately 2,080 miles of pipeline. Its operations are in Oklahoma, Texas, Kansas, Pennsylvania, and West Virginia. This segment enhances our ability to gather and market not only our own natural gas and NGLs but also that owned by third parties and serves as a mechanism through which we can construct or acquire existing natural gas gathering and processing facilities. During 2019, 2018, and 2017 this segment purchased $40.6 million, $81.4 million, and $63.2 million, respectively, of our oil and natural gas segment's natural gas and NGLs production, and provided gathering and transportation services of $6.9 million, $7.3 million, and $6.7 million, respectively. Intercompany revenue from services and purchases of production between this business segment and our oil and natural gas segment has been eliminated in our consolidated financial statements. Our mid-stream segment gathered an average of 435,646 Mcf per day in 2019 compared to 393,613 Mcf per day in 2018 and 385,209 Mcf per day in 2017. It processed an average of 164,482 Mcf per day in 2019 compared to 158,189 Mcf per day in 2018 and 137,625 Mcf per day in 2017, and sold NGLs of 625,873 gallons per day in 2019 compared to 663,367 gallons per day in 2018 and 534,140 gallons per day in 2017. Gas gathering volumes per day in 2019 increased primarily due to higher volumes at our Cashion and Pittsburgh Mills facilities. Volumes processed in 2019 increased due to connecting new wells to our processing facilities in 2019 primarily on the Cashion system. NGLs sold in 2019 decreased primarily due to lower NGL recoveries due to operating in full ethane rejection. At-the-Market (ATM) Common Stock Program On April 4, 2017, we entered into a Distribution Agreement (the Agreement) with a sales agent, under which we may offer and sell, from time to time, through the sales agent shares of our common stock, par value $0.20 per share (the Shares), up to an aggregate offering price of $100.0 million. We intended to use the net proceeds from these sales to fund (or offset costs of) acquisitions, future capital expenditures, repay amounts outstanding under our revolving credit facility, and general corporate purposes. On May 2, 2018, we terminated the Distribution Agreement. The Distribution Agreement was terminable at will on written notification by us with no penalty. As of the date of termination, we had sold 787,547 shares of our common stock under the Distribution Agreement resulting in net proceeds of approximately $18.6 million. We paid the sales agent a commission of 2.0% of the gross sales price per share sold. As a result of the termination, there will be no more sales of our common stock under the Distribution Agreement. Our Credit Agreements and Senior Subordinated Notes Unit Credit Agreement. Our Unit credit agreement is scheduled to mature on the earlier of (a) October 18, 2023, (b) November 16, 2020, to the extent that, on or before that date, all the Notes are not repurchased, redeemed, or refinanced with indebtedness having a maturity date at least six months following October 18, 2023, and (c) any earlier date on which the commitment amounts under the Unit credit agreement are reduced to zero or otherwise terminated. Under the Unit credit agreement, the amount we can borrow is the lesser of the amount we elect as the commitment amount or the value of the borrowing base as determined by the lenders, but in either event not to exceed the maximum credit agreement amount of $1.0 billion. Effective January 17, 2020, our elected commitment amount and borrowing base is $200.0 million. At December 31, 2019, we were charged a commitment fee of 0.375% on the amount available but not borrowed. That fee varies based on the amount borrowed as a percentage of the total borrowing base. Total fees of $3.3 million in origination, agency, syndication, and other related fees are being amortized over the life of the Unit credit agreement. Under the agreement, we have pledged as collateral 80% of the proved developed producing (discounted as present worth at 8%) total value of our oil and gas properties. Pursuant to the mortgages covering such oil and gas properties, Unit Petroleum has also pledged as collateral certain items of its personal property. On May 2, 2018, we entered into a Pledge Agreement with BOKF, NA (dba Bank of Oklahoma), as administrative agent to benefit the secured parties, granting a security interest in the limited liability membership interests and other equity interests we own in Superior (which as of this report is 50% of the aggregate outstanding equity interests of Superior) as additional collateral for our obligations under the Unit credit agreement. The lenders under our Unit credit agreement and their respective participation interests are: The borrowing base amount-which is subject to redetermination by the lenders on April 1st and October 1st of each year-is based primarily on a percentage of the discounted future value of our oil and natural gas reserves. We or the lenders may request a one-time special redetermination of the borrowing base between each scheduled redetermination. In addition, we may request a redetermination following the completion of an acquisition that meets the requirements in the Unit credit agreement. Effective January 17, 2020, our borrowing base was reduced from $275.0 million to $200.0 million. At our election, any part of the outstanding debt under the Unit credit agreement may be fixed at a London Interbank Offered Rate (LIBOR). LIBOR interest is computed as the sum of the LIBOR base for the applicable term plus 1.50% to 2.50% depending on the level of debt as a percentage of the borrowing base and is payable at the end of each term, or every 90 days, whichever is less. Borrowings not under LIBOR bear interest at the prime rate specified in the Unit credit agreement that cannot be less than LIBOR plus 1.00% plus a margin. The credit agreement provides that if ICE Benchmark Administration no longer reports the LIBOR or Administrative Agent determines in good faith that the rate so reported no longer accurately reflects the rate available to Lender in the London Interbank Market or if such index no longer exists or accurately reflects the rate available to Administrative Agent in the London Interbank Market, Administrative Agent may select a replacement index. Interest is payable at the end of each month and the principal may be repaid in whole or in part at any time, without a premium or penalty. At December 31, 2019, we had $108.2 million outstanding borrowings. We can use borrowings for financing general working capital requirements for (a) exploration, development, production and acquisition of oil and gas properties, (b) acquisitions and operation of mid-stream assets up to certain limits, (c) issuance of standby letters of credit, (d) contract drilling services and acquisition of contract drilling equipment, and (e) general corporate purposes. The Unit credit agreement prohibits, among other things: •the payment of dividends (other than stock dividends) during any fiscal year over 30% of our consolidated net income for the preceding fiscal year; •the incurrence of additional debt with certain limited exceptions; •the creation or existence of mortgages or liens, other than those in the ordinary course of business and with certain limited exceptions, on any of our properties, except in favor of our lenders; and •investments in Unrestricted Subsidiaries (as defined in the Unit credit agreement) over $200.0 million. The Unit credit agreement also requires that we have at the end of each quarter: •a current ratio (as defined in the Unit credit agreement) of not less than 1 to 1. •a leverage ratio of funded debt to consolidated EBITDA (as defined in the Unit credit agreement) for the most recently ended rolling four fiscal quarters of no greater than 4 to 1. As of December 31, 2019, we were in compliance with the covenants in the Unit credit agreement. We have engaged in discussions with the lenders under the Unit credit agreement to enter into an amendment to the Unit credit agreement to, among other things, permit the issuance of the new Second Lien Senior Secured Notes (the New Notes), the incurrence of guarantees of the New Notes and the grant of liens securing the New Notes, each of which are currently not permitted under the Unit credit agreement. Due to the Credit Agreement Extension Condition, the company's debt associated with the Unit credit agreement is reflected as a current liability in its consolidated balance sheet as of December 31, 2019. The classification as a current liability is based on the uncertainty regarding the company's ability to repay or refinance the 2021 Senior Notes before November 16, 2020. On March 11, 2020, we entered into a Standstill and Amendment Agreement (Standstill Agreement) with the lenders and administrative agent party to the Unit credit agreement. The Standstill Agreement, among other things, provides that during the standstill period (as defined below), the administrative agent and lenders under the Unit credit agreement agree to temporarily standstill from making any final determination in connection with the pending scheduled redetermination of the borrowing base that was, under the Unit credit agreement, otherwise scheduled to be made on or about April 1, 2020, and from otherwise exercising certain of their respective rights and remedies under the Unit credit agreement. The standstill period will begin after the effective date of the Standstill Agreement and will continue until the earlier of: (i) the receipt by any credit party from the administrative agent of notice of the occurrence of any termination event and (ii) 3:00 p.m. central time on April 15, 2020. “Termination event” is defined under the Standstill Agreement to include the occurrence of any one or more of the following: (i) any representation or warranty made or deemed to have been made by any credit party under the Standstill Agreement being false, misleading or erroneous in any material respect when made or deemed to have been made, (ii) any credit party failing to perform, observe or comply with any covenant, agreement or term contained in the Standstill Agreement in any material respect or (iii) any default which is not cured within five (5) business days or event of default occurring under the Unit credit agreement. Under the Standstill Agreement, we have agreed to limit our borrowings under the Unit credit agreement to $15.0 million, net of repayments. The Standstill Agreement is expected to allow the parties to discuss proposals for addressing various credit matters, with a view to possibly entering into further modifications to the Unit credit agreement. We are currently engaged in discussions with respect to such credit matters; however, there can be no assurance that we will reach any agreement with respect to those matters by the end of the standstill period, if at all. The above summary of the Unit credit agreement does not take into account the proposed amendments. Superior Credit Agreement. On May 10, 2018, Superior, a limited liability company equally owned between us and SP Investor Holdings, LLC, entered into a five-year, $200.0 million senior secured revolving credit facility with an option to increase the credit amount up to $250.0 million, subject to certain conditions. The amounts borrowed under the Superior credit agreement bear annual interest at a rate, at Superior’s option, equal to (a) LIBOR plus the applicable margin of 2.00% to 3.25% or (b) the alternate base rate (greater of (i) the federal funds rate plus 0.5%, (ii) the prime rate, and (iii) third day LIBOR plus 1.00%) plus the applicable margin of 1.00% to 2.25%. The obligations under the Superior credit agreement are secured by, among other things, mortgage liens on certain of Superior’s processing plants and gathering systems. The credit agreement provides that if ICE Benchmark Administration no longer reports the LIBOR or Administrative Agent determines in good faith that the rate so reported no longer accurately reflects the rate available to Lender in the London Interbank Market or if such index no longer exists or accurately reflects the rate available to Administrative Agent in the London Interbank Market, Administrative Agent may select a replacement index. Superior is charged a commitment fee of 0.375% on the amount available but not borrowed which varies based on the amount borrowed as a percentage of the total borrowing base. Superior paid $1.7 million in origination, agency, syndication, and other related fees. These fees are being amortized over the life of the Superior credit agreement. The Superior credit agreement requires that Superior maintain a Consolidated EBITDA to interest expense ratio for the most-recently ended rolling four quarters of at least 2.50 to 1.00, and a funded debt to Consolidated EBITDA ratio of not greater than 4.00 to 1.00. Additionally, the Superior credit agreement contains a number of customary covenants that, among other things, restrict (subject to certain exceptions) Superior’s ability to incur additional indebtedness, create additional liens on its assets, make investments, pay distributions, enter into sale and leaseback transactions, engage in certain transactions with affiliates, engage in mergers or consolidations, enter into hedging arrangements, and acquire or dispose of assets. As of December 31, 2019, Superior was in compliance with the Superior credit agreement covenants. The borrowings from the Superior credit agreement will be used to fund capital expenditures and acquisitions, provide general working capital, and for letters of credit for Superior. As of December 31, 2019, we had $16.5 million outstanding borrowings under the Superior credit agreement. Superior's credit agreement is not guaranteed by Unit. The current lenders under the Superior credit agreement and their respective participation interests are: 6.625% Senior Subordinated Notes. We have an aggregate principal amount of $650.0 million, 6.625% senior subordinated notes (the Notes). Interest on the Notes is payable semi-annually (in arrears) on May 15 and November 15 of each year. The Notes will mature on May 15, 2021. In issuing the Notes, we incurred $14.7 million of fees that are being amortized as debt issuance cost over the life of the Notes. The Notes are subject to an Indenture dated as of May 18, 2011, between us and Wilmington Trust, National Association (successor to Wilmington Trust FSB), as Trustee (the Trustee), as supplemented by the First Supplemental Indenture dated as of May 18, 2011, between us, the Guarantors, and the Trustee, and as further supplemented by the Second Supplemental Indenture dated as of January 7, 2013, between us, the Guarantors and the Trustee (as supplemented, the 2011 Indenture), establishing the terms and providing for issuing the Notes. The Guarantors are our direct and indirect subsidiaries. The discussion of the Notes in this report is qualified by and subject to the actual terms of the 2011 Indenture. Unit, as the parent company, has no significant independent assets or operations. The guarantees by the Guarantors of the Notes (registered under registration statements) are full and unconditional, joint and several, subject to certain automatic customary releases, are subject to certain restrictions on the sale, disposition, or transfer of the capital stock or substantially all of the assets of a subsidiary guarantor, and other conditions and terms set out in the 2011 Indenture. Effective April 3, 2018, Superior is no longer a Guarantor of the Notes. Excluding Superior, any of our other subsidiaries that are not Guarantors are minor. There are no significant restrictions on our ability to receive funds from any of our subsidiaries through dividends, loans, advances, or otherwise. We may redeem all or, from time to time, a part of the Notes at certain redemption prices, plus accrued and unpaid interest. If a “change of control” occurs, subject to certain conditions, we must offer to repurchase from each holder all or any part of that holder’s Notes at a purchase price in cash equal to 101% of the principal amount of the Notes plus accrued and unpaid interest, if any,theron to the date of purchase. The 2011 Indenture contains customary events of default. The 2011 Indenture also contains covenants including those that limit our ability and the ability of certain of our subsidiaries to incur or guarantee additional indebtedness; pay dividends on our capital stock or redeem capital stock or subordinated indebtedness; transfer or sell assets; make investments; incur liens; enter into transactions with our affiliates; and merge or consolidate with other companies. We were in compliance with all covenants under the 2011 Indentures as of December 31, 2019. If an event of default occurs under the credit agreement that accelerates the maturity of at least $25.0 million of borrowings, it will cause a default under the 2011 Indenture which may in turn accelerate the maturity of the Notes. On November 5, 2019, we filed with the SEC a registration statement on Form S-4 (the Registration Statement) regarding an offer to exchange (the Exchange Offer) any and all of our existing Notes for the New Notes, on the terms and conditions in the Registration Statement, and the related consent solicitation. The Registration Statement is not yet effective. See “Risk Factors-We may not complete the Exchange Offer and Consent Solicitation at all, or may complete the Exchange Offer with respect to less than all of our senior subordinated notes.” Capital Requirements Oil and Natural Gas Dispositions, Acquisitions, and Capital Expenditures. Most of our capital expenditures for this segment are discretionary and directed toward growth. Any decision to increase our oil, NGLs, and natural gas reserves through acquisitions or through drilling depends on the prevailing or expected market conditions, potential return on investment, future drilling potential, and opportunities to obtain financing, which provide us flexibility in deciding when and if to incur these costs. We completed drilling 115 gross wells (29.15 net wells) in 2019 compared to 117 gross wells (33.16 net wells) in 2018, and 70 gross wells (25.71 net wells) in 2017. On April 3, 2017, we closed an acquisition of certain oil and natural gas assets located primarily in Grady and Caddo Counties in western Oklahoma. The final adjusted value of consideration given was $54.3 million. As of January 1, 2017, the effective date of the acquisition, the estimated proved oil and gas reserves of the acquired properties were 3.2 million barrels of oil equivalent (MMBoe). The acquisition added approximately 8,300 net oil and gas leasehold acres to our core Hoxbar area in southwestern Oklahoma including approximately 47 proved developed producing wells. This acquisition included 13 potential horizontal drilling locations not otherwise included in our existing acreage. Of the acreage acquired, approximately 71% was held by production. We also received one gathering system as part of the transaction. In December 2018, we closed on an acquisition of certain oil and natural gas assets located primarily in Custer County, Oklahoma. The total preliminary adjusted value of consideration given was $29.6 million. As of November 1, 2018, the effective date of the acquisition, the estimated proved oil and gas reserves for the acquired properties was 2.6 MMBoe net to Unit. The acquisition added approximately 8,667 net oil and gas leasehold acres to our Penn Sands area in Oklahoma including approximately 44 wells. Of the acreage acquired, approximately 82% was held by production. Capital expenditures for oil and gas properties on the full cost method for 2019 by this segment, excluding a $0.1 million addition in the ARO liability and $3.7 million in acquisitions (including associated ARO), totaled $264.9 million compared to 2018 capital expenditures of $344.3 million (excluding a $7.6 million reduction in the ARO liability and $30.7 million in acquisitions), and 2017 capital expenditures of $215.4 million (excluding an $4.0 million reduction in the ARO liability and $59.0 million in acquisitions). For 2020, we do not currently have any plans to drill wells pending our ability to refinance or restructure our debt. We sold non-core oil and natural gas assets, net of related expenses, for $21.8 million, $22.5 million, and $18.6 million during 2019, 2018, and 2017, respectively. Proceeds from those dispositions reduced the net book value of our full cost pool with no gain or loss recognized. Contract Drilling Dispositions, Acquisitions, and Capital Expenditures. During 2017, we built our tenth BOSS drilling rig and placed it into service for a third party operator under a long term contract. We also returned to service 14 SCR drilling rigs that had been previously stacked. During 2018, we built our 11th BOSS drilling and placed it into service for a third party operator under a long term contract. We also made modifications to nine SCR rigs to meet customer requirements. In December 2018, our Board of Directors approved a plan to sell 41 drilling rigs (29 mechanical drilling rigs and 12 SCR diesel-electric drilling rigs) and other equipment. This plan satisfies the criteria of assets held for sale under ASC 360-10-45-9. The plan included a strategic decision to focus on our new BOSS drilling rigs and specific SCR drilling rigs and sell the other drilling rigs that we now choose not to market. We estimated the fair value of the 41 drilling rigs we will no longer use based on the estimated market value from third-party assessments (Level 3 fair value measurement) less cost to sell. Based on these estimates, in December 2018, we recorded a non-cash write-down of approximately $147.9 million, pre-tax ($111.7 million, net of tax). During 2019, we sold six of these drilling rigs and some of the other equipment to unaffiliated third parties. As of December 31, 2019, we determined that $10.8 million of the assets held for sale would not be sold in the next twelve months and were moved back to long-lived assets. Seven drilling rigs and equipment will be marketed for sale throughout the next twelve months and remain classified as assets held for sale. The net book value of those assets is $5.9 million. During 2019, we completed construction and placed into service with third party operators under long-term contracts our 12th and 13th BOSS drilling rigs. Our 14th BOSS drilling rig was completed and placed into service in December of 2019 for a third party operator under a long-term contract. For 2020, we do not currently have an approved capital plan for this segment. Capital expenditures incurred would be within anticipated cash flows. We spent $40.6 million for capital expenditures during 2019 compared to $75.5 million in 2018, and $36.1 million in 2017. Mid-Stream Dispositions, Acquisitions, and Capital Expenditures. At the Cashion processing facility in central Oklahoma, total throughput volume for the fourth quarter of 2019 averaged approximately 67.7 MMcf per day and total production of natural gas liquids increased to 326,337 gallons per day. We are continuing to connect new wells to this system from third party producers. Since the beginning of 2019, we have connected 35 new wells to this system from producers who continue to drill in the area. Construction of the 60 MMcf per day Reeding processing facility is complete and is fully operational. The total processing capacity on the Cashion system is 105 MMcf per day. With the assets from the recent acquisition in December, we will process the additional volume from these assets at the Reeding facility which is expected to begin April 1, 2020. In the Appalachian region at the Pittsburgh Mills gathering system, average gathered volume for December 2019 was 148.4 MMcf per day while the average gathered volume for the fourth quarter of 2019 was approximately 150.3 MMcf per day. During 2019, we added seven new wells to this system which accounted for a significant increase in gathered volume. Since these wells have been in production since the beginning of the year, we are seeing less of a decline than was expected from these wells. We are currently preparing to connect four new infill wells to this system which are expected to begin production in the second quarter of 2020. At the Hemphill processing facility located in the Texas panhandle, average total throughput volume for the fourth quarter of 2019 was 62.2 MMcf per day and total production of natural gas liquids declined to 141,137 gallons per day due to lower wellhead volume and operating in full ethane rejection. Since the first of this year, we connected eight new wells to the Hemphill system. At this time there are no active rigs in the area and we have not budgeted any new well connects for this system. At the Segno gathering system located in East Texas, the average throughput volume for the fourth quarter of 2019 was 59.9 MMcf per day. During 2019, we connected two new Unit Petroleum wells to this system. Unit Petroleum continues to rework and recomplete wells in the area around this system. During the fourth quarter of 2019, we disposed of three small gathering systems. We sold the Scipio gathering system, which is located in Southeast Oklahoma, to the producer. There was no net book value and resulted in a small gain less than $0.1 million. We discontinued the operations and abandoned the Ford and Briscoe gathering systems and recorded an impairment on those assets of $0.8 million. Also in December of 2019, we closed on an acquisition for $16.1 million that included approximately 572 miles of pipeline and related compressor stations. The transaction closed on December 30, 2019 and the effective date of the purchase was December 1, 2019. During 2019, our mid-stream segment incurred $64.4 million in capital expenditures which includes $16.1 million for an acquisition as compared to $44.8 million in 2018, and $22.2 million, in 2017. For 2020, our estimated capital expenditures will be approximately $28.0 million. Contractual Commitments At December 31, 2019, we had these contractual obligations: _________________________ 1.See previous discussion in MD&A regarding our debt. This obligation is presented under the Notes and the Unit and Superior credit agreements and includes interest calculated using our December 31, 2019 interest rates of 6.625% for the Notes and 4.0% for our Unit credit agreement and 3.9% for our Superior credit agreement. At December 31, 2019, our Unit credit agreement is reflected as a current liability in our consolidated balance sheet due to the uncertainty regarding the company's ability to repay or refinance the 2021 Senior Notes before November 16, 2020. The outstanding Unit credit agreement balance as of December 31, 2019 was $108.2 million. Our Superior credit agreement has a maturity date of May 10, 2023 and an outstanding balance of $16.5 million as of December 31, 2019. 2.We lease certain office space, land and equipment, including pipeline equipment and office equipment under the terms of operating leases under ASC 842 expiring through March 2032. We also have short-term lease commitments of $0.4 million. This is lease office space or yards in Edmond and Oklahoma City, Oklahoma; Houston, Texas; Englewood, Colorado; and Pinedale, Wyoming under the terms of operating leases expiring through October 2020. Additionally, we have several equipment leases and lease space on short-term commitments to stack excess drilling rig equipment and production inventory. 3.Maintenance and interest payments are included in our finance lease agreements. The finance leases are discounted using annual rates of 4.0%. Total maintenance and interest remaining are $2.3 million and $0.3 million, respectively. 4.We have committed to purchase approximately $0.9 million of new drill pipe and equipment over the next year. 5.We have firm transportation commitments to transport our natural gas from various systems for approximately $2.8 million over the next twelve months and $0.7 million for the two years thereafter. During the second quarter of 2018, as part of the Superior transaction, we entered into a contractual obligation that commits us to spend $150.0 million to drill wells in the Granite Wash/Buffalo Wallow area over three years starting January 1, 2019. This amount is included in our future drilling plans. For each dollar of the $150.0 million that we do not spend (over the three-year period), we would forgo receiving $0.58 of future distributions from our 50% ownership interest in our consolidated mid-stream subsidiary. At December 31, 2019, if we elected not to drill or spend any additional money in the designated area before December 31, 2021, the maximum amount we could forgo from distributions would be $72.7 million. Total spent towards the $150.0 million as of December 31, 2019 was $24.7 million. At December 31, 2019, we also had these commitments and contingencies that could create, increase or accelerate our liabilities: _________________________ 1.We provide a salary deferral plan which allows participants to defer the recognition of salary for income tax purposes until actual distribution of benefits, which occurs at either termination of employment, death or certain defined unforeseeable emergency hardships. We recognize payroll expense and record a liability, included in other long-term liabilities in our Consolidated Balance Sheets, at the time of deferral. 2.Effective January 1, 1997, we adopted a separation benefit plan (Separation Plan). The Separation Plan allows eligible employees whose employment with us is involuntarily terminated or with an employee who has completed 20 years of service, voluntarily or involuntarily terminated, to receive benefits equivalent to four weeks salary for every whole year of service completed with the company up to a maximum of 104 weeks. To receive payments the recipient must waive certain claims against us in exchange for receiving the separation benefits. On October 28, 1997, we adopted a Separation Benefit Plan for Senior Management (Senior Plan). The Senior Plan provides certain officers and key executives of the company with benefits generally equivalent to the Separation Plan. The Compensation Committee of the Board of Directors has absolute discretion in the selection of the individuals covered in this plan. On May 5, 2004 we also adopted the Special Separation Benefit Plan (Special Plan). This plan is identical to the Separation Benefit Plan with the exception that the benefits under the plan vest on the earliest of a participant’s reaching the age of 65 or serving 20 years with the company. 3.When a well is drilled or acquired, under ASC 410 “Accounting for Asset Retirement Obligations,” we record the fair value of liabilities associated with the retirement of long-lived assets (mainly plugging and abandonment costs for our depleted wells). 4.We have recorded a liability for those properties we believe do not have sufficient oil, NGLs, and natural gas reserves to allow the under-produced owners to recover their under-production from future production volumes. 5.We have recorded a liability for future estimated payments related to workers’ compensation claims primarily associated with our contract drilling segment. 6.This amount includes commitments under finance lease arrangements for compressors in our mid-stream segment. 7.We have recorded a liability related to the timing of the revenue recognized on certain demand fees in our mid-stream segment. Derivative Activities Periodically we enter into derivative transactions locking in the prices to be received for a portion of our oil, NGLs, and natural gas production. Any change in the fair value of all our derivatives are reflected in the statement of operations. Commodity Derivatives. Our commodity derivatives should reduce our exposure to price volatility and manage price risks. Our decision on the type and quantity of our production and the price(s) of our derivative(s) is based, in part, on our view of current and future market conditions. As of December 31, 2019, based on our fourth quarter 2019 average daily production, the approximated percentages of our production under derivative contracts are as follows: Regarding the commodities subject to derivative contracts, those contracts limit the risk of adverse downward price movements. However, they also limit increases in future revenues that would otherwise result from price movements above the contracted prices. Using derivative transactions has the risk that the counterparties may not meet their financial obligations under the transactions. Based on our evaluation at December 31, 2019, we believe the risk of non-performance by our counterparties is not material. At December 31, 2019, the fair values of the net assets we had with each of the counterparties to our commodity derivative transactions are: If a legal right of set-off exists, we net the value of the derivative arrangements we have with the same counterparty in our Consolidated Balance Sheets. At December 31, 2019, we recorded the fair value of our commodity derivatives on our balance sheet as current derivative assets of $0.6 million and long-term derivative liabilities of less than $0.1 million. At December 31, 2018, we recorded the fair value of our commodity derivatives on our balance sheet as current derivative assets of $12.9 million and long-term derivative liabilities of $0.3 million. All derivatives are recognized on the balance sheet and measured at fair value. Any changes in our derivatives' fair value before their maturity (i.e., temporary fluctuations in value) are reported in gain (loss) on derivatives in our Consolidated Statements of Operations. These gains (losses) are as follows at December 31: Stock and Incentive Compensation During 2019, we granted awards covering 1,500,213 shares of restricted stock. These awards were granted as retention incentive awards. These stock awards had an estimated fair value as of the grant date of $22.6 million. Compensation expense will be recognized over the awards' three year vesting period. During 2019, we recognized $7.4 million in additional compensation expense and capitalized $1.4 million for these awards. During 2018, we granted awards covering 1,279,255 shares of restricted stock. These awards were granted as retention incentive awards and are being recognized over the awards' three year vesting period. During 2017, we granted awards covering 708,276 shares of restricted stock. These awards were granted as retention incentive awards and are being recognized over their two and three year vesting periods. During 2019, we recognized compensation expense of $12.8 million for our restricted stock grants and capitalized $2.4 million of compensation cost for oil and natural gas properties. Insurance We are self-insured for certain losses relating to workers’ compensation, general liability, control of well, and employee medical benefits. Insured policies for other coverage contain deductibles or retentions per occurrence that range from zero to $1.0 million. We have purchased stop-loss coverage to limit, to the extent feasible, per occurrence and aggregate exposure to certain types of claims. There is no assurance that the insurance coverage we have will protect us against liability from all potential consequences. If insurance coverage becomes more expensive, we may choose to self-insure, decrease our limits, raise our deductibles, or any combination of these rather than pay higher premiums. Oil and Natural Gas Limited Partnerships and Other Entity Relationships. We were the general partner of 13 oil and natural gas partnerships formed privately or publicly. Effective January 1, 2019, we elected to terminate and wind down all of the remaining employee limited partnerships at a repurchase cost of $0.6 million, net of Unit's interest. Each partnership’s revenues and costs were shared under formulas set out in that partnership’s agreement. The partnerships repaid us for contract drilling, well supervision and general and administrative expense. Related party transactions for contract drilling and well supervision fees are the related party’s share of such costs. These costs were billed the same as billings to unrelated third parties for similar services. General and administrative reimbursements consisted of direct general and administrative expense incurred on the related party’s behalf and indirect expenses assigned to the related parties. Allocations were based on the related party’s level of activity and were considered by us to be reasonable. During 2018 and 2017, the total we received for these fees was $0.2 million and $0.2 million, respectively. Our proportionate share of assets, liabilities, and net income relating to the oil and natural gas partnerships is included in our consolidated financial statements. Effects of Inflation The effect of inflation in the oil and natural gas industry is primarily driven by the prices for oil, NGLs, and natural gas. Increases in these prices increase the demand for our contract drilling rigs and services. This increase in demand affects the dayrates we can obtain for our contract drilling services. During periods of higher demand for our drilling rigs we have experienced increases in labor costs and the costs of services to support our drilling rigs. Historically, during this same period, when oil, NGLs, and natural gas prices declined, labor rates did not come back down to the levels existing before the increases. If commodity prices increase substantially for a long period, shortages in support equipment (like drill pipe, third party services, and qualified labor) can cause additional increases in our material and labor costs. Increases in dayrates for drilling rigs also increase the cost of our oil and natural gas properties. Commodity prices also can affect our fracking and completion costs and there has been downward pressure on these costs in the last half of 2019. How inflation will affect us in the future will depend on increases, if any, realized in our drilling rig rates, the prices we receive for our oil, NGLs, and natural gas, and the rates we receive for gathering and processing natural gas. Off-Balance Sheet Arrangements We do not currently utilize any off-balance sheet arrangements with unconsolidated entities to enhance liquidity and capital resource positions, or for any other purpose. However, as is customary in the oil and gas industry, we are subject to various contractual commitments. Results of Operations 2019 versus 2018 _________________________ 1.NM - A percentage calculation is not meaningful due to a zero-value denominator or a percentage change greater than 200. Oil and Natural Gas Oil and natural gas revenues decreased $97.3 million or 23% in 2019 as compared to 2018 due primarily to lower NGLs and natural gas prices and production partially offset by higher oil prices and production. Oil production increased 12%, NGLs production decreased 3%, and natural gas production decreased 5%. Average oil prices between the comparative years increased 3% to $57.49 per barrel, NGLs prices decreased 44% to $12.42 per barrel, and natural gas prices decreased 17% to $2.04 per Mcf. Oil and natural gas operating costs increased $3.4 million or 3% between the comparative years of 2019 and 2018 primarily due to higher saltwater disposal expense and G&A expenses, partially offset by lower LOE. DD&A increased $35.1 million or 26% primarily due to a 29% increase in our DD&A rate partially offset by an 1% decrease in equivalent production. The increase in our DD&A rate between periods resulted primarily from the cost of wells drilled in between the periods and decreased reserves due to lower prices. During 2019, we recorded a non-cash ceiling test write-down of $559.4 million, pre-tax ($422.4 million, net of tax) due to the reduction of the 12-month average commodity prices and the removal of proved undeveloped reserves due to the uncertainty regarding our ability to finance future capital expenditures. We did not have a ceiling test write-down in 2018. We also recorded in 2019 a $0.5 million impairment on gathering systems with wells no longer producing. Contract Drilling Drilling revenues decreased $28.1 million or 14% in 2019 as compared to 2018. The decrease was due primarily to a 25% decrease in the average number of drilling rigs in use partially offset by a 7% increase in the average dayrate compared to 2018. Average drilling rig utilization decreased from 32.8 drilling rigs in 2018 to 24.6 drilling rigs in 2019. Drilling operating costs decreased $15.4 million or 12% in 2019 compared to 2018. The decrease was due primarily to less drilling rigs operating partially offset by increased direct cost per day and increased indirect cost. Contract drilling depreciation decreased $6.0 million or 10% also due primarily to less drilling rigs operating and the transfer of 41 drilling rigs to assets held for sale at the end of 2018 partially offset by accelerated depreciation on drilling rigs stacked more than 49 months. In 2019, we recognized goodwill impairment charges of $62.8 million, pre-tax ($59.8 million, net of tax) representing all of our goodwill which is related to our contract drilling segment. In 2018, our Board of Directors approved a plan to sell 41 drilling rigs (29 mechanical drilling rigs and 12 SCR diesel-electric drilling rigs) and other equipment. This plan satisfies the criteria of assets held for sale under ASC 360-10-45-9. The plan included a strategic decision to focus on our new BOSS drilling rigs and specific SCR drilling rigs and sell the other drilling rigs that we now choose not to market. We estimated the fair value of the 41 drilling rigs we will no longer use based on the estimated market value from third-party assessments (Level 3 fair value measurement) less cost to sell. Based on these estimates, in December 2018, we recorded a non-cash write-down of approximately $147.9 million, pre-tax ($111.7 million, net of tax). During 2019, we sold six of these drilling rigs and some of the other equipment to unaffiliated third parties. As of December 31, 2019, we determined that $10.8 million of the assets held for sale would not be sold in the next twelve months and were moved back to long-lived assets. Seven drilling rigs and equipment will be marketed for sale throughout the next twelve months and remain classified as assets held for sale. The net book value of those assets is $5.9 million. Mid-Stream Our mid-stream revenues decreased $43.3 million or 19% in 2019 as compared to 2018 primarily due to decreased NGLs, gas and condensate sales partially offset by higher transportation revenue. Gas processing volumes per day increased 4% between the comparative years due to connecting new wells to our processing systems. Gas gathering volumes per day increased 11% primarily due to connecting new wells at several of our gathering and processing systems. Operating costs decreased $34.2 million or 20% in 2019 compared to 2018 primarily due to an decrease in purchase prices. Depreciation and amortization increased $2.8 million or 6% primarily due to placing additional capital assets into service in 2019. The mid-stream segment had $3.0 million impairments due to decrease in value of line fill due to lower prices and from the retirement of two older systems. General and Administrative General and administrative expenses decreased $0.5 million or 1% in 2019 compared to 2018 primarily due to lower employee costs. Gain (Loss) on Disposition of Assets (Gain) loss on disposition of assets decreased $4.2 million in 2019 compared to 2018. The loss in 2019 was primarily from the retirement of old rig inventory, while the gain in 2018 was primarily for the sale of drilling equipment and vehicles. Other Income (Expense) Interest expense, net of capitalized interest, increased $2.6 million between the comparative years of 2019 and 2018. We capitalized interest based on the net book value associated with unproved properties not being amortized, the construction of additional drilling rigs, and the construction of gas gathering systems. Capitalized interest for 2019 was $16.2 million compared to $16.5 million in 2018, and was netted against our gross interest of $53.2 million and $51.0 million for 2019 and 2018, respectively. Our average interest rate decreased from 6.5% to 6.4% and our average debt outstanding was $59.6 million higher in 2019 as compared to 2018 primarily due to the pay down of our Unit credit agreement in the second quarter of 2018. Gain (loss) on derivatives increased $7.4 million primarily due to fluctuations in forward prices used to estimate the fair value in mark-to-market accounting. Income Tax Benefit Income tax benefit increased $118.3 million in 2019 compared to 2018. We recognized an income tax benefit of $132.3 million in 2019 compared to an income tax benefit of $14.0 million in 2018. The 2019 income tax benefit was higher primarily due to the larger pre-tax loss recognized in 2019 as compared to 2018. Our effective tax rate was 19.3% for 2019 compared to 26.0% for 2018. The effective tax rate for the current year was lower as compared to 2018 because a substantial amount of the goodwill impairment was not deductible for income tax purposes as well as recording a valuation allowance of $19.7 million. The valuation allowance was due to determining it was more likely than not that the deferred tax asset for net operating loss carryforwards were not fully realizable. We paid $0.3 million in state income taxes during 2019 due to the sale of 50% interest in our mid-stream segment in 2018.

<s>[INST] For discussion related to changes in financial condition and results of operations for 2018 as compared with 2017, refer to Part II, Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations in our 2018 Form 10K, which was filed with the SEC on February 26, 2019. General We were founded in 1963 as a contract drilling company. Today, we operate, manage, and analyze our results of operations through our three principal business segments: Oil and Natural Gas carried out by our subsidiary Unit Petroleum Company. This segment explores, develops, acquires, and produces oil and natural gas properties for our own account. Contract Drilling carried out by our subsidiary Unit Drilling Company. This segment contracts to drill onshore oil and natural gas wells for others and for our own account. MidStream carried out by our subsidiary Superior Pipeline Company, L.L.C. and its subsidiaries. This segment buys, sells, gathers, processes, and treats natural gas for third parties and for our own account. We own 50% of this subsidiary. Business Outlook As discussed in other parts of this report, among other things, our success depends, to a large degree, on the prices we receive for our oil and natural gas production, the demand for oil, natural gas, and NGLs, and the demand for our drilling rigs which influences the amounts we can charge for those drilling rigs. While our operations are all within the United States, events outside the United States affect us and our industry. On March 9, 2020, the price of oil fell approximately 20% due to a dispute over production levels between Russia and Saudi Arabia, as a result of which Saudi Arabia increased its production to record levels. We cannot anticipate whether or when this dispute will be resolved and production returned to normalized levels. In the absence of a resolution, oil prices could remain at current levels, or decline further, for an extended period of time. As a result of record commodity price declines and our substantial debt burden, we do not believe that forecasted cash and available credit capacity will be sufficient to meet commitments as they come due over the next twelve months. Our ability to continue as a going concern is dependent on our ability to refinance our debt liability that is coming due. These factors, among others, raise substantial doubt about our ability to continue as a going concern. Our consolidated financial statements do not include any adjustments that might result from the outcome of this uncertainty. We cannot assure you that we will be successful in our efforts to generate revenues, become profitable, raise additional outside capital or to continue as a going concern. If we are not successful in our efforts to raise additional capital or to restructure our capital structure sufficient to support our operations, we would be unlikely to be able to raise capital in the near term and may be forced to seek protection under Chapter 11. In an effort to address these circumstances, we sought to extend the maturity profile of our debt through the Exchange Offer. However, we have been advised by certain holders of a large percentage of our outstanding senior subordinated notes that they do not intend to participate in the Exchange Offer, which raises doubts regarding our ability to complete the Exchange Offer and increases the likelihood we may need to seek protection under Chapter 11. Fluctuating commodity prices can result in significant changes to our industry and us. Depressed commodity prices, particularly for the extended time, can result in industry wide reductions in drilling activity and spending which reduce the rates for and the number of our drilling rigs we were able to put to work. Such industry wide reductions in drilling activity and spending for extended periods also reduces the rates for and the number of our drilling rigs we can work. In addition, sustained lower commodity prices impact the liquidity condition of some of our industry partners and customers, which could limit their ability to meet their financial obligations to us. During the last three years, commodity prices have been volatile. Our oil and natural gas segment used two to three drilling rigs throughout 2017. With improved commodity prices during the first quarter of 2018, our oil and natural gas segment put four of our drilling rigs to work and increased the number to six drilling rigs for a brief period during the third quarter [/INST] Negative. </s>

BUCKEYE PARTNERS, L.P.

2015-02-26

2014-12-31

Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations The following discussion should be read in conjunction with our consolidated financial statements and our accompanying notes thereto included in Item 8 of this Report. Business Overview We own and operate a diversified network of integrated assets providing midstream logistic solutions, primarily consisting of the transportation, storage and marketing of liquid petroleum products. We are one of the largest independent liquid petroleum products pipeline operators in the United States in terms of volumes delivered, with approximately 6,000 miles of pipeline. Our terminal network comprises more than 120 liquid petroleum products terminals with aggregate storage capacity of over 110 million barrels across our portfolio of pipelines, inland terminals and marine terminals located primarily in the East Coast and Gulf Coast regions of the United States and in the Caribbean. Our flagship marine terminal in The Bahamas, BORCO, is one of the largest marine crude oil and refined petroleum products storage facilities in the world and provides an array of logistics and blending services for petroleum products. Our network of marine terminals enables us to facilitate global flows of crude oil, refined petroleum products, and other commodities, and to offer our customers connectivity to some of the world’s most important bulk storage and blending hubs. In September 2014, we expanded our network of marine midstream assets by acquiring a controlling interest in a company with assets located in Corpus Christi and the Eagle Ford play in Texas. We are also a wholesale distributor of refined petroleum products in certain areas served by our pipelines and terminals. Finally, Buckeye operates and/or maintains third-party pipelines under agreements with major oil and gas, petrochemical and chemical companies, and performs certain engineering and construction management services for third parties. Our primary business objective is to provide stable and sustainable cash distributions to our LP Unitholders, while maintaining a relatively low investment risk profile. The key elements of our strategy are to: (i) operate in a safe and environmentally responsible manner; (ii) maximize utilization of our assets at the lowest cost per unit; (iii) maintain stable long-term customer relationships; (iv) optimize, expand and diversify our portfolio of energy assets through accretive acquisitions and organic growth projects; and (v) maintain a solid, conservative financial position and our investment-grade credit rating. Overview of Operating Results Net income attributable to our unitholders was $273.0 million for the year ended December 31, 2014, which was an increase of $112.7 million, or 70.3%, from $160.3 million for the corresponding period in 2013. The increase was primarily related to a non-cash asset impairment charge of $169.0 million recorded in 2013 related to our decision to divest our natural gas storage business. Operating income was $495.3 million for the year ended December 31, 2014, which is an increase of $17.3 million, or 3.6%, from $478.0 million the corresponding period in 2013. Our results for the year ended December 31, 2014 include year-over-year improvement in our Pipelines & Terminals, Global Marine Terminals and Development & Logistics segments, while our Merchant Services segment experienced an operating loss as a result of weaker business conditions in the various refined petroleum markets in which we serve, and unfavorable results from implementing strategies during the second quarter of 2014 intended to increase the utilization of our physical assets, grow our marketing business and mitigate risk. In 2014, our net income attributable to unitholders was also negatively impacted by the continued decline in the financial performance of our discontinued natural gas storage operations, primarily due to unfavorable market conditions, including low natural gas prices, compressed seasonal spreads and low volatility, as well as a reduction in revenue in our Pipelines & Terminals segment related to a litigation contingency reserve for ongoing FERC proceedings. Revenues for our Pipelines & Terminals segment grew significantly in 2014, with the most significant contributor to this improvement attributed to the effective commercialization and integration of the terminals acquired from Hess in December 2013. Capital investments in internal growth and diversification initiatives, including expanding our butane blending capabilities and our crude oil handling services, also drove the year-over-year increase. More specifically, we benefitted from the contribution of 1.1 million barrels of new crude oil storage capacity that was placed in service during 2014 as well as the crude oil pipeline to rail facility that became operational in late 2013 at our Chicago Complex. Completed growth capital projects across our terminals continued to generate incremental cash flows related to higher butane blending margins and further butanization initiatives, including the installation of butane blending capabilities at five additional facilities. We also benefited from tariff increases put in place in March and July of 2014. Our Global Marine Terminals segment benefited from year-over-year contribution driven primarily by the St. Lucia, Port Reading and Raritan Bay terminalling assets acquired from Hess in December 2013. The integration of these assets into our legacy portfolio has created synergies from providing complementary storage positions across our assets. In addition, internal capital growth initiatives generated period-over-period improvements and include the pipeline connection to Linden that was completed in the second quarter of 2014, the commencement of the gasoline blending and storage contract upon completion of this pipeline and the completed truck rack placed in service in late 2013. Furthermore, we benefited from the integration of assets acquired in the Buckeye Texas Partners transaction. Key contributors to growth for our Development & Logistics segment include our third-party engineering and operations business, which benefited from improved margins and new contract operations opportunities. In addition, contributions from the LPG storage caverns continue to increase due to the return of recent capital investments and rail capabilities at these facilities. The loss in our Merchant Services segment was primarily due to implementing strategies during the second quarter of 2014 intended to increase the utilization of our physical assets, grow our marketing business and mitigate risk. These losses were attributed to: (i) costs associated with entering into new markets to grow our marketing business and support the optimization of our underlying physical assets; (ii) losses on the liquidation of physical positions in markets less liquid than in our core markets; (iii) losses resulting from the timing of activity intended to mitigate risk on gasoline and distillates for the summer driving season and upcoming heating season; and (iv) a significant decline in the value of ethanol which is carried in inventory to support our gasoline business. The strategies that led to the loss in the second quarter were terminated and we continue to institute process improvements to manage our commodity risk. These losses were partially offset by increased earnings as a result of higher rack margins. Also partially offsetting our overall increase in net income attributable to our unitholders was an increase in interest expense resulting from the long term debt issuances in 2013, including the debt issued to partially fund the assets acquired from Hess, and the increase in depreciation and amortization expense due to the assets acquired from Hess and the Buckeye Texas Partners transaction. See the “Results of Operations” section below for further discussion and analysis of our operating segments. Results of Operations Consolidated Summary Our summary operating results were as follows for the periods indicated (in thousands, except per unit amounts): (1) Represents loss from the operations of our Natural Gas Storage disposal group. See Note 4 in the Notes to Consolidated Financial Statements for more information. Non-GAAP Financial Measures Adjusted EBITDA is the primary measure used by our senior management, including our Chief Executive Officer, to: (i) evaluate our consolidated operating performance and the operating performance of our business segments; (ii) allocate resources and capital to business segments; (iii) evaluate the viability of proposed projects; and (iv) determine overall rates of return on alternative investment opportunities. Distributable cash flow is another measure used by our senior management to provide a clearer picture of cash available for distribution to its unitholders. Adjusted EBITDA and distributable cash flow eliminate: (i) non-cash expenses, including but not limited to, depreciation and amortization expense resulting from the significant capital investments we make in our businesses and from intangible assets recognized in business combinations; (ii) charges for obligations expected to be settled with the issuance of equity instruments; and (iii) items that are not indicative of our core operating performance results and business outlook. We believe that investors benefit from having access to the same financial measures that we use and that these measures are useful to investors because they aid in comparing our operating performance with that of other companies with similar operations. The Adjusted EBITDA and distributable cash flow data presented by us may not be comparable to similarly titled measures at other companies because these items may be defined differently by other companies. The following table presents Adjusted EBITDA from continuing operations by segment and on a consolidated basis, distributable cash flow and a reconciliation of income from continuing operations, which is the most comparable financial measure under generally accepted accounting principles (“GAAP”), to Adjusted EBITDA and distributable cash flow for the periods indicated (in thousands): (1) Includes $12.3 million of depreciation and amortization expense for the year ended December 31, 2014, representing 100% of ownership interest in Buckeye Texas. (2) Represents acquisition and transition expense related to the Hess Terminals Acquisition in December 2013 and the Buckeye Texas Partners Transaction in September 2014. (3) Represents a contingent liability associated with ongoing FERC litigation proceedings. (4) Represents the amortization of the negative fair values allocated to certain unfavorable storage contracts acquired in connection with the BORCO acquisition. The following table presents product volumes transported and average daily throughput for the Pipelines & Terminals segment and total volumes sold for the Merchant Services segment for the periods indicated: (1) Includes diesel fuel and heating oil. (2) Includes liquefied petroleum gas, intermediate petroleum products and crude oil. (3) Amounts for 2014 and 2013 include throughput volumes at terminals acquired from Hess in December 2013. (4) Amounts include volumes related to fuel oil supply and distribution services which began in late 2012. Year Ended December 31, 2014 Compared to Year Ended December 31, 2013 Consolidated Adjusted EBITDA was $763.6 million for the year ended December 31, 2014, which is an increase of $114.8 million, or 17.7%, from $648.8 million for the corresponding period in 2013. The increase in Adjusted EBITDA was primarily related to positive contribution from the assets acquired from Hess in December 2013 in the Global Marine Terminals and Pipelines & Terminals segments and benefit from growth capital spending in the Pipelines & Terminals segment. These increases in Adjusted EBITDA were partially offset by the loss in the Merchant Services segment as a result of weaker business conditions in the various refined petroleum markets in which we serve, and unfavorable results from implementing strategies in that segment during the second quarter of 2014 intended to increase the utilization of our physical assets, grow our marketing business and mitigate risk. These losses were attributed to: (i) costs associated with entering into new markets to grow our marketing business and support the optimization of our underlying physical assets; (ii) losses on the liquidation of physical positions in markets less liquid than in our core markets; (iii) losses resulting from the timing of activity intended to mitigate risk on gasoline and distillates for the summer driving season and upcoming heating season; and (iv) a significant decline in the value of ethanol which is carried in inventory to support our gasoline business. Revenue was $6,620.2 million for the year ended December 31, 2014, which is an increase of $1,566.1 million, or 31.0%, from $5,054.1 million for the corresponding period in 2013. The increase in revenue was primarily related to increased product sales volumes in our Merchant Services segment, as well as the benefit of the terminals acquired from Hess in December 2013 in both our Pipelines & Terminals and Global Marine Terminals segments. These increases were partially offset by the litigation contingency reserve, recorded as a reduction in revenue, associated with ongoing FERC proceedings in our Pipelines & Terminals segment. Operating income was $495.3 million for the year ended December 31, 2014, which is an increase of $17.3 million, or 3.6%, from $478.0 million in the corresponding period in 2013. The increase in operating income was primarily related to the benefit of the terminals acquired from Hess in December 2013 in both our Global Marine Terminals and Pipelines & Terminals segments. These increases were partially offset by the increase in depreciation and amortization expense primarily due to the assets acquired from Hess, assets acquired in the Buckeye Texas Partners Transaction in September 2014, the loss in the Merchant Services segment discussed above, as well as the litigation contingency reserve, recorded as a reduction in revenue, associated with ongoing FERC proceedings in our Pipelines & Terminals segment. Distributable cash flow was $526.8 million for the year ended December 31, 2014, which is an increase of $72.6 million, or 16.0%, from $454.2 million for the corresponding period in 2013. The increase in distributable cash flow was primarily related to an increase of $114.8 million in Adjusted EBITDA as described above, partially offset by a $34.3 million increase in interest expense, excluding amortization of deferred financing costs, debt discounts and other, primarily resulting from the long-term debt issuances in 2013, including the debt issued to partially fund the assets acquired from Hess in December 2013 and a $7.9 million increase in maintenance capital expenditures. Adjusted EBITDA by Segment Pipelines & Terminals. Adjusted EBITDA from the Pipelines & Terminals segment was $511.3 million for the year ended December 31, 2014, which was an increase of $40.2 million, or 8.5%, from $471.1 million for the corresponding period in 2013. The positive factors impacting Adjusted EBITDA were related to a $68.4 million increase in revenue resulting from an increase in terminalling throughput and storage contracts, including those associated with the assets acquired from Hess in December 2013, $33.4 million of incremental revenue from capital investments in internal growth and diversification initiatives, including butane blending capabilities, crude oil handling services and storage and throughput of other hydrocarbons, a $14.6 million increase in revenue due to increases in average pipeline tariff rates and longer-haul shipments, a $6.0 million increase in earnings from equity investments primarily due to a decrease in maintenance expense, a $4.6 million increase in other revenue, including a favorable settlement related to certain pipeline transportation services and a $2.4 million increase resulting from higher pipeline volumes. The negative factors impacting Adjusted EBITDA were an $80.8 million increase in operating expenses, primarily related to incremental costs necessary to operate the terminals acquired from Hess in December 2013 and outside services for asset-maintenance activities, and $8.4 million in less favorable settlement experience primarily related to high volumetric gains experienced in 2013 as well as, to a lesser extent, falling commodity prices in 2014. Pipeline volumes slightly increased despite weaker gasoline shipments resulting from extreme weather conditions in early 2014. Overall terminalling volumes increased by 16.5% due to effective commercialization and integration of the terminals acquired from Hess in December 2013. Legacy terminalling volumes increased by 4.4% due to higher demand for gasoline, distillates and jet fuel and new customer contracts and service offerings at select locations, including the benefit of contributions from growth capital spending. Global Marine Terminals. Adjusted EBITDA from the Global Marine Terminals segment was $239.6 million for the year ended December 31, 2014, which was an increase of $89.8 million, or 60.0%, from $149.7 million for the corresponding period in 2013. The positive factors impacting Adjusted EBITDA were a $103.5 million increase in storage and terminalling revenue primarily as a result of the assets acquired from Hess in December 2013 and a $32.8 million increase in revenue from ancillary services. Ancillary services include the berthing of ships at our jetties, heating services and settlement gains/losses. The increase in revenue was partially offset by a $46.5 million increase in operating expenses primarily related to incremental costs necessary to operate the assets acquired from Hess in December 2013. Merchant Services. Adjusted EBITDA from the Merchant Services segment was a loss of $8.1 million for the year ended December 31, 2014, which was a decrease of $20.7 million from earnings of $12.6 million for the corresponding period in 2013. The loss experienced during the period is primarily attributed to losses in the second quarter described above, partially offset by strong domestic rack margins. Adjusted EBITDA was positively impacted by a $1,368.0 million increase in revenue, which included a $1,854.9 million increase due to 46.5% of higher volumes sold, partially offset by a $486.9 million decrease in refined petroleum product sales due to a price decrease of $0.24 per gallon (average sales prices per gallon were $2.67 and $2.91 for the 2014 and 2013 periods, respectively). Adjusted EBITDA was negatively impacted by a $1,383.0 million increase in cost of product sales, which included a $1,843.3 million increase due to 46.5% of higher volumes sold, offset by a $460.3 million decrease in refined petroleum product cost due to a price decrease of $0.23 per gallon (average cost prices per gallon were $2.66 and $2.89 for the 2014 and 2013 periods, respectively) and a $5.7 million increase in operating expenses. Development & Logistics. Adjusted EBITDA from the Development & Logistics segment was $20.7 million for the year ended December 31, 2014, which was an increase of $5.4 million, or 35.0%, from $15.4 million for the corresponding period in 2013. The increase in Adjusted EBITDA was primarily due to a $19.5 million increase in third-party engineering and operations revenue primarily due to increased project activity and $2.9 million increase in revenue related to the LPG storage caverns primarily due to the favorable seasonal impact of the depletion of inventory and a one-time gain recognition of inventory, partially offset by a $17.0 million increase in engineering and operations expenses. Year Ended December 31, 2013 Compared to Year Ended December 31, 2012 Consolidated Adjusted EBITDA was $648.8 million for the year ended December 31, 2013, which is an increase of $96.4 million, or 17.4%, from $552.4 million for the corresponding period in 2012. The increase in Adjusted EBITDA was primarily related to positive contributions from increased pipeline and terminalling volumes directly attributable to growth capital spending and higher blending capabilities, particularly butane blending, in the Pipelines & Terminals segment and increased storage capacity at and customer utilization of our BORCO facility in the Global Marine Terminals segment. In addition, higher margins in the Merchant Services segment were primarily due to lower product costs resulting from risk management activities and the generation of RINs. Revenue was $5,054.1 million for the year ended December 31, 2013, which is an increase of $768.2 million, or 17.9%, from $4,285.9 million for the corresponding period in 2012. The increase in revenue was primarily related to new fuel oil supply and distribution services in the Caribbean and increased product sales volumes in our Merchant Services segment. In addition, revenue in our Pipelines & Terminals segment increased as a result of increased pipeline and terminalling volumes directly attributable to our growth capital spending and higher butane blending capabilities. Our Global Marine Terminals segment benefitted from incremental storage capacity brought online at our BORCO facility. Operating income was $478.0 million for the year ended December 31, 2013, which is an increase of $133.5 million, or 38.7%, from $344.5 million the corresponding period in 2012. The increase in operating income was primarily related to increased pipeline and terminalling volumes directly attributable to our growth capital spending and diversification initiatives, as well as a non-cash asset impairment charge in 2012 in the Pipelines & Terminals segment. In addition, higher margins and lower operating costs in our Merchant Services segment contributed to our overall increase in operating income. These increases in operating income were offset by increased operating and depreciation expense largely attributable to the capacity expansion completed and brought online in the Global Marine Terminals segment. Distributable cash flow was $454.2 million for the year ended December 31, 2013, which is an increase of $68.4 million, or 17.7%, from $385.8 million for the corresponding period in 2012. The increase in distributable cash flow was primarily related to an increase of $96.4 million in Adjusted EBITDA as described above, partially offset by an increase in maintenance capital expenditures of $17.4 million and increase in interest expense of $11.0 million related to long-term debt issuances in 2013, including the debt issued in the fourth quarter of 2013 to partially fund the Hess Terminals acquisition. Adjusted EBITDA by Segment Pipelines & Terminals. Adjusted EBITDA from the Pipelines & Terminals segment was $471.1 million for the year ended December 31, 2013, which was an increase of $61.6 million, or 15.0%, from $409.5 million for the corresponding period in 2012. The positive factors impacting Adjusted EBITDA were related to $49.6 million of incremental revenue from capital investments in internal growth and diversification initiatives, including expanded butane blending capabilities, crude-handling services, as well as storage and throughput of other hydrocarbons, a $17.8 million increase in revenue due to higher pipeline and terminalling volumes on our legacy assets, $6.9 million increase in revenue resulting from an increase in pipeline capacity rentals, terminalling storage contracts and throughput and storage revenue at the terminals acquired from Hess in December 2013, $5.6 million more of favorable settlement experience despite the successful resolution of a $10.6 million product settlement allocation matter in 2012 and a $0.7 million increase in earnings due to the purchase of an additional ownership interest in WesPac Memphis in the second quarter of 2013. The negative factors impacting Adjusted EBITDA were a $16.9 million increase in operating expenses, primarily related to higher operating costs due to internal growth and pipeline integrity costs, a $1.2 million decrease in revenue due to lower average pipeline tariff rates resulting from shorter-haul shipments and a $0.9 million decrease in earnings from equity investments due to higher maintenance costs. Pipeline volumes increased by 2.9% due to stronger demand for gasoline and middle distillates resulting from changes in regional production and supply, partially offset by the idling of a portion of our NORCO pipeline system in early 2013. Terminalling volumes increased by 6.4% due to higher demand for gasoline, distillates and other hydrocarbons, resulting from new customer contracts and service offerings at select locations, effective commercialization of acquired assets, continued positive contribution from our recently completed internal growth projects and favorable market conditions. Global Marine Terminals. Adjusted EBITDA from the Global Marine Terminals segment was $149.7 million for the year ended December 31, 2013, which was an increase of $21.1 million, or 16.4%, from $128.6 million for the corresponding period in 2012. The positive factors impacting Adjusted EBITDA were a $28.9 million increase in storage revenue primarily as a result of incremental storage capacity brought online at our BORCO facility and assets acquired from Hess in December 2013 and a $5.3 million increase in revenues from ancillary services due to increased customer utilization of our facilities. Ancillary services include the berthing of ships at our jetties and heating services. The increase in revenue was offset by a $13.1 million increase in operating expenses primarily due to increased costs necessary to operate the expanded capabilities of the BORCO facility, one-time costs related to certain organizational changes in the second quarter of 2013 and costs associated with taking certain tankage out of service for maintenance activities and project work to improve the capabilities for handling anticipated heavy crude volumes. Merchant Services. Adjusted EBITDA from the Merchant Services segment was $12.6 million for the year ended December 31, 2013, which was an increase of $11.5 million from $1.1 million for the corresponding period in 2012. In 2012, we developed and executed a strategy to mitigate basis risk that included the reduction of refined petroleum product inventories in the Midwest. In 2013, we continued to benefit from the execution of our strategy, which included focusing on fewer, more strategic locations in which to transact business, better managing our inventories and reducing the cost structure of the business. Sales volumes increased as we executed this strategy. In addition, beginning in late 2012, the segment began to provide fuel oil supply and distribution services to third parties in the Caribbean. This activity has also contributed to our increase in sales volumes for the period. Furthermore, we benefited from improved rack margins, largely the result of risk management activities to lower product costs, and the generation of RINs, which are tradable “credits” generated by blending biofuels into finished gasoline or diesel products. The increase in Adjusted EBITDA was primarily related to a $651.4 million increase in revenue, which included a $728.4 million increase due to 21.8% of higher sales volumes, offset by a $77.0 million decrease as a result of a $0.06 per gallon decrease in refined petroleum product sales price (average sales prices per gallon were $2.91 and $2.97 for the 2013 and 2012 periods, respectively) and a $0.8 million decrease in operating expenses primarily related to overhead costs. The increase in revenue was partially offset by a $640.7 million increase in cost of product sales, which included a $725.3 million increase due to 21.8% of higher sales volumes, offset by a $84.6 million decrease as a result of a $0.06 per gallon decrease in refined petroleum product cost price (average cost prices per gallon were $2.89 and $2.95 for the 2013 and 2012 periods, respectively). Development & Logistics. Adjusted EBITDA from the Development & Logistics segment was $15.4 million for the year ended December 31, 2013, which was an increase of $2.2 million, or 16.6%, from $13.2 million for the corresponding period in 2012. The increase in Adjusted EBITDA was primarily due to an $8.1 million increase in third-party engineering and operations revenue as a result of new contracts and higher fees and a $0.9 million increase in revenue related to the LPG storage caverns, partially offset by a $6.0 million increase in third-party engineering and operations expense and a $0.8 million increase in operating expenses, which primarily related to overhead costs. General Outlook for 2015 The full year contribution from our recent acquisition of Buckeye Texas is expected to drive meaningful improvement in our year-over-year performance. We continue our implementation efforts around these assets, and we have made and expect to continue to make substantial investments in the Corpus Christi facilities during 2015. We expect to complete the construction of 3.8 million barrels of additional storage capacity, which will be placed in service ratably as tankage is completed in 2015 and into early 2016. Additionally, the condensate splitter is anticipated to be in service by mid-2015. Once complete, these facilities will offer our customer and partner, Trafigura, a premier deep-water, high-volume marine terminal, a condensate splitter and an LPG storage complex in Corpus Christi, Texas, as well as three crude oil and condensate gathering facilities in the Eagle Ford play. Importantly, all of these assets are backed by long-term seven to ten year minimum volume throughput and storage contracts with Trafigura that support substantially all the capacity and cash flows expected from these assets. We expect to invest additional capital in 2015 in a number of projects, including potential pipeline extensions and expansions for transportation and/or storage of crude oil, refined products and natural gas liquids in and around our system footprint, both in the Midwest and around the East Coast. We recently announced an open season on a significant pipeline expansion project intended to facilitate refined product movements from advantaged Midwestern refiners eastward to markets in Eastern Ohio and Western Pennsylvania. We have historically generated strong returns on our organic growth capital investments, and we expect this trend to continue. We also expect to incrementally benefit in 2015 from previous capital investments in projects completed in 2014. We completed the addition of 1.1 million barrels of crude oil storage capacity that was placed in service at our Chicago Complex as well as the high capacity pipeline connection between Perth Amboy and our Linden hub. We will see a full year contribution from those investments in 2015. We also completed the crude rail loading and unloading facility at our Perth Amboy facility in 2014, and we are actively exploring options to utilize the facility to potentially handle a heavier crude slate, export Canadian-sourced crude oil and handle petroleum feedstock components such as LPGs, naphtha and natural gasoline. We believe both producers and refiners continue to value the optionality and flexibility that rail logistics provide and expect these assets to provide a substantial incremental contribution in 2015. In 2014, we installed new leadership in our Merchant Services segment that has been busy implementing a number of new processes and analyses to allow further optimization of this business. We expect this business to continue to focus on its core strategy of optimizing the utilization of the hard assets across our system, driving more profitable operations in 2015. In addition, we believe this business will benefit in 2015 from contango in the refined products markets. We have seen declining crude prices in the second half of 2014 and early 2015 and expect prices to remain significantly below pricing levels we saw over the past few years. While certain aspects of our business will be negatively impacted by this decline in prices, other businesses are expected to benefit, as contango drives interest in storage and lower refined products prices potentially drives higher throughput volumes. Overall, we believe Buckeye is well positioned for the current market environment. Volumes on our pipeline systems and terminals are expected to experience moderate growth, primarily as the result of capital projects. We posted a tariff increase as of January 1, 2015 on our market-based systems and expect growth on our index-based systems. Tariffs on our pipelines serving the New York City airports remain subject to the ongoing FERC matter. We continue to look for ways to provide new solutions for our customers by leveraging our existing asset footprint. Ultimately, our ability to increase transportation and storage revenues is largely dependent on the strength of the overall economy in the markets we serve. We believe that, under current market conditions, we could raise additional capital in both the debt and equity markets on acceptable terms. This could include utilizing the at-the-market equity issuance program, which is the most cost-efficient means to raise equity if necessary. We will continue to evaluate opportunities throughout 2015 to acquire or construct assets that are complementary to our businesses and support our long-term growth strategy and will determine the appropriate financing structure for any opportunity we pursue. The forward-looking statements contained in this “General Outlook for 2015” speak only as of the date hereof. Although the expectations in the forward-looking statements are based on our current beliefs and expectations, caution should be taken not to place undue reliance on any such forward-looking statements because such statements speak only as of the date hereof. Except as required by federal and state securities laws, we undertake no obligation to publicly update or revise any forward-looking statements, whether as a result of new information, future events or any other reason. All such forward-looking statements are expressly qualified in their entirety by the cautionary statements contained or referred to in this Report, including under the captions “Risk Factors” and “Cautionary Note Regarding Forward-Looking Statements” and elsewhere in this Report and in our future periodic reports filed with the SEC. In light of these risks, uncertainties and assumptions, the forward-looking events discussed in this “General Outlook for 2015” may not occur. Liquidity and Capital Resources General Our primary cash requirements, in addition to normal operating expenses and debt service, are for working capital, capital expenditures, business acquisitions and distributions to partners. Our principal sources of liquidity are cash from operations, borrowings under our $1.5 billion revolving Credit Facility and proceeds from the issuance of our LP Units. We will, from time to time, issue debt securities to permanently finance amounts borrowed under our Credit Facility. The BMSC entities fund their working capital needs principally from their own operations and their portion of our Credit Facility. Our financial policy has been to fund maintenance capital expenditures with cash from continuing operations. Expansion and cost reduction capital expenditures, along with acquisitions, have typically been funded from external sources including our Credit Facility, as well as debt and equity offerings. Our goal has been to fund at least half of these expenditures with proceeds from equity offerings in order to maintain our investment-grade credit rating. Based on current market conditions, we believe our borrowing capacity under our Credit Facility, cash flows from continuing operations and access to debt and equity markets, if necessary, will be sufficient to fund our primary cash requirements, including our expansion plans over the next 12 months. Current Liquidity As of December 31, 2014, we had $10.3 million of working capital and $1,334.0 million of availability under our Credit Facility, but, except for borrowings that are used to refinance other debt, we are limited to $1,209.2 million of additional borrowing capacity by the financial covenants under our Credit Facility. Capital Structuring Transactions As part of our ongoing efforts to maintain a capital structure that is closely aligned with the cash-generating potential of our asset-based business, we may explore additional sources of external liquidity, including public or private debt or equity issuances. Matters to be considered will include cash interest expense and maturity profile, all to be balanced with maintaining adequate liquidity. We have a universal shelf registration statement that does not place any dollar limits on the amount of debt and equity securities that we may issue thereunder and a traditional shelf registration statement on file with the SEC under which we may issue equity securities with a value, as of December 31, 2014, not to exceed $674.5 million. The timing of any transaction may be impacted by events, such as strategic growth opportunities, legal judgments or regulatory or environmental requirements. The receptiveness of the capital markets to an offering of debt or equity securities cannot be assured and may be negatively impacted by, among other things, our long-term business prospects and other factors beyond our control, including market conditions. In addition, we periodically evaluate engaging in strategic transactions as a source of capital or may consider divesting non-core assets where our evaluation suggests such a transaction is in the best interest of Buckeye. Capital Allocation We continually review our investment options with respect to our capital resources that are not distributed to our unitholders or used to pay down our debt and seek to invest these capital resources in various projects and activities based on their return to Buckeye. Potential investments could include, among others: add-on or other enhancement projects associated with our current assets; greenfield or brownfield development projects; and merger and acquisition activities. Debt At December 31, 2014, we had the following debt obligations (in thousands): In October 2014, we repaid in full the $275.0 million principal amount outstanding under the 5.300% Notes and $7.3 million of related accrued interest using funds available under our Credit Facility. In September 2014, we issued an aggregate of $600.0 million of senior unsecured notes in an underwritten public offering, including the $300.0 million of 4.350% Notes and the $300.0 million of 5.600% Notes, at 99.825% and 99.876%, respectively, of their principal amounts. Total proceeds from this offering, after underwriting fees, expenses and debt issuance costs of $5.3 million, were $593.8 million. We used the net proceeds from this offering to fund a portion of the Buckeye Texas Partners Transaction (see Note 3), to settle all interest rate swaps relating to the forecasted refinancing of the 5.300% Notes for $51.5 million (see Note 17) and for general partnership purposes. We also used the net proceeds to reduce the indebtedness outstanding under our Credit Facility. In September 2014, the Credit Facility was modified and extended (through a new credit agreement) to provide for an increased borrowing capacity of $1.5 billion. The Credit Facility’s maturity date is September 30, 2019, with an option to extend the term for up to two one-year periods and a $500.0 million accordion option to increase the commitments with the consent of the lenders. At December 31, 2014, BMSC had $166.0 million collectively outstanding under the Credit Facility, all of which was classified as current liabilities in our consolidated balance sheets, as related funds were used to finance current working capital needs. See Note 14 in the Notes to Consolidated Financial Statements for additional information. Equity In September 2014, we completed a public offering of 6.75 million LP Units pursuant to an effective shelf registration statement, which priced at $80.00 per unit. In October 2014, the underwriters exercised an option to purchase up to an additional 1.0 million LP Units, resulting in total gross proceeds of $621.0 million before deducting underwriting fees and estimated offering expenses of $22.0 million. We used the net proceeds from this offering to reduce the indebtedness outstanding under our Credit Facility, to fund a portion of the Buckeye Texas Partners Transaction and for general partnership purposes. In August 2014, we completed a public offering of 2.6 million LP Units pursuant to an effective shelf registration statement, through which the underwriters also exercised an option to purchase 0.4 million additional LP Units. The offering priced at $76.60 per unit, resulting in total gross proceeds of $229.0 million before deducting underwriting fees and estimated offering expenses of $2.4 million. We used the net proceeds from this offering to reduce the indebtedness outstanding under our Credit Facility and for general partnership purposes. During the year ended December 31, 2014, we sold 1.0 million LP Units in aggregate under the Equity Distribution Agreements, received $74.5 million in net proceeds after deducting commissions and other related expenses, and paid $0.8 million of compensation in aggregate to the agents under the Equity Distribution Agreements. Cash Flows from Operating, Investing and Financing Activities The following table summarizes our cash flows from operating, investing and financing activities for the periods indicated (in thousands): Operating Activities 2014. Net cash provided by operating activities was $599.6 million for the year ended December 31, 2014, primarily related to $274.9 million of net income, $196.4 million of depreciation and amortization, a $71.3 million decrease in accounts receivables, and a $70.1 million decrease in inventory, partially offset by a $51.5 million settlement to terminate the interest rate swap agreements related to the forecasted refinancing of the 5.300% Notes. 2013. Net cash provided by operating activities was $385.5 million for the year ended December 31, 2013, primarily related to $164.4 million of net income and $155.2 million of depreciation and amortization, partially offset by a $62 million settlement to terminate the interest rate swap agreements related to the 4.150% Notes, a $69.7 million increase in accounts receivables and an increase in interest and debt expense. 2012. Net cash provided by operating activities was $441.6 million for the year ended December 31, 2012, primarily related to $230.6 million of net income, $146.4 million of depreciation and amortization and $39.1 million associated with a reduction in inventory, partially offset by an increase of $73.7 million in accounts receivables. In 2012, we developed and executed a strategy to mitigate our basis risk that included the reduction of refined petroleum product inventories in the Midwest. Future Operating Cash Flows. Our future operating cash flows will vary based on a number of factors, many of which are beyond our control, including demand for our services, the cost of commodities, the effectiveness of our strategy, legal environmental and regulatory requirements and our ability to capture value associated with commodity price volatility. Investing Activities 2014. Net cash used in investing activities of $1,191.5 million for the year ended December 31, 2014 primarily related to $472.1 million of capital expenditures and $824.7 million of acquisition costs, primarily related to the Buckeye Texas Partners Transaction, partially offset by $103.4 million cash proceeds from the sale of our Natural Gas Storage disposal group. 2013. Net cash used in investing activities of $1,204.7 million for the year ended December 31, 2013 primarily related to $361.4 million of capital expenditures and $856.4 million related to the Hess Terminals Acquisition. 2012. Net cash used in investing activities of $590.3 million for the year ended December 31, 2012 primarily related to $331.3 million of capital expenditures and a $260.3 million acquisition of the Perth Amboy Facility. See below for a discussion of capital spending. For further discussion on our acquisitions, see Note 3 in the Notes to Consolidated Financial Statements. We have capital expenditures, which we define as “maintenance capital expenditures,” in order to maintain and enhance the safety and integrity of our pipelines, terminals, storage facilities and related assets, and “expansion and cost reduction capital expenditures” to expand the reach or capacity of those assets, to improve the efficiency of our operations and to pursue new business opportunities. Capital expenditures, excluding non-cash changes in accruals for capital expenditures, were as follows for the periods indicated (in thousands): (1) Includes maintenance capital expenditures related to the Natural Gas Storage disposal group of $0.8 million, $0.1 million and $0.4 million for the years ended December 31, 2014, 2013 and 2012, respectively. (2) Includes expansion and cost reduction capital expenditures related to the Natural Gas Storage disposal group of $0.1 million and $2 million for the years ended December 31, 2013 and 2012, respectively. Capital expenditures increased for the year ended December 31, 2014, as compared to the corresponding period in 2013 primarily due to increases in expansion and cost reduction capital expenditures. Our expansion and cost reduction capital expenditures were $392.0 million for the year ended December 31, 2014, which is an increase of $102.2 million, or 35.2%, from $289.9 million for the corresponding period in 2013. Year-to-year fluctuations in our expansion and cost reduction capital expenditures are primarily driven by spending on our major growth capital projects. Our most significant growth capital expenditures for the year ended December 31, 2014 included cost reduction and revenue generating projects related to storage tank enhancements across our portfolio of terminalling assets, butane blending, completion of rail offloading facilities, crude oil storage/transportation and a pipeline integrity enhancement program that improved the operational efficiencies in our pipeline systems. Our maintenance capital expenditures were $80.1 million for the year ended December 31, 2014, which is an increase of $8.5 million, or 12%, from $71.6 million for the corresponding period in 2013. Year-to-year fluctuations in our maintenance capital expenditures are primarily driven by the timing and cost of pipeline integrity and similar projects. Our most significant maintenance capital expenditures for the year ended December 31, 2014 included truck rack infrastructure upgrades, pump replacements and pipeline and tank integrity work necessary to maintain the operating capacity and equipment reliability of our existing infrastructure, as well as address environmental regulations. Capital expenditures increased for the year ended December 31, 2013, as compared to the corresponding period in 2012 primarily due to increases in maintenance capital expenditures. Our maintenance capital expenditures were $71.6 million for the year ended December 31, 2013, which is an increase of $17.2 million, or 31.5%, from $54.4 million for the corresponding period in 2012. Year-to-year fluctuations in our maintenance capital expenditures are primarily driven by the timing and cost of pipeline integrity and similar projects. In 2012, maintenance capital spending was lower due to cancellation of certain project work that had been planned on a line that was idle late in the fourth quarter 2012. Otherwise, our most significant maintenance capital expenditures for the year ended December 31, 2013 included truck rack infrastructure upgrades, pump replacements and pipeline and tank integrity work necessary to maintain the operating capacity and equipment reliability of our existing infrastructure, as well as address environmental regulations. Our expansion and cost reduction capital expenditures were $289.9 million for the year ended December 31, 2013, which is an increase of $12.9 million, or 4.7%, from $276.9 million for the corresponding period in 2012. Year-to-year fluctuations in our expansion and cost reduction capital expenditures are primarily driven by spending on our major growth capital projects. Our most significant growth capital expenditures for the year ended December 31, 2013 included significant investments in storage tank expansion at BORCO and Perth Amboy, butane blending, rail offloading facilities, crude oil storage/transportation and various other cost reduction and revenue generating projects. We estimate our capital expenditures for the period indicated as follows (in thousands): (1) Includes 100% of Buckeye Texas Partners related capital expenditures. Estimated maintenance capital expenditures include replacement of tank floors and tank roofs and upgrades to station and terminalling equipment, field instrumentation and cathodic protection systems. Estimated major expansion and cost reduction expenditures include the construction of a deep-water, marine terminal, a condensate splitter, an LPG storage complex and three crude oil and condensate gathering facilities in South Texas, storage tank enhancement and refurbishment projects across our system, and various upgrades and expansions of our butane blending business. The build-out of the facilities in South Texas is funded through additional partnership contributions by us and Trafigura based on our respective ownership interests. Financing Activities 2014. Net cash flows provided by financing activities of $595.1 million for the year ended December 31, 2014 primarily related to $899.7 million of net proceeds from the issuance of an aggregate 11.8 million LP Units, and $599.1 million of proceeds from the issuance of the 4.350% and 5.600% Notes due October 15, 2024 and October 15, 2044, respectively, partially offset by $527.2 million of cash distributions paid to our unitholders ($ 4.425 per LP Unit), $275.0 million related to the repayment of the 5.300% Notes and $89.0 million of net repayments under the Credit Facility. 2013. Net cash flows provided by financing activities of $817.4 million for the year ended December 31, 2013 primarily related to $1.3 billion of proceeds from the issuance of the 4.150%, 2.650% and 5.850% Notes due July 1, 2023, November 15, 2018 and November 15, 2043, respectively, $903.0 million of net proceeds from the issuance of an aggregate 16.0 million LP Units, partially offset by $655.8 million of net repayments under the Credit Facility, $428.8 million of cash distributions paid to our unitholders ($4.225 per LP Unit) and $300.0 million related to the repayment of the 4.625% Notes. 2012. Net cash flows provided by financing activities of $142.5 million for the year ended December 31, 2012 primarily related to $296.0 million of net borrowings under the Credit Facility and $246.8 million of net proceeds from the issuance of 4.3 million LP Units, partially offset by $371.2 million ($4.15 per LP Unit) of cash distributions paid to our unitholders. For further discussion on our equity offerings, see Note 22 in the Notes to Consolidated Financial Statements. Contractual Obligations The following table summarizes our contractual obligations as of December 31, 2014 (in thousands): (1) Includes long-term debt portion borrowed by Buckeye under our Credit Facility. See Note 14 in the Notes to Consolidated Financial Statements for additional information regarding our debt obligations. (2) Includes amounts due on our notes and amounts and commitment fees due on our Credit Facility. The interest amount calculated on the Credit Facility is based on the assumption that the amount outstanding and the interest rate charged both remain at their current levels. (3) Includes leases for tugboats and a barge in our Global Marine Terminals segment. (4) Includes leases for properties in connection with both the jetty and inland dock operations in our Global Marine Terminals segment. (5) Includes short-term purchase obligations for products and services with third-party suppliers and payment obligations relating to capital projects we have committed to. The prices that we are obligated to pay under these contracts approximate current market prices. For the year ended 2015, our rights-of-way payments are expected to be $6.7 million, which includes an estimated amount for annual escalation. In addition, our obligations related to our pension and postretirement benefit plans are discussed in Note 19 in the Notes to Consolidated Financial Statements. Employee Stock Ownership Plan Services Company provides the Employee Stock Ownership Plan (“ESOP”) to the majority of its employees hired before September 16, 2004. Employees hired by Services Company after September 15, 2004 and certain employees covered by a union multiemployer pension plan do not participate in the ESOP. The ESOP owns all of the outstanding common stock of Services Company. The ESOP was frozen with respect to benefits effective March 27, 2011 (the “Freeze Date”). No Services Company contributions have been or will be made on behalf of current participants in the ESOP on and after the Freeze Date. Even though contributions under the ESOP are no longer being made, each eligible participant’s ESOP account will continue to be credited with its share of any stock dividends or other stock distributions associated with Services Company stock. All Services Company stock has been allocated to ESOP participants. See Note 19 in the Notes to Consolidated Financial Statements for further information. Off-Balance Sheet Arrangements At December 31, 2014 and 2013, we had no off-balance sheet debt or arrangements. Critical Accounting Policies and Estimates The preparation of consolidated financial statements in conformity with GAAP requires our management to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenue and expenses during the reporting period and disclosure of contingent assets and liabilities at the date of the consolidated financial statements. Estimates and assumptions about future events and their effects cannot be made with certainty. Estimates may change as new events occur, when additional information becomes available and if our operating environment changes. Actual results could differ from our estimates. See Note 2 in the Notes to Consolidated Financial Statements for our significant accounting policies. The following describes significant estimates and assumptions affecting the application of these policies: Basis of Presentation and Principles of Consolidation The consolidated financial statements include the accounts of our subsidiaries controlled by us and VIEs, of which we are the primary beneficiary. A VIE is required to be consolidated by its primary beneficiary which is generally defined as the party who has (i) the power to direct the activities of a VIE that most significantly impact the VIE’s economic performance and (ii) the obligation to absorb losses of the VIE or the right to receive benefits that could potentially be significant to the VIE. We evaluate our relationships with our VIEs on an ongoing basis to determine whether we continue to be the primary beneficiary. Third party or affiliate ownership interests in our consolidated VIEs are presented as noncontrolling interests. All intercompany transactions are eliminated in consolidation. In September 2014, we acquired an 80% interest in Buckeye Texas, a newly-formed entity. Buckeye Texas does not have sufficient resources to complete its initial build-out and activities without financial support of its joint owners. Accordingly, we concluded Buckeye Texas is a VIE of which we are the primary beneficiary. In making this conclusion, we evaluated the activities that significantly impact the economics of the VIE, including our role to perform all services reasonably required to construct, operate and maintain the assets. Business Combinations We allocate the total purchase price of a business combination to the assets acquired and the liabilities assumed based on their estimated fair values at the acquisition date, with the excess purchase price recorded as goodwill. An income, market or cost valuation method may be utilized to estimate the fair value of the assets acquired or liabilities assumed in a business combination. The income valuation method represents the present value of future cash flows over the life of the asset using: (i) discrete financial forecasts, which rely on management’s estimates of revenue and operating expenses; (ii) long-term growth rates; and (iii) appropriate discount rates. The market valuation method uses prices paid for a reasonably similar asset by other purchasers in the market, with adjustments relating to any differences between the assets. The cost valuation method is based on the replacement cost of a comparable asset at prices at the time of the acquisition reduced for depreciation of the asset. Valuation of Goodwill Goodwill represents the excess of purchase price over fair value of net assets acquired. Our goodwill amounts are assessed for impairment: (i) on an annual basis on January 1 of each year; or (ii) on an interim basis if circumstances indicate it is more likely than not the fair value of a reporting unit is less than its carrying value. Subsequent to the acquisition of our interest in Buckeye Texas, which is consolidated into our Global Marine Terminals segment, we identified two reporting units within Global Marine Terminals, comprised of: (i) our legacy operations in the Caribbean and New York Harbor; and (ii) the newly acquired operations in Buckeye Texas. We tested these reporting units for impairment as of our annual testing date of January 1, 2015. For our annual goodwill impairment test as of January 1, 2015, we performed a qualitative assessment to determine whether the fair value of the Pipelines & Terminals reporting unit was more likely than not less than the carrying value. Based on our assessment, the Pipelines & Terminals reporting unit had: (i) a substantial excess of fair value over carrying value in its latest quantitative assessment; (ii) continued positive performance in Adjusted EBITDA over the prior year; (iii) projected increases in Adjusted EBITDA primarily as a result of contributions from internal capital projects and accretive acquisitions; and (iv) positive industry and market factors. We determined that the fair value of the reporting unit exceeded the carrying amount; therefore, the two-step impairment test was not required. Additionally, we performed quantitative assessments to determine the fair value of each of the remaining reporting units. The estimate of the fair value of the reporting unit is determined using a combination of an expected present value of future cash flows and a market multiple valuation method. The present value of future cash flows is estimated using: (i) discrete financial forecasts, which rely on management’s estimates of revenue and operating expenses; (ii) long-term growth rates; and (iii) an appropriate discount rate. The market multiple valuation method uses appropriate market multiples from comparable companies on the reporting unit’s earnings before interest, tax, depreciation and amortization. We evaluate industry and market conditions for purposes of weighting the income and market valuation approach. Based on such calculations, each reporting unit’s fair value was in excess of its carrying value. We did not record any goodwill impairment charges during the years ended December 31, 2014, 2013 or 2012. Valuation of Long-Lived Assets and Equity Method Investments We assess the recoverability of our long-lived assets whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. Estimates of undiscounted future cash flows include: (i) discrete financial forecasts, which rely on management’s estimates of revenue and operating expenses; (ii) long-term growth rates; and (iii) estimates of useful lives of the assets. Such estimates of future undiscounted cash flows are highly subjective and are based on numerous assumptions about future operations and market conditions. In December 2013, the Board approved a plan to divest the natural gas storage facility and related assets that our former subsidiary, Lodi, owned and operated in Northern California. We refer to this group of assets as our Natural Gas Storage disposal group. The estimated fair value less costs to sell was determined to be less than its carrying value, which resulted in the recognition of a non-cash asset impairment charge of $169.0 million, which included the write-down of long-lived assets. In July 2014, we signed a purchase and sale agreement to sell our Natural Gas Storage disposal group. As a result of the execution of the purchase and sale agreement, subsequent changes in the carrying value of the net assets and the completed sale in December 2014, we recorded additional non-cash asset impairment charges of $23.4 million during the year ended December 31, 2014. We recorded these asset impairment charges within “Loss from discontinued operations” on our consolidated statements of operations for the years ended December 31, 2014 and 2013, respectively. See Notes 4 and 5 in the Notes to Consolidated Financial Statements for further discussion. During the fourth quarter of 2012, we recorded a $60.0 million non-cash asset impairment charge in our Pipelines & Terminals segment relating to a portion of Buckeye’s NORCO pipeline system. See Note 5 and 11 in the Notes to Consolidated Financial Statements for further discussion. We evaluate equity method investments for impairment whenever events or changes in circumstances indicate that there is an “other than temporary” loss in value of the investment. Estimates of future cash flows include: (i) discrete financial forecasts, which rely on management’s estimates of revenue and operating expenses; (ii) long-term growth rates; and (iii) probabilities assigned to different cash flow scenarios. There were no impairments of our equity investments during the years ended December 31, 2014, 2013 or 2012. Reserves for Environmental Matters We record environmental liabilities at a specific site when environmental assessments occur or remediation efforts are probable, and the costs can be reasonably estimated based upon past experience, discussion with operating personnel, advice of outside engineering and consulting firms, discussion with legal counsel, or current facts and circumstances. The estimates related to environmental matters are uncertain because: (i) estimated future expenditures are subject to cost fluctuations and change in estimated remediation period; (ii) unanticipated liabilities may arise; and (iii) changes in federal, state and local environmental laws and regulations may significantly change the extent of remediation. Valuation of Derivatives We are exposed to financial market risks, including changes in interest rates and commodity prices, in the course of our normal business operations. We use derivative instruments to manage these risks. Our Merchant Services segment primarily uses exchange-traded refined petroleum product futures contracts to manage the risk of market price volatility on its refined petroleum product inventories and its physical derivative contracts. The futures contracts used to hedge refined petroleum product inventories are designated as fair value hedges with changes in fair value of both the futures contracts and physical inventory reflected in earnings. Physical contracts and futures contracts that have not been designated in a hedge relationship are marked-to-market. The fixed-price and index purchase contracts are typically executed with credit worthy counterparties and are short-term in nature, thus evaluated for credit risk in the same manner as the fixed-price sales contracts. However, because the fixed-price sales contracts are privately negotiated with customers of the Merchant Services segment who are generally smaller, private companies that may not have established credit ratings, the determination of an adjustment to fair value to reflect counterparty credit risk (a “credit valuation adjustment”) requires significant management judgment. Each customer is evaluated for performance under the terms and conditions of their contracts; therefore, we evaluate: (i) the historical payment patterns of the customer; (ii) the current outstanding receivables balances for each customer and contract; and (iii) the level of performance of each customer with respect to volumes called for in the contract. We then evaluated the specific risks and expected outcomes of nonpayment or nonperformance by each customer and contract. We continue to monitor and evaluate performance and collections with respect to these fixed-price contracts.

<s>[INST] Business Overview We own and operate a diversified network of integrated assets providing midstream logistic solutions, primarily consisting of the transportation, storage and marketing of liquid petroleum products. We are one of the largest independent liquid petroleum products pipeline operators in the United States in terms of volumes delivered, with approximately 6,000 miles of pipeline. Our terminal network comprises more than 120 liquid petroleum products terminals with aggregate storage capacity of over 110 million barrels across our portfolio of pipelines, inland terminals and marine terminals located primarily in the East Coast and Gulf Coast regions of the United States and in the Caribbean. Our flagship marine terminal in The Bahamas, BORCO, is one of the largest marine crude oil and refined petroleum products storage facilities in the world and provides an array of logistics and blending services for petroleum products. Our network of marine terminals enables us to facilitate global flows of crude oil, refined petroleum products, and other commodities, and to offer our customers connectivity to some of the world’s most important bulk storage and blending hubs. In September 2014, we expanded our network of marine midstream assets by acquiring a controlling interest in a company with assets located in Corpus Christi and the Eagle Ford play in Texas. We are also a wholesale distributor of refined petroleum products in certain areas served by our pipelines and terminals. Finally, Buckeye operates and/or maintains thirdparty pipelines under agreements with major oil and gas, petrochemical and chemical companies, and performs certain engineering and construction management services for third parties. Our primary business objective is to provide stable and sustainable cash distributions to our LP Unitholders, while maintaining a relatively low investment risk profile. The key elements of our strategy are to: (i) operate in a safe and environmentally responsible manner; (ii) maximize utilization of our assets at the lowest cost per unit; (iii) maintain stable longterm customer relationships; (iv) optimize, expand and diversify our portfolio of energy assets through accretive acquisitions and organic growth projects; and (v) maintain a solid, conservative financial position and our investmentgrade credit rating. Overview of Operating Results Net income attributable to our unitholders was $273.0 million for the year ended December 31, 2014, which was an increase of $112.7 million, or 70.3%, from $160.3 million for the corresponding period in 2013. The increase was primarily related to a noncash asset impairment charge of $169.0 million recorded in 2013 related to our decision to divest our natural gas storage business. Operating income was $495.3 million for the year ended December 31, 2014, which is an increase of $17.3 million, or 3.6%, from $478.0 million the corresponding period in 2013. Our results for the year ended December 31, 2014 include yearoveryear improvement in our Pipelines & Terminals, Global Marine Terminals and Development & Logistics segments, while our Merchant Services segment experienced an operating loss as a result of weaker business conditions in the various refined petroleum markets in which we serve, and unfavorable results from implementing strategies during the second quarter of 2014 intended to increase the utilization of our physical assets, grow our marketing business and mitigate risk. In 2014, our net income attributable to unitholders was also negatively impacted by the continued decline in the financial performance of our discontinued natural gas storage operations, primarily due to unfavorable market conditions, including low natural gas prices, compressed seasonal spreads and low volatility, as well as a reduction in revenue in our Pipelines & Terminals segment related to a litigation contingency reserve for ongoing FERC proceedings. Revenues for our Pipelines & Terminals segment grew significantly in 2014, with the most significant contributor to this improvement attributed to the effective commercialization and integration of the terminals acquired from Hess in December 2013. Capital investments in internal growth and diversification initiatives, including expanding our butane blending capabilities and our crude oil handling services, also drove the yearoveryear increase. More specifically, we benef [/INST] Positive. </s>

BUCKEYE PARTNERS, L.P.

2016-02-25

2015-12-31

Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations The following discussion should be read in conjunction with our consolidated financial statements and our accompanying notes thereto included in Item 8 of this Report. Business Overview We own and operate a diversified network of integrated assets providing midstream logistic solutions, primarily consisting of the transportation, storage and marketing of liquid petroleum products. We are one of the largest independent liquid petroleum products pipeline operators in the United States in terms of volumes delivered, with approximately 6,000 miles of pipeline. We also use our service expertise to operate and/or maintain third-party pipelines and perform certain engineering and construction services for our customers. Additionally, we are one of the largest independent terminalling and storage operators in the United States in terms of capacity available for service. Our terminal network comprises more than 120 liquid petroleum products terminals with aggregate storage capacity of over 110 million barrels across our portfolio of pipelines, inland terminals and marine terminals located primarily in the East Coast and Gulf Coast regions of the United States and in the Caribbean. Our network of marine terminals enables us to facilitate global flows of crude oil and refined petroleum products offering our customers connectivity between supply areas and market centers through some of the world’s most important bulk storage and blending hubs. Our flagship marine terminal in The Bahamas, BORCO, is one of the largest marine crude oil and refined petroleum products storage facilities in the world and provides an array of logistics and blending services for the global flow of petroleum products. Our recent expansion into the Gulf Coast has added another regional hub with world-class marine terminalling, storage and processing capabilities. We are also a wholesale distributor of refined petroleum products in areas served by our pipelines and terminals. In December 2015, we realigned our reportable segments into three reportable segments as a result of changes in our organizational structure and renamed one of our reportable segments. Our three reportable segments are: Domestic Pipelines & Terminals (formerly known as Pipelines & Terminals), Global Marine Terminals and Merchant Services. We merged our previously reported Development & Logistics segment into the Domestic Pipelines & Terminals segment. See Note 25 in the Notes to Consolidated Financial Statements for a more detailed discussion of our business segments. We have adjusted our prior period segment information to conform to current year presentation. Our primary business objective is to provide stable and sustainable cash distributions to our unitholders, while maintaining a relatively low investment risk profile. The key elements of our strategy are to: (i) operate in a safe and environmentally responsible manner; (ii) maximize utilization of our assets at the lowest cost per unit; (iii) maintain stable long-term customer relationships; (iv) optimize, expand and diversify our portfolio of energy assets through accretive acquisitions and organic growth projects; and (v) maintain a solid, conservative financial position and our investment-grade credit rating. Overview of Operating Results Net income attributable to our unitholders was $437.2 million for the year ended December 31, 2015, which was an increase of $164.3 million, or 60.2%, from $273.0 million for the corresponding period in 2014. Operating income was $604.1 million for the year ended December 31, 2015, which is an increase of $108.8 million, or 22.0%, from $495.3 million the corresponding period in 2014. Our operating income results for the year ended December 31, 2015 include year-over-year improvement in each of our three segments despite mixed business conditions in a declining price environment. Our Global Marine Terminals segment benefited from continued improvement in capacity utilization and higher rates on contract renewals. Our continued efforts to provide new service offerings and enhance our marine asset portfolio capabilities resulted in strong demand for our services. Internal growth capital investments also yielded additional capacity that our commercial teams were able to successfully contract. The development of structure in the crude oil and refined petroleum products markets additionally assisted in the year-over-year success in this segment. Our interest in Buckeye Texas acquired in September 2014 was also a key driver for the increase over prior year. In the fourth quarter of 2015, we completed the commissioning and start-up of our condensate splitters and liquid petroleum gas refrigerated storage, which are in service under long-term agreements with Trafigura Trading LLC (“Trafigura”). These increases in net income were partially offset by an increase in depreciation and amortization expense due to the Buckeye Texas assets. Our Merchant Services segment benefited from the elimination of certain commercial strategies from 2014 and more effective supply management. In 2015, the contribution from rack sales was lower as a result of competition from local refineries and our focused efforts to reduce volumes due to our improved inventory management process. This segment continues to drive increased utilization of our pipeline and terminal assets. Our Domestic Pipelines & Terminals segment benefited from higher terminalling throughput volumes, particularly in refined petroleum products, and higher storage revenue from new contracts. Our investment in organic growth capital projects continues to drive customer activity to our terminals as we have enhanced our service offerings across our system. In 2015, pipeline transportation revenues increased year-over-year as a result of higher gasoline and jet fuel volumes, as well as the lower FERC litigation accruals recorded as a reduction of revenue. These increases were partially offset by lower product recoveries from our terminalling throughput activities, a decrease in average pipeline tariff rates, lower butane blending margins and increased operating expenses. See the “Results of Operations” section below for further discussion and analysis of our operating segments. Results of Operations Consolidated Summary Our summary operating results were as follows for the periods indicated (in thousands, except per unit amounts): _____________________________ (1) Represents loss from the operations of our Natural Gas Storage disposal group. See Note 4 in the Notes to Consolidated Financial Statements for more information. Non-GAAP Financial Measures Adjusted EBITDA is the primary measure used by our senior management, including our Chief Executive Officer, to: (i) evaluate our consolidated operating performance and the operating performance of our business segments; (ii) allocate resources and capital to business segments; (iii) evaluate the viability of proposed projects; and (iv) determine overall rates of return on alternative investment opportunities. Distributable cash flow is another measure used by our senior management to provide a clearer picture of cash available for distribution to our unitholders. Adjusted EBITDA and distributable cash flow eliminate: (i) non-cash expenses, including but not limited to, depreciation and amortization expense resulting from the significant capital investments we make in our businesses and from intangible assets recognized in business combinations; (ii) charges for obligations expected to be settled with the issuance of equity instruments; and (iii) items that are not indicative of our core operating performance results and business outlook. We believe that investors benefit from having access to the same financial measures that we use and that these measures are useful to investors because they aid in comparing our operating performance with that of other companies with similar operations. The Adjusted EBITDA and distributable cash flow data presented by us may not be comparable to similarly titled measures at other companies because these items may be defined differently by other companies. The following table presents Adjusted EBITDA from continuing operations by segment and on a consolidated basis, distributable cash flow and a reconciliation of income from continuing operations, which is the most comparable financial measure under generally accepted accounting principles (“GAAP”), to Adjusted EBITDA and distributable cash flow for the periods indicated (in thousands): ____________________________ (1) Includes 100% of the depreciation and amortization expense of $49.3 million and $12.3 million for Buckeye Texas for the years ended December 31, 2015 and 2014, respectively. (2) Acquisition and transition expense consists of transaction costs, costs for transitional employees, and other employee and third-party costs related to the integration of the acquired assets that are non-recurring in nature. (3) Represents reductions in revenue related to settlement of a FERC proceeding. See Note 6 in the Notes to Consolidated Financial Statements for further discussion. (4) Represents the amortization of the negative fair values allocated to certain unfavorable storage contracts acquired in connection with the BORCO acquisition. (5) Represents expenditures that maintain the operating, safety and/or earnings capacity of our existing assets. The following table presents product volumes and average tariff rates for the Domestic Pipelines & Terminals segment in barrels per day (“bpd”), percent of capacity utilization for the Global Marine Terminals segment and total volumes sold in gallons for the Merchant Services segment for the periods indicated: _____________________________ (1) Includes diesel fuel and heating oil. (2) Includes LPG, intermediate petroleum products and crude oil. (3) Includes throughput of two underground propane storage caverns previously reported in our Development & Logistics segment. We have adjusted our prior period throughput volumes to conform to current year presentation. (4) Represents the ratio of contracted capacity to capacity available to be contracted. Based on total capacity (i.e., including out of service capacity), average capacity utilization rates are approximately 85%, 74% and 88% for the years ended December 31, 2015, 2014 and 2013, respectively. Year Ended December 31, 2015 Compared to Year Ended December 31, 2014 Consolidated Adjusted EBITDA was $868.1 million for the year ended December 31, 2015, which is an increase of $104.5 million, or 13.7%, from $763.6 million for the corresponding period in 2014. The increase in Adjusted EBITDA was primarily related to increased storage revenue due to higher storage utilization and rates at our terminalling facilities and positive contributions from the Buckeye Texas assets in our Global Marine Terminals segment and elimination of certain commercial strategies from 2014 and more effective supply management in our Merchant Services segment. The increase in Adjusted EBITDA was partially offset by a decrease in revenue related to settlements and butane blending margins in our Domestic Pipelines & Terminals segment. Settlement revenues decreased in our Domestic Pipelines & Terminals segment due to lower product recoveries from our terminalling throughput activities and prior year volumetric pipeline settlement gains. In addition, butane blending activities in our Domestic Pipelines & Terminals segment were negatively impacted due to the narrowed spread between butane and gasoline prices. Revenue was $3,453.4 million for the year ended December 31, 2015, which is a decrease of $3,166.8 million, or 47.8%, from $6,620.2 million for the corresponding period in 2014. The decrease in revenue was primarily related to the decrease in sales volume and a decline of refined petroleum product prices in our Merchant Services segment, as well as lower product recoveries from our terminalling throughput activities in our Domestic Pipelines & Terminals segment. The decrease in revenue was partially offset by the revenue increase in our Global Marine Terminals segment primarily due to higher storage utilization and rates at our terminalling facilities and lower FERC litigation accruals recorded as a reduction in revenue in our Domestic Pipelines & Terminals segment. Operating income was $604.1 million for the year ended December 31, 2015, which is an increase of $108.8 million, or 22.0%, from $495.3 million for the corresponding period in 2014. The increase in operating income was primarily related to increased storage revenue due to higher storage utilization and rates at our terminalling facilities in the Global Marine Terminals segment and elimination of certain commercial strategies from 2014 and more effective supply management in our Merchant Services segment. The increase in operating income was partially offset by the decrease in revenue related to settlements and butane blending margins in our Domestic Pipelines & Terminals segment, as well as an increase in depreciation and amortization expense primarily due to the Buckeye Texas assets in our Global Marine Terminals segment. Distributable cash flow was $612.4 million for the year ended December 31, 2015, which is an increase of $85.7 million, or 16.3%, from $526.8 million as compared to the corresponding period in 2014. The increase in distributable cash flow was primarily related to an increase of $104.5 million in Adjusted EBITDA as described above, partially offset by a $20.2 million increase in maintenance capital expenditures primarily resulting from increased tank integrity projects. Adjusted EBITDA by Segment Domestic Pipelines & Terminals. Adjusted EBITDA from the Domestic Pipelines & Terminals segment was $522.2 million for the year ended December 31, 2015, which is a decrease of $9.9 million, or 1.9%, from $532.1 million for the corresponding period in 2014. The decrease in Adjusted EBITDA is due to a $19.2 million increase in operating expenses, which include higher payroll expense and legal fees related to certain FERC matters, and a $4.9 million decrease in earnings from equity investments primarily due to an increase in integrity spending, partially offset by a $14.2 million increase in revenues, excluding the accrual related to certain FERC litigation that was recorded as a reduction in revenue. The increase in revenues is comprised of a $26.3 million increase resulting from higher terminalling throughput volumes and higher storage revenue from new contracts, a $13.2 million increase in revenue from capital investments in internal growth and diversification initiatives, including diluent and crude oil handling services and a $9.5 million increase in revenue resulting from higher pipeline volumes. These increases were partially offset by a $26.8 million decrease in revenue related to lower product recoveries from our terminalling throughput activities, as well as the narrowed spread between butane and gasoline prices, and an $8.0 million decrease in revenue resulting from lower average pipeline tariff rates primarily due to a shift between intra-state and inter-state shipments. Pipeline volumes increased by 2.1% due to stronger demand for jet fuel and gasoline resulting from growth capital projects placed into service mid-year 2014. Terminalling volumes increased by 5.9% due to higher demand for gasoline, distillates and jet fuel, new customer contracts and service offerings at select locations, including contributions from growth capital spending, which were partially offset by a decrease in crude-by-rail volumes. Global Marine Terminals. Adjusted EBITDA from the Global Marine Terminals segment was $323.8 million for the year ended December 31, 2015, which is an increase of $84.2 million, or 35.1%, from $239.6 million for the corresponding period in 2014. The increase in Adjusted EBITDA is primarily due to a $58.4 million increase in storage and terminalling revenue as a result of greater customer utilization and higher service rates and a $39.7 million increase in the contribution from our joint venture interest in Buckeye Texas. The average capacity utilization of our marine storage assets was 96% for the year ended December 31, 2015, which is an increase from 85% in the corresponding period in 2014. The increase in storage revenue resulted from internal growth capital investments which increased available storage capacity and diversified our asset capabilities, as well as improved market conditions which were the result of the development of structure in the crude oil and refined petroleum products markets. This increase in Adjusted EBITDA is partially offset by a $7.5 million increase in operating expenses related to outside services for asset maintenance activities and incremental costs necessary to support the higher utilization of our facilities, as well as a $6.4 million decrease in ancillary revenues primarily due to higher product settlement gains in the prior year. Merchant Services. Adjusted EBITDA from the Merchant Services segment was $22.0 million for the year ended December 31, 2015, which is an improvement of $30.1 million from a loss of $8.1 million for the corresponding period in 2014. The positive factors impacting Adjusted EBITDA were primarily related to the elimination of certain commercial strategies from 2014 and more effective supply management. The elimination of certain commercial strategies included liquidating our physical positions in markets less liquid than our core markets. Adjusted EBITDA was positively impacted by a $3,349.9 million decrease in cost of product sales, which included a $2,113.9 million decrease due to 39.5% of lower volumes sold and a $1,236.0 million decrease in refined petroleum product cost due to a price decrease of $1.01 per gallon (average prices per gallon were $1.65 and $2.66 for the 2015 and 2014 periods, respectively) and a $1.1 million decrease in operating expenses, which primarily related to overhead and administrative costs. Adjusted EBITDA was negatively impacted by a $3,320.9 million decrease in revenue, which included a $2,117.8 million decrease due to 39.5% of lower volumes sold and a $1,203.1 million decrease in refined petroleum product sales due to a price decrease of $0.99 per gallon (average sales prices per gallon were $1.68 and $2.67 for the 2015 and 2014 periods, respectively). Year Ended December 31, 2014 Compared to Year Ended December 31, 2013 Consolidated Adjusted EBITDA was $763.6 million for the year ended December 31, 2014, which is an increase of $114.8 million, or 17.7%, from $648.8 million for the corresponding period in 2013. The increase in Adjusted EBITDA was primarily related to positive contribution from the assets acquired from Hess in December 2013 in the Global Marine Terminals and Domestic Pipelines & Terminals segments and benefit from growth capital spending in the Domestic Pipelines & Terminals segment. These increases in Adjusted EBITDA were partially offset by the loss in the Merchant Services segment as a result of weaker business conditions in the various refined petroleum markets in which we serve, and unfavorable results from implementing strategies in that segment during the second quarter of 2014 intended to increase the utilization of our physical assets, grow our marketing business and mitigate risk. These losses were attributed to: (i) costs associated with entering into new markets to grow our marketing business and support the optimization of our underlying physical assets; (ii) losses on the liquidation of physical positions in markets less liquid than in our core markets; (iii) losses resulting from the timing of activity intended to mitigate risk on gasoline and distillates for the summer driving season and upcoming heating season; and (iv) a significant decline in the value of ethanol which is carried in inventory to support our gasoline business. Revenue was $6,620.2 million for the year ended December 31, 2014, which is an increase of $1,566.1 million, or 31.0%, from $5,054.1 million for the corresponding period in 2013. The increase in revenue was primarily related to increased product sales volumes in our Merchant Services segment, as well as the benefit of the terminals acquired from Hess in December 2013 in both our Domestic Pipelines & Terminals and Global Marine Terminals segments. These increases were partially offset by a litigation contingency accrual, recorded as a reduction in revenue, associated with FERC proceedings in our Domestic Pipelines & Terminals segment. Operating income was $495.3 million for the year ended December 31, 2014, which is an increase of $17.3 million, or 3.6%, from $478.0 million in the corresponding period in 2013. The increase in operating income was primarily related to the benefit of the terminals acquired from Hess in December 2013 in both our Global Marine Terminals and Domestic Pipelines & Terminals segments. These increases were partially offset by the increase in depreciation and amortization expense primarily due to the assets acquired from Hess in December 2013, assets acquired in the Buckeye Texas Partners Transaction in September 2014, the loss in the Merchant Services segment discussed above, as well as the litigation contingency accrual, recorded as a reduction in revenue, associated with FERC proceedings in our Domestic Pipelines & Terminals segment. Distributable cash flow was $526.8 million for the year ended December 31, 2014, which is an increase of $72.6 million, or 16.0%, from $454.2 million for the corresponding period in 2013. The increase in distributable cash flow was primarily related to an increase of $114.8 million in Adjusted EBITDA as described above, partially offset by a $34.3 million increase in interest expense, excluding amortization of deferred financing costs, debt discounts and other, primarily resulting from the long-term debt issuances in 2013, including the debt issued to partially fund the assets acquired from Hess in December 2013 and a $7.9 million increase in maintenance capital expenditures. Adjusted EBITDA by Segment Domestic Pipelines & Terminals. Adjusted EBITDA from the Domestic Pipelines & Terminals segment was $532.1 million for the year ended December 31, 2014, which was an increase of $45.6 million, or 9.4%, from $486.5 million for the corresponding period in 2013. The positive factors impacting Adjusted EBITDA were related to a $68.4 million increase in revenue resulting from an increase in terminalling throughput and storage contracts, including those associated with the assets acquired from Hess in December 2013, $33.4 million of incremental revenue from capital investments in internal growth and diversification initiatives, including butane blending capabilities, crude oil handling services and storage and throughput of other hydrocarbons, a $14.6 million increase in revenue due to increases in average pipeline tariff rates and longer-haul shipments, a $10.8 million increase in other revenue, including a favorable settlement related to certain pipeline transportation services, a $6.0 million increase in earnings from equity investments primarily due to a decrease in maintenance expense and a $2.4 million increase resulting from higher pipeline volumes. The negative factors impacting Adjusted EBITDA were an $81.6 million increase in operating expenses, primarily related to incremental costs necessary to operate the terminals acquired from Hess in December 2013 and outside services for asset-maintenance activities, and $8.4 million in less favorable settlement experience primarily related to high volumetric gains experienced in 2013 as well as, to a lesser extent, falling commodity prices in 2014. Pipeline volumes slightly increased despite weaker gasoline shipments resulting from extreme weather conditions in early 2014. Overall terminalling volumes increased by 16.5% due to effective commercialization and integration of the terminals acquired from Hess in December 2013. Legacy terminalling volumes increased by 4.4% due to higher demand for gasoline, distillates and jet fuel and new customer contracts and service offerings at select locations, including the benefit of contributions from growth capital spending. Global Marine Terminals. Adjusted EBITDA from the Global Marine Terminals segment was $239.6 million for the year ended December 31, 2014, which was an increase of $89.8 million, or 60.0%, from $149.7 million for the corresponding period in 2013. The positive factors impacting Adjusted EBITDA were a $103.5 million increase in storage and terminalling revenue primarily as a result of the assets acquired from Hess in December 2013 and a $32.8 million increase in revenue from ancillary services. Ancillary services include the berthing of ships at our jetties, heating services and settlement gains/losses. The increase in revenue was partially offset by a $46.5 million increase in operating expenses primarily related to incremental costs necessary to operate the assets acquired from Hess in December 2013. Merchant Services. Adjusted EBITDA from the Merchant Services segment was a loss of $8.1 million for the year ended December 31, 2014, which was a decrease of $20.7 million from earnings of $12.6 million for the corresponding period in 2013. The loss experienced during the period is primarily attributed to losses in the second quarter described above, partially offset by strong domestic rack margins. Adjusted EBITDA was positively impacted by a $1,368.0 million increase in revenue, which included a $1,854.9 million increase due to 46.5% of higher volumes sold, partially offset by a $486.9 million decrease in refined petroleum product sales due to a price decrease of $0.24 per gallon (average sales prices per gallon were $2.67 and $2.91 for the 2014 and 2013 periods, respectively). Adjusted EBITDA was negatively impacted by a $1,383.0 million increase in cost of product sales, which included a $1,843.3 million increase due to 46.5% of higher volumes sold, offset by a $460.3 million decrease in refined petroleum product cost due to a price decrease of $0.23 per gallon (average cost prices per gallon were $2.66 and $2.89 for the 2014 and 2013 periods, respectively) and a $5.7 million increase in operating expenses. General Outlook for 2016 We expect our year-over-year performance to improve in 2016 as a result of progress made in 2015 on the construction of our Buckeye Texas facility, additional capital investments made across our portfolio of assets and continued high utilization and increased rates for our storage capacity. At Buckeye Texas, we completed the commissioning of our refrigerated and compressed LPG storage complex late in the third quarter of 2015 and brought our two condensate splitters into service late in the fourth quarter of 2015. These assets, combined with additional storage and dock capacity expected to be completed in the first quarter of 2016, are expected to generate incremental cash flows compared to 2015. In addition, we invested in bringing new storage capacity on-line across our system, including the conversion of over 2 million barrels of fuel oil tanks into flexible service at our BORCO facility, the return to commercial service of 1.5 million barrels of capacity at our St. Lucia facility, and expansion of storage capacity at our Chicago Complex through the completion of a bi-directional pipeline connecting this important Midwestern hub to an additional terminal that had been previously underutilized. We also expanded our service capabilities in the New York Harbor by increasing gasoline blending capacity. We expect these investments to generate incremental cash flows in 2016 as we benefit from the full year impact. We have begun construction on our Michigan-Ohio pipeline and terminal expansion project, which will allow us to offer expanded transportation service of refined petroleum products from points in Michigan and western Ohio to destinations in eastern Ohio and western Pennsylvania. We expect this project to be in operation in the fourth quarter of 2016, although the full run-rate will not be realized until 2017. Volumes across our pipeline systems are expected to be impacted by the strength in aviation fuel and gasoline, partially offset by weakness in distillates. Until the completion of our Michigan-Ohio expansion project, we expect to see downward pressure from the impact of changing product flows, primarily on our Central Pennsylvania system. Throughput volumes across our domestic terminals are expected to increase moderately from the completion of growth capital initiatives in the Midwest and increased customer demand in the Southeast. Our Merchant Services segment continues to benefit from inventory risk management activities and asset optimization. We expect that our inventory risk management strategy will drive more stable results and allow us to seize opportunities to lock in contango value, when presented, in 2016. Our results in 2015 reflect the benefit of our diversified asset base with limited exposure to commodity prices. The impact of lower commodity prices in 2016 could negatively impact the value we realize on our settlement revenues and butane blending margins; however, our storage assets could benefit from the strong demand for storage as liquid petroleum product inventories are at elevated levels. Overall, we believe our diversified portfolio of assets is well positioned for the current market environment. We believe that we have sufficient liquidity available on our $1.5 billion revolving Credit Facility, as well as the ability to utilize our at-the-market equity issuance program to meet our expected capital needs for 2016. Under current market conditions, we believe that we could raise additional capital in both the debt and equity markets on acceptable terms to fund appropriate asset or business acquisitions. We will continue to evaluate opportunities throughout 2016 to acquire or construct assets that are complementary to our businesses and support our long-term growth strategy and will determine the appropriate financing structure on acceptable terms for any opportunity we pursue. The forward-looking statements contained in this “General Outlook for 2016” speak only as of the date hereof. Although the expectations in the forward-looking statements are based on our current beliefs and expectations, caution should be taken not to place undue reliance on any such forward-looking statements because such statements speak only as of the date hereof. Except as required by federal and state securities laws, we undertake no obligation to publicly update or revise any forward-looking statements, whether as a result of new information, future events or any other reason. All such forward-looking statements are expressly qualified in their entirety by the cautionary statements contained or referred to in this Report, including under the captions “Risk Factors” and “Cautionary Note Regarding Forward-Looking Statements” and elsewhere in this Report and in our future periodic reports filed with the SEC. In light of these risks, uncertainties and assumptions, the forward-looking events discussed in this “General Outlook for 2016” may not occur. Liquidity and Capital Resources General Our primary cash requirements, in addition to normal operating expenses and debt service, are for working capital, capital expenditures, business acquisitions and distributions to unitholders. Our principal sources of liquidity are cash from operations, borrowings under our $1.5 billion revolving Credit Facility and proceeds from the issuance of our LP Units. We will, from time to time, issue debt securities to permanently finance amounts borrowed under our Credit Facility. The BMSC entities fund their working capital needs principally from their own operations and their portion of our Credit Facility. Our financial policy has been to fund maintenance capital expenditures with cash from continuing operations. Expansion and cost reduction capital expenditures, along with acquisitions, have typically been funded from external sources including our Credit Facility, as well as debt and equity offerings. Our goal has been to fund at least half of these expenditures with proceeds from equity offerings in order to maintain our investment-grade credit rating. Based on current market conditions, we believe our borrowing capacity under our Credit Facility, cash flows from continuing operations and access to debt and equity markets, if necessary, will be sufficient to fund our primary cash requirements, including our expansion plans over the next 12 months. Current Liquidity As of December 31, 2015, we had $47.2 million of working capital and $1,027.5 million of availability under our Credit Facility. We are limited to $933.1 million of additional borrowing capacity by the financial covenants under our Credit Facility, except for borrowings that are used to refinance other debt. Capital Structuring Transactions As part of our ongoing efforts to maintain a capital structure that is closely aligned with the cash-generating potential of our asset-based business, we may explore additional sources of external liquidity, including public or private debt or equity issuances. Matters to be considered will include cash interest expense and maturity profile, all to be balanced with maintaining adequate liquidity. We have a universal shelf registration statement that does not place any dollar limits on the amount of debt and equity securities that we may issue thereunder and a traditional shelf registration statement on file with the SEC under which we may issue equity securities with a value, as of December 31, 2015, not to exceed $836.5 million. The timing of any transaction may be impacted by events, such as strategic growth opportunities, legal judgments or regulatory or environmental requirements. The receptiveness of the capital markets to an offering of debt or equity securities cannot be assured and may be negatively impacted by, among other things, our long-term business prospects and other factors beyond our control, including market conditions. In addition, we periodically evaluate engaging in strategic transactions as a source of capital or may consider divesting non-core assets where our evaluation suggests such a transaction is in the best interest of our business. Capital Allocation We continually review our investment options with respect to our capital resources that are not distributed to our unitholders or used to pay down our debt and seek to invest these capital resources in various projects and activities based on their return on investment. Potential investments could include, among others: add-on or other enhancement projects associated with our current assets; greenfield or brownfield development projects; and merger and acquisition activities. Debt At December 31, 2015, we had the following debt obligations (in thousands): In December 2015, Buckeye and its indirect wholly-owned subsidiaries, BMSC, as borrowers, exercised their option to extend our existing Credit Facility by one year to September 30, 2020, resulting in a remaining option to extend the term for one additional year. At December 31, 2015, Buckeye and BMSC collectively had $472.5 million outstanding under the Credit Facility, of which $111.5 million, attributable to BMSC, was classified as current liabilities in our consolidated balance sheet, as related funds were used to finance current working capital needs. See Note 14 in the Notes to Consolidated Financial Statements for additional information. Equity During the year ended December 31, 2015, we sold 2.2 million LP Units in aggregate under the Equity Distribution Agreements, received $161.5 million in net proceeds after deducting commissions and other related expenses, and paid $1.6 million of compensation in aggregate to the agents under the Equity Distribution Agreements. Cash Flows from Operating, Investing and Financing Activities The following table summarizes our cash flows from operating, investing and financing activities for the periods indicated (in thousands): Operating Activities 2015. Net cash provided by operating activities was $710.2 million for the year ended December 31, 2015, primarily related to $437.5 million of net income, $221.3 million of depreciation and amortization, $53.7 million in other non-cash items and a $56.8 million decrease in working capital, partially offset by $52.8 million in litigation settlement payments. 2014. Net cash provided by operating activities was $599.6 million for the year ended December 31, 2014, primarily related to $274.9 million of net income and $196.4 million of depreciation and amortization, a $71.3 million decrease in accounts receivables, and a $70.1 million decrease in inventory, partially offset by a $51.5 million settlement to terminate the interest rate swap agreements related to the forecasted refinancing of the 5.300% Notes. 2013. Net cash provided by operating activities was $385.5 million for the year ended December 31, 2013, primarily related to $164.4 million of net income and $155.2 million of depreciation and amortization, partially offset by a $62.0 million settlement to terminate the interest rate swap agreements related to the 4.150% Notes, a $69.7 million increase in accounts receivables and an increase in interest and debt expense. Future Operating Cash Flows. Our future operating cash flows will vary based on a number of factors, many of which are beyond our control, including demand for our services, the cost of commodities, the effectiveness of our strategy, legal environmental and regulatory requirements and our ability to capture value associated with commodity price volatility. Investing Activities 2015. Net cash used in investing activities of $614.9 million for the year ended December 31, 2015 primarily related to $594.5 million of capital expenditures, $21.4 million in escrow deposits, partially offset by $10.3 million of proceeds from the sale and disposition of assets, primarily due to the disposition of an ammonia pipeline in Texas. 2014. Net cash used in investing activities of $1,191.5 million for the year ended December 31, 2014 primarily related to $472.1 million of capital expenditures and $824.7 million of acquisition costs, primarily related to the Buckeye Texas Partners Transaction, partially offset by $103.4 million cash proceeds from the sale of our Natural Gas Storage disposal group. 2013. Net cash used in investing activities of $1,204.7 million for the year ended December 31, 2013 primarily related to $361.4 million of capital expenditures and $856.4 million related to the Hess Terminals Acquisition. See below for a discussion of capital spending. For further discussion on our acquisitions, see Note 3 in the Notes to Consolidated Financial Statements. We have capital expenditures, which we define as “maintenance capital expenditures,” in order to maintain and enhance the safety and integrity of our pipelines, terminals, storage and processing facilities and related assets, and “expansion and cost reduction capital expenditures” to expand the reach or capacity of those assets, to improve the efficiency of our operations and to pursue new business opportunities. Capital expenditures, excluding non-cash changes in accruals for capital expenditures, were as follows for the periods indicated (in thousands): _____________________________ (1) Includes maintenance capital expenditures related to the Natural Gas Storage disposal group of $0.8 million and $0.1 million for the years ended December 31, 2014 and 2013, respectively. (2) Includes expansion and cost reduction capital expenditures related to the Natural Gas Storage disposal group of $0.1 million for the year ended December 31, 2013. (3) Amounts exclude accruals for capital expenditures. Expansion and cost reduction amounts including accruals for capital expenditures were $516.5 million and $340.5 million for the year ended December 31, 2015 and 2014, respectively. Capital expenditures increased for the year ended December 31, 2015, as compared to the corresponding period in 2014 primarily due to increases in expansion and cost reduction capital expenditures. Our expansion and cost reduction capital expenditures were $494.9 million for the year ended December 31, 2015, which is an increase of $102.9 million, or 26.2%, from $392.0 million for the corresponding period in 2014. Year-to-year fluctuations in our expansion and cost reduction capital expenditures are primarily driven by spending on our major organic growth capital projects. Our most significant organic growth capital expenditures for the year ended December 31, 2015 included cost reduction and revenue generating projects related to enhancements across our portfolio of terminalling assets, butane blending capabilities, completion of rail unloading facilities, crude oil storage/transportation/processing and a pipeline integrity enhancement program that improved the operational efficiencies in our pipeline systems, and the significant completion of a deep-water, marine terminal, two condensate splitters, an LPG storage complex and three crude oil and condensate gathering facilities in South Texas. The build-out of the facilities in South Texas was funded through additional partnership contributions by us and Trafigura based on our respective ownership interests in Buckeye Texas. Our maintenance capital expenditures were $99.6 million for the year ended December 31, 2015, which is an increase of $19.5 million, or 24.3%, from $80.1 million for the corresponding period in 2014. Year-to-year fluctuations in our maintenance capital expenditures are primarily driven by the timing and cost of asset integrity and facility infrastructure projects. Our most significant maintenance capital expenditures for the year ended December 31, 2015 included truck rack upgrades, pump replacements and pipeline and tank integrity work necessary to maintain the operating capacity and equipment reliability of our existing infrastructure, as well as to address environmental regulations. Capital expenditures increased for the year ended December 31, 2014, as compared to the corresponding period in 2013 primarily due to increases in expansion and cost reduction capital expenditures. Our expansion and cost reduction capital expenditures were $392.0 million for the year ended December 31, 2014, which is an increase of $102.2 million, or 35.2%, from $289.9 million for the corresponding period in 2013. Year-to-year fluctuations in our expansion and cost reduction capital expenditures are primarily driven by spending on our major organic growth capital projects. Our most significant organic growth capital expenditures for the year ended December 31, 2014 included cost reduction and revenue generating projects related to storage tank enhancements across our portfolio of terminalling assets, butane blending capabilities, completion of rail unloading facilities, crude oil storage/transportation and a pipeline integrity enhancement program that improved the operational efficiencies in our pipeline systems. Our maintenance capital expenditures were $80.1 million for the year ended December 31, 2014, which is an increase of $8.5 million, or 11.9%, from $71.6 million for the corresponding period in 2013. Year-to-year fluctuations in our maintenance capital expenditures are primarily driven by the timing and cost of pipeline integrity and similar projects. Our most significant maintenance capital expenditures for the year ended December 31, 2014 included truck rack infrastructure upgrades, pump replacements and pipeline and tank integrity work necessary to maintain the operating capacity and equipment reliability of our existing infrastructure, as well as to address environmental regulations. We estimate our capital expenditures for the period indicated as follows (in thousands): _____________________________ (1) Includes 100% of Buckeye Texas Partners related capital expenditures. Estimated maintenance capital expenditures include replacement of tank floors and tank roofs, pipeline integrity, marine dock structure upgrades and upgrades to station and terminalling equipment, field instrumentation and cathodic protection systems. Estimated major expansion and cost reduction expenditures include the capacity expansion of our pipeline system and terminalling capacity in the Midwest, LPG storage/loading facility in Western Pennsylvania, various tank construction and conversion projects in our Global Marine Terminals and Domestic Pipelines & Terminals segments, as well as an expansion between facilities in the New York Harbor. Financing Activities 2015. Net cash flows used in financing activities of $98.6 million for the year ended December 31, 2015 primarily related to $591.0 million of cash distributions paid to unitholders ($4.625 per LP Unit), partially offset by $306.5 million of net borrowings under the Credit Facility and $161.5 million of net proceeds from the issuance of 2.2 million LP Units under the Equity Distribution Agreements. 2014. Net cash flows provided by financing activities of $595.1 million for the year ended December 31, 2014 primarily related to $899.7 million of net proceeds from the issuance of an aggregate 11.8 million LP Units, and $599.1 million of proceeds from the issuance of the 4.350% and 5.600% Notes due October 15, 2024 and October 15, 2044, respectively, partially offset by $527.2 million of cash distributions paid to our unitholders ($4.425 per LP Unit), $275.0 million related to the repayment of the 5.300% Notes and $89.0 million of net repayments under the Credit Facility. 2013. Net cash flows provided by financing activities of $817.4 million for the year ended December 31, 2013 primarily related to $1.3 billion of proceeds from the issuance of the 4.150%, 2.650% and 5.850% Notes due July 1, 2023, November 15, 2018 and November 15, 2043, respectively, $903.0 million of net proceeds from the issuance of an aggregate 16.0 million LP Units, partially offset by $616.2 million of net repayments under the Credit Facility, $428.8 million of cash distributions paid to our unitholders ($4.225 per LP Unit) and $300.0 million related to the repayment of the 4.625% Notes. For further discussion on our equity offerings, see Note 22 in the Notes to Consolidated Financial Statements. Contractual Obligations The following table summarizes our contractual obligations as of December 31, 2015 (in thousands): _____________________________ (1) Includes long-term debt portion borrowed under our Credit Facility. See Note 14 in the Notes to Consolidated Financial Statements for additional information regarding our debt obligations. (2) Includes amounts due on our notes and amounts and commitment fees due on our Credit Facility. The interest amount calculated on the Credit Facility is based on the assumption that the amount outstanding and the interest rate charged both remain at their current levels. (3) Includes leases for tugboats and a barge in our Global Marine Terminals segment. (4) Includes leases for properties in connection with both the jetty and inland dock operations in our Global Marine Terminals segment. (5) Includes short-term purchase obligations for products and services with third-party suppliers and payment obligations relating to capital projects. The prices that we are obligated to pay under these contracts approximate current market prices. For the year ended December 31, 2016, our rights-of-way payments are expected to be $7.2 million, which include an estimated amount for annual escalation. In addition, our obligations related to our pension and postretirement benefit plans are discussed in Note 19 in the Notes to Consolidated Financial Statements. Employee Stock Ownership Plan Services Company provides the Employee Stock Ownership Plan (“ESOP”) to the majority of its employees hired before September 16, 2004. Employees hired by Services Company after September 15, 2004 and certain employees covered by a union multiemployer pension plan do not participate in the ESOP. The ESOP owns all of the outstanding common stock of Services Company. The ESOP was frozen with respect to benefits effective March 27, 2011 (the “Freeze Date”). No Services Company contributions have been or will be made on behalf of current participants in the ESOP on and after the Freeze Date. Even though contributions under the ESOP are no longer being made, each eligible participant’s ESOP account will continue to be credited with its share of any stock dividends or other stock distributions associated with Services Company stock. All Services Company stock has been allocated to ESOP participants. See Note 19 in the Notes to Consolidated Financial Statements for further information. Off-Balance Sheet Arrangements At December 31, 2015 and 2014, we had no off-balance sheet debt or arrangements. Critical Accounting Policies and Estimates The preparation of consolidated financial statements in conformity with GAAP requires our management to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenue and expenses during the reporting period and disclosure of contingent assets and liabilities at the date of the consolidated financial statements. Estimates and assumptions about future events and their effects cannot be made with certainty. Estimates may change as new events occur, when additional information becomes available and if our operating environment changes. Actual results could differ from our estimates. See Note 2 in the Notes to Consolidated Financial Statements for our significant accounting policies. The following describes significant estimates and assumptions affecting the application of these policies: Basis of Presentation and Principles of Consolidation The consolidated financial statements include the accounts of our subsidiaries controlled by us and variable interest entities (“VIEs”), of which we are the primary beneficiary. A VIE is required to be consolidated by its primary beneficiary which is generally defined as the party who has (i) the power to direct the activities of a VIE that most significantly impact the VIE’s economic performance, and (ii) the obligation to absorb losses of the VIE or the right to receive benefits that could potentially be significant to the VIE. We evaluate our relationships with our VIEs on an ongoing basis to determine whether we continue to be the primary beneficiary. Third party or affiliate ownership interests in our consolidated VIEs are presented as noncontrolling interests. All intercompany transactions are eliminated in consolidation. In February 2015, the FASB issued guidance changing the criteria for reporting entities that are required to evaluate whether they should consolidate certain legal entities. All legal entities are subject to reevaluation under the revised consolidation model. Specifically, the amendments modify the evaluation of whether limited partnerships and similar legal entities are variable interest entities or voting interest entities, while also eliminating the presumption that a general partner should consolidate a limited partnership. We adopted this guidance on January 1, 2015. Our adoption did not have a material impact on our consolidated financial statements as there were no changes to the entities consolidated as a result of the adoption of this guidance. Upon adoption of this guidance, we concluded that Buckeye Texas and Sabina Pipeline are VIEs of which we are the primary beneficiary. In making this conclusion, we evaluated the legal form of the VIEs and the activities that significantly impact the economics of the VIEs, including our role to perform all services reasonably required to operate and maintain the assets of the VIEs. Business Combinations We allocate the total purchase price of a business combination to the assets acquired and the liabilities assumed based on their estimated fair values at the acquisition date, with the excess purchase price recorded as goodwill. An income, market or cost valuation method may be utilized to estimate the fair value of the assets acquired or liabilities assumed in a business combination. The income valuation method represents the present value of future cash flows over the life of the asset using: (i) discrete financial forecasts, which rely on management’s estimates of revenue and operating expenses; (ii) long-term growth rates; and (iii) appropriate discount rates. The market valuation method uses prices paid for a reasonably similar asset by other purchasers in the market, with adjustments relating to any differences between the assets. The cost valuation method is based on the replacement cost of a comparable asset at prices at the time of the acquisition reduced for depreciation of the asset. Valuation of Goodwill Goodwill represents the excess of purchase price over fair value of net assets acquired. Our goodwill amounts are assessed for impairment: (i) on an annual basis each year; or (ii) on an interim basis if circumstances indicate it is more likely than not the fair value of a reporting unit is less than its carrying value. In the fourth quarter of 2015, we changed the date of our annual goodwill impairment test for all reporting units from January 1st to October 31st. The change is preferable as it better aligns our goodwill impairment testing procedures with our annual budget process and alleviates resource constraints in connection with the year-end closing and financial reporting process. Due to significant judgments and estimates that are utilized in a goodwill impairment analysis, we determined it was impracticable to objectively determine operating and valuation estimates as of each October 31st for periods prior to October 31, 2015. As a result, we prospectively applied the change in the annual impairment test date to October 31, 2015. The change in accounting principle does not delay, accelerate, or avoid an impairment charge. For our annual goodwill impairment test as of October 31, 2015, we performed quantitative assessments to determine the fair value of each of our reporting units. The estimate of the fair value of the reporting unit is determined using a combination of an expected present value of future cash flows and a market multiple valuation method. The present value of future cash flows is estimated using: (i) discrete financial forecasts, which rely on management’s estimates of revenue and operating expenses; (ii) long-term growth rates; and (iii) an appropriate discount rate. The market multiple valuation method uses appropriate market multiples from comparable companies on the reporting unit’s earnings before interest, tax, depreciation and amortization. We evaluate industry and market conditions for purposes of weighting the income and market valuation approach. Based on such calculations, each reporting unit’s fair value was in excess of its carrying value. We did not record any goodwill impairment charges during the years ended December 31, 2015, 2014 or 2013. Valuation of Long-Lived Assets and Equity Method Investments We assess the recoverability of our long-lived assets whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. If events or circumstances are identified, the carrying amount of the asset is compared to the estimated discounted future cash flows to determine if an impairment exists. Estimates of undiscounted future cash flows include: (i) discrete financial forecasts, which rely on management’s estimates of revenue and operating expenses; (ii) long-term growth rates; and (iii) estimates of useful lives of the assets. The identification of impairment indicators and the estimates of future undiscounted cash flows are highly subjective and are based on numerous assumptions about future operations and market conditions. In December 2013, the Board approved a plan to divest the natural gas storage facility and related assets that our former subsidiary, Lodi, owned and operated in Northern California. We refer to this group of assets as our Natural Gas Storage disposal group. The estimated fair value less costs to sell was determined to be less than its carrying value, which resulted in the recognition of a non-cash asset impairment charge of $169.0 million, which included the write-down of long-lived assets. In July 2014, we signed a purchase and sale agreement to sell our Natural Gas Storage disposal group. As a result of the execution of the purchase and sale agreement, subsequent changes in the carrying value of the net assets and the completed sale in December 2014, we recorded additional non-cash asset impairment charges of $23.4 million during the year ended December 31, 2014. We recorded these asset impairment charges within “Loss from discontinued operations” on our consolidated statements of operations for the years ended December 31, 2014 and 2013, respectively. See Notes 4 and 5 in the Notes to Consolidated Financial Statements for further discussion. We evaluate equity method investments for impairment whenever events or changes in circumstances indicate that there is an “other than temporary” loss in value of the investment. Estimates of future cash flows include: (i) discrete financial forecasts, which rely on management’s estimates of revenue and operating expenses; (ii) long-term growth rates; and (iii) probabilities assigned to different cash flow scenarios. There were no impairments of our equity investments during the years ended December 31, 2015, 2014 or 2013. Reserves for Environmental Matters We record environmental liabilities at a specific site when environmental assessments occur or remediation efforts are probable, and the costs can be reasonably estimated based upon past experience, discussion with operating personnel, advice of outside engineering and consulting firms, discussion with legal counsel, or current facts and circumstances. The estimates related to environmental matters are uncertain because: (i) estimated future expenditures are subject to cost fluctuations and change in estimated remediation period; (ii) unanticipated liabilities may arise; and (iii) changes in federal, state and local environmental laws and regulations may significantly change the extent of remediation. Valuation of Derivatives We are exposed to financial market risks, including changes in interest rates and commodity prices, in the course of our normal business operations. We use derivative instruments to manage these risks. Our Merchant Services segment primarily uses exchange-traded refined petroleum product futures contracts to manage the risk of market price volatility on its refined petroleum product inventories and its physical derivative contracts which we designated as fair value hedges with changes in fair value of both the futures contracts and physical inventory reflected in earnings. Our Domestic Pipelines & Terminals segment uses exchange-traded refined petroleum contracts to hedge certain expected future transactions which we designated as cash flow hedges with the effective portion of the hedge reported in other comprehensive income and reclassified into earnings when the expected future transaction affects earnings. Our Merchant Services segment entered into these contracts on behalf of our Domestic Pipelines & Terminals segment. In both cases, any gains or losses incurred on the derivative instrument that are not effective in offsetting changes in fair value or cash flows of the hedged item are recognized immediately in earnings. Physical forward contracts and futures contracts that have not been designated in a hedge relationship are marked-to-market. Futures contracts are valued using quoted market prices obtained from the New York Mercantile Exchange. Physical derivative contracts are valued using market approaches based on observable market data inputs, including published commodity pricing data, which is verified against other available market data, and market interest rate and volatility data, and are net of credit value adjustments. The fixed-price and index purchase contracts are typically executed with credit worthy counterparties and are short-term in nature, thus evaluated for credit risk in the same manner as the fixed-price sales contracts. However, because the fixed-price sales contracts are privately negotiated with customers of the Merchant Services segment who are generally smaller, private companies that may not have established credit ratings, the determination of an adjustment to fair value to reflect counterparty credit risk (a “credit valuation adjustment”) requires significant management judgment. Each customer is evaluated for performance under the terms and conditions of their contracts; therefore, we evaluate: (i) the historical payment patterns of the customer; (ii) the current outstanding receivables balances for each customer and contract; and (iii) the level of performance of each customer with respect to volumes called for in the contract. We then evaluated the specific risks and expected outcomes of nonpayment or nonperformance by each customer and contract. We continue to monitor and evaluate performance and collections with respect to these fixed-price contracts.

<s>[INST] Business Overview We own and operate a diversified network of integrated assets providing midstream logistic solutions, primarily consisting of the transportation, storage and marketing of liquid petroleum products. We are one of the largest independent liquid petroleum products pipeline operators in the United States in terms of volumes delivered, with approximately 6,000 miles of pipeline. We also use our service expertise to operate and/or maintain thirdparty pipelines and perform certain engineering and construction services for our customers. Additionally, we are one of the largest independent terminalling and storage operators in the United States in terms of capacity available for service. Our terminal network comprises more than 120 liquid petroleum products terminals with aggregate storage capacity of over 110 million barrels across our portfolio of pipelines, inland terminals and marine terminals located primarily in the East Coast and Gulf Coast regions of the United States and in the Caribbean. Our network of marine terminals enables us to facilitate global flows of crude oil and refined petroleum products offering our customers connectivity between supply areas and market centers through some of the world’s most important bulk storage and blending hubs. Our flagship marine terminal in The Bahamas, BORCO, is one of the largest marine crude oil and refined petroleum products storage facilities in the world and provides an array of logistics and blending services for the global flow of petroleum products. Our recent expansion into the Gulf Coast has added another regional hub with worldclass marine terminalling, storage and processing capabilities. We are also a wholesale distributor of refined petroleum products in areas served by our pipelines and terminals. In December 2015, we realigned our reportable segments into three reportable segments as a result of changes in our organizational structure and renamed one of our reportable segments. Our three reportable segments are: Domestic Pipelines & Terminals (formerly known as Pipelines & Terminals), Global Marine Terminals and Merchant Services. We merged our previously reported Development & Logistics segment into the Domestic Pipelines & Terminals segment. See Note 25 in the Notes to Consolidated Financial Statements for a more detailed discussion of our business segments. We have adjusted our prior period segment information to conform to current year presentation. Our primary business objective is to provide stable and sustainable cash distributions to our unitholders, while maintaining a relatively low investment risk profile. The key elements of our strategy are to: (i) operate in a safe and environmentally responsible manner; (ii) maximize utilization of our assets at the lowest cost per unit; (iii) maintain stable longterm customer relationships; (iv) optimize, expand and diversify our portfolio of energy assets through accretive acquisitions and organic growth projects; and (v) maintain a solid, conservative financial position and our investmentgrade credit rating. Overview of Operating Results Net income attributable to our unitholders was $437.2 million for the year ended December 31, 2015, which was an increase of $164.3 million, or 60.2%, from $273.0 million for the corresponding period in 2014. Operating income was $604.1 million for the year ended December 31, 2015, which is an increase of $108.8 million, or 22.0%, from $495.3 million the corresponding period in 2014. Our operating income results for the year ended December 31, 2015 include yearoveryear improvement in each of our three segments despite mixed business conditions in a declining price environment. Our Global Marine Terminals segment benefited from continued improvement in capacity utilization and higher rates on contract renewals. Our continued efforts to provide new service offerings and enhance our marine asset portfolio capabilities resulted in strong demand for our services. Internal growth capital investments also yielded additional capacity that our commercial teams were able to successfully contract. The development of structure in the crude oil and refined petroleum products markets additionally assisted in the yearoveryear success in this segment. Our interest in Buckeye Texas acquired in September 2014 was also a key driver for the increase over prior year. In the fourth quarter of 2015, we completed the commissioning and startup of our condensate splitters and liquid petroleum gas refrigerated storage, which are in service under longterm agreements with Trafigura Trading LLC (“Trafig [/INST] Positive. </s>

BUCKEYE PARTNERS, L.P.

2017-02-24

2016-12-31

Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations The following discussion should be read in conjunction with our consolidated financial statements and our accompanying notes thereto included in Item 8 of this Report. Business Overview We own and operate a diversified network of integrated assets providing midstream logistic solutions, primarily consisting of the transportation, storage, processing and marketing of liquid petroleum products. We are one of the largest independent liquid petroleum products pipeline operators in the United States in terms of volumes delivered, with approximately 6,000 miles of pipeline. We also use our service expertise to operate and/or maintain third-party pipelines and perform certain engineering and construction services for our customers. Additionally, we are one of the largest independent terminalling and storage operators in the United States in terms of capacity available for service. Our terminal network comprises more than 120 liquid petroleum products terminals with aggregate storage capacity of over 115 million barrels across our portfolio of pipelines, inland terminals and marine terminals located primarily in the East Coast, Midwest and Gulf Coast regions of the United States and in the Caribbean. Our network of marine terminals enables us to facilitate global flows of crude oil and refined petroleum products offering our customers connectivity between supply areas and market centers through some of the world’s most important bulk storage and blending hubs. Our flagship marine terminal in The Bahamas, BBH, is one of the largest marine crude oil and refined petroleum products storage facilities in the world and provides an array of logistics and blending services for the global flow of petroleum products. Our Gulf Coast regional hub, Buckeye Texas, offers world-class marine terminalling, storage and processing capabilities. Our recent acquisition of an indirect 50% equity interest in VTTI expands our international presence with premier storage and marine terminalling services for petroleum products predominantly located in key global energy hubs, including Northwest Europe, the United Arab Emirates and Singapore. We are also a wholesale distributor of refined petroleum products in areas served by our pipelines and terminals. Our primary business objective is to provide stable and sustainable cash distributions to our unitholders, while maintaining a relatively low investment risk profile. The key elements of our strategy are to: (i) operate in a safe and environmentally responsible manner; (ii) maximize utilization of our assets at the lowest cost per unit; (iii) maintain stable long-term customer relationships; (iv) optimize, expand and diversify our portfolio of energy assets through accretive acquisitions and organic growth projects; and (v) maintain a solid, conservative financial position and our investment-grade credit rating. Overview of Operating Results Net income attributable to our unitholders was $535.6 million for the year ended December 31, 2016, which was an increase of $98.4 million, or 22.5%, from $437.2 million for the corresponding period in 2015. Operating income was $733.3 million for the year ended December 31, 2016, which is an increase of $129.2 million, or 21.4%, from $604.1 million for the corresponding period in 2015. The increase in net income attributable to our unitholders was the result of increased contributions from each of our business segments. Our Global Marine Terminals segment benefited from higher asset utilization due to strong customer demand for our storage, throughput and terminalling services over the prior year, as well as increased available storage capacity as a result of capital investments, including the commissioning of the Buckeye Texas assets during the fourth quarter of 2015. In our Domestic Pipelines & Terminals segment, increases in terminalling storage and throughput revenue, pipeline transportation revenue and product recoveries, as well as $14 million in proceeds from the exercise by a customer of an early buy-out provision in a crude-by-rail contract, were the primary drivers for the increase over the prior year. Additionally, our Merchant Services segment benefited from higher margins due to continued effective inventory management. These increases in net income attributable to our unitholders were partially offset by increases in depreciation and amortization expense due to the commissioning of the Buckeye Texas assets in our Global Marine Terminals segment during the fourth quarter of 2015 and expansion capital projects placed into service during 2015. In addition, an increase in interest and debt expense, due to lower capitalization of interest as a result of the placement in service of significant asset infrastructure at Buckeye Texas during the fourth quarter of 2015 and interest expense related to the long-term debt issued in the fourth quarter of 2016 to partially fund the VTTI Acquisition, also partially offset the increases to net income attributable to our unitholders. See the “Results of Operations” section below for further discussion and analysis of our operating segments. Results of Operations Consolidated Summary Our summary operating results were as follows for the periods indicated (in thousands, except per unit amounts): _____________________________ (1) Represents loss from the operations of our Natural Gas Storage disposal group. See Note 4 in the Notes to Consolidated Financial Statements for more information. Non-GAAP Financial Measures Adjusted EBITDA and distributable cash flow are measures not defined by accounting principles generally accepted in the United States of America (“GAAP”). We define Adjusted EBITDA as earnings before interest expense, income taxes, depreciation and amortization, further adjusted to exclude certain non-cash items, such as non-cash compensation expense; transaction and transitions costs associated with acquisitions; and certain other operating expense or income items, reflected in net income, that we do not believe are indicative of our core operating performance results and business outlook. We define distributable cash flow as Adjusted EBITDA less cash interest expense, cash income tax expense, and maintenance capital expenditures. Adjusted EBITDA and distributable cash flow are non-GAAP financial measures that are used by our senior management, including our Chief Executive Officer, to assess the operating performance of our business and optimize resource allocation. We use Adjusted EBITDA as a primary measure to: (i) evaluate our consolidated operating performance and the operating performance of our business segments; (ii) allocate resources and capital to business segments; (iii) evaluate the viability of proposed projects; and (iv) determine overall rates of return on alternative investment opportunities. We use distributable cash flow as a performance metric to compare cash-generating performance of Buckeye from period to period and to compare the cash-generating performance for specific periods to the cash distributions (if any) that are expected to be paid to our unitholders. Distributable cash flow is not intended to be a liquidity measure. We believe that investors benefit from having access to the same financial measures that we use and that these measures are useful to investors because they aid in comparing our operating performance with that of other companies with similar operations. The Adjusted EBITDA and distributable cash flow data presented by us may not be comparable to similarly titled measures at other companies because these items may be defined differently by other companies. The following table presents Adjusted EBITDA from continuing operations by segment and on a consolidated basis, distributable cash flow and a reconciliation of income from continuing operations, which is the most comparable financial measure under GAAP, to Adjusted EBITDA and distributable cash flow for the periods indicated (in thousands): ____________________________ (1) Includes 100% of the depreciation and amortization expense of $71.7 million, $49.3 million and $12.3 million for Buckeye Texas for the years ended December 31, 2016, 2015 and 2014, respectively. (2) Represents transaction, internal and third-party costs related to asset acquisition and integration. (3) Represents reductions in revenue related to settlement of a FERC proceeding. (4) Represents costs incurred at our BBH facility as a result of Hurricane Matthew, which occurred in October 2016, consisting of $11.0 million of operating expenses and a $5.8 million write-off of damaged long-lived assets for the year ended December 31, 2016. (5) Represents amortization of negative fair value allocated to certain unfavorable storage contracts acquired in connection with the BBH acquisition. (6) Represents recoveries of property damages caused by third parties, primarily related to an allision with a ship dock at our terminal located in Pennsauken, New Jersey. (7) Represents expenditures that maintain the operating, safety and/or earnings capacity of our existing assets, including hurricane-related expenditures. (8) Represents expenditures to repair or replace long-lived assets damaged as a result of Hurricane Matthew. The following table presents product volumes in barrels per day (“bpd”) and average tariff rates in cents per barrel for our Domestic Pipelines & Terminals segment, percent of capacity utilization for our Global Marine Terminals segment and total volumes sold in gallons for the Merchant Services segment for the periods indicated: _____________________________ (1) Includes diesel fuel and heating oil. (2) Includes LPG, intermediate petroleum products and crude oil. (3) Includes throughput of two underground propane storage caverns. (4) Represents the ratio of contracted capacity to capacity available to be contracted. Based on total capacity (i.e., including out of service capacity), average capacity utilization rates are approximately 92%, 85% and 74% for the years ended December 31, 2016, 2015 and 2014, respectively. Year Ended December 31, 2016 Compared to Year Ended December 31, 2015 Consolidated Income from continuing operations was $548.7 million for the year ended December 31, 2016, which was an increase of $110.3 million, or 25.2%, from $438.4 million for the corresponding period in 2015. The increase in income from continuing operations was primarily due to higher storage revenues, reflecting increased capacity utilization, internal growth capital investments and new storage contracts; higher pipeline transportation and terminalling throughput revenues; favorable product recoveries; higher contributions from the Buckeye Texas assets; $14 million in proceeds from the exercise by a customer of an early buy-out provision in a crude-by-rail contract at our Albany, New York terminal; and continued effective inventory management in our Merchant Services segment. The increase in income from continuing operations was partially offset by an increase in depreciation and amortization expense primarily due to the Buckeye Texas assets which were commissioned in the fourth quarter of 2015 and expansion capital projects placed into service during 2015 and 2016, as well as an increase in interest and debt expense due to lower capitalization of interest as a result of the placement in service of significant asset infrastructure at Buckeye Texas during the fourth quarter of 2015 and interest expense related to the long-term debt issued in the fourth quarter of 2016 to partially fund the VTTI Acquisition. Revenue was $3,248.4 million for the year ended December 31, 2016, which is a decrease of $205.0 million, or 5.9%, from $3,453.4 million for the corresponding period in 2015. The decrease in revenue was primarily related to a decline of refined petroleum product prices and a decrease in sales volume in our Merchant Services segment. This decrease in revenue was partially offset by higher storage revenues, reflecting increased capacity utilization, internal growth capital investments, and new storage contracts; higher pipeline transportation and terminalling throughput revenues; favorable product recoveries; and higher contributions from the Buckeye Texas assets. Adjusted EBITDA was $1,028.0 million for the year ended December 31, 2016, which is an increase of $159.9 million, or 18.4%, from $868.1 million for the corresponding period in 2015. The increase in Adjusted EBITDA was primarily related to increased contributions from our joint venture interest in Buckeye Texas and higher storage revenues, reflecting increased capacity utilization, internal growth capital investments, and new storage contracts; higher pipeline transportation and terminalling throughput revenues; favorable product recoveries; as well as continued effective inventory management in our Merchant Services segment. Distributable cash flow was $726.6 million for the year ended December 31, 2016, which is an increase of $114.2 million, or 18.6%, from $612.4 million for the corresponding period in 2015. The increase in distributable cash flow was primarily related to an increase of $159.9 million in Adjusted EBITDA as described above. This increase was partially offset by a $24.0 million increase in maintenance capital expenditures, excluding hurricane-related maintenance capital expenditures, primarily resulting from increased tank integrity project costs, marine dock structure upgrades, and upgrades to station and terminalling equipment and a $23.5 million increase in interest and debt expense, excluding amortization of deferred financing costs, debt discounts and other. This increase was due to lower capitalization of interest as a result of the placement in service of significant asset infrastructure at Buckeye Texas during the fourth quarter of 2015 and interest expense related to the long-term debt issued in the fourth quarter of 2016 to partially fund the VTTI Acquisition. Adjusted EBITDA by Segment Domestic Pipelines & Terminals. Adjusted EBITDA from the Domestic Pipelines & Terminals segment was $568.4 million for the year ended December 31, 2016, which is an increase of $46.2 million, or 8.8%, from $522.2 million for the corresponding period in 2015. The increase in Adjusted EBITDA was primarily due to a $37.1 million net increase in revenue, a $5.2 million increase in earnings from equity investments, and a $3.9 million decrease in operating expenses. The increase in revenue was due to a $40.1 million increase in terminalling throughput and product recovery revenue, reflecting new terminalling-services contracts and $14 million in proceeds from the exercise by a customer of an early buy-out provision in a crude-by-rail contract at our Albany, New York terminal, as well as a $23.4 million increase in storage revenue, primarily due to storage capacity brought back into service, internal growth capital investments, and new storage contracts. These increases were partially offset by a $13.6 million decrease in certain blending activities, a $7.2 million decrease in project management revenues, and $5.6 million decrease in other revenues. The decrease in project management revenues was due to a decrease in project activity. Pipeline volumes decreased by 2.3% due to a decline in distillate volumes, reflecting lower industrial activity and warmer weather, which was partially offset by higher gasoline volumes due to increased customer demand. Terminalling volumes increased by 1.9% due to higher gasoline volumes, reflecting increased customer demand, partially offset by absence of throughput activity and subsequent termination of a crude-by-rail contract at our Albany, New York terminal. Global Marine Terminals. Adjusted EBITDA from the Global Marine Terminals segment was $427.2 million for the year ended December 31, 2016, which was an increase of $103.4 million, or 31.9%, from $323.8 million for the corresponding period in 2015. The increase in Adjusted EBITDA was primarily due to a $135.0 million net increase in revenue, partially offset by a $31.6 million increase in operating expenses. The increase in revenue was due to a $138.5 million increase in revenue from storage and terminalling services, reflecting increased contributions from our joint venture interest in Buckeye Texas, as a result of assets commissioned during the fourth quarter of 2015. Our internal growth capital investments since the second quarter of 2015 increased available storage capacity and diversified our asset capabilities at Buckeye Texas and other marine storage terminals. In addition, such capital investments enabled us to achieve an increase in storage and terminalling services revenue in 2016. The average capacity utilization of our marine storage assets was 99% for the year ended December 31, 2016, which was an increase from 96% in the corresponding period in 2015. These increases in revenue were partially offset by a $3.5 million decrease in ancillary revenues, which was principally due to lower berthing activity and other related ancillary services. Operating expenses increased by $31.6 million, primarily due to the operation of the Buckeye Texas assets. Merchant Services. Adjusted EBITDA from the Merchant Services segment was $32.4 million for the year ended December 31, 2016, which was an increase of $10.4 million, or 47.3%, from $22.0 million for the corresponding period in 2015. Adjusted EBITDA was positively impacted by continued effective inventory management and a decrease in operating expenses. Adjusted EBITDA was positively impacted by a $423.8 million decrease in cost of product sales, which included a $58.1 million decrease due to 2.9% lower volumes sold and a $365.7 million decrease in refined petroleum product cost due to lower commodity prices by $0.31 per gallon (average prices per gallon were $1.34 and $1.65 for the 2016 and 2015 periods, respectively) and a $2.4 million decrease in operating expenses. Adjusted EBITDA was negatively impacted by a $415.8 million decrease in revenue, which included a $59.2 million decrease due to 2.9% lower volumes sold and a $356.6 million decrease in refined petroleum product sales due to lower commodity prices by $0.31 per gallon (average sales prices per gallon were $1.37 and $1.68 for the 2016 and 2015 periods, respectively). Year Ended December 31, 2015 Compared to Year Ended December 31, 2014 Consolidated Income from continuing operations was $438.4 million for the year ended December 31, 2015, which is an increase of $103.9 million, or 31.1%, from $334.5 million for the corresponding period in 2014. The increase in income from continuing operations was primarily related to increased storage revenue due to higher storage utilization and rates at our terminalling facilities in the Global Marine Terminals segment and elimination of certain commercial strategies from 2014 and more effective inventory management in our Merchant Services segment. The increase in income from continuing operations was partially offset by the decrease in revenue related to settlements and butane blending margins in our Domestic Pipelines & Terminals segment, as well as an increase in depreciation and amortization expense primarily due to the Buckeye Texas assets in our Global Marine Terminals segment. Revenue was $3,453.4 million for the year ended December 31, 2015, which is a decrease of $3,166.8 million, or 47.8%, from $6,620.2 million for the corresponding period in 2014. The decrease in revenue was primarily related to the decrease in sales volume and a decline of refined petroleum product prices in our Merchant Services segment, as well as lower product recoveries from our terminalling throughput activities in our Domestic Pipelines & Terminals segment. The decrease in revenue was partially offset by the revenue increase in our Global Marine Terminals segment primarily due to higher storage utilization and rates at our terminalling facilities and lower FERC litigation accruals recorded as a reduction in revenue in our Domestic Pipelines & Terminals segment. Adjusted EBITDA was $868.1 million for the year ended December 31, 2015, which is an increase of $104.5 million, or 13.7%, from $763.6 million for the corresponding period in 2014. The increase in Adjusted EBITDA was primarily related to increased storage revenue due to higher storage utilization and rates at our terminalling facilities and positive contributions from the Buckeye Texas assets in our Global Marine Terminals segment and elimination of certain commercial strategies from 2014 and more effective inventory management in our Merchant Services segment. The increase in Adjusted EBITDA was partially offset by a decrease in revenue related to settlements and butane blending margins in our Domestic Pipelines & Terminals segment. Settlement revenues decreased in our Domestic Pipelines & Terminals segment due to lower product recoveries from our terminalling throughput activities and prior year volumetric pipeline settlement gains. In addition, butane blending activities in our Domestic Pipelines & Terminals segment were negatively impacted due to the narrowed spread between butane and gasoline prices. Distributable cash flow was $612.4 million for the year ended December 31, 2015, which is an increase of $85.7 million, or 16.3%, from $526.8 million as compared to the corresponding period in 2014. The increase in distributable cash flow was primarily related to an increase of $104.5 million in Adjusted EBITDA as described above, partially offset by a $20.2 million increase in maintenance capital expenditures primarily resulting from increased tank integrity projects. Adjusted EBITDA by Segment Domestic Pipelines & Terminals. Adjusted EBITDA from the Domestic Pipelines & Terminals segment was $522.2 million for the year ended December 31, 2015, which is a decrease of $9.9 million, or 1.9%, from $532.1 million for the corresponding period in 2014. The decrease in Adjusted EBITDA is due to a $19.2 million increase in operating expenses, which include higher payroll expense and legal fees related to certain FERC matters, and a $4.9 million decrease in earnings from equity investments primarily due to an increase in integrity spending, which were partially offset by a $14.2 million increase in revenues, excluding the accrual related to certain FERC litigation that was recorded as a reduction in revenue. The increase in revenues is comprised of a $26.3 million increase resulting from higher terminalling throughput volumes and higher storage revenue from new contracts, a $13.2 million increase in revenue from capital investments in internal growth and diversification initiatives, including diluent and crude oil handling services and a $9.5 million increase in revenue resulting from higher pipeline volumes. These increases were partially offset by a $26.8 million decrease in revenue related to lower product recoveries from our terminalling throughput activities, as well as the narrowed spread between butane and gasoline prices, and an $8.0 million decrease in revenue resulting from lower average pipeline tariff rates primarily due to a shift between intra-state and inter-state shipments. Pipeline volumes increased by 2.1% due to stronger demand for jet fuel and gasoline resulting from growth capital projects placed into service mid-year 2014. Terminalling volumes increased by 5.9% due to higher demand for gasoline, distillates and jet fuel, new customer contracts and service offerings at select locations, including contributions from growth capital spending, which were partially offset by a decrease in crude-by-rail volumes. Global Marine Terminals. Adjusted EBITDA from the Global Marine Terminals segment was $323.8 million for the year ended December 31, 2015, which is an increase of $84.2 million, or 35.1%, from $239.6 million for the corresponding period in 2014. The increase in Adjusted EBITDA is primarily due to a $58.4 million increase in storage and terminalling revenue as a result of greater customer utilization and higher service rates and a $39.7 million increase in the contribution from our joint venture interest in Buckeye Texas. The average capacity utilization of our marine storage assets was 96% for the year ended December 31, 2015, which is an increase from 85% in the corresponding period in 2014. The increase in storage revenue resulted from internal growth capital investments which increased available storage capacity and diversified our asset capabilities, as well as improved market conditions which were the result of the development of structure in the crude oil and refined petroleum products markets. This increase in Adjusted EBITDA is partially offset by a $7.5 million increase in operating expenses related to outside services for asset maintenance activities and incremental costs necessary to support the higher utilization of our facilities, as well as a $6.4 million decrease in ancillary revenues primarily due to higher product settlement gains in the prior year. Merchant Services. Adjusted EBITDA from the Merchant Services segment was $22.0 million for the year ended December 31, 2015, which is an improvement of $30.1 million from a loss of $8.1 million for the corresponding period in 2014. The positive factors impacting Adjusted EBITDA were primarily related to the elimination of certain commercial strategies from 2014 and more effective inventory management. The elimination of certain commercial strategies included liquidating our physical positions in markets less liquid than our core markets. Adjusted EBITDA was also positively impacted by a $3,349.9 million decrease in cost of product sales, which included a $2,113.9 million decrease due to 39.5% of lower volumes sold and a $1,236.0 million decrease in refined petroleum product cost due to a price decrease of $1.01 per gallon (average prices per gallon were $1.65 and $2.66 for the 2015 and 2014 periods, respectively) and a $1.1 million decrease in operating expenses, which primarily related to overhead and administrative costs. Adjusted EBITDA was negatively impacted by a $3,320.9 million decrease in revenue, which included a $2,117.8 million decrease due to 39.5% of lower volumes sold and a $1,203.1 million decrease in refined petroleum product sales due to a price decrease of $0.99 per gallon (average sales prices per gallon were $1.68 and $2.67 for the 2015 and 2014 periods, respectively). General Outlook for 2017 We expect our year-over-year performance to improve in 2017 based on the strength of our underlying asset portfolio combined with our growth capital investment opportunities. Our acquisition of an indirect 50% equity interest in VTTI, which we closed in early January 2017, is expected to be a key contributor to that improvement. In addition, we expect our successful growth capital projects executed during 2016 across our portfolio of assets to generate incremental cash flow. The full-year contribution from our equity interest in VTTI is expected to drive improvement in our year-over-year performance. VTTI, one of the largest independent global marine terminal businesses in the world, owns and operates approximately 55 million barrels of crude and petroleum products storage across 14 terminals located on five continents. This transaction expands our world-wide presence and furthers our strategy for diversification to new geographic locations. We expect VTTI to be a key growth engine for Buckeye, as further demonstrated by VTTI's announcement of recent acquisitions and growth initiatives. Importantly, we expect this investment to be immediately accretive in 2017. We achieved the mechanical completion of the first phase of our Michigan-Ohio pipeline and terminal expansion project in late 2016 and we expect our customers to ramp up throughput volumes in the first quarter of 2017. This project allows us to offer expanded transportation service of refined petroleum products from supply sources in Michigan and western Ohio to destinations in eastern Ohio and western Pennsylvania. Our customers, including Midwestern refiners, have signed up for multi-year commitments to move refined products eastward. This project provides our customers with increased access to these eastern markets to allow them to deliver into arbitrage opportunities between higher East Coast and lower Midwestern refined product market prices. In late 2016, we successfully completed an open season on a second phase of the Michigan/Ohio project that will further expand Buckeye’s capabilities to move more refined product barrels from Midwestern refineries to Pittsburgh as well as to destinations in central Pennsylvania. This is a significant multi-year project that includes the partial reversal of our existing Laurel pipeline. We are now moving forward with engineering and permitting work, including seeking necessary regulatory approvals, and we currently expect to bring this project on-line in the second half of 2018. We also continue to make progress on our infrastructure upgrades across our New York Harbor terminals as we work to create an interconnected complex similar to our very successful Chicago Complex. The initiatives are expected to enhance our competitive position through improved interconnectivity, marine handling, blending and pipeline takeaway capabilities. The completion of these various facility improvements is scheduled for late 2017 into early 2018. We also expect to invest further in our Chicago Complex to support the growing needs of major Midwestern refinery customers. We are assessing opportunities to further expand storage capacity, throughput capacity and service capabilities at this key hub. In addition, we expect to benefit from a full-year contribution of a number of capital investment projects that were completed in 2016. We completed the refurbishment or construction of approximately 5 million barrels of additional storage capacity across our domestic and international terminals. We also increased our butane blending and vapor recovery capabilities and completed a number of additional improvements and debottlenecks across our system in 2016, and we expect a full-year contribution from those projects in 2017. We expect tariff increases, primarily on our market-based tariff pipelines, to drive throughput revenue growth, although current pricing index projections do not indicate a significant change in FERC index-based tariffs in July 2017. We expect volumes to be positively impacted from projects coming on-line, including the first phase of our Michigan/Ohio project as well as the full-year impact from a pipeline reversal completed in late 2016 that provides Philadelphia-area refiners access to markets in upstate New York and New York Harbor. We expect modest impacts to throughput volumes from continued strength in gasoline and jet fuel demand in the markets we serve. Throughput volumes across our domestic terminals are expected to increase moderately from the completion of growth capital initiatives across our system and customer growth primarily in the Southeast. Additionally, a customer terminated a crude-by-rail contract at our Albany facility during 2016 and, although we are working to secure replacement volumes by introducing new services offerings, we expect a year-over-year decline in contribution from this facility. Our results in 2016 reflect the benefit of our diversified asset base and limited exposure to commodity price cycles. If we experience higher commodity prices in 2017, we would expect to see improved butane blending and settlement revenues as a result. We anticipate continued tightening of the supply and demand balances to have an impact on the shape of the forward curve and market structure, which could pressure recontracting rates for storage. However, we believe our market position and continually improving asset capabilities positions us well to serve our customers as supply and demand patterns evolve and market structure changes. We believe the geographic and product diversification as well as the service capabilities of our pipeline, terminal, processing and marketing assets are well positioned for success despite potential continued volatility in product prices. Our Merchant Services segment will continue to focus on driving higher utilization across our system while capturing incremental value when opportunities in the market are present. We expect this approach along with our continued inventory and inventory management efforts to drive stable results in 2017. We have $125 million of long-term debt maturing in mid-2017. We believe that we have sufficient liquidity available on our $1.5 billion revolving Credit Facility to satisfy this maturity. We plan to access the debt capital market in late 2017 in advance of a $300 million long-term debt maturity in January 2018. We have executed approximately $350 million of forward starting interest rate hedges that mature in late 2017 to partially mitigate the risk of rising interest rates on our expected issuance. We believe our Credit Facility and our ability to utilize our at-the-market equity issuance program will be sufficient to meet our remaining expected capital needs for 2017. Under current market conditions, we believe that we could raise additional capital in both the debt and equity capital markets on acceptable terms to fund appropriate asset or business acquisitions. We will continue to evaluate opportunities throughout 2017 to acquire or construct assets that are complementary to our businesses and support our long-term growth strategy and will determine the appropriate financing structure on acceptable terms for any opportunity we pursue. The forward-looking statements contained in this “General Outlook for 2017” speak only as of the date hereof. Although the expectations in the forward-looking statements are based on our current beliefs and expectations, caution should be taken not to place undue reliance on any such forward-looking statements because such statements speak only as of the date hereof. Except as required by federal and state securities laws, we undertake no obligation to publicly update or revise any forward-looking statements, whether as a result of new information, future events or any other reason. All such forward-looking statements are expressly qualified in their entirety by the cautionary statements contained or referred to in this Report, including under the captions “Risk Factors” and “Cautionary Note Regarding Forward-Looking Statements” and elsewhere in this Report and in our future periodic reports filed with the SEC. In light of these risks, uncertainties and assumptions, the forward-looking events discussed in this “General Outlook for 2017” may not occur. Liquidity and Capital Resources General Our primary cash requirements, in addition to normal operating expenses and debt service, are for working capital, capital expenditures, business acquisitions and distributions to unitholders. Our principal sources of liquidity are cash from operations, borrowings under our $1.5 billion revolving Credit Facility and proceeds from the issuance of our LP Units. We will, from time to time, issue debt securities to permanently finance amounts borrowed under our Credit Facility. The BMSC entities fund their working capital needs principally from their own operations and their portion of our Credit Facility. Our financial policy has been to fund maintenance capital expenditures with cash from continuing operations. Expansion and cost reduction capital expenditures, along with acquisitions, have typically been funded from external sources including our Credit Facility, as well as debt and equity offerings. Our goal has been to fund at least half of these expenditures with proceeds from equity offerings in order to maintain our investment-grade credit rating. Based on current market conditions, we believe our borrowing capacity under our Credit Facility, cash flows from continuing operations and access to debt and equity markets, if necessary, will be sufficient to fund our primary cash requirements, including our expansion plans over the next 12 months. Current Liquidity As of December 31, 2016, we had $919.3 million of working capital and $1.5 billion of availability under our Credit Facility. However, in early January 2017 we paid $1.15 billion of cash consideration for the VTTI Acquisition, which was partially funded through our Credit Facility. Capital Structuring Transactions As part of our ongoing efforts to maintain a capital structure that is closely aligned with the cash-generating potential of our asset-based business, we may explore additional sources of external liquidity, including public or private debt or equity issuances. Matters to be considered will include cash interest expense and maturity profile, all to be balanced with maintaining adequate liquidity. We have a universal shelf registration statement that does not place any dollar limits on the amount of debt and equity securities that we may issue thereunder and a traditional shelf registration statement on file with the SEC that allows us to issue up to an aggregate of $1 billion in equity securities. In March 2016, we entered into an Equity Distribution Agreement, under which we may offer to sell up to $500.0 million in aggregate gross sales proceeds of LP Units from time to time through the ATM Underwriters, acting as agents of the Partnership or as principals, subject in each case to the terms and conditions set forth in the Equity Distribution Agreement. All issuances of equity securities under the Equity Distribution Agreement have been issued pursuant to the traditional shelf registration statement. At December 31, 2016, we had $890.0 million of unsold securities available under the traditional shelf registration statement. The timing of any transaction may be impacted by events, such as strategic growth opportunities, legal judgments or regulatory or environmental requirements. The receptiveness of the capital markets to an offering of debt or equity securities cannot be assured and may be negatively impacted by, among other things, our long-term business prospects and other factors beyond our control, including market conditions. In addition, we periodically evaluate engaging in strategic transactions as a source of capital or may consider divesting non-core assets where our evaluation suggests such a transaction is in the best interest of our business. Capital Allocation We continually review our investment options with respect to our capital resources that are not distributed to our unitholders or used to pay down our debt and seek to invest these capital resources in various projects and activities based on their return on investment. Potential investments could include, among others: add-on or other enhancement projects associated with our current assets; greenfield or brownfield development projects; and merger and acquisition activities. Debt At December 31, 2016, we had the following debt obligations (in thousands): In November 2016, we issued the 3.950% Notes in an underwritten public offering at 99.644% of their principal amount. Total proceeds from this offering, after underwriting fees, expenses and debt issuance costs of $5.2 million, were $592.7 million. In January 2017, we used the net proceeds from this offering to fund a portion of the purchase price for the VTTI Acquisition. In September 2016, we entered into our $250.0 million Term Loan due September 30, 2019, with an option to extend the term with consenting lenders for up to two one-year periods. We used the proceeds from the Term Loan to reduce the indebtedness outstanding under our Credit Facility. See Note 14 in the Notes to Consolidated Financial Statements for additional information. In September 2016, Buckeye and its indirect wholly-owned subsidiaries, BMSC, as borrowers, exercised their remaining option with consenting lenders to extend $1.4 billion of our existing $1.5 billion revolving Credit Facility by one year to September 30, 2021. At December 31, 2016, Buckeye and BMSC collectively had no outstanding balance under the Credit Facility. Equity In October 2016, we completed a public offering of 7.75 million LP Units pursuant to an effective shelf registration statement, which priced at $66.05 per unit. The underwriters also exercised an option to purchase 1.16 million additional LP Units, resulting in total gross proceeds of $588.7 million before deducting underwriting fees and other related expenses of $8.0 million. We used the net proceeds from this offering to initially reduce the indebtedness outstanding under our Credit Facility and for general partnership purposes, as well as to subsequently fund a portion of the purchase price for the VTTI Acquisition in January 2017. During the year ended December 31, 2016, we sold 1.6 million LP Units in aggregate under the Equity Distribution Agreement, received $108.4 million in net proceeds after deducting commissions and other related expenses, including $1.1 million of compensation paid in aggregate to the agents under the Equity Distribution Agreement. See Note 22 in the Notes to Consolidated Financial Statements for additional information. Cash Flows from Operating, Investing and Financing Activities The following table summarizes our cash flows from operating, investing and financing activities for the periods indicated (in thousands): Operating Activities 2016. Net cash provided by operating activities was $717.9 million for the year ended December 31, 2016, primarily related to $548.7 million of net income, $254.7 million of depreciation and amortization and a $103.3 million net decrease in the fair value of derivatives, which were partially offset by a $162.3 million increase in inventory, primarily driven by the change in commodity prices. 2015. Net cash provided by operating activities was $710.2 million for the year ended December 31, 2015, primarily related to $437.5 million of net income, $221.3 million of depreciation and amortization, a $56.8 million decrease in working capital, $29.2 million of non-cash unit-based compensation expense and $12.2 million of amortization of losses on terminated interest rate swaps, which were partially offset by a $52.8 million in litigation settlement payments. 2014. Net cash provided by operating activities was $599.6 million for the year ended December 31, 2014, primarily related to $274.9 million of net income and $196.4 million of depreciation and amortization, a $71.3 million decrease in accounts receivables, and a $70.1 million decrease in inventory, which were partially offset by a $51.5 million settlement to terminate the interest rate swap agreements related to the forecasted refinancing of the $5.300% Notes. Future Operating Cash Flows. Our future operating cash flows will vary based on a number of factors, many of which are beyond our control, including demand for our services, the cost of commodities, the effectiveness of our strategy, legal, environmental and regulatory requirements and our ability to capture value associated with commodity price volatility. Investing Activities 2016. Net cash used in investing activities of $481.7 million for the year ended December 31, 2016 primarily related to $486.3 million of capital expenditures and $26.0 million related to the acquisition of the Indianola terminalling facility, which were partially offset by $19.9 million in refunded escrow deposits. 2015. Net cash used in investing activities of $614.9 million for the year ended December 31, 2015 primarily related to $594.5 million of capital expenditures and $21.4 million in escrow deposits, which were partially offset by $10.3 million of proceeds from the sale and disposition of assets, primarily due to the disposition of an ammonia pipeline in Texas. 2014. Net cash used in investing activities of $1,191.5 million for the year ended December 31, 2014 primarily related to $472.1 million of capital expenditures and $824.7 million of acquisition costs, primarily related to the Buckeye Texas Partners Transaction, which were partially offset by $103.4 million cash proceeds from the sale of our Natural Gas Storage disposal group. See below for a discussion of capital spending. For further discussion on our acquisitions, see Note 3 in the Notes to Consolidated Financial Statements. We have capital expenditures, which we define as “maintenance capital expenditures,” in order to maintain and enhance the safety and integrity of our pipelines, terminals, storage and processing facilities and related assets, and “expansion and cost reduction capital expenditures” to expand the reach or capacity of those assets, to improve the efficiency of our operations and to pursue new business opportunities. Capital expenditures, excluding non-cash changes in accruals for capital expenditures, were as follows for the periods indicated (in thousands): _____________________________ (1) Includes maintenance capital expenditures of $6.1 million related to the BBH facility as a result of Hurricane Matthew for the year ended December 31, 2016 and $0.8 million related to the Natural Gas Storage disposal group for the year ended December 31, 2014. (2) Amounts exclude accruals for capital expenditures. Expansion and cost reduction amounts including accruals for capital expenditures were $327.7 million, $516.5 million and $340.5 million for the years ended December 31, 2016, 2015 and 2014, respectively. Total capital expenditures decreased for the year ended December 31, 2016, as compared to the corresponding period in 2015 primarily due to decreases in expansion and cost reduction capital expenditures. Our expansion and cost reduction capital expenditures were $356.6 million for the year ended December 31, 2016, which is a decrease of $138.3 million, or 27.9%, from $494.9 million for the corresponding period in 2015. Year-to-year fluctuations in our expansion and cost reduction capital expenditures were primarily driven by the completion of major organic growth capital projects associated with the initial build-out of our facilities at Buckeye Texas, including the significant completion of a deep-water marine terminal, two condensate splitters, an LPG storage complex and three crude oil and condensate gathering facilities in 2015. Our most significant organic growth capital expenditures for the year ended December 31, 2016 included cost reduction and revenue generating projects related to enhancements across our portfolio of terminalling assets, butane blending capabilities, completion of rail unloading facilities, crude oil storage/transportation/processing and a pipeline integrity enhancement program that improved the operational efficiencies in our pipeline systems. Our maintenance capital expenditures were $129.7 million for the year ended December 31, 2016, which is an increase of $30.1 million, or 30.2%, from $99.6 million for the corresponding period in 2015. Year-to-year fluctuations in our maintenance capital expenditures were primarily driven by the increased asset integrity and facility infrastructure projects. Our most significant maintenance capital expenditures for the year ended December 31, 2016 included tank integrity work necessary to maintain operating capacity, repairs to our BBH facility as a result of Hurricane Matthew, marine dock structure upgrades and upgrades to station and terminalling equipment. Capital expenditures increased for the year ended December 31, 2015, as compared to the corresponding period in 2014 primarily due to increases in expansion and cost reduction capital expenditures. Our expansion and cost reduction capital expenditures were $494.9 million for the year ended December 31, 2015, which is an increase of $102.9 million, or 26.2%, from $392.0 million for the corresponding period in 2014. Year-to-year fluctuations in our expansion and cost reduction capital expenditures are primarily driven by spending on our major organic growth capital projects. Our most significant organic growth capital expenditures for the year ended December 31, 2015 included cost reduction and revenue generating projects related to enhancements across our portfolio of terminalling assets, butane blending capabilities, completion of rail unloading facilities, crude oil storage/transportation/processing and a pipeline integrity enhancement program that improved the operational efficiencies in our pipeline systems, and the significant completion of a deep-water, marine terminal, two condensate splitters, an LPG storage complex and three crude oil and condensate gathering facilities in South Texas. The build-out of the facilities in South Texas was funded through additional partnership contributions by us and Trafigura based on our respective ownership interests in Buckeye Texas. Our maintenance capital expenditures were $99.6 million for the year ended December 31, 2015, which is an increase of $19.5 million, or 24.3%, from $80.1 million for the corresponding period in 2014. Year-to-year fluctuations in our maintenance capital expenditures are primarily driven by the timing and cost of asset integrity and facility infrastructure projects. Our most significant maintenance capital expenditures for the year ended December 31, 2015 included truck rack upgrades, pump replacements and pipeline and tank integrity work necessary to maintain the operating capacity and equipment reliability of our existing infrastructure, as well as to address environmental regulations. We estimate our capital expenditures for the period indicated as follows (in thousands): _____________________________ (1) Includes 100% of Buckeye Texas’ capital expenditures. Estimated maintenance capital expenditures include tank refurbishments and upgrades to station and terminalling equipment, pipeline integrity, field instrumentation and cathodic protection systems and exclude capital expenditures expected to be incurred in response to Hurricane Matthew. Estimated major expansion and cost reduction expenditures include the capacity expansion of our pipeline system and terminalling capacity in the Midwest, various tank construction and conversion projects in our Global Marine Terminals and Domestic Pipelines & Terminals segments, as well as an expansion of facilities in the New York Harbor. Financing Activities 2016. Net cash flows provided by financing activities of $399.2 million for the year ended December 31, 2016 primarily related to $689.1 million of net proceeds from the issuance of an aggregate 10.5 million LP Units, $597.9 million of proceeds from the issuance of the 3.950% Notes due December 1, 2026, and $250.0 million of borrowings on our Term Loan, partially offset by $641.7 million of cash distributions paid to unitholders ($4.825 per LP Unit) and $472.5 million of net repayments under the Credit Facility. 2015. Net cash flows used in financing activities of $98.6 million for the year ended December 31, 2015 primarily related to $591.0 million of cash distributions paid to unitholders ($4.625 per LP Unit), partially offset by $306.5 million of net borrowings under the Credit Facility and $161.5 million of net proceeds from the issuance of 2.2 million LP Units under the Equity Distribution Agreements. 2014. Net cash flows provided by financing activities of $595.1 million for the year ended December 31, 2014 primarily related to $899.7 million of net proceeds from the issuance of an aggregate 11.8 million LP Units, and $599.1 million of proceeds from the issuance of the 4.350% and 5.600% Notes due October 15, 2024 and October 15, 2044, respectively, partially offset by $527.2 million of cash distributions paid to our unitholders ($4.425 per LP Unit), $275.0 million related to the repayment of the 5.300% Notes and $89.0 million of net repayments under the Credit Facility. For further discussion on our equity offerings, see Note 22 in the Notes to Consolidated Financial Statements. Contractual Obligations The following table summarizes our contractual obligations as of December 31, 2016 (in thousands): _____________________________ (1) Includes long-term debt portion borrowed under our Credit Facility. See Note 14 in the Notes to Consolidated Financial Statements for additional information regarding our debt obligations. (2) Includes amounts due on our notes and amounts and commitment fees due on our Credit Facility. The interest amount calculated on the Credit Facility is based on the assumption that the amount outstanding and the interest rate charged both remain at their current levels. (3) Includes leases for tugboats and a barge in our Global Marine Terminals segment. (4) Includes leases for properties in connection with both the jetty and inland dock operations in our Global Marine Terminals segment. (5) Includes short-term purchase obligations for products and services with third-party suppliers and payment obligations relating to capital projects. The prices that we are obligated to pay under these contracts approximate current market prices. For the year ended December 31, 2017, our rights-of-way payments are expected to be $7.3 million, which include an estimated amount for annual escalation. In addition, our obligations related to our pension and postretirement benefit plans are discussed in Note 19 in the Notes to Consolidated Financial Statements. Employee Stock Ownership Plan Services Company provides the Employee Stock Ownership Plan (“ESOP”) to the majority of its employees hired before September 16, 2004. Employees hired by Services Company after September 15, 2004 and certain employees covered by a union multiemployer pension plan do not participate in the ESOP. The ESOP owns all of the outstanding common stock of Services Company. The ESOP was frozen with respect to benefits effective March 27, 2011 (the “Freeze Date”). No Services Company contributions have been or will be made on behalf of current participants in the ESOP on and after the Freeze Date. Even though contributions under the ESOP are no longer being made, each eligible participant’s ESOP account will continue to be credited with its share of any stock dividends or other stock distributions associated with Services Company stock. All Services Company stock has been allocated to ESOP participants. See Note 19 in the Notes to Consolidated Financial Statements for further information. Off-Balance Sheet Arrangements At December 31, 2016 and 2015, we had no off-balance sheet debt or arrangements. Critical Accounting Policies and Estimates The preparation of consolidated financial statements in conformity with GAAP requires our management to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenue and expenses during the reporting period and disclosure of contingent assets and liabilities at the date of the consolidated financial statements. Estimates and assumptions about future events and their effects cannot be made with certainty. Estimates may change as new events occur, when additional information becomes available and if our operating environment changes. Actual results could differ from our estimates. See Note 2 in the Notes to Consolidated Financial Statements for our significant accounting policies. The following describes significant estimates and assumptions affecting the application of these policies: Basis of Presentation and Principles of Consolidation The consolidated financial statements include the accounts of our subsidiaries controlled by us and variable interest entities (“VIEs”), of which we are the primary beneficiary. A VIE is required to be consolidated by its primary beneficiary, which is generally defined as the party who has (i) the power to direct the activities of a VIE that most significantly impact the VIE’s economic performance, and (ii) the obligation to absorb losses of the VIE or the right to receive benefits that could potentially be significant to the VIE. We evaluate our relationships with our VIEs, which include Buckeye Texas and Sabina Pipeline, on an ongoing basis to determine whether we continue to be the primary beneficiary. Third party or affiliate ownership interests in our consolidated VIEs are presented as noncontrolling interests. All intercompany transactions are eliminated in consolidation. Business Combinations We allocate the total purchase price of a business combination to the assets acquired and the liabilities assumed based on their estimated fair values at the acquisition date, with the excess purchase price recorded as goodwill. An income, market or cost valuation method may be utilized to estimate the fair value of the assets acquired or liabilities assumed in a business combination. The income valuation method represents the present value of future cash flows over the life of the asset using: (i) discrete financial forecasts, which rely on management’s estimates of revenue and operating expenses; (ii) long-term growth rates; and (iii) appropriate discount rates. The market valuation method uses prices paid for a reasonably similar asset by other purchasers in the market, with adjustments relating to any differences between the assets. The cost valuation method is based on the replacement cost of a comparable asset at prices at the time of the acquisition, reduced for depreciation of the asset. Valuation of Goodwill Goodwill represents the excess of purchase price over fair value of net assets acquired. Our goodwill amounts are assessed for impairment: (i) on an annual basis on October 31st of each year; or (ii) on an interim basis if circumstances indicate it is more likely than not that the fair value of a reporting unit is less than its carrying value. For our annual goodwill impairment test as of October 31, 2016, we performed quantitative assessments to determine the fair value of each of our reporting units. The estimate of the fair value of the reporting unit is determined using a combination of an expected present value of future cash flows and a market multiple valuation method. The present value of future cash flows is estimated using: (i) discrete financial forecasts, which rely on management’s estimates of revenue and operating expenses; (ii) long-term growth rates; and (iii) an appropriate discount rate. The market multiple valuation method uses appropriate market multiples from comparable companies on the reporting unit’s earnings before interest, tax, depreciation and amortization. We evaluate industry and market conditions for purposes of weighting the income and market valuation approach. Based on such calculations, each reporting unit’s fair value was in excess of its carrying value. We did not record any goodwill impairment charges during the years ended December 31, 2016, 2015 or 2014. Valuation of Long-Lived Assets and Equity Method Investments We assess the recoverability of our long-lived assets whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. If events or circumstances are identified, the carrying amount of the asset is compared to the estimated discounted future cash flows to determine if an impairment exists. Estimates of undiscounted future cash flows include: (i) discrete financial forecasts, which rely on management’s estimates of revenue and operating expenses; (ii) long-term growth rates; and (iii) estimates of useful lives of the assets. The identification of impairment indicators and the estimates of future undiscounted cash flows are highly subjective and are based on numerous assumptions about future operations and market conditions. In December 2013, the Board approved a plan to divest the natural gas storage facility and related assets that our former subsidiary, Lodi, owned and operated in Northern California. We refer to this group of assets as our Natural Gas Storage disposal group. In July 2014, we signed a purchase and sale agreement to sell our Natural Gas Storage disposal group. As a result of the execution of the purchase and sale agreement, subsequent changes in the carrying value of the net assets of our Natural Gas Storage disposal group, and the completed sale in December 2014, we recorded non-cash asset impairment charges of $23.4 million during the year ended December 31, 2014. We recorded these asset impairment charges within “Loss from discontinued operations” on our consolidated statements of operations for the year ended December 31, 2014. See Notes 4 and 5 in the Notes to Consolidated Financial Statements for further discussion. We evaluate equity method investments for impairment whenever events or changes in circumstances indicate that there is an “other than temporary” loss in value of the investment. Estimates of future cash flows include: (i) discrete financial forecasts, which rely on management’s estimates of revenue and operating expenses; (ii) long-term growth rates; and (iii) probabilities assigned to different cash flow scenarios. There were no impairments of our equity investments during the years ended December 31, 2016, 2015 or 2014. Reserves for Environmental Matters We record environmental liabilities at a specific site when environmental assessments occur or remediation efforts are probable, and the costs can be reasonably estimated based upon past experience, discussion with operating personnel, advice of outside engineering and consulting firms, discussion with legal counsel, or current facts and circumstances. The estimates related to environmental matters are uncertain because: (i) estimated future expenditures are subject to cost fluctuations and change in estimated remediation period; (ii) unanticipated liabilities may arise; and (iii) changes in federal, state and local environmental laws and regulations may significantly change the extent of remediation. Valuation of Derivatives We are exposed to financial market risks, including changes in interest rates and commodity prices, in the course of our normal business operations. We use derivative instruments to manage these risks. Our Merchant Services segment primarily uses exchange-traded refined petroleum product futures contracts to manage the risk of market price volatility on its refined petroleum product inventories and its physical derivative contracts, which we designated as fair value hedges, with changes in fair value of both the futures contracts and physical inventory reflected in earnings. Our Merchant Services segment also uses exchange-traded refined petroleum contracts to hedge expected future transactions related to certain gasoline inventory that we manage on behalf of a third party, which are designated as cash flow hedges, with the effective portion of the hedge reported in other comprehensive income and reclassified into earnings when the expected future transaction affects earnings. Any gains or losses incurred on the derivative instruments that are not effective in offsetting changes in fair value or cash flows of the hedged item are recognized immediately in earnings. Additionally, our Merchant Services segment enters into exchange-traded refined petroleum product futures contracts on behalf of our Domestic Pipelines & Terminals segment to manage the risk of market price volatility on the narrowing gasoline-to-butane pricing spreads associated with our butane blending activities managed by a third party. These futures contracts are not designated in a hedge relationship for accounting purposes. Physical forward contracts and futures contracts that have not been designated in a hedge relationship are marked-to-market. Futures contracts are valued using quoted market prices obtained from the NYMEX. Physical derivative contracts are valued using market approaches based on observable market data inputs, including published commodity pricing data, which is verified against other available market data, and market interest rate and volatility data, and are net of credit value adjustments. The fixed-price and index purchase contracts are typically executed with credit worthy counterparties and are short-term in nature, thus evaluated for credit risk in the same manner as the fixed-price sales contracts. However, because the fixed-price sales contracts are privately negotiated with customers of the Merchant Services segment who are generally smaller, private companies that may not have established credit ratings, the determination of an adjustment to fair value to reflect counterparty credit risk (a “credit valuation adjustment”) requires significant management judgment. Each customer is evaluated for performance under the terms and conditions of their contracts; therefore, we evaluate: (i) the historical payment patterns of the customer; (ii) the current outstanding receivables balances for each customer and contract; and (iii) the level of performance of each customer with respect to volumes called for in the contract. We then evaluated the specific risks and expected outcomes of nonpayment or nonperformance by each customer and contract. We continue to monitor and evaluate performance and collections with respect to these fixed-price contracts. Additionally, we utilize forward-starting interest rate swaps to manage interest rate risk related to forecasted interest payments on anticipated debt issuances. When entering into interest rate swap transactions, we are exposed to both credit risk and market risk. We manage our credit risk by entering into swap transactions only with major financial institutions with investment-grade credit ratings. We manage our market risk by aligning the swap instrument with the existing underlying debt obligation or a specified expected debt issuance generally associated with the maturity of an existing debt obligation. The fair value of the swap instruments are calculated by discounting the future cash flows of both the fixed rate and variable rate interest payments using appropriate discount rates with consideration given to our non-performance risk.

<s>[INST] Business Overview We own and operate a diversified network of integrated assets providing midstream logistic solutions, primarily consisting of the transportation, storage, processing and marketing of liquid petroleum products. We are one of the largest independent liquid petroleum products pipeline operators in the United States in terms of volumes delivered, with approximately 6,000 miles of pipeline. We also use our service expertise to operate and/or maintain thirdparty pipelines and perform certain engineering and construction services for our customers. Additionally, we are one of the largest independent terminalling and storage operators in the United States in terms of capacity available for service. Our terminal network comprises more than 120 liquid petroleum products terminals with aggregate storage capacity of over 115 million barrels across our portfolio of pipelines, inland terminals and marine terminals located primarily in the East Coast, Midwest and Gulf Coast regions of the United States and in the Caribbean. Our network of marine terminals enables us to facilitate global flows of crude oil and refined petroleum products offering our customers connectivity between supply areas and market centers through some of the world’s most important bulk storage and blending hubs. Our flagship marine terminal in The Bahamas, BBH, is one of the largest marine crude oil and refined petroleum products storage facilities in the world and provides an array of logistics and blending services for the global flow of petroleum products. Our Gulf Coast regional hub, Buckeye Texas, offers worldclass marine terminalling, storage and processing capabilities. Our recent acquisition of an indirect 50% equity interest in VTTI expands our international presence with premier storage and marine terminalling services for petroleum products predominantly located in key global energy hubs, including Northwest Europe, the United Arab Emirates and Singapore. We are also a wholesale distributor of refined petroleum products in areas served by our pipelines and terminals. Our primary business objective is to provide stable and sustainable cash distributions to our unitholders, while maintaining a relatively low investment risk profile. The key elements of our strategy are to: (i) operate in a safe and environmentally responsible manner; (ii) maximize utilization of our assets at the lowest cost per unit; (iii) maintain stable longterm customer relationships; (iv) optimize, expand and diversify our portfolio of energy assets through accretive acquisitions and organic growth projects; and (v) maintain a solid, conservative financial position and our investmentgrade credit rating. Overview of Operating Results Net income attributable to our unitholders was $535.6 million for the year ended December 31, 2016, which was an increase of $98.4 million, or 22.5%, from $437.2 million for the corresponding period in 2015. Operating income was $733.3 million for the year ended December 31, 2016, which is an increase of $129.2 million, or 21.4%, from $604.1 million for the corresponding period in 2015. The increase in net income attributable to our unitholders was the result of increased contributions from each of our business segments. Our Global Marine Terminals segment benefited from higher asset utilization due to strong customer demand for our storage, throughput and terminalling services over the prior year, as well as increased available storage capacity as a result of capital investments, including the commissioning of the Buckeye Texas assets during the fourth quarter of 2015. In our Domestic Pipelines & Terminals segment, increases in terminalling storage and throughput revenue, pipeline transportation revenue and product recoveries, as well as $14 million in proceeds from the exercise by a customer of an early buyout provision in a crudebyrail contract, were the primary drivers for the increase over the prior year. Additionally, our Merchant Services segment benefited from higher margins due to continued effective inventory management. These increases in net income attributable to our unitholders were partially offset by increases in depreciation and amortization expense due to the commissioning of the Buckeye Texas assets in our Global Marine Terminals segment during the fourth quarter of 2015 and expansion capital projects placed into service during 2015. In addition, an increase in interest and debt expense, due to lower capitalization of interest as a result of the placement in service of significant asset infrastructure at Buckey [/INST] Negative. </s>